1 Corporate Financial Planing Ch1 2

Master in Finance
Corporate Financial Planning

0. Interest Rates (Revision)
Bibliography
- Berk and DeMarzo (2011) Ch 4
1.0 Interest Rate (Revision)
A) Effective Annual Rate (EAR)
– Indicates the total amount of interest that will be earned
at the end of one year
– Considers the effect of compounding
• Also referred to as the effective annual yield (EAY) or annual
percentage yield (APY)
Copyright @ Ana Venâncio

Adjusting the Discount Rate to Different Time Periods
– Earning a 5% return annually is not the same as
earning 2.5% every six months.
General Equation for Discount Rate Period Conversion
Equivalent n-Period Discount Rate  (1  r )n  1
•(1.05)0.5 – 1= 1.0247 – 1 = .0247 = 2.47%

– Note: n = 0.5 since we are solving for the six month (or 1/2 year)
rate

Example
– Suppose an investment pays interest quarterly with the
interest rate quoted as an effective annual rate (EAR) of
9%.
• What amount of interest will you earn each quarter?

Solution
– A 9% EAR is approximately equivalent to earning:
(1.09)1/4 – 1 = 2.1778% per quarter.

B) Annual Percentage Rate
– indicates the amount of simple interest earned in one
year.
• Simple interest is the amount of interest earned without
the effect of compounding
• The APR is typically less than the effective annual rate

(EAR)

Converting an APR to an EAR
k
 APR 
1  EAR  1  
 k 
– The EAR increases with the frequency of compounding.

Effective Annual Rates for a 6% APR with Different
Compounding Periods

Example
– A firm is considering purchasing or leasing a luxury
automobile for the CEO. The vehicle is expected to last 3
years. You can buy the car for $65,000 up front , or you
can lease it for $1,800 per month for 36 months. The
firm can borrow at an interest rate of 8% APR with
quarterly compounding. Should you purchase the system
outright or pay $1,800 per month?

Solution
– Compute the discount rate that corresponds to monthly
compounding:
1
.08 4
(1  )  1.082432  1.08243212  1  0.66227% per month
4
– Present value of the 36 monthly payments
1  1 
PV  $1,800  1  36 
 $57, 486
0.0066227  1.0066227 
– Paying $1,800 per month for 36 months is equivalent to
paying $57,486 today. This is $65,000 - $57,486 =
$7,514 lower than the cost of purchasing the system, so it
is better to lease the vehicle rather than buy it.
1. Working Capital Management
Bibliography
- Berk and DeMarzo (2011) Ch 26 pages 848-868
- Damodaran (2001) Ch 13 -14 pages 389-450
Outline
1.1 Overview of Working Capital
1.2 Trade Credit
1.3 Receivables Management
1.4 Payables Management
1.5 Inventory Management
1.6 Cash Management
1.7. Alternative Investments (Near Cash Investments)
Learning Objectives
1. Define working capital management, cash cycle, and operating
cycle.
2. Compute the cost of trade credit and compare that cost to
alternative sources of financing.
3. Discuss ways that companies provide trade credit to their
customers.
4. List the three steps involved in establishing a credit policy, and
two methods used to monitor the effectiveness of that policy.
5. Discuss the importance of monitoring accounts payable,
inventory, and cash; identify ways those items can
be managed.
1.1. Overview of Working Capital
Most projects require the firm to invest in net working capital.
Net Working Capital =Current Assets – Current Liabilities
Noncash Working Capital =Noncash Current Assets – Noncash

Current Liabilities
How should firms manage their working capital efficiently? How

does it affect firm value?

A) Operating Cycle versus Cash Cycle

A) Operating Cycle versus Cash Cycle
Firm’s operating cycle is the average length of time between
when a firm purchases its inventory and when it receives the
cash back from selling its product
Firm’s cash cycle is the length of time between when the firm
pays cash to purchase its inventory and when it receives cash
from sales

B) Cash Conversion Cycle (CCC)
CCC = Accounts Receivable Days + Inventory Days – Accounts
Payable Days
Accounts Receivable Days= Accounts Receivable

Sales*(1+VAT)/365
Inventory Days= Inventory ,
Cost of Goods Sold/365
Accounts Payable Days = Accounts Payable ,
Cost of Goods Sold *(1+VAT)/365

C) Firm Value and Working Capital
• Any reduction on working capital requirements
generates a positive free cash flow that the firm can
distribute immediately to shareholders:
– Thus, efficiently managing working capital will maximize
firm value

Example
– Jackson Enterprises is considering a new project that will cost
$10,000,000.
– The project will require an investment today of $1,500,000 for

net working capital.
– The firm will recover the investment in net working capital when
the project ends in ten years.
– The discount rate for this type of cash flow is 5.6% per year.
– What is the present value of the cost of working capital for the
project?

Solution
– The investment in working capital results in a cash outflow
today of $1,500,000 and a cash inflow of $1,500,000 in
ten years.
$1,500, 000
NPV  $1,500, 000   $630,135
(1  .056)10
• The investment in working capital costs the firm $630,135.

D) Trade-off from Reducing Working Capital
Reducing working capital can increase cash flows, but this benefit has
to be offset against:
a) Default Risk
b) Lost of Sales
Decreasing working capital can also make the firms more risky. The
effects of working capital changes on liquidity risk depend on:
a) Access to Financing
b) State of Economy
c) Uncertainty about Future Cash Flows

1.2. Trade Credits
– The credit that the firm extends to its customers.
How managers can compare the costs and benefits of trade to

determine the optimal credit policy?
Terms of Sale and Credit (how the credit will be offered):

2 /10, Net 30
Percentage Number of days Number of days
discount for that discount is before total
early payment available payment is due

A) Effective Interest Rate
We can convert the cash discount into an effective interest rate:
– Assume a firm sells a product for $100 and offers its

customer terms of 2 /10, net 30.
– The customer doesn’t have to pay anything for the first 10
days, so it effectively has a zero-interest loan for this
period.
• If the customer takes advantage of the discount and pays within
the 10-day discount period, the customer pays only $98 for the
product.

– Rather than pay within 10 days, the customer has the option to
use the $98 for an additional 20 days
• The interest rate for the 20-day term of the loan is
$2 ÷ $98 = 2.04%.
– With a 365-day year, this rate over 20 days corresponds to an effective
annual rate of:
365
𝐶𝑎𝑠ℎ 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝐸𝑥𝑡𝑟𝑎 𝑑𝑎𝑦𝑠 𝑡𝑜 𝑚𝑎𝑘𝑒 𝑡ℎ𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡
𝐸𝐴𝑅 = 1 + −1
𝑃𝑟𝑖𝑐𝑒 − 𝐶 𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡
EAR  (1.0204)365 / 20  1  44.6%

– A policy of providing a cash discount of 2% and allowing
an extra 20 days for payment is equivalent of offering
credit at an annualized interest rate of 44.6%
– By not taking the discount, the firm is effectively paying
44.6% annually to finance the purchase.
• If the firm can obtain a bank loan at a lower interest rate, it would
be better off borrowing at the lower rate on day 10 and using the
cash proceeds of the loan to take advantage of the discount
offered by the supplier. The firm would then repay the bank loan
on day 30.

Example
– Your firm purchases goods from its supplier on terms of
2/10, net 45.
– What is the effective annual cost to your firm if it chooses
not to take advantage of the trade discount offered?

Solution
 365 
 
 .02   45 10 
Effective Annual Cost  1    1  23.45%
 .98 

B) Costs of Offering Credit
1- Exposes the firm to the possibility that the customer will

default on the payment resulting in losses from bad debts and
collection costs
2- Interest foregone between the time of the sale and the time
of payment by the customer,

C) Benefits of Trade Credit
– Trade credit is simple and convenient to use, and it
therefore 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 to a
firm
– Generate sales that would not have occurred otherwise

D) Why Offer Trade Credit?
• Providing financing at below-market rates is an indirect way to
lower prices for only certain customers.
– For example, automobile manufacturer’s often offer low
cost financing, but only for the most qualified buyers.
• Because a supplier may have an ongoing business relationship
with its customer, it may have more information about the credit
quality of the customer than a bank.
• If the buyer defaults, the supplier may be able to seize the
inventory as collateral.

1.3. Receivables Management
Determining the Credit Policy :
– Establishing Credit Standards
• Determine who will qualify for credit
– Establishing Credit Terms

• Determine the “net” period and if a discount will be offered
– Establishing a Collection Policy

• Determine course of action to take if a customer does not pay as
agreed

1.3. Receivables Management
Monitoring accounts receivable:
- Compare the credit terms with the account receivable
days outstanding
- Aging schedule: categorizes the number of days they have
been on the firm’s book

1.4. Payable Management
• A firm should borrow using accounts payable only if trade
credit is the least expensive source of funding
– The cost of the trade credit depends on the
credit terms.
• The higher the discount percentage offered, the greater the cost of
forgoing the discount.
• The shorter the loan period, the greater the cost of forgoing the
discount.
– A firm should always pay on the latest day allowed

1.4. Payable Management
Monitoring accounts payable :
- Compare the credit terms with the account payable days
outstanding
Stretching Accounts Payable
– When a firm ignores a payment in the due period and pays later
• For example:
– Given Net 30 terms, a firm may pay on day 45
– Given 2/10 Net 30 terms, a firm may pay on day 12 and still
take the 2% discount

1.5. Inventory Management
BENEFITS COSTS
1. Prevent stock-out and 1. Acquisition costs
Meet customer needs 2. Order Costs
- risk that firm will not be 3. Carrying costs
able to obtain an input it
needs for production or they
can run the risk of losing
sales

A) Determining the Optimal Level
The Economic Order Quantity (EOQ) is the order that minimizes
the total cost of new orders and the carrying cost of inventory
Total Cost = purchase cost + ordering cost + holding cost
- Purchase cost: unit price × annual demand quantity: P×D

- Ordering cost: each order has a fixed cost S, and we need to
order D/Q times per year. This is S × D/Q
- Holding cost: the average quantity in stock Q/2: cost is H × Q/2

To determine the minimum point we set the ordering cost equal
to the holding cost
𝑬𝑶𝑸(𝑸∗ )
2 × 𝐴𝑛𝑢𝑎𝑙 𝐷𝑒𝑚𝑎𝑛𝑑 (𝑈𝑛𝑖𝑡𝑠) × 𝑂𝑟𝑑𝑒𝑟𝑖𝑛𝑔 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑂𝑟𝑑𝑒𝑟
=
Holding Cost per Unit
Assumptions EOQ
1- It assumes that the demand is constant over time
2- It assumes that inventory can be replenished instantaneously
3- It assumes that the ordering costs are fixed and not a
function of the size of the order
EQQ with Safety Inventory
Inventory
Level
Q Q
Safety Inventory
L L Time

B) Inventory Management Practices
Firms have become more sophisticated in using the technology
to manage inventory:
1- The just-in-time inventory system focuses on keeping the minimum

level of inventory
2- Computers have been used to schedule the deliver of raw
materials closer to actual production (material requirement planning)
3- Many firms have turned to reengineering their production process
to speed up production and reduce inventory
4- Firms have focused in reducing the number of items and brand
names they carry
1.6. Cash Management
Reasons for holding cash
– Transactions Balance
• The amount of cash a firm needs to be able to pay its bills
– Precautionary Balance
• The amount of cash a firm holds to counter the uncertainty
surrounding its future cash needs
– Compensating Balance
• An amount a bank may require to a firm in order to maintain an
account at the bank as compensation for services the bank may
perform

A) How much Operating Cash to Hold
- Depends on the nature of the business
- Size of the firm
- Sophistication of both banking technology and payment

procedures
- Availability of investments

A.1) Determining the Optimal Cash Balance – Baumol Model
Same approach as defined to inventory
To determine the minimum point we set the interest foregone by
holding cash instead of market securities equal to cost of selling
market securities
𝑂𝑝𝑡𝑖𝑚𝑎𝑙 𝐶𝑎𝑠ℎ 𝐵𝑎𝑙𝑎𝑛𝑐𝑒

2 × 𝐴𝑛𝑢𝑎𝑙 Cash Usage Rate × 𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 Sale of Securities
=
Annual Interest Rate
Limitations: The model assumes that firms do not receive cash

A.2) Determining the Optimal Cash Balance – Miller-Orr Model
Applies to firms with uncertain cash inflows and cash outflows
The spread between the lower and upper limit is defined to
minimize the sum of transaction costs and interest costs.
The spread increases as cash flows become more variable:
Spread between upper and lower cash balance limits
1
3 Transaction Cost × Variance of Cash − Flows 3
=3×
4 Dailly Interest Rate
Limitations: it does not answer how much a firm should hold in
cash and it assumes that there are significant costs of selling
securities

B) Managing Float: Availability Float
The amount of time it take for a firm to be able to use funds
after a customer has paid for its goods
• Mail Float: How long it takes a firm to receive a customer's
payment check after the customer has mailed it
• Processing Float: How long it takes a firm to process a
customer’s payment check and deposit it in the bank
• Availability Float: How long it takes a bank to give a firm credit
for customer payments the firm has deposited in the bank

C) Managing Float : Disbursement Float
The amount of time it takes before a firm’s payments to its
suppliers actually result in a cash outflow for the firm
It is a function of mail float, processing float, and check-
clearing float

Example
Assume that a firm makes payment of $1 million a day and it

takes 5 days for the checks to clear; assume that firm receives
$800,000 a day in checks and it takes 4 days to clear.
• Calculate the Net Float.

Solution
Net Float = Disbursement Float – Availability Float

= $1 million × 5 − $800,000 × 4 = $1.8 million

1.7. Alternative Investments (Near Cash Investments)
• Thus far, it has been assumed that the firm will
invest any cash in short-term securities
– A firm may choose from a variety of short-term securities
that differ with regard to their default risk and liquidity risk

A) Alternative Investments

B) Treasury Bills
Yield on Bank Discount Basis

𝐹𝑣 − 𝑃 360
𝑌𝐵𝐷 =
𝐹𝑣 𝑡
𝐹𝑣 = 𝐹𝑎𝑐𝑒 𝑉𝑎𝑙𝑢𝑒; 𝑃 = 𝐶𝑢𝑟𝑟𝑒𝑛𝑡 𝑃𝑟𝑖𝑐𝑒;
𝑡 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑑𝑎𝑦𝑠 𝑟𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔 𝑡𝑜 𝑚𝑎𝑡𝑢𝑟𝑖𝑡𝑦
Return on Treasury Bill
365
𝐹𝑣 𝑡
𝑅𝑇𝐵 = −1
𝑃

C) Repurchase Agreements
Repo Rate
𝑅𝑒𝑝𝑜 𝑇𝑒𝑟𝑚
𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡 = 𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 × 𝑅𝑒𝑝𝑜 𝑅𝑎𝑡𝑒 ×
360
Return on Repo
365
𝑃𝑟𝑖𝑛𝑐𝑖𝑝𝑎𝑙 𝑡
𝑅𝑅 = −1
𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝑃𝑟𝑖𝑐𝑒

D) Alternative Investments (cont.)

E) When Investments in Cash and Near-Cash Reduces
Firm Value
Conditions under which cash balance negatively affects firm
value:
1- The cash is invested at a rate that is lower than the market

value
2- Management is not trusted with large cash balance
3- The firm is underlevered: it uses less debt than it should

F) Investment in Risky Securities
Firm can invest in risk securities (bonds and stocks) because:
a) Higher returns: corporate bonds, high-yield bonds and stocks
b) Strategic interest
c) Investment in undervalued securities

Quiz
1. What is the difference between a firm’s cash cycle

and operating cycle?
2. How does working capital impact a firm’s value?
3. Why do companies provide trade credit?
4. List three reasons why a firm holds cash.
5. What trade-off does a firm face when choosing how
to invest its cash?

2. Short-Term
Financial Planning
Bibliography
- Berk and DeMarzo (2011) Ch 27 pages 869-888
Outline
2.1 Forecasting Short-Term Financing Needs
2.2 The Matching Principle
2.3 Short-Term Financing with Bank Loans
2.4 Short-Term Financing with Commercial Paper
2.5 Short-Term Financing with Secured Financing
Learning Objectives
1. Show how future cash flow forecasts allow a company to
determine whether it has a cash flow surplus or deficit,
and whether it is a long- or short-term imbalance.
2. Discuss the recommendations of the matching principle
with respect to long- and short-term needs for funds.
3. Describe three types of bank loans, and how they may
be used for short-term cash needs.
4. Identify the factors that affect the effective annual rate
of a bank loan.

Learning Objectives
5. Define commercial paper and discuss its advantages for
large corporations.
6. Describe the use of inventory and accounts receivable
as security for loans.
7. Define factoring, floating liens, trust receipts loan, and a
warehouse arrangement.

Example Assuming Level Sales
• Assume that it is December 2012. Springfield
Snowboards manufactures snowboarding equipment,
which it sells primarily to retailers.
• Springfield anticipates that in 2013 its sales will grow by
10% to $20 million and its total net income will be
$1,950,000.
• Assuming sales and production will occur uniformly
throughout the year, management’s forecast of its
quarterly net income and statement of cash flows for
2013 is presented on the following slide.

Example Assuming Level Sales - Projected
Financial Statement

Example Assuming Level Sales
• Based on these projections, Springfield will
accumulate excess cash on an ongoing basis.
– If the surplus is likely to be long term, Springfield could
reduce the surplus by paying some of it out as a dividend
or by repurchasing shares.

2.1 Forecasting Short-Term Financing Needs
• Firms require short-term financing for 2 reasons:
– Seasonalities: When sales are concentrated during a few
months, sources and uses of cash are also likely to be
seasonal
– Occasionally, a company will encounter circumstances in
which cash flows are temporarily negative for an
unexpected reason, creating a short-term financing need
– Negative cash flow shocks
– Positive cash flow shocks

A) Example Assuming Seasonal Sales
• In the Springfield example, it was previously
assumed that sales occur uniformly throughout the
year. Now assume that 20% of sales occur during
the first quarter, 10% during each of the second and
third quarters, and 60% of sales during the fourth
quarter.
• It is still assumed that production occurs uniformly
throughout the year.
• The new forecasted statement of cash flows is shown on the
following slide.

A) Example Assuming Seasonal Sales - Projected
Financial Statements

A) Example Assuming Seasonal Sales
• Although net income is unchanged from the original
forecast, the introduction of seasonal sales creates
some dramatic swings in Springfield’s short-term
cash flows.
– As a result, Springfield has negative net cash flows during
the second and third quarters,

B) Example Assuming Negative Cash Flow Shocks
• In the Springfield example, assume that during April
2013, management learns that some manufacturing
equipment has broken unexpectedly. It will cost an
additional $1,000,000 to replace the equipment in the
2nd quarter.
• The original assumption of level sales is used.
•The impact is shown on the following slide.

– Projected Financial Statements

• In this case, the one-time expenditure of $1 million
to replace equipment results in a negative net cash
flow of $513,000 during the second quarter of
2013.
• If its cash reserves are insufficient, Springfield will
have to borrow to cover the $513,000 shortfall.
– However, the company continues to generate positive
cash flow in the following quarters, and by the fourth
quarter it will have generated enough cumulative cash
flow to repay any loan.

C) Example Assuming Positive Cash Flow Shocks
• Now assume that during the first quarter of 2013,
Springfield announces a deal where it will be the
exclusive supplier to a new major customer, leading
to an overall sales increase of 20% for the firm and
as a result agrees to pay a one-time expense
$500,000 for marketing . The increased sales will
begin in the second quarter.
• An extra $1 million in capital expenditures is also
required during the first quarter to increase
production capacity.
C) Example Assuming Positive Cash Flow Shocks –
Projected Financial Statements

C) Example Assuming Positive Cash Flow Shocks
• Forecasted net income is lower during the first quarter,
due to the $500,000 increase in marketing expenses.
However, net income in the following quarters is higher,
reflecting the higher sales.
• There is an increase accounts receivable and accounts
payable during the first two quarters due to the higher
level of sales.
• Even though the opportunity to grow more rapidly is
positive, it results in a negative net cash flow during the
first quarter.
– However, because the company will be even more profitable in
subsequent quarters, this financing need is temporary.
2.2 The Matching Principle
One policy that minimizes these transaction costs is
the matching principle:
– A firm’s short-term needs should be financed with
short-term debt and long-term needs should be
financed with long-term sources of funds

A) Permanent Working Capital
– The amount that a firm must keep invested in its short-
term assets to support its continuing operations. The
investment in working capital is required so long as firm
remains in business, it constitutes long-term investment:
•The matching principle suggests that the firm should
finance this permanent investment in working capital
with long-term sources of funds.

B) Temporary Working Capital
– The difference between the actual level of short-term
working capital needs and its permanent working capital
requirements
•The matching principle suggests that the firm should
finance this temporary investment in working capital
with short-term sources of funds.

C) Aggressive Financing Policy
– Financing part or all of a firm’s permanent working
capital with short-term debt
– Why? The value of short-term debt is less sensitive to
firm’s credit quality than long-term debt: short-term debt
will have lower agency costs
– One risk of an aggressive financing policy is funding risk:
•risk of incurring financial distress costs should a firm
not be able to refinance its debt in timely manner or
at a reasonable rate
D) Conservative Financing Policy
– Financing all of a firm’s permanent working capital with
long-term debt.

2.3 Short-Term Financing with Bank Loans
Bank notes are typically initiated with a promissory note:
– A written statement that indicates the amount of a loan,
the date payment is due, and the interest rate
Type of bank loans:

• Single, end-of-period payment loans;
• Lines of credit
• Bridge loans

A) Single, End-of-Period Payment Loan
– This type of loan requires that the firm pay interest on
the loan and pay back the principal in one lump sum at
the end of the loan.
– The interest rate may be fixed or variable.
•With a variable interest rate, the terms of the loan may
indicate that the rate will vary with some spread relative to
a benchmark rate:
• Prime Rate: The rate banks charge their most creditworthy
customers
• LIBOR: The rate of interest at which banks borrow funds
from each other in the London inter-bank market
B) Line of Credit
– A bank loan arrangement in which a bank agrees to lend a
firm any amount up to a stated maximum
• This flexible agreement allows the firm to draw upon then line of
credit whenever it chooses
Types of Lines of Credit
• Uncommitted: it does not legally bind a bank to provide funds
• Committed: legally binding agreement that obligates a bank to
provide funds to a firm (up to a stated credit limit)
• Revolving: a credit commitment for a specific time period,
which a company can use as needed

C) Bridge Loan
– A type of short-term bank loan that is often used to
“bridge the gap” until a firm can arrange for long-term
financing
• They are often quoted as discount Loan

– a loan in which the borrower is required to pay the
interest at the beginning of the period
•The lender deducts the interest from the loan
proceeds when the loan is made.

D) Common Loan Stipulations and Fees
• Commitment Fees: it is associated with a committed line
of credit
• Loan Origination Fee: a bank charge to cover checks and
legal fees and it reduces the amount of usable proceeds
that the firm receives
• Compensating Balance Requirements: a bank reduces
the usable loan proceeds. The firm must hold a certain
percentage of the principal of the loan in an account at
the bank

Example
XHouse has a $1,000,000 bank loan at 8% (APR with

monthly compounding). The bank requires that XHouse
maintain a 20% compensating balance. If XHouse earns
2% (APR with monthly compounding) on its compensating
balance accounts, what is the EAR of a six-month loan?

Solution
– At the end of six months, XHouse will owe the bank
$1,040,673.
– However, the 20% compensating balance will grow from
$200,000 to $202,008.
– Applying the compensating balance toward the loan,
XHouse will need $1,040,673 - $202,008 = $838,665
to pay off the loan. The six-month interest rate paid is
$838,665/$800,000 -1 = 4.8331%.
– Thus, the EAR is 1.0483312 -1 = 9.900%

2.4. Short-Term Financing with Commercial Paper
– Short-term, unsecured debt issued by large
corporations that is usually a cheaper source of
funds than a short-term bank loan
•Most commercial paper has a face value of at
least $100,000.
•Average maturity is 30 days and the maximum
maturity is 270 days.
•Commercial paper is rated by credit rating agencies.

A) Types of Commercial Paper
• Direct Paper
– Commercial paper that a firm sells directly to
investors
• Dealer Paper
– Commercial paper that dealers sell to investors in
exchange for a spread (or fee) for their services
•The spread decreases the proceeds that the
issuing firm receives, thus increasing the effective
cost of the paper.

Example
– A firm issues 180 day commercial paper with a

$1,000,000 face value and receives $950,000.
– What effective annual rate is the firm paying for its

funds?

Solution
365
 $1, 000, 000  180
Effective Annual Rate     1  10.96%
 $950, 000 

2.5 Short-Term Financing with Secured Financing
– A type of corporate loan in which specific assets are

pledged as a firm’s collateral
• Commercial banks, finance companies, and factors(Firms
that purchase the receivables of other companies), are
the most common sources for secured short-term loans.

A) Accounts Receivable as Collateral
Firms can use accounts receivable as security for a loan by:
• Pledging: an agreement in which a lender accepts
accounts receivable as collateral for a loan
•The lender typically lends a percentage of the value of
the accepted invoices.
• Factoring: an arrangement in which a firm sells
receivables to the lender (the factor) and the lender
agrees to pay the firm the amount due from its
customers at the end of the firm’s payment period.
• With recourse or without recourse
B) Inventory as Collateral
Ways that inventory can be used as collateral for a loan :
• Floating Lien, General Lien or Blanket Lien: a financial
arrangement in which all of a firm’s inventory is used to
secure a loan
•This is the riskiest setup from the standpoint of the lender
because the value of the collateral used to secure the loan
dwindles as inventory is sold.
• Trust Receipt Loan or Floor Planning: a type of loan in which
distinguishable inventory items are held in a trust as security
for the loan
•As these items are sold, the firm remits the proceeds from
their sale to the lender in repayment of the loan.
B) Inventory as Collateral
• Warehouse Arrangement: when the inventory that serves as
collateral for a loan is stored in a warehouse. A warehouse
arrangement is the least risky collateral arrangement from
the standpoint of the lender:
• Public Warehouse: a business that exists for the sole
purpose of storing and tracking the inflow and outflow of
inventory. This arrangement provides the lender with the
tightest control over the inventory.
• Field Warehouse: a warehouse arrangement that is
operated by a third party, but is set up on the borrower’s
premises in a separate area
Example
– Firm A wants to borrow $5 million for one month. Using

its inventory as collateral, it can obtain a 8% (APR) loan.
The lender requires that a warehouse arrangement be
used and the warehouse fee is $30,000, payable at the
end of the month.
– Calculate the effective annual rate of this loan for Firm A

Solution
– At the end of one month, Firm A will owe:

•Interest of: 8% ÷ 12 × $5,000,000 = $33,333
•Warehouse fee of: $30,000
•Total Cost = $63,333
12
 $5, 063,333 
EAR     1  16.3%
 $5, 000, 000 

Quiz
1. What is the effect of seasonality on short-term cash
flows?
2. What is the difference between temporary and
permanent working capital?
3. What is the difference between a committed and
uncommitted line of credit?
4. What is commercial paper?
5. What is the difference between a floating lien and a
trust receipt?

1 Corporate Financial Planing Ch1 2

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Master in Finance

Corporate Financial Planning

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•(1.05)0.5 – 1= 1.0247 – 1 = .0247 = 2.47%

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(1.09)1/4 – 1 = 2.1778% per quarter.

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• The APR is typically less than the effective annual rate

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Net Working Capital =Current Assets – Current Liabilities

Noncash Working Capital =Noncash Current Assets – Noncash

How should firms manage their working capital efficiently? How

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Accounts Receivable Days= Accounts Receivable

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– The project will require an investment today of $1,500,000 for

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• The investment in working capital costs the firm $630,135.

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How managers can compare the costs and benefits of trade to

Terms of Sale and Credit (how the credit will be offered):

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– Assume a firm sells a product for $100 and offers its

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EAR  (1.0204)365 / 20  1  44.6%

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1- Exposes the firm to the possibility that the customer will

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– Establishing Credit Terms

– Establishing a Collection Policy

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– A firm should always pay on the latest day allowed

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Total Cost = purchase cost + ordering cost + holding cost

- Purchase cost: unit price × annual demand quantity: P×D

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1- The just-in-time inventory system focuses on keeping the minimum

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- Depends on the nature of the business

- Size of the firm

- Sophistication of both banking technology and payment

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𝑂𝑝𝑡𝑖𝑚𝑎𝑙 𝐶𝑎𝑠ℎ 𝐵𝑎𝑙𝑎𝑛𝑐𝑒

Limitations: The model assumes that firms do not receive cash

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