MGT201 (Financial Management)
MGT201
Lecture No. 40
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topics:
Cash Management &
Working Capital Financing
Cash Dividend Payout Decision:
• Link between Dividend Policy & Cash Management – Cash Dividends are paid out of Cash!
•
Cash is an idle asset that do not generate any return for the company
• How should firm decide to pay Cash Dividend based on Its Impact on Share Price and Firm’s Value?
• Gordon’s Formula:
Dividend policy issue of the company can be seen through Gordon’s Formula.
–
Po (Share Price) = DIV1 / (r
E
– g)
= EPS x (DIV1/EPS) / (r
= Required rate of return on equity
E
– (P
DIV1 = Forecasted dividend in the next year b
x ROE)).
r
E
g = Growth rate in dividends
P b
= Plough back ratio
The two criteria that can help to decide about dividend are ROE and r return. r
.
E
.
• ROE is financial accounting measure of the firm’s ability to internally generate a
E
is the return that the firm’s shareholders REQUIRE. Firms try to keep
ROE HIGHER than r
E
• If ROE < r
E
then firm is not generating enough return to meet shareholder requirements so it is better to payout the dividend. Lower ROE means company is not finding sufficient projects to generate enough return higher than rate of return on equity.
• If firm makes Dividend payout, in this case, share price Po (and Firm Value) will
RISE as dividend announcement has positive impact on company’s share price.
• If ROE > r
E
then firm is better off to Plough the Retained Earnings back into the business and investing in Positive NPV Projects or the Firm’s core business.
In this case, company is generating higher return than the return shareholders require, so the best use of internally generated retained earnings is to use them as a cheap source of capital or financing.
•
In this case of ROE > r
E
if firm makes Dividend payout, share price (and Firm
Value) Po will FALL. Here it makes sense for the company to keep cash and invest it in investments as company is generating positive higher returns on its projects rather than paying dividend.
• If ROE = r
E company. then dividend payment has no impact on share price of the
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MGT201 (Financial Management)
Inventory Management:
In the last lecture we studied working capital and cash management in detail. Now we discuss inventory management, another part of working capital.
• 3 Types of Inventories: Raw Material, Work in Process, Finished Goods
• Issues to Consider in Inventory Management:
– Inventory is acquired BEFORE sales so estimates must be accurate. EOQ
(Economic Order Quantity) difficult to estimate otherwise:
• Shortfall in Inventories: interruptions in production and loss or sales orders
•
Surplus Inventories: high carrying costs, wastage, and depreciation
– Case of Eid Time Sales: Using Short-term Finance or Loan to buy extra inventory can be Risky because if you can’t sell it, you will be forced to sell at a Deep Discount.
So sell at a loss. Cash trickling in BUT Retained Earnings being wiped out. Not enough cash to pay interest on the loan. Possibly default and bankruptcy.
–
Inventory Costs:
• Carrying Costs (cost of capital, storage / warehouse rent, insurance premium, wastage) as high as 20 – 30 % of Inventory value!
• Shipping Costs: Generally Less than 5% of Inventory value!
•
Cost of Running Short Loss of sales, customers, and goodwill difficult to estimate.
•
Inventory Management Policies:
– Technology Based: Dynamic Systems – not only Static EOQ Software for inventory but Dynamic Computer Software that considers Usage Growth Rates.
MRP (Material Resource Planning) and ERP (Economic Resource Planning)
Software.
– JIT: Just in Time. Developed by Toyota. Supplies arrive just a few hours before they are used. Inventory and Working Capital is minimized. Improves overall
Efficiency.
–
Outsourcing: Instead of making all the parts yourself, buy them from outside suppliers at a lower cost and avoid any unionism issues. Example: IT Divisions of Large American MNC’s outsource the writing of computer software to
Pakistani software houses.
Accounts Receivables Management:
This is another area of working capital. Accounts receivables are created out of credit sales.
• Most firms would prefer to sell for Cash BUT Competition forces them to sell on
Credit. Example: Fabric trading in Pakistan where sellers offer 1 to 3 months credit
(and even longer).
•
Account Receivables
= Credit Sales per day x Average Number of Days of Credit
– Example:
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MGT201 (Financial Management)
Account Receivables
=Rs.10000 / day x 30 days
=Rs.300000 of fabric “Stuck in the market” or “In Rolling” at any given time.
• A/c Receivables (other than Profit portion which appears in Retained Earnings) need to be Financed somehow i.e. Short-term loan, trade credit, etc.
• A/c Receivables = Daily Sales x ACP
– ACP = Average Collection Period
= weighted average days of credit. Can be obtained from Ageing Schedule
(Financial Accounting)
–
Example: Firm makes 30% of sales on 30 day credit and 70% on 60 day credit. So ACP
= (0.3x30) + (0.7x60)
= 9 + 42
= 51 Days
– Try to Minimize Average Collection Period and daily credit sales.
Credit Policy:
• Factors considered for credit:
–
Credit Quality Aspect: Proper Assessment of Credit-worthiness of each credit customer (Credit Quality)
– Minimize Time (Credit Duration or ACP) and Value (Credit Given)
– Creative Credit Terms
•
Incentivize Customers to pay cash and to pay quickly
– “Sell on 5/10.net 30 basis”. 30 basis Means customer must pay full cash value within 30 days. 5/10.net means 5% discount for customers who pay within 10 days. So it is an incentive for customer to pay cash quickly.
• Impose Carrying Charge on Late Payments
– Example: 2% late payment Charges if bill is not paid within 30 days. Means
24% penal interest per year! Example: If customer does NOT pay Rs.100000 bill within 1 month, then he will have to pay Rs.2000 extra for every month that he is late!
Working Capital Financing Policies:
It involves the discussion regarding how firms should finance this working capital.
•
Sales fluctuate with Nature of Business, Time, Season, State of Economy:
– Economic Growth or Boom: High inventories and Current Assets
– Economic Recession: Low inventories and Current Assets
• Never drop to zero because always need minimal “Permanent
Current Assets.”
• Total Assets = Fixed + Permanent Current + Temporary Current.
–
Total assets steadily grow with life of healthy company.
– Temporary Current Assets fluctuate with time. Extra Spontaneous Inventory can be financed by short-term debt financing or loan
• 3 Policies for Working Capital Financing (based on Maturity Matching
Principle)
– Aggressive
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MGT201 (Financial Management)
• Maximum Short-term financing at low cost (but risk of non-renewal of loan)
• Use short-term financing for Temporary Current Assets and even partly to buy Permanent Current Inventory
– Conservative
•
Maximum Long-term financing. Safe but higher interest costs.
• Use long-term financing for Fixed Assets, entire Permanent Assets, and even part of Temporary Current Assets
– Moderate
•
Balance of Long and Short-term Financing.
• Long Term Financing for Fixed and Permanent Current Assets. Use
Short Term Financing for Permanent Current Assets. Use
Spontaneous Current Liability Financing for Temporary Current
Assets
• Advantages of Short Term Debt or Loan
– Speed of getting finance as they are short run
– Flexibility (not locked in)
– Lower Interest Rates (generally Upward Sloping or Normal Yield Curve)
• Disadvantage of Short Term Debt is that cost of debt is uncertain and variable in long run. Non-renewable.
Graphical View of Financing Maturity Matching Principle Match the Maturity of
Financing to Usage of Asset:
Value (Rupees)
TEMPORARY CURRENT ASSETS –
Usage Less than 1 Year
Spontaneous
Current
Liabilities &
Short Term
Financing
“PERMANENT” CURRENT ASSETS
– Usage More than 1 Year
Short Term
Financing
& Long
Term
Financing
FIXED ASSETS –
Usage More than 1 Year
Long Term
Debt &
Equity
Time (Months)
Firms generally pursue moderate policy of financing. Basic logic behind this is MATURITY
MATCHING PRINCIPLE.
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