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 Twelve Current Investment Decisions

2. 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 12-2 12.1 The Investments Involved 12.2 The Operating Cycle and the Cash Cycle 12.3 Some Aspects of Short-term Financial Policy 12.4 The Cash Budget 12.5 A Short-term Financial Plan 12.6 Summary and Conclusions Chapter Organisation

3. 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 12-3 Chapter Objectives Understand the components of the operating cycle and the cash cycle. Explain the key issues in a firm’s short-term financial policy. Understand and apply the inventory model. Prepare a cash budget.

4. 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 12-4 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.

5. 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 12-5 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

6. 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 12-6 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

7. 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 12-7 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.

8. 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 12-8 Example—Operating Cycle (continued) a) Find the inventory period:

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 Example—Operating Cycle (continued) b) Find the accounts receivable period:

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 Example—Operating Cycle (continued)

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 Example—Cash Cycle a) Find the payables period:

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—Cash Cycle (continued)

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 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

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 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.

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 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.

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 Carrying Costs and Shortage Costs

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 Carrying Costs and Shortage Costs

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 Carrying Costs and Shortage Costs

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 The Inventory Model The economic quantity (EOQ) is the optimal quantity of inventory ordered that minimises the costs of purchasing and holding the inventory. Where TC = total costX = order size EOQ = economic order qtyA = acquisition costs Y = total demandC = carrying costs P = price per unit

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 Example—EOQ Smile Camera Shop sells 10 000 rolls of film per year, each with a wholesale price of $3.20. The cost of processing each order placed is $10.00 and carrying costs are 20 cents per roll per year. Calculate the EOQ.

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 EOQ Example With Quantity Discounts Smile Camera Shop is offered a 2-cent-per-roll discount if 2000–3500 rolls of film are ordered, and a 3-cent-per-roll discount if more than 3500 rolls are ordered at a time. Determine the optimal order quantity.

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 EOQ Example With Quantity Discounts (continued) Calculate the total cost for each quantity: Smile Camera Shop would be better off purchasing in lots of 2000 to reduce the total cost.

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 Inventory Management Under Uncertainty Inventory management requires two decisions: – quantity to be ordered – reorder point Safety stock is the additional inventory held when demand is uncertain so as to reduce the probability of a stock out. Reorder point takes into account the lead time from placement of an order to receipt of the goods.

24. 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 12-24 EOQ Example Under Uncertainty Smile Camera Shop’s EOQ (with quantity discounts) is 2000 rolls of film and five orders are placed each year. Determine the reorder point if it takes 30 days to fill an order, a safety stock of 100 is desired and daily usage is 30 rolls.

25. 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 12-25 Qty 2 100 1 000 100 Time Reorder points EOQ Example Under Uncertainty Safety stock Reorder point

26. 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 12-26 Cash Budget Forecast of cash receipts and disbursements over the next short-term planning period. Primary tool in short-term financial planning. Helps determine when the firm should experience cash surpluses and when it will need to borrow to cover working-capital costs. Allows a company to plan ahead and begin the search for financing before the money is actually needed.

27. 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 12-27 Example—Cash Budget Projected sales for the first six months of 2004: Jan.$130 000Apr.$140 000 Feb.$125 000May$155 000 Mar.$145 000Jun.$145 000 Analysis of collection of accounts receivable: – collected in month of sale20% – collected in month following sale60% – collected in second month following sale20% Actual sales for November and December were $125 000 and $120 000 respectively.

28. 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 12-28 Example—Cash Budget (continued) Wages and other expenses are 30 per cent of total monthly sales. Purchases are 50 per cent of the month’s estimated sales, all paid for in the month of purchase. Monthly interest payments are $15 000 (interest rate is 1.5 per cent per month). An annual dividend of $60 000 is payable in March. The beginning cash balance is $30 000. The minimum cash balance is $20 000.

29. 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 12-29 Cash Collections

30. 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 12-30 Cash Disbursements

31. 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 12-31 Cash Budget

32. 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 12-32 Short-term Financial Planning