SHORT-TERM CREDIT FINANCING

WORKING CAPITAL FINANCE- refers to optimal level, mix and use of current assets and
current liabilities

WORKING CAPITAL FINANCING POLICIES

A) AGGRESSIVE FINANCING STRATEGY- operations are conducted with a minimum
amount of working capital. This is also known as restricted policy.

B) CONSERVATIVE FINANCING STRATEGY- A company seeks to minimize liquidity

risk by increasing working capital. This is also known as relaxed policy.

C) MODERATE FINANCING STRATEGY- also known as semi-aggressive or semi-

conservative financing strategy. Under this strategy, working capital maintained
is relatively not too high (conservative) nor too low (aggressive). This is also
known as a balanced policy.

D) MATCHING POLICY- This is achieved by matching the maturity of financing

source with an asset’s useful life. This is also known as self-liquidating policy orw
hedging policy.

• Short-term assets are financed with short-term liabilities

• Long-term assets are funded by long-term financing sources
HEDGING- financing assets with liabilities of similar maturity.

TOTAL FINANCING REQUIREMENT

A. PERMANENT financing requirement (Minimum operation requirement)
- Fixed and long-term assets
- Permanent Current Assets

B. TEMPORARY financing requirement (Seasonal operation requirement)

FACTORS OF CONSIDERATIONS IN SELECTING SOURCES OF SHORT-TERM FUNDS

• COST: The effective costs of various credit sources
• AVAILABILITY: The readiness of credit as to when needed and how much is
needed.
• INFLUENCE: The influence of use of one credit source and availability of other
sources of financing.
• REQUIREMENT: The additional covenants unique to various sources of financing
(e.g., loans)

SOURCES OF SHORT-TERM FUNDS

• UNSECURED CREDITS (Accruals, trade credit and commercial papers)
• SECURED LOANS ( Receivable financing- pledging and factoring)
• BANKING CREDITS (Loan, line of credit, revolving credit agreement)

COSTS OF SHORT-TERM CREDIT

• Cost of TRADE CREDIT with supplier
COST= [Discount rate/ (100%- Discount Rate)] x [360 days/ (Credit period –
Discount period)]
*This type of financing cost is caused by foregoing cash discounts (opportunity
costs)

• Cost of BANK LOANS (EFFECTIVE ANNUAL RATE)

o
o Without compensating balance:
If not discounted (cash proceeds normally is equal to face value)
COST= Interest/Amount Received (Face)

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 If discounted (Cash proceeds is net of interest/deducted in advance)
COST= Interest/(Face Value- Interest)

o With compensating balance:

If not discounted:
COST= Interest/ (Face Value – CB) or COST= Nominal%/(100%-CB%)

If discounted:
COST= Interest/ (Face Value- Interest- CB) or COST= N%/(100%--N%-CB%)

• Cost of COMMERCIAL PAPERS

COST= ([Interest + Issue costs)/(Face Value- Int.- Issue Cost)] x (360 days/Term)

Sample Problems:
1. Cost of Trade Credit
CPL Trading Co. purchases merchandise for P200,000, 2/10, n/30.
Required:
A) The annual cost of trade credit.
B) The annual cost of trade credit if term is changed to 1/15, n/20.

2. Cost of Bank Loans

CPL Trading Co. was granted a P200,000 bank loan with 12% stated interest.
Required: The effective annual rate, under the following cases:
A. CPL receives the entire amount of P200,000.
B. CPL is granted a discounted loan
C. CPL is required to maintain a compensating balance of P10,000 under the
non-discounted loan.
D. CPL is required to maintain a compensating balance of 10% under a
discounted loan.

3. Cost of Commercial Paper

CPL Co. plans to sell a 180-day commercial paper amounting to P100,000,000, which it
expects to pay a discounted interest of 12% per annum. CPL expects to incur P100,000
in dealer placement fees and paper issue costs.
Required: Determine the effective cost of CPL’s credit.

4. Cost of Factoring Receivables

CPL Co. has P200,000 in receivable that carries 30-day credit term, 2% factor’s fee, 6%
holdback reserve, and an interest of 12% per annum on advances.
Required: Determine the following:
A. Cash proceeds from factoring receivable.
B. Effective annual financing cost of factoring the receivable.

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 LONG-TERM FINANCING DECISIONS

Long-term Financing Decisions- primarily aimed in determining the best mix of the
permanent sources of funds used by a firm in a manner that will achieve the optimal
capital structure.

Capital Structure- refers to the mix of the long-term sources of fund used by the firm. It is
composed of long-term debt, preferred stock and common stockholders’ equity.

Financial Structure- refers to the mix of all the firm’s assets

Capital Structure= Financial Structure (Total Assets) – Current Liabilities

Optimal Capital Structure- refers to the mix of long-term sources of funds that will
minimize the firm’s overall cost of capital, at which the stock price is at maximum.
OBJECTIVE: To maximize the market value of the firm through an optimal mix of long-
term sources of funds.

COST OF CAPITAL
-the cost of using funds; it is also called hurdle rate, required rate of return, cut-off rate
-the weighted average rate of return the company must pay to its long-term creditors
and shareholders for the use of their funds

SOURCE CAPITAL COST OF CAPITAL

Creditors Long-term Debt After-Tax rate of interest
Stockholders:
Preferred Preference Shares
Preferred dividends per
share/ Current market
price or Net issuance
price
Common Ordinary Shares CAPM or DGM

COMPUTATION OF COST OF ORDINARY SHARES:

1. Capital Asset Pricing Model (CAPM)
R=Rf +B(Rm-Rf)
Where R= rate of return (or cost of capital)
Rf= risk-free rate determined by government securities

B= beta coefficient of an individual stock which is the correlation between the volatility
(price variation) of the stock market and the volatility of the price of the individual stock
Example: If the price of an individual stock rises 10% and the stock market 15%, the beta
is 1.5.

Rm= market return

(Rm-Rf)=market risk premium or the amount above risk-free rate required to induce
average investors to enter the market

B(Rm-Rf)= risk premium

Example: Assume a beta of 1.5, a market rate of return of approximately 16% and an
expected risk-free rate of 12%. What is the R?
R=Rf +B(Rm-Rf)

2. The Dividend Growth model

a. Cost of retained earnings= D1/Po +G
where: Po= current price
D1= next dividend
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 G= growth rate dividends per share (it is assumed that the dividend payout ratio,
retention rate, and therefore the EPS growth rate are constant)
Example: A company’s dividend is expected to be P5 while the market price is P60 and
the dividend is expected to grow at a constant rate of 10%, the cost of retained
earnings is:

b. Cost of new Ordinary shares = D1/ [Po(1-Flotation cost) + G]

Flotation cost= the cost of issuing new securities

CAPITAL REQUIREMENTS: ADDITIONAL FUNDS NEEDED (AFN)

Financial Management requires thorough analysis of the firm’s capital requirements.
Generally, the additional (external) funds needed can be determined by using the
following formula:

Required increase in assets -> Change in Sales x (Assets/Sales)

Spontaneous increase in liabilities-> Change in Sales x (Liab./Sales)
- *Increase in retained earnings-> Earnings after tax- Dividend Payment
ADDITIONAL FUNDS NEEDED

*Alternative computation: increase in retained earnings= (Expected sales x profit

margin) x retention ratio

FACTORS INFLUENCING LONG-TERM FINANCING DECISIONS

Ø BUSINESS RISK-uncertainty inherent in projections of future returns on assets. The
greater the business risk, the less debt should be included in its capital structure
Ø TAX POSITION- generally, the higher the firm’s tax rate, the more debt it should
include in its capital structure. Reason: interest expense is tax deductible.
Ø FINANCIAL FLEXIBILITY- the firm’s ability to raise capital on reasonable terms even
under adverse conditions
Ø MANAGERIAL AGGRESSIVENESS- refers to some financial managers’ inclination to
use more debt to boost profit

SAMPLE PROBLEMS:
1. Additional Funds needed
Ryu Corporation’s sales are expected to increase from P5,000,000 in 2013 to P6,000,000
in 2014. Its assets totaled P3,000,000 at the end of 2013. Ryu has full capacity, so its
assets must grow in proportion to projected sales. At the end of 2013, current liabilities
are P1,000,000 (of which 200,000 are accounts payable, 400,000 notes payable and
300,000 accruals). The after-tax profit margin is projected to be 10%. The forecasted
pay-out ratio is 75%. Determine the additional funds needed from external sources.
Note: Increase in assets – Increase in liabilities – Increase in retained earnings=
additional funds needed

Key financial ratios

• Capital intensity ratio = assets/sales
• After-tax profit margin=after-tax profit/ sales
• Dividend payout ratio= dividends/ earnings= dividends per share/ EPS
• Retention ratio= 100%- dividend payout ratio

2. Targeted Capital Structure

Omega Company has the following capital structure:
Debt (16%) 750,000
Preferred Stock (12.5%, P100 par) 300,000
Common Stock (P10 par) 1,000,000
Retained earnings 450,000
TOTAL 2,500,000
Omega Company considers the following options for the financing of its planned
expansion that requires additional external financing for P300,000,000
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OPTION A
• 60% borrowing at 18%
• The balance through the issuance of common shares at P15 per share

OPTION B
• 20% borrowing at 18%
• 15% preferred stock at 12.50% to be issued at par
• 65% common stock to be sold at P15 per share

Corporate tax rate is 35%.

The project is likely to generate earnings before interest and taxes of P230,000,000.

Required:
Between option A and B, which option shall be selected to achieve the higher EPS?

SOURCES OF INTERMIDEATE AND LONG-TERM FINANCING

1) INTERNAL SOURCES:
Ø OPERATIONS (Retained Earnings)
Earnings available after the payment of interest, taxes and preferred stock dividends
may be used to either pay common, cash dividends or be plowed back into the
company in the form of additional capital investment.
Advantages of internal financing:
1. The after-tax opportunity cost is lower than that for newly issued common stock.
2. Financing with retained earnings leaves the present control structure intact.

2) EXTERNAL Sources
Ø Debt (Bonds) Financing
Basic Types of Bonds or Long-term Debt:
A) Debenture Bonds - unsecured loan; issued by companies with good credit ratings.
B) Mortgage Bonds - Secured loan with pledge of certain assets, such as real property.
C) Income Bonds - pay interest only if the issuing company has earnings.
D) Serial Bonds - bonds with staggered maturities.
E) Floating Bonds - bonds with varying interest rates.

Ø Equity (Common) Financing

The sale of common stock is frequently more attractive to investors than debt, because
it grows in value with the success of the firm. The higher the common stock value, the
more advantageous equity financing is over debt financing.

Ø Hybrid Financing

These are sources of funds that possess a combination of features; these include
preferred stock, leasing, and option securities such as warrants and convertibles.

o Preferred Stock — a hybrid security because some of its characteristics are

similar to those of both common stocks and bonds. Legally, like common
stock, it represents a part of ownership or equity in a firm. However, as in
bonds, it has only a limited claim on a firm’s earnings and assets.
o Lease Financing
Lease — a rental agreement that typically requires a series of fixed
payments that extend over several periods.

Leasing vs. Borrowing —- leasing represents an alternative to borrowing.

The lease payments are very similar to loan amortization, with part of
payment applied to principal, and part to interest. Like loan agreements,
lease contracts usually contain restrictive covenants like the requirement

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 to maintain minimum debt-equity ratios of minimum level of liquid assets.
Basic difference: ownership of the asset.

Leasing Benefits
§ Increased Flexibility - in some cases, lease can be cancelled or
replaced with a new one depending on the need of the firm.
§ Tax Savings - the tax shield generated by lease payments usually
exceeds that from depreciation if the asset were purchased.

Types of Leases
1, OPERATING LEASE - usually short-term and often cancelable; obligation is not shown
on the balance sheet, maintenance and upkeep of asset is usually provided by the
lessor; lease payment is treated as rent expense.

2. CAPITAL OR FINANCIAL LEASE - non-cancelable, long-term lease that fully amortizes

the lessor’s cost of the asset; service and maintenance are usually provided by the
lessee.

3. SALES AND LEASEBACK- assets that are already owned by a firm are purchased by |
the lessor and are subsequently leased back to the firm.

Ø Convertible Securities - preferred stock or bond issue that can be exchanged for
a specified number of shares of common stock at the will of the owner. These are
generally considered hybrid securities because they provide the stable income
associated with preferred stock and bonds in addition to the possibility of capital
gains associated with common stocks.
Ø Warrant - an option granted by the corporation to purchase a specified number
of shares of common stock at a stated price exercisable until some time in the
future called the expiration date. Usually, it is attached to debt instruments as an
incentive for investors to buy the combined issue at a lower interest rate.
Ø Option - it is a contract that gives its holders the right to buy (or sell) stocks at
some predetermined price (usually less than stock’s market prices) within a
specified period of time.

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