1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-1 Chapter Four: 2012 MCPD Liquidity Management : Cases and Impact

2. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 26-2 Executive Summary We are solidly in to the third great question of corporate finance.

3. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 26-3 The Balance-Sheet Model of the Firm Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt What long- term investments should the firm engage in? The Capital Budgeting Decision

4. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 26-4 The Balance-Sheet Model of the Firm How can the firm raise the money for the required investments? The Capital Structure Decision Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

5. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 26-5 The Balance-Sheet Model of the Firm How much short- term cash flow does a company need to pay its bills? The Net Working Capital Investment Decision Net Working Capital Current Assets Fixed Assets 1 Tangible 2 Intangible Shareholders’ Equity Current Liabilities Long-Term Debt

6. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 26-6 26.1 Tracing Cash and Net Working Capital Current Assets are cash and other assets that are expected to be converted to cash with the year. Cash Marketable securities Accounts receivable Inventory Current Liabilities are obligations that are expected to require cash payment within the year. Accounts payable Accrued wages Taxes Current Assets are cash and other assets that are expected to be converted to cash with the year. Cash Marketable securities Accounts receivable Inventory Current Liabilities are obligations that are expected to require cash payment within the year. Accounts payable Accrued wages Taxes

7. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 26-7 26.2 Defining Cash in Terms of Other Elements Net Working Capital + Fixed Assets = Long- Term Debt +Equity Net Working Capital =Cash Other Current Assets Current Liabilities +–Cash= Long- Term Debt +Equity– Net Working Capital (excluding cash) Fixed Assets –

8. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 26-8 26.2 Defining Cash in Terms of Other Elements An increase in long-term debt and or equity leads to an increase in cash—as does a decrease in fixed assets or a decrease in the non-cash components of net working capital. The Sources and Uses of Cash Statement follows from this reasoning. An increase in long-term debt and or equity leads to an increase in cash—as does a decrease in fixed assets or a decrease in the non-cash components of net working capital. The Sources and Uses of Cash Statement follows from this reasoning. Cash= Long- Term Debt +Equity– Net Working Capital (excluding cash) Fixed Assets –

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-9 Current Investment Decisions Involve the administration of the company’s current assets (cash and marketable securities, receivables and inventory), and the financing needed to support these assets. Problems in using discounted cash flow techniques to evaluate these decisions: – identification of all relevant cash inflows and outflows – determining the size and timing of these cash flows – determining the correct discount rate.

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-10 Operating Cycle versus Cash Cycle Operating cycle—the time period between the acquisition of inventory and the collection of cash from receivables. Operating cycle = Inventory period + A/cs receivable period Cash cycle—the time period between the outlay of cash for purchases and the collection of cash from receivables. Cash cycle = Operating cycle – A/cs payable period

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-11 Cash Flow Time Line Accounts receivable period Cash received Time Inventory sold Inventory purchased Inventory period Accounts payable period Cash paid for inventory Operating cycle Cash cycle

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-12 Example—Operating Cycle The following information has been provided for Overcredit Co.: Sales for the year were $510 000 (assume all credit) and the cost of goods sold was $350 000. Calculate the operating cycle and cash cycle.

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-13 Example—Operating Cycle (continued) a) Find the inventory period:

14. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-14 Example—Operating Cycle (continued) b) Find the accounts receivable period:

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-15 Example—Operating Cycle (continued)

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-16 Example—Cash Cycle a) Find the payables period:

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-17 Example—Cash Cycle (continued)

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-18 Short-term Financial Policy Size of investments in current assets - Flexible policy—maintain a high ratio of current assets to sales - Restrictive policy—maintain a low ratio of current assets to sales Financing of current assets - Flexible policy—less short-term debt and more long-term debt - Restrictive policy—more short-term debt and less long-term debt

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-19 Short-term Financial Policy The size of the firm’s investment in current assets is determined by its short-term financial policies. Flexible policy actions include: – keeping large cash and securities balances – keeping large amounts of inventory – granting liberal credit terms. Restrictive policy actions include: – keeping low cash and securities balances – keeping small amounts of inventory – allowing few or no credit sales.

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-20 Costs of Investments Need to manage the trade-off between carrying costs and shortage costs. Carrying costs increase with the level of investment in current assets, and include the costs of maintaining economic value and opportunity costs. Shortage costs decrease with increases in the level of investment in current assets, and include trading costs and the costs related to being short of the current asset. For example, sales lost as a result of a shortage of finished goods inventory.

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-21 Carrying Costs and Shortage Costs

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-22 Carrying Costs and Shortage Costs

23. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3e Ross, Thompson, Christensen, Westerfield and Jordan Slides prepared by Sue Wright 12-23 Carrying Costs and Shortage Costs

24. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 26-24 Alternative Financing Policies for Current Assets A flexible short-term finance policy means low proportion of short-term debt relative to long- term financing. A restrictive short-term finance policy means high proportion of short-term debt relative to long-term financing. A flexible short-term finance policy means low proportion of short-term debt relative to long- term financing. A restrictive short-term finance policy means high proportion of short-term debt relative to long-term financing.

25. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 26-25 Alternative Financing Policies for Current Assets In an ideal world, short-term assets are always financed with short-term debt and long-term assets are always financed with long-term debt. In this world, net working capital is always zero. In an ideal world, short-term assets are always financed with short-term debt and long-term assets are always financed with long-term debt. In this world, net working capital is always zero.

26. McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc. All Rights Reserved. 26-26 Financing Policy for an Idealized Economy Long-term debt plus common stock $ Time 012345012345 Current assets = Short-term debt Fixed assets: a growing firm Grain elevator operators buy crops after harvest, store them, and sell them during the year. Inventory is financed with short-term debt. Net working capital is always zero.