1 Working Capital Policy

2 Learning Objectives Understand the importance of working capital. Understand the importance of working capital. The liquidity-profitability trade-off. The liquidity-profitability trade-off. Determining the optimal level of current assets. Determining the optimal level of current assets. The risk and return implications of alternative approaches to working capital financing policy. The risk and return implications of alternative approaches to working capital financing policy.

3 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. 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: 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)

4 Managing Current Assets & Liabilities Net Working Capital Net Working Capital = Current Assets - Current Liabilities Determining the “Correct” level of Working Capital Determining the “Correct” level of Working Capital –Balance Risk & Return –Benefits of Working Capital Higher Liquidity (Lowers Risk) Higher Liquidity (Lowers Risk) –Costs of Working Capital Lower Returns - $$ invested in lower returning securities rather than production. Lower Returns - $$ invested in lower returning securities rather than production.

5 Firm 1 Firm 1 ST Debt100 LT Debt400 Common Stock500 Total Liabilities&Equity1000 Firm 1 Marketable Securities 0 Other Current Assets200 Fixed Assets800 Total Assets1000 Firm 1 Operating Earnings150 Interest Earned0 EBT 150 Taxes (40%)-60 Net Income90 Example: Risk-Return Trade-off Compare the 2 following companies Current Assets Current Liabilities Current Ratio = = = 2 Current Ratio 2

6 Firm 1 Firm 1 ST Debt100 LT Debt400 Common Stock500 Total Liabilities&Equity1000 Firm 1 Marketable Securities0 Other Current Assets200 Fixed Assets800 Total Assets1000 Firm 1 Operating Earnings150 Interest Earned0 EBT 150 Taxes (40%)-60 Net Income90 Current Ratio2 Return on Assets = Net Income Assets = Example: Risk-Return Trade-off Compare the 2 following companies =.09 = 9% ROA 9%

7 Firm 2: $200 Marketable Securities Financed with Common Stock 200 x 4% = $8 interest earned Firm 1 Firm 2 Marketable Securities0200 Other Current Assets Fixed Assets Total Assets Firm 1 Firm 2 ST Debt LT Debt Common Stock Total Liabilities&Equity Firm 1 Firm 2 Operating Earnings Interest Earned08 EBT Taxes (40%) Net Income9095 Current Ratio2 ROA9% Example: Risk-Return Trade-off Compare the 2 following companies

8 Firm 1 Firm 2 Marketable Securities0200 Other Current Assets Fixed Assets Total Assets Firm 1 Firm 2 ST Debt LT Debt Common Stock Total Liabilities&Equity Firm 1 Firm 2 Operating Earnings Interest Earned08 EBT Taxes (40%) Net Income9095 Current Ratio 2 ROA9% = Current Ratio = CA CL Example: Risk-Return Trade-off Compare the 2 following companies = 4 4

9 Firm 1 Firm 2 Marketable Securities0200 Other Current Assets Fixed Assets Total Assets Firm 1 Firm 2 ST Debt LT Debt Common Stock Total Liabilities&Equity Firm 1 Firm 2 Operating Earnings Interest Earned08 EBT Taxes (40%) Net Income9095 Current Ratio 2 4 ROA9% = Example: Risk-Return Trade-off Compare the 2 following companies =.079 = 7.9% 7.9% Return on Assets = NI Assets

10 Firm 1 Higher ROA Less Liquid Riskier Firm 2 Lower ROA More Liquid Less Risky Example: Risk-Return Trade-off Compare the 2 following companies Firm 1 Firm 2 Marketable Securities0200 Other Current Assets Fixed Assets Total Assets Firm 1 Firm 2 ST Debt LT Debt Common Stock Total Liabilities&Equity Firm 1 Firm 2 Operating Earnings Interest Earned08 EBT Taxes (40%) Net Income9095 Current Ratio 2 4 ROA 9% 7.9%

11 Time Total Assets Assume ZERO Long-term Growth $5M Variation in assets over time FixedAssets }

12 Time Total Assets FixedAssets Permanent Current Assets } } $5M $7M Variation in assets over time

13 Temporary Current Assets Variation in assets over time Time Total Assets FixedAssets Permanent Current Assets } } $5M $7M $10M

14 Different Approaches to Financing Conservative Approach 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

15 Financing Current Assets: Conservative Approach Temporary Current Assets Time Total Assets FixedAssets Permanent Current Assets } } $5M $7M $10M Temporary Current Assets Time Total Assets FixedAssets Permanent Current Assets } } $5M $7M $10M Short-termSources Long-termSources

16 Different Approaches to Financing Conservative Approach 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) 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

17 Financing Current Assets: Moderate Approach Temporary Current Assets Time Total Assets FixedAssets Permanent Current Assets } } $5M $7M $10M Temporary Current Assets Time Total Assets FixedAssets Permanent Current Assets } } $5M $7M $10M Long-termSources

18 Financing Current Assets: Moderate Approach Short-termSources Temporary Current Assets Time Total Assets FixedAssets Permanent Current Assets } } $5M $7M $10M Temporary Current Assets Time Total Assets FixedAssets Permanent Current Assets } } $5M $7M $10M Long-termSources

19 Different Approaches to Financing Conservative Approach 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) 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 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

20 Long-term Sources Financing Current Assets: Aggressive Approach Temporary Current Assets Time Total Assets FixedAssets Permanent Current Assets } } $5M $7M $10M Temporary Current Assets Time Total Assets FixedAssets Permanent Current Assets } } $5M $7M $10M Short-termSources

21 Managing (WARM, SOFT) Cash

22 Learning Objectives Factors that affect a firm’s minimum cash balance. Factors that affect a firm’s minimum cash balance. Factors that affect a firm’s maximum cash balance. Factors that affect a firm’s maximum cash balance. How to establish an optimum cash balance using the Miller-Orr model. How to establish an optimum cash balance using the Miller-Orr model. Preparation of a cash budget. Preparation of a cash budget. Managing cash inflows and outflows to maximize value. Managing cash inflows and outflows to maximize value.

23 How much cash should a firm keep on hand? Managers must keep enough cash to make payments when needed. (Minimum balance) 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) 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)

24 The size of the minimum cash balance depends on: How quickly and cheaply a firm can raise cash when needed. How quickly and cheaply a firm can raise cash when needed. How accurately managers can predict cash requirements. How accurately managers can predict cash requirements. How much precautionary cash the managers need for emergencies. How much precautionary cash the managers need for emergencies. Link to Dun & Bradstreet

25 The firm’s maximum cash balance depends on: Available (short-term) investment opportunities Available (short-term) investment opportunities –e.g. money market funds, CDs, commercial paper Expected return on investment opportunities (opportunity cost) 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 Transaction cost of withdrawing cash and making an investment Link to Bureau of Economic Analysis

26 Choosing the Optimum Cash Balance Days of the Month | | | | | | | | | | | | | | Dollars in the Cash Account Cash Balances in a Typical Month

27 Days of the Month | | | | | | | | | | | | | | Dollars in the Cash Account Cash Balances in a Typical Month Choosing the Optimum Cash Balance Invest Excess Cash

28 Days of the Month | | | | | | | | | | | | | | Dollars in the Cash Account Cash Balances in a Typical Month Choosing the Optimum Cash Balance Sell Securities to obtain cash

29 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). 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: Depends on: –transaction costs of buying or selling securities –variability of daily cash –return on short-term investments

30 The Miller-Orr Model - Target Cash Balance (Z) 3 x TC x V 4 x r Z = + L 3 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

31 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). The Miller-Orr Model - Target Cash Balance (Z)

32 The Miller-Orr Model - Target Cash Balance (Z) Example Example 3 x 50 x 100,000 4 x.05/365 Z = + $1,000 = $3,014 + $1,000 = $4,014 3

33 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 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 In the previous example: H = 3 ($4,014) - 2($1,000) = $10,042

34 Forecasting Cash Needs - Cash Budget Used to determine monthly needs and surpluses for cash during the planning period 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. 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. Payments to suppliers are typically made some time after shipment is received. Receipts from credit customers are received some time after sale is recorded. Receipts from credit customers are received some time after sale is recorded.

35 Cash Budget - Problem Rocky Mountain Climbing, Inc. (RMC) has the following information: Previous Sales November ,000 December ,000 Forecast Sales January ,000 February ,000 March ,000 April ,000

36 Cash Budget - Problem Rocky Mountain Climbing, Inc. (RMC) has the following information: Previous Sales: November ,000 December ,000 December ,000 Forecast sales for: January ,000 February ,000 March ,000 April ,000 Collections : 30% of customers pay cash 50% pay in month after sale 20% pay 2 months after sale

37 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 $14,000 per month Taxes$10,000 due in March Cash Balance (Dec. 31, 2007) = $28,000 Minimum balance required by bank = $25,000 (ST borrowing rate = 6% annually)

38 Steps in the Cash Budget Forecast of monthly collections and other cash inflows Forecast of monthly collections and other cash inflows Forecast of purchases and other cash outflows Forecast of purchases and other cash outflows Summarize the effect on net monthly cash flows and determine borrowing needs or surpluses. Summarize the effect on net monthly cash flows and determine borrowing needs or surpluses.

39 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 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 In January, sales are 120,000 Collections: Collections: –30% x $120,000 (January sales) = 36,000 –50% x $125,000 (December sales)= 62,500 –20% x $130,000 (November sales)= 26,000 Total cash collected in January =$124,500 Total cash collected in January =$124,500

40 Collection of January Sales Nov Dec Jan Feb Mar Sales 130, , , , ,000 36,000 Cash Budget - Collections Sales made in January will not be fully collected until March. 120,000 x.30

41 Sales made in January will not be fully collected until March. Cash Budget - Collections Collection of January Sales Nov Dec Jan Feb Mar Sales 130, , , , ,000 36, ,000 x.30 60, ,000 x.50

42 Sales made in January will not be fully collected until March. Cash Budget - Collections Collection of January Sales Nov Dec Jan Feb Mar Sales 130, , , , ,000 36, ,000 x.30 60, ,000 x.50 24, ,000 x.20

43 Calculate collections for other months. Cash Budget - Collections Cash Budget RMC, Inc. Sales130,000125,000120,000260,000140,000 Collections: Month of Sale (30%)36,00078,00042,000 First Month (50%)62,50060,000130,000 2nd Month (20%)26,00025,00024,000 Total Collections124,500163,000196,000 Nov Dec Jan Feb Mar

44 Payments for January Purchases Nov Dec Jan Feb Mar Sales 130, , , , ,000 75% of January Sales Purchased in November Purchases are made 2 months prior to sale and are paid for 1 month later. Cash Budget - Purchases/Payments 90,000

45 Cash Budget - Purchases/Payments Payments for January Purchases Nov Dec Jan Feb Mar Sales 130, , , , ,000 90,000 90,000 75% of January Sales Purchased in November, Paid for in December Purchases are made 2 months prior to sale and are paid for 1 month later.

46 Calculate payments for all months. Note that in order to do a cash budget, you will need forecasts of sales for April. Cash Budget - Purchases/Payments Cash Budget RMC, Inc. Sales130,000125,000120,000260,000140,000140,000 Purchases195,000105,000105,000 Payments195,000105,000105,000 Nov Dec Jan Feb Mar Apr

47 Jan Feb Mar Cash Budget RMC, Inc. Cash Collections 124,500163,000196,000 Material Payments195,000105,000105,000 Summary of Previous Calculations

48 Jan Feb Mar Cash Budget RMC, Inc. Cash Collections 124,500163,000196,000 Material Payments195,000105,000105,000 Other Payments: Other Expenses14,00014,00014,000 Tax Payments0010,000 Remaining Cash Outflows

49 Jan Feb Mar Cash Budget RMC, Inc. Cash Collections 124,500163,000196,000 Material Payments195,000105,000105,000 Other Payments: Rent2,0002,0002,000 Other Expenses12,00012,00012,000 Tax Payments0010,000 Net Monthly Change(84,500)44,00067,000

50 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,000 Ending Cash (No Borrow) Needed (Borrowing) Loan Repayment Interest Cost Ending Cash Balance Cumulative Borrowing Analysis of Borrowing Needs

51 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,000 Ending Cash (No Borrow)(56,500) Needed (Borrowing) Loan Repayment Interest Cost Ending Cash Balance Cumulative Borrowing Analysis of Borrowing Needs

52 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,000 Ending Cash (No Borrow)(56,500) Needed (Borrowing) Loan Repayment Interest Cost Ending Cash Balance25,000 Cumulative Borrowing Target Ending Balance Analysis of Borrowing Needs

53 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,000 Ending Cash (No Borrow)(56,500) Needed (Borrowing)81,500 Loan Repayment0 Interest Cost0 Ending Cash Balance25,000 Cumulative Borrowing Analysis of Borrowing Needs Borrowing Required to cover Minimum Balance and Deficit 56,500+25,000

54 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,000 Ending Cash (No Borrow)(56,500) Needed (Borrowing)81,500 Loan Repayment0 Interest Cost0 Ending Cash Balance25,000 Cumulative Borrowing81,500 Analysis of Borrowing Needs

55 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,000 Ending Cash (No Borrow)(56,500)69,000 Needed (Borrowing)81,500 Loan Repayment0 Interest Cost0 Ending Cash Balance25,000 Cumulative Borrowing81,500 Analysis of Borrowing Needs

56 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,000 Ending Cash (No Borrow)(56,500)69,000 Needed (Borrowing)81,5000 Loan Repayment0 Interest Cost0408 Ending Cash Balance25,00025,000 Cumulative Borrowing81,500 Analysis of Borrowing Needs Interest Incurred on Prior Month Borrowing Interest Incurred on Prior Month Borrowing 81,500 x.005

57 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,000 Ending Cash (No Borrow)(56,500)69,000 Needed (Borrowing)81,5000 Loan Repayment043,592 Interest Cost0408 Ending Cash Balance25,00025,000 Cumulative Borrowing81,500 Analysis of Borrowing Needs Amount that can be repaid from monthly surplus 69, ,000=$43,592

58 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,000 Ending Cash (No Borrow)(56,500)69,000 Needed (Borrowing)81,5000 Loan Repayment043,592 Interest Cost0408 Ending Cash Balance25,00025,000 Cumulative Borrowing81,500 New Loan Balance 81, ,592=$37,908 Analysis of Borrowing Needs 37,908

59 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,00025,000 Ending Cash (No Borrow)(56,500)69,00092,000 Needed (Borrowing)81,5000 Loan Repayment043,592 Interest Cost0408 Ending Cash Balance25,00025,000 Cumulative Borrowing81,50037,908 Analysis of Borrowing Needs

60 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,00025,000 Ending Cash (No Borrow)(56,500)69,00092,000 Needed (Borrowing)81,50000 Loan Repayment043,592 Interest Cost0408 Ending Cash Balance25,00025,000 Cumulative Borrowing81,50037,908 Analysis of Borrowing Needs Interest Incurred on Prior Month Borrowing Interest Incurred on Prior Month Borrowing 37,908 x

61 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,00025,000 Ending Cash (No Borrow)(56,500)69,00092,000 Needed (Borrowing)81,50000 Loan Repayment043,592 Interest Cost Ending Cash Balance25,00025,000 Cumulative Borrowing81,50037,908 Analysis of Borrowing Needs Repay Outstanding Loan Balance 37,908

62 Jan Feb Mar Cash Budget RMC, Inc. Net Monthly Change(84,500)44,00067,000 Beginning Cash Balance28,00025,00025,000 Ending Cash (No Borrow)(56,500)69,00092,000 Needed (Borrowing)81,50000 Loan Repayment043,59237,908 Interest Cost Ending Cash Balance25,00025,000 Cumulative Borrowing81,50037,9080 Analysis of Borrowing Needs Ending Cash Balance $53,902-$25,000=$28,902 Surplus 53,902

63 Jan Feb Mar Cash Budget RMC, Inc. Ending Cash Balance25,00025,00053,902 Cumulative Borrowing81,50037,9080 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. Analysis of Borrowing Needs

64 Managing Cash Inflows and Outflows Generally managers try to increase the amount of cash flowing into a business during any given time period. 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. They also try to slow down cash outflows. Collect early and Pay late (but not too late). Collect early and Pay late (but not too late).

65 Managing Cash Flows Can increase cash inflows (or speed them up) by: 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: Can decrease cash outflows (or slow them down) by: –Cutting costs –Taking full advantage of time allowed to pay obligations

66 Managing Cash Flows Can speed up inflows by: 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: Can slow down cash outflows by: –Delaying the payment of bills –Using remote disbursement banks

67 Accounts Receivable and Inventory

68 Learning Objectives How and why firms manage accounts receivable and inventory. How and why firms manage accounts receivable and inventory. Computation of optimum levels of accounts receivable and inventory. Computation of optimum levels of accounts receivable and inventory. Alternative inventory management approaches. Alternative inventory management approaches. How firms make credit decisions and create collection policies. How firms make credit decisions and create collection policies.

69 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. 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.) 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. Holding adequate inventory is necessary to avoid loss of sales due to stock-outs.

70 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. 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. This is similar to the method we used in determining the best capital budgeting projects to undertake. Link to Hoover’s Online

71 Accounts Receivable Management The terms of sale are generally stated in the form X / Y, n Z 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. 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.

72 Effects of Tightening Credit Policy Raise credit standards Raise credit standards –Fewer credit customers (could reduce sales) –Lower accounts receivable Shorten net due period Shorten net due period –Fewer credit customers (could reduce sales) –Accounts paid sooner –Lower accounts receivable Reduce discount percentage Reduce discount percentage –Fewer credit customers (could reduce sales) –Fewer take the discount Shorten discount period Shorten discount period –Same as above

73 Average Collection Period (ACP) Old Policy; 2/10, n30 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 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

74 Analysis of Accts. Receivable Changes Develop pro forma financial statements for each policy under consideration. 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 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. 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). Choose the policy change that maximizes the value of the firm (highest NPV).

75 Example: ABC Corporation is considering a credit policy change from offering no credit to offering 30 days credit with no discount (n 30). 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? Why might they do this? -Increase sales -Increase market share What costs will the firm incur as a result? What costs will the firm incur as a result? -Cost of carrying accounts receivable -Potential increase in bad debts -Credit analysis and collection costs Analysis of Accts. Receivable Changes

76 Analysis of Accts. Receivable Changes Assume the Net Incremental Cash Flows associated with ABC’s new credit policy are as follows: Assume the Net Incremental Cash Flows associated with ABC’s new credit policy are as follows: External financing (Init. Investment)= $28,000 t=0 External financing (Init. Investment)= $28,000 t=0 –Increase in sales = $30,000 t=1,2... –Increase in COGS= $15,000 –Increase in Bad Debts = $3,000 –increase in Other Expenses= $5,000 –Increase in Interest Expense= $500 –Increase in Taxes=$2,600 –Total Incr. Operating Cash Flow= $3,900/yr.

77 Analysis of Accts. Receivable Changes Calculate the NPV of the change (k = 12%): 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 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 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. Since NPV > 0, ABC should undertake the credit policy change, assuming that the assumptions are valid and that the projected cash flows are accurate.

78 How Firms Make Credit Decisions The Five Cs of Credit: The Five Cs of Credit: Character is the borrower’s willingness to pay based on past payment patterns. 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. 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. Capital is how much wealth the borrower has to fall back on. Collateral is what the lender gets if the borrower fails to pay. Collateral is what the lender gets if the borrower fails to pay. Conditions faced by the borrower in the business marketplace are also considered. Conditions faced by the borrower in the business marketplace are also considered. Link to Credit Scoring

79 Methods of Collection Send reminder letters. Send reminder letters. Make telephone calls. Make telephone calls. Hire collection agencies. Hire collection agencies. Sue the customer. Sue the customer. Settle for a reduced amount. Settle for a reduced amount. Write off the bill as a loss. Write off the bill as a loss. Sell accounts receivable to factors. Sell accounts receivable to factors. Most firms use some of the following:

80 Inventory Management Typically, inventory accounts for about four to five percent of a firm's assets. 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. 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. The economic order quantity (EOQ) model attempts to determine the order size that will minimize total inventory costs.

81 Inventory Management Determining Optimal Inventory Determining Optimal Inventory –Economic Order Quantity (EOQ) Total Inventory Costs = Total Carrying Costs Total Ordering Costs + Link to Bloomberg.com

82 Time Order Quantity Q InventoryLevel(units) The EOQ Model assumes the firm orders a fixed amount Q at equal intervals.

83 Time Order Quantity QInventoryLevel(units) The EOQ Model Average Inventory = Order Quantity 2 Q2Q2

84 = Total Inventory Costs ( ) CC + ( ) OC OQ 2 S OQ Where: OQ= Order Size (order quantity) S = Annual Sales Volume CC= Carrying Cost per Unit OC = Ordering Cost per Order Total Inventory Costs = Total Carrying Costs Total Ordering Costs +

85 Order Size (units) Cost($) Ordering Costs = ( )OC S OQ Ordering Costs

86 Carrying Costs Order Size (units) Cost($) Carrying Costs = ( ) CC OQ 2 = ( )OC S OQ Ordering Costs

87 Total Costs = Carrying Costs + Order Costs Order Size (units) Cost($) Carrying Costs = ( ) CC OQ 2 = ( )OC S OQ Ordering Costs

88 Inventory Management –The economic order quantity that minimizes the total costs of inventory.  Determining Optimal Inventory EOQ = 2 x S x OC CC

89 Inventory Management –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? = =  29 cars 2(1200)26 75  Determining Optimal Inventory EOQ = 2 x S x OC CC

90 Inventory Management Determining Optimal Inventory Determining Optimal Inventory –Economic Order Quantity (EOQ) EOQ  autos in each order Place 1,200/ 29 = 41.4 orders each year 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?

91 Inventory Management with Safety Stock- Order before inventory is at zero. EOQ Depleted Stock During Delivery Inventory Order Point Actual Delivery Time Safety Stock TimeInventoryLevel(units)

92 Time Order Quantity Q InventoryLevel(units)

93 ABC Inventory Classification System Tool to reduce inventory carrying costs: classify different types of inventory according to value. 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.

94 Just In Time Inventory Control (JIT) Developed in Japan. Developed in Japan. Reduce raw material inventory carrying costs by making deals with suppliers that require them to deliver the raw materials as needed. 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. Carrying costs are passed on to suppliers. Can result in higher costs if delivery is delayed: shut down of whole production line. Can result in higher costs if delivery is delayed: shut down of whole production line.

95 Short Term Financing

96 Learning Objectives The need for short-term financing. The need for short-term financing. The advantages and disadvantages of short- term financing. The advantages and disadvantages of short- term financing. Three types of short-term financing. Three types of short-term financing. Computation of the cost of trade credit, commercial paper, and bank loans. 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. How to use accounts receivable and inventory as collateral for short-term loans.

97 Why Do Firms Need Short-term Financing? Profits may not be sufficient to keep up with growth-related financing needs. 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. 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: Short-term financing instead of long-term sources of financing due to: –easier availability –usually lower cost

98 Sources of Short-term Financing Short-term loans. Short-term loans. –borrowing from banks and other financial institutions for one year or less. Trade credit. Trade credit. –borrowing from suppliers Commercial paper. Commercial paper. –only available to large credit- worthy businesses.

99 Types of short-term loans: Promissory note 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 Self-liquidating loan –The proceeds of the loan are used to acquire assets that generate cash to repay the loan (e.g. inventory).

100 Types of short-term loans: Line of Credit 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 Revolving credit agreement –Formal agreement with bank to extend credit to a firm for a period of time (can be more than one year).

101 Trade Credit Trade credit is the act of obtaining funds by delaying payment to suppliers. 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. 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. 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. 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.

102 Estimation of Cost of Short-Term Credit Calculation is easiest if the loan is for a one year period: 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 Rate is used to determine the cost of the credit to be able to compare differing terms. Effective Interest Rate Interest you pay Amount you get to use = Example: 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%

103 Variations in Loan Terms A discount loan requires that interest be paid up front when the loan is given. 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: This changes the effective cost in the previous example since you only get to use: ($10,000 - $1,000) = $9,000. ($10,000 - $1,000) = $9,000. Effective cost = $1,000/$9,000 =.1111 = 11.11%. Effective cost = $1,000/$9,000 =.1111 = 11.11%.

104 Variations in Loan Terms Sometimes lenders require that a minimum amount, called a compensating balance be kept in your bank account. 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. 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%. Effective cost for a $10,000 simple interest 10% loan with a $500 compensating balance = $1,000/($10,000-$500) =.1053 = 10.53%.

105 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. 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: e.g. A 1 month $10,000 loan requires that interest of $90 be paid: the monthly rate = 90/10,000 =.0090 =.9%. the monthly rate = 90/10,000 =.0090 =.9%.  Use the following formula to equate: Effective Annual = Rate $ Interest $ you get to use ( Periods/yr ) ()

106 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? $10,000 loan for 1 month with monthly interest equal to $90. What is the effective annual interest rate? Effective annual rate = (1.009) =.1135 =11.35% Effective annual rate = (1.009) =.1135 =11.35% Link to CNNfn

107 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. 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: $10,000 loan with.9%monthly interest: K= ( , ) =.1146  k = 11.46%  Effective annual rate

108 Sources of Short Term Credit Cost of Trade 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. 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.

109 Cost of Trade Credit 2/10 net 60 Assume your purchase is $100 list. Assume your purchase is $100 list. If you take the discount, you pay $98. If you don’t take the discount, you pay $100. 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). 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).

110 The formula for cost of trade credit is similar to the previous equations. 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 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)]) =.1589 = 15.89%. The cost of trade credit for this example: [1 +(2/98)]) =.1589 = 15.89%. Cost of Trade Credit 2/10 net 60 Cost of Credit Discount % 100-Discount% days to pay - disc. pd. ( ) = ( (

111 Computing the Cost of Trade Credit Another Example Effective Annual Cost, k, of Passing Up a Discount; 2/10, n40 Effective Annual Cost, k, of Passing Up a Discount; 2/10, n40 K = ( ) ( – 10 ) -1 =.2786  k = 27.86%

112 Commercial Paper Commercial paper is quoted on a discount basis so discount yield must be converted to effective annual interest rate for comparison. 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) 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 the price = Par - D Compute Effective Annual Rate = (par/price) (365/DTG) - 1 Compute Effective Annual Rate = (par/price) (365/DTG) - 1

113 Cost of Commercial Paper Example $1 million issue of 90 day c.p. quoted at 4% discount yield. $1 million issue of 90 day c.p. quoted at 4% discount yield. Step 1: Calculate D =.04 x $1 mill. x = $10,000 Step 2: Calculate price = $1,000,000 - $10,000 = $990,000 Step 3: Calculate effective rate = (1,000,000 / 990,000) (365/90) -1 = 4.16%

114 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. 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. 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. Accounts receivable can also be sold outright. This is known as factoring.

115 Inventory as Collateral A major problem with inventory financing is valuing the inventory. 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. 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.

116 Inventory as Collateral Blanket Lien: A general claim against the borrowers inventory if there is a default 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 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) Warehousing: Inventory pledged as collateral is removed from the control of the borrower (either in an on-site or public warehouse)