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Principles Used in Chapter 16

Principle 1:

The Risk-Return Trade-Off – We Won’t Take On Additional Risk Unless We Expect to Be Compensated with Additional Return.

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Cash Flow Process

Two typical sources of cash: external and internal

Irregular increases or decreases in the firm’s cash holdings can come from several sources such as:

Sale of securities (stocks and bonds) Nonmarketable-debt contracts Payment of dividend, interest, tax bills Share repurchases

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Other sources of cash reductions:

Acquisition of fixed assets

Purchase of inventory

Cash Flow Process

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Motives for Holding Cash

Three Motives:

Transactions Motive

Precautionary Motive

Speculative Motive

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Balances held to meet cash needs that arise in the ordinary course of doing business.

Transactions Motive

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Buffer stock of liquid assets

Maintain balances to satisfy possible, but as yet unknown, needs

Precautionary Motive

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Cash held to take advantage of potential profit-making situations

Speculative Motive

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Cash Management

Cash management program must minimize the firm’s risk of insolvency.

Insolvency – The situation in which the firm is unable to meet its maturing liabilities on time.

A company is technically insolvent in that it lacks the necessary liquidity to make prompt payment on its current debt obligations.

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The Trade-off A large cash balance will help minimize

the chance of insolvency, but it penalizes the company’s profitability.

A smaller cash balance will increase the chance of insolvency, but it will free up excess cash for investment and enhance profitability.

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Cash Management Objectives

Two prime objectives:

1. Enough cash must be on hand to meet disbursal needs in the course of doing business.

2. Investment in idle cash balances must be reduced to a minimum.

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Two conditions would allow the firm to operate for extended periods with cash balances near or at zero:

Completely accurate forecast of net cash flows over the planning horizon.

Perfect synchronization of cash receipts and disbursements.

Cash Management Objectives

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Cash Management Decisions

What can be done to speed up cash collections and slow down or better control cash outflows?

What should be the composition of a marketable securities portfolio?

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Collection and Disbursement Procedures

Efficiency of firm’s cash management program can be improved:

By accelerating cash receipts

By improving the methods used to distribute cash

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Speeding up Collection What can be done to accelerate

collection procedures?

Reduce Float

Lockbox System

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Float and Managing Cash Inflow

Float – The time from when a check is written until the actual recipient can draw upon or use the funds.

Mail Float

Processing Float

Transit Float

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Mail Float

Time lapse from the moment a customer mails a remittance check until the firm begins to process it.

Processing Float

The time required for the firm to process remittance checks before they can be deposited in the bank.

Float and Managing Cash Inflow

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Transit Float

The time necessary for a deposited check to clear through the commercial banking system and become usable funds to the company

Disbursing Float

Availability of funds in the company’s bank account during the time the payment check is clearing through the banking system

Float and Managing Cash Inflow

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Lockbox Arrangement Commercial banking service where

customers mail checks to a post office box (rather than company) to expedite cash collection The bank providing the lock box service is

authorized to open the box, collect the mail, process the checks, and deposit the checks directly into the company’s account.

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Benefits of Lockbox Arrangement Reduces mail and processing float and

can reduce transit float

Funds deposited in this manner are usually available for company use in one business day or less

Elimination of clerical functions

Early knowledge of dishonored checks

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Benefit of Float Reduction

The financial benefit of float reduction can be calculated with the following formula:

Sales per day X days of float reduction X assumed yield

Sales per day = Annual revenues / days in year

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Management of Cash Outflow

Goal: to increase company’s float by slowing down the disbursement and collection process through:

Zero balance accounts

Payable-through drafts

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Composition of Marketable-Securities Portfolio General Selection Criteria for

proper marketable securities mix:

Financial risk

Interest rate risk

Liquidity

Taxability

Yields

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Financial Risk

Refers to the uncertainty of expected returns from a security attributable to possible changes in the financial capacity of the security issuer to make future payments to the security owner.

If the chance of default on the terms of the instrument is high, then the financial risk is said to be high.

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Interest Rate Risk

Refers to the uncertainty of expected return from a financial instrument attributable to changes in interest rates.

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Liquidity

Refers to the ability to transform a security into cash.

Should an unforeseen event require that a significant amount of cash be immediately available, then a sizable portion of the portfolio might have to be sold. Manager should prefer securities that can be sold at or near its prevailing market price.

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Taxability

The tax treatment of the income a firm receives from its security investments does not affect the ultimate mix of the marketable-securities portfolio as much as the criteria mentioned earlier.

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Yields

Affected by previous factors of financial risk, interest rates, liquidity and taxability.

The yield criterion involves an evaluation of the risks and benefits inherent in all of these factors.

For example: If a given risk is assumed, such as lack of liquidity, a higher yield may be expected on the nonliquid instrument.

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Marketable Security Alternatives

Money market securities generally have short-term maturity and are highly marketable.

Characteristics of Marketable Securities in terms of five key attributes:

Denominations in which securities are available

Maturities that are offered

Basis used

Liquidity of the instrument

Taxability of the investment returns

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Examples of Marketable Securities

U.S. Treasury Bills Direct obligations of the U.S. government sold by the

U.S. treasury on a regular basis.

Federal Agency Securities Debt obligations of corporations and agencies that

have been created to effect various lending programs of the U.S. government.

Banker’s Acceptances Draft (order to pay) drawn on a specific bank by an

exporter in order to obtain payment for goods shipped to a customer who maintains an account with that specific bank.

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Examples of Marketable Securities

Negotiable Certificates of Deposit Marketable receipt for funds that have been

deposited in a bank for a fixed period.

Commercial Paper Short-term unsecured promissory notes

sold by large businesses.

Money market mutual funds Pooling of the funds of a large number of

small savers.

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Repurchase agreements

Legal contracts that involve the actual sale of securities by a borrower to the lender, with a commitment on the part of the borrower to repurchase the securities at the contract price plus a stated interest charge.

Examples of Marketable Securities

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Accounts Receivable Management

Accounts receivable is less liquid compared to cash and marketable securities. Account receivables typically comprise 25% of a firm’s assets.

Size of investment in accounts receivable is determined by:

The percentage of credit sales to total sales

The level of sales

Credit and collection policies

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Credit and Collection Policy

Decision Variables:

The Terms of Sale

The Type of Customer

The Collection Effort

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Terms of Sale Identify the possible discount for

early payment, the discount period, and the total credit period.

They are stated in the form a/b, net c

Thus a customer can deduct a% if paid within b days, otherwise it must be paid within c days.

Example 1/10, net 45 Discount of 2% if paid within 10 days; otherwise due in 45 days.

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Type of Customer This involves determining the type of

customer who qualifies for trade credit.

Need to consider the costs of credit investigation, collection costs, default costs.

May use credit scoring or a numerical evaluation of each applicant to determine their short-run financial well-being.

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Collection Efforts

The probability of default increases with the age of the account. Thus, eliminating past-due receivables is key. One common way of evaluating the situation is with ratio analysis – average collection period, ratio of receivables to assets, ratio of credit sales to receivables, ratio of bad debt to sales.

A direct trade-off exists between collection expenses and lost goodwill on one hand and noncollection of accounts on the other.

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Inventory Management Involves the control of the assets that

are produced to be sold in the normal course of the firm’s operations.

The purpose of carrying inventory is to uncouple the operations of the firm – that is, to make each function of the business independent of each other function – so that delays or shutdowns in one area do not affect the production and sale of the final product.

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The Trade-off Risk: If inventory level is low, it is possible

that there will be delays in production and customer delivery.

Return: But low inventory will reduce storage and handling costs and release funds tied up in inventory. Thus it will increase returns.

Similarly, high levels of inventory will reduce delays but increase costs.

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Inventories Raw materials

Basic materials purchased to be used in the firm’s production operations.

Work in process Partially finished goods requiring additional

work before they become finished goods.

Finished goods Goods on which production has been

completed but are not yet sold.

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Inventory Management Techniques

Effective inventory management is directly related to the size of the investment in inventory.

Effective management is essential to the goal of maximization of shareholder wealth.

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To control the investment in inventory, management must solve two problems:

Order quantity problem

Order point problem

Inventory Management Techniques

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Order Quantity Problem Involves determining the optimal

order size for an inventory item given its expected usage, carrying costs, and ordering costs.

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Total Inventory Costs Total inventory costs = total carrying

costs + total ordering costs Total carrying costs = number of orders *

carrying cost per order = Q/2 * C Total ordering costs = number of orders *

ordering cost per order = S/Q * O Where

Q = inventory order size in units C = Carrying cost per unit S = total demand for units O = Ordering cost per order

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EOQ Assumptions

Constant or uniform demand

Constant unit price

Constant carrying costs

Constant ordering costs

Instantaneous delivery

Independent orders

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Order Point Problem The two most limiting assumptions in

EOQ – constant demand and instantaneous delivery – are dealt with through the inclusion of safety stock.

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Safety stock

Inventory held to accommodate any unusually large and unexpected usage during delivery time

Order point problem

The decision about how much safety stock to hold or how low should the inventory be depleted before it is ordered?

Order Point Problem

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Determination of Order Point

Inventory Order Point = Delivery time stock + safety stock

Delivery-time stock – Inventory needed between the order date and the receipt of the inventory ordered.

The order point is reached when inventory falls to a level equal to the delivery-time stock plus the safety stock. See figure 16-8.

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Just-in-Time Inventory System Aim is to operate with the lowest average level

of inventory possible.

Within the EOQ model, the basics are to:

Reduce ordering costs

Reduce safety stocks

This is achieved by attempts to receive continuous flow of deliveries of component parts.

The result is to actually have about 2 to 4 hours worth of inventory on hand.

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Inflation and EOQ

Inflation affects the EOQ Model in two ways:

Anticipatory buying – buying in anticipation of a price increase to secure the goods at a lower cost.

Increased carrying costs – as inflation pushes up interest rates, the costs of carrying inventory increases. As “C” increases, the optimal EOQ declines in the EOQ model.