Fundamentals of Corporate Finance Phần 4 docx

FINANCE IN ACTION

Your total payment at the end of the month would be

Repayment of face value plus interest = $100,000 + $1,000 = $101,000

Earlier you learned to distinguish between simple interest and compound interest. We

have just seen that your 12 percent simple interest bank loan costs 1 percent per month.

One percent per month compounded for 1 year cumulates to 1.0112 = 1.1268. Thus the

compound, or effective, annual interest rate on the bank loan is 12.68 percent, not the

quoted rate of 12 percent.

The general formula for the equivalent compound interest rate on a simple interest

loan is

Effective annual rate = (1 + quoted annual interest rate)

m

– 1

m

where the annual interest rate is stated as a fraction (.12 in our example) and m is the

number of periods in the year (12 in our example).

DISCOUNT INTEREST

The interest rate on a bank loan is often calculated on a discount basis. Similarly, when

companies issue commercial paper, they also usually quote the interest rate as a dis￾188

The Hazards of Secured Bank Lending

The National Safety Council of Australia’s Victoria Divi￾sion had been a sleepy outfit until John Friedrich took

over. Under its new management, NSC members

trained like commandos and were prepared to go any￾where and do anything. They saved people from drown￾ing, they fought fires, found lost bushwalkers and went

down mines. Their lavish equipment included 22 heli￾copters, 8 aircraft and a mini-submarine. Soon the NSC

began selling its services internationally.

Unfortunately the NSC’s paramilitary outfit cost mil￾lions of dollars to run— far more than it earned in rev￾enue. Friedrich bridged the gap by borrowing $A236

million of debt. The banks were happy to lend because

the NSC’s debt appeared well secured. At one point the

company showed $A107 million of receivables (that is,

money owed by its customers), which it pledged as se￾curity for bank loans. Later checks revealed that many

of these customers did not owe the NSC a cent. In

other cases banks took comfort in the fact that their

loans were secured by containers of valuable rescue

gear. There were more than 100 containers stacked

around the NSC’s main base. Only a handful contained

any equipment, but these were the ones that the

bankers saw when they came to check that their loans

were safe. Sometimes a suspicious banker would ask

to inspect a particular container. Friedrich would then

explain that it was away on exercise, fly the banker

across the country in a light plane and point to a con￾tainer well out in the bush. The container would of

course be empty, but the banker had no way to know

that.

Six years after Friedrich was appointed CEO, his

massive fraud was uncovered. But a few days before a

warrant could be issued, Friedrich disappeared. Al￾though he was eventually caught and arrested, he shot

himself before he could come to trial. Investigations re￾vealed that Friedrich was operating under an assumed

name, having fled from his native Germany, where he

was wanted by the police. Many rumors continued to

circulate about Friedrich. He was variously alleged to

have been a plant of the CIA and the KGB and the NSC

was said to have been behind an attempted counter￾coup in Fiji. For the banks there was only one hard truth.

Their loans to the NSC, which had appeared so well se￾cured, would never be repaid.

Source: Adapted from Chapter 7 of T. Sykes, The Bold Riders (St.

Leonards, NSW, Australia: Allen & Unwin, 1994).

Working Capital Management and Short-Term Planning 189

count. With a discount interest loan, the bank deducts the interest up front. For exam￾ple, suppose that you borrow $100,000 on a discount basis for 1 year at 12 percent. In

this case the bank hands you $100,000 less 12 percent, or $88,000. Then at the end of

the year you repay the bank the $100,000 face value of the loan. This is equivalent to

paying interest of $12,000 on a loan of $88,000. The effective interest rate on such a

loan is therefore $12,000/$88,000 = .1364, or 13.64 percent.

Now suppose that you borrow $100,000 on a discount basis for 1 month at 12 per￾cent. In this case the bank deducts 1 percent up-front interest and hands you

Face value of loan × (1 – quoted annual interest rate ) number of periods in the year

= $100,000 × (1 – .12) = $99,000 12

At the end of the month you repay the bank the $100,000 face value of the loan, so you

are effectively paying interest of $1,000 on a loan of $99,000. The monthly interest rate

on such a loan is $1,000/$99,000 = 1.01 percent and the compound, or effective, annual

interest rate on this loan is 1.010112 – 1 = .1282, or 12.82 percent. The effective inter￾est rate is higher than on the simple interest rate loan because the interest is paid at the

beginning of the month rather than the end.

The general formula for the equivalent compound interest rate on a discount interest

loan is

1

m

Effective annual rate on a discount loan = – 1 1 – quoted annual interest rate

m

where the quoted annual interest rate is stated as a fraction (.12 in our example) and m

is the number of periods in the year (12 in our example).

INTEREST WITH COMPENSATING BALANCES

Bank loans often require the firm to maintain some amount of money on balance at the

bank. This is called a compensating balance. For example, a firm might have to main￾tain a balance of 20 percent of the amount of the loan. In other words, if the firm bor￾rows $100,000, it gets to use only $80,000, because $20,000 (20 percent of $100,000)

must be left on deposit in the bank.

If the compensating balance does not pay interest (or pays a below-market rate of in￾terest), the actual interest rate on the loan is higher than the stated rate. The reason is

that the borrower must pay interest on the full amount borrowed but has access to only

part of the funds. For example, we calculated above that a firm borrowing $100,000 for

1 month at 12 percent simple interest must pay interest at the end of the month of

$1,000. If the firm gets the use of only $80,000, the effective monthly interest rate is

$1,000/$80,000 = .0125, or 1.25 percent. This is equivalent to a compound annual in￾terest rate of 1.012512 – 1 = .1608, or 16.08 percent.

In general, the compound annual interest rate on a loan with compensating bal￾ances is

Effective annual rate on a = ( 1 + actual interest paid ) m

– 1 loan with compensating balances borrowed funds available

where m is the number of periods in the year (again 12 in our example).

190 SECTION TWO

Self-Test 6 Suppose that Dynamic Mattress needs to raise $20 million for 6 months. Bank A quotes

a simple interest rate of 7 percent but requires the firm to maintain an interest-free com￾pensating balance of 20 percent. Bank B quotes a simple interest rate of 8 percent but

does not require any compensating balances. Bank C quotes a discount interest rate of

7.5 percent and also does not require compensating balances. What is the effective (or

compound) annual interest rate on each of these loans?

Summary

Why do firms need to invest in net working capital?

Short-term financial planning is concerned with the management of the firm’s short-term,

or current, assets and liabilities. The most important current assets are cash, marketable

securities, inventory, and accounts receivable. The most important current liabilities are

bank loans and accounts payable. The difference between current assets and current

liabilities is called net working capital.

Net working capital arises from lags between the time the firm obtains the raw materials

for its product and the time it finally collects its bills from customers. The cash conversion

cycle is the length of time between the firm’s payment for materials and the date that it gets

paid by its customers. The cash conversion cycle is partly within management’s control. For

example, it can choose to have a higher or lower level of inventories. Management needs to

trade off the benefits and costs of investing in current assets. Higher investments in current

assets entail higher carrying costs but lower expected shortage costs.

How does long-term financing policy affect short-term financing requirements?

The nature of the firm’s short-term financial planning problem is determined by the amount

of long-term capital it raises. A firm that issues large amounts of long-term debt or common

stock, or which retains a large part of its earnings, may find that it has permanent excess

cash. Other firms raise relatively little long-term capital and end up as permanent short-term

debtors. Most firms attempt to find a golden mean by financing all fixed assets and part of

current assets with equity and long-term debt. Such firms may invest cash surpluses during

part of the year and borrow during the rest of the year.

How does the firm’s sources and uses of cash relate to its need for short-term bor￾rowing?

The starting point for short-term financial planning is an understanding of sources and uses

of cash. Firms forecast their net cash requirement by forecasting collections on accounts

receivable, adding other cash inflows, and subtracting all forecast cash outlays. If the

forecast cash balance is insufficient to cover day-to-day operations and to provide a buffer

against contingencies, you will need to find additional finance. For example, you may

borrow from a bank on an unsecured line of credit, you may borrow by offering receivables

or inventory as security, or you may issue your own short-term notes known as commercial

paper.

How do firms develop a short-term financing plan that meets their need for cash?

The search for the best short-term financial plan inevitably proceeds by trial and error. The

financial manager must explore the consequences of different assumptions about cash

Working Capital Management and Short-Term Planning 191

requirements, interest rates, limits on financing from particular sources, and so on. Firms

are increasingly using computerized financial models to help in this process. Remember the

key differences between the various sources of short-term financing—for example, the

differences between bank lines of credit and commercial paper. Remember too that firms

often raise money on the strength of their current assets, especially accounts receivable and

inventories.

www.businessfinancemag.com/ Business Finance Magazine has resources and software reviews

for financial planning

www.toolkit.cch.com/ Financial planning resources of all kinds

http://edge.lowe.org/quick/finance/ Short-term financial management tools

www.ibcdata.com/index.html Short-term investment and money fund rates

net working capital carrying costs line of credit

cash conversion cycle shortage costs commercial paper

1. Working Capital Management. Indicate how each of the following six different transac￾tions that Dynamic Mattress might make would affect (i) cash and (ii) net working capital:

a. Paying out a $2 million cash dividend.

b. A customer paying a $2,500 bill resulting from a previous sale.

c. Paying $5,000 previously owed to one of its suppliers.

d. Borrowing $1 million long-term and investing the proceeds in inventory.

e. Borrowing $1 million short-term and investing the proceeds in inventory.

f. Selling $5 million of marketable securities for cash.

2. Short-Term Financial Plans. Fill in the blanks in the following statements:

a. A firm has a cash surplus when its ________ exceeds its ________. The surplus is nor￾mally invested in ________.

b. In developing the short-term financial plan, the financial manager starts with a(n)

________ budget for the next year. This budget shows the ________ generated or ab￾sorbed by the firm’s operations and also the minimum ________ needed to support these

operations. The financial manager may also wish to invest in ________ as a reserve for

unexpected cash requirements.

3. Sources and Uses of Cash. State how each of the following events would affect the firm’s

balance sheet. State whether each change is a source or use of cash.

a. An automobile manufacturer increases production in response to a forecast increase in

demand. Unfortunately, the demand does not increase.

b. Competition forces the firm to give customers more time to pay for their purchases.

c. The firm sells a parcel of land for $100,000. The land was purchased 5 years earlier for

$200,000.

d. The firm repurchases its own common stock.

e. The firm pays its quarterly dividend.

f. The firm issues $1 million of long-term debt and uses the proceeds to repay a short-term

bank loan.

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Key Terms

Quiz

192 SECTION TWO

4. Cash Conversion Cycle. What effect will the following events have on the cash conversion

cycle?

a. Higher financing rates induce the firm to reduce its level of inventory.

b. The firm obtains a new line of credit that enables it to avoid stretching payables to its sup￾pliers.

c. The firm factors its accounts receivable.

d. A recession occurs, and the firm’s customers increasingly stretch their payables.

5. Managing Working Capital. A new computer system allows your firm to more accurately

monitor inventory and anticipate future inventory shortfalls. As a result, the firm feels more

able to pare down its inventory levels. What effect will the new system have on working cap￾ital and on the cash conversion cycle?

6. Cash Conversion Cycle. Calculate the accounts receivable period, accounts payable period,

inventory period, and cash conversion cycle for the following firm:

Income statement data:

Sales 5,000

Cost of goods sold 4,200

Balance sheet data:

Beginning of Year End of Year

Inventory 500 600

Accounts receivable 100 120

Accounts payable 250 290

7. Cash Conversion Cycle. What effect will the following have on the cash conversion cycle?

a. Customers are given a larger discount for cash transactions.

b. The inventory turnover ratio falls from 8 to 6.

c. New technology streamlines the production process.

d. The firm adopts a policy of reducing outstanding accounts payable.

e. The firm starts producing more goods in response to customers’ advance orders instead

of producing for inventory.

f. A temporary glut in the commodity market induces the firm to stock up on raw materi￾als while prices are low.

8. Compensating Balances. Suppose that Dynamic Sofa (a subsidiary of Dynamic Mattress)

has a line of credit with a stated interest rate of 10 percent and a compensating balance of

25 percent. The compensating balance earns no interest.

a. If the firm needs $10,000, how much will it need to borrow?

b. Suppose that Dynamic’s bank offers to forget about the compensating balance require￾ment if the firm pays interest at a rate of 12 percent. Should the firm accept this offer?

Why or why not?

c. Redo part (b) if the compensating balance pays interest of 4 percent. Warning: You can￾not use the formula in the material for the effective interest rate when the compensating

balance pays interest. Think about how to measure the effective interest rate on this loan.

Practice

Problems

Working Capital Management and Short-Term Planning 193

9. Compensating Balances. The stated bank loan rate is 8 percent, but the loan requires a

compensating balance of 10 percent on which no interest is earned. What is the effective in￾terest rate on the loan? What happens to the effective rate if the compensating balance is

doubled to 20 percent?

10. Factoring. A firm sells its accounts receivables to a factor at a 1.5 percent discount. The av￾erage collection period is 1 month. What is the implicit effective annual interest rate on the

factoring arrangement? Suppose the average collection period is 1.5 months. How does this

affect the implicit effective annual interest rate?

11. Discount Loan. A discount bank loan has a quoted annual rate of 6 percent.

a. What is the effective rate of interest if the loan is for 1 year and is paid off in one pay￾ment at the end of the year?

b. What is the effective rate of interest if the loan is for 1 month?

12. Compensating Balances. A bank loan has a quoted annual rate of 6 percent. However, the

borrower must maintain a balance of 25 percent of the amount of the loan, and the balance

does not earn any interest.

a. What is the effective rate of interest if the loan is for 1 year and is paid off in one pay￾ment at the end of the year?

b. What is the effective rate of interest if the loan is for 1 month?

13. Forecasting Collections. Here is a forecast of sales by National Bromide for the first 4

months of 2001 (figures in thousands of dollars):

Month: 1 2 3 4

Cash sales 15 24 18 14

Sales on credit 100 120 90 70

On average, 50 percent of credit sales are paid for in the current month, 30 percent in the

next month, and the remainder in the month after that. What are expected cash collections

in months 3 and 4?

14. Forecasting Payments. If a firm pays its bills with a 30-day delay, what fraction of its pur￾chases will be paid for in the current quarter? In the following quarter? What if its payment

delay is 60 days?

15. Short-Term Planning. Paymore Products places orders for goods equal to 75 percent of its

sales forecast in the next quarter. What will be orders in each quarter of the year if the sales

forecasts for the next five quarters are:

Quarter in Coming Year Following Year

First Second Third Fourth First quarter

Sales forecast $372 $360 $336 $384 $384

16. Forecasting Payments. Calculate Paymore’s cash payments to its suppliers under the as￾sumption that the firm pays for its goods with a 1-month delay. Therefore, on average, two￾thirds of purchases are paid for in the quarter that they are purchased and one-third are paid

in the following quarter.

17. Forecasting Collections. Now suppose that Paymore’s customers pay their bills with a 2-

month delay. What is the forecast for Paymore’s cash receipts in each quarter of the coming

year? Assume that sales in the last quarter of the previous year were $336.

18. Forecasting Net Cash Flow. Assuming that Paymore’s labor and administrative expenses

are $65 per quarter and that interest on long-term debt is $40 per quarter, work out the net

cash inflow for Paymore for the coming year using a table like Table 2.7.