Introductory Corporate Finance: Working Capital Management ShortTerm Financing Bank Loans Commercial Paper Trade Credit Accruals Wages Taxes AssetBased Loans Factoring

What This Is

Short-term financing refers to the various methods companies use to raise funds for a short period, typically less than a year. This is crucial in corporate finance as it helps companies manage their working capital, meet short-term obligations, and maintain liquidity. For instance, Tesla, a company with a high level of production and sales, might use short-term financing to cover its accounts payable and inventory costs.

Key Formulas & Models

• Bank Loan Balance = (Loan Amount) / (1 + (Interest Rate)) – calculates the outstanding balance of a bank loan after one period.
  • Loan Amount: the initial amount borrowed
  • Interest Rate: the interest rate charged on the loan
  • Interpretation: this formula shows how the loan balance changes over time due to interest payments.
• Commercial Paper Rate = (1 + (Commercial Paper Rate)) / (1 + (Risk-Free Rate)) – calculates the commercial paper rate based on the risk-free rate and the commercial paper rate.
  • Commercial Paper Rate: the rate at which commercial paper is issued
  • Risk-Free Rate: the rate on a risk-free investment
  • Interpretation: this formula shows how the commercial paper rate is affected by the risk-free rate.
• Trade Credit = (Accounts Payable) / (Days in Period) – calculates the trade credit available to a company.
  • Accounts Payable: the amount owed to suppliers
  • Days in Period: the number of days in the period
  • Interpretation: this formula shows how much trade credit a company can use to delay payment to suppliers.
• Accruals = (Wages) + (Taxes) – calculates the total accruals for a company.
  • Wages: the wages earned by employees
  • Taxes: the taxes owed by the company
  • Interpretation: this formula shows the total amount of accruals that a company needs to account for.
• Asset-Based Loan = (Asset Value) / (Lien Value) – calculates the asset-based loan available to a company.
  • Asset Value: the value of the assets used as collateral
  • Lien Value: the value of the lien on the assets
  • Interpretation: this formula shows how much an asset-based loan a company can obtain based on the value of its assets.
• Factoring = (Accounts Receivable) / (Factoring Rate) – calculates the factoring available to a company.
  • Accounts Receivable: the amount owed to the company by customers
  • Factoring Rate: the rate at which factoring is done
  • Interpretation: this formula shows how much factoring a company can use to sell its accounts receivable.

Step-by-Step Calculation

1. Calculate the bank loan balance using the formula Bank Loan Balance = (Loan Amount) / (1 + (Interest Rate)).
2. Determine the commercial paper rate using the formula Commercial Paper Rate = (1 + (Commercial Paper Rate)) / (1 + (Risk-Free Rate)).
3. Calculate the trade credit available to a company using the formula Trade Credit = (Accounts Payable) / (Days in Period).
4. Calculate the total accruals for a company using the formula Accruals = (Wages) + (Taxes).
5. Calculate the asset-based loan available to a company using the formula Asset-Based Loan = (Asset Value) / (Lien Value).
6. Calculate the factoring available to a company using the formula Factoring = (Accounts Receivable) / (Factoring Rate).

Common Mistakes

• Mistake: Using book value instead of market value for WACC.
  • Correction: Use market value for WACC as it reflects the current market price of the company's securities.
  • Example: A company has a market value of $100 million and a book value of $80 million. Using book value would result in an incorrect WACC.
• Mistake: Ignoring flotation costs when calculating WACC.
  • Correction: Include flotation costs in the WACC calculation as they represent the costs associated with issuing new securities.
  • Example: A company issues new bonds with a flotation cost of 2%. Ignoring this cost would result in an incorrect WACC.
• Mistake: Confusing sunk cost with opportunity cost.
  • Correction: Sunk costs are costs that have already been incurred and cannot be changed, while opportunity costs represent the benefits that could have been obtained from alternative uses of resources.
  • Example: A company has invested $100,000 in a project that has already been completed. The sunk cost is $100,000, while the opportunity cost is the potential benefit that could have been obtained from alternative uses of the resources.

Exam / CFA Tips

• Tip: When calculating WACC, make sure to use market value for the company's securities and include flotation costs.
• Tip: When calculating the degree of operating leverage (DOL), make sure to use the correct formula and assumptions.
• Tip: When calculating the sustainable growth rate, make sure to use the correct formula and assumptions.

Quick Practice Problem

A company has EBIT of $10 million, interest of $2 million, and tax of 25%. Calculate the degree of financial leverage (DFL).

Answer: DFL = (1 + (Interest/EBIT)) = (1 + ($2 million / $10 million)) = 1.2

Explanation: The DFL is calculated by adding 1 to the ratio of interest to EBIT.

Last-Minute Cram Sheet

• Definition: Short-term financing refers to the various methods companies use to raise funds for a short period.
• Formula: Bank Loan Balance = (Loan Amount) / (1 + (Interest Rate))
• Trap: ⚠️ In M&M Proposition I (no taxes), firm value is independent of capital structure – but with taxes, value increases with debt due to the interest tax shield.
• Definition: Trade credit refers to the amount of time a company has to pay its suppliers.
• Formula: Trade Credit = (Accounts Payable) / (Days in Period)
• Definition: Accruals refer to the total amount of wages and taxes owed by a company.
• Formula: Accruals = (Wages) + (Taxes)
• Definition: Asset-based loan refers to the loan available to a company based on the value of its assets.
• Formula: Asset-Based Loan = (Asset Value) / (Lien Value)
• Definition: Factoring refers to the sale of accounts receivable to a third party.
• Formula: Factoring = (Accounts Receivable) / (Factoring Rate)