Chapter 16
June 04
1
2
Key Concepts and Skills
Be able to compute the operating and cash cycles and
understand why they are important
Understand the essentials of short-term financial
planning
Understand the different types of short-term financial
policy and the costs of each
Short-Term Financial
Planning
Chapter Outline
Tracing Cash and Net Working Capital
The Operating Cycle and the Cash Cycle
Some Aspects of Short-Term Financial Policy
The Cash Budget
A Short-Term Financial Plan
Short-Term Borrowing
3
4
Sources and Uses of Cash
Sources of Cash
™Obtaining financing:
™ Increase in long-term debt
™ Increase in equity
™ Increase in current liabilities
™Selling assets
™ Decrease in current assets
™ Decrease in fixed assets
Uses of Cash
™Paying creditors or
stockholders
™ Decrease in long-term debt
™ Decrease in equity
™ Decrease in current
liabilities
™Buying assets
™ Increase in current assets
™ Increase in fixed assets
1
Chapter 16
June 04
5
The Operating Cycle
6
The Cash Cycle
The time it takes to receive inventory, sell it and collect
on the receivables generated from the sale
The time between payment for inventory and receipt
from the sale of inventory
The cash cycle measures how long we need to finance
inventory and receivables
Operating cycle = inventory period + accounts receivable period
Cash Cycle = Operating cycle – Accounts Payable Period
time it takes to
collect on
receivables
time inventory
sits on the
shelf
=
365
Inventory Turnover
Ratio
365
Receivables Turnover
=
7
Example - Cash Cycle
Inventory
Purchased
Cash
Received
Inventory
Sold
Inventory
Period
Accounts receivable period
AP Period
time between receipt
of inventory and
payment for it
Previously
Defined
Cash Cycle
Cash
Paid for
Inventory
=
365
Payables Turnover
8
Example
Item
Beginning
Ending
Average
Inventory
200,000
300,000
250,000
Accounts
Receivable
160,000
200,000
180,000
75,000
100,000
87,500
Accounts
Payable
Net Sales = $1,150,000
Cost of Goods Sold = $820,000
Operating Cycle
2
Chapter 16
June 04
9
Example - Operating Cycle
Operating cycle = inventory period + accounts receivable period
168 days
=
111 days
57 days
365
where
Cash
Received
Inventory
Sold
InventoryPeriod
AR period 57
111
where
Inventory
Turnover =
Ratio
=
Inventory
Purchased
365
Receivables Turnover
=
Inventory Turnover Ratio
10
Example - Cash Cycle
Receivables
Turnover =
COGS
Average
Inventory
365
$820,000 / $250,000
=
Credit Sales
Average AP
365
$1,150,000 / $180,000
11
Example - Cash Cycle
Cash Cycle = Operating cycle – Accounts Payable Period
129 days
168 days
39 days
=
Operating Cycle
168
12
Example - Cash Cycle
Inventory
Purchased
Cash
Paid for
Inventory
Cash
Received
365
Payables Turnover
where
Payables
Turnover
=
=
COGS
Average AP
365
$820,000 / $87,500
AP Period 39
Cash Cycle 129
Operating Cycle
168
3
Chapter 16
June 04
Financing Current Assets
13
Compare the 2 following companies
Determining the “Correct” level of Current Assets
™Balance Risk & Return
™Benefits of Current Assets
Balance Sheet
Marketable Securities
Other Current Assets
Fixed Assets
Total Assets
™Higher Liquidity (Lowers Risk)
™Costs of Current Assets
™Lower Returns - $$ invested in lower returning
securities rather than production.
Firm 1
0
200
800
1000
ST Debt
LT Debt
Common Stock
Total Liabilities&Equity
Income Statement
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Example of Risk-Return Trade-off
Compare the 2 following companies
15
Marketable Securities
Other Current Assets
Fixed Assets
Total Assets
Income Statement
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Current Ratio
ROA
Firm 1 Firm 2
150
150
8
0
150
158
63
60
90
95
2
9%
Firm 1 Firm 2
ST Debt
100
100
LT Debt
400
400
700
Common Stock
500
Total Liabilities&Equity 1000 1200
Firm 2:
$200 Marketable Securities
Financed with Common Stock
200 x 4% = $8 interest earned
on marketable
securities
Firm 1
150
0
150
60
90
Current Ratio =
=
Firm 1
100
400
500
1000
Current Assets
Current Liabilities
200 = 2
100
Return on Assets =
Net Income
Assets
=
90
= 9%
1000
16
Example of Risk-Return Trade-off
Compare the 2 following companies
Balance Sheet
Firm 1 Firm 2
0
200
200
200
800
800
1000 1200
14
Example of Risk-Return Trade-off
Balance Sheet
Marketable Securities
Other Current Assets
Fixed Assets
Total Assets
Firm 1 Firm 2
0
200
200
200
800
800
1000 1200
Income Statement
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Current Ratio
ROA
Firm 1 Firm 2
150
150
8
0
150
158
63
60
90
95
2
9%
ST Debt
LT Debt
Common Stock
Total Liabilities&Equity
Firm 1 Firm 2
100
100
400
400
700
500
1000 1200
Current Assets
Current Liabilities
= 400 = 4
100
Current Ratio =
Net Income
Assets
= 95 = 7.9%
1200
Return on Assets =
4
Chapter 16
June 04
17
Example of Risk-Return Trade-off
Compare the 2 following companies
Flexible (Conservative) Policy
Marketable Securities
Other Current Assets
Fixed Assets
Total Assets
Firm 1 Firm 2
ST Debt
100
100
LT Debt
400
400
700
Common Stock
500
Total Liabilities&Equity 1000 1200
Income Statement
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Current Ratio
ROA
2
9%
High liquidity
Conclusion
Firm 1 Firm 2
150
150
8
0
150
158
63
60
90
95
4
7.9%
Firm 1
Firm 2
Higher ROA
Less Liquid
Riskier
Lower ROA
More Liquid
Less Risky
18
Restrictive (Aggressive) Policy
™Large amounts of cash and
marketable securities
™Large amounts of inventory
™Liberal credit policies (large
accounts receivable)
™Relatively low levels of
short-term liabilities
Balance Sheet
Firm 1 Firm 2
0
200
200
200
800
800
1000 1200
Short-Term Financial Policy
™Low cash and marketable
security balances
™Low inventory levels
™Little or no credit sales (low
accounts receivable)
™Relatively high levels of
short-term liabilities
Low liquidity
What is the correct balance??
19
Financing Current Assets
Financing Current Assets
Flexible (Conservative) Approach
Dollars
Dollars
Total seasonal
variation in Current Assets
Current Assets
20
Total Liabilities
and Owners Equity
Marketable
Securities
Permanent Assets
Time
Policy always implies a short-term
cash surplus and a large investment
in cash and marketable securities.
Time
5
Chapter 16
June 04
Financing Current Assets
21
Restrictive (Aggressive) Approach
Dollars
Total Liabilities
and Owners Equity
Short Term
Loans
Choosing the Best Policy
22
Best policy will be a combination of flexible and
restrictive policies
Things to consider
™Cash reserves
™Relative interest rates
Compromise policy – borrow short-term to meet peak
needs, maintain a cash reserve for emergencies
Policy uses long-term financing for
permanent asset requirements only and
short-term borrowing for seasonal
variations.
Financing Current Assets
Time
23
Compromise Approach
Dollars
Marketable
Securities
Total Liabilities
and Owners Equity
Short Term
Loans
Cash Budget
24
Primary tool in short-run financial planning
™Identify short-term needs and potential opportunities
™Identify when short-term financing may be required
How it works
™Identify sales and cash collections
™Identify various cash outflows
™Subtract outflows from inflows and determine investing
and financing needs
Time
6
Chapter 16
June 04
25
Example: Cash Budget Information
• Expected Sales for 2000 by quarter (millions)
™Q1: $57; Q2: $66; Q3: $66; Q4: $90
• Beginning Accounts Receivable = $30
• Average collection period = 30 days
• Purchases from suppliers = 50% of next quarter’s
estimated sales
• Accounts payable period = 45 days
• Wages, taxes and other expenses = 25% of sales
• Interest and dividends = $5 million per quarter
• Major expansion planned for quarter 2 costing $35 million
• Beginning cash balance = $5 million with minimum cash
balance of $2 million
27
Cash Collections
Example: Cash Budget – Cash Collections
Q1
Beginning
Receivables
30
Sales
57
Cash Collections
Q2
Q3
Q4
?
Ending Receivables
28
Cash Collections
One Quarter = 90 days
One Quarter = 90 days
Average Collection Period = 30 days
Average Collection Period = 30 days
Beginning
Receivables
26
Beginning
Receivables
30 days
Beginning AR
Collected in 30 days
60 days
90 days
30 days
60 days
90 days
Sales from first 30 days
collected in 2nd 30 days
7
Chapter 16
June 04
29
Cash Collections
30
Cash Collections
One Quarter = 90 days
One Quarter = 90 days
Average Collection Period = 30 days
Average Collection Period = 30 days
Beginning
Receivables
Beginning
Receivables
30 days
60 days
90 days
30 days
60 days
90 days
Sales from 3rd 30 days collected
in next quarter (this amount is the
beginning balance for the
following quarter)
Sales from 2nd 30 days
collected in 3rd 30 days
31
Cash Collections
32
Cash Collections
One Quarter = 90 days
One Quarter = 90 days
Average Collection Period = 30 days
Average Collection Period = 30 days
Beginning
Receivables
Beginning
Receivables
30 days
60 days
90 days
30 days
60 days
90 days
For Quarterly Budget:
Total Cash Collections = Beginning Receivables
+ % of Sales Collected x Period Sales
2/3
1/3
% of Sales Collected =
90 – Avg Collection Period =
90
2
3
Total Cash Collections = Beginning Receivables + 2/3 x Sales
8
Chapter 16
June 04
Example: Cash Budget – Cash Collections
Q1
Q2
Q3
33
Example: Cash Budget – Cash Collections
Q4
Q1
Beginning
Receivables
30
Beginning
Receivables
30
Sales
57
Sales
57
Cash Collections
68
?
Cash Collections
68
Ending Receivables
19
?
Ending Receivables
= Beginning Receivables + 2/3 x Sales
= 30 + 2/3 x 57
Q2
Q3
34
Q4
= Beginning Receivables + Sales - Collections
= 30 + 57 - 68
Example: Cash Budget – Cash Collections
Q3
35
Q4
36
Example: Cash Budget – Cash Disbursement
Q1
Q1
Q2
Beginning
Receivables
30
19
22
22
Payment of A/P = 50%
of sales
Sales
57
66
66
90
Wages, taxes, other
expenses
Cash Collections
68
63
66
82
Ending Receivables
19
22
22
30
Q2
Q3
Q4
28.50
?
Capital Expenditures
Long-term financing
(interest and dividends)
Total Disbursements
9
Chapter 16
June 04
37
Payment of A/P
From Original Problem
•Purchases from suppliers = 50% of next quarter’s est. sales
•Accounts payable period = 45 days
Sales: Q1: $57; Q2: $66; Q3: $66; Q4: $90
Payment for Purchases
$28.50 2nd Q
1st Q
38
Example: Cash Budget – Cash Disbursement
Sales: Q1: $57; Q2: $66; Q3: $66; Q4: $90
Q1
Payment of A/P = 50%
of sales
Q2
Q3
Q4
28.50
Wages, taxes, other
expenses
Capital Expenditures
3rd Q
Long-term financing
(interest and dividends)
$57
$28.50
Total Disbursements
Purchase 50% of $57
39
40
Example: Cash Budget – Cash Disbursement
Example: Cash Budget – Cash Disbursement
Sales: Q1: $57; Q2: $66; Q3: $66; Q4: $90
Sales: Q1: $57; Q2: $66; Q3: $66; Q4: $90
Q1
Q2
Q3
Q4
Q1
Payment of A/P = 50%
of sales
28.50
Payment of A/P = 50%
of sales
28.50
Wages, taxes, other
expenses
14.25
Wages, taxes, other
expenses
14.25
?
Capital Expenditures
Capital Expenditures
Long-term financing
(interest and dividends)
Long-term financing
(interest and dividends)
Total Disbursements
Total Disbursements
Q2
Q3
Q4
-5.00
47.75
?
= 25% of Sales
= .25 x 57
10
Chapter 16
June 04
41
Example: Cash Budget – Cash Disbursement
42
Example: Cash Budget – Net Cash Flow
Sales: Q1: $57; Q2: $66; Q3: $66; Q4: $90
Q1
Payment of A/P = 50%
of sales
Wages, taxes, other
expenses
Q3
14.25 16.50 16.50
Capital Expenditures
Q4
45.00
22.50
--
35.00
--
5.00
5.00
5.00
5.00
47.75 89.50 54.50
72.50
Long-term financing
(interest and dividends)
Total Disbursements
Q2
28.50 33.00 33.00
--
43
Example: Cash Budget – Cash Balance
Q1
Beginning Cash
Balance
5.00
Q2
25.25
Q3
Summary
Q1
Q2
Q3
Total Cash Collections
68.00
63.00
66.00 82.00
Total Cash Disbursements
47.75
89.50
54.50 72.50
Net Cash Flow
20.25 (26.50)
Q1
Beginning Cash
5.00
Net Cash Inflow
20.25
New Short-Term Debt
Net Cash Inflow
Ending Cash
Balance
20.25 (26.50)
25.25 (1.25)
11.50 9.50
10.25 19.75
Minimum Cash
Balance
-2.00
-2.00 -2.00
Cumulative
surplus (deficit)
23.25
(3.25)
8.25 17.75
9.50
44
Q2
Q3
Q4
Surplus, therefore no
ST Debt Needed this
Month
0.00
0.00
Interest on Short-Term Debt
Example: Cash Budget – Cash Balance (Slide 43)
Short-Term Debt Repayment
0.00 Q1
Q2
Q3
Q4
Ending Cash Balance
-2.00
11.50
Short-Term Financial Plan
Q4
(1.25) 10.25
Q4
Beginning Cash
Balance
5.00
25.25
(1.25)
Net Cash Inflow
Cumulative Surplus after loans
20.25
(26.50)
11.50
9.50
Ending Cash
Balance
25.25
(1.25)
10.25
19.75
Beginning Short-Term DebtMinimum Cash 0.00
-2.00
-2.00
-2.00
-2.00
23.25
(3.25)
8.25
17.75
Minimum Cash Balance
Balance
Change in Short-Term Debt
Ending Short-Term Debt
Cumulative surplus
(deficit)
10.25
11
Chapter 16
June 04
45
Short-Term Financial Plan
Q1
Beginning Cash
5.00
Net Cash Inflow
20.25
Q2
Q3
Q4
Q1
25.25
46
Short-Term Financial Plan
Q2
Q3
Beginning Cash
5.00
25.25
Net Cash Inflow
20.25
(26.50)
0.00
3.25
Q4
Deficit, Need loan to
cover this amount
New Short-Term Debt
0.00
New Short-Term Debt
Interest on Short-Term Debt
0.00
Interest on Short-Term Debt
0.00
0.00
Example: Cash Budget – Cash Balance (Slide 43)
0.00 Q1
Short-Term Debt Repayment
Q2
Q3
Q4
Short-Term Debt Repayment
0.00
Ending Cash Balance
25.25
Ending Cash Balance
Minimum Cash Balance
-2.00
Minimum Cash Balance
Beginning Cash
Balance
-2.00
25.25
5.00
25.25
(1.25)
Cumulative Surplus after loans
23.25
Net Cash Inflow
Cumulative Surplus after loans
23.25
20.25
(26.50)
11.50
9.50
25.25
(1.25)
10.25
19.75
-2.00
-2.00
-2.00
-2.00
23.25
(3.25)
8.25
17.75
Ending Cash
Balance
Beginning Short-Term Debt
0.00
Change in Short-Term Debt
0.00
0.00
Change in Short-Term Debt
Ending Short-Term Debt
0.00
Ending Short-Term Debt
Beginning Short-Term DebtMinimum Cash 0.00
Balance
47
Short-Term Financial Plan
Q1
Q2
Beginning Cash
5.00
25.25
Net Cash Inflow
Q3
2.00
0.00
Cumulative surplus
(deficit)
0.00
10.25
48
Short-Term Financial Plan
Q4
Q1
Q2
Q3
Q4
Beginning Cash
5.00
25.25
2.00
Net Cash Inflow
20.25
(26.50)
11.50
0.00
3.25
0.00
Surplus
20.25
(26.50)
New Short-Term Debt
0.00
3.25
New Short-Term Debt
Interest on Short-Term Debt
0.00
0.00
Interest on Short-Term Debt
0.00
0.00
Example: Cash Budget – Cash Balance (Slide 43)
Short-Term Debt Repayment
0.00 Q1 0.00 Q2
Q3
Q4
0.00
0.00
Ending Cash Balance
25.25
2.00
Minimum Cash Balance
-2.00
-2.00
Short-Term Debt Repayment
Cumulative Surplus after loans
23.25
Ending Cash Balance
Minimum Cash Balance
0.00
25.25
Beginning Cash
Balance
-2.00
25.25
(1.25)
Net Cash Inflow
20.25
(26.50)
11.50
9.50
Ending Cash
Balance
25.25
(1.25)
10.25
19.75
-2.00
0.00 -2.003.25-2.00
-2.00
Cumulative Surplus after loans
3.25
2.00
5.00
Beginning Short-Term Debt
0.00
0.00
Change in Short-Term Debt
0.00
3.25
Change in Short-Term Debt
Ending Short-Term Debt
0.00
3.25
Ending Short-Term Debt
23.25
Beginning Short-Term DebtMinimum Cash 0.00
Balance
0.00
Cumulative surplus
(deficit)
0.00
-2.00
0.00
3.25
23.25
3.25
(3.25)
8.25
10.25
17.75
12
Chapter 16
June 04
49
Short-Term Financial Plan
Q1
Q2
Q3
Q4
Beginning Cash
5.00
25.25
2.00
Net Cash Inflow
50
Short-Term Financial Plan
Q1
Q2
Q3
Beginning Cash
5.00
25.25
2.00
Net Cash Inflow
20.25
(26.50)
11.50
20.25
(26.50)
11.50
New Short-Term Debt
0.00
3.25
0.00
New Short-Term Debt
0.00
3.25
0.00
Interest on Short-Term Debt
0.00
0.00
0.10
Interest on Short-Term Debt
0.00
0.00
0.10
Short-Term Debt Repayment
0.00
0.00
Short-Term Debt Repayment
0.00
0.00
3.25
Ending Cash Balance
25.25
2.00
Ending Cash Balance
25.25
2.00
10.15
Minimum Cash Balance
-2.00
-2.00
Minimum Cash Balance
-2.00
-2.00
-2.00
Cumulative Surplus after loans
23.25
0.00
Cumulative Surplus after loans
23.25
0.00
8.15
Borrow $3.25
for 1 quarter
at 12% APR
Beginning Short-Term Debt
0.00
0.00
Beginning Short-Term Debt
0.00
0.00
3.25
Change in Short-Term Debt
0.00
3.25
Change in Short-Term Debt
0.00
3.25
-3.25
Ending Short-Term Debt
0.00
3.25
Ending Short-Term Debt
0.00
3.25
0.00
51
Short-Term Financial Plan
Q1
Beginning Cash
Q2
5.00
Q3
Q4
2.00
10.15
Net Cash Inflow
20.25 (26.50) 11.50
Example: Cash Budget – Cash Balance (Slide 43)
New Short-Term Debt
0.00
3.25
0.00
9.50
Interest on Short-Term Debt
0.00
Q1
Beginning Cash
5.00
Net Cash
Inflow
Ending Cash
Balance
20.25
Balance
Short-Term
Debt Repayment
Minimum
Ending Cash
Cash
Balance
Balance
25.25
Minimum
Cash
Cumulative
Surplus
after loans-2.00
Balance
Cumulative surplus
23.25
25.25
Q2
Q3
25.25
(1.25)
0.00
0.00
Q4
0.10
0.00
3.25
0.00
10.15
19.65
10.25
(26.50)
25.25 11.502.009.50
(1.25)
0.00
0.00
19.75
-2.00
-2.00
-2.00
-2.00
23.25 -2.000.00
8.15
17.65
-2.00
(3.25)
10.25
-2.00
8.25
17.75
3.25
0.00
Change in Short-Term Debt
0.00
3.25
-3.25
0.00
Ending Short-Term Debt
0.00
3.25
0.00
0.00
Beginning (deficit)
Short-Term Debt
0.00
0.00
Why Do Firms Need Short-term Financing?
Q4
52
™Profits may not be sufficient to keep up with growthrelated financing needs.
™Firms may prefer to borrow now for their needs
rather than wait until they have saved enough.
™Short-term financing instead of long-term sources
of financing due to:
™easier availability
™usually lower cost
13
Chapter 16
June 04
Sources of Short Term Financing
53
Bank Loans
Estimation of Cost of Short-Term Credit
Cost of Bank Loans
Simple Interest Loan
™Simple
™Compensating Balance
Commercial Paper
™Discount Interest
APR
=
Loans Based on Short-Term Assets
Interest
365
Amount Received x Days
™Factoring Accounts Receivable
™Inventory or Warehouse Loans
Amount you pay vs.
Amount you can use
Estimation of Cost of Short-Term Credit
Cost of Bank Loans
Simple Interest Loan
APR
=
55
APR
=
Interest
Amount Received
Adjustment for less
than annual term
Estimation of Cost of Short-Term Credit
56
Cost of Bank Loans
Simple Interest Loan
Interest
365
Amount Received x Days
**If Loan is for ONE Year, reduced to:
54
APR
=
Interest
365
Amount Received x Days
Example:
AU Corp needs to borrow $1000 to purchase a supply of Tee Shirts for
graduation. They will repay the loan plus $25 interest in 30 days. What is
the cost of the loan (APR)?
APR
$25
= $1000 x
365
30
= 0.3042 = 30.42%
14
Chapter 16
June 04
57
Estimation of Cost of Short-Term Credit
Annual Percentage Rate (APR) aka Nominal Rate
™Use to determine the cost of the credit to be able to
compare differing terms--standardizes the term to one
year.
Effective Annual Rate (EAR) or (APY)
™Takes into account the compounding that
occurs on loans of less than one year. The
real cost of the loan if it were renewed each
time it matured.
(
EAR = 1 +
i M
-- 1
M
)
Previous Example:
.3042
EAR = 1 +
12.2
(
where:
i = APR
M = # of compounding
=
periods in year
12.2
)–1=
Estimation of Cost of Short-Term Credit
Cost of Bank Loans
Compensating Balance
™ The bank requires a certain percentage of the loan to be on deposit in the
bank; the borrower receives the loan amount minus the compensating
balance requirement.
™ The Compensating Balance requirement can be satisfied from the
amount borrowed, or if the firm already has an cash account with the
lender, this account can be used for the compensating balance
Example:
Tiger, Inc. borrows $1,800 for 6 months. The bank requires a
compensating balance equal to 10% of the amount borrowed and charges
12% on the loan per year. What is the nominal cost of the loan?
=30.42%
365
= 12.2
30
APR
=
0.3505 = 35.05%
Estimation of Cost of Short-Term Credit
58
59
Cost of Bank Loans
Compensating Balance
Interest
365
Amount Received x Days
Estimation of Cost of Short-Term Credit
60
Cost of Bank Loans
Compensating Balance
™ The bank requires a certain percentage of the loan to be on deposit in the
bank; the borrower receives the loan amount minus the compensating
balance requirement.
™ The Compensating Balance requirement can be satisfied from the
amount borrowed, or if the firm already has an cash account with the
lender, this account can be used for the compensating balance
™ The bank requires a certain percentage of the loan to be on deposit in the
bank; the borrower receives the loan amount minus the compensating
balance requirement.
™ The Compensating Balance requirement can be satisfied from the
amount borrowed, or if the firm already has an cash account with the
lender, this account can be used for the compensating balance
Example:
Example:
Tiger, Inc. borrows $1,800 for 6 months. The bank requires a
compensating balance equal to 10% of the amount borrowed and charges
12% on the loan per year. What is the nominal cost of the loan?
Tiger, Inc. borrows $1,800 for 6 months. The bank requires a
compensating balance equal to 10% of the amount borrowed and charges
12% on the loan per year. What is the nominal cost of the loan?
APR
=
Interest Charge on Loan:
.12
$1,800 x
x 6 = $108
Interest
12
Monthly
Interest Rate
# of Months
APR
=
Interest
Amount Received
Face Value –
Compensating
Balance
15
Chapter 16
June 04
Estimation of Cost of Short-Term Credit
61
Example:
Tiger, Inc. borrows $1,800 for 6 months. The bank requires a
compensating balance equal to 10% of the amount borrowed and charges
12% on the loan per year. What is the nominal cost of the loan?
APR
APR
=
Interest
Face Value –
Compensating
Balance
$108
=
x
$1800 – $180
10% of $1800
12
6
x
Estimation of Cost of Short-Term Credit
Cost of Bank Loans
Compensating Balance
™ The bank requires a certain percentage of the loan to be on deposit in the
bank; the borrower receives the loan amount minus the compensating
balance requirement.
™ The Compensating Balance requirement can be satisfied from the
amount borrowed, or if the firm already has an cash account with the
lender, this account can be used for the compensating balance
Example:
365
Days
Tiger, Inc. borrows $1,800 for 6 months. The bank requires a
compensating balance equal to 10% of the amount borrowed and charges
12% on the loan per year. What is the nominal cost of the loan?
= 0.133 = 13.3%
Alternative Formula for Compensating Balance
6 month loan
APR
Nominal Rate
1 – Compensating
=
Balance Rate
Estimation of Cost of Short-Term Credit
Commercial Paper and Discount Interest
• Short-term unsecured promissory notes issued by
major corporations
• Maturities range from one or more days to a
maximum of 270 days (9 months)
• Generally sold on a discount basis
• Generally cheaper than bank loans
• Prestige of being able to offer commercial paper
62
63
=
.12
1 – .10
= 0.133 = 13.3%
Estimation of Cost of Short-Term Credit
64
Cost of Commercial Paper
Discount Interest
™Interest is paid when the money is borrowed; the borrower
receives the loan amount minus interest paid.
™Upon maturity, the borrow pays back the face value of the loan.
APR
APR
=
=
Interest
365
Amount Received x Days
Interest
Face Value - Interest Paid
x
365
Days
16
Chapter 16
June 04
Estimation of Cost of Short-Term Credit
65
Cost of Commercial Paper
Discount Interest
Estimation of Cost of Short-Term Credit
66
Cost of Commercial Paper
Discount Interest
Example:
Example:
Snowy issues $10 million of Commercial Paper with a 90 day term. Interest
rate is 9% per year, interest is discounted. What is the APR and APY of
this Commercial Paper ?
Snowy issues $10 million of Commercial Paper with a 90 day term. Interest
rate is 9% per year, interest is discounted. What is the APR of this
Commercial Paper ?
=
APR
Interest
Face Value - Interest Paid
x
365
Days
APR
Interest Paid:
$10,000,000 x .09 x 90 = $221,918
365
Daily Interest
Rate
APR
Interest
Face Value - Interest Paid
$221,918
= $10,000,000 – $221,918
x
365
Days
x 365
90
= 0.0920 = 9.20%
# of Days
Estimation of Cost of Short-Term Credit
=
67
68
Factoring Accounts Receivable
™Borrower’s Accounts Receivable are SOLD outright (at
a discount) to a factor, the factor then collects the A/R
from the borrower’s customers.
Example:
You have an average of $1 million in receivables and you borrow money by
factoring receivables with a discount of 2.5%. The receivables turnover is
12 times per year.
Discount %
x
1 – Discount % Receivables Turnover
APR
=
APR
.025
= 1 – .025
EAR =
x 12
= 0.3077 = 30.77%
12
(1 + .3077
12 ) – 1 =
0.3550 = 35.50%
17