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

2. Topics Covered Inventories Credit Management Cash
Marketable Securities

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

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. 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. 22

6. Managing Inventories Inventory 60 30 Inventory, thousands of units
Average Inventory
Weeks

7. Inventories Determination of optimal order size Total costs
Carrying costs
Inventory costs, dollars
Total order costs
Order size
Optimal
order size 24

8. Inventories
Economic Order Quantity - Order size that minimizes total inventory costs. 23

9. Inventories Just-in-time inventory management
Managing inventories of cash
Upper limit
Cash
Balance
Return point
Lower limit
Time 26

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. 25

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. 3

12. Terms of Sale
Terms of Sale - Credit, discount, and payment terms offered on a sale. Example - 5/10 net percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due 3

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 5

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? 7

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 8

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 10

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. 9

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. 17

19. The Credit Decision The credit decision and its probable payoffs
Payoff = Rev - Cost
Payoff = - Cost
Customer pays = p
Customer defaults = 1-p
Payoff = 0
Offer credit
Refuse credit 20

20. The Credit Decision
Based on the probability of payoffs, the expected profit can be expressed as:
The break even probability of collection is: 23

21. Collection Policy
Collection Policy - Procedures to collect and monitor receivables. Aging Schedule - Classification of accounts receivable by time outstanding. 24

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

23. Collection Policy
Sample aging schedule for accounts receivable 25

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

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

27. Payment Methods
% of firms using

28. Marketable Securities
Microsoft 2006 cash investments

29. Money Market Investments

30. Money Market Investments

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

32. Web Resources Web Links www.decisioneering.com www.jaxworks.com
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