The Role of Trade Credit and the Cost of Capital

• Abstract In this paper we show that working capital in the form of trade credit may constitute a significant share of firms’ debt capacity. Despite its character of a short-term debt, such capital seems to be a long-term element of the financial structure of the firm. This has implications for the determination of the cost of capital. We analyse the cost of different types of working capital in the context of firms’ investment appraisal arguing that cash com¬mitted to trade credit extended by suppliers should generally be omitted from free cash flow. The required rate of return should then be based on the total weighted average cost of capital, which includes the implicit (market based) interest cost of trade credit. We argue that the opportunity cost of trade credit should be expected to be higher than the average interest cost of interest-bearing debts albeit lower than the partial weighted average cost of capital based on long term (interest-bearing) debt and equity capital. Hence, in a (near) optimal capital structure, the total weighted average cost of capital would be lower than the partial weighted average cost of capital

Subject headings

SAMHÄLLSVETENSKAP  -- Ekonomi och näringsliv (hsv//swe)

SOCIAL SCIENCES  -- Economics and Business (hsv//eng)

Keyword

Cost of capital

trade finance

working capital

capital budgeting

Publication and Content Type

vet (subject category)

kon (subject category)