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A Short-Term Financing Plan

OPTIONS FOR SHORT-TERM FINANCING

Suppose that Dynamic can borrow up to $40 million from the bank at an interest cost of 8 percent per year or 2 percent per quarter. Dynamic can also raise capital by putting off paying its bills and thus increasing its accounts payable. In effect, this is taking a loan from its suppliers. The financial manager believes that Dynamic can defer the following amounts in each quarter:

That is, $52 million can be saved in the first quarter by not paying bills in that quarter. (Note that Table 2.7 was prepared assuming these bills are paid in the first quarter.) If deferred, these payments must be made in the second quarter. Similarly, $48 million of the second quarter`s bills can be deferred to the third quarter and so on.

Stretching payables is often costly, however, even if no ill will is incurred.7 This is because many suppliers offer discounts for prompt payment, so that Dynamic loses the discount if it pays late. In this example we assume the lost discount is 5 percent of the amount deferred. In other words, if a $52 million payment is delayed in the first quarter, the firm must pay 5 percent more, or $54.6 million in the next quarter. This is like borrowing at an annual interest rate of over 20 percent (1.054 Ј 1 = .216, or 21.6%). With these two options, the short-term financing strategy is obvious: use the lower cost bank loan first. Stretch payables only if you can`t borrow enough from the bank. Table 2.9 shows the resulting plan. The first panel (cash requirements) sets out the cash that needs to be raised in each quarter. The second panel (cash raised) describes the various sources of financing the firm plans to use. The third and fourth panels describe how the firm will use net cash inflows when they turn positive.

In the first quarter the plan calls for borrowing the full amount available from the bank ($40 million). In addition, the firm sells the $5 million of marketable securities it held at the end of 2000. Thus under this plan it raises the necessary $45 million in the first quarter.

In the second quarter, an additional $15 million must be raised to cover the net cash outflow predicted in Table 2.7. In addition, $.8 million must be raised to pay interest on the bank loan. Therefore, the plan calls for Dynamic to maintain its bank borrowing and to stretch $15.8 million in payables. Notice that in the first two quarters, when net cash flow from operations is negative, the firm maintains its cash balance at the minimum acceptable level. Additions to cash balances are zero. Similarly, repayments of outstanding debt are zero. In fact outstanding debt rises in each of these quarters.

In the third and fourth quarters, the firm generates a cash-flow surplus, so the plan calls for Dynamic to pay off its debt. First it pays off stretched payables, as it is required to do, and then it uses any remaining cash-flow surplus to pay down its bank loan. In the third quarter, all of the net cash inflow is used to reduce outstanding short-term borrowing. In the fourth quarter, the firm pays off its remaining short-term borrowing and

uses the extra $3 million to increase its cash balances.

a From Table 2.7, bottom line. A negative cash requirement implies positive cash flow from operations.

b The interest rate on the bank loan is 2 percent per quarter applied to the bank loan outstanding at the start of the quarter. Thus the interest due in the second quarter is .02 $40 million = $.8 million.

c The ¬interest ­ cost of the stretched payables is 5 percent of the amount of payment deferred. For example, in the third quarter, 5 percent of the $15.8 million stretched in the second quarter is about $.8 million.

7 In fact, ill will is likely to be incurred. Firms that stretch payments risk being labeled as credit risks. Since stretching is so expensive, suppliers reason that only customers that cannot obtain credit at reasonable rates elsewhere will resort to it. Suppliers naturally are reluctant to act as the lender of last resort.