Working Capital Management Part 2 _ M5

Question 1

Who gets the risk in a short-term and long-term loans lender vs. borrower?

Answer 1

• Short-term loans provide risk interest rate to borrower: When a company utilizes short-term financing, it is not locked into a rate for a long-term period of time.
• Short-term financing typically has lower interest rates than long-term financing. Consequently, the cost of borrowing is less with short–term financing.
• Long-term financing the lender has an increased interest rate risk Because interest rates may change over the duration of long-term loans. Lenders charge a premium to borrowers to compensate for this risk.

Question 2

What are the reasons businesses should hold cash on hand or in the bank?

Answer 2

There are three primary motives for holding cash:
1. Transactions demand; Maintain adequate cash needed for transactions.
2. Precautionary demand; Satisfy compensating balance requirements.
3. Speculative demand; Maintain a precautionary balance.

• Cash is generally held in very short-term liquid investments which are low risk, low return.

Question 3

What are the different forms of short-term borrowing methods?

Answer 3

SECURE LOANS

• Letters of credit represent a third-party guarantee of obligations incurred by a company. (Basically, guarantees payments to creditors)
• Issued by debtor to assure creditors/investors that they do pay.

UNSECURE LOANS

• A line of credit is short-term borrowing from a financial institution to ensure that an entity meets cash flow requirements.
• Debentures Do not enhance trade credit capabilities.
• Subordinated debentures Least favorable debt and do not enhance trade credit capabilities.

Question 4

What are the methods in converting A/R into cash?

Answer 4

1. Collection agencies - used to collect overdue AR.
2. Factoring AR - selling AR to a factor for cash.
3. Cash discounts - offering cash discounts to customers for paying AR quickly (or paying at all). For example: 2/10, net 30.
4. Electronic fund transfers - a method of payment, which electronically transfers funds between banks.

Question 5

How to calculate dollar impact on A/R credit change policy?

Answer 5

• decrease the average number of days in collection from 75 to 50 days
• reduce the ratio of credit sales to total revenue from 70 to 60 percent.
• projected sales would be five percent less, if projected
  sales are $50 million
• Assume a 360-day year.

Explanation
Credit Policy Change
No………………………………………………………..Yes
Sales Projections $50,000,000 × 95% = $47,500,000
Credit Sales Ratio × 70%…………………………..× 60%
Sales on Credit 35,000,000…………………..28,500,000
Collection Day Ratio × 75/360…………………..× 50/360
Accounts Receivable $7,291,667…………….− 3,958,333
Decrease in A/R $3,333,334

Question 6

What is the primary reason for a company to agree to a debt covenant limiting the percentage of its long-term debt?

Answer 6

• To reduce the coupon rate (rate issuer pays to the buyer) on NEW bonds being sold.
• A debt covenant is a provision in a bond indenture (contract between the bond issuer and the bond holders) that the bond issuer will either do (affirmative covenants) or not do (negative covenants) certain things.

Question 7

What are the different periods described?

Answer 7

• The average collection period measures the number of days after a typical credit sale is made until the firm receives the payment.
• The inventory conversion period measures the number of days in the inventory cycle.
• “Float” measures the number of days it takes a typical check to “clear” through the banking system.
• “Credit period (term)” measures the number of days before a typical account becomes delinquent