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1
Working CapitalPolicy
2
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.
3
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)
4
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.
5
Firm 1ST Debt 100
LT Debt 400
Common Stock 500
Total Liabilities&Equity 1000
Firm 1Marketable Securities 0Other Current Assets 200Fixed Assets 800Total Assets 1000
Firm 1 Operating Earnings 150Interest Earned 0EBT 150Taxes (40%) -60Net Income 90
Example: Risk-Return Trade-offCompare the 2 following companies
Current Assets Current Liabilities
Current Ratio =
200100
=
= 2Current Ratio 2
6
Firm 1ST Debt 100
LT Debt 400
Common Stock 500
Total Liabilities&Equity 1000
Firm 1Marketable Securities 0Other Current Assets 200Fixed Assets 800Total Assets 1000
Firm 1 Operating Earnings 150Interest Earned 0EBT 150Taxes (40%) -60Net Income 90
Current Ratio 2
Return on Assets = Net Income
Assets
90 1000
=
Example: Risk-Return Trade-offCompare the 2 following companies
= .09 = 9%
ROA 9%
7
Firm 2:
$200 Marketable Securities Financed with Common Stock
200 x 4% = $8 interest earned
Firm 1 Firm 2Marketable Securities 0 200Other Current Assets 200 200Fixed Assets 800 800Total Assets 1000 1200
Firm 1 Firm 2ST Debt 100 100LT Debt 400 400Common Stock 500 700Total Liabilities&Equity 1000 1200
Firm 1 Firm 2Operating Earnings 150 150Interest Earned 0 8EBT 150 158Taxes (40%) -60 -63Net Income 90 95
Current Ratio 2ROA 9%
Example: Risk-Return Trade-offCompare the 2 following companies
8
Firm 1 Firm 2Marketable Securities 0 200Other Current Assets 200 200Fixed Assets 800 800Total Assets 1000 1200
Firm 1 Firm 2ST Debt 100 100LT Debt 400 400Common Stock 500 700Total Liabilities&Equity 1000 1200
Firm 1 Firm 2Operating Earnings 150 150Interest Earned 0 8EBT 150 158Taxes (40%) -60 -63Net Income 90 95
Current Ratio 2 ROA 9%
400100
=
Current Ratio = CACL
Example: Risk-Return Trade-offCompare the 2 following companies
= 44
9
Firm 1 Firm 2Marketable Securities 0 200Other Current Assets 200 200Fixed Assets 800 800Total Assets 1000 1200
Firm 1 Firm 2ST Debt 100 100LT Debt 400 400Common Stock 500 700Total Liabilities&Equity 1000 1200
Firm 1 Firm 2Operating Earnings 150 150Interest Earned 0 8EBT 150 158Taxes (40%) -60 -63Net Income 90 95
Current Ratio 2 4ROA 9%
95 1200
=
Example: Risk-Return Trade-offCompare the 2 following companies
=.079 = 7.9%
7.9%
Return on Assets = NI
Assets
10
Firm 1Higher ROALess LiquidRiskier
Firm 2Lower ROAMore LiquidLess Risky
Example: Risk-Return Trade-offCompare the 2 following companies
Firm 1 Firm 2Marketable Securities 0 200Other Current Assets 200 200Fixed Assets 800 800Total Assets 1000 1200
Firm 1 Firm 2ST Debt 100 100LT Debt 400 400Common Stock 500 700Total Liabilities&Equity 1000 1200
Firm 1 Firm 2Operating Earnings 150 150Interest Earned 0 8EBT 150 158Taxes (40%) -60 -63Net Income 90 95
Current Ratio 2 4ROA 9% 7.9%
11
Time
Total Assets
Assume ZERO Long-term Growth
$5M
Variation in assets over time
FixedAssets}
12
Time
Total Assets
FixedAssets
PermanentCurrent Assets}
}$5M
$7M
Variation in assets over time
13
Temporary Current Assets
Variation in assets over time
Time
Total Assets
FixedAssets
PermanentCurrent Assets}
}$5M
$7M
$10M
14
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
15
Financing Current Assets:Conservative Approach
Temporary Current Assets
Time
Total Assets
FixedAssets
PermanentCurrent Assets}
}$5M
$7M
$10MTemporary Current Assets
Time
Total Assets
FixedAssets
PermanentCurrent Assets}
}$5M
$7M
$10M
Short-termSources
Lo
ng
-te
rmS
ou
rce
s
16
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
17
Financing Current Assets:Moderate Approach
Temporary Current Assets
Time
Total Assets
FixedAssets
PermanentCurrent Assets}
}$5M
$7M
$10MTemporary Current Assets
Time
Total Assets
FixedAssets
PermanentCurrent Assets}
}$5M
$7M
$10ML
on
g-t
erm
So
urc
es
18
Financing Current Assets:Moderate Approach
Short-termSources
Temporary Current Assets
Time
Total Assets
FixedAssets
PermanentCurrent Assets}
}$5M
$7M
$10MTemporary Current Assets
Time
Total Assets
FixedAssets
PermanentCurrent Assets}
}$5M
$7M
$10ML
on
g-t
erm
So
urc
es
19
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
20
Long-term Sources
Financing Current Assets:Aggressive Approach
Temporary Current Assets
Time
Total Assets
FixedAssets
PermanentCurrent Assets}
}$5M
$7M
$10MTemporary Current Assets
Time
Total Assets
FixedAssets
PermanentCurrent Assets}
}$5M
$7M
$10M
Short-termSources
21
Managing (WARM, SOFT) Cash
23
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)
24
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
25
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
26
Choosing the Optimum Cash Balance
Days of the Month
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Do
llars
in th
e C
ash
Acc
oun
t
Cash Balances in a Typical Month
27Days of the Month
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Do
llars
in th
e C
ash
Acc
oun
t
Cash Balances in a Typical Month
Choosing the Optimum Cash Balance
Invest Excess Cash
28Days of the Month
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Do
llars
in th
e C
ash
Acc
oun
t
Cash Balances in a Typical Month
Choosing the Optimum Cash Balance
Sell Securities toobtain cash
29
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
30
The Miller-Orr Model- Target Cash Balance
(Z)
3 x TC x V 4 x r
Z = + L3
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
31
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
(Z)
32
The Miller-Orr Model- Target Cash Balance
(Z) Example
3 x 50 x 100,000 4 x .05/365
Z = + $1,000
= $3,014 + $1,000 = $4,014
3
33
The Miller-Orr Mode- Upper Limit
The upper limit for the cash account (H) is determined by the equation:
H = 3Z - 2Lwhere:Z = Target cash balanceL = Lower limit
In the previous example:H = 3 ($4,014) - 2($1,000) =
$10,042
34
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.
35
Cash Budget - Problem
Rocky Mountain Climbing, Inc. (RMC) has the following information:
Previous Sales November 2007 130,000December 2007 125,000
Forecast Sales January 2008 120,000February 2008 260,000March 2008 140,000April 2008 140,000
36
Cash Budget - Problem
Rocky Mountain Climbing, Inc. (RMC) has the following information:Previous Sales: November 2007 130,000
December 2007 125,000Forecast sales for: January 2008 120,000
February 2008 260,000March 2008 140,000April 2008 140,000
Collections : 30% of customers pay cash 50% pay in month after sale 20% pay 2 months after sale
37
Cash Budget - Problem
Other information for RMC Cash Budget:
Purchases of inventory are 75% of salesand are made 2 months before saleand are paid for 1 month after delivery
Other expenses $14,000 per monthTaxes $10,000 due in March
Cash Balance (Dec. 31, 2007) = $28,000Minimum balance required by bank = $25,000(ST borrowing rate = 6% annually)
38
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.
39
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
40
Collection of January Sales
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000
36,000
Cash Budget - CollectionsSales made in January will not be fullycollected until March.
120,000 x .30120,000 x .30
41
Sales made in January will not be fullycollected until March.
Cash Budget - Collections
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 .30120,000 x .30
60,000
120,000 x .50120,000 x .50
42
Sales made in January will not be fullycollected until March.
Cash Budget - Collections
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 .30120,000 x .30
60,000
120,000 x .50120,000 x .50
24,000
120,000 x .20120,000 x .20
43
Calculate collections for other months.
Cash Budget - Collections
Cash BudgetRMC, Inc.
Sales 130,000 125,000 120,000 260,000 140,000Collections:Month of Sale (30%) 36,000 78,000 42,000First Month (50%) 62,500 60,000 130,0002nd Month (20%) 26,000 25,000 24,000Total Collections 124,500 163,000 196,000
Nov Dec Jan Feb Mar
44
Payments for January Purchases
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000
75% of January Sales Purchased in November
75% of January Sales Purchased in November
Purchases are made 2 months prior to sale and are paid for 1 month later.
Cash Budget - Purchases/Payments
90,000
45
Cash Budget - Purchases/Payments
Payments for January Purchases
Nov Dec Jan Feb Mar
Sales 130,000 125,000 120,000 260,000 140,000
90,000 90,00075% of January Sales Purchased in November, Paid for in December
75% of January Sales Purchased in November, Paid for in December
Purchases are made 2 months prior to sale and are paid for 1 month later.
46
Calculate payments for all months. Note that in order to do a cash budget,you will need forecasts of sales for April.
Cash Budget - Purchases/Payments
Cash BudgetRMC, Inc.
Sales 130,000 125,000 120,000 260,000 140,000 140,000Purchases 195,000 105,000 105,000Payments 195,000 105,000 105,000
Nov Dec Jan Feb Mar Apr
47
Jan Feb Mar
Cash BudgetRMC, Inc.
Cash Collections 124,500 163,000 196,000Material Payments 195,000 105,000 105,000
Summary of Previous CalculationsSummary of Previous Calculations
48
Jan Feb Mar
Cash BudgetRMC, Inc.
Cash Collections 124,500 163,000 196,000Material Payments 195,000 105,000 105,000Other Payments:Other Expenses 14,000 14,000 14,000Tax Payments 0 0 10,000
Remaining Cash OutflowsRemaining Cash Outflows
49
Jan Feb Mar
Cash BudgetRMC, Inc.
Cash Collections 124,500 163,000 196,000Material Payments 195,000 105,000 105,000Other Payments:Rent 2,000 2,000 2,000Other Expenses 12,000 12,000 12,000Tax Payments 0 0 10,000Net Monthly Change (84,500) 44,000 67,000
50
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow)Needed (Borrowing)Loan RepaymentInterest CostEnding Cash BalanceCumulative Borrowing
Analysis of Borrowing Needs
51
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow) (56,500)Needed (Borrowing)Loan RepaymentInterest CostEnding Cash BalanceCumulative Borrowing
Analysis of Borrowing Needs
52
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow) (56,500)Needed (Borrowing)Loan RepaymentInterest CostEnding Cash Balance 25,000Cumulative Borrowing
Target Ending BalanceTarget Ending Balance
Analysis of Borrowing Needs
53
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow) (56,500)Needed (Borrowing) 81,500Loan Repayment 0Interest Cost 0Ending Cash Balance 25,000Cumulative Borrowing
Analysis of Borrowing Needs
Borrowing Required to cover Minimum Balance and Deficit
Borrowing Required to cover Minimum Balance and Deficit
56,500+25,000
54
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000Ending Cash (No Borrow) (56,500)Needed (Borrowing) 81,500Loan Repayment 0Interest Cost 0Ending Cash Balance 25,000Cumulative Borrowing 81,500
Analysis of Borrowing Needs
55
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500Loan Repayment 0Interest Cost 0Ending Cash Balance 25,000Cumulative Borrowing 81,500
Analysis of Borrowing Needs
56
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500 0Loan Repayment 0Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500
Analysis of Borrowing Needs
Interest Incurred on PriorMonth Borrowing
Interest Incurred on PriorMonth Borrowing
81,500 x .005
57
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500
Analysis of Borrowing Needs
Amount that can be repaid from monthly surplus
Amount that can be repaid from monthly surplus
69,000 - 408 - 25,000=$43,592
58
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000Ending Cash (No Borrow) (56,500) 69,000Needed (Borrowing) 81,500 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500
New Loan BalanceNew Loan Balance
81,500 - 43,592=$37,908
Analysis of Borrowing Needs
37,908
59
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908
Analysis of Borrowing Needs
60
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0 0Loan Repayment 0 43,592Interest Cost 0 408Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908
Analysis of Borrowing Needs
Interest Incurred on PriorMonth Borrowing
Interest Incurred on PriorMonth Borrowing
37,908 x .005
190
61
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0 0Loan Repayment 0 43,592Interest Cost 0 408 190Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908
Analysis of Borrowing Needs
Repay Outstanding Loan Balance
Repay Outstanding Loan Balance
37,908
62
Jan Feb Mar
Cash BudgetRMC, Inc.
Net Monthly Change (84,500) 44,000 67,000Beginning Cash Balance 28,000 25,000 25,000Ending Cash (No Borrow) (56,500) 69,000 92,000Needed (Borrowing) 81,500 0 0Loan Repayment 0 43,592 37,908Interest Cost 0 408 190Ending Cash Balance 25,000 25,000Cumulative Borrowing 81,500 37,908 0
Analysis of Borrowing Needs
Ending Cash BalanceEnding Cash Balance
$53,902-$25,000=$28,902 Surplus
53,902
63
Jan Feb Mar
Cash BudgetRMC, Inc.
Ending Cash Balance 25,000 25,000 53,902Cumulative 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.
Analysis of Borrowing Needs
64
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).
65
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
66
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
67
Accounts Receivableand Inventory
68
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.
69
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.
70
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
71
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.
72
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
73
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
74
Analysis of Accts. Receivable Changes Develop pro forma financial
statements for each policy under consideration.
Use the pro formas to estimate incremental cash flows 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).
75
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 Changes
76
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.
77
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 = $4,500
Since NPV > 0, ABC should undertake the credit policy change, assuming that the assumptions are valid and that the projected cash flows are accurate.
78
How Firms Make Credit Decisions The Five Cs of Credit: Character is the borrower’s willingness to pay
based on past payment patterns. Capacity is the borrower’s ability to pay
based on forecasts of future cash flows. Capital is how much wealth the borrower has
to fall back on. Collateral is what the lender gets if the
borrower fails to pay. Conditions faced by the borrower in the
business marketplace are also considered.Link to Credit Scoring
79
Methods of Collection
Send reminder letters. Make telephone calls. Hire collection agencies. Sue the customer. Settle for a reduced amount. Write off the bill as a loss. Sell accounts receivable to
factors.
Most firms use some of the following:
80
Inventory Management
Typically, inventory accounts for about four to five percent of a firm's assets.
In order to effectively manage the investment in inventory, two problems must be dealt with: how much to order and how often to order.
The economic order quantity (EOQ) model attempts to determine the order size that will minimize total inventory costs.
81
Inventory Management
Determining Optimal Inventory– Economic Order Quantity (EOQ)
TotalInventory
Costs=
TotalCarrying
Costs
TotalOrdering
Costs+
Link to Bloomberg.com
82
Time
OrderQuantity
Q
InventoryLevel
(units)
The EOQ Model assumes the firm orders a fixed amount Q at equal intervals.
83Time
OrderQuantity
Q
InventoryLevel
(units)
The EOQ Model
Average Inventory = Order Quantity2
Q2
84
=Total
InventoryCosts
( ) CC + ( ) OCOQ2
S OQ
Where:OQ = Order Size (order quantity)S = Annual Sales VolumeCC = Carrying Cost per UnitOC = Ordering Cost per Order
TotalInventory
Costs=
TotalCarrying
Costs
TotalOrdering
Costs+
85Order Size (units)
Cost($)
Ordering Costs
= ( )OC S OQ
Ordering Costs
86
Carrying Costs
Order Size (units)
Cost($)
Carrying Costs = ( ) CC OQ 2
= ( )OC S OQ
Ordering Costs
87
Total Costs = Carrying Costs + Order Costs
Order Size (units)
Cost($)
Carrying Costs = ( ) CC OQ 2
= ( )OC S OQ
Ordering Costs
88
Inventory Management
– The economic order quantity that minimizes the total costs of inventory.
Determining Optimal Inventory
EOQ =2 x S x OC
CC
89
Inventory Management
– 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?
=
= 28.84 29 cars
2(1200)2675
Determining Optimal Inventory
EOQ =2 x S x OC
CC
90
Inventory Management Determining Optimal Inventory
– Economic Order Quantity (EOQ)
EOQ autos in each order
Place 1,200/ 29 = 41.4 orders each year
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?
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Inventory Management with Safety Stock- Order before inventory is at zero.
EOQ
Depleted StockDuring Delivery
Inventory Order Point
Actual Delivery Time
SafetyStock
Time
InventoryLevel
(units)
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Time
OrderQuantity
Q
InventoryLevel
(units)
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ABC Inventory Classification System 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.
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Just In Time Inventory Control (JIT) 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.
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Short Term Financing
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Learning Objectives
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.
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Why Do Firms Need Short-term Financing? 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
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Sources of Short-term Financing 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.
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Types of short-term loans: 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).
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Types of short-term loans: 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).
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Trade Credit
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.
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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.
Effective Interest Rate
Interest you pay Amount you get to use
=
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%
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Variations in Loan Terms 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%.
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Variations in Loan Terms 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%.
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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 $90 be paid: the monthly rate = 90/10,000 = .0090 = .9%.
Use the following formula to equate:
EffectiveAnnual = Rate
1 + -1$ Interest$ you get to use
(Periods/yr)( )
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Cost of Short-Term CreditFor 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
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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:
K=(1+90
10,000 - 90 )12
-1 = .1146
k = 11.46%
Effective annual rate
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Sources of Short Term Credit 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.
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Cost of Trade Credit 2/10 net 60 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).
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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%.
Cost of Trade Credit 2/10 net 60
Costof Credit
Discount %100-Discount%
1 + -1365
days to pay - disc. pd.( )=( (
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Computing the Cost of Trade CreditAnother Example Effective Annual Cost, k, of
Passing Up a Discount; 2/10, n40
K =(1+2
100 - 2 )( 365
40 – 10 )-1 = .2786
k = 27.86%
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Commercial Paper
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
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Cost of Commercial Paper Example
$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%
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Accounts Receivable as Collateral 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.
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Inventory as Collateral
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.
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Inventory as Collateral
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)