1. Chapter 02 Working Capital and Current Assets Management

2. Working capital management involves the financing and management of the current assets of the firm. Current assets are by their nature changing daily, if not hourly. How much inventory to be carried and how do we get the funds to pay it. Unlike the long term decisions there can be no deferral of action.

3. Cash Receipt budget: Assume the case of the Goldman corporation, The corporation’s RO 100,000 sales is break down into following months. Monthly Sales Pattern Jan Feb March April May June 15,000 10,000 15,000 25,000 15,000 20,000

4. Monthly cash receipt: Dec Jan Feb March April May June Sales…………. 12,000 15,000 10,000 15,000 25,000 15,000 20,000 Collection (20 % of current sales) 3000 2000 3000 5000 3000 4000 Collections: (80% of previous month’s sales ) ….. 9600 12,000 8000 12,000 20,000 12,000 12,600 14,000 11,000 17,000 23,000 16,000

5. Cash Management I Minimizing cash balance as well as accurate knowledge of when cash moves into and out of the company can improve overall profitability. Reasons for holding the cash balances: There are several reasons for holding the cash for: (a) Transaction balance (b) Compensating balance (c) Precautionary balance

6. Collections and Disbursements I Float: There are two cash balances of importance: the corporation’s recorded amount and the amount credited to the corporation by the bank. The difference between the two is called Float. And it arises from time delays in mailing, processing and clearing checks through the banking system.

7. Inventory Management I Inventory is usually divided into three categories. (a) Raw material (b) Work in process (c) Finished Goods The amount of the inventory is not always totally controlled by company management because it is affected by sales, production and economic conditions.

8. The inventory Decision Model I Substantial research has been devoted to the problem of determining optimum inventory size, order quantity, usage rate and similar considerations. In developing the inventory model, we must evaluate two basic costs associated with inventory: the carrying cost and ordering costs. Through the careful analysis of both of these variables, we can determine the optimum order size to pace to minimize costs.

9. Economic Ordering Quantity: EOQ = √2SO / C, Where S = Total sales in units O = Ordering cost for each order C = carrying cost per unit in dollars. Let assume that we anticipate selling 2,000 units, that it will cost us $8 to place each order, and that the price per unit is $1, with a 20 percent carrying cost to maintain the average inventory (the carrying charge per unit is $0.20) EOQ = √2SO / C = √ 2 × 2000 × $8 / 0.20 = √160,000 = 400 units.

10. Total cost for inventory 1. Ordering costs = 2000 = 5 400 5 orders at $8 per order = $40 2. Carrying costs = Average inventory in units × carrying cost per unit. 200 × $0.20 = $40 3. Order Carrying cost cost …………… …. $40 ……………..+40 Total cost …………… $80

11. I Carrying costs: Carrying costs include interest on funds tied up in inventory, and the costs of the warehouse space, insurance premium and material handling expenses. The larger the order we place, the greater the average inventory we will have on hand, and the higher the carrying cost. Ordering Costs: As a seasonal factor, we must consider the cost of ordering and the processing inventory into stocks. If we maintain relatively low average inventory in stocks, we must order many times and total ordering cost will be high. As the order size is increases, carrying cost go up because we have more inventory on hand. With larger orders of course we will order less frequently and overall ordering costs will go down

12. Q.1 Midwest tires has expected sales of 12,000 tires this year, an ordering cost of $6 per order, and carrying costs of $1.60 per tire. Required: (a) What is economic ordering quantity. (b) How many orders will be placed during the year. (c) What will the average inventory be?

13. Management of Accounts Receivable: Credit Policy Administration; a) Credit standards b) Terms of credit c) Collection policy

14. Credit standards: The firm must determine the nature of the credit risk on the basis of prior record of payment, financial stability, current net worth and others factors. Terms of Trade: If the firm averages $5000 in daily credit sales and allows 30-day terms, the average account receivable balance will be $150,000. if the customers are carried for 60 days, we must maintain $300,000 in receivables and much additional financing will be required.

15. Collection policy: A number of quantitative measures may be applied to the credit department (a) Average collection period = Accounts receivables Average daily credit sales = Accounts receivables Credit sales / 365 (b) Ratio of bad debt to credit sales = Bad Debt Credit Sales

16. Q.1: Zahra tours and travels has annual credeit sales of RO 1,080,000 and an average collection period of 40 days in 1991. Assume a 360 day a year. Required: what is company’s average accounts receivables balance? Q.2: The lulu hypermarket financial statement shows the Bad debt to RO 305,000 and the credit sales is RO 9,874,500. Required: what is bad debt ratio

17. Cost of debt The cost of the debt measure by the interest rate or yield paid to bondholders For example: assume the firm is preparing to issue the new debt. Assume the debt issue the pays RO100 per year in interest has the 20 year life and currently selling for RO 940, in order to find the yield to maturity on the debt we use the following formula

18. Annual Yield Interest + Principal Payment – Price of the bond to = payment Number of years of maturity Maturity ______________________________________________ 0.6 (Price of the Bond) + 0.4 (Principal Payment) 1000 - 940 RO 100 + 20 Y’ = ___________________ 0.6(940) + 0.4(1000) Y’ = 103 = 10.68% 964

19. Kd = (cost of capital) = Y(Yield)(1 - T) = 10.68%(1 - 0.34) = 7.05% Cost of preferred stock: the cost of the preferred is similar to the costs of the debt in that annual payment is made, but dissimilar in that there is no maturity date in which principal is made KP(cost of preferred stock) = Dp Pp – F Where, Kp = cost of the preferred cost Dp = the annual dividends on preferred Pp = the price of preferred cost F = Floatation or selling costs.

20. Cost of common equity: In determining the cost of common stock, the firm must be sensitive to the pricing and performance of current and future stockholders. The model we use for valuation of the cost of the common equity is Po = D1 Ke - g Where, Po = Price of the Stock Today D1 = dividends at the end of the first year Ke = required rate of return g = Constant growth rate in dividends Ke = D1 = g Po

21. Alternate calculation of the required rate of the return: Under the capital asset pricing model (CAPM), the required return for common stock (other investments) can be described by the following formula: Kj = Rf + β(Km - Rf) Where, Kj = Required return on common stock Rf = Risk free rate of return Β = Beta coefficient Km = Return in the market as measured by an appropriate index

22. Cost of New Common Stock If we issuing new common stock, we must earn a slightly higher return than Ke, which represent the required rate of return of present stock holders. The higher return is needed to cover the distribution cost of the new securities. Kn = D1 + g Po – F Where,

23. The omantel has a RO1000 par value bond outstanding with a 25 years to maturity. The bond carries an annual interest payment of RO 88 and currently selling for RO 925. omantel is in 25% bracket.