1. Chapter 30 Principles PrinciplesofCorporateFinance Ninth Edition Working Capital Management Slides by Matthew Will Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved McGraw Hill/Irwin

2. 30- 2 Topics Covered  Inventories  Credit Management  Cash  Marketable Securities

3. 30- 3 Working Capital Current assets and liabilities for U.S. manufacturing firms (2 nd qtr. 2006)…$ billions

4. 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

5. 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.

6. 30- 6 Managing Inventories 0 3 69 12 Inventory Average Inventory Weeks Inventory, thousands of units 60 30

7. 30- 7 Inventories Determination of optimal order size Inventory costs, dollars Order size Total costs Carrying costs Total order costs Optimal order size

8. 30- 8 Inventories Economic Order Quantity - Order size that minimizes total inventory costs.

9. 30- 9 Inventories  Just-in-time inventory management  Managing inventories of cash Cash Balance Time Upper limit Return point Lower limit

10. 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.

11. 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.

12. 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

13. 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

14. 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?

15. 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

16. 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

17. 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.

18. 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.

19. 30- 19 The Credit Decision The credit decision and its probable payoffs Refuse credit Offer credit Payoff = Rev - Cost Payoff = - Cost Customer pays = p Customer defaults = 1-p Payoff = 0

20. 30- 20 The Credit Decision  Based on the probability of payoffs, the expected profit can be expressed as: The break even probability of collection is:

21. 30- 21 Collection Policy Collection Policy - Procedures to collect and monitor receivables. Aging Schedule - Classification of accounts receivable by time outstanding.

22. 30- 22 Factoring Total factoring volume measured in millions of Euros Factoring volume (millions)

23. 30- 23 Collection Policy Sample aging schedule for accounts receivable

24. 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

25. 30- 25 Cash How purchases are paid. Percentage of total by payment type for 2004.

26. 30- 26 Cash  Electronic Funds Transfer (EFT)  Automated Clearinghouse (ACH)  2005 ACH transaction volume = $31.1 trillion  International cash management  Compensating balances

27. 30- 27 Payment Methods % of firms using

28. 30- 28 Marketable Securities Microsoft 2006 cash investments

29. 30- 29 Money Market Investments

30. 30- 30 Money Market Investments

31. 30- 31 Short Term Assets $ billion Short term assets held by US non-financial corporations (2 nd quarter 2006)

32. 30- 32 Web Resources www.decisioneering.com www.jaxworks.com www.toolkit.cch.com www.bis.org www.federalreserve.gov www.ecb.int Click to access web sites Internet connection required