Working Capital Management
Cash Cycle: length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale
of the output produced from that inventory.
Operating Cycle: avg. length of time between when a firm originally purchases its inventory and when it receives the cash back from
selling its product.
Reasons to provide trade credit: indirectly, to lower prices and there may be advantages in making loans to customers relative to
other potential sources of credit.
Credit Policy - three steps - establishing credit standards; credit terms and collection policy.
Cost of the discount to the selling firm = discount % * selling price = X
Interest rate = X / (100 – X)
Which corresponds to an EAR = (1 + interest rate) ^365/(total nº days – nºdays w/discount)
Thus, by not taking the discount, the firm is effectively paying (interest rate) to borrow the money for (≠ days), which translates to
an EAR of … %.
Note 1: If the firm can obtain a bank loan at a lower interest rate, it would be better off borrowing at the lower rate and using the
cash proceeds of the loan to take advantage of the discount offered by the supplier.
Note 2: if a customer does not take the discount, he will have the use of (100 – X) for an additional (≠ days). It will cost him (X).
Note 3: the longer the (≠ days) the smaller the EAR.
_Calculate the cost of the trade credit if your firm does not take the discount.
_The effective annual cost of trade credit, if you choose to forgo the discount, Do: Interest & EAR
_ (100 – X) = 100/(1+EAR) ^ (≠DAYS/365)
How to manage working capital requirements?
By managing the float, the length of a firm’s receivables, and payables.
Collection Float: the amount of time it takes for a firm to be able to use funds after a customer has paid for its goods. By reducing
CF, a firm can reduce WC needs.
Disbursement Float: the amount of time it takes before payments to suppliers actually result in a cash outflow for the firm. By
extending this float, it will length payables and reduce its WC needs.
How can they reduce these floats? By implementing electronic check processing.
Note: If the collection float is reduced, u will have an additional (avg. daily collections * days it was reduced).
How to know if Receivables/Payables are being well managed?
Look at the avg. accounts payables days outstanding = accounts payable balance / COGS. If it is > than the days of the Trade Credit
it’s because it’s not managing it well.
Note: Efficient inventory management increases the firm’s FCF and thus the firm value.
Cost of holding Inventory: acquisition costs, order costs, and carrying costs.
Note 1: If inventory increases, its inventory days will increase, all else equal. This will, therefore, increase the cash cycle of the firm.
Note 2: If a firm begins to take discounts offered by its suppliers, its accounts payable days will decrease. All else equal, this will
cause the cash cycle of the firm to increase.
Net working capital = current assets - current liabilities.
Treasury Bills & Certificates of Deposit are considered to be free of default risk, so they offer lower returns than a security that has
default risk associated with it.
Short-term tax exempts have default risk, but the interest on these instruments is free from federal taxation; thus, they offer a
lower yield than a similarly risky, fully taxable security.
Commercial paper exposes the investor to default risk and the interest earned is fully taxable. It would, therefore, have to offer the
investor a higher before-tax return than the other instruments.
Short-Term Financial Planning
Matching Principle: specifies that short-term needs for funds should be financed with short-term sources of funds and long-term
needs with long-term sources of funds.
Permanent WC = the amount that a firm must keep invested in its short-term assets to support its continuing operations. =
minimum level o NWC
Temporary WC = is the ≠ between the actual level of investment in short-term assets and the permanent WC investment.
Commitment Fees: increase the effective cost of the loan to the firm. It is multiple to the unused portion of the borrowed funds.
_cost of the loan = interest on borrowed funds + commitment fee on unused funds.
Loan Origination Fee: reduces the amount of usable proceeds that the firm receives. Additional interest charge. Charged on the
principal of the loan.
AT TIME 0:
_ (+) amount borrowed = amount of the loan * (1 – loan origination fee)
AT END:
_ (-) amount of the loan
_ (-) interest payment = total amount of the loan * APR/nº of periods in a year)
Compensating Balance Requirements: reduces the usable loan proceeds. The firm must hold a certain % of the principal in an
account at the bank. Note if it’s a non-interest-bearing account or not. If not,
AT TIME 0:
_ (+) loan proceeds available = loan amount – (1 + compensating balance)
AT END:
_ (-) [loan amount * (1 + APR/nº of periods)] - compensating the balance
But, if the bank pays something on its compensating balance account,
_ (-) [loan amount * (1 + APR/nº of periods)] – (compensating the balance * (1 + something/nºperiods)
Commercial Paper: short-term, unsecured debt
AT TIME 0:
_ (+) what it receives
AT END:
_ (-) face value
Warehouse Financing: inventory that serves as collateral is stored in a warehouse.
AT TIME 0:
_ (+) amount borrowed
AT END:
_ (-) [ amount borrowed * (1 + APR/nº of periods)] – warehouse fee
After,
Interest Rate = (value at END) / (value at TIME 0) – 1
EAR = (1 + interest rate) ^ nº of period – 1
Accounts Receivable as collateral: Pledging (lender reviews the invoices that represent the credit sales of the borrowing firm and
decides which credit account It will accept as collateral. Factoring (firms sell receivables to the lender, and the lender agrees to pay
the firm the amount due from its customers at the end of the firm’s payment period.
Inventory as collateral: Floating/General/Blanket lien (all inventory is used to secure the loan) – the riskiest. Trust Receipt (inventory
is held in a trust as security for the loan). Warehouse Agreement (the inventory that serves as collateral is stored in a warehouse).
•
WC needs = change in NWC = Acc. Receivable +/- Inventory - Acc. Payable
•
•
Surplus (change in cash) = [(NI + D – change in NWC) -> (= CFO)] – CAPEX
Inventory = Initial stock + purchase – COGS = final stock; purchases = avg. of COGS.
Which alternative to choose?
a)
Forgo the discount on its trade credit agreement that offers terms of …
DO: interest rate; EAR
b)
Borrow the money from Bank A, which has offered to lend the firm … for … days at an APR of …. The bank will require a (no interest) compensating balance of … of the face value of the loan and will charge a … loan origination fee, which means Handto-Mouth must borrow even more than the ….
DO:
amount needed = (the amount borrowed + face value) / (1 – compensating balance fee)
interest expense = amount needed * APR/nºperiods
total interest at the END = interest expense + face value or (amount borrowed * APR/nº periods)
usable proceeds = amount borrowed
interest per period = (total interest at the END/amount borrowed)
EAR = (1+interest) ^ 365/nºdays
c)
Borrow the money from Bank B, which has offered to lend the firm …. for … days at an APR of …. The loan has a … loan
origination fee.
interest rate = APR/nº of periods
Interest expense = amount needed * interest rate
Total interest charge = interest expense + (amount borrowed * loan origination fee)
interest per period = (total interest at the END/amount borrowed)
EAR = (1+interest) ^ 365/nºdays
Most expensive: the one where EAR is bigger.
Which of the following one-year $1000 bank loans offers the lowest effective annual rate?
1.
2.
3.
A loan with an APR of 6%, compounded monthly
A loan with an APR of 6%, compounded annually, that also has a compensating balance requirement of 10% (on
which no interest is paid)
A loan with an APR of 6%, compounded annually, that has a 1% loan origination fee
The effective annual rates of each of the alternatives are calculated as follows.
1.
2.
3.
Since the APR is 6%, the monthly rate is 6%/12 = 0.5%. This translates to an effective annual rate of (1.005) 12 – 1 = 6.2%.
The compensating balance is $1,000 × 0.10 = $100. Therefore, the borrower will have use of only $900 of the $1,000. The
interest is 0.06 × $1,000 = $60. The interest rate per period is $60 / $900 = 6.7%. Since this alternative assumes annual
compounding, the effective annual rate is 6.7% as well.
The interest expense is 0.06 × $1,000, and the loan origination fee is 0.01 × $1,000 = $10. The loan origination fee reduces the
usable proceeds of the loan to $990 because it is paid at the beginning of the loan. The interest rate per period is $70 / $990 =
7.1%. Since the loan is compounded annually in this case, 7.1% is the effective annual rate.
Thus, alternative (a) offers the lowest effective annual cost.
Note: What is she paying divided by what she received = interest, then EAR.
The Ohio Valley Steel Corporation has borrowed $5 million for one month at a stated annual rate of 9%, using inventory
stored in a field warehouse as collateral. The warehouse charges a $5000 fee, payable at the end of the month. What is the
effective annual rate of this loan?
The monthly interest rate is 9% / 12 = 0.75%, so Ohio Valley Steel must pay 0.0075  $5,000,000 = $37,500 in interest on the loan.
Combining this with the $5,000 warehouse fee makes the monthly cost of the loan $42,500. Since the fee is paid at the end of the
month, Ohio Valley Steel has used the full $5,000,000 for the month. The interest rate per period is $42,500 / $5,000,000 = 0.85%.
There are 12 months in a year, so the effective annual rate is (1.0085) 12 – 1 = 10.7%.
How to see the change effect of a policy in a firm value:
Note: After-tax operating margin = EBIT * (1-T) / SALES
Firm value = FCF / (WACC – g)
FCF = EBIT (1-t) + Dep – CAPEX – change in NWC
The Company Abercrombie & Fitch has a $1 billion cash surplus and it is considering three alternatives:
a)
b)
c)
It can buy a 180-day treasury bill that is currently quoted at a yield on a bank discount basis of 5.6%.
Yield = (FV-P)/FV * 360/n; FV = excess cash then P = excess cash / (1+EAR) ^n/365;
It can buy commercial paper by Google Inc., which is rated A1+ by S&P, the highest possible rating. The interest
rate, over six months, not annualized, is 2.98%.
(1+EAR) = (1+i2) ^ 2; i2 = 2,98%
It can enter into a repurchase agreement to buy $1.029 billion of treasury bills for $1 billion, with a dealer in
securities. The dealer promises to deliver $1.029 billion to you in six months.
T-bill repurchase $ = T-bill price/(1+EAR) ^ n/365
In terms of risk (order most to least): T-bill, Repurchase, Commercial Paper || In terms of Liquidity: T-bill, Commercial
Paper, Repurchase
Apple Inc has a $100,000 cash surplus for 120 days. Discuss the best-maximizing alternative:
a) It can deposit in PNC bank at a benchmark interest rate deducted from a spread of 0.2%. The 4-month LIBOR rate is 1.3%. EAR
= Benchmark – spread b) It can buy commercial paper by Google Inc, which is rated A1+ by S&P and with a face value of $101,800
and a maturity of 120 days. 100 000 = FV / (1+EAR) ^N/365 c) It can buy a 120-day treasury bill with a face value of $101,500.
100 000 = FV / (1+EAR) ^N/365 d) It can take advantage of the discount to pay its suppliers. The goods were bought on terms
0.75/30, Net 120. In addition, it can deposit in PNC bank at a benchmark interest rate deducted from a spread of 0.1%. The 1 month
LIBOR rate is 0.4% (100-X) = 100 / (1+ EAR) ^ n/365; EAR TOTAL = (1+0,003) ^ 30/120 * (1+0,031) * 90/120 – 1
In terms of risk (order most to least): deposit, t-bill, combo (discount), Commercial Paper || In terms of Liquidity: deposit, tbill, combo, commercial paper
Colgate-Palmolive needs a $100,000 loan for the next 180 days. The firm is trying to decide between the following alternatives:
a) Offer its clients a trade credit term of 0.75/15, Net 60 b) Sell their account receivables to a factor firm. The benchmark interest rate
is a 2-month Euribor rate of +1 %. The 2-month Euribor rate is 4%. Assume that the Colgate trade credit term is 2 months. The stamp
duty is 4% and the flat commission of the factor firm is 0.5%. c) Borrow the money from Bank A for 30 days at the monthly APR
benchmark interest rate plus a spread of 0.75%. The 1-month Euribor rate is 3.5%. The stamp duty is 4%. (1 + EAR) = (1 + (spread
+ Euribor) *(1+stamp duty) * nº periods
Raising Equity Capital
Private companies can raise “external” funding:
. angel investors:
. venture capital firms
. privet equity firms
. institutional investors
. corporate investors
Pre-money Valuation = nº of shares outstanding before * share $ used in funding round
Post-money Valuation = Pre-money Valuation + Amount Invested
Ownership = money invested / total sh. outstanding in that moment
Post-transaction valuation = sh. owned * share $
Advantages of IPO: greater liquidity, better access to capital.
Disadvantages of IPO: regulatory and financial reporting requirements
Primary Offering: if the shares are being sold to raise new capital.
Secondary Offering: if the shares are sold by earlier investors.
Best Efforts: the underwriter does not guarantee that the stock will be sold.
Firm Commitment: guarantees that will sell all of the stock at the offer price.
Auction IPOs: investors place bids.
Underwriter: an investment bank that manages the IPO process and helps the company sell its stock.
SEC demands: a registration statement; a preliminary prospectus (circulates to the investors) and the final prospectus.
Value a company through PV or comparable companies.
Total Market Value = revenues/earnings * P/R or P/E multiple
Price per share = Total Market Value / nº outstanding shares
Greenshoe Provision: underwriter is to issue more stock, amounting to 15% of the original offer size at the IPO offer price.
IPO PUZZLES:
. IPOs are underpriced on avg.
. New issues are highly cyclical
. Transaction costs are high
. Long-run performance after an IPO is poor on avg.
The Seasoned Equity (SEO): sale of stock by a company that is already publicly traded.
i.
Cash offer: new shares sold to investors at large
ii.
Rights offer: new shares offered only to existing shareholders
Stock $ has a negative reaction to an SEO!!
How many shares must the venture capitalist receive to end up with 20% of the company? What is the implied price per
share of this funding round? 8,000,000 = (founder’s ownership) so, TOTAL = x
Suppose venture capital firm GSB partners raised $100 of committed capital. Each year over the 10-year life of the fund, 2%
of this committed capital will be used to pay GSB’s management fee. As is typical in the venture capital industry, GSB will
only invest $80 million (committed capital less lifetime management fees). A the end of 10 years, the investments made by the
fund are worth $400 million. GSB also charges 20% carried interest on the profits of the fund (net of management fees).
$100 million invested; Profit = 400 – 100 = 300; Carried interest = 20%  300 = $60 million LP payoff = 400 – 60 = 340; IRR =
1/10
−1=13.02%solves
(340/100)
Margoles Publishing recently completed its IPO. The stock was offered at a price of $14 per share. On the first day of trading,
the stock closed at $19 per share. What was the initial return on Margoles? Who benefited from this underpricing? Who lost,
and why?
The initial return on Margoles Publishing stock is (closed price – offered price) / (closed price) = … %
Who gains from the price increase? Investors who were able to buy at the IPO price of $14/share see an immediate return of 35.7%
on their investment. Owners of the other shares outstanding that were not sold as part of the IPO see the value of their shares increase.
To the extent that the investors who were able to obtain shares in the IPO have other relationships with the investment banks, the
investment banks may benefit indirectly from the deal through their future business with these customers.
Who loses from the price increase? The original shareholders lose because they sold stock for $14.00 per share when the market was
willing to pay $19.00 per share.
What was the dollar cost of this fee? The total dollar value of the IPO was (share $) × (nº shares). The spread equaled (fee tax) ×
total dollar value.
How much did your firm raise from the IPO? (shares issued in IPO * (share $ - fee * share $)
What is the market value of the firm after the IPO? sh. $ on the day of IPO * sh. outstanding (sh. before + new sh.)
Assume that the post-IPO value of your firm is its fair market value. Suppose your firm could have issued shares directly to
investors at their fair market value, in a perfect market with no underwriting spread and no underpricing. What would the
share price have been in this case, if you raise the same amount as in part (a)? the market value of firm assets absent new cash
raised = mrk. value aft. IPO – money raised; sh. $ = that divided by sh. outstanding prior to the issuance; money raised
Comparing part (b) and part (c), what is the total cost to the firm’s original investors due to market imperfections from the
IPO? (c. sh. $ - b. sh. $) * prior sh. outstanding
Payout Policy
When a firm wants to distribute cash to its shareholders, it can pay a cash dividend or it can repurchase shares (open market
repurchases, tender offer, Dutch auction repurchase, or a targeted repurchase).
Declaration date: that will pay dividends to all shareholders of record on the record date.
Ex-dividend date: the first day on which the stock trades w/o the right to dividend.
Stock split: distribution of additional shares rather than cash to shareholders from the firm itself.
Spin-off: shares of a subsidiary
In Perfect Capital Markets, stock $ falls by the amount of the dividend when a dividend is paid. An open-market share repurchase
has no effect on the stock $, and the stock $ is the same as the cum-dividend price if a dividend were paid instead.
Cum-dividend: $ before the ex-dividend date. = curr. dividend + PV (future dividends) w/ unleveled cost of capital
Ex-dividend: price reflects only the dividend in the future. = PV (future dividends)
Enterprise Value = PV (FCF) = FCF/unlevered cost of capital
When tx. Rate on dividends > tx. Rate on capital gains, the optimal dividend policy is for firms to pay no dividends. Go for share
repurchase.
We take out from the sh. outstanding the share repurchased!!!
Effective dividend Tax Rate measures the net tax cost to the investor per dollar of dividend income received. Varies because of:
investment horizon, tax jurisdiction, etc.
Effective Tax Disadvantage of Retaining Cash = ( 1 – (1-tc)(1-tg)/(1-ti)) ; tc = ti – corporate tax
Signaling w/ Payout Policy
Increase in dividends – good news; Cut dividends – bad news
Sh. repurchases – good news; stock might be undervalued.
IF the company has debt, take out the debt from the market value before computing shares $.
IF it distributes dividends, take out that value from market value and debt before computing shares $.
IF it makes a sh. repurchase, take out that value from market value and debt, and take out from the outstanding shares the sh.
repurchased before computing shares $.
Sh. repurchased = cash / curr. share $ - the one w/ cash in mark value but less debt.
Suppose the board of Natsam Corporation decided to do the share repurchase in Problem 7(b), but you, as an investor, would
have preferred to receive a dividend payment. How can you leave yourself in the same position as if the board had elected to
make the dividend payment instead?
If you sell 0.5/15 of one share you receive $0.50 and your remaining shares will be worth $14.50, leaving you in the same position as
if the firm had paid a dividend.
Dividend payout makes share $ drop so if u are a holder of a stock option u prefer a sh. repurchase!!
The HNH Corporation will pay a constant dividend of $2 per share, per year, in perpetuity. Assume all investors pay a 20%
tax on dividends and that there is no capital gains tax. Suppose that other investments with equivalent risk to HNH stock offer
an after-tax return of 12%.
1.
What is the price of a share of HNH stock?
2.
Assume that management makes a surprise announcement that HNH will no longer pay dividends but will use the cash
to repurchase stock instead. What is the price of a share of HNH stock now?
1.
2.
P = $1.60/0.12 = $13.33
P = $2/0.12 = $16.67
Suppose that all capital gains are taxed at a 25% rate and that the dividend tax rate is 50%. Arbuckle Corp. is currently
trading for $30 and is about to pay a $6 special dividend.
a. Absent any other trading frictions or news, what will its share price be just after the dividend is paid?
Suppose Arbuckle made a surprise announcement that it would do a share repurchase rather than pay a special dividend.
2.
3.
a.
b.
c.
What net tax savings per share for an investor would result from this decision?
What would happen to Arbuckle’s stock price upon the announcement of this change?
t*_d=(50%–25%)/(1–25%)=33.3%,P_ex=30–6(1–t*)=$26
With a dividend, the tax would be 6  50% = $3 for the dividend, with a tax savings of 4  25% = $1 for capital loss, for a net
tax from the dividend of $2 per share. This amount would be saved if Arbuckle does a share repurchase instead.
Stock price rises to by $2 to $32 to reflect the tax savings.
Clovix Corporation has $50 million in cash, 10 million shares outstanding, and a current share price of $30. Clovix is deciding
whether to use the $50 million to pay an immediate special dividend of $5 per share, or to retain and invest it at the risk-free
rate of 10% and use the $5 million in interest earned to increase its regular annual dividend of $0.50 per share. Assume perfect
capital markets.
Suppose Clovix pays the special dividend. How can a shareholder who would prefer an increase in the regular dividend create
it on her own? Invest the $5 special dividend, and earn interest of $0.50 per year.
Suppose Clovix increases its regular dividend. How can a shareholder who would prefer the special dividend create it on her
own? Borrow $5 today, and use the increase in the regular dividend to pay the interest of $0.50 per year on the loan.
Enterprise Value = Equity + Debt – Cash
Equity = EV + Cash
If management expects good news to come out, they would prefer to do the repurchase first, so that the stock price would rise. On the
other hand, if they expect bad news to come out, they would prefer to do the repurchase after the news comes out.
A 3:2 stock split means for every two shares currently held, the investor receives a third share. Share price = $20 × 2/3 = $20/ 1.50 =
$13.33 per share.
LEASING
Risk-free monthly lease rate
PV (lease payment) = cost of asset – RV/(1+rate^n-1)
PV (lease payments) = L(1+1/rate(1-1/rate^n-1))
L =??
The monthly payment for a five-year $200,000 risk-free loan
Loan amount = M * 1/rate * (1-1/rate ^ n)
M =??
What residual value must the lessor recover to break even in a perfect market with no risk?
PV (Residual Value) = Purchase Price – PV (Lease Payments)
Monthly lease payment in a perfect market for the following leases:
1.0
A fair market value lease
PV (lease payment) = cost of asset – RV/(1+rate ^ n-1)
PV (lease payments) = L(1+1/rate(1-1/rate^n-1))
L =??
2.0
A $1.00 out lease
PV (lease payment) = cost of asset
PV (lease payments) = L(1+1/rate(1-1/rate^n-1))
L =??
3.0
A fixed-price lease with an $80,000 final price
PV (lease payment) = cost of asset – final receive/(1+rate ^ n-1)
PV (lease payments) = L(1+1/rate(1-1/rate^n-1))
L =??
Capital lease: increase PPE and Debt
Operational Lease: no change
If fair-market lease
If PV (Lease payment) / purchase $ > 90% - capital lease
If Lease Term is >= 75% of the economic life of the asset – a capital lease
Otherwise, IT’S OL
w/ cancellation option, PV (lease payments) = L(1+1/rate(1-1/rate^n-1)) + cancellation option/(1+rate/nºperiods) ^ n
TRUE TAX LEASE
(BUY)
FCF 0 = CAPEX
FCF 1-X = DEPRECIATION TAX SHIELD
(LEASE)
FCF 0 – (X-1) = after-tax lease payments = lease payments * (1-tx)
(INCREMENTAL FCF) – (leasing vs buying)
FCF 0 = - after-tax lease payments – (-CAPEX)
FCF 1-(X-1) = after-tax lease payments – (- Depreciation tax. Shield)
FCF X = 0 – (- Depreciation tax. Shield)
Lease-equivalent Loan = PV (Incremental FCF) at an after-tax borrowing rate until its worthless * Raiz de 2
After-tax borrowing rate = borrowing cost * (1-tx. rate)
Note: this leasing leads to the same FCF as buying the equipment and borrowing (l-e-l) initially.
1.
better off leasing the equipment or financing the purchase using the lease equivalent loan?
Leasing up-front payment = lease payments * (1-tx)
Buying up-front payment = purchase $ - (l-e-l)
If Buying < Leasing, Lease is not attractive!
Or
Calculate NPV (LEASE-BUY) if positive – lease is attractive!!
TABLE
Capex – year 0 as minus
Depreciation tax shield – all years as plus
FCF (BUY)
Lease payments – all minus last year, as minus
Income tax savings – all years minus last year, as plus
FCF (LEASE)
LEASE VS BUY
lease – buy!!
NPV = POSITIVE YEAR 0 – FCF/(1+AFT.-TAX BORROWING RATE)
BREAK-EVEN lease rate
NPV (L-B) = (increase in L) * (1-tx.rate) * (1+1/ aft.-tax borrowing rate(1-1/ aft.-tax borrowing rate^n-1))  increase in L = ….