C7

Chapter
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
7
•Short-Term Finance and
Planning

Introduction
• Net working capital - short term financial decisions…
Current assets minus current liabilities
• Working capital management - short-term financial
decisions
• 3 important questions:
1) What is a reasonable level of cash to keep on
hand (in bank) to pay bills?
2) How much should the firm borrow in the short
term?
3) How much credit should be extended to
customers?
2

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?
Risk-Return Trade-off:
Current assets earn low returns, but help
reduce the risk of illiquidity.
3

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?
Risk-Return Trade-off:
Current liabilities are less expensive, but increase
the risk of illiquidity.
4

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.
5

Balance Sheet
Temporary Temporary
Current Assets Short-term financing
Permanent Permanent
Fixed Assets Financing
and
Spontaneous
Financing
6

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.
7

Figure 15-1
© 2011 Pearson Prentice Hall. All rights reserved.
8

9
Sources and Uses of Cash
• Balance sheet identity (rearranged)
• NWC + fixed assets = long-term debt + equity
• NWC = cash + other CA – CL
• Cash = long-term debt + equity + CL – CA other than
cash – fixed assets
• Sources
• Increasing long-term debt, equity or current liabilities
• Decreasing current assets other than cash or fixed
assets
• Uses
• Decreasing long-term debt, equity or current liabilities
• Increasing current assets other than cash or fixed
assets

Cash Conversion Cycle (CCC)
- to evaluate the effectiveness of the working capital management.
- To minimize working capital: speeding up the collection of cash
from sales, increasing inventory turns and slowing down the
disbursement of cash.
CCC = days of sales outstanding (DSO) + days of sales in
inventory (DSI) + days of payable outstanding (DPO)
Where:
DSO = account receivable/(sales/365)
DSI = inventories/(COGS/365)
DPO = account payable/(COGS/365)
*** number of days in 1 year – 360 or 365 (depends on the questions)
10

11
The Operating Cycle
• Operating cycle – time between
purchasing the inventory and collecting the
cash from selling the inventory
• Inventory period – time required to
purchase and sell the inventory
• Accounts receivable period – time required
to collect on credit sales
• Operating cycle = inventory period +
accounts receivable period

12
Cash Cycle
• Cash cycle
• Amount of time we finance our inventory
• Difference between when we receive cash
from the sale and when we have to pay for the
inventory
• Accounts payable period – time between
purchase of inventory and payment for the
inventory
• Cash cycle = Operating cycle –
accounts payable period

Company Industry Operating
cycle
Account
payable
period
Cash
cycle
Tesco
PLC
Retail 37 69 -32
SP Setia Property
develop
ment
367 96 271
Proton Manufa
cturing
101 81 20
Air Asia Service 11 7 4
Cash cycles (day) for selected listed
companies
14

15
Short-Term Financial Policy
• Size of investments in current assets
• Flexible (conservative) policy – maintain a
high ratio of current assets to sales
• Restrictive (aggressive) policy – maintain a
low ratio of current assets to sales
• Financing of current assets
• Flexible (conservative) policy – less short-term
debt and more long-term debt
• Restrictive (aggressive) policy – more short-
term debt and less long-term debt

16
Carrying vs. Shortage Costs
• Managing short-term assets involves a
trade-off between carrying costs and
shortage costs
• Carrying costs – increase with increased
levels of current assets, the costs to store and
finance the assets
• Shortage costs – decrease with increased
levels of current assets
• Trading or order costs
• Costs related to safety reserves, i.e., lost sales and
customers and production stoppages

The optimal investment in
current assets
17

Financing Policies for Current
Assets (Flexible VS Restrictive)
19

Financing Policies for Current
Assets (Compromise policy)
20

21
Choosing the Best Policy
• Cash reserves
• High cash reserves mean that firms will be less likely to experience
financial distress and are better able to handle emergencies or take
advantage of unexpected opportunities
• Cash and marketable securities earn a lower return and are zero NPV
investments
• Maturity hedging
• Try to match financing maturities with asset maturities
• Finance temporary current assets with short-term debt
• Finance permanent current assets and fixed assets with long-term debt
and equity
• Interest Rates
• Short-term rates are normally lower than long-term rates, so it may be
cheaper to finance with short-term debt
• Firms can get into trouble if rates increase quickly or if it begins to have
difficulty making payments – may not be able to refinance the short-term
loans
• Have to consider all these factors and determine a compromise
policy that fits the needs of the firm

22
Cash Budget
• Forecast of cash inflows and outflows over
the next short-term planning period
• Primary tool in short-term financial planning
• Helps determine when the firm should
experience cash surpluses and when it will
need to borrow to cover working-capital costs
• Allows a company to plan ahead and begin
the search for financing before the money is
actually needed

Example of cash budget
• The following is the sales budget for ABC Inc:
• Credit sales are collected as follows:
• 20% in the month of the sale
• 30% in the month after sale
• 50% in the second month after sale.
23
Year Sales ( in thousand)
Feb 2013 RM150
Mar 2013 RM170
Apr 2013 RM190
May 2013 RM220
June 2013 RM250

24
Cash Budget Information
• Other expenses
• Wages, taxes and other expense are 30% of
sales
• Cash purchases of RM50,000 , RM25,000 and
35,000 respectively in Apr, May and June 2013.
• A major capital expenditure of $100,000 is
expected in May 2013
• The initial cash balance is $80,000 and the
company maintains a minimum balance of
$500,000
• Interest on accumulated loan is at 12% annual
interest and is paid in the following month.

25
ABC Inc’s Cash budget for Apr-June
2013 (in thousand)
Feb Mar Apr May June
Sales 150 170 190 220 250
Cash Collection:
Cash sales (20%) 30 34 38 44 50
2nd
collection (30%) 45 51 57 66
3rd
collection (50%) 75 85 95
Total cash collection 164 186 211

26
2013 (in thousand)
Cash disbursement:
Wages, taxes & other
expenses
57 66 75
Cash purchases 50 25 35
Capital expenditure 100
Total cash
disbursement
107 191 110

27
2013 (in thousand)
Change in net cash
(cash collection-
cash disbursement)
57 -5 101
Beginning balance 80 500 500
Interest expenses - (3.63) (3.71)
Additional financing 363 8.63 (97.29)
Ending balance 500 500 500
Accumulated financing 363 371.63 274.34

Cost of Short-term Credit
28
Interest = principal × rate × time
Cost of short-term financing = annual percentage
rate (APR)
APR = (interest / principal) * (1 / time)
A company plans to borrow $1,000 for 180 days.
At maturity, the company will repay the $1,000
principal amount plus $40 interest. What is the
APR?
APR = ($40/$1,000) × [1/(180/360)]
= .04 × (180/90)
= .08 or 8%

Annual Percentage Yield (APY)
27
 APR does not consider compound interest. To account for the influence
of compounding, we must calculate APY or annual percentage yield
 APY = (1 + i/m)m
– 1
 Where:
 i is the nominal rate of interest per year;
 m is number of compounding period within a year
 In the previous example,
 # of compounding periods 360/180 = 2
 Rate = 8%
 APY = (1 + .08/2)2
–1
= .0816 or 8.16%
APR or APY ?
-Because the differences between APR and APY are usually small,
we can use the simple interest values of APR to compute the cost of
short-term credit.

Sources and Costs of Short-term
Credit
30
Short-term credit sources can be classified into two basic
groups:
 Unsecured sources
-Unsecured loans include all of those sources that have as
their security only the lender’s faith in the ability of the
borrower to repay the funds when due.
-Major sources-accrued wages and taxes, trade credit,
unsecured bank loans, and commercial paper
-Since employees are paid periodically (biweekly or
monthly), firms accrue a wage payable account that is, in
essence, a loan from their employees.
- Similarly, if taxes are deferred or paid periodically, the
firm has the use of the tax money.

31
Unsecured source: Trade credit arises spontaneously with
the firm’s purchases. Often, the credit terms offered with
trade credit involve a cash discount for early payment.
Terms such as 2/10 net 30 means a 2% discount is offered
for payment within 10 days, or the full amount is due in 30
days
A 2% penalty is involved for not paying within 10 days.
Effective Cost of Passing Up a Discount
-Terms 2/10 net 30
-The equivalent APR of this discount is:
APR = $.02/$.98 × [1/(20/360)]
= .3673 or 36.73%
-The effective cost of delaying payment for 20 days is 36.73%

30
Unsecured source: bank credit
 Commercial banks provide unsecured short-term credit in two forms:
1) Lines of credit
-Informal agreement between a borrower and a bank about the maximum
amount of credit the bank will provide the borrower at any one time.
-There is no legal commitment on the part of the bank to provide the stated
credit.
-Banks usually require that the borrower maintain a minimum balance in the
bank throughout the loan period (known as compensating balance).
-Interest rate on line of credit tends to be floating.
-Revolving Credit- is a variant of the line of credit form of financing, a legal
obligation is involved
2) Transaction loans (notes payable)
-Transaction loan is made for a specific purpose. This is the type of loan
that most individuals associate with bank credit and is obtained by signing
a promissory note.

31
Unsecured source: Commercial Paper
 The largest and most credit worthy companies are able to use commercial
paper—a short-term promise to pay that is sold in the market for short-term
debt securities.
 Maturity: Usually 6 months or less.
 Interest Rate: Slightly lower (1/2 to 1%) than the prime rate on commercial
loans.
 New issues of commercial paper are placed directly or dealer placed.
 Advantages:
1) Interest rates
 Rates are generally lower than rates on bank loans
2)Compensating-balance requirement
 No minimum balance requirements are associated with commercial
paper
3)Amount of credit
 Offers the firm with very large credit needs a single source for all its
short-term financing
4)Prestige
 Signifies credit status

34
 Secured sources
-Involve the pledge of specific assets as collateral in the event the
borrower defaults in payment of principal or interest
-Primary Suppliers: Commercial banks, finance companies, and factors
-Principal sources of collateral: Accounts receivable and inventories
-Secured Sources of Loans
* Secured loans have assets of firm pledged as collateral. If there is a
default, the lender has first claim to the pledged assets. Because of its
liquidity, accounts receivable is regarded as the prime source for collateral.
*Accounts Receivable loans
 Pledging Accounts Receivable
 Factoring Accounts Receivable
* Inventory loans

Pledging Accounts Receivable
35
Borrower pledges accounts receivable as collateral for a loan
obtained from either a commercial bank or a finance company
The amount of the loan is stated as a percentage of the face
value of the receivables pledged
If the firm pledges a general line, then all of the accounts are
pledged as security. (Simple and inexpensive)
If the firm pledges specific invoices each invoice must be
evaluated for creditworthiness. (more expensive)
Credit Terms: Interest rate is 2–5% higher than the bank’s prime
rate. In addition, handling fee of 1–2% of the face value of
receivables is charged.
While pledging has the attraction of offering considerable
flexibility to the borrower and providing financing on a continuous
basis, the cost of using pledging as a source of short-term
financing is relatively higher compared to other sources.

Factoring Accounts Receivable
36
• Factoring accounts receivable involves the
outright sale of a firm’s accounts to a financial
institution called a factor.
• A factor is a firm (such as commercial
financing firm or a commercial bank) that
acquires the receivables of other firms. The
factor bears the risk of collection in exchange
for a fee of 1–3 percent of the value of all
receivables factored.

Secured Sources: Inventory Loans
37
• These are loans secured by inventories
• The amount of the loan that can be obtained
depends on the marketability and perishability of
the inventory
• Types:
• Floating lien agreement
• Chattel Mortgage agreement
• Field warehouse-financing agreement
• Terminal warehouse agreement

Types of Inventory Loans
38
Floating or blanket Lien Agreement
The borrower gives the lender a lien against all its inventories.
Chattel Mortgage Agreement
The inventory is identified and the borrower retains title to the
inventory but cannot sell the items without the lender’s
consent.
Field warehouse-financing agreement
Inventories used as collateral are physically separated from
the firm’s other inventories and are placed under the control of
a third-party field-warehousing firm.
Terminal warehouse agreement
inventories pledged as collateral are transported to a public
warehouse that is physically removed from the borrower’s
premises.

EXERCISES:
39
Calculate the effective cost of the following trade credit terms when
payment is made on the net due date (360 days in 1 year)
a) 2/10, net 30
b) 3/15, net 30
a) (0.02/0.98) x [1/(20/360)]= 0.36734 or 36.73%
b) (0.03/0.97) x [1/(15/360)] = 0.74226 or 74.23%
Compute the EAR for a & b.
a) [1+(0.3673/18)]^18 - 1 = 43.85%
b) [1+(0.7423/24)]^24 - 1 = 107.73%

40
The Rosewood Corporation established a line of credit with a local bank.
The maximum amount that can be borrowed under the terms of the
agreement is $500,000 at a rate of 10 percent. A compensating balance
averaging 15 percent of the loan is required. Prior to the agreement,
Rosewood had maintained an account at the bank averaging $25,000. Any
additional funds needed for the compensating balance will also have to be
borrowed at the 10 percent rate. If the firm needs $280,000 for 6 months,
what is the annual cost of the loan?
Borrowed Funds = $280,000 - $25,000
0.85
Borrowed Funds = $304,411.8
Rate = $304,411.80 × (.10/2) × 1
$280,000 (180/360)
Rate = .1087 per year

41
MovieTone, Inc. is a producer and distributor of specialty DVDs. It sells directly to large
retail firms on terms of net 60 and has average monthly sales of $350,000. It has recently
decided to pledge all of its accounts receivable to its bank. The bank advances up to 80
percent of the face value of these receivables at a rate of 4 percent over the prime rate,
while charging 2.5 percent on all receivables pledged for processing to cover billing and
collection services. Prior to this arrangement MovieTone was spending $50,000 a year on
its credit department. The prime rate is 6 percent.
a. What is the average level of accounts receivable?
b. What is the effective cost of using this short-term credit for one year?
a. 2 × $350,000 = $700,000
b. Rate = $56,000 + $105,000 - $50,000 × 1 = 0.1982
560,000 (360/360)
Annual interest expense = 0.10 × 0.80 × $700,000 = $56,000
Processing fee = .025 × $350,000 x12 = $105,000

The EPG manufacturing Company uses
commercial paper regular to support its needs
for short-term financing. The firm plan to sell
$100 million in 270-day-maturity paper, on which
it expects to pay discounted interest at a rate of
12% per annum. In addition, EPG expects to
incur a cost of approximately $100,000 in dealer
placement fees an other expenses of issuing
paper. What is the effective cost of credit to
EPG?
41

The Burlington Western Company plans to issue
a commercial paper of $20 million. The
commercial paper will carry a 270-day maturity
and require interest based on a rate of 11% per
annum. In addition, the firm will have to pay fees
totaling $200,000 to bring the issue to market and
place it. What is the effective cost of the
commercial paper to Burlington Western?
42

Calculate the effective cost of the following
trade credit terms when payment is made
on the net due date.
a) 3/15 net 45
b) 2/15 net 60
• Calculate the EAR for (a) and (b).
43

Penn Inc. needs to borrow $250,000 for the next 6 months. The
company has a line of credit with a bank that allows the company
to borrow funds with an 8% interest rate subject to a 20% of loan
compensating balance. Currently, Penn Inc. has no funds on
deposit with the bank and will need the loan to cover the
compensating balance as well as their other financing needs.
a) How much will Penn Inc. need to borrow?
b) What will be the annual percentage rate, or APR, for this
financing?
c) If the company maintains $20,000 in its bank account,
recalculate APR.
44

A project for Jevon and Aaron, Inc. results
in additional accounts receivable of
RM400,000, additional inventory of
RM180,000, and additional accounts
payable of RM70,000. What is the
additional investment in net working
capital?
45

A company collects 25 percent of its
sales during the month of sale, 65
percent one month after the sale, and
10 percent two months after the sale.
The company expects sales of
RM50,000 in August, RM80,000 in
September, RM90,000 in October, and
RM60,000 in November. How much
money is expected to be collected in
October?

Syarikat Untung Rugi Sdn. Bhd has projected the following budget for the
second quarter of 2012:
ITEMS APRIL (RM) MAY (RM) JUNE (RM)
Credit sales 380,000 396,000 438,000
Credit purchases 147,000 175,500 200,500
Cash
disbursement:
Wages, taxes &
expenses
39,750 48,210 50,300
Interest on existing
debt
11,400 11,400 11,400
Equipment
purchases
83,000 91,000 0

The company predicts that 5 percent of its credit sales
will never be collected. 40 percents of its sales will be
collected in the month of sale, and the remaining 55
percent will be collected in the following month. Credit
purchases will be paid in the month following the
purchase. In March 2012, credit sales were RM210,000
and credit purchases were RM156,000. Using this
information,
a) What is Syarikat Untung Rugi’s projected total
disbursement for May 2012?
b) What is Syarikat Untung Rugi’s projected total cash
receipts for April 2012?
48

The Carmel Corporation’s projected sales for the first eight months
of 2001 are as follows:
January: $100,000 May:$275,000
February:$110,000 June:$250,000
March:$130,000 July:$235,000
April:$250,000 August:$160,000
• Of Carmel’s sales, 20% is for cash, another 60% is collected in the
month following sale, and 20 percent is collected in the second
month following sale. November and December sales for 2000 were
$220,000 and $175,000, respectively.
• Carmel purchases its raw materials two months in advance of its
sales equal to 70% of its final sales price. The supplier is paid one
month after it makes delivery.
49

• In addition, Carmel pays $10,000 per month for rent and $20,000
each month for other expenditures. Tax prepayments for
$23,000 are made in March and June.
• The company’s cash balance at December 31, 2000, was
$22,000; a minimum balance of $20,000 must be maintained at
all times.
• Assume that any short-term financing needed to maintain that
cash balance would be paid off in the month following the month
of financing, if sufficient funds are available.
• Interest on short-term loans (12% annually) is paid monthly.
Borrowing to meet estimated monthly cash needs takes place at
the beginning of the month.
Prepare a cash budget for Carmel covering the first seven
months of 2001.
50

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