Chapter 10 – Working-Capital
Management and Short-term
Financing
Working-Capital Management
Current Assets
 Cash, marketable securities, inventory,
accounts receivable.
Long-Term Assets
 Equipment, buildings, land.
 Which earn higher rates of return?
 Which help avoid risk of illiquidity?
Working-Capital Management
Current Assets
 Cash, marketable securities, inventory,
accounts receivable.
Long-Term Assets
 Equipment, buildings, land.
Risk-Return Trade-off:
Current assets earn low returns, but
help reduce the risk of illiquidity.
Working-Capital Management
Current Liabilities
 Short-term notes, accrued expenses,
accounts payable.
Long-Term Debt and Equity
 Bonds, preferred stock, common stock.
 Which are more expensive for the firm?
 Which help avoid risk of illiquidity?
Working-Capital Management
Current Liabilities
 Short-term notes, accrued expenses,
accounts payable.
Long-Term Debt and Equity
 Bonds, preferred stock, common stock.
Risk-Return Trade-off:
Current liabilities are less expensive,
but increase the risk of illiquidity.
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
To illustrate, let’s finance all current assets
with current liabilities,
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
To illustrate, let’s finance all current assets
with current liabilities,
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
To illustrate, let’s finance all current assets
with current liabilities, and finance all
fixed assets with long-term financing.
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
To illustrate, let’s finance all current assets
with current liabilities, and finance all
fixed assets with long-term financing.
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
Suppose we use long-term financing to
finance some of our current assets.
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
Suppose we use long-term financing to
finance some of our current assets.
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
Suppose we use long-term financing to
finance some of our current assets.
This strategy would be less risky, but more
expensive!
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
Suppose we use current liabilities to finance
some of our fixed assets.
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
Suppose we use current liabilities to finance
some of our fixed assets.
Balance Sheet
Current Assets
Current Liabilities
Fixed Assets
Long-Term Debt
Preferred Stock
Common Stock
Suppose we use current liabilities to finance
some of our fixed assets.
This strategy would be less expensive, but
more risky!
The Hedging Principle
Permanent Assets (those held > 1 year)
 Should be financed with permanent and
spontaneous sources of financing.
Temporary Assets (those held < 1 year)
 Should be financed with temporary
sources of financing.
Balance Sheet
Temporary
Current Assets
Balance Sheet
Temporary
Current Assets
Temporary
Short-term financing
Balance Sheet
Temporary
Current Assets
Permanent
Fixed Assets
Temporary
Short-term financing
Balance Sheet
Temporary
Current Assets
Temporary
Short-term financing
Permanent
Fixed Assets
Permanent
Financing
and
Spontaneous
Financing
The Hedging Principle
Permanent Financing
 Intermediate-term loans, long-term debt,
preferred stock, common stock.
Spontaneous Financing
 Accounts payable that arise spontaneously
in day-to-day operations (trade credit,
wages payable, accrued interest and taxes).
Short-term financing
 Unsecured bank loans, commercial paper,
loans secured by A/R or inventory.
Cost of Short-Term Credit
Interest = principal x rate x time
Example: Borrow $10,000 at 8.5% for 9
months.
Interest = $10,000 x .085 x 3/4 year
= $637.50
Cost of Short-Term Credit
We can use this simple relationship:
Interest = principal x rate x time
to solve for rate, and get the
Cost of Short-Term Credit
We can use this simple relationship:
Interest = principal x rate x time
to solve for rate, and get the
Annual Percentage Rate (APR)
Cost of Short-Term Credit
We can use this simple relationship:
Interest = principal x rate x time
to solve for rate, and get the
Annual Percentage Rate (APR)
APR =
interest
principal
x
1
time
Cost of Short-Term Credit
Cost of Short-Term Credit
APR =
interest
principal
x
1
time
Cost of Short-Term Credit
APR =
interest
principal
x
1
time
Example: If you pay $637.50 in
interest on $10,000 principal for 9
months:
Cost of Short-Term Credit
APR =
interest
principal
x
1
time
Example: If you pay $637.50 in
interest on $10,000 principal for 9
months:
APR = 637.50/10,000 x 1/.75 = .085
= 8.5% APR
Cost of Short-Term Credit
Annual Percentage Yield (APY) is
similar to APR, except that it
accounts for compound interest:
Cost of Short-Term Credit
Annual Percentage Yield (APY) is
similar to APR, except that it
accounts for compound interest:
APY =
(1+ )
i
m
m
- 1
Cost of Short-Term Credit
Annual Percentage Yield (APY) is
similar to APR, except that it
accounts for compound interest:
APY =
(1+ )
i
m
m
- 1
i = the nominal rate of interest
m = the # of compounding periods per year
Cost of Short-Term Credit
What is the (APY) of a 9% loan with
monthly payments?
APY = ( 1 + ( .09 / 12 ) 12 -1 ) = .0938
=
9.38%
Sources of Short-term Credit
Unsecured
Sources of Short-term Credit
Unsecured
 Accrued wages and taxes.
Sources of Short-term Credit
Unsecured
 Accrued wages and taxes.
 Trade credit.
Sources of Short-term Credit
Unsecured
 Accrued wages and taxes.
 Trade credit.
 Bank credit.
Sources of Short-term Credit
Unsecured
 Accrued wages and taxes.
 Trade credit.
 Bank credit.
 Commercial paper.
Sources of Short-term Credit
Unsecured
 Accrued wages and taxes.
 Trade credit.
 Bank credit.
 Commercial paper.
 Secured
Sources of Short-term Credit
Unsecured
 Accrued wages and taxes.
 Trade credit.
 Bank credit.
 Commercial paper.
Secured
 Accounts receivable loans.
Sources of Short-term Credit
Unsecured
 Accrued wages and taxes.
 Trade credit.
 Bank credit.
 Commercial paper.
Secured
 Accounts receivable loans.
 Inventory loans.