Week 12

Question 1

What occurs in the operating and cash cycle of a business?

Which is longer?

Answer 1

Operating cycle:
Buying inventory => pays for the inventory => firm sells the product => firm receives payment.

Cash cycle => paying for the inventory (cash outflow) => when the firm receives payment (cash inflow).

The operating cycle is therefore longer than the cash cycle.

Question 2

What is the equation for the cash conversion cycle?

What does it mean if this is negative?

Answer 2

The Cash conversion cycle (CCC) = inventory days + accounts receivable days – accounts payable days.

Where the inventory days = inventory / average daily COGS.

Where the Accounts receivable days = (accounts receivable/average daily sales)

Where the Accounts payable days = (accounts payable/average daily COGS).

A negative cash conversion cycle means the firm receives cash in before they pay for the input.

Question 3

What is the discount rate used for free cash flow?

Answer 3

Cost of capital or the cost of equity,

depending on whether interest has already been removed.

Question 4

What does a change in working capital do to our free cash flow?

Answer 4

Decrease our free cash flow,

A decrease in working capital will increase free cash flow.

An increase in working capital will decrease our free cash flow, a decrease in working capital will increase free cash flow.

Question 5

What is trade credit?

Answer 5

The loan extended by one trader to another when the goods and services are bought on credit.

Question 6

What are the benefits of trade credit for customer firms?

Answer 6

It is simple and convenient,
Has lower transaction costs than alternative sources of funds,
It is a flexible source of funds and can be used as needed,
It is sometimes the only source of funding available for a firm.

Question 7

What are the benefits of trade credit for supplier firms?

Answer 7

It provides financing at below-market rates as an indirect way to lower prices for certain customers,
a supplier may have ongoing business with its customer, it may have more information about the credit quality of the customer than a traditional outside lender would have, if the buyer defaults, the supplier may be able to seize the inventory as collateral.

Question 8

What are the three steps to determining credit policy and the 5C’s of credit?

Answer 8

3 steps:

• Establishing credit standards,
• Establishing credit terms,
• Establishing a collection policy.

The 5 C’s of credit are:

• Character,
• Capacity,
• Capital,
• Collateral,
• Conditions.

Question 9

What are the benefits of holding inventory?

What about the costs?

Answer 9

Inventory helps minimize the risk that the firm will not be able to obtain an input it needs for production and helps avoid stock-outs.

Factors such as seasonality in demand mean that customer purchases do not perfectly match the most efficient production cycle.

The costs of holding inventory are:

• Acquisition costs,
• Order costs,
• Carrying costs.

Question 10

What is Just-in-time inventory management?

Answer 10

A perfect state of inventory management, in which a firm acquires inventory precisely when needed so that its inventory balance is always zero, or very close to it.

Question 11

What are the motivations for holding cash?

What can a firm do if it has too much?

Answer 11

• Transactions balance, meeting day to day needs.
• Precautionary balance, to compensate for the uncertainty associated with its cash flows.
• Compensating balance, to satisfy bank requirements.

If a firm has excess cash there are several short-term securities that firms with excess cash can invest in.

Question 12

Why is it important to forecast short-term financing needs?

Answer 12

To allow us to see any problems with cash surplus or deficit, and whether this is temporary or permanent.

Question 13

What is the matching principle in terms of financing?

Answer 13

Short-term needs should be financed with short-term debt and long-term needs should be financed with long-term sources of funds.

Question 14

What is permanent working capital and temporary working capital?

Answer 14

PWC: The amount that a firm must keep invested in short-term assets to support continuing operations.
TWC: The difference between the actual level of investment in short term assets and the permanent working capital investment.

Question 15

What is an aggressive financing policy?

What about conservative?

What are the problems?

Answer 15

AFP involves financing part or all of the permanent working capital with short-term debt,

This has funding risk if we cannot roll over the debt, however the value of short term debt is lower than long term which can be useful,

CFP we finance short-term needs with long-term debt, this is a nonproductive use of cash.

Question 16

What can be used to meet short-term financing needs?

Answer 16

With unsecured debt like bank loans, public debt, or secured debt. They could also use trade credit.

Question 17

How do bank loans work?

What are some common stipulations?

Answer 17

For bank loans a promissory note is created, this could be a single, end of period payment loan based on a benchmark rate (prime rate or LIBOR), a line of credit (which could be uncommitted, committed, revolving, or evergreen), or a bridge loan which is often a discount loan with fixed interest rate that the firm will use while waiting for more long term credit.
Common loan stipulations include: commitment fees, a loan origination fee, and a compensating balance requirement.

Question 18

What is an uncommited, committed, revolving, and evergreen line of credit?

Answer 18

In an uncommitted line of credit the agreement is informal, the bank can withdraw the agreement if the company is not doing well, for committed it is much harder. Revolving is like a credit card with a fixed maturity, and evergreen has no fixed maturity. A firm will only pay interest on the money borrowed, not the full amount though there will likely be a commitment fee on the unused funds only.

Question 19

What does a compensating balance stipulation mean?

Answer 19

In a compensating balance a firm must keep a portion of the loan principal on hand, but must pay interest on the full loan amount.

Question 20

What is commerical paper?

Answer 20

Commercial paper is a short-term, unsecured debt used by large corporations, it is usually cheaper than a short-term bank loan, the minimum face value is $25,000, but most have a face value of over $100,000. The interest on commercial paper is typically paid by selling them at an initial discount.

Question 21

What is a secured loan?

Answer 21

Secured loans are loans collateralized with short-term assets, they typically come from commercial banks, Finance companies, Factors(firms that purchase the receivables of other companies).

Question 22

How can accounts receivable be used as loan collateral?

Answer 22

Accounts receivable can be used as collateral, either with pledging of accounts receivable, in which the lender reviews the invoices and decides which credit accounts it will accept as collateral, based on its own credit standards. Or factoring of accounts receivable in which the firm sells receivables to the lender, the lender pays the firm the amount due from its customers at the end of the firm’s payment period less a factor fee.

Question 23

How can inventory be used as loan collateral?

Answer 23

Inventory can be used as collateral, this could be as floating lien (general lien, or blanket lien), in which case all of the inventory is used to secure the loan. Or it could be with Trust receipts loan or floor planning (in which distinguishable inventory items are held in a trust as security for the loan. Or it could be Warehouse arrangement, in which inventory that serves as collateral is stored in a separate warehouse.