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16model 10/6/2009 8:16 Chapter 16. Model for Financing Current Assets In this chapter, we addressed the topic of working capital management, and now we will discuss the policies set for finance working capital. Using short-term financing to support the firm's productive assets has both advantages a disadvantages. An aggressive policy entails heavy reliance upon short-term debt, while a conservative policy woul for less use of short-term debt. At first glance, short-term debt financing offers firms greater speed, more flexibility, and generally lower interest r However, short-term financing still carries a risk. Long-term financing allows firms to lock in an interest expense, whereas short-term financing can expose a firm to a wildly fluctuating interest expense. Over reliance on short-ter debt could quickly lead to default if a substantial recession should hit. The major sources of short-term debt financing are short-term bank loans (notes payable), accruals, and trade cre (accounts payable). TRADE CREDIT Accounts payable, or trade credit, is the largest single category of short-term debt on the balance sheet, representin approximately 40 percent of the average nonfinancial corporation's current liabilities. Accounts payable, like accr is a spontaneous liability because it generally experiences corresponding growth to a firm's productive assets. A fi credit policy tells us the terms by which they allow customers to purchase goods on credit. For example, Microchi Electronics' credit policy is on terms of 2/10, net 30. This is interpreted as a 2% discount if paid within the first ten days, but the full invoice amount is due within 30 days if the discount is not taken. If we are told that Microchip's annual purchases are $11,923,333, we can calculate the firm's average daily A/P. (We will use a 365-day accountin year.) Annual chip purchases $11,923,333 Days/year 365 Daily A/P $32,667 From the firm's trade terms, we also know the following: % Discount 2% Discount period (in days) 10 Days until due 30 If Microchip's customers decide to take advantage of the discount, the average accounts payable can be determine multiplying the daily accounts payable by the discount period. Average A/P (w/discount) $326,667 However, if the firm's customers decide to not take advantage of the discount, we assume that they will take the fu to pay off the debt. We can determine the average accounts payable under this scenario, too. Average A/P (w/o discount) $980,000 A B C D E F G H 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49
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The difference between these two average accounts payable figures tells the amount of credit Microchip offers to it customers. Microchip's customers can use this trade credit to build up its cash account, to pay off debt, to expand inventories, or to extend credit to its customers. Trade Credit
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