Financial management principles and applications 6th edition petty solutions manual

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CHAPTER 7

Working-capital management and short-term financing © 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442539174/Petty/Financial Management/6e

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CHAPTER ORIENTATION

This chapter is falls into two main parts. First, there is a brief outline of the nature of working capital. Working-capital management is shown to be critical to a firm’s liquidity and the hedging principle suggests that short-term finance should be used to fund short-term liquidity needs. The second part of the chapter looks at specific types of short-term finance, describing how these operate and how to estimate their cost.

CHAPTER OUTLINE

1.

Working capital

Working capital comprises a firm’s current assets and current liabilities and net working capital is measured by the difference between the amount of such assets and liabilities.

A firm’s net working capital is a fundamental measure of the firm’s liquidity and is used to assist in making decisions concerning the appropriate amount to invest in current assets and also the amount of short-term financing required.

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2.

Managing current assets and liabilities In managing the firm’s liquidity, there is a trade-off between risk and return.

Holding extra marketable securities boosts liquidity but tends to reduce profitability because these types of securities tend to be low yielding.

Similarly, the firm can boost liquidity by using long-term debt in place of shortterm debt, but this too tends to reduce profitability. Thus, there is a trade-off between liquidity and profitability for most firms—increasing (decreasing) liquidity minimises risks of running out of cash, but the consequence is decreased (increased) profit.

3.

The hedging principle and the appropriate level of working capital The hedging principle provides a useful basis for the firm’s working-capital decisions. The hedging principle or rule of self-liquidating debt requires that those asset needs of the firm not financed by ‘spontaneous’ sources (i.e. payables and accruals) should be financed in accordance with the following rule: •

Permanent asset investments are to be financed with permanent sources of financing and temporary investments are to be financed with temporary sources of financing. This concept is based on the notion of maturity matching.

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Here: a permanent investment in an asset is one which the firm expects to hold for a period longer than one year. Such an investment may involve current or fixed assets. An example would be the minimum level of inventories that a firm seeks to maintain at all times.

A temporary asset investment comprises the firm’s investment in current assets that will be liquidated and not replaced during the year. An example would be a seasonal build-up in inventories that a firm experiences which will be eliminated over a period of time.

Spontaneous sources of financing include all those sources that arise ‘automatically’ as a result of the firm’s continuing operations (e.g. trade credit) or that arise naturally as a part of doing business (e.g. wages payable, interest payable, taxes payable, etc.).

Temporary sources of financing include all forms of current or short-term financing not categorised as spontaneous. Examples include bank overdrafts, bank bills and loans, secured against receivables or inventories.

Permanent sources of financing include all long-term sources such as debt having a maturity longer than one year such as term loans, debentures and leases, as well as equity finance in the form of ordinary and preference shares.

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4.

Short-term financing and its cost

The question of how much short-term financing is needed by a firm comes from the previous discussion of the hedging principle. (Chapter 6 of the textbook also dealt with this question as part of the budgetary context of estimating a firm’s discretionary financing needs or DFN for the forthcoming period.)

Having decided how much finance, there are three basic factors that should be considered by the firm in selecting which source(s) of short-term financing to use: •

The effective cost of credit.

•

The availability of credit (amount needed for relevant time period).

•

The effect of the use of a particular source of credit on the cost and availability of other sources.

Of these three factors, this chapter emphasises determination of the cost of particular types of short-term finance.

The cost of finance can be computed most precisely via the effective annual rate of interest (EAR), as shown in Chapter 4. However, this chapter demonstrates computations whereby the cost of finance is estimated by means of a nominal annual interest rate (j) also known as the Annual Percentage Rate (APR), which is termed ‘RATE’ for the purposes of this chapter:

RATE =

Interest 1  Principal Time

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5.

Sources of short-term finance

Specific sources of funds will fit into one of two basic groups: unsecured or secured credit. Some of these specific sources of short-term finance are:

Accrued wages and taxes: Accrued wages provide a useful source of shortterm financing for the firm due to the delay between the provision of services to the firm by employees and the later date when these amounts are actually paid.

Firms, too, are exposed to a number of taxation liabilities, for example, income tax, payroll tax, GST, etc. In Australia, most taxation authorities request payment of assessed amounts at the end of the quarter in which the tax liability accrues. This delay provides firms with the benefit of being able to use such funds ‘interest free’ for up to three months.

Trade credit provides one of the most flexible sources of financing available to the firm. To arrange for credit, the firm need only place an order with one of its suppliers. The supplier then checks the firm’s credit standing and, if the credit is good, the supplier sends the merchandise. Trade credit is known by accountants as accounts payable. It is a spontaneous source of finance because it tends to grow as the firm’s sales and credit purchases grow.

Some firms seek to extend trade credit accounts beyond the prescribed credit period, referred to as stretching trade credit. Continued violation of specified trade credit terms via this means may, however, result in the withdrawal of trade credit by suppliers. © 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442539174/Petty/Financial Management/6e

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A bank overdraft is a line of credit provided by a bank. It enables a firm to withdraw funds from an account in excess of the credit balance, up to the amount of the overdraft limit. The overdraft facility may be unsecured or secured by a charge over specific or general assets of the firm.

The total cost of an overdraft facility is basically a function of the overdraft interest rate together with other account fees and charges including an unused limit fee. An unused limit fee arises where the firm does not use the full amount of the overdraft limit for the relevant period.

A promissory note is a financial instrument whereby the borrower (issuer, drawer) promises to pay a sum, the maturity or face value V in n days’ time.

The investor (lender, holder) who buys the note will do so on the basis of advancing the borrower a sum (the principal) P which represents V minus the amount of interest (discount) D. Promissory notes are known as a discount-type security because the interest arising on the financial instrument is calculated as the difference between the discounted principal amount and the amount repaid by the borrower at maturity.

Promissory notes are generally restricted to ‘prime’ borrowers with very good credit ratings, such as leading public companies and government authorities.

The prime status is necessary to attract investors, since the issuer (borrower) is the only party with an obligation to repay the debt. Because promissory notes do not contain any promise to repay other than the promise of the borrower, they are often called one-name paper or commercial paper.

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A bill of exchange (also known as a commercial bill) is a written order requiring payment, either on demand or at a specified time. Bills had their origins as instruments to facilitate trade and enabled a debtor to require payment from a creditor to whom goods or services had been provided. As with promissory notes, bills of exchange are a discount-type security. If the bill is accepted by a bank then the financing is known as a bank bill.

A bank bill is used by firms that do not have the financial standing to issue promissory notes, generally arising from a relatively lower credit rating or where the (relatively lower) amount to be raised does not warrant a promissory note issue. Bill finance using an intermediary such as a bank requires the drawer (borrower) to incur a number of fees and charges in addition to the interest rate on the financing. Such fees and charges may include:

•

Accommodation/facility/acceptance fees payable to the intermediary at inception.

•

Establishment fees payable at inception to the intermediary for preparing the relevant documentation.

•

Maintenance fees and activity fees for ongoing monitoring of the funding.

•

Rollover fees if a bill is replaced on maturity with a new bill facility.

•

Government fees and charges.

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Accounts receivable or inventory loans: In addition to the above sources of short-term credit, firms with current assets in the form of accounts receivables and/or inventories may use these as collateral for a short-term loan. That is, the receivables or inventories are pledged against a loan. Such loans are flexible because the amount of these current assets tends to increase in line with the creation of new business. The amount of the loan is stated as a percentage of the face value of the receivables or inventories pledged.

As an alternative to the pledging, the accounts receivable may be sold outright, a process that is called factoring.

Although inventories can provide an excellent source of collateral to the lender due to their relative liquidity, the nature of such collateral can also create difficulties in their monitoring. To overcome such issues, inventory loans are often administered by collateral management companies whose role is to actively monitor the adequacy of the loan collateral. The cost of such service is ultimately borne by the borrower, which makes such types of short-term loans relatively costly in comparison with alternatives.

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SOLUTIONS TO REVIEW QUESTIONS

7-l

Working capital is usually defined as the firm’s investment in current assets.

Net working capital (NWC) refers to the difference between the firm’s current assets and its current liabilities, as shown by the equation: NWC = Current assets – Current liabilities

7-2

Other things remaining the same, the greater the firm’s investment in current assets, the greater its liquidity. The firm may choose to invest additional funds in cash and/or marketable securities as a means of increasing its liquidity (which reduces the risk of illiquidity). However, these asset investments earn little or no return. Therefore, the firm can reduce its risk of illiquidity only by reducing its overall return on invested funds and vice versa.

7-3

Advantages and disadvantages of short-term debt (compared to long-term debt): Advantages •

The interest rate is usually lower for short-term debt (that is, if the term structure of interest rates is upward-sloping).

•

Funds are borrowed only when they are needed and can be repaid, typically without much penalty, when no longer required.

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Disadvantages •

Short-term debts must be repaid sooner; hence, there is a greater risk of illiquidity.

•

Interest costs on short-term debts vary from year to year, whereas long-term debt agreements may ‘lock in’ the cost of funds to the firm (if at a fixed rate). Hence, greater uncertainty (risk) may follow from taking out short-term debt.

7-4

The hedging principle involves matching the maturities of the sources of financing (of the firm’s assets) with the useful lives of the assets. To implement the hedging principle, the firm must use long-term sources of funds to finance the permanent asset investments that are not financed by spontaneous sources (payables), and also finance with short-term sources of funds all the temporary asset investments that are not funded by spontaneous sources of financing.

7-5

(a)

A permanent investment in an asset is one that the firm expects to hold for a period longer than one year.

(b)

Temporary asset investments are comprised of the firm’s investments in current assets that will be liquidated and not replaced within the current year.

(c)

Permanent sources of financing include intermediate and long-term debt, preference shares and ordinary shares.

(d)

Temporary financing consists of the various sources of short-term debt including secured and unsecured bank loans, bank bills, loans secured by accounts receivable and loans secured by inventories.

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(e)

Spontaneous financing consists of trade credit and other accounts payable which arise ‘spontaneously’ in the firm’s day-to-day operations.

Examples include wages and salaries payable, accrued interest and accrued taxation.

7-6

Any classification of the term (time to maturity) of debt is somewhat arbitrary but, conventionally, long-term sources of funds have maturities longer than five years. Intermediate-term financing includes those sources of funds having maturities longer than one but less than five years. Short-term financing must be repaid within one year.

7-7 The important factors in selecting a source of short-term credit are as follows: •

the effective cost of credit

•

the availability of credit, and

•

the effect of the use of a particular source of credit on the cost and availability of other sources of credit.

7-8

(i)

‘2/10, net 30’ means that a 2% discount is offered for payment within 10 days or the full amount is due in 30 days.

(ii)

‘4/20, net 60’ means 4% discount within 20 days, full amount 60 days.

(iii)

‘3/15, net 45’ means 3% within 15 days, full amount 45 days.

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7-9

(a)

An overdraft is an agreement between the borrower and the bank as to the maximum amount of credit (overdraft limit) that the bank will provide to the borrower at any one time, by allowing the borrower to make withdrawals (including drawing cheques) from the borrower’s account. From an accounting viewpoint, an overdrawn balance is a debt owing to the bank and therefore it represents a debit balance (an asset account) from the bank’s perspective. An overdraft is an example of ‘revolving credit’, whereby the balance of the account may fluctuate from credit to debit and back again as long as it does not exceed the overdraft limit.

(b)

A promissory note is a promise by the borrower to pay the lender a specified amount of money at a specified time in the future in return for a discounted amount received ‘today’.

(c)

The prime rate of interest represents that rate which a bank charges its most creditworthy borrowers.

(d)

A bank bill refers to a bill of exchange that has been ‘accepted’ by a bank. In effect, this means that the bank guarantees the repayment of the bill at maturity.

(e)

An overdraft limit represents the maximum amount by which the bank’s customer account can be overdrawn. Therefore, it is the maximum debit balance that the account can reach (from the bank’s perspective).

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7-10

(a)

A promissory note is essentially a ‘promise’ on the part of the borrower to repay the lender the face value of the note on maturity. The debt is ‘unsecured’, which means that there is no guarantee that the debt will be repaid. Because of this, promissory notes are normally only issued by high-rated borrowers.

(b)

A bill of exchange, or commercial bill, is similar to a promissory note, in that it is a short-term discount security, but the difference is that it is in effect a written order from the borrower to another party requiring them to pay the face value of the bill to the holder on maturity. The effect of this arrangement is that the creditworthiness of the bill depends on the creditworthiness of the party making the repayment – not the borrower. (The borrower in turn is liable to repay the party making the payment.) As long as the party making the payment has a high credit rating, this enables smaller companies with lower credit ratings to access short-term debt. It is common for the party making the payment to the holder to be a bank, in which case the bill is referred to as a bank bill.

(c)

The drawer of a bill is the party ‘drawing up’ the instruction to repay the face value of the bill to the holder on maturity. This is in effect the borrower. Once the instruction has been accepted, the bill has value and can be sold in order to raise the necessary funds.

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(d)

The acceptor of a bill is the party whom the drawer has instructed to repay the holder of the bill. The instruction is only valid if that party ‘accepts’ the instruction, and will do so for a fee based on the creditworthiness of the drawer/borrower.

(e)

The discounter of a bill is the party that purchases the bill, once it has been accepted, and thereby effectively is lending the money to the drawer/borrower. Because the only cash flow to the holder of a bill is the face value at maturity, the lender will pay a discounted amount (based on the time value of money) to purchase the bill, and is therefore referred to as a ‘discounter’.

7-11

Leading is a strategy for managing working capital in a multinational firm that has a ‘long’ position, which means an excess of assets over liabilities denominated in a foreign currency. Such a position means there is an adverse exposure to depreciation of the relevant foreign currency and so the firm should ‘lead’ or speed-up the disposal of assets, before there is further currency depreciation. In contrast, lagging is the process of delaying payment of a bill that is denominated in a depreciating currency until the currency has weakened.

7-12

Cash-flow lending refers to situations where banks base assessment of the borrower’s creditworthiness on the expected ability to repay the debt, which depends largely on the lender generating sufficient net cash flows during the life of the loan. In contrast, secured lending assesses creditworthiness on the availability of security such as assets that can be pledged as collateral for the debt.

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7-13

(a)

The overdraft limit is the maximum amount that the borrower can be overdrawn, i.e. the maximum amount they are able to borrow.

(b)

If the overdraft limit has not been reached, a bank will normally charge an unused limit fee. This fee results from the practice of customers arranging large overdrafts but not always using them. This represents a source of liquidity risk for the bank, as it needs to have sufficient funds available should the customer suddenly decide to draw funds up to the overdraft limit, without notice. The fee acts as a disincentive to customers to seek unnecessarily large overdrafts, as well as compensating the bank for liquidity risk.

(c)

If payments from an account exceed the amount deposited, the account has a negative balance and is said to be ‘overdrawn’. If the customer repays sufficient funds to restore a positive balance, the account is said to be in credit. This is because the account is a liability from the point of view of the bank, and hence a credit on the balance sheet.

(d)

An overdraft is a type of revolving credit because the customer can draw on borrowed funds and repay some or all of those funds at any time, rather than having to borrow specific amounts from time to time as required.

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7-14

A bank overdraft is a very flexible source of finance for managing a firm’s cash position. Once the overdraft has been set up, the firm can borrow (up to the overdraft limit) and repay some or all of the borrowed funds without notice.

Most other forms of finance require specific arrangements (involving transaction fees) each time money needs to be borrowed. The other advantage is that the customer only pays interest on the outstanding balance, rather than the credit limit (as opposed to other types of loans, where interest is payable on the total amount of the loan, even if all of those funds are not always required).

The disadvantage is that the interest rate is likely to be higher than for other types of loans, and the customer is likely to be subject to an unused limit fee in order to compensate the bank for the credit risk associated with overdrafts.

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SOLUTIONS TO PROBLEMS Students should be made aware that solutions identified by an asterisk * are also provided with brief check answers at MyFinanceLab at www.pearsoned.com.au/myfinancelab

7-1*

(a)

Tharp’s Tarp’s pro-forma balance sheet appears as follows: Current Assets

$3.50m1

Debt

$1.65m2

Fixed Assets

2.00m

Equity

3.85m

Total

$5.50m

$5.50m

The firm’s pro-forma statement of earnings is: Sales

$7,000,000

EBIT

1,050,000

Interest

(181,500)3

EBT

868,500

Taxes (30%)

(260,550)

Net Income

$ 607,950

1

Current assets = 50% of sales of $7 million

2

Debt = 30% of total assets of $5.5 million

3

Interest expense = 11% of debt of $1.65 million

Return on Equity = ($607,950 / 3,850,000) = 15.79%

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(b)

Current Assets

$2.80m1

Debt

$1.44m2

Fixed Assets

2.00m

Equity

3.36m

Total

$4.80m

Sales

$7,000,000

EBIT

1,050,000

Interest

(158,400)3

EBT

891,600

Taxes

(267,480)

Net Income

$4.80m

$ 624,120

1

Current assets = 40% of sales of $7 million

2

Debt = 30% of total assets of $4.8 million

3

Interest expense = 11% of debt of $1.44 million

Return on equity = ($624,120 / 3,360,000) = 18.58%

c)

This is obviously a simplifying assumption. Certainly some positive return would be expected from added investment in current assets as shown by the calculated return on equity.

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7-2

(a)

Current ratio = $1,250,000 / 1,050,000 = 1.19 Net working capital = $1,250,000 – 1,050,000 = $200,000 Return on total assets = $250,132 / 2,050,000 = 12.20% Return on equity = $250,132 / 800,000 = 31.27%

(b)

Current ratio = $1,250,000 / 250,000 = 5.00 Net working capital = $1,250,000 – 250,000 = $1,000,000 Return on total assets = $266,9321 / 2,050,000 = 13.02% 1

Net income = (401,332 – 20,000) × (1 – 0.3) = 266,932

Return on equity: 266,932 / 1,600,000 = 16.68%

Note: Liquidity has improved dramatically with the current ratio rising from 1.19 to 5.00 and net working capital from $200,000 to $1,000,000. However, the return to the ordinary shareholders is substantially lower due to the reduction of financial leverage.

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(c)

For 3 months inventories and receivables will increase by $800,000.

For the remaining 9 months of the year, $800,000 can be invested in marketable securities earning 6%.

Net income

401,332

Interest income

36,0001 437,332

Interest expense

(100,000)2 337,332

Tax @ 30%

(101,200)

Net income

$236,132

1

Interest income on marketable securities = $800,000 × 0.06 × 9/12

= $36,000 2

Interest expense: New loan - 800,000 × 0.10 = $80,000 Existing long term - $200,000 × 0.10 = $20,000

Current ratio: 2,050,000 / 250,000 = 8.20 Net working capital: 2,050,000 – 250,000 = $1,800,000 Return on total assets: 236,132 / 2,850,000 = 8.29% Return on equity: 236,132 / 1,600,000 = 14.76%

Note:The liquidity position has steadily improved as the current ratio and net working capital are 8.2 and $1,800,000, respectively. However, profitability has steadily declined due to the cost of permanent financing sources (the loans) exceeding the earnings on marketable securities. Both total assets and equity are earning less return. © 2012 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442539174/Petty/Financial Management/6e

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7-3*

Re-analysis of part (c) of 7-2, assuming that a three-month short-term note is used instead of bonds:

Net Income

401,332

Interest Expense

(40,000)1 361,332

1

Tax @ 30%

(108,400)

Net Income

$252,932

Interest expense: Short term - 800,000 × 0.10 × 3/12 = $20,000 Long term - $200,000 × 0.10 = $20,000

Current ratio: 2,050,000 / 1,050,000 = 1.95 Net working capital: 2,050,000 – 1,050,000 = $1,000,000 Return on total assets: 252,932 / 2,850,000 = 8.87% Return on equity: 252,932 / 1,600,000 = 15.81%

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7-4

Instructor's Note: This problem takes the financial planning analysis of Chapter 6 one step further by requiring that a specific financing plan be devised which meets certain constraints placed on the plan by the firm’s management.

(a)

Canoob Wax Ltd: Forecast of Financial Needs (all values in $ millions) Non-

Trade

Curren curren

credit

Predicte

t

t

Long- Ordinar

Add.

Total

&

term

y

funds

assets1 assets2

assets

A/P3

debt4

equity4

needed

Year

d sales

20X7

30

7.50

9.0

16.50

3.0

3

9

1.50

20X8

33

8.25

9.6

17.85

3.3

3

9

2.55

20X9

39

9.75

10.2

19.95

3.9

3

9

4.05

2X10

42

10.50

10.8

21.30

4.2

3

9

5.10

2X11

45

11.25

11.4

22.65

4.5

3

9

6.15

1

0.25 × Sales

3

0.10 × Sales

2

Growing by $0.6m each year

4

Assumed to remain unchanged

(b)

Trade

Short-

Long-

Total

credit &

term

term

Ordinar Current

Debt

Year

assets

A/P

debt

debt

y equity

ratio

ratio

20X7

16.50

3.0

0.00

3.9

9.60

2.5x

42%

20X8

17.85

3.3

0.00

3.9

10.65

2.5x

40%

20X9

19.95

3.9

0.00

3.9

12.15

2.5x

39%

2X10

21.30

4.2

1.05

3.9

12.15

2.0x

43%

2X11

22.65

4.5

1.05

3.9

13.20

2.0x

42%

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The solution to this part of the problem involves developing a financial plan to raise the discretionary financing needed (as per part (a)) which satisfies the current ratio and debt ratio constraints placed upon the plan by management. The solution offered here is but one of many that satisfies those demands.

7-5

RATE =

a 365  (1 − a ) ( c − b )

where a = amount of the discount b = the discount period c = the net period

(a)

(b)

(c)

(d)

7-6

RATE =

0.02 365  = 37.24% (1 − 0.02 ) ( 30 − 10 )

RATE =

0.03 365  = 75.26% (1 − 0.03) ( 30 − 15)

RATE =

0.03 365  = 37.63% (1 − 0.03) ( 45 − 15)

RATE =

0.02 365  = 16.55% (1 − 0.02 ) ( 60 − 15)

EAR = (1 + j / m ) − 1 m

where j = nominal annual interest rate or APR m = the number of compounding periods in a year

(a)

EAR = (1 + 0.3724 /18.25 )

(b)

EAR = (1 + 0.7526 / 24.33)

(c)

EAR = (1 + 0.3763 /12.17 )

(d)

EAR = (1 + 0.1655 / 8.11)

18.25

− 1 = 44.58%

24.33

− 1 = 109.84%

12.17

− 1 = 44.86%

8.11

− 1 = 17.80%

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7-7

RATE =

u i  L + b  − 1   b  u 

where b = balance of the overdraft (amount overdrawn) i = interest rate per annum on the overdrawn amount L = overdraft limit U = percentage rate per annum on the unused limit

(a)

(b)

RATE =

(i)

(ii)

(c)

0.01   0.10   100, 000 + 60, 000  − 1  = 10.67%  60, 000   0.01  

RATE =

0.01   0.10   100, 000 + 80, 000  − 1  = 10.25%  80, 000   0.01  

RATE =

0.01   0.10   100, 000 + 40, 000  − 1  = 11.50%  40, 000   0.01  

There is an inverse relationship between the effective rate paid on the borrowed funds and the outstanding balance, because of the impact of the unused limit fee. This would tend to act as a strong disincentive against obtaining an unnecessarily high overdraft limit.

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7-8

RATE =

u i  L + b  − 1   b  u 

where b = balance of the overdraft (amount overdrawn) i = interest rate per annum on the overdrawn amount L = overdraft limit U = percentage rate per annum on the unused limit

(a)

(i)

(ii)

(b)

RATE =

0.005   0.09  6, 000, 000 + 2, 400, 000  − 1  = 9.75%  2, 400, 000   0.005  

RATE =

0.005   0.09  10, 000, 000 + 2, 400, 000  − 1  = 10.58%  2, 400, 000   0.005  

Based its current financing needs, the second alternative is more costly because of the higher amount being paid in unused limit fees. However, the company needs to evaluate its future need for funds. If it is likely to require in excess of $6,000,000 in the future, it may be worth accepting the second offer now, rather than trying to get access to those funds at short notice when they are required.

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7-9

(a)

If A-3 rated companies pay 1.5% more than A-1 rated companies, XYZ Childcare will pay 6.5% + 1.5% = 8.0%.

( 365)( 50, 000, 000 ) = $48,102, 267 365V = 365 + RATE ( n ) 365 + ( 0.08 )(180 )

(b)

P=

(c)

The fee is equal to 0.003 × 50,000,000 = $150,000. Incorporating the effect of the $150,000 fee, the issue proceeds of $48,102,267 are reduced to net proceeds of $47,952,267. Thus, the fee can be incorporated into the interest rate as follows:

RATE =

7-10

365  V  365  50, 000, 000    − 1 =  − 1 = 8.66% n  P  180  47,952, 267 

( 365)(1, 000, 000) = $975,936 365V = 365 + RATE ( n ) 365 + ( 0.10 )( 90 )

(a)

P=

(b)

The fee is equal to 0.0025 × 1,000,000 = $2,500. Incorporating the effect of the $2,500 fee, the issue proceeds of $975,936 are reduced to net proceeds of $9,73,436. Thus, the fee can be incorporated into the interest rate as follows:

RATE =

365  V  365  1, 000, 000    − 1 =  − 1 = 11.07% n  P  90  973, 436 

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7-11

(a)

Interest = 0.14 × 100,000 = $14,000 Therefore, the face value (maturity value) of the bill is $114,000.

(b)

Alternative A:

RATE = 14.00%

Alternative B:

RATE = 16,300 / 100,000 = 16.30%

Therefore, Alternative A is the less costly loan.

(c)

If the bank (Alternative A) charges a $2,000 arrangement fee (payable ‘upfront’), then the proceeds of the bill P are reduced to $98,000, but the maturity value V is still the same face value of $114,000. The total cost (including interest and the upfront fee) is $16,000 and the cost of the loan is 16,000 / 98,000 = 16.33% Therefore, Alternative B is now the less costly loan.

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7-12* (i)

$500,000 loan = 0.80 × Accounts Receivable  Accounts receivable = 500,000 / 0.8 = $625,000 Fee = 0.01 × 625,000 = $6,250 Interest cost = 0.11 × 500,000 × 90 / 365 = 13,562

RATE =

(ii)

13,562 + 6, 250 365  = 16.07% 500, 000 90

Warehousing cost = 2,000 × 3 months = $6,000 Interest cost = 0.09 × 500,000 × 90 / 365 = 11,096

RATE =

11, 096 + 6, 000 365  = 13.87% 500, 000 90

The insurance company loan secured by inventory would be preferred since its cost is lower under the conditions presented to S-J.

7-13

P=

( 365)( 20, 000, 000 ) = $18, 495, 060 365V = 365 + RATE ( n ) 365 + ( 0.11)( 270 )

Incorporating the effect of the $200,000 fee, the issue proceeds of $18,495,060 are reduced to net proceeds of $18,295,060. Thus, the fee can be incorporated into the interest rate as follows:

RATE =

365  V  365  20, 000, 000    − 1 =  − 1 = 12.60% n  P  270  18, 295, 060 

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7-14* P =

365V 365 + RATE ( n )

First bill:

P=

( 365)( 200, 000 ) = $192,867 365 + ( 0.15 )( 90 )

Second bill:

P=

( 365)( 200, 000 ) = $192, 638 365 + ( 0.155 )( 90 )

Third bill:

P=

( 365)( 200, 000 ) = $193, 442 365 + ( 0.1375 )( 90 )

Establishment fee = 200,000 × 0.4% = $800 payable at commencement.

Stamp duty = 200,000 × 0.05% = $100 payable at day 0, day 90 and day 180.

The total cash flows arising from the bill financing are: $192,867 ($800) ($100)

$192,638 ($200,000) ($100)

$193,442 ($200,000) ($100)

($200,000)

90 days

180 days

270 days

($7,462)

($6,658)

($200,000)

90 days

180 days

270 days

Hence, the net cash flows are: $191,967

The 90-day compound interest rate is obtained by solving the following equation: 191,967 =

7, 462 6, 658 200, 000 + + 2 (1 + RATE ) (1 + RATE ) (1 + RATE )3

Using trial and error, a spreadsheet or a financial calculator, the solution is 3.843%. The annual percentage rate (APR) is found as follows:

APR = 3.843 

365 = 15.59% 90

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7-15

P=

365V 365 + RATE ( n )

First bill:

P=

( 365)(100, 000 ) = $97,126 365 + ( 0.12 )( 90 )

Second bill:

P=

( 365)(100, 000 ) = $97, 406 365 + ( 0.108 )( 90 )

Establishment fee = 100,000 × 0.3% = $300 payable at commencement.

Activity fee = 100,000 × 0.1% = $100 payable at day 0 and day 90.

The total cash flows arising from the bill financing are: $97,126 ($300) ($100)

$97,406 ($100,000) ($100)

($100,000)

90 days

180 days

Hence, the net cash flows are: $96,726

($2,694)

($100,000)

90 days

180 days

The 90-day compound interest rate is obtained by solving the following equation:

96, 726 =

2, 694 100, 000 + (1 + RATE ) (1 + RATE )2

Using trial and error, a spreadsheet or a financial calculator, the solution is 3.080%. The annual percentage rate (APR) is found as follows:

APR = 3.080 

365 = 12.49% 90

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7-16

Fee = 12 × 200,000 × 0.01 = $24,000 Interest cost = 0.75 × 400,000 × 0.13 = 39,000

RATE =

7-17* (a)

39, 000 + 24, 000 365  = 21% 300, 000 365

The average monthly amount of receivables sales is $400,000.

Face value of receivables factored

$400,000

Less: Factoring fee (6%)

(24,000)

Add:

Savings in credit department costs

Funds obtained by the firm each month

RATE =

(b)

1,500 $377,500

22,500 365  = 72.52% 377,500 30

The factor takes over management of the receivables, as reflected in the saving in monthly credit department administration costs. Factoring also removes the risk associated with their collection, such as bad debts and late payments. However, as shown here, the cost to the firm is very high.

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7-18

(a)

$400,000 loan = 0.80 × Acc. Rec.  Acc. Rec. = 400,000 / 0.8 = $500,000 Fee = 0.01 × 500,000 = $5,000 Interest cost = 0.11 × 400,000 × 90 / 365 = 10,849

RATE =

(b)

10,849 + 5, 000 365  = 16.07% 400, 000 90

Warehousing cost = 2,000 × 3 months = $6,000 Interest cost = 0.09 × 400,000 × 90 / 365 = 8,877

RATE =

8,877 + 6, 000 365  = 15.08% 400, 000 90

The inventory loan would be preferred since its cost is lower.

7-19

(a)

Field warehousing cost = 2,000 × 3 months = $6,000 Interest cost = 0.14 × 200,000 × 90 / 365 = 6,904

RATE =

(b)

6,904 + 6, 000 365  = 26.17% 200, 000 90

New interest cost = 0.14 × 280,000 × 90 / 365 = 9,665

RATE =

9, 665 + 6, 000 365  = 22.69% 280, 000 90

The cost of credit has declined because the fixed monthly warehouse fee of $2,000 is spread over a larger loan amount.

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7-20

(a)

The new plan will, in effect, reduce AMB’s annual wages payable by $250,000. Thus, with an annual opportunity cost of funds of 12% p.a., the dollar cost of the plan is: 0.12 × 250,000 = $30,000 per year

(b)

Assuming 26 fortnightly pay periods, AMB’s total wage bill for the year is: 250,000 × 26 = $6,500,000 Therefore, assuming the same wage level, AMB would have been equally well off if they had granted an increase in wages of $30,000 / $6,500,000 = 0.462% with retention of the monthly wage payment plan.

7-21

(a)

Assuming the firm cannot delay payment of its accounts beyond the normal trading terms (or else supply would be cut off), the cost of forgoing the trade discount of 2/10 net 30 for each month of the fourmonth period is equivalent to borrowing at the following annual rate: RATE =

(b)

0.02 365  = 74.49% 0.98 10

Pledged receivables fee = 0.0075 × 500,000 = $3,750 Interest cost = 0.085 × 250,000 × 120 / 365 = $6,986

RATE =

6,986 + 3, 750 365  = 13.06% 250, 000 120

The best alternative is to enter the pledging arrangement, because it has the lowest annual percentage cost.

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SOLUTION TO CASE STUDY Source of finance

Interest cost

Flexibility

Suitable for:

Nil

Occurs

Long-term funding of

wages and

automatically.

working capital.

taxes

Grows

Possibly seasonal

spontaneously as the

funding if size of the

business grows. No

work force is seasonal.

Spontaneous Accrued

security required.

Trade credit

Nil – as long as there is Occurs

Long-term funding of

no discount forgone.

automatically.

working capital.

The effective cost of

Grows

Possibly seasonal

this can be very high.

spontaneously as the

funding if the level of

business grows. No

sales is seasonal.

security required.

Discretionary Bank

The explicit interest

Relatively easy to set Daily fluctuations in

overdraft

cost is generally less

up as long as the

financing needs, as

than other sources of

borrower meets the

well as short-term

funding, but the

bank’s credit

emergency funding.

effective cost of any

standards. It is likely

unused limit fee must

that security will

be taken into account.

need to be provided.

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Bank bill

The cost of borrowing is

Some effort required

Short-term funding (e.g.

facility

usually low, and varies

to set up but not

seasonal funding). The

with short-term interest

difficult, as long as the maturity of the bills

rates. However,

borrower meets the

used can be matched

additional fees must be

bank’s credit

with the funding

paid, which depend on

standards. Allows for

requirements. A rollover

the borrower’s

adjustment each time

facility can also provide

creditworthiness, and

the bills mature.

flexible longer-term

needs to be taken into

Security will need to

financing.

account.

be provided.

Accounts

Both interest costs and

Can involve pledging

Suitable for short-term

receivable

fees need to be

of accounts receivable

financing (e.g. a number

loans

considered. This can be

(collateral for a loan)

of months). Given the

quite high, depending on

or factoring. Some

high cost, not

the credit quality of the

setting up required,

recommended as a

accounts receivable.

but not excessively

continuing source of

difficult.

finance.

Inventory

Both interest costs and

Some setting up

Suitable for short-term

loans

fees need to be

required, but not

financing (e.g. a

considered. This can be excessively difficult.

number of months).

quite high, depending

A field warehousing

Given the high cost,

on the marketability

agreement provides

not recommended as a

and perishability of

additional security.

continuing source of

inventory.

finance.

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Promissory notes have been omitted from this table because they are not normally available to SMEs. Because they are unsecured, only large creditworthy companies are normally able to access this source of finance.

A combination of these sources of finance is often recommended, to minimise risk in the event that one or more sources of finance becomes unavailable or excessively expensive, as well as to meet different funding needs. For example, spontaneous sources of finance are the least expensive and can be used to some extent for ongoing finance, but the amount available is limited. Discretionary sources of finance have an explicit cost and take some effort to set up, but give more flexibility. Some can be available for emergency funding (e.g. a bank overdraft), and some are suitable for short-term or seasonal funding (e.g. accounts receivable and inventory loans), while others can provide a flexible and convenient source of continuing finance (e.g. a bank bill rollover facility).

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SOLUTIONS TO CONCEPT CHECK QUESTIONS

7.1

Net working capital is the difference between the firm’s current assets and current liabilities and relates to liquidity in that it refers to the ability to have sufficient cash to pay commitments when they fall due.

7.2

Making reference to Figure 7.1 (Page 211) it can be seen that investment in additional marketable securities and inventories will result in LOWER firm profitability and HIGHER firm liquidity. Alternatively, increasing the use of short-term verses long-term sources of financing will result in HIGHER firm profitability and LOWER firm liquidity.

7.3

The hedging

principle involves matching

the cash flow generating

characteristics of an asset with the maturity of the source of funding used to acquire the asset.

7.4

Permanent investments in assets are those assets that will not be liquidated or replaced within 12 months. Temporary investments in assets are those assets that will be liquidated or replaced within 12 months.

7.5

Trade credit is a spontaneous source of finance.

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7.6

Three basic factors that influence a firm’s choice between alternative sources of short-term finance are: •

The effective cost of credit.

•

The availability of credit in the amount needed and for what period when financing is required.

•

The influence of the use of a particular credit source on the cost and availability of other sources of funding.

7.7

The EAR is preferable because it incorporates the influences and effects of compounding whereas the nominal rate does not.

7.8

Spontaneous sources of short-term finance include: •

Accrued wages and taxes

•

Trade credit

Discretionary sources of short-term finance include:

7.9

•

Bank overdrafts

•

Secured lending

•

Promissory notes

•

Bills of exchange

In Australia, most business firms – whether they are large or small – make extensive use of a bank overdraft as a key component of working-capital management. A bank overdraft is seen as integral in smoothing the bumps of cash flowing.

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7.10

A promissory note is a short-term financial instrument whereby the borrower (drawer) promises to repay the face value, at maturity to the holder. A bill is a short-term financial instrument requiring the face value to be paid on demand or at a specified date.

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SOLUTIONS TO SELF-TEST QUESTIONS

ST-1 (a)

Current ratio = Current assets/Current liabilities = $100,000/$60,000 = 1.67

Net working capital

= Current assets – Current liabilities = $100,000 – $60,000 = $40,000

Return on total assets = Net income/Total assets = $20,000/$200,000 = 10%

(b)

Current ratio = $120,000/$60,000 = 2.00 (previously 1.67)

Net working capital = $120,000 – $60,000 = $60,000 (previously $40,000)

Return on total assets = $21,120/$220,000 = 9.64% (previously 10%)

(c)

Yes, the firm’s liquidity position as measured by the current ratio and the amount of net working capital has definitely improved. However, as we see in the return-on-total-assets ratio, profitability has been adversely affected.

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(d)

Simplex’s return on total assets declined from 10% to 9.64% as a result of the new financing plan. This occurred because it was earning 10% after taxes on its $200,000 investment and it invested $20,000 in marketable securities earning only 5.6% after taxes. The result was a decline in firm profitability in relation to assets.

ST-2 (a)

Current ratio = Current assets/Current liabilities = $100,000/$70,000 = 1.43

Net working capital

= Current assets – Current liabilities = $100,000 – $70,000 = $30,000

Return on total assets = Net income/Total assets = $38,400/$300,000 = 12.8%

(b)

Instructor's Note: There is an error in the text in this question. The after-tax income figure of $41,440 is incorrect. It is based on a 30% tax rate. The correct figure is $37,888. The calculation is shown below. This figure has been used in the following solution. To use the incorrect figure in the text would result in an invalid conclusion.

.

Operating income

72,800

Plus: Interest income1

1,600

Less: Interest expense2

(15,200)

Earnings before tax

59,200

Less Taxes (36%)

(21,312)

Net income

37,888

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1

Interest income = 0.08 × 40,000 × ½ = $1,600

2

Interest expense = 0.13 × 40,000 + 0.10 × 100,000 = $15,200

Current ratio = $100,000/$30,000 = 3.33 (previously 1.43)

Net working capital

= $100,000 – $30,000 = $70,000 (previously

$30,000)

Return on total assets = $37,888/$300,000 = 12.6% (previously 12.8%)

(c)

Yes, the current ratio of 3.33 is now well above the standard of 2 when the funds are needed.

(d)

Company profitability declined slightly because the firm used a permanent source of financing to replace a more flexible short-term source. The firm actually saves interest expense through the plan during the six-month period when the funds are needed (13% on long-term funds versus 14% on short-term notes); however, during the six months when the funds are not needed, the firm can earn a before-tax return of only 8%, while the funds cost 13%. In this case, the added liquidity of the plan appears to overshadow the modest loss in expected profitability.

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ST-3 The promissory notes would have an issue price of $100,000 – $4,931.51 = $95,068.49, which for 2,000 notes results in funds of $190,136,980 being raised.

After payment of the placement fee, the company would obtain total finance of $190,136,980 – $125,000 = $190,011,980 (P). The sum repaid is $200,000,000 (V) in 180 days’ time. Thus, the annual cost of finance can be found in two ways:

RATE = =

200, 000, 000 − 190, 011,980 365  = 10.66% 190, 011,980 180 365  V  365  200, 000, 000    − 1 = − 1 = 10.66% n  P  180  190, 011,980 

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