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At the end of the month you repay the bank the $100,000 face value of the loan, so you
are effectively paying interest of $1,000 on a loan of $99,000. The monthly interest rate
on such a loan is $1,000/$99,000 = 1.01 percent and the compound, or effective, annual
interest rate on this loan is 1.010112 “ 1 = .1282, or 12.82 percent. The effective inter-
est rate is higher than on the simple interest rate loan because the interest is paid at the
beginning of the month rather than the end.
The general formula for the equivalent compound interest rate on a discount interest
loan is
1 m

Effective annual rate on a discount loan = quoted annual interest rate “1
where the quoted annual interest rate is stated as a fraction (.12 in our example) and m
is the number of periods in the year (12 in our example).

Bank loans often require the firm to maintain some amount of money on balance at the
bank. This is called a compensating balance. For example, a firm might have to main-
tain a balance of 20 percent of the amount of the loan. In other words, if the firm bor-
rows $100,000, it gets to use only $80,000, because $20,000 (20 percent of $100,000)
must be left on deposit in the bank.
If the compensating balance does not pay interest (or pays a below-market rate of in-
terest), the actual interest rate on the loan is higher than the stated rate. The reason is
that the borrower must pay interest on the full amount borrowed but has access to only
part of the funds. For example, we calculated above that a firm borrowing $100,000 for
1 month at 12 percent simple interest must pay interest at the end of the month of
$1,000. If the firm gets the use of only $80,000, the effective monthly interest rate is
$1,000/$80,000 = .0125, or 1.25 percent. This is equivalent to a compound annual in-
terest rate of 1.012512 “ 1 = .1608, or 16.08 percent.
In general, the compound annual interest rate on a loan with compensating bal-
ances is

( )
Effective annual rate on a actual interest paid m
= 1+ “1
loan with compensating balances borrowed funds available
where m is the number of periods in the year (again 12 in our example).

Suppose that Dynamic Mattress needs to raise $20 million for 6 months. Bank A quotes
Self-Test 6
a simple interest rate of 7 percent but requires the firm to maintain an interest-free com-
pensating balance of 20 percent. Bank B quotes a simple interest rate of 8 percent but
does not require any compensating balances. Bank C quotes a discount interest rate of
7.5 percent and also does not require compensating balances. What is the effective (or
compound) annual interest rate on each of these loans?

Why do firms need to invest in net working capital?
Short-term financial planning is concerned with the management of the firm™s short-term,
or current, assets and liabilities. The most important current assets are cash, marketable
securities, inventory, and accounts receivable. The most important current liabilities are
bank loans and accounts payable. The difference between current assets and current
liabilities is called net working capital.
Net working capital arises from lags between the time the firm obtains the raw materials
for its product and the time it finally collects its bills from customers. The cash conversion
cycle is the length of time between the firm™s payment for materials and the date that it gets
paid by its customers. The cash conversion cycle is partly within management™s control. For
example, it can choose to have a higher or lower level of inventories. Management needs to
trade off the benefits and costs of investing in current assets. Higher investments in current
assets entail higher carrying costs but lower expected shortage costs.

How does long-term financing policy affect short-term financing requirements?
The nature of the firm™s short-term financial planning problem is determined by the amount
of long-term capital it raises. A firm that issues large amounts of long-term debt or common
stock, or which retains a large part of its earnings, may find that it has permanent excess
cash. Other firms raise relatively little long-term capital and end up as permanent short-term
debtors. Most firms attempt to find a golden mean by financing all fixed assets and part of
current assets with equity and long-term debt. Such firms may invest cash surpluses during
part of the year and borrow during the rest of the year.

How does the firm™s sources and uses of cash relate to its need for short-term bor-
The starting point for short-term financial planning is an understanding of sources and uses
of cash. Firms forecast their net cash requirement by forecasting collections on accounts
receivable, adding other cash inflows, and subtracting all forecast cash outlays. If the
forecast cash balance is insufficient to cover day-to-day operations and to provide a buffer
against contingencies, you will need to find additional finance. For example, you may
borrow from a bank on an unsecured line of credit, you may borrow by offering receivables
or inventory as security, or you may issue your own short-term notes known as commercial

How do firms develop a short-term financing plan that meets their need for cash?
The search for the best short-term financial plan inevitably proceeds by trial and error. The
financial manager must explore the consequences of different assumptions about cash
Working Capital Management and Short-Term Planning 191

requirements, interest rates, limits on financing from particular sources, and so on. Firms
are increasingly using computerized financial models to help in this process. Remember the
key differences between the various sources of short-term financing”for example, the
differences between bank lines of credit and commercial paper. Remember too that firms
often raise money on the strength of their current assets, especially accounts receivable and

www.businessfinancemag.com/ Business Finance Magazine has resources and software reviews
Related Web for financial planning
Links www.toolkit.cch.com/ Financial planning resources of all kinds
http://edge.lowe.org/quick/finance/ Short-term financial management tools
www.ibcdata.com/index.html Short-term investment and money fund rates

net working capital carrying costs line of credit
Key Terms cash conversion cycle shortage costs commercial paper

1. Working Capital Management. Indicate how each of the following six different transac-
Quiz tions that Dynamic Mattress might make would affect (i) cash and (ii) net working capital:

a. Paying out a $2 million cash dividend.
b. A customer paying a $2,500 bill resulting from a previous sale.
c. Paying $5,000 previously owed to one of its suppliers.
d. Borrowing $1 million long-term and investing the proceeds in inventory.
e. Borrowing $1 million short-term and investing the proceeds in inventory.
f. Selling $5 million of marketable securities for cash.

2. Short-Term Financial Plans. Fill in the blanks in the following statements:

a. A firm has a cash surplus when its ________ exceeds its ________. The surplus is nor-
mally invested in ________.
b. In developing the short-term financial plan, the financial manager starts with a(n)
________ budget for the next year. This budget shows the ________ generated or ab-
sorbed by the firm™s operations and also the minimum ________ needed to support these
operations. The financial manager may also wish to invest in ________ as a reserve for
unexpected cash requirements.

3. Sources and Uses of Cash. State how each of the following events would affect the firm™s
balance sheet. State whether each change is a source or use of cash.

a. An automobile manufacturer increases production in response to a forecast increase in
demand. Unfortunately, the demand does not increase.
b. Competition forces the firm to give customers more time to pay for their purchases.
c. The firm sells a parcel of land for $100,000. The land was purchased 5 years earlier for
d. The firm repurchases its own common stock.
e. The firm pays its quarterly dividend.
f. The firm issues $1 million of long-term debt and uses the proceeds to repay a short-term
bank loan.

4. Cash Conversion Cycle. What effect will the following events have on the cash conversion

a. Higher financing rates induce the firm to reduce its level of inventory.
b. The firm obtains a new line of credit that enables it to avoid stretching payables to its sup-
c. The firm factors its accounts receivable.
d. A recession occurs, and the firm™s customers increasingly stretch their payables.

5. Managing Working Capital. A new computer system allows your firm to more accurately
monitor inventory and anticipate future inventory shortfalls. As a result, the firm feels more
able to pare down its inventory levels. What effect will the new system have on working cap-
ital and on the cash conversion cycle?
6. Cash Conversion Cycle. Calculate the accounts receivable period, accounts payable period,
inventory period, and cash conversion cycle for the following firm:

Income statement data:
Sales 5,000
Cost of goods sold 4,200

Balance sheet data:

Beginning of Year End of Year
Inventory 500 600
Accounts receivable 100 120
Accounts payable 250 290

7. Cash Conversion Cycle. What effect will the following have on the cash conversion cycle?

a. Customers are given a larger discount for cash transactions.
b. The inventory turnover ratio falls from 8 to 6.
c. New technology streamlines the production process.
d. The firm adopts a policy of reducing outstanding accounts payable.
e. The firm starts producing more goods in response to customers™ advance orders instead
of producing for inventory.
f. A temporary glut in the commodity market induces the firm to stock up on raw materi-
als while prices are low.

8. Compensating Balances. Suppose that Dynamic Sofa (a subsidiary of Dynamic Mattress)
has a line of credit with a stated interest rate of 10 percent and a compensating balance of
Problems 25 percent. The compensating balance earns no interest.

a. If the firm needs $10,000, how much will it need to borrow?
b. Suppose that Dynamic™s bank offers to forget about the compensating balance require-
ment if the firm pays interest at a rate of 12 percent. Should the firm accept this offer?
Why or why not?
c. Redo part (b) if the compensating balance pays interest of 4 percent. Warning: You can-
not use the formula in the material for the effective interest rate when the compensating
balance pays interest. Think about how to measure the effective interest rate on this loan.
Working Capital Management and Short-Term Planning 193

9. Compensating Balances. The stated bank loan rate is 8 percent, but the loan requires a
compensating balance of 10 percent on which no interest is earned. What is the effective in-
terest rate on the loan? What happens to the effective rate if the compensating balance is
doubled to 20 percent?
10. Factoring. A firm sells its accounts receivables to a factor at a 1.5 percent discount. The av-
erage collection period is 1 month. What is the implicit effective annual interest rate on the
factoring arrangement? Suppose the average collection period is 1.5 months. How does this
affect the implicit effective annual interest rate?
11. Discount Loan. A discount bank loan has a quoted annual rate of 6 percent.

a. What is the effective rate of interest if the loan is for 1 year and is paid off in one pay-
ment at the end of the year?
b. What is the effective rate of interest if the loan is for 1 month?
12. Compensating Balances. A bank loan has a quoted annual rate of 6 percent. However, the
borrower must maintain a balance of 25 percent of the amount of the loan, and the balance
does not earn any interest.

a. What is the effective rate of interest if the loan is for 1 year and is paid off in one pay-
ment at the end of the year?
b. What is the effective rate of interest if the loan is for 1 month?

13. Forecasting Collections. Here is a forecast of sales by National Bromide for the first 4
months of 2001 (figures in thousands of dollars):
Month: 1 2 3 4
Cash sales 15 24 18 14
Sales on credit 100 120 90 70

On average, 50 percent of credit sales are paid for in the current month, 30 percent in the
next month, and the remainder in the month after that. What are expected cash collections
in months 3 and 4?
14. Forecasting Payments. If a firm pays its bills with a 30-day delay, what fraction of its pur-
chases will be paid for in the current quarter? In the following quarter? What if its payment
delay is 60 days?
15. Short-Term Planning. Paymore Products places orders for goods equal to 75 percent of its
sales forecast in the next quarter. What will be orders in each quarter of the year if the sales
forecasts for the next five quarters are:
Quarter in Coming Year Following Year
First Second Third Fourth First quarter
Sales forecast $372 $360 $336 $384 $384

16. Forecasting Payments. Calculate Paymore™s cash payments to its suppliers under the as-
sumption that the firm pays for its goods with a 1-month delay. Therefore, on average, two-
thirds of purchases are paid for in the quarter that they are purchased and one-third are paid
in the following quarter.
17. Forecasting Collections. Now suppose that Paymore™s customers pay their bills with a 2-
month delay. What is the forecast for Paymore™s cash receipts in each quarter of the coming
year? Assume that sales in the last quarter of the previous year were $336.
18. Forecasting Net Cash Flow. Assuming that Paymore™s labor and administrative expenses
are $65 per quarter and that interest on long-term debt is $40 per quarter, work out the net
cash inflow for Paymore for the coming year using a table like Table 2.7.

19. Short-Term Financing Requirements. Suppose that Paymore™s cash balance at the start of
the first quarter is $40 and its minimum acceptable cash balance is $30. Work out the short-
term financing requirements for the firm in the coming year using a table like Table 2.8. The
firm pays no dividends.
20. Short-Term Financing Plan. Now assume that Paymore can borrow up to $100 from a line
of credit at an interest rate of 2 percent per quarter. Prepare a short-term financing plan. Use
Table 2.9 to guide your answer.
21. Short-Term Plan. Recalculate Dynamic Mattress™s financing plan (Table 2.9) assuming that


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