Ch.
15:
Introduction to
Working Capital
Management
10/2/20 1
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?
10/2/20 2
Working-Capital Management
Illiquidity
Illiquid refers to the state of a stock, bond, or other assets that
cannot easily and readily be sold or exchanged for cash without a
substantial loss in value. ... Illiquidity occurs when a security or
other asset that cannot easily and quickly be sold or exchanged
for cash without a substantial loss in value.
Examples of illiquid assets include penny stocks, microcap
stocks and nanocap stocks; ownership interests in private
companies; collectibles like art and antiques; partnership shares
in hedge funds and alternative investments; certain types of
options, futures and forward contracts; and some types of bonds
and debt ...
10/2/20 3
Working-Capital Management
Illiquidity Risk
The illiquidity risk premium is an excess return paid to
investors for tying up capital. The premium compensates
the investor for forfeiting the options to contain mark-to-
market losses and to adapt positions to a changing
environment.
Illiquidity and Insolvency
Being illiquid means that you don't have resources
available to meet your current obligations. Figuring this
out is straightforward: either you can pay your bills or
you can't.
Being insolvent means that you owe more than you
own.
10/2/20 4
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.
10/2/20 5
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?
10/2/20 6
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.
10/2/20 7
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,
10/2/20 8
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,
10/2/20 9
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.
10/2/20 10
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.
10/2/20 11
Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt
Preferred Stock
Common Stock
10/2/20 12
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.
10/2/20 13
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.
10/2/20 14
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!
10/2/20 15
Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt
Preferred Stock
Common Stock
10/2/20 16
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.
10/2/20 17
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.
10/2/20 18
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
10/2/20 risky! 19
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.
10/2/20 20
Balance Sheet
Temporary
Current Assets
10/2/20 21
Balance Sheet
Temporary Temporary
Current Assets Short-term financing
10/2/20 22
Balance Sheet
Temporary Temporary
Current Assets Short-term financing
Permanent
Fixed Assets
10/2/20 23
Balance Sheet
Temporary Temporary
Current Assets Short-term financing
Permanent Permanent
Fixed Assets Financing
and
Spontaneous
Financing
10/2/20 24
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
10/2/20 25
Cost of Short-Term Credit
Interest = principal x rate x time
ex: borrow $10,000 at 8.5% for 9 months
Interest = $10,000 x .085 x 3/4 year
= $637.50
10/2/20 26
Cost of Short-Term Credit
We can use this simple relationship:
Interest = principal x rate x time
to solve for rate, and get the
10/2/20 27
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)
10/2/20 28
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)
interest 1
APR = x
principal time
10/2/20 29
Cost of Short-Term Credit
10/2/20 30
Cost of Short-Term Credit
interest 1
APR = x
principal time
10/2/20 31
Cost of Short-Term Credit
interest 1
APR = x
principal time
example: If you pay $637.50 in
interest on $10,000 principal for 9
months:
10/2/20 32
Cost of Short-Term Credit
interest 1
APR = x
principal 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
10/2/20 33
Cost of Short-Term Credit
Annual Percentage Yield (APY) is
similar to APR, except that it
accounts for compound interest:
10/2/20 34
Cost of Short-Term Credit
Annual Percentage Yield (APY) is
similar to APR, except that it
accounts for compound interest:
APY = (i m
m 1 + ) - 1
10/2/20 35
Cost of Short-Term Credit
Annual Percentage Yield (APY) is
similar to APR, except that it
accounts for compound interest:
APY = (i m
m 1 + ) - 1
i = the nominal rate of interest
m = the # of compounding periods per year36
10/2/20
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%
10/2/20 37
Sources of Short-term Credit
Unsecured
10/2/20 38
Sources of Short-term Credit
Unsecured
accrued wages and taxes
10/2/20 39
Sources of Short-term Credit
Unsecured
accrued wages and taxes
trade credit
10/2/20 40
Sources of Short-term Credit
Unsecured
accrued wages and taxes
trade credit
bank credit
10/2/20 41
Sources of Short-term Credit
Unsecured
accrued wages and taxes
trade credit
bank credit
commercial paper
10/2/20 42
Sources of Short-term Credit
Unsecured
accrued wages and taxes
trade credit
bank credit
commercial paper
Secured
10/2/20 43
Sources of Short-term Credit
Unsecured
accrued wages and taxes
trade credit
bank credit
commercial paper
Secured
accounts receivable loans
10/2/20 44
Sources of Short-term Credit
Unsecured
accrued wages and taxes
trade credit
bank credit
commercial paper
Secured
accounts receivable loans
inventory loans
10/2/20 45
