The Role of Trade Credit and the Cost of Capital

Abstract

Trade credit and other types of working capital, like inventory, may constitute significant components of a long-term investment in capacity expansion, particularly within businesses dependent on working capital, like wholesaling and retailing. Still the treatment of cash committed to these types of working capital is often lacking in consistency; the focus tends to be on net cash flow effects (see for example Allen, 1976; Kroll, 1985; Kaplan and Ruback, 1995; Mills, 1996). The standard approach is to regard the net of the initial working capital cash flow of a project as an investment that will be recovered at the termination of the project. Cash committed to inventory or trade credit in the form of receivables or payables, is thus implicitly assumed to be equally sensitive to changes in the economic environment. This may often, though, be considered as a major simplification or even an anomaly. Different types of working capital are exposed to different kinds of risk (cf. Cooley et al., 1975). Even in the deterministic case of certainty, it may be misleading to only consider net working capital if there is exposure to inflation (cf. Kim, 1979). As we will show in this chapter, a consistent treatment of cash committed to trade credit and inventory may be of vital importance not only for the investment appraisal decision, but also for an accurate determination of the overall cost of capital, and thus the optimal capital structure of the firm.