Working Capital
Download
1 / 115

Working Capital Policy - PowerPoint PPT Presentation


  • 165 Views
  • Uploaded on

Working Capital Policy. Chapter 17. Learning Objectives. Understand the importance of working capital. The liquidity-profitability trade-off. Determining the optimal level of current assets. The risk and return implications of alternative approaches to working capital financing policy.

loader
I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.
capcha
Download Presentation

PowerPoint Slideshow about 'Working Capital Policy' - aqua


An Image/Link below is provided (as is) to download presentation

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.


- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
Learning objectives

Working Capital

Policy

Chapter 17


Learning objectives
Learning Objectives

  • Understand the importance of working capital.

  • The liquidity-profitability trade-off.

  • Determining the optimal level of current assets.

  • The risk and return implications of alternative approaches to working capital financing policy.


The importance of managing and accumulating working capital
The Importance of Managing and Accumulating Working Capital

  • Working capital is the amount of the firm’s current assets: cash, accounts receivable, marketable securities, inventory and prepaid expenses.

  • Managing the level and financing of working capital is necessary:

    • to keep costs under control (e.g. storage of inventory)

    • to keep risk levels at an appropriate level (e.g. liquidity)


Managing current assets liabilities
Managing Current Assets & Liabilities

  • Net Working Capital

    = Current Assets - Current Liabilities

  • Determining the “Correct” level of Working Capital

    • Balance Risk & Return

    • Benefits of Working Capital

      • Higher Liquidity (Lowers Risk)

    • Costs of Working Capital

      • Lower Returns - $$ invested in lower returning securities rather than production.


Learning objectives

Firm 1

ST Debt 100

LT Debt 400

Common Stock 500

Total Liabilities&Equity 1000

Firm 1

Marketable Securities 0

Other Current Assets 200

Fixed Assets 800

Total Assets 1000

Firm 1

Operating Earnings 150

Interest Earned 0

EBT 150

Taxes (40%) -60

Net Income 90

Current Assets

Current Liabilities

Current Ratio =

200

100

=

Example: Risk-Return Trade-off

Compare the 2 following companies

= 2

Current Ratio 2


Learning objectives

Firm 1

ST Debt 100

LT Debt 400

Common Stock 500

Total Liabilities&Equity 1000

Firm 1

Marketable Securities 0

Other Current Assets 200

Fixed Assets 800

Total Assets 1000

Firm 1

Operating Earnings 150

Interest Earned 0

EBT 150

Taxes (40%) -60

Net Income 90

Current Ratio 2

Net Income

Assets

Return on Assets =

90

1000

=

.09 = 9%

=

Example: Risk-Return Trade-off

Compare the 2 following companies

ROA 9%


Learning objectives

Firm 1Firm 2

Marketable Securities 0 200

Other Current Assets 200 200

Fixed Assets 800 800

Total Assets 1000 1200

Firm 1Firm 2

ST Debt 100 100

LT Debt 400 400

Common Stock 500 700

Total Liabilities&Equity 1000 1200

Firm 1Firm 2

Operating Earnings 150 150

Interest Earned 0 8

EBT 150 158

Taxes (40%) -60 -63

Net Income 90 95

Current Ratio 2

ROA 9%

Example: Risk-Return Trade-off

Compare the 2 following companies

Firm 2:

$200 Marketable Securities

Financed with Common Stock

200 x 4% = $8 interest earned


Learning objectives

Firm 1Firm 2

Marketable Securities 0 200

Other Current Assets 200 200

Fixed Assets 800 800

Total Assets 1000 1200

Firm 1Firm 2

ST Debt 100 100

LT Debt 400 400

Common Stock 500 700

Total Liabilities&Equity 1000 1200

Firm 1Firm 2

Operating Earnings 150 150

Interest Earned 0 8

EBT 150 158

Taxes (40%) -60 -63

Net Income 90 95

Current Ratio 2

ROA 9%

CA

CL

Current Ratio =

400

100

=

4

Example: Risk-Return Trade-off

Compare the 2 following companies

= 4


Learning objectives

Firm 1Firm 2

Marketable Securities 0 200

Other Current Assets 200 200

Fixed Assets 800 800

Total Assets 1000 1200

Firm 1Firm 2

ST Debt 100 100

LT Debt 400 400

Common Stock 500 700

Total Liabilities&Equity 1000 1200

Firm 1Firm 2

Operating Earnings 150 150

Interest Earned 0 8

EBT 150 158

Taxes (40%) -60 -63

Net Income 90 95

Current Ratio 2 4

ROA 9%

NI

Assets

Return on Assets =

95

1200

=

7.9%

Example: Risk-Return Trade-off

Compare the 2 following companies

=.079 = 7.9%


Learning objectives

Firm 1Firm 2

Marketable Securities 0 200

Other Current Assets 200 200

Fixed Assets 800 800

Total Assets 1000 1200

Firm 1Firm 2

ST Debt 100 100

LT Debt 400 400

Common Stock 500 700

Total Liabilities&Equity 1000 1200

Firm 1Firm 2

Operating Earnings 150 150

Interest Earned 0 8

EBT 150 158

Taxes (40%) -60 -63

Net Income 90 95

Current Ratio 2 4

ROA 9% 7.9%

Example: Risk-Return Trade-off

Compare the 2 following companies

Firm 2

Lower ROA

More Liquid

Less Risky

Firm 1

Higher ROA

Less Liquid

Riskier


Learning objectives

Variation in assets over time

Total Assets

}

$5M

Fixed

Assets

Time

Assume ZERO Long-term Growth


Learning objectives

Variation in assets over time

Total Assets

$7M

}

Permanent

Current Assets

}

$5M

Fixed

Assets

Time


Learning objectives

Total Assets

$7M

}

Permanent

Current Assets

}

$5M

Fixed

Assets

Time

Variation in assets over time

$10M

Temporary Current Assets


Different approaches to financing
Different Approaches to Financing

  • Conservative Approach

    • Finance all fixed assets, permanent current assets, and some temporary with LT debt or equity. ST financing is used for the remaining temp. current assets.

    • Lower risk, lower return


Learning objectives

Total Assets

Total Assets

$10M

$10M

Temporary Current Assets

Temporary Current Assets

$7M

$7M

}

}

Permanent

Current Assets

Permanent

Current Assets

}

}

Long-term

Sources

$5M

$5M

Fixed

Assets

Fixed

Assets

Time

Time

Financing Current Assets:

Conservative Approach

Short-term

Sources


Different approaches to financing1
Different Approaches to Financing

  • Conservative Approach

    • Finance all fixed assets, permanent current assets, and some temporary with LT debt or equity. ST financing is used for the remaining temp. current assets.

    • Lower risk, lower return

  • Moderate Approach (Maturity Matching)

    • Finance fixed assets and permanent current assets with LT funds and temporary current assets with ST funds.

    • Moderate risk, moderate return


Learning objectives

Total Assets

Total Assets

$10M

Temporary Current Assets

$7M

$7M

}

}

Permanent

Current Assets

Permanent

Current Assets

}

}

$5M

$5M

Long-term

Sources

Fixed

Assets

Fixed

Assets

Time

Time

Financing Current Assets:

Moderate Approach

$10M

Temporary Current Assets


Learning objectives

Total Assets

Total Assets

$10M

$10M

Temporary Current Assets

Temporary Current Assets

$7M

$7M

}

}

Permanent

Current Assets

Permanent

Current Assets

}

}

$5M

$5M

Long-term

Sources

Fixed

Assets

Fixed

Assets

Time

Time

Financing Current Assets:

Moderate Approach

Short-term

Sources


Different approaches to financing2
Different Approaches to Financing

  • Conservative Approach

    • Finance all fixed assets, permanent current assets, and some temporary with LT debt or equity. ST financing is used for the remaining temp. current assets.

    • Lower risk, lower return

  • Moderate Approach (Maturity Matching)

    • Finance fixed assets and permanent current assets with LT funds and temporary current assets with ST funds.

    • Moderate risk, moderate return

  • Aggressive Approach

    • Finance all temporary current assets, permanent current assets, and some fixed assets with ST debt. LT financing is used for the remaining fixed assets.

    • Higher risk, higher return


Learning objectives

Total Assets

Total Assets

Short-term

Sources

$10M

$10M

Temporary Current Assets

Temporary Current Assets

$7M

$7M

}

}

Permanent

Current Assets

Permanent

Current Assets

}

}

$5M

$5M

Fixed

Assets

Fixed

Assets

Time

Time

Financing Current Assets:

Aggressive Approach

Long-term Sources



How much cash should a firm keep on hand
How much cash should a firm keep on hand?

  • Managers must keep enough cash to make payments when needed. (Minimum balance)

  • But since cash is a non-earning asset, managers should invest excess returns and keep just the amount of cash that is necessary.(Maximum balance)


The size of the minimum cash balance depends on
The size of the minimum cash balance depends on:

  • How quickly and cheaply a firm can raise cash when needed.

  • How accurately managers can predict cash requirements.

  • How much precautionary cash the managers need for emergencies.

Link to Dun & Bradstreet


The firm s maximum cash balance depends on
The firm’s maximum cash balance depends on:

  • Available (short-term) investment opportunities

    • e.g. money market funds, CDs, commercial paper

  • Expected return on investment opportunities (opportunity cost)

    • If high expected return, firms are quick to invest excess cash

  • Transaction cost of withdrawing cash and making an investment

Link to Bureau of Economic Analysis


Choosing the optimum cash balance
Choosing the Optimum Cash Balance

Cash Balances in a Typical Month

Dollars in the Cash Account

| | | | | | | | | | | | | | | | | | | | | | | | | | | |

Days of the Month


Choosing the optimum cash balance1

Cash Balances in a Typical Month

Invest Excess

Cash

Dollars in the Cash Account

| | | | | | | | | | | | | | | | | | | | | | | | | | | |

Days of the Month

Choosing the Optimum Cash Balance


Choosing the optimum cash balance2

Cash Balances in a Typical Month

Sell Securities to

obtain cash

Dollars in the Cash Account

| | | | | | | | | | | | | | | | | | | | | | | | | | | |

Days of the Month

Choosing the Optimum Cash Balance


The miller orr model
The Miller - Orr Model

  • The Miller-Orr Model provides a formula for determining the optimum cash balance, the point at which to sell securities (lower limit) and when to invest excess cash (upper limit).

  • Depends on:

    • transaction costs of buying or selling securities

    • variability of daily cash

    • return on short-term investments


The miller orr model target cash balance z

3

3 x TC x V

4 x r

Z = + L

The Miller-Orr Model - Target Cash Balance (Z)

where: TC = transaction cost of buying

or selling securities

V = variance of daily cash flows

r = return on short-term

investments

L = minimum cash requirement


The miller orr model target cash balance z1
The Miller-Orr Model - Target Cash Balance (Z)

Example:Suppose that short-term securities yield 5% per year (r) and it costs the firm $50 each time it buys or sells securities (TC). The variance of cash flows is $100,000 (V) and your bank requires $1,000 minimum checking account balance (L).


The miller orr model target cash balance z2

3

3 x 50 x 100,000

4 x .05/365

Z = + $1,000

= $3,014 + $1,000 = $4,014

The Miller-Orr Model - Target Cash Balance (Z)

  • Example


The miller orr mode upper limit
The Miller-Orr Mode - Upper Limit

  • The upper limit for the cash account (H) is determined by the equation: H = 3Z - 2L where: Z = Target cash balance L = Lower limit

  • In the previous example: H = 3 ($4,014) - 2($1,000) = $10,042


Forecasting cash needs cash budget
Forecasting Cash Needs - Cash Budget

  • Used to determine monthly needs and surpluses for cash during the planning period

  • Examines timing of cash inflows and outflows i.e. when checks are written and when deposits are made.

  • Payments to suppliers are typically made some time after shipment is received.

  • Receipts from credit customers are received some time after sale is recorded.


Cash budget problem
Cash Budget - Problem

Rocky Mountain Climbing, Inc. (RMC) has the

following information:

Previous Sales November 2007 130,000

December 2007 125,000

Forecast Sales January 2008 120,000

February 2008 260,000

March 2008 140,000

April 2008 140,000


Cash budget problem1
Cash Budget - Problem

Rocky Mountain Climbing, Inc. (RMC) has the

following information:

Previous Sales: November 2007 130,000

December 2007 125,000

Forecast sales for: January 2008 120,000

February 2008 260,000

March 2008 140,000

April 2008 140,000

Collections : 30% of customers pay cash

50% pay in month after sale

20% pay 2 months after sale


Cash budget problem2
Cash Budget - Problem

Other information for RMC Cash Budget:

Purchases of inventory are 75% of sales

and are made 2 months before sale

and are paid for 1 month after delivery

Other expenses $14,000 per month

Taxes $10,000 due in March

Cash Balance (Dec. 31, 2007) = $28,000

Minimum balance required by bank = $25,000

(ST borrowing rate = 6% annually)


Steps in the cash budget
Steps in the Cash Budget

  • Forecast of monthly collections and other cash inflows

  • Forecast of purchases and other cash outflows

  • Summarize the effect on net monthly cash flows and determine borrowing needs or surpluses.


Cash budget collections
Cash Budget - Collections

  • In each month RMC will collect cash from sales that have occurred in that month and in the preceding two months.

  • In January, sales are 120,000

  • Collections:

    • 30% x $120,000 (January sales) = 36,000

    • 50% x $125,000 (December sales) = 62,500

    • 20% x $130,000 (November sales) = 26,000

  • Total cash collected in January =$124,500


Cash budget collections1

Collection of January Sales

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

Cash Budget - Collections

Sales made in January will not be fully

collected until March.

36,000

120,000 x .30


Cash budget collections2

Collection of January Sales

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

36,000

120,000 x .30

Cash Budget - Collections

Sales made in January will not be fully

collected until March.

60,000

120,000 x .50


Cash budget collections3

Collection of January Sales

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

60,000

36,000

120,000 x .30

120,000 x .50

Cash Budget - Collections

Sales made in January will not be fully

collected until March.

24,000

120,000 x .20


Cash budget collections4

Cash Budget

RMC, Inc.

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

Collections:

Month of Sale (30%) 36,000 78,000 42,000

First Month (50%) 62,500 60,000 130,000

2nd Month (20%) 26,000 25,000 24,000

Total Collections 124,500 163,000 196,000

Cash Budget - Collections

Calculate collections for other months.


Cash budget purchases payments

Payments for January Purchases

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

Cash Budget - Purchases/Payments

Purchases are made 2 months prior to

sale and are paid for 1 month later.

90,000

75% of January Sales Purchased in November


Cash budget purchases payments1

Payments for January Purchases

Nov Dec Jan Feb Mar

Sales 130,000 125,000 120,000 260,000 140,000

Cash Budget - Purchases/Payments

Purchases are made 2 months prior to

sale and are paid for 1 month later.

90,000

90,000

75% of January Sales Purchased in November, Paid for in December


Cash budget purchases payments2

Cash Budget

RMC, Inc.

Nov Dec Jan Feb Mar Apr

Sales 130,000 125,000 120,000 260,000 140,000 140,000

Purchases 195,000 105,000 105,000

Payments 195,000 105,000 105,000

Cash Budget - Purchases/Payments

Calculate payments for all months.

Note that in order to do a cash budget,

you will need forecasts of sales for April.


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Cash Collections 124,500 163,000 196,000

Material Payments 195,000 105,000 105,000

Summary of Previous Calculations


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Cash Collections 124,500 163,000 196,000

Material Payments 195,000 105,000 105,000

Other Payments:

Other Expenses 14,000 14,000 14,000

Tax Payments 0 0 10,000

Remaining Cash Outflows


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Cash Collections 124,500 163,000 196,000

Material Payments 195,000 105,000 105,000

Other Payments:

Rent 2,000 2,000 2,000

Other Expenses 12,000 12,000 12,000

Tax Payments 0 0 10,000

Net Monthly Change (84,500) 44,000 67,000


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000

Ending Cash (No Borrow)

Needed (Borrowing)

Loan Repayment

Interest Cost

Ending Cash Balance

Cumulative Borrowing


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000

Ending Cash (No Borrow) (56,500)

Needed (Borrowing)

Loan Repayment

Interest Cost

Ending Cash Balance

Cumulative Borrowing


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000

Ending Cash (No Borrow) (56,500)

Needed (Borrowing)

Loan Repayment

Interest Cost

Ending Cash Balance 25,000

Cumulative Borrowing

Target Ending Balance


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Borrowing Required to cover Minimum Balance and Deficit

56,500+25,000

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000

Ending Cash (No Borrow) (56,500)

Needed (Borrowing) 81,500

Loan Repayment 0

Interest Cost 0

Ending Cash Balance 25,000

Cumulative Borrowing


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000

Ending Cash (No Borrow) (56,500)

Needed (Borrowing) 81,500

Loan Repayment 0

Interest Cost 0

Ending Cash Balance 25,000

Cumulative Borrowing 81,500


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,00025,000

Ending Cash (No Borrow) (56,500) 69,000

Needed (Borrowing) 81,500

Loan Repayment 0

Interest Cost 0

Ending Cash Balance 25,000

Cumulative Borrowing 81,500


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Interest Incurred on Prior

Month Borrowing

81,500 x .005

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000 25,000

Ending Cash (No Borrow) (56,500) 69,000

Needed (Borrowing) 81,500 0

Loan Repayment 0

Interest Cost 0 408

Ending Cash Balance 25,000 25,000

Cumulative Borrowing 81,500


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Amount that can be repaid from monthly surplus

69,000 - 408 - 25,000=$43,592

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000 25,000

Ending Cash (No Borrow) (56,500) 69,000

Needed (Borrowing) 81,500 0

Loan Repayment 0 43,592

Interest Cost 0 408

Ending Cash Balance 25,000 25,000

Cumulative Borrowing 81,500


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

New Loan Balance

81,500 - 43,592=$37,908

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000 25,000

Ending Cash (No Borrow) (56,500) 69,000

Needed (Borrowing) 81,500 0

Loan Repayment 0 43,592

Interest Cost 0 408

Ending Cash Balance 25,000 25,000

Cumulative Borrowing 81,500

37,908


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000 25,000 25,000

Ending Cash (No Borrow) (56,500) 69,000 92,000

Needed (Borrowing) 81,500 0

Loan Repayment 0 43,592

Interest Cost 0 408

Ending Cash Balance 25,000 25,000

Cumulative Borrowing 81,500 37,908


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Interest Incurred on Prior

Month Borrowing

37,908 x .005

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000 25,000 25,000

Ending Cash (No Borrow) (56,500) 69,000 92,000

Needed (Borrowing) 81,500 0 0

Loan Repayment 0 43,592

Interest Cost 0 408

Ending Cash Balance 25,000 25,000

Cumulative Borrowing 81,500 37,908

190


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000 25,000 25,000

Ending Cash (No Borrow) (56,500) 69,000 92,000

Needed (Borrowing) 81,500 0 0

Loan Repayment 0 43,592

Interest Cost 0 408 190

Ending Cash Balance 25,000 25,000

Cumulative Borrowing 81,500 37,908

37,908

Repay Outstanding Loan Balance


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Ending Cash Balance

$53,902-$25,000=$28,902 Surplus

Analysis of Borrowing Needs

Net Monthly Change (84,500) 44,000 67,000

Beginning Cash Balance 28,000 25,000 25,000

Ending Cash (No Borrow) (56,500) 69,000 92,000

Needed (Borrowing) 81,500 0 0

Loan Repayment 0 43,592 37,908

Interest Cost 0 408 190

Ending Cash Balance 25,000 25,000

Cumulative Borrowing 81,500 37,908 0

53,902


Learning objectives

Cash Budget

RMC, Inc.

Jan Feb Mar

Analysis of Borrowing Needs

Ending Cash Balance 25,000 25,000 53,902

Cumulative Borrowing 81,500 37,908 0

RMC needs to raise $81,500 in short-term debt in January, would probably take out a short-term bank loan. In March RMC has a 28,902 surplus. It would probably invest in marketable securities at this point in time.


Managing cash inflows and outflows
Managing Cash Inflows and Outflows

  • Generally managers try to increase the amount of cash flowing into a business during any given time period.

  • They also try to slow down cash outflows.

  • Collect early and Pay late (but not too late).


Managing cash flows
Managing Cash Flows

  • Can increase cash inflows (or speed them up) by:

    • Increasing cash sales

    • Increasing credit sales collections

  • Can decrease cash outflows (or slow them down) by:

    • Cutting costs

    • Taking full advantage of time allowed to pay obligations


Managing cash flows1
Managing Cash Flows

  • Can speed up inflows by:

    • Tightening up credit policy (as long as savings from reduced bad debts and collection costs exceed sales that may be lost)

    • Obtaining computerized fund transfers from customers

    • Using collection centers

    • Using a lockbox system

  • Can slow down cash outflows by:

    • Delaying the payment of bills

    • Using remote disbursement banks


Learning objectives

Accounts Receivable

and Inventory

Chapter 19


Learning objectives1
Learning Objectives

  • How and why firms manage accounts receivable and inventory.

  • Computation of optimum levels of accounts receivable and inventory.

  • Alternative inventory management approaches.

  • How firms make credit decisions and create collection policies.


Why do firms accumulate accounts receivable and inventory
Why do firms accumulate accounts receivable and inventory?

  • Given that accounts receivable and inventory are assets that do not provide an explicit rate of return, it is important to understand why firms might still want to have these investments.

  • Granting credit is often an essential business practice and can enhance sales. (But also will increase costs.)

  • Holding adequate inventory is necessary to avoid loss of sales due to stock-outs.


Finding the optimum level of accounts receivable
Finding the Optimum Level of Accounts Receivable

  • Firm’s managers must review the firm’s credit policies and evaluate the impact of any proposed changes in policies based on the NPV of incremental cash flows due to the change.

  • This is similar to the method we used in determining the best capital budgeting projects to undertake.

Link to Hoover’s Online


Accounts receivable management
Accounts Receivable Management

  • The terms of sale are generally stated in the form X / Y, n Z

  • This means that the customer can deduct X percentage if the account is paid within Y days; otherwise, the account must be paid within Z days.

    Example: 2/10 n 30

    • The company offers a 2% discount if account paid in 10 days.

    • Balance due in 30 days.


Effects of tightening credit policy
Effects of Tightening Credit Policy

  • Raise credit standards

    • Fewer credit customers (could reduce sales)

    • Lower accounts receivable

  • Shorten net due period

    • Fewer credit customers (could reduce sales)

    • Accounts paid sooner

    • Lower accounts receivable

  • Reduce discount percentage

    • Fewer credit customers (could reduce sales)

    • Fewer take the discount

  • Shorten discount period

    • Same as above


Average collection period acp
Average Collection Period (ACP)

  • Old Policy; 2/10, n30

    • 35% of customers pay in 10 days

    • 62% of customers pay in 30 days

    • 3% of customers pay in 100 days

    • ACP=(.35x10)+(.62x30)+(.03x100)=25.1 days

  • New Policy; 2/10, n40

    • 35%of customers pay in 10 days

    • 60% of customers pay in 40 days

    • 5% of customers pay in 100 days

    • ACP=(.35x10)+(.60x40)+(.05x100)=32.5 days


Analysis of accts receivable changes
Analysis of Accts. Receivable Changes

  • Develop pro forma financial statements for each policy under consideration.

  • Use the pro formas to estimate incremental cashflows by comparing forecasts to current policy cash flows.

  • Use the incremental cash flows to estimate the NPV of each policy change.

  • Choose the policy change that maximizes the value of the firm (highest NPV).


Analysis of accts receivable changes1
Analysis of Accts. Receivable Changes

  • Example:ABC Corporation is considering a credit policy change from offering no credit to offering 30 days credit with no discount (n 30).

  • Why might they do this?

    -Increase sales

    -Increase market share

  • What costs will the firm incur as a result?

    -Cost of carrying accounts receivable

    -Potential increase in bad debts

    -Credit analysis and collection costs


Analysis of accts receivable changes2
Analysis of Accts. Receivable Changes

  • Assume the Net Incremental Cash Flows associated with ABC’s new credit policy are as follows:

  • External financing (Init. Investment) = $28,000 t=0

    • Increase in sales = $30,000 t=1,2...

    • Increase in COGS = $15,000

    • Increase in Bad Debts = $3,000

    • increase in Other Expenses = $5,000

    • Increase in Interest Expense = $500

    • Increase in Taxes = $2,600

    • Total Incr. Operating Cash Flow = $3,900/yr.


Analysis of accts receivable changes3
Analysis of Accts. Receivable Changes

  • Calculate the NPV of the change (k = 12%):

  • PV of the expected inflows of $3,900 per year from t = 0 to infinity (perpetuity) = $3,900 / .12 = $32,500

  • NPV = PV of inflows - initial investment = $32,500 - $28,000 = $4,500

  • Since NPV > 0, ABC should undertake the credit policy change, assuming that the assumptions are valid and that the projected cash flows are accurate.


How firms make credit decisions
How Firms Make Credit Decisions

  • The Five Cs of Credit:

  • Character is the borrower’s willingness to pay based on past payment patterns.

  • Capacity is the borrower’s ability to pay based on forecasts of future cash flows.

  • Capital is how much wealth the borrower has to fall back on.

  • Collateral is what the lender gets if the borrower fails to pay.

  • Conditions faced by the borrower in the business marketplace are also considered.

Link to Credit Scoring


Methods of collection
Methods of Collection

Most firms use some of the following:

  • Send reminder letters.

  • Make telephone calls.

  • Hire collection agencies.

  • Sue the customer.

  • Settle for a reduced amount.

  • Write off the bill as a loss.

  • Sell accounts receivable to factors.


Inventory management
Inventory Management

  • Typically, inventory accounts for about four to five percent of a firm's assets.

  • In order to effectively manage the investment in inventory, two problems must be dealt with: how much to order and how often to order.

  • The economic order quantity (EOQ) model attempts to determine the order size that will minimize total inventory costs.


Inventory management1

Total

Inventory

Costs

Total

Carrying

Costs

Total

Ordering

Costs

=

+

Inventory Management

  • Determining Optimal Inventory

    • Economic Order Quantity (EOQ)

Link to Bloomberg.com


The eoq model assumes the firm orders a fixed amount q at equal intervals
The EOQ Model assumes the firm orders a fixed amount Q at equal intervals.

Inventory

Level

(units)

Order

Quantity

Q

Time


The eoq model

Inventory equal intervals.

Level

(units)

Q

2

Order Quantity

2

Average Inventory =

Order

Quantity

Q

Time

The EOQ Model


Learning objectives

Total equal intervals.

Inventory

Costs

Total

Carrying

Costs

Total

Ordering

Costs

Total

Inventory

Costs

OQ

2

S

OQ

( ) CC + ( ) OC

=

+

=

Where:

OQ = Order Size (order quantity)

S = Annual Sales Volume

CC = Carrying Cost per Unit

OC = Ordering Cost per Order


Learning objectives

S equal intervals.

OQ

Ordering Costs

= ( )OC

Cost

($)

Ordering Costs

Order Size (units)


Learning objectives

S equal intervals.

OQ

Ordering Costs

= ( )OC

OQ

2

Carrying Costs = ( ) CC

Cost

($)

Order Size (units)

Carrying Costs


Learning objectives

S equal intervals.

OQ

Ordering Costs

= ( )OC

OQ

2

Carrying Costs = ( ) CC

Total Costs = Carrying Costs + Order Costs

Cost

($)

Order Size (units)


Inventory management2

2 x S x OC equal intervals.

CC

EOQ =

Inventory Management

  • The economic order quantity that minimizes the total costs of inventory.

  • Determining Optimal Inventory


Inventory management3

2 x S x OC equal intervals.

CC

EOQ =

2(1200)26

75

=

= 28.84  29 cars

Inventory Management

  • Determining Optimal Inventory

  • Economic Order Quantity (EOQ)

Example:

Awesome Autos expects to sell 1,200 new automobiles in the next year. It currently costs $26 per order placed with the manufacturer. Carrying costs amount to $75 per auto. How many autos should they order each time they place an order?


Inventory management4
Inventory Management equal intervals.

  • Determining Optimal Inventory

    • Economic Order Quantity (EOQ)

Example:

Awesome Autos expects to sell 1,200 new automobiles in the next year. It currently costs $26 per order placed with the manufacturer. Carrying costs amount to $75 per auto. How many autos should they order each time they place an order?

EOQ autos in each order

Place 1,200/ 29 = 41.4 orders each year


Inventory management with safety stock order before inventory is at zero

Inventory equal intervals.

Level

(units)

Time

Inventory Management with Safety Stock- Order before inventory is at zero.

Inventory Order Point

EOQ

Depleted Stock

During Delivery

Safety

Stock

Actual Delivery Time


Learning objectives

Inventory equal intervals.

Level

(units)

Order

Quantity

Q

Time


Abc inventory classification system
ABC Inventory Classification System equal intervals.

  • Tool to reduce inventory carrying costs: classify different types of inventory according to value.

    Example:

    • Class A: Expensive items are assigned a serial number and are checked daily. Replaced only as sold.

    • Class B: Moderately priced items are assigned a serial number but are checked less often (monthly) and managed according to EOQ.

    • Class C: Small inexpensive items. Check inventory annually and reorder by visual check.


Just in time inventory control jit
Just In Time Inventory Control (JIT) equal intervals.

  • Developed in Japan.

  • Reduce raw material inventory carrying costs by making deals with suppliers that require them to deliver the raw materials as needed.

  • Carrying costs are passed on to suppliers.

  • Can result in higher costs if delivery is delayed: shut down of whole production line.


Learning objectives

Short Term equal intervals.

Financing

Chapter 20


Learning objectives2
Learning Objectives equal intervals.

  • The need for short-term financing.

  • The advantages and disadvantages of short-term financing.

  • Three types of short-term financing.

  • Computation of the cost of trade credit, commercial paper, and bank loans.

  • How to use accounts receivable and inventory as collateral for short-term loans.


Why do firms need short term financing
Why Do Firms Need Short-term Financing? equal intervals.

  • Profits may not be sufficient to keep up with growth-related financing needs.

  • Firms may prefer to borrow now for their needs rather than wait until they have saved enough.

  • Short-term financing instead of long-term sources of financing due to:

    • easier availability

    • usually lower cost


Sources of short term financing
Sources of Short-term Financing equal intervals.

  • Short-term loans.

    • borrowing from banks and other financial institutions for one year or less.

  • Trade credit.

    • borrowing from suppliers

  • Commercial paper.

    • only available to large credit- worthy businesses.


Types of short term loans
Types of short-term loans: equal intervals.

  • Promissory note

    • A legal IOU that spells out the terms of the loan agreement, usually the loan amount, the term of the loan and the interest rate.

    • Often requires that loan be repaid in full with interest at the end of the loan period.

  • Self-liquidating loan

    • The proceeds of the loan are used to acquire assets that generate cash to repay the loan (e.g. inventory).


Types of short term loans1
Types of short-term loans: equal intervals.

  • Line of Credit

    • The borrowing limit that a bank sets for a firm.

    • May include many promissory notes that the firm has taken out at different times and with overlapping payment periods.

    • Usually informal agreement and may change over time

  • Revolving credit agreement

    • Formal agreement with bank to extend credit to a firm for a period of time (can be more than one year).


Trade credit
Trade Credit equal intervals.

  • Trade credit is the act of obtaining funds by delaying payment to suppliers.

  • Even though it is obtained by simply delaying payment, it is not always free.

  • The cost of trade credit may be some interest charge that the supplier charges on the unpaid balance. More often, it is in the form of a lost discount that would be given to firms who pay earlier.

  • Credit has a cost. That cost may be passed along to the customer as higher prices, borne by the seller as lower profits, or some of both.


Estimation of cost of short term credit

Effective equal intervals.

Interest Rate

Interest you pay

Amount you get to use

=

Estimation of Cost of Short-Term Credit

  • Calculation is easiest if the loan is for a one year period:

  • Effective Interest Rate is used to determine the cost of the credit to be able to compare differing terms.

Example: You borrow $10,000 from a bank and must pay $1,000 interest at the end of the year

Your effective rate is the same as the stated rate = $1,000/$10,000 = .10 = 10%


Variations in loan terms
Variations in Loan Terms equal intervals.

  • A discount loan requires that interest be paid up front when the loan is given.

  • This changes the effective cost in the previous example since you only get to use:

    ($10,000 - $1,000) = $9,000.

  • Effective cost = $1,000/$9,000 = .1111 = 11.11%.


Variations in loan terms1
Variations in Loan Terms equal intervals.

  • Sometimes lenders require that a minimum amount, called a compensating balance be kept in your bank account.

  • If your compensating balance requirement is $500, then the amount you can use is reduced by that amount.

  • Effective cost for a $10,000 simple interest 10% loan with a $500 compensating balance = $1,000/($10,000-$500) = .1053 = 10.53%.


Cost of short term credit for periods less than one year

( equal intervals.Periods/yr)

Effective

Annual =

Rate

$ Interest

$ you get

to use

1 + -1

(

)

Cost of Short-Term CreditFor Periods Less Than One Year

  • When loans are for less than one year, we must convert the cost to annual terms for comparison.

  • e.g. A 1 month $10,000 loan requires that interest of $90 be paid:

    the monthly rate = 90/10,000 = .0090 = .9%.

  • Use the following formula to equate:


Cost of short term credit for periods less than one year1
Cost of Short-Term Credit equal intervals.For Periods Less Than One Year

  • $10,000 loan for 1 month with monthly interest equal to $90. What is the effective annual interest rate?

  • Effective annual rate = (1.009)12 - 1 = .1135 =11.35%

Link to CNNfn


Cost of short term credit for periods less than one year2

12 equal intervals.

K=(1+

)

90

10,000 - 90

-1 = .1146

Cost of Short-Term CreditFor Periods Less Than One Year

  • What if the loan is a discount loan? Must pay the interest up front so that reduces the dollars available to use.

  • $10,000 loan with .9%monthly interest:

  • Effective annual rate

  • k = 11.46%


Sources of short term credit
Sources of Short Term Credit equal intervals.

  • Cost of Trade Credit

    • Typically receive a discount if you pay early.

    • Stated as: 2/10, net 60

      • Purchaser receives a 2% discount if payment is made within 10 days of the invoice date, otherwise payment is due within 60 days of the invoice date.

    • The cost is the form of the lost discount.


Cost of trade credit 2 10 net 60
Cost of Trade Credit 2/10 net 60 equal intervals.

  • Assume your purchase is $100 list.

  • If you take the discount, you pay $98. If you don’t take the discount, you pay $100.

  • Therefore, you are paying $2 for the privilege of borrowing $98 for the additional 50 days. (Note: the first 10 days are free in this example).


Learning objectives

( ) equal intervals.

365

days to pay - disc. pd.

(

-1

1 +

(

Discount %

100-Discount%

Cost

of Credit

=

Cost of Trade Credit 2/10 net 60

  • The formula for cost of trade credit is similar to the previous equations.

  • The exponent is the number of times per year the firm can take 50 days of credit.

  • The cost of trade credit for this example:[1 +(2/98)])7.3 -1 = .1589 = 15.89%.


Computing the cost of trade credit another example

( equal intervals.

365

40 – 10

(1+

)

K =

)

-1 = .2786

2

100 - 2

Computing the Cost of Trade CreditAnother Example

  • Effective Annual Cost, k, of Passing Up a Discount; 2/10, n40

  • k = 27.86%


Commercial paper
Commercial Paper equal intervals.

  • Commercial paper is quoted on a discount basis so discount yield must be converted to effective annual interest rate for comparison.

  • Compute the discount from face value (D)

    • D = (Discount yield x par x DTG)/360

    • DTG = days to go (to maturity)

  • Compute the price = Par - D

  • Compute Effective Annual Rate = (par/price)(365/DTG) - 1


Cost of commercial paper example
Cost of Commercial Paper Example equal intervals.

  • $1 million issue of 90 day c.p. quoted at 4% discount yield.

    Step 1: Calculate D = .04 x $1 mill. x 90 360 = $10,000

    Step 2: Calculate price = $1,000,000 - $10,000 = $990,000

    Step 3: Calculate effective rate = (1,000,000 / 990,000) (365/90)-1 = 4.16%


Accounts receivable as collateral
Accounts Receivable as Collateral equal intervals.

  • A pledge is a promise that the borrowing firm will pay the lender any payments received from the accounts receivable collateral in the event of default.

  • Since accounts receivable fluctuate over time, the lender may require certain safeguards to ensure that the value of the collateral does not go below the balance of the loan.

  • Accounts receivable can also be sold outright. This is known as factoring.


Inventory as collateral
Inventory as Collateral equal intervals.

  • A major problem with inventory financing is valuing the inventory.

  • For this reason, lenders will generally make a loan in the amount of only a fraction of the value of the inventory. The fraction will differ depending on the type of inventory.


Inventory as collateral1
Inventory as Collateral equal intervals.

  • Blanket Lien: A general claim against the borrowers inventory if there is a default

  • Trust Receipt: A legal document that identifies specific inventory as security for a loan

  • Warehousing: Inventory pledged as collateral is removed from the control of the borrower (either in an on-site or public warehouse)