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8/3/2019 Chapter 24 - Working Capital Management - Current Assets and Current Liabilities
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Prepared byPrepared byKen HartviksenKen Hartviksen
INTRODUCTION TOINTRODUCTION TO
CORPORATE FINANCECORPORATE FINANCE
Laurence BoothLaurence Booth W. Sean ClearyW. Sean Cleary
Chapter 24Chapter 24 Working CapitalWorking CapitalManagement: Current Assets and CurrentManagement: Current Assets and CurrentLiabilitiesLiabilities
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CHAPTER 24CHAPTER 24
Working Capital Management:Working Capital Management:
Current Assets and CurrentCurrent Assets and Current
LiabilitiesLiabilities
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Lecture AgendaLecture Agenda
Learning ObjectivesLearning Objectives
Important TermsImportant Terms
Cash ManagementCash Management Reasons for Holding CashReasons for Holding Cash D
etermining the Optimal Cash BalanceD
etermining the Optimal Cash Balance Cash Management TechniquesCash Management Techniques
Accounts Receivable ManagementAccounts Receivable Management The Credit DecisionThe Credit Decision Credit PoliciesCredit Policies The Collection ProcessThe Collection Process
Inventory ManagementInventory Management
Inventory Management ApproachesInventory Management Approaches Evaluating Inventory ManagementEvaluating Inventory Management
Short Short--Term Financing ConsiderationsTerm Financing Considerations
Summary and ConclusionsSummary and Conclusions Concept Review QuestionsConcept Review Questions
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Learning ObjectivesLearning Objectives
You should understand the following:You should understand the following: How to manage individual asset items, such as cash,How to manage individual asset items, such as cash,
receivables, and inventoryreceivables, and inventory
The nature of the major sources of shortThe nature of the major sources of short--term financing, suchterm financing, such
as trade credit, bank loans, factoring arrangements, andas trade credit, bank loans, factoring arrangements, and
money market securitiesmoney market securities
The fact that in evaluating current asset and current liabilityThe fact that in evaluating current asset and current liability
decisions, the final decision rests on the standard problem ofdecisions, the final decision rests on the standard problem of
trading off expected benefits and potential coststrading off expected benefits and potential costs
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Important Chapter TermsImportant Chapter Terms
ABC approachABC approach
CapacityCapacity
CharacterCharacter
ConditionsConditions
Credit analysisCredit analysis
Credit enhancementsCredit enhancements
Economic Order QuantityEconomic Order Quantity
Factoring arrangementsFactoring arrangements
Finance motiveFinance motive Float Float
Just Just--inin--time inventorytime inventorysystemssystems
Materials requirementMaterials requirementplanningplanning
Open accountOpen account
Optimal cash balanceOptimal cash balance
Precautionary motivePrecautionary motive
PrepaymentsPrepayments
SecuritizationSecuritization
Special purpose vehiclesSpecial purpose vehicles
Speculative motiveSpeculative motive
Terms of creditTerms of credit
Transactions motiveTransactions motive
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Cash and Marketable SecuritiesCash and Marketable Securities
Working Capital ManagementWorking Capital Management
Current Assets and Current LiabilitiesCurrent Assets and Current Liabilities
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Cash and Marketable SecuritiesCash and Marketable SecuritiesReasons for Holding CashReasons for Holding Cash
1.1. Transactions motiveTransactions motive
2.2. Precautionary motivePrecautionary motive
3.3. Finance motiveFinance motive4.4. Speculative motiveSpeculative motive
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Cash and Marketable SecuritiesCash and Marketable SecuritiesDetermining the Optimal Cash BalanceDetermining the Optimal Cash Balance
The optimal cash balance is the amount of cashThe optimal cash balance is the amount of cash
that balances the risks of illiquidity against thethat balances the risks of illiquidity against the
sacrifice in expected return that is associatedsacrifice in expected return that is associatedwith maintaining cash.with maintaining cash.
Differs substantially across firmsDiffers substantially across firms Firms with predictable cash flows will have lower optimalFirms with predictable cash flows will have lower optimal
cash balance requirementcash balance requirement
Firms with excess borrowing capacity (unused line of creditFirms with excess borrowing capacity (unused line of creditfor example) can hold less cash.for example) can hold less cash.
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Cash and Marketable SecuritiesCash and Marketable SecuritiesCash Management TechniquesCash Management Techniques
Cash flow synchronization can free up cash (and lowerCash flow synchronization can free up cash (and lowerthe amount of capital a firm requires)the amount of capital a firm requires)
This is done by:This is done by:
Speeding up cash inflows:Speeding up cash inflows: Bill clients earlier each monthBill clients earlier each month
Increase cash sales through incentivesIncrease cash sales through incentives
Encourage customers to pay using electronic payments systemsEncourage customers to pay using electronic payments systemssuch as direct deposit, automatic debit, debit card, rather thansuch as direct deposit, automatic debit, debit card, rather thancheque.cheque.
Delaying outflows:Delaying outflows: Arrange with suppliers for more liberal trade credit terms (net 40Arrange with suppliers for more liberal trade credit terms (net 40
rather than net 30 for example)rather than net 30 for example)
Paying employees once a month rather than twice.Paying employees once a month rather than twice.
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Cash ManagementsCash ManagementsFloatFloat
Float is the time that elapses between the time theFloat is the time that elapses between the time thepaying firm initiates payment, and the time the fundspaying firm initiates payment, and the time the fundsare available for use by the receiving firm.are available for use by the receiving firm.
It has three major sources:It has three major sources:
1.1. The time it takes the cheque to reach the firm after it is mailed byThe time it takes the cheque to reach the firm after it is mailed bythe customer.the customer.2.2. The time it takes the receiving firm to process the cheque andThe time it takes the receiving firm to process the cheque and
deposit in an account, anddeposit in an account, and3.3. The time it takes the cheque to clear through the banking systemThe time it takes the cheque to clear through the banking system
so that the funds are available to the firm.so that the funds are available to the firm.
Float has been reduced or eliminated through:Float has been reduced or eliminated through: Debit cardsDebit cards Preauthorized paymentsPreauthorized payments Electronic funds transfer (EFT) and electronic data interchangeElectronic funds transfer (EFT) and electronic data interchange
(EDI) systems.(EDI) systems.
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AccountsR
eceivableAccountsR
eceivable
Working Capital ManagementWorking Capital Management
Current Assets and Current LiabilitiesCurrent Assets and Current Liabilities
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Accounts ReceivableAccounts Receivable
1.1. The decision to extend credit to customers hasThe decision to extend credit to customers has
significant cash flow and credit risk implications for thesignificant cash flow and credit risk implications for the
firm.firm.
Firms often dont have a choice, if the availability of credit is anFirms often dont have a choice, if the availability of credit is an
important factor in the customers purchase decision process (ifimportant factor in the customers purchase decision process (ifcompetitors offer credit, then the firm must at least match thosecompetitors offer credit, then the firm must at least match thosecredit terms, and then choose to compete on another basis.)credit terms, and then choose to compete on another basis.)
2.2. The second decision (once the firm has decided toThe second decision (once the firm has decided to
extend credit) is to determine which customers will beextend credit) is to determine which customers will be
granted credit.granted credit.3.3. The credit terms must be established.The credit terms must be established.
4.4. The collection process must be decided.The collection process must be decided.
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Accounts ReceivableAccounts ReceivableThe Credit DecisionThe Credit Decision
The decision to extend credit is determined:The decision to extend credit is determined:
Nature of the product sold,Nature of the product sold,
The industryThe industry Practices of competitors.Practices of competitors.
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Accounts ReceivableAccounts ReceivableCredit AnalysisCredit Analysis
The process designed to assess the risk of nonThe process designed to assess the risk of non--paymentpayment
by potential customers, which involves collectingby potential customers, which involves collecting
information about potential customers with respect toinformation about potential customers with respect to
their credit history, their ability to make payments astheir credit history, their ability to make payments asreflected in their expected cash flows, and their overallreflected in their expected cash flows, and their overall
financial stability.financial stability.
From the firms point of view:From the firms point of view:
Often willing to extend credit on terms better than a bankOften willing to extend credit on terms better than a bank
because:because: The potential for the firm developing a good customer into theThe potential for the firm developing a good customer into the
future, andfuture, and
Losses are limited to production costs in the case of default.Losses are limited to production costs in the case of default.
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Accounts ReceivableAccounts ReceivableCredit PoliciesCredit Policies
The firm must choose what terms of credit toThe firm must choose what terms of credit tooffer its customers.offer its customers.
Terms of credit include:Terms of credit include:
The due dateThe due date The discount amount (if any)The discount amount (if any)
Options include:Options include:
Cash on delivery (COD)Cash on delivery (COD)
Cash before delivery (CBD)Cash before delivery (CBD) Net 30, net 40Net 30, net 40 -- no incentive for early paymentno incentive for early payment
2/10 net 302/10 net 30 -- a 2% discount for early paymenta 2% discount for early payment
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Accounts ReceivableAccounts ReceivableChange in Credit Policy AnalysisChange in Credit Policy Analysis
When extending more lenient credit terms the firm hopes toWhen extending more lenient credit terms the firm hopes to
increase revenues through the sale of more units, andincrease revenues through the sale of more units, and
perhaps even charge higher prices.perhaps even charge higher prices.
These benefits are offset by financing costs and the increasedThese benefits are offset by financing costs and the increasedrisk of nonrisk of non--payment.payment.
Evaluation of these decisions can use an NPV framework:Evaluation of these decisions can use an NPV framework:
CF-CFs)PV(FutureNPV 0![ 24-1]
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Accounts ReceivableAccounts ReceivableThe Collection ProcessThe Collection Process
The firm must monitor outstanding A/R by customer andThe firm must monitor outstanding A/R by customer andby category.by category.
The firm must then determine what action it will takeThe firm must then determine what action it will takewhen late payments occur.when late payments occur.
Charge interest on outstanding balancesCharge interest on outstanding balances Notify customer of arrears (email, mail, telephone)Notify customer of arrears (email, mail, telephone)
Actions on unpaid amounts:Actions on unpaid amounts:
Allow no further purchases on creditAllow no further purchases on credit
Choose from a number of additional options to collect:Choose from a number of additional options to collect:
1.1. Take legal actionTake legal action2.2. Sell receivable to a collection agencySell receivable to a collection agency
3.3. Write off the debt as uncollectable.Write off the debt as uncollectable.
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Evaluating Receivables ManagementEvaluating Receivables Management
Use of productivity ratios introduced in ChapterUse of productivity ratios introduced in Chapter
4 can give a tool for evaluating the firms ability4 can give a tool for evaluating the firms ability
to manage its accounts receivable.to manage its accounts receivable.
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Evaluating Receivables ManagementEvaluating Receivables ManagementReceivables TurnoverReceivables Turnover
Measures the sales generated by every dollar ofMeasures the sales generated by every dollar of
receivables.receivables.
ReceivableAccounts
Sales
turnoversReceivable
!
!
RT
AR
S
[4- 16]
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Evaluating Receivables ManagementEvaluating Receivables ManagementAverage Collection PeriodAverage Collection Period
Estimates the number of days it takes a firm to collect onEstimates the number of days it takes a firm to collect onits accounts receivable.its accounts receivable.
If ACP is 40 days, and the firms credit policy is net 30,If ACP is 40 days, and the firms credit policy is net 30,clearly, customers are not paying in keeping with theclearly, customers are not paying in keeping with thefirms policy, and there may be concerns about thefirms policy, and there may be concerns about thequality of the firms customers, and what might happen ifquality of the firms customers, and what might happen ifeconomic conditions deteriorate.economic conditions deteriorate.
turnoversReceivable
AR
TurnoversReceivable
365
PeriodCollectionAverage
!
!!
ACP
ADS
AR
[4- 17]
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InventoryInventory
Working Capital ManagementWorking Capital Management
Current Assets and Current LiabilitiesCurrent Assets and Current Liabilities
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InventoryInventory
The level of inventory a firm holds is a trade off betweenThe level of inventory a firm holds is a trade off between
benefits and costs:benefits and costs:
Benefits of Holding Inventory:Benefits of Holding Inventory:
Take advantage of largeTake advantage of large--volume discountsvolume discounts Reduce the probability of production disruptions because of lack ofReduce the probability of production disruptions because of lack of
inventoryinventory
Minimize lost sales because of stockMinimize lost sales because of stock--outsouts
Costs of Holding Inventory:Costs of Holding Inventory:
Financing costs associated with inventory investmentFinancing costs associated with inventory investment Storage, handling, insurance, spoilage and obsolescence costs.Storage, handling, insurance, spoilage and obsolescence costs.
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InventoryInventoryInventory Management ApproachesInventory Management Approaches
ABC ApproachABC Approach
Economic Order Quantity (EOQ) ModelEconomic Order Quantity (EOQ) Model
Materials Requirement Planning (MRP)Materials Requirement Planning (MRP) Just Just--inin--time (JIT) Inventory systems.time (JIT) Inventory systems.
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InventoryInventoryEvaluating Inventory ManagementEvaluating Inventory Management
Use of financial ratios can give some indicationUse of financial ratios can give some indication
of the effectiveness of a firms inventoryof the effectiveness of a firms inventory
management.management.
Ratios, however, do not measure shortageRatios, however, do not measure shortage
costs, financing costs, etc.costs, financing costs, etc.
These ratios include:These ratios include:
Inventory turnoverInventory turnover Average days sales in inventory.Average days sales in inventory.
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Productivity RatiosProductivity RatiosInventory TurnoverInventory Turnover
Estimates the number of times, ending inventory wasEstimates the number of times, ending inventory wasturned over (sold) in the year.turned over (sold) in the year.
A ratio that involves both stock and flow valuesA ratio that involves both stock and flow values
Is strongly a function of ending inventoryIs strongly a function of ending inventoryvaluemanagers often try to improve this ratio as theyvaluemanagers often try to improve this ratio as theyapproach year end through inventory reductionapproach year end through inventory reductionstrategies (cash and carry sales/inventory clearance,strategies (cash and carry sales/inventory clearance,etc.)etc.)
TurnoverInventoryINV
CGS!
[4- 18]
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Productivity RatiosProductivity RatiosInventory TurnoverInventory Turnover
When Cost of Goods Sold is not available, it may beWhen Cost of Goods Sold is not available, it may be
necessary to estimate inventory turnover using sales.necessary to estimate inventory turnover using sales.
Use of the sales figure is less valid than Cost of GoodsUse of the sales figure is less valid than Cost of Goods
Sold because Cost of Goods Sold is based on inventoriedSold because Cost of Goods Sold is based on inventoriedcost, but Sales includes a profit margin on top ofcost, but Sales includes a profit margin on top of
inventoried cost.inventoried cost.
TurnoverInventoryINV
Sales!
[4- 19]
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Productivity RatiosProductivity RatiosAverage Days Sales in Inventory (ADSI)Average Days Sales in Inventory (ADSI)
Estimates the number of days of sales tied up inEstimates the number of days of sales tied up in
inventory (based on ending inventory values)inventory (based on ending inventory values)
turnoverInventory
ADS
INV
365
(ADSI)inventoryinsalesdaysAverage
!
! [4- 20]
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ShortShort--Term Financing ConsiderationsTerm Financing Considerations
Working Capital ManagementWorking Capital Management
Current Assets and Current LiabilitiesCurrent Assets and Current Liabilities
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ShortShort--Term Financing ConsiderationsTerm Financing Considerations
Investment in current assets tend to rise andInvestment in current assets tend to rise and
fall with the volume of activity.fall with the volume of activity.
Accruals and accounts payable (trade credit)Accruals and accounts payable (trade credit)are spontaneous liabilities.are spontaneous liabilities.
Other sources of financing must be negotiatedOther sources of financing must be negotiated
and before using the firm must evaluate theand before using the firm must evaluate the
cost effectiveness of alternative financingcost effectiveness of alternative financingmechanisms.mechanisms.
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ShortShort--Term Financing ConsiderationsTerm Financing Considerations
To estimate the annual effective rate of return or cost (k) ofTo estimate the annual effective rate of return or cost (k) of
any financing alternative:any financing alternative:
1cos
1365
-)ricePurchase p
tfinancingn-Day(k
/n![ 24-2]
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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsTrade CreditTrade Credit
Often a very important source of shortOften a very important source of short--term financing.term financing.
Offers a number of advantages:Offers a number of advantages:
Readily availableReadily available
ConvenientConvenient FlexibleFlexible
Usually does not entail any restrictive covenants or pledges ofUsually does not entail any restrictive covenants or pledges ofsecurity.security.
There is no explicit cost associated with credit termsThere is no explicit cost associated with credit terms
such as:such as: Net 30Net 30
Net 40Net 40
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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsTrade CreditTrade Credit
There is usually a high implicit cost to a firm that forgoesThere is usually a high implicit cost to a firm that forgoes
discounts on early payment such as:discounts on early payment such as:
2/10 Net 302/10 Net 30
Example: assume (2/10 net 30)Example: assume (2/10 net 30)
Approximate percentage cost = (2/98)(365/20) = 37.2%Approximate percentage cost = (2/98)(365/20) = 37.2%
The firm is being charged 2% for the use of funds from day 10 toThe firm is being charged 2% for the use of funds from day 10 today 30 (20 days).day 30 (20 days).
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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsBank Loans and Factor ArrangementsBank Loans and Factor Arrangements
Options include:Options include:
Operating loans / lines of creditOperating loans / lines of credit Secured by accounts receivable and inventory to a maximumSecured by accounts receivable and inventory to a maximum
percent of those assetspercent of those assets
Interest only paymentsInterest only payments
Balance can be retired at the firms discretionBalance can be retired at the firms discretion
Factor arrangementsFactor arrangements
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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsMoney Market InstrumentsMoney Market Instruments
Large firms with high credit ratings may be able toLarge firms with high credit ratings may be able tobyby--pass financial institutions and borrow directlypass financial institutions and borrow directly
from the money market.from the money market.
Two forms of money market instruments:Two forms of money market instruments: Commercial paperCommercial paper
Bankers acceptancesBankers acceptances The firm pays a stamping fee, and is able to borrow based on theirThe firm pays a stamping fee, and is able to borrow based on their
banks credit rating.banks credit rating.
Money market securities:Money market securities: Sold at a discount from face valueSold at a discount from face value
Maturities at time of issue of 30, 60, 90 daysMaturities at time of issue of 30, 60, 90 days
Face amounts of $100,000 or more.Face amounts of $100,000 or more.
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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsMoney Market InstrumentsMoney Market Instruments
The annualized yield on a money market instrument:The annualized yield on a money market instrument:
365
yieldannualeApproximatturityDaysto mapriceMarket
Discountv![ 24-3]
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ShortShort--Term Financing ConsiderationsTerm Financing ConsiderationsSecuritizationsSecuritizations
Special purpose vehicles (SPVs) are conduits forSpecial purpose vehicles (SPVs) are conduits forpackaging portfolios of receivables and selling them topackaging portfolios of receivables and selling them toinvestors in the money market; a recent innovation ininvestors in the money market; a recent innovation in
financing trade credit.financing trade credit.
Credit enhancements are actions taken to reduce creditCredit enhancements are actions taken to reduce creditrisk, such as requiring collateral, insurance or otherrisk, such as requiring collateral, insurance or otheragreements.agreements.
Asset Asset--backed commercial paper (ABCP) is an example.backed commercial paper (ABCP) is an example. The subThe sub--prime mortgage problems in the U.S. has exposed theprime mortgage problems in the U.S. has exposed the
problems with ABCP where investors have become concernedproblems with ABCP where investors have become concerned
about the underlying asset values (packages of receivables) andabout the underlying asset values (packages of receivables) andthe market is actively repricing these money market instrumentsthe market is actively repricing these money market instruments
In some cases the market has disappeared for some of theseIn some cases the market has disappeared for some of thesemoney market instruments.money market instruments.
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Summary and ConclusionsSummary and Conclusions
In this chapter you have learned:In this chapter you have learned:
That the optimal level of investment in cash,That the optimal level of investment in cash,receivables and inventory occurs when thereceivables and inventory occurs when thebenefits balance the costsbenefits balance the costs
The advantages, the disadvantages andThe advantages, the disadvantages andassociated effective annual costs of the mostassociated effective annual costs of the mostcommon shortcommon short--term financing options available toterm financing options available tocompanies.companies.
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Concept Review QuestionsConcept Review Questions
Working Capital ManagementWorking Capital Management
Current Assets and LiabilitiesCurrent Assets and Liabilities
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Concept Review Question 1Concept Review Question 1Motives for Holding CashMotives for Holding Cash
Why do firms hold cash?Why do firms hold cash?
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Concept Review Question 1Concept Review Question 1FloatFloat
What is float and why is it important to the firm?What is float and why is it important to the firm?
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Internet LinksInternet Links
Securitization NetSecuritization Net -- http://www.securitization.net/http://www.securitization.net/
Dun & Bradstreet Small Business solutionsDun & Bradstreet Small Business solutions --
http://smallbusiness.dnb
.com/credithttp://smallbusiness
.dnb
.com/credit--reports/browsereports/browse--products.aspproducts.asp
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CopyrightCopyright
Copyright 2007 JohnWiley & SonsCopyright 2007 JohnWiley & Sons
Canada, Ltd. All rights reserved.Canada, Ltd. All rights reserved.
Reproduction or translation of thisReproduction or translation of this
work beyond that permitted bywork beyond that permitted byAccess Copyright (the CanadianAccess Copyright (the Canadian
copyright licensing agency) iscopyright licensing agency) is
unlawful. Requests for furtherunlawful. Requests for furtherinformation should be addressed toinformation should be addressed to
the Permissions Department, Johnthe Permissions Department, John
Wiley & Sons Canada, Ltd.Wiley & Sons Canada, Ltd. TheThe
purchaser may make backpurchaser may make back--up copiesup copies
for his or her own use only and not forfor his or her own use only and not fordistribution or resale.distribution or resale. The author andThe author and
the publisher assume nothe publisher assume no
responsibility for errors, omissions,responsibility for errors, omissions,
or damages caused by the use ofor damages caused by the use of
these files or programs or from thethese files or programs or from the
use of the information containeduse of the information contained
herein.herein.