Working Capital
Policy
1
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.
2
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)
3
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.
4
Example: Risk-Return Trade-off
Compare the 2 following companies
Marketable Securities
Other Current Assets
Fixed Assets
Total Assets
Firm 1
0
200
800
1000
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Firm 1
150
0
150
-60
90
Current Ratio
2
Firm 1
ST Debt
100
LT Debt
400
Common Stock
500
Total Liabilities&Equity 1000
Current Ratio = Current Assets
Current Liabilities
= 200
100
= 2
5
Example: Risk-Return Trade-off
Compare the 2 following companies
Marketable Securities
Other Current Assets
Fixed Assets
Total Assets
Firm 1
0
200
800
1000
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Firm 1
150
0
150
-60
90
Firm 1
ST Debt
100
LT Debt
400
Common Stock
500
Total Liabilities&Equity 1000
Return on Assets =
=
Net Income
Assets
90
1000
= .09 = 9%
Current Ratio
ROA
2
9%
6
Example: Risk-Return Trade-off
Compare the 2 following companies
Marketable Securities
Other Current Assets
Fixed Assets
Total Assets
Firm 1
0
200
800
1000
Firm 2
200
200
800
1200
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Firm 1
150
0
150
-60
90
Firm 2
150
8
158
-63
95
Current Ratio
ROA
2
9%
Firm 1
ST Debt
100
LT Debt
400
Common Stock
500
Total Liabilities&Equity 1000
Firm 2
100
400
700
1200
Firm 2:
$200 Marketable Securities
Financed with Common Stock
200 x 4% = $8 interest earned
7
Example: Risk-Return Trade-off
Compare the 2 following companies
Marketable Securities
Other Current Assets
Fixed Assets
Total Assets
Firm 1
0
200
800
1000
Firm 2
200
200
800
1200
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Firm 1
150
0
150
-60
90
Firm 2
150
8
158
-63
95
Current Ratio
ROA
2
9%
4
Firm 1
ST Debt
100
LT Debt
400
Common Stock
500
Total Liabilities&Equity 1000
Firm 2
100
400
700
1200
Current Ratio = CA
CL
=
400
100
=4
8
Example: Risk-Return Trade-off
Compare the 2 following companies
Marketable Securities
Other Current Assets
Fixed Assets
Total Assets
Firm 1
0
200
800
1000
Firm 2
200
200
800
1200
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Firm 1
150
0
150
-60
90
Firm 2
150
8
158
-63
95
2
9%
4
7.9%
Current Ratio
ROA
Firm 1
ST Debt
100
LT Debt
400
Common Stock
500
Total Liabilities&Equity 1000
Return on Assets =
=
Firm 2
100
400
700
1200
NI
Assets
95
1200
=.079 = 7.9%
9
Example: Risk-Return Trade-off
Compare the 2 following companies
Marketable Securities
Other Current Assets
Fixed Assets
Total Assets
Firm 1
0
200
800
1000
Firm 2
200
200
800
1200
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Firm 1
150
0
150
-60
90
Firm 2
150
8
158
-63
95
2
9%
4
7.9%
Current Ratio
ROA
Firm 1
ST Debt
100
LT Debt
400
Common Stock
500
Total Liabilities&Equity 1000
Firm 2
100
400
700
1200
Firm 1
Firm 2
Higher ROA
Less Liquid
Riskier
Lower ROA
More Liquid
Less Risky
10
Variation in assets over time
Total Assets
$5M
}
Fixed
Assets
Time
Assume ZERO Long-term Growth
11
Variation in assets over time
Total Assets
$7M
$5M
}
Permanent
Current Assets
}
Fixed
Assets
Time
12
Variation in assets over time
Total Assets
$10M
Temporary Current Assets
$7M
$5M
}
Permanent
Current Assets
}
Fixed
Assets
Time
13
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
14
Financing Current Assets:
Conservative Approach
Total Assets
Short-term
Sources
$10M
$7M
$5M
Long-term
Sources
Temporary Current Assets
}
Permanent
Current Assets
}
Fixed
Assets
Time
15
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
16
Financing Current Assets:
Moderate Approach
Total Assets
$10M
Temporary Current Assets
$5M
Long-term
Sources
$7M
}
Permanent
Current Assets
}
Fixed
Assets
Time
17
Financing Current Assets:
Moderate Approach
Total Assets
Short-term
Sources
$10M
Temporary Current Assets
$5M
Long-term
Sources
$7M
}
Permanent
Current Assets
}
Fixed
Assets
Time
18
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
19
Financing Current Assets:
Aggressive Approach
Total Assets
$10M
Short-term
Sources
Temporary Current Assets
$7M
}
$5M
Long-term Sources
Permanent
Current Assets
}
Fixed
Assets
Time
20
Managing (WARM, SOFT) Cash
21
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)
23
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
24
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
25
Choosing the Optimum Cash
Balance
Cash Balances in a Typical Month
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Days of the Month
26
Choosing the Optimum Cash
Balance
Cash Balances in a Typical Month
Invest Excess
Cash
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Days of the Month
27
Choosing the Optimum Cash
Balance
Cash Balances in a Typical Month
Sell Securities to
obtain cash
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Days of the Month
28
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
29
The Miller-Orr Model
- Target Cash Balance (Z)
3
Z=
3 x TC x V
+L
4xr
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
30
The Miller-Orr Model
- Target Cash Balance (Z)
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).
31
The Miller-Orr Model
- Target Cash Balance (Z)

Example
3
Z=
3 x 50 x 100,000 + $1,000
4 x .05/365
= $3,014 + $1,000 = $4,014
32
The Miller-Orr Mode
- Upper Limit


The upper limit for the cash account (H) is
determined by the equation:
H = 3Z - 2L
where:
Z = Target cash balance
L = Lower limit
In the previous example:
H = 3 ($4,014) - 2($1,000) = $10,042
33
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.
34
Cash Budget - Problem
Rocky Mountain Climbing, Inc. (RMC) has the
following information:
Previous Sales
November 2007
December 2007
130,000
125,000
January 2008
February 2008
March 2008
April 2008
120,000
260,000
140,000
140,000
Forecast Sales
35
Cash Budget - Problem
Rocky Mountain Climbing, Inc. (RMC) has the
following information:
Previous Sales:
November 2007
130,000
December 2007
125,000
Forecast sales for: January 2008
120,000
February 2008
260,000
March 2008
140,000
April 2008
140,000
Collections : 30% of customers pay cash
50% pay in month after sale
20% pay 2 months after sale
36
Cash Budget - Problem
Other information for RMC Cash Budget:
Purchases of inventory are 75% of sales
and are made 2 months before sale
and are paid for 1 month after delivery
Other expenses
Taxes
$14,000 per month
$10,000 due in March
Cash Balance (Dec. 31, 2007) = $28,000
Minimum balance required by bank = $25,000
(ST borrowing rate = 6% annually)
37
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.
38
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)
– 50% x $125,000 (December sales)
– 20% x $130,000 (November sales)

Total cash collected in January
= 36,000
= 62,500
= 26,000
=$124,500
39
Cash Budget - Collections
Sales made in January will not be fully
collected until March.
Collection of January Sales
Nov
Sales 130,000
Dec
Jan
Feb
Mar
125,000
120,000
260,000
140,000
36,000
120,000 x .30
40
Cash Budget - Collections
Sales made in January will not be fully
collected until March.
Collection of January Sales
Nov
Sales 130,000
Dec
Jan
Feb
Mar
125,000
120,000
260,000
60,000
140,000
36,000
120,000 x .30
120,000 x .50
41
Cash Budget - Collections
Sales made in January will not be fully
collected until March.
Collection of January Sales
Nov
Sales 130,000
Dec
Jan
Feb
Mar
125,000
120,000
260,000
60,000
140,000
24,000
36,000
120,000 x .30
120,000 x .50
120,000 x .20
42
Cash Budget - Collections
Calculate collections for other months.
Nov
Sales
130,000
Collections:
Month of Sale (30%)
First Month (50%)
2nd Month (20%)
Total Collections
Cash Budget
RMC, Inc.
Dec
Jan
125,000
120,000
Feb
260,000
Mar
140,000
36,000
62,500
26,000
124,500
78,000
60,000
25,000
163,000
42,000
130,000
24,000
196,000
43
Cash Budget Purchases/Payments
Purchases are made 2 months prior to
sale and are paid for 1 month later.
Payments for January Purchases
Nov
Sales 130,000
90,000
Dec
Jan
Feb
Mar
125,000
120,000
260,000
140,000
75% of January Sales Purchased in
November
44
Cash Budget Purchases/Payments
Purchases are made 2 months prior to
sale and are paid for 1 month later.
Payments for January Purchases
Nov
Sales 130,000
90,000
Dec
Jan
Feb
Mar
125,000
120,000
260,000
140,000
90,000
75% of January Sales Purchased in
November, Paid for in December
45
Cash Budget Purchases/Payments
Calculate payments for all months.
Note that in order to do a cash budget,
you will need forecasts of sales for April.
Nov
Sales
130,000
Purchases
Payments
Cash Budget
RMC, Inc.
Dec
Jan
Feb
125,000
120,000
260,000
195,000
105,000
105,000
195,000
105,000
Mar
140,000
Apr
140,000
105,000
46
Cash Collections
Material Payments
Cash Budget
RMC, Inc.
Jan
124,500
195,000
Feb
163,000
105,000
Mar
196,000
105,000
Summary of Previous Calculations
47
Cash Collections
Material Payments
Other Payments:
Other Expenses
Tax Payments
Cash Budget
RMC, Inc.
Jan
124,500
195,000
Feb
163,000
105,000
Mar
196,000
105,000
14,000
0
14,000
0
14,000
10,000
Remaining Cash Outflows
48
Cash Collections
Material Payments
Other Payments:
Rent
Other Expenses
Tax Payments
Net Monthly Change
Cash Budget
RMC, Inc.
Jan
124,500
195,000
Feb
163,000
105,000
Mar
196,000
105,000
2,000
12,000
0
(84,500)
2,000
12,000
0
44,000
2,000
12,000
10,000
67,000
49
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
Needed (Borrowing)
Loan Repayment
Interest Cost
Ending Cash Balance
Cumulative Borrowing
Feb
44,000
Mar
67,000
50
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
Loan Repayment
Interest Cost
Ending Cash Balance
Cumulative Borrowing
Feb
44,000
Mar
67,000
51
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Feb
Mar
Net Monthly Change
(84,500)
44,000
67,000
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
Target Ending Balance
Loan Repayment
Interest Cost
Ending Cash Balance
25,000
Cumulative Borrowing
52
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Feb
Mar
Net Monthly Change
(84,500)
44,000
67,000
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000 Borrowing Required to
Cumulative Borrowing
cover Minimum Balance
and Deficit
56,500+25,000
53
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
Feb
44,000
Mar
67,000
54
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
Feb
44,000
25,000
69,000
Mar
67,000
55
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
Feb
44,000
25,000
69,000
0
Mar
67,000
408
25,000
Interest Incurred on Prior
Month Borrowing
81,500 x .005
56
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
Mar
67,000
Amount that can be repaid from
monthly surplus
69,000 - 408 - 25,000=$43,592
57
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
37,908
Mar
67,000
New Loan Balance
81,500 - 43,592=$37,908
58
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
37,908
Mar
67,000
25,000
92,000
59
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
37,908
Mar
67,000
25,000
92,000
0
190
Interest Incurred on Prior
Month Borrowing
37,908 x .005
60
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
37,908
Mar
67,000
25,000
92,000
0
37,908
190
Repay Outstanding Loan
Balance
61
Analysis of Borrowing Needs
Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
Beginning Cash Balance
28,000
Ending Cash (No Borrow)
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Cumulative Borrowing
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
37,908
Mar
67,000
25,000
92,000
0
37,908
190
53,902
0
Ending Cash Balance
$53,902-$25,000=$28,902 Surplus
62
Analysis of Borrowing Needs
Ending Cash Balance
Cumulative Borrowing
Cash Budget
RMC, Inc.
Jan
25,000
81,500
Feb
25,000
37,908
Mar
53,902
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.
63
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).
64
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
65
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
66
Accounts Receivable
and Inventory
67
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.
68
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.
69
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
70
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.
71
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
72
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
73
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).
74
Analysis of Accts.
Receivable Changes



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
75
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
t=1,2...
– Increase in COGS
– Increase in Bad Debts
– increase in Other Expenses
– Increase in Interest Expense
– Increase in Taxes
– Total Incr. Operating Cash Flow
= $30,000
= $15,000
= $3,000
= $5,000
=
$500
= $2,600
=
$3,900/yr.
76
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
=
$4,500
Since NPV > 0, ABC should undertake the credit
policy change, assuming that the assumptions are
valid and that the projected cash flows are
accurate.
77
How Firms Make Credit
Decisions






The Five Cs of Credit:
Character is the borrower’s willingness to pay based
on past payment patterns.
Capacity is the borrower’s ability to pay based on
forecasts of future cash flows.
Capital is how much wealth the borrower has to fall
back on.
Collateral is what the lender gets if the borrower
fails to pay.
Conditions faced by the borrower in the business
marketplace are also considered.
Link to Credit Scoring
78
Methods of Collection
Most firms use some of the following:







Send reminder letters.
Make telephone calls.
Hire collection agencies.
Sue the customer.
Settle for a reduced amount.
Write off the bill as a loss.
Sell accounts receivable to factors.
79
Inventory Management



Typically, inventory accounts for about four
to five percent of a firm's assets.
In order to effectively manage the
investment in inventory, two problems must
be dealt with: how much to order and how
often to order.
The economic order quantity (EOQ) model
attempts to determine the order size that
will minimize total inventory costs.
80
Inventory Management

Determining Optimal Inventory
– Economic Order Quantity (EOQ)
Total
Total
Inventory = Carrying +
Costs
Costs
Total
Ordering
Costs
Link to Bloomberg.com
81
The EOQ Model assumes the firm
orders a fixed amount Q at equal
intervals.
Inventory
Level
(units)
Order
Quantity
Q
Time
82
The EOQ Model
Inventory
Level
(units)
Average Inventory =
Order Quantity Q
2
2
Order
Quantity
Q
Time
83
Total
Total
Inventory = Carrying +
Costs
Costs
Total
Inventory =
Costs
(
Total
Ordering
Costs
OQ
S
)
CC + (
)
OC
2
OQ
Where:
OQ = Order Size (order quantity)
S
= Annual Sales Volume
CC
= Carrying Cost per Unit
OC
= Ordering Cost per Order
84
Ordering Costs = ( S )OC
OQ
Cost
($)
Ordering Costs
Order Size (units)
85
Ordering Costs = ( S )OC
OQ
Cost
($)
Carrying Costs = ( OQ ) CC
2
Carrying Costs
Order Size (units)
86
Ordering Costs = ( S )OC
OQ
Carrying Costs = ( OQ ) CC
2
Total Costs = Carrying Costs + Order Costs
Cost
($)
Order Size (units)
87
Inventory Management
Determining Optimal Inventory
– The economic order quantity that
minimizes the total costs of inventory.
EOQ =
2 x S x OC
CC
88
Inventory Management
Determining Optimal Inventory
– 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?
2(1200)26
=
75
2 x S x OC
EOQ =
CC
= 28.84  29 cars
89
Inventory Management

Determining Optimal Inventory
– 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?
EOQ autos in each order
Place 1,200/ 29 = 41.4 orders each year
90
Inventory Management with Safety
Stock- Order before inventory is at
zero.
Inventory
Level
(units)
Inventory Order Point
EOQ
Depleted Stock
During Delivery
Safety
Stock
Actual Delivery Time
Time
91
Inventory
Level
(units)
Order
Quantity
Q
Time
92
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.
93
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.
94
Short Term
Financing
95
Learning Objectives





The need for short-term financing.
The advantages and disadvantages of shortterm 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.
96
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
97
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.
98
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).
99
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).
100
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.
101
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 you pay
=
Interest Rate 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%
102
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%.
103
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%.
104
Cost of Short-Term Credit
For 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:
Effective
Annual =
Rate
(1 +
$ Interest
$ you get
to use
(Periods/yr)
-1
)
105
Cost of Short-Term Credit
For 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
106
Cost of Short-Term Credit
For 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:
Effective annual rate
90
K= 1+
10,000 - 90
(
12
) -1 = .1146
k = 11.46%
107
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.
108
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).
109
Cost of Trade Credit 2/10 net 60


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 Credit
(
1+
Discount %
100-Discount%
365
days to pay - disc. pd.
(
(

)
-1
110
Computing the Cost of Trade
Credit
Another 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%
111
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
112
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)
= 4.16%
(365/90)
-1
113
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.
114
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.
115
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)
116