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Topics Covered
Working Capital Terminology Working Capital Financing Policies Cash Conversion Cycle Why hold cash? Goals of Managing Cash, Inventory and Credit Policy Cash Budgeting Sources and Costs of Short-Term Financing

Working capital terminology


Gross working capital total current assets. Net working capital current assets minus non-interest bearing current liabilities. Working capital policy deciding the level of each type of current asset to hold, and how to finance current assets. Working capital management controlling cash, inventories, and A/R, plus short-term liability management.
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Working capital financing policies

Moderate Match the maturity of the assets with the maturity of the financing. Aggressive Use short-term financing to finance permanent assets. Conservative Use permanent capital for permanent assets and temporary assets.
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Moderate financing policy


$ Temp. C.A. S-T Loans

Perm C.A.

Fixed Assets

L-T Fin: Stock, Bonds, Spon. C.L. Years

Lower dashed line would be more aggressive.

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Conservative financing policy


$
Marketable securities

Zero S-T Debt L-T Fin: Stock, Bonds, Spon. C.L. Years
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Perm C.A.

Fixed Assets

Cash conversion cycle

The cash conversion cycle focuses on the length of time between when a company makes payments to its creditors and when a company receives payments from its customers.

Inventory Receivables Payables CCC = conversion + collection deferral . period period period
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Cash conversion cycle


Inventory Receivables Payables CCC conversion collection deferral period period period Payables Days per year Days sales CCC deferral Inventory turnover outstanding period 365 CCC 46 - 30 4.82 CCC 76 46 - 30 92 days.
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Cash doesnt earn a profit, so why should the firm hold it?
1. 2.

3.
4.

Transactions must have some cash to operate. Precaution safety stock. Reduced by line of credit and marketable securities. Compensating balances for loans and/or services provided. Speculation to take advantage of bargains and to take discounts. Reduced by credit lines and marketable securities.
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The goal of cash management

To meet the above objectives, especially to have cash for transactions, yet not have any excess cash. To minimize transactions balances in particular, and also needs for cash to meet other objectives.

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Minimizing cash holdings


Use a lockbox Insist on wire transfers from customers Synchronize inflows and outflows Use a remote disbursement account Reduce need for safety stock of cash

Increase forecast accuracy Hold marketable securities Negotiate a line of credit


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Inventory costs

Types of inventory costs

Carrying costs storage and handling costs, insurance, property taxes, depreciation, and obsolescence. Ordering costs cost of placing orders, shipping, and handling costs. Costs of running short loss of sales or customer goodwill, and the disruption of production schedules.

Reducing inventory levels generally reduces carrying costs, increases ordering costs, and may increase the costs of running short.
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Elements of credit policy


Credit Period How long to pay? Shorter period reduces DSO and average A/R, but it may discourage sales. 2. Cash Discounts Lowers price. Attracts new customers and reduces DSO. 3. Credit Standards Tighter standards tend to reduce sales, but reduce bad debt expense. Fewer bad debts reduce DSO. 4. Collection Policy How tough? Tougher policy will reduce DSO but may damage customer relationships.
1.
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Short-term credit

Debt scheduled for repayment within 1 year. Major sources of short-term credit

From the firms perspective, S-T credit is riskier than L-T debt.

Accounts payable (trade credit) Bank loans Commercial loans Accruals

Always a required payment around the corner. May have trouble rolling over loans.
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Advantages and disadvantages of using short-term financing

Advantages

Speed Flexibility Lower cost than long-term debt Fluctuating interest expense Firm may be at risk of default as a result of temporary economic conditions

Disadvantages

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What is trade credit?

Trade credit is credit furnished by a firms suppliers. Trade credit is often the largest source of short-term credit, especially for small firms. Spontaneous, easy to get, but cost can be high.

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Nominal cost of trade credit

The firm loses 0.01($3,030,303) = $30,303 of discounts to obtain $246,575 in extra trade credit:
rNOM = $30,303 / $246,575 = 0.1229 = 12.29%

The $30,303 is paid throughout the year, so the effective cost of costly trade credit is higher.

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Nominal cost of trade credit formula


rNOM Discount % 365 days 1 - Discount % Days taken - Disc. period 1 365 99 40 - 10 0.1229 12.29%

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Effective cost of trade credit


Periodic rate = 0.01 / 0.99 = 1.01% Periods/year = 365 / (40-10) = 12.1667 Effective cost of trade credit

EAR

= (1 + periodic rate)N 1
= (1.0101)12.1667 1 = 13.01%

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Add-on interest

Interest = 0.08 ($100,000) = $8,000 Face amount = $100,000 + $8,000 = $108,000 Monthly payment = $108,000/12 = $9,000 Avg loan outstanding = $100,000/2 = $50,000 Approximate cost = $8,000/$50,000 = 16.0% To find the appropriate effective rate, recognize that the firm receives $100,000 and must make monthly payments of $9,000 (like an annuity).
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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

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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.

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Managing Inventories

60 Inventory, thousands of units

Inventory

30

Average Inventory

6
Weeks

12

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Inventories
Determination of optimal order size
Inventory costs, dollars
Total costs Carrying costs

Total order costs Optimal order size Order size

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

Economic Order Quantity =

2 x annual sales x cost per order carrying cost

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Inventories
Just-in-time inventory management Managing inventories of cash
Upper limit

Cash Balance
Return point

Lower limit

Time

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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.

Initial cash balance =

2 x annual cash outflows x cost per sale of securities interest rate

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Working Capital
Net Working Capital - Current assets minus current liabilities. Often called working capital. Cash Conversion Cycle - Period between firms 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.

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Terms of Sale
Terms of Sale - Credit, discount, and payment terms offered on a sale. Example - 5/10 net 30

5 - percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due

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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

Effective annual rate = 1 +

discount discounted price

365 / extra days credit

- 1

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Terms of Sale
Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?

Effective annual rate 1+ 1 +

365/extra days credit discount discounted price 5 365/50 95

-1

- 1 = .454, or 45.4%

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Credit Agreements
Terminology
open account promissory note commercial draft sight draft time draft trade acceptance bankers acceptance irrevocable letter of credit conditional sale

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Credit Analysis
Numerical Credit Scoring categories
The customers character The customers capacity to pay The customers capital The collateral provided by the customer The condition of the customers business

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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 customers ability to pay its bills.

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The Credit Decision


Credit Policy - Standards set to determine the amount and nature of credit to extend to customers. Credit Scoring What your lender wont 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.

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The Credit Decision


The credit decision and its probable payoffs

Customer pays = p

Payoff = Rev - Cost

Offer credit Customer defaults = 1-p Payoff = - Cost

Refuse credit Payoff = 0

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The Credit Decision


Based on the probability of payoffs, the expected profit can be expressed as:

p x PV(Rev - Cost) - (1 - p) x (PV(cost)


The break even probability of collection is:

PV(Cost) p = PV(Rev)

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

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Collection Policy
Sample aging schedule for accounts receivable

Customer' s Less than More than 1 - 2 months 2 - 3 months Total Owed Name 1 month 3 months A 10,000 0 0 0 10,000 B 8,000 3,000 0 0 11,000 * * * * * * * * * * * * * * * * * * Z 5,000 4,000 6,000 15,000 30,000 Total $200,000 $40,000 $15,000 $43,000 $298,000

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Cash
Cash does not pay interest
Move money from cash accounts into short term securities Sweep programs MMDAs Concentration banking Lock-box system

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Cash
How purchases are paid. Percentage of total by payment type for 2004.
100% 80% 60% 40% 20% 0% Direct debits Credit transfers Credit/debit cards Checks

UK

Canada

Germany

Netherlands

Switzerland

Sweden

France

USA

Italy

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

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Payment Methods
120

100

% of firms using

80

60

Receive payments
Make payments

40

20

0 Direct payments Direct deposits Wire transfers

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Marketable Securities
Microsoft 2006 cash investments

Investment Money market mutual funds Commercial paper Certificates of deposit US Govt and agency securities Foreign govt bonds Mortgage backed securities Corporate notes and bonds Municipal securities Other Total

Amount $723 million 3,242 364 4,904 6,034 4,285 7,605 4,008 383 31,548

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Money Market Investments


Investment Borrower MATURITIES When Issued 4 weeks, 3 months, or 6 months Marketability Excellent secondary market Very good secondary market Basis for Calculating Interest Comments

Treasury bills

U.S. government

Discount

Federal agency FHLB, "Fannie Mae," benchmark bills and Sallie Mae," Freddie Overnight to 360 discount notes Mac," etc. days

Discount

Auctioned weekly Benchmark bills by regular auction; discount notes sold through dealers Tax-anticipation notes (TANs), revenue anticipation notes (RANs), bond anticipation notes (BANs), etc. Long-term bonds with put options to demand repayment

Municipalities, Tax-exempt states, school municipal notes districts, etc. Tax-exempt variableMunicipalities, rate demand bond states, universities, (VRDBs) etc.

3 months to 1 year

10-40 years

Good secondary market Good secondary market

Usually interestbearing with interest at maturity

Variable interest rate

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Money Market Investments


Investment Non-negotiable time deposits and negotiable certificates of deposit (CDs) Borrower MATURITIES When Issued Marketability Basis for Calculating Interest Comments Usually 1 to 3 months; also Fair secondary longer-maturity market for Interest-bearing with variable-rate CDs negotiable CDs interest at maturity Receipt for time deposit Maximum 270 days; usually less than 10 years Minimum 270 days;usually less than 10 years Dealers or issuer will repurchase paper Dealers will repurchase notes Fair secondary market Unsecured promissory note; may be placed through dealer or directly with investor Unsecured promissory note placed through dealer Demand to pay that has been accepted by a bank

Commercial banks, savings and loans Industrial firms, finance companies, and bank holding Commercial paper companies; also (CP) municipalities Largely finance companies and Medium-term notes banks; also industrial (MTNs) firms Bankers' acceptances (Bas) Major commercial banks

Usually discount

Interest-bearing; usually fixed rate

1-6 months Overnight to about 3 months; also open repos (continuing contracts)

Discount

Repurchase agreements (repos)

Dealers in U.S. government securities

No secondary market

Repurchase price set higher than selling Sales of government price; difference securities by dealer with quoted as repo simultaneous agreement interest rate to repurchase.

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Working Capital
Example - Cash Conversion Cycle Given the aggregate balance sheet and income statement for US Manufacturing firms, calculate the cash conversion cycle.

average accounts payable Payable period = annual COGS/365 (359 + 334)/2 = 3,960 / 365 = 31.9 days
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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Working Capital
Example - Cash Conversion Cycle Given the aggregate balance sheet and income statement for US Manufacturing firms, calculate the cash conversion cycle.

Inventoryperiod 44.8 days


Receivables period = 41.6 days

Payable period = 31.9 days

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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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CCC
CCC=INVENTORY PERIOD PLUS RECEIVABLE PERIOD MINUS PAYABLE PERIOD 44.8 + 41.6 31.9 = 54.5 DAYS What does the 54.5 days mean here?

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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Cash Budgeting
Steps to preparing a cash budget
Step 1 - Forecast the sources of cash. Step 2 - Forecast uses of cash. Step 3 - Calculate whether the firm is facing a cash shortage or surplus.

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Cash Budgeting
Example - Dynamic Mattress Company

Dynamic forecasted sources of cash


Quarter Sales, $mil 1st 2nd 3rd 4th 87.50 78.50 116.00 131.00

AR ending balance = AR beginning balance + sales collections

Irwin/McGraw Hill

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Cash Budgeting
Example - Dynamic Mattress Company Dynamic collections on AR
Qtr 1st 1. Beginning receivables 2. Sales 3. Collections . Sales in current Qtr (80%) . Sales in previous Qtr (20%) Total collections 4. Receivables at end of period . (4 = 1 + 2 - 3)
Irwin/McGraw Hill

2nd 32.5 78.5 62.8 17.5 80.3 $30.7

3rd 30.7 116.0 92.8 15.7 108.5 $38.2

4th 38.2 131.0 104.8 23.2 128.0 $41.2

30.0 87.5 70 15.0 85.0 $32.5

Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Cash Budgeting
Example - Dynamic Mattress Company

Dynamic forecasted uses of cash Payment of accounts payable Labor, administration, and other expenses Capital expenditures Taxes, interest, and dividend payments

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19- 53

Cash Budgeting
Example - Dynamic Mattress Company
Qtr

Dynamic cash budget

1st Sources of cash collections on AR other Total Sources Uses of cash payment of AP labor and admin expenses capital expenditures taxes, interest, & dividends Total uses of cash Net cash inflow (sources minus uses) 65.0 30.0 32.5 4.0 131.5 $45.0 85.0 1.5 86.5

2nd

3rd

4th

80.3 0.0 80.3

108.5 12.5 121.0

128.0 0.0 128.0

60.0 30.0 1.3 4.0 95.3 $15.0

55.0 30.0 5.5 4.5 95.0 $26.0

50.0 30.0 8.0 5.0 93.0 $35.0

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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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Cash Budgeting
Example - Dynamic Mattress Company Dynamic short term financing requirements
Cash at start of period + Net cash flow = Cash at end of period Min operating cash balance Cumulative short term financing required (minimum cash balance minus caash at end of period)
Irwin/McGraw Hill
Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

5 - 45 - 40 5 $45

- 40 - 15 - 55 5 $60

- 55 + 26 - 29 5 $34

- 29 + 35 + 6 5 - $1

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Sources of Short Term Financing


Bank loans Commercial paper Secured loans

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19- 56

Cost of Bank Loans


Simple Interest
annual interest rate Amount of loan X number of periods in the year

Effective annual rate

(1 +
Irwin/McGraw Hill

quoted annual interest rate n

)
n

- 1

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Readings
1. S. Mian and C.W. Smith, Extending Trade Credit and Financing, Journal of Applied Corporate Finance 7, (Spring 1994), pp: 75-84 2. A. Dittmar, Corporate Cash Policy and How to Manage it with Stock repurchases, Journal of Applied Corporate Finance 20, (Summer 2008), pp: 22-34 3. M.A. Petersen and R.G. Rajan, Trade Credit: Theories and Evidence, Review of Financial Studies 10, (Fall 1979), pp:661-692

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Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved

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