Chapter 02
Working Capital and Current Assets
Management
Working capital management involves the financing and
management of the current assets of the firm. Current assets are
by their nature changing daily, if not hourly. How much inventory
to be carried and how do we get the funds to pay it. Unlike the
long term decisions there can be no deferral of action.
Cash Receipt budget:
Assume the case of the Goldman corporation, The corporation’s RO
100,000 sales is break down into following months.
Monthly Sales Pattern
Jan
Feb
March
15,000
10,000
15,000
April
May
June
25,000 15,000 20,000
Monthly cash receipt:
Dec Jan
Feb
March
April May June
Sales…………. 12,000 15,000 10,000 15,000 25,000 15,000 20,000
Collection
(20 % of current sales)
3000 2000 3000 5000 3000
4000
Collections:
(80% of previous
month’s sales) …..
9600 12,000 8000 12,000 20,000 12,000
12,600 14,000 11,000 17,000 23,000 16,000
Cash Management I
Minimizing cash balance as well as accurate knowledge of when
cash moves into and out of the company can improve overall
profitability.
Reasons for holding the cash balances:
There are several reasons for holding the cash for:
(a)
Transaction balance
(b)
Compensating balance
(c)
Precautionary balance
Collections and Disbursements I
Float:
There are two cash balances of importance: the corporation’s
recorded amount and the amount credited to the corporation by
the bank. The difference between the two is called Float. And it
arises from time delays in mailing, processing and clearing
checks through the banking system.
Inventory Management I
Inventory is usually divided into three categories.
(a)
Raw material
(b)
Work in process
(c)
Finished Goods
The amount of the inventory is not always totally controlled by
company management because it is affected by sales,
production and economic conditions.
The inventory Decision Model I
Substantial research has been devoted to the problem of
determining optimum inventory size, order quantity, usage rate
and similar considerations.
In developing the inventory model, we must evaluate two basic
costs associated with inventory: the carrying cost and ordering
costs. Through the careful analysis of both of these variables, we
can determine the optimum order size to pace to minimize costs.
Economic Ordering Quantity:
EOQ = √2SO / C , Where
S = Total sales in units
O = Ordering cost for each order
C = carrying cost per unit in dollars.
Let assume that we anticipate selling 2,000 units, that it will cost us
$8 to place each order, and that the price per unit is $1, with a 20
percent carrying cost to maintain the average inventory (the
carrying charge per unit is $0.20)
EOQ = √2SO / C = √ 2 × 2000 × $8 / 0.20 = √160,000
= 400 units.
1.
Total cost for inventory
Ordering costs = 2000 = 5
400
5 orders at $8 per order = $40
2. Carrying costs = Average inventory in units × carrying cost per
unit.
200 × $0.20 = $40
3. Order Carrying cost cost …………… …. $40
……………..+40
Total cost ……………
$80
I
Carrying costs: Carrying costs include interest on funds tied up in
inventory, and the costs of the warehouse space, insurance
premium and material handling expenses.
The larger the order we place, the greater the average inventory
we will have on hand , and the higher the carrying cost.
Ordering Costs: As a seasonal factor, we must consider the cost of
ordering and the processing inventory into stocks. If we maintain
relatively low average inventory in stocks, we must order many
times and total ordering cost will be high.
As the order size is increases, carrying cost go up because we
have more inventory on hand. With larger orders of course we
will order less frequently and overall ordering costs will go down
Q.1 Midwest tires has expected sales of 12,000 tires this year, an
ordering cost of $6 per order, and carrying costs of $1.60 per tire.
Required: (a) What is economic ordering quantity.
(b) How many orders will be placed during the year.
(c) What will the average inventory be?
Management of Accounts Receivable:
Credit Policy Administration;
a)
b)
c)
Credit standards
Terms of credit
Collection policy
Credit standards: The firm must determine the nature of the credit
risk on the basis of prior record of payment, financial stability,
current net worth and others factors.
Terms of Trade: If the firm averages $5000 in daily credit sales and
allows 30-day terms, the average account receivable balance will
be $150,000. if the customers are carried for 60 days, we must
maintain $300,000 in receivables and much additional financing
will be required.
Collection policy: A number of quantitative measures may be
applied to the credit department
(a)
Average collection period = Accounts receivables
Average daily credit sales
= Accounts receivables
Credit sales / 365
(b) Ratio of bad debt to credit sales = Bad Debt
Credit Sales
Q.1: Zahra tours and travels has annual credeit sales of RO
1,080,000 and an average collection period of 40 days in 1991.
Assume a 360 day a year.
Required: what is company’s average accounts receivables
balance?
Q.2: The lulu hypermarket financial statement shows the Bad debt
to RO 305,000 and the credit sales is RO 9,874,500.
Required: what is bad debt ratio
Cost of debt

The cost of the debt measure by the interest rate or yield paid to
bondholders
For example: assume the firm is preparing to issue the new debt.
Assume the debt issue the pays RO100 per year in interest has
the 20 year life and currently selling for RO 940 , in order to find
the yield to maturity on the debt we use the following formula
Yield
to =
Maturity
Annual
Interest + Principal Payment – Price of the bond
payment
Number of years of maturity
______________________________________________
0.6 (Price of the Bond) + 0.4 (Principal Payment)
1000 - 940
RO 100 +
20
Y’ = ___________________
0.6(940) + 0.4(1000)
Y’ = 103 = 10.68%
964
Kd = (cost of capital) = Y(Yield)(1 - T)
= 10.68%(1 - 0.34)
= 7.05%
Cost of preferred stock: the cost of the preferred is similar to the
costs of the debt in that annual payment is made, but dissimilar
in that there is no maturity date in which principal is made
KP(cost of preferred stock) = Dp
Pp – F
Where,
Kp = cost of the preferred cost
Dp = the annual dividends on preferred
Pp = the price of preferred cost
F = Floatation or selling costs.
Cost of common equity:
In determining the cost of common stock, the firm must be sensitive
to the pricing and performance of current and future
stockholders. The model we use for valuation of the cost of the
common equity is
Po = D1
Ke - g
Where,
Po = Price of the Stock Today
D1 = dividends at the end of the first year
Ke = required rate of return
g = Constant growth rate in dividends
Ke = D1 = g
Po
Alternate calculation of the required rate of the return:
Under the capital asset pricing model (CAPM), the required return
for common stock (other investments) can be described by the
following formula:
Kj = Rf + β(Km - Rf)
Where,
Kj = Required return on common stock
Rf = Risk free rate of return
Β = Beta coefficient
Km = Return in the market as measured by an appropriate
index
Cost of New Common Stock
If we issuing new common stock, we must earn a slightly higher
return than Ke, which represent the required rate of return of
present stock holders. The higher return is needed to cover the
distribution cost of the new securities.
Kn = D1
+g
Po – F
Where,

The omantel has a RO1000 par value bond
outstanding with a 25 years to maturity. The
bond carries an annual interest payment of
RO 88 and currently selling for RO 925.
omantel is in 25% bracket.