Principles
of
Corporate
Finance
Chapter 30
Working Capital
Management
Ninth Edition
Slides by
Matthew Will
McGraw Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved
30- 2
Topics Covered
 Inventories
 Credit Management
 Cash
 Marketable Securities
30- 3
Working Capital
Current assets and liabilities for U.S.
manufacturing firms (2nd qtr. 2006)…$ billions
Currenty Assets
Current Liabilities
Cash
265
Short-term loans
138
Other shirt-term financial
investments
199
Accounts payable
436
Accounts receivable
634
Accrued income taxes
65
Inventories
570
Current payments due on
long-term debt
104
Other current asets
311
Other current liabilities
723
Total
1979
Total
1466
Net working capital (current assets-current liabilities) = $1979-1466=$513 billion.
30- 4
Inventory Management
 Components of Inventory
– Raw materials
– Work in process
– Finished goods
 Goal = Minimize amount of cash tied up in inventory
 Tools used to minimize inventory
– Just-in-time
– Lean manufacturing
30- 5
Inventories
As the firm increases its order size, the
number of orders falls and therefore the
order costs decline. However, an increase
in order size also increases the average
amount in inventory, so that the carrying
cost of inventory rises. The trick is to strike
a balance between these two costs.
30- 6
Managing Inventories
Inventory
Inventory, thousands of units
60
30
Average
Inventory
0
3
6
9
Weeks
12
30- 7
Inventories
Inventory costs, dollars
Determination of optimal order size
Total costs
Carrying
costs
Total order costs
Optimal
order size
Order size
30- 8
Inventories
Economic Order Quantity - Order size that
minimizes total inventory costs.
Economic Order Quantity =
2 x annual sales x cost per order
carrying cost
30- 9
Inventories
Just-in-time inventory management
Managing inventories of cash
Upper limit
Cash
Return point
Balance
Lower limit
Time
30- 10
Inventories
 The optimal amount of short term securities sold
to raise cash will be higher when annual cash
outflows are higher and when the cost per sale of
securities is higher. Conversely, the initial cash
balance falls when the interest is higher.
Initial cash balance =
2 x annual cash outflows x cost per sale of securities
interest rate
30- 11
Working Capital
Net Working Capital - Current assets minus current
liabilities. Often called working capital.
Cash Conversion Cycle - Period between firm’s
payment for materials and collection on its sales.
Carrying Costs - Costs of maintaining current
assets, including opportunity cost of capital.
Shortage Costs - Costs incurred from shortages in
current assets.
30- 12
Terms of Sale
Terms of Sale - Credit, discount, and payment terms
offered on a sale.
Example - 5/10 net 30
5 - percent discount for early payment
10 - number of days that the discount is available
net 30 - number of days before payment is due
30- 13
Terms of Sale
 A firm that buys on credit is in effect borrowing
from its supplier. It saves cash today but will have
to pay later. This, of course, is an implicit loan
from the supplier.
 We can calculate the implicit cost of this loan
Effective annual rate
(
= 1 +
)
discount
discounted price
365 / extra days credit
- 1
30- 14
Terms of Sale
Example - On a $100 sale, with terms 5/10 net 60,
what is the implied interest rate on the credit
given?
Effective annual rate


 1+
365/extra days credit
discount
discounted price
 1 +
5 365/50
95

-1
- 1 = .454, or 45.4%
30- 15
Credit Agreements
 Terminology
–
–
–
–
–
–
–
–
–
open account
promissory note
commercial draft
sight draft
time draft
trade acceptance
banker’s acceptance
irrevocable letter of credit
conditional sale
30- 16
Credit Analysis
Numerical Credit Scoring categories
–
–
–
–
–
The customer’s character
The customer’s capacity to pay
The customer’s capital
The collateral provided by the customer
The condition of the customer’s business
30- 17
Credit Analysis
Credit Analysis - Procedure to determine the
likelihood a customer will pay its bills.
 Credit agencies, such as Dun & Bradstreet provide
reports on the credit worthiness of a potential
customer.
 Financial ratios can be calculated to help
determine a customer’s ability to pay its bills.
30- 18
The Credit Decision
Credit Policy - Standards set to determine the
amount and nature of credit to extend to
customers.
Credit Scoring – What your lender won’t tell tell
you.
 Extending credit gives you the probability of
making a profit, not the guarantee. There is still a
chance of default.
 Denying credit guarantees neither profit or loss.
30- 19
The Credit Decision
The credit decision and its probable payoffs
Customer pays = p
Payoff = Rev - Cost
Offer credit
Customer defaults = 1-p
Refuse credit
Payoff = 0
Payoff = - Cost
30- 20
The Credit Decision
 Based on the probability of payoffs, the expected
profit can be expressed as:
p x PV(Rev - Cost) - (1 - p) x (PV(cost)
The break even probability of collection is:
PV(Cost)
p =
PV(Rev)
30- 21
Collection Policy
Collection Policy - Procedures to collect and
monitor receivables.
Aging Schedule - Classification of accounts
receivable by time outstanding.
30- 22
Factoring
Total factoring volume measured in millions of Euros
Factoring volume (millions)
1,200,000
1,000,000
800,000
Rest of world
Europe
600,000
Americas
400,000
200,000
0
1999
2000
2001
2002
2003
2004
2005
2006
30- 23
Collection Policy
Sample aging schedule for accounts receivable
Customer' s Less than
More than
1 - 2 months 2 - 3 months
Total Owed
Name
1 month
3 months
A
10,000
0
0
0
10,000
B
8,000
3,000
0
0
11,000
*
*
*
*
*
*
*
*
*
*
*
*
*
*
*
*
*
*
Z
5,000
4,000
6,000
15,000
30,000
Total $200,000
$40,000
$15,000
$43,000
$298,000
30- 24
Cash
Cash does not pay interest
– Move money from cash accounts into short
term securities
– “Sweep programs”
– MMDAs
– Concentration banking
– Lock-box system
30- 25
Cash
How purchases are paid. Percentage of total by payment type for 2004.
100%
Direct debits
Credit transfers
Credit/debit cards
Checks
80%
60%
40%
20%
USA
UK
Switzerland
Sweden
Netherlands
Italy
Germany
France
Canada
0%
30- 26
Cash
 Electronic Funds Transfer (EFT)
 Automated Clearinghouse (ACH)
 2005 ACH transaction volume = $31.1 trillion
 International cash management
 Compensating balances
30- 27
Payment Methods
120
% of firms using
100
80
60
Receive payments
Make payments
40
20
0
Direct
payments
Direct deposits
Wire transfers
30- 28
Marketable Securities
Microsoft 2006 cash investments
Investment
Money market mutual funds
Commercial paper
Certificates of deposit
US Govt and agency securities
Foreign govt bonds
Mortgage backed securities
Corporate notes and bonds
Municipal securities
Other
Total
Amount
$723 million
3,242
364
4,904
6,034
4,285
7,605
4,008
383
31,548
30- 29
Money Market Investments
Investment
Treasury bills
Borrower
MATURITIES
When Issued
Marketability
Basis for
Calculating Interest
U.S. government
4 weeks, 3
months, or 6
months
Excellent
secondary
market
Discount
Very good
secondary
market
Discount
Federal agency
FHLB, "Fannie Mae,"
benchmark bills and Sallie Mae," Freddie Overnight to 360
discount notes
Mac," etc.
days
Municipalities,
Tax-exempt
states, school
municipal notes
districts, etc.
Tax-exempt variableMunicipalities,
rate demand bond
states, universities,
(VRDBs)
etc.
3 months to 1
year
10-40 years
Good
secondary
market
Good
secondary
market
Usually interestbearing with interest
at maturity
Variable interest rate
Comments
Auctioned weekly
Benchmark bills by
regular auction;
discount notes sold
through dealers
Tax-anticipation notes
(TANs), revenue
anticipation notes
(RANs), bond
anticipation notes
(BANs), etc.
Long-term bonds with
put options to demand
repayment
30- 30
Money Market Investments
Investment
Borrower
Non-negotiable time
deposits and
negotiable
certificates of
deposit (CDs)
Commercial banks,
savings and loans
Industrial firms,
finance companies,
and bank holding
Commercial paper
companies; also
(CP)
municipalities
Largely finance
companies and
Medium-term notes banks; also industrial
(MTNs)
firms
Bankers'
acceptances (Bas)
Repurchase
agreements (repos)
MATURITIES
When Issued
Marketability
Basis for
Calculating Interest
Comments
Usually 1 to 3
months; also
Fair secondary
longer-maturity
market for
Interest-bearing with
variable-rate CDs negotiable CDs interest at maturity Receipt for time deposit
Maximum 270
days; usually
less than 10
years
Minimum 270
days;usually
less than 10
years
Dealers or
issuer will
repurchase
paper
Usually discount
Dealers will
repurchase
notes
Interest-bearing;
usually fixed rate
Major commercial
banks
1-6 months
Fair secondary
market
Discount
Dealers in U.S.
government
securities
Overnight to
about 3 months;
also open repos
(continuing
contracts)
No secondary
market
Unsecured promissory
note; may be placed
through dealer or
directly with investor
Unsecured promissory
note placed through
dealer
Demand to pay that has
been accepted by a
bank
Repurchase price set
higher than selling
Sales of government
price; difference
securities by dealer with
quoted as repo
simultaneous agreement
interest rate
to repurchase.
30- 31
Short Term Assets
Short term assets held by US non-financial corporations
(2nd quarter 2006)
600
400
300
200
Tax-exempt
Agency
securities
Treasury
securities
Repos
Commercial
paper
0
Money-market
funds
100
Cd s and time
deposits
$ billion
500
30- 32
Web Resources
Click to access web sites
Internet connection required
www.decisioneering.com
www.jaxworks.com
www.toolkit.cch.com
www.bis.org
www.federalreserve.gov
www.ecb.int