Part Seven Asset Management

Learning Objectives Understand how firms manage cash Understand how to accelerate collections and manage disbursements Understand the characteristics of various short- term securities Understand the major components of inventory management Be able to use the EOQ model to determine optimal inventory levels

20-3 Reasons for Holding Cash Speculative motive – hold cash to take advantage of unexpected opportunities Precautionary motive – hold cash in case of emergencies Transaction motive – hold cash to pay the day- to-day bills Trade-off between opportunity cost of holding cash relative to the transaction cost of converting marketable securities to cash for transactions

20-4 Understanding Float Float – difference between cash balance recorded in the cash account and the cash balance recorded at the bank Disbursement float –Generated when a firm writes checks –Available balance at bank – book balance > 0 Collection float –Checks received increase book balance before the bank credits the account –Available balance at bank – book balance < 0 Net float = disbursement float + collection float

20-5 Example: Types of Float You have $3000 in your checking account. You just deposited $2000 and wrote a check for $2500. –What is the disbursement float? –What is the collection float? –What is the net float? –What is your book balance? –What is your available balance?

20-6 Example: Measuring Float Size of float depends on the dollar amount and the time delay Delay = mailing time + processing delay + availability delay Suppose you mail a check for $1000 and it takes 3 days to reach its destination, 1 day to process and 1 day before the bank makes the cash available What is the average daily float (assuming 30-day months)? –Method 1: (3+1+1)(1000)/30 = –Method 2: (5/30)(1000) + (25/30)(0) =

20-7 Example: Cost of Float Cost of float – opportunity cost of not being able to use the money Suppose the average daily float is $3 million with a weighted average delay of 5 days. –What is the total amount unavailable to earn interest? 5*3 million = 15 million –What is the NPV of a project that could reduce the delay by 3 days if the cost is $8 million? Immediate cash inflow = 3*3 million = 9 million NPV = 9 – 8 = $1 million

20-8 Cash Collection Payment PaymentPayment Cash Mailed ReceivedDeposited Available Mailing TimeProcessing DelayAvailability Delay Collection Delay One of the goals of float management is to try to reduce the collection delay. There are several techniques that can reduce various parts of the delay.

20-9 Example: Accelerating Collections – Part I Your company does business nationally and currently all checks are sent to the headquarters in Tampa, FL. You are considering a lock-box system that will have checks processed in Phoenix, St. Louis and Philadelphia. The Tampa office will continue to process the checks it receives in house. –Collection time will be reduced by 2 days on average –Daily interest rate on T-billls =.01% –Average number of daily payments to each lockbox is 5000 –Average size of payment is $500 –The processing fee is $.10 per check plus $10 to wire funds to a centralized bank at the end of each day.

20-10 Example: Accelerating Collections – Part II Benefits –Average daily collections = 3(5000)(500) = 7,500,000 –Increased bank balance = 2(7,500,000) = 15,000,000 Costs –Daily cost =.1(15,000) + 3*10 = 1530 –Present value of daily cost = 1530/.0001 = 15,300,000 NPV = 15,000,000 – 15,300,000 = -300,000 The company should not accept this lock-box proposal

20-11 Cash Disbursements Slowing down payments can increase disbursement float – but it may not be ethical or optimal to do this Controlling disbursements –Zero-balance account –Controlled disbursement account

20-12 Investing Cash Money market – financial instruments with an original maturity of one year or less Temporary Cash Surpluses –Seasonal or cyclical activities – buy marketable securities with seasonal surpluses, convert securities back to cash when deficits occur –Planned or possible expenditures – accumulate marketable securities in anticipation of upcoming expenses

20-13 Figure 20.6

20-14 Characteristics of Short-Term Securities Maturity – firms often limit the maturity of short-term investments to 90 days to avoid loss of principal due to changing interest rates Default risk – avoid investing in marketable securities with significant default risk Marketability – ease of converting to cash Taxability – consider different tax characteristics when making a decision

21-15 Inventory Management Inventory can be a large percentage of a firm’s assets There can be significant costs associated with carrying too much inventory There can also be significant costs associated with not carrying enough inventory Inventory management tries to find the optimal trade-off between carrying too much inventory versus not enough

21-16 Types of Inventory Manufacturing firm –Raw material – starting point in production process –Work-in-progress –Finished goods – products ready to ship or sell Remember that one firm’s “raw material” may be another firm’s “finished good” Different types of inventory can vary dramatically in terms of liquidity

21-17 Inventory Costs Carrying costs – range from 20 – 40% of inventory value per year –Storage and tracking –Insurance and taxes –Losses due to obsolescence, deterioration or theft –Opportunity cost of capital Shortage costs –Restocking costs –Lost sales or lost customers Consider both types of costs and minimize the total cost

21-18 Inventory Management - ABC Classify inventory by cost, demand and need Those items that have substantial shortage costs should be maintained in larger quantities than those with lower shortage costs Generally maintain smaller quantities of expensive items Maintain a substantial supply of less expensive basic materials

21-19 EOQ Model The EOQ model minimizes the total inventory cost Total carrying cost = (average inventory) x (carrying cost per unit) = (Q/2)(CC) Total restocking cost = (fixed cost per order) x (number of orders) = F(T/Q) Total Cost = Total carrying cost + total restocking cost = (Q/2)(CC) + F(T/Q)

21-20 Figure 21.3

21-21 Example: EOQ Consider an inventory item that has carrying cost = $1.50 per unit. The fixed order cost is $50 per order and the firm sells 100,000 units per year. –What is the economic order quantity?

21-22 Extensions Safety stocks –Minimum level of inventory kept on hand –Increases carrying costs Reorder points –At what inventory level should you place an order? –Need to account for delivery time Derived-Demand Inventories –Materials Requirements Planning (MRP) –Just-in-Time Inventory

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