Trade Credit and Capital Structure

Transcription

1 Trade Credit and Capital Structure John R. Birge (Joint work with Song (Alex) Yang, London Business School, and Xiaodong Xu, BNP Paribas) The University of Chicago Booth School of Business SCF Symposium March 2011 Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

2 Themes Background Trade credit plays a key role in supply chain finance Trade credit provides a flexible risk-sharing mechanism Tax advantages of debt and distress costs imply optimal capital structure choices Early commitment considerations in supply chains lead to different implications from traditional analyses Empirical results support the theory Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

3 How to view trade credit? Background Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

4 How to view trade credit? Background The supplier proposes a contract. The order is delivered. Demand is realized. Time The retailer places an order. Payment is due. Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

5 How to view trade credit? Background The supplier proposes a contract. The order is delivered. Demand is realized. Time The retailer places an order. Payment is due. Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

6 How to view trade credit? Background The supplier proposes a contract. The order is delivered. Demand is realized. Time The retailer places an order. Payment is due. The credit suppliers extend to buyers. Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

7 How to view trade credit? Background The supplier proposes a contract. The order is delivered. Demand is realized. Time The retailer places an order. Payment is due. The credit suppliers extend to buyers. Accounts Receivable (suppliers) and Accounts Payable (buyers). Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

8 Background How to view trade credit? The supplier proposes a contract. The order is delivered. Demand is realized. Net period Time The retailer places an order. Payment is due. The credit suppliers extend to buyers. Accounts Receivable (suppliers) and Accounts Payable (buyers). Net (one-part) terms net 30: payment is due within 30 days. Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

9 Background How to view trade credit? The supplier proposes a contract. The order is delivered. Demand is realized. Net period Time Discount period The retailer places an order. Discount applies. Payment is due. The credit suppliers extend to buyers. Accounts Receivable (suppliers) and Accounts Payable (buyers). Net (one-part) terms net 30: payment is due within 30 days. Two-Part Terms 2/10 net 30: payment is due within 30 days, if paid within 10 days, 2% discount applies. Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

10 Background Trade Credit across Industries Trade credit (payables) vary by industry Payable days generally increase in value of goods Strong relationship with inventory days Yang and Birge: Trade Credit in Supply Chains Article submitted to ; manuscript no. (Please, provide the mansucript number!) Figure 1 Payable Days versus Inventory Days by Sub-category 70 Payable Days = Inventory Days 60 (2.44) (3.01) Payable Days Inventory Days Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

11 Background Trade Credit and Operations Trade credit: The single largest source of short-term financing in U.S. Rajan and Zingales (1995): 15% (vs. debt in current liability (7.4%)); Operations deal with short-term decisions: inventory, pricing, etc. Trade credit links firms financial flows; supply chain links firms material and information flows How should trade credit be studied in a supply chain setting? Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

12 Background Petersen and Rajan (1997): The SINGLE MOST IMPORTANT source of short-term external finance in the United States. Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

13 Background Petersen and Rajan (1997): The SINGLE MOST IMPORTANT source of short-term external finance in the United States. 32.0% Inventory 15.1% 5.0% Cash & Eq 2.1% Ct. Debt Accounts Payable Assets Liabilities Figure: balance sheet items as a fraction of total assets (median) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

14 Background Petersen and Rajan (1997): The SINGLE MOST IMPORTANT source of short-term external finance in the United States. Main Findings (Yang and Birge 2009) 32.0% Inventory 15.1% 5.0% Cash & Eq 2.1% Ct. Debt Accounts Payable Assets Liabilities Figure: balance sheet items as a fraction of total assets (median) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

15 Background Petersen and Rajan (1997): The SINGLE MOST IMPORTANT source of short-term external finance in the United States. Main Findings (Yang and Birge 2009) Trade credit serves as a risk-sharing mechanism in supply chains; 32.0% Inventory 15.1% 5.0% Cash & Eq 2.1% Ct. Debt Accounts Payable Assets Liabilities Figure: balance sheet items as a fraction of total assets (median) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

16 Background Petersen and Rajan (1997): The SINGLE MOST IMPORTANT source of short-term external finance in the United States. Main Findings (Yang and Birge 2009) Trade credit serves as a risk-sharing mechanism in supply chains; The optimal trade credit term balances operational profits and costs of financial distress; 32.0% Inventory 5.0% Cash & Eq Assets 2.1% Ct. Debt Liabilities 15.1% Accounts Payable Figure: balance sheet items as a fraction of total assets (median) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

17 Background Petersen and Rajan (1997): The SINGLE MOST IMPORTANT source of short-term external finance in the United States. Main Findings (Yang and Birge 2009) Trade credit serves as a risk-sharing mechanism in supply chains; The optimal trade credit term balances operational profits and costs of financial distress; 32.0% Inventory 5.0% Cash & Eq Assets 2.1% Ct. Debt Liabilities 15.1% Accounts Payable Retailers finances their inventory using a portfolio of cash, trade credit, and short-term debt. Figure: balance sheet items as a fraction of total assets (median) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

18 However... Background Treat trade credit as given, why? Quoted: net 30, or 2/10 net 30 Reported mismatch: Ng et. al (1999) In actuality: Discounts or terms exaggerated: Antov and Atanasova (2007) Large variation in balance sheet positions Terms difficult to enforce Our view: trade credit is a mechanism to improve supply chain performance (and possibly equity market performance (Cohen and Frazzini (2009)) Trade credit allows for productive risk sharing Markets appear to be slow to incorporate supply chain effects into prices Supply-chain partner connections can be informative Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

19 Background Problems Addressed in Research Project Why do firms use trade credit? How can firms use trade credit as a mechanism to improve supply chain performance? How does trade credit perform relative to other forms of financing? What is the effect of different seniority for different forms of credit and should one be preferred? What is the effect of multiple suppliers on supply chain performance with trade credit? Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

20 Literature Background Theory of trade credit Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

21 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

22 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

23 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

24 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) price discrimination: Brennan et al. (1988) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

25 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) price discrimination: Brennan et al. (1988) quality control: Long et al. (1993), Kim and Shin (2007), Babich and Tang (2010) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

26 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) price discrimination: Brennan et al. (1988) quality control: Long et al. (1993), Kim and Shin (2007), Babich and Tang (2010) Empirical support: financing, default, price, quality (e.g., Klapper, Laeven, and Rajan (2010)) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

27 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) price discrimination: Brennan et al. (1988) quality control: Long et al. (1993), Kim and Shin (2007), Babich and Tang (2010) Empirical support: financing, default, price, quality (e.g., Klapper, Laeven, and Rajan (2010)) Priorities/Reclamation Rights Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

28 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) price discrimination: Brennan et al. (1988) quality control: Long et al. (1993), Kim and Shin (2007), Babich and Tang (2010) Empirical support: financing, default, price, quality (e.g., Klapper, Laeven, and Rajan (2010)) Priorities/Reclamation Rights Schwartz (1989, 1997), Adler (1991), Barclay and Smith Jr (1995) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

29 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) price discrimination: Brennan et al. (1988) quality control: Long et al. (1993), Kim and Shin (2007), Babich and Tang (2010) Empirical support: financing, default, price, quality (e.g., Klapper, Laeven, and Rajan (2010)) Priorities/Reclamation Rights Schwartz (1989, 1997), Adler (1991), Barclay and Smith Jr (1995) Garvin (1996), Katz and Dion (2005), Morris (2007) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

30 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) price discrimination: Brennan et al. (1988) quality control: Long et al. (1993), Kim and Shin (2007), Babich and Tang (2010) Empirical support: financing, default, price, quality (e.g., Klapper, Laeven, and Rajan (2010)) Priorities/Reclamation Rights Schwartz (1989, 1997), Adler (1991), Barclay and Smith Jr (1995) Garvin (1996), Katz and Dion (2005), Morris (2007) Operations-Finance interaction Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

31 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) price discrimination: Brennan et al. (1988) quality control: Long et al. (1993), Kim and Shin (2007), Babich and Tang (2010) Empirical support: financing, default, price, quality (e.g., Klapper, Laeven, and Rajan (2010)) Priorities/Reclamation Rights Schwartz (1989, 1997), Adler (1991), Barclay and Smith Jr (1995) Garvin (1996), Katz and Dion (2005), Morris (2007) Operations-Finance interaction irrelevance results of Modigliani and Miller (1958) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

32 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) price discrimination: Brennan et al. (1988) quality control: Long et al. (1993), Kim and Shin (2007), Babich and Tang (2010) Empirical support: financing, default, price, quality (e.g., Klapper, Laeven, and Rajan (2010)) Priorities/Reclamation Rights Schwartz (1989, 1997), Adler (1991), Barclay and Smith Jr (1995) Garvin (1996), Katz and Dion (2005), Morris (2007) Operations-Finance interaction irrelevance results of Modigliani and Miller (1958) individual firm combinations: Xu and Birge (2004) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

33 Background Literature Theory of trade credit financing motive: Schwartz (1977), Emery (1984) default related: Frank and Maksimovic (1998) (liquidation), Wilner (2000), Cuñat (2007), Boissay and Gropp (2009) (liquidity, continuation) transaction cost: Ferris (1981) price discrimination: Brennan et al. (1988) quality control: Long et al. (1993), Kim and Shin (2007), Babich and Tang (2010) Empirical support: financing, default, price, quality (e.g., Klapper, Laeven, and Rajan (2010)) Priorities/Reclamation Rights Schwartz (1989, 1997), Adler (1991), Barclay and Smith Jr (1995) Garvin (1996), Katz and Dion (2005), Morris (2007) Operations-Finance interaction irrelevance results of Modigliani and Miller (1958) individual firm combinations: Xu and Birge (2004) supply chain effects: Gupta (2008), Lai et al. (2009), Kouvelis and Zhao (2009), Caldentey and Chen (2009) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

34 The Basic Trade Credit Model 1 Background 2 The Basic Trade Credit Model 3 Empirical Tests 4 Multiple Creditors and Priority Rules 5 Capital Structure Model 6 Conclusion Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

35 The Basic Trade Credit Model Problems with Fixed Wholesale Prices versus Trade Credit Capital Utilization: Lower financing cost may be possible with trade credit Risk-sharing: With up-front payment, risk is not shared efficiently Chain profits are reduced by double marginalization without risk sharing Result: Suppliers may improve profits with trade credit contract Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

36 The Basic Trade Credit Model Model of a Two-part Trade Credit Contract Suppliers propose: w 1: cash price, paid upon delivery w 2: credit price, only paid in full when no bankruptcy Buyer responds: Order cash and credit amounts: x 1 and x 2 Borrow from the bank: D = w 1x 1 (K C f ) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

37 The Basic Trade Credit Model Result without Trade Credit (Bank loan only) Results: As buyer s cash position increases, supplier s profit improves but buyer s profit does not always improve Fully coordinating only when no loan is needed Yang and Birge: Trade Credit in Supply Chains 14 Article submitted to ; manuscript no. (Please, provide the mansucript number!) Table 1 Monotone Results under the Optimal Price-Only Contract Kr w x w θw πw s πw r πw c [0, κ b w) [κ b w, κ nb w ) 0 [κ nb w, ) 0 Figure 4 Optimal Wholesale Contract with Bank Loan 30% 25% 20% 15% 10% 5% 100% nb nb (x xw )/x w w 95% F(θ )(default prob.) w 90% 85% 80% 75% π r w /πr nb π s w /πs nb 0% nb K /κ r w 70% nb K /κ r w probability. The sudden drop of x w corresponds to the region Kr [κb w, κnb w ], where the retailer stops borrowing (θw = 0) and only orders the amount allowed by his internal cash. In the right panel, the profits suggest that with a price-only contract, the retailer s financial constraint actually hurts Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

38 The Basic Trade Credit Model Result with Trade Credit: No Fixed Costs/Other Debts Assumption: (K C f ) 0: Buyer does not need to borrow if suppliers extend full credit Result: Suppliers propose open account: w 1 = w 2 (no-interest loan) Buyers use full credit facility: x = x 2 Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

39 The Basic Trade Credit Model Additional Cost Implications: Seniority Matters The Basic Framework: Risk-neutral (equivalent) parties; Supplier offers open account contract with price w; Retailer with cash position, K R 0, responses with quantity x, and borrows B from the bank; Perfect financial market; Basic Result: B + K R = 0. Focus: How does seniority matter? Bank Loan is Senior; (Leftover) Inventory As Bank Loan s Collateral; Equal Seniority; Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

40 The Basic Trade Credit Model When Bank Loan is Senior... Supplier receives nothing until bank loan and factoring (if any) are fully paid off Total losses to distress costs can be lowered by maintaining hierarchy of seniority Yang and Birge: Trade Credit in Supply Chains Article submitted to ; manuscript no. (Please, provide the mansucript number!) 17 Figure 5 Seniority and Default Thresholds Revenue Revenue Retailer Retailer Trade creditor (Supplier) Trade creditor rb Bank loan tc Factor Bank loan x Demand rb Demand f tc the x-axis represents the realized demand ξ and the y-axis represents total revenue. Default thresholds and order quantity are marked based on our seniority arrangement, and the darkened area Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

41 The Basic Trade Credit Model How Trade Credit Extends Efficiency Bank loan increases buyer s capability but at higher cost Trade credit increases buyer s capability but the cost becomes lower (as some is shared with Yang and creditors) Birge: Trade Credit in Supply Chains Article submitted to ; manuscript no. (Please, provide the mansucript number!) 21 Figure 6 Marginal Revenue vs. Marginal Cost for the Retailer: Cases with Different Sources of Financing MR or MC Marginal Revenue Marginal Cost w Cash w Cash Bank Loan xt I: no leverage Order II: levered with only a bank loan Quantity A D w2 C w 1 =w 2 w1 B Bank Cash Trade Cash Trade Loan Credit Credit E III: moderately levered with cheap trade credit IV: highly levered with both a bank loan and trade credit in Proposition 4, together with the price-only contract with a bank loan, are presented in four panels, in which the x-axis represents the order quantity and the y-axis represents marginal revenue or marginal cost. Clearly, the optimal order quantity is determined when marginal cost equals marginal revenue. In panel I, the retailer has sufficient internal resource; the contract degenerates Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

42 profit Birge (Chicago increases Booth) as K decreases, The Role of correcting Trade Credit and thecapital problem Structure with in Supply thechains price-only contract. 24 March / 39 The Basic Trade Credit Model Supply Chain Performance with Trade Credit As buyer s capital increases, supplier s profits decline while retailer s profits rise Yang and Birge: Trade Credit Supply Chains As Article buyer s submittedcapital to ; manuscript increases, no. (Please, provide the offered the mansucript price number!) and the order quantity decline 23 Figure 8 Optimal Trade Credit Contract: Supply Chain Performance w 2 /w nb x t /x w nb π r tc /πr nb π s tc /πs nb tc K /κ r r tc K /κ r r monotonically as K r increases. Whereas the retailer faces a relatively constant return, the supplier s

43 The Basic Trade Credit Model General Conclusions from Simple Single Supplier-Buyer Model Trade credit improves supplier s profit when junior to bank loan Buyer s profit can also increase with trade credit if the buyer has sufficient cash Hypotheses for empirical study: Trade credit (payables) should increase with buyer s inventory holdings Trade credit should be more highly correlated with inventory for buyer s with greater seasonal inventory variation Bank loans (current debt) should not vary with buyer s inventory positions for buyer s with low seasonal inventory variation Bank loans (current debt) should increase with buyer s inventory positions for buyer s with high seasonal inventory variation Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

44 Empirical Tests 1 Background 2 The Basic Trade Credit Model 3 Empirical Tests 4 Multiple Creditors and Priority Rules 5 Capital Structure Model 6 Conclusion Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

45 5.1. How Much Trade Credit Do Retailers Used? Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39 assets of around $424 million). These companies usually have easy access to financial markets Empirical Tests have fewer information issues, hence fitting our model. Second, the most recent data are chose Regression for Hypothesis Testing the wide usage of information technology weakens the transaction-related motive of trade cre Third, as retailers represent the end of the entire supply chain and sell goods to end consum Regression equations: they normally carry less accounts receivable (our data show that the median receivable days retailers are fewer than seven), most Payable t of which = αpay t should + βpay t be related INV t to credit + ɛ t card transactions, al pay ing us to isolate companies role as CDebt t borrowers. = αdebt t Finally, + βdebt INV t for two reasons, t + ɛ t we select companies wh debt fiscal years are largely aligned with the calender year. First, many retailers expect large sales d ing holiday season (the fourth calender quarter), hence building large amounts of inventory, w allows Sortus by toinventory test the hypothesis; variation second, this selection minimizes the fiscal-year-end effect. W these criteria, High (33% we have of 2,127 sales in firm-year Q4) samples. Table 2 summarizes some descriptive statistic our datalow set. (26% of sales in Q4) Table 2 Descriptive Statistics Assets Balance Sheet Items as a Fraction of Total Assets ($ Million) Inventory Cash & Eq Receivable Payable Ct. Debt Mean % 10.3% 8.7% 17.3% 7.4% Q % 2.1% 1.6% 10.1% 0.2% Q % 5.0% 4.3% 15.1% 2.1% Q % 13.6% 11.8% 21.4% 7.6%

46 Cumulat 30% Empirical Tests 10% Payable Days across Firms and Industries Payable Days Yang and Birge: Trade Credit in Supply Chains 30 Article submitted to ; manuscript no. (Please, provide the mansucript number!) firm-years with extra cash, and firms-years of The figure illustrates three important features. Figure 12 Cumulative Distribution of Payable Days First, most companies have long outstanding payable days. For example, the median company s 90% payable days > 40, which is beyond the net period of most industries reported in Ng et al. (1999). Cumulative Distribution Second, payable days cover a wide range, suggesting the usage and terms of trade credit vary 70% among companies. Third, the usage of trade credit of firm-years with extra cash is similar to that of all firm-years, implying the implicit interest of trade credit is unlikely to be high. 50% Table 3 summarizes the quartiles of accounts payable days and inventory days (91.25*Average All (N = 2127) Quarterly Inventory/Cost of Goods Sold) within each subcategory of retailers. The data suggests 30% Cash/Sales >0.05 (N = 675) that even within a subcategory in the retail sector, the2008 usage (N of= trade 176) credit varies greatly. In addition, most subcategories 10% have a median payable days greater than 30. The above two observations Payable Days further suggest that in practice, trade credit terms can be quite flexible even within a sub-industry, and the net period is not strictly enforced. firm-years with extra cash, and firms-years of The figure illustrates three important features. Table First, 3 most Quartiles companies of Accounts havepayable long outstanding Days Inventory payable Daysdays. by Subcategory For example, in Retail the median company s Subcategory in Retail Num. of Payable Days Inventory Days payable(north days America > 40, which Industryis Classification beyond the System) net period Firm-Years of most industries reported in Ng et al. (1999). Q1 Q2 Q3 Q1 Q2 Q3 All Retailers Second, Motor payable Vehicledays and Parts cover Dealers a wide (441) range, suggesting 183 the 5.7usage and terms of trade credit vary Furniture and Home Furnishings Stores (442) among Electronics companies. andthird, Appliance the Stores usage (443) of trade credit of97 firm-years with 49.8 extra 35.0 cash 67.4 is109.8 similar to that Building Material and Garden Equipment and of all firm-years, Supplies Dealers implying (444) the implicit interest of trade 68 credit is unlikely to be83.0 high Food and Beverage Stores (445) TableHealth 3 summarizes and Personalthe Carequartiles Stores (446) of accounts payable days42.8 and63.0 inventory 14.9 days 48.9 (91.25*Average 95.0 Gasoline Stations (447) Quarterly Clothing Inventory/Cost and Clothing Accessories of Goods Stores Sold) (448) within each 543subcategory of retailers The data suggests Sporting Goods, Hobby, Book, and that even Music within stores a(451) subcategory in the retail sector, the 208usage 49.3 of 62.5 trade 88.5credit varies greatly In addition, most Miscellaneous subcategories Store Retailers have a(453) median payable days109 greater than The 57.3above 84.8 two 113.6observations Nonstore Retailers (454) General Merchandise Stores (452) further suggest that in practice, trade credit terms can be quite flexible even within a sub-industry, and the net period is not strictly enforced. All (N = 2127) Cash/Sales >0.05 (N = 675) 2008 (N = 176) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

47 Empirical Tests group (β > 0.6) and in the low group (β < 0.4) are both statistically and economically significant, Regression Results Hypotheses: suggesting companies with higher leverage use more accounts payable to finance inventory. In addition, R 2 in the high group is much larger than that in the low group. Adding changes in cash and receivable as independent variables does not alter this result. Second, in panel B, the influence of inventory change on the level of short term debt is barely significant in the low group (t-stat 2 and R 2 0), where the influence is much stronger in the high group (t-stat > 8 and R 2 > 5%). By β H pay > β L pay > 0 adding Cash & Eq as an independent variable, the influence in the high group remains the same, whereas that in the low group becomes insignificant (t-stat < 0.5). This finding again suggests that β H debt > β L debt = 0 during the regular period, companies use little short-term debt to finance inventory. However, during the period with high leverages, they use some short-term debt, making the inventory financing portfolio more diversified. Table 5 Regression of Payable and Ct. Debt on Inventory, Receivable and Cash & Eq. Panel A: Payable Regression L H L H L H L H Inventory (14.48) (26.57) (13.97) (26.22) (14.84) (28.22) (14.37) (27.89) Receivable (5.51) (2.98) (5.59) (4.01) Cash & Eq (2.99) (9.33) (3.15) (9.73) Adjusted R Panel B: Ct. Debt Regression L H L H L H L H Inventory (2.10) (9.15) (1.81) (8.82) (0.76) (9.32) (0.50) (9.00) Receivable (2.56) (3.05) (2.47) (3.31) Cash & Eq (-6.48) (2.53) (-6.44) (2.84) Adjusted R Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

48 Empirical Tests 1 Background 2 The Basic Trade Credit Model 3 Empirical Tests 4 Multiple Creditors and Priority Rules 5 Capital Structure Model 6 Conclusion Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

49 Comparisons to Theory Empirical Tests Theoretical model (trade-credit/bank loan vs. financing need): Empirical results (payables/short-term debt beta vs. financing need): Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

50 Multiple Creditors and Priority Rules 1 Background 2 The Basic Trade Credit Model 3 Empirical Tests 4 Multiple Creditors and Priority Rules 5 Capital Structure Model 6 Conclusion Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

51 Multiple Creditors and Priority Rules Extension: Multiple Suppliers and Other Risks Suppliers share in the risk of each other s product s demand even if demands are independent Questions: Does the advantage of trade credit extend in these cases? How should priority of claims be set? Basic Results: Buyers and suppliers still have an advantage from trade credit Suppliers generally should prefer to be junior to bank loans Additional complications with other financial claims (e.g., long-term or credit secured with other assets) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

52 Capital Structure Model Relationship to Capital Structure Debt (trade and other) has tax advantage but causes distress Traditional models consider the tradeoff but provide often not early production commitment Early commitment effects lead to different relationships Can observe the relationship with profitability and inventory Commit for purchase/sale Realize demand/revenue Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

53 Basic Model Capital Structure Model Decisions: Debt D t, equity E t, capacity investment (orders) x t, sales y t, and continuation (or bankruptcy s b ) Financial distress: Proportional deadweight cost α Tax rates on profits τ Random process ω t for demand s t, unit cost c t, loan rate r t, fixed costs K t Competitive financial market, no issuing costs V t(k t, D t 1, ω t ) = max xt,y t,s b,d t,e t {0, c tx t K t + 1 ( 1+r f y t (p ty t τ(p ty t c tx t r td t K t)) f t(s) ds yt + (p ts τ(p ts c tx t r td t K t)) f t(s) ds s s s b + p tsf (s)ds + α psf t(s)ds s b 0 +E s(e ω t+1 (s,ω t ) [V t+1(k t+1 (y t, s), D t, ω t+1 )]))}, s b subject to D t = 1+rt (D 1+r f t[1 F t(s b )] + α p tsf (s)ds, 0 x t + k t = y t, 0 c tx t + K t 1 D 1+r t + E t D t t 1, (5.1) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

54 Capital Structure Model Model Implications Firm value is more sensitive to mis-specification of the operational decisions x t than to the equity and debt decisions E t and D t Market leverage (ratio of debt to market value V t ) has a convex relationship to firm margins as measured by p t c t with initial negative relationship between leverage and margins for low margins Leverage may then increase in operating margin for high margin values As fixed costs rise, leverage should decrease Since observed firms with large losses are more likely to have expected high operating margins, operating margins are most likely decreasing in profits of firms with substantial losses and then increasing Combining the implications on profitability, leverage should first increase in observed profits (as a fraction of sales) and then follow a convex or U-shaped relationship Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

55 Implied relationship Capital Structure Model High-fixed cost firms with high but decreasing margins as observed profit increases Low-fixed cost firms with increasing margins in observed profit Combination of increases-decrease-increase for observed leverage High Fixed Leverage Low Fixed Total Profit Margin Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

56 Capital Structure Model Hypotheses to Test H1: Firms with operating losses exhibit an increasing relationship between debt-to-market-value ratio and pre-tax operating margin. H2: Firms with low positive operating margins exhibit a decreasing relationship between debt-to-market-value ratio and pre-tax operating margin. H3: Firms with high positive operating margins may exhibit a increasing relationship between debt-to-market-value ratio and pre-tax operating margin, depending on the distribution of demand for the firm s products or services. H4: The volatility of inventories is initially decreasing in operating margin as firm losses decrease to zero and then increases as operating margin becomes significantly positive. Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

57 Empirical results Capital Structure Model Compare pre-tax operation margin and market leverage using Value Line and Compustat firms Compare within years and within industry Table: Average market leverage by pre-tax operating margin deciles 2006 (Value Line). US 2006 Data N = 5609 Decile Max pre-tax Average Standard Test op. margin leverage deviation statistic % 16.72% 24.78% % 21.02% 29.10% % 26.24% 31.75% % 22.68% 25.72% % 20.39% 24.86% % 18.94% 22.45% % 16.88% 19.13% % 16.02% 19.49% % 17.19% 21.30% % 21.60% 23.45% Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

58 Empirical Relationship Capital Structure Model Leverage versus deciles of pre-tax operating margin/sales Consistent for each year, industry, and dataset 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

59 Capital Structure Model Inventory Volatility Relationship H4: The volatility of inventories is initially decreasing in operating margin as firm losses decrease to zero and then increases as operating margin becomes significantly positive. Table: Average of CoV of inventory by average pre-tax operating margin deciles over the period (N = 1513) Decile Average CoV of Inventory Test statistic Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

60 Current Study Capital Structure Model Investigate effect of change in US law (BAPCA) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

61 Current Study Capital Structure Model Investigate effect of change in US law (BAPCA) Prediction is that trade credit and efficiency declined as trade credit treated as more senior Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

62 Current Study Capital Structure Model Investigate effect of change in US law (BAPCA) Prediction is that trade credit and efficiency declined as trade credit treated as more senior Validate prediction that trade credit is best (and efficiency improving) when: Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

63 Current Study Capital Structure Model Investigate effect of change in US law (BAPCA) Prediction is that trade credit and efficiency declined as trade credit treated as more senior Validate prediction that trade credit is best (and efficiency improving) when: Little risk transfer for other projects/suppliers Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

64 Capital Structure Model Current Study Investigate effect of change in US law (BAPCA) Prediction is that trade credit and efficiency declined as trade credit treated as more senior Validate prediction that trade credit is best (and efficiency improving) when: Little risk transfer for other projects/suppliers Higher potential costs from financial distress Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

65 Additional Questions Capital Structure Model Does extension of trade credit increase order quantities and efficiency? Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

66 Additional Questions Capital Structure Model Does extension of trade credit increase order quantities and efficiency? How are de facto trade credit terms determined and enforced? Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

67 Additional Questions Capital Structure Model Does extension of trade credit increase order quantities and efficiency? How are de facto trade credit terms determined and enforced? How do payment times affect buying behavior? Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

68 Additional Questions Capital Structure Model Does extension of trade credit increase order quantities and efficiency? How are de facto trade credit terms determined and enforced? How do payment times affect buying behavior? How does access to external credit markets affect trade credit terms? Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

69 Additional Questions Capital Structure Model Does extension of trade credit increase order quantities and efficiency? How are de facto trade credit terms determined and enforced? How do payment times affect buying behavior? How does access to external credit markets affect trade credit terms? When should firms factor receivables? Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

70 Additional Questions Capital Structure Model Does extension of trade credit increase order quantities and efficiency? How are de facto trade credit terms determined and enforced? How do payment times affect buying behavior? How does access to external credit markets affect trade credit terms? When should firms factor receivables? When is it best to acquire/merge with a supplier/buyer from coordination perspective? Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

71 Additional Questions Capital Structure Model Does extension of trade credit increase order quantities and efficiency? How are de facto trade credit terms determined and enforced? How do payment times affect buying behavior? How does access to external credit markets affect trade credit terms? When should firms factor receivables? When is it best to acquire/merge with a supplier/buyer from coordination perspective? Does order quantity actually decline with buyer s cash position (as the basic model predicts)? Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

72 Conclusions Conclusion 1 Trade credit plays an important role in increasing the efficiency of supply chains (possibly even more than with vertical integration) Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

73 Conclusions Conclusion 1 Trade credit plays an important role in increasing the efficiency of supply chains (possibly even more than with vertical integration) 2 Trade credit can benefit both buyers and suppliers Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

74 Conclusions Conclusion 1 Trade credit plays an important role in increasing the efficiency of supply chains (possibly even more than with vertical integration) 2 Trade credit can benefit both buyers and suppliers 3 Trade credit should generally be used before bank loans Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

75 Conclusions Conclusion 1 Trade credit plays an important role in increasing the efficiency of supply chains (possibly even more than with vertical integration) 2 Trade credit can benefit both buyers and suppliers 3 Trade credit should generally be used before bank loans 4 Priority rules play an important role in trade credit usage and supply chain performance Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

76 Conclusions Conclusion 1 Trade credit plays an important role in increasing the efficiency of supply chains (possibly even more than with vertical integration) 2 Trade credit can benefit both buyers and suppliers 3 Trade credit should generally be used before bank loans 4 Priority rules play an important role in trade credit usage and supply chain performance 5 Capital structure decisions also depend on firm operating performance Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

77 Conclusions Conclusion 1 Trade credit plays an important role in increasing the efficiency of supply chains (possibly even more than with vertical integration) 2 Trade credit can benefit both buyers and suppliers 3 Trade credit should generally be used before bank loans 4 Priority rules play an important role in trade credit usage and supply chain performance 5 Capital structure decisions also depend on firm operating performance 6 Leverage is consistent with a tradeoff theory that includes early commitment of resources before the realization of demand uncertainty Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39

78 Questions? Conclusion Birge (Chicago Booth) The Role of Trade Credit and Capital Structure in Supply Chains 24 March / 39