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Working Capital Management:

Introduction
 The concept of working capital management
originated with the old Yankee peddler, who
would borrow to buy inventory, sell the
inventory to pay off the bank loan, and then
repeat the cycle
 Working Capital
 A firm’s investment in short-term assets (cash,
marketable securities, inventory, and accounts
receivable)

May 27, 2020 Lecture7_Working Capital Management 1


Working Capital Management:
Introduction

 Working Capital Terminology


 “Gross” working capital - simply refers to
current assets
 “Net” working capital - defined as current
assets minus current liabilities
 Current assets: assets normally converted into
cash within one year (i.e. cash, marketable
securities, receivables, inventories)
 Current liabilities: liabilities expected to be
liquidated within one year
May 27, 2020 Lecture7_Working Capital Management 2
Working Capital Management:
Introduction
 Working capital management refers to a
firm’s investment in (and administration of)
short-term assets (current assets) and
current liabilities
 This is done within policy guidelines
 Working capital policies are the firm’s basic
policies regarding target levels for each category
of current assets and how current assets will be
financed

May 27, 2020 Lecture7_Working Capital Management 3


Working Capital Management:
Introduction
 Working capital management has 2 major/broad
objectives:
 To increase the profitability of a company
 To ensure that it has sufficient liquidity to meet short-
term obligations as they fall due and so continue as a
going concern
 Note that the twin goals of profitability and liquidity
will often conflict – How?
 as assets become more liquid they give rise to lower
returns - How?
May 27, 2020 Lecture7_Working Capital Management 4
Working Capital Management:
Introduction
 Working Capital Decision Areas
 Alternative working capital policies
 Cash management
 Inventory management
 Accounts receivable management
 Working capital financing policies
 Trade credit

May 27, 2020 Lecture7_Working Capital Management 5


Working Capital Policies

 Working Capital policies will need to take


into account a number of factors:
 the nature of the firm’s business
 Different businesses will have different working
capital requirements
 reflect the credit policies of a company’s
competitors:
 It makes no economic sense to lose business
because of an unfavourable comparison of trade

May 27, 2020 Lecture7_Working Capital Management 6


Working Capital Policies
 Working capital policies can be classified as:
 Aggressive (also called restricted policy)
 Moderate (Sometimes also called “relaxed policy”)
 Conservative
 Note that working capital policies can be
classified when comparing them with those of
similar companies
 There are no specific benchmarks for classification

May 27, 2020 Lecture7_Working Capital Management 7


Working Capital Policies
 Aggressive Working Capital policies:
 a firm chooses to operate with lower levels
of stock, debtors and cash, for a given level
of activity or sales
 An aggressive policy
 increases profitability, since less cash is tied
up in current assets
 increases risk, since the possibility of cash
shortages or running out of stock (i.e.
stockouts) is increased
May 27, 2020 Lecture7_Working Capital Management 8
Working Capital Policies
 Conservative working capital policy:
 A more flexible working capital policy for a given level of
turnover.
 This policy implies:
 maintaining a larger cash balance;
 investing in short-term securities;
 offering more generous credit terms to customers;
 holding higher levels of stock
 This a policy gives rise to a lower risk of financial or
stock problems, but at the expense of reducing
profitability

May 27, 2020 Lecture7_Working Capital Management 9


Working Capital Policies
 Moderate Working Capital policy:
 This would tread a middle path between
aggressive and conservative approaches
 The three WC policy approaches are
shown in figure 1

May 27, 2020 Lecture7_Working Capital Management 10


Working Capital Policies

Figure 1: Level of investment in working


capital Conservative
Level of
W/Capital Moderate
investment
Aggressive

Turnover (Tshs)
May 27, 2020 Lecture7_Working Capital Management 11
Working Capital Policies:
Example
Sikujua Ltd (SKL)
SKL Ind. Avg.
Current ratio 1.75x 2.25x
Debt/Assets 58.76% 50.00%
Turnover of cash & securities 16.67x 22.22x
DSO (days) 45.63 32.00
Inv. turnover 4.82x 7.00x
F. A. turnover 11.35x 12.00x
T. A. turnover 2.08x 3.00x
Profit margin 2.07% 3.50%
ROE 10.45% 21.00%

May 27, 2020 Lecture7_Working Capital Management 12


Working Capital Policies: Example
 How does SKL’s working capital policy
compare with its industry?
 SKI appears to have large amounts of
working capital given its level of sales.
 Working capital policy is reflected in current
ratio, turnover of cash and securities, inventory
turnover, and DSO.
 These ratios indicate SKI has large amounts of
working capital relative to its level of sales.
 What does this imply regarding SKL’s policy?
 SKI is either very conservative or inefficient.
May 27, 2020 Lecture7_Working Capital Management 13
Working Capital Policies: Example

 Is SKL inefficient or just conservative?


 A conservative (relaxed) policy may be
appropriate if it leads to greater profitability.
 However, SKL is not as profitable as the
average firm in the industry. This suggests
the company has excessive working capital

May 27, 2020 Lecture7_Working Capital Management 14


Financing Working Capital
 To assist in policy decisions on the financing of
WC a firm’s assets are divided into 3 categories
(Cheatham, 1989):
 fixed assets - long-term assets from which a
company expects to derive benefit over several years
 permanent current assets - represent the core
level of investment needed to sustain normal levels
of trading activity (e.g. investment in buffer stock)
 fluctuating current assets - the variations in the
level of current assets arising from normal business
activity
May 27, 2020 Lecture7_Working Capital Management 15
Financing Working Capital
 Short-term sources of finance are usually cheaper
and more flexible than long-term sources.
 Comparing overdraft rates with long-term loan rates
 However, short-term sources of finance are riskier
than long-term sources from a borrower’s point of
view
 may not be renewed (e.g. an overdraft is technically
repayable on demand);
 or can be renewed on less favourable terms

May 27, 2020 Lecture7_Working Capital Management 16


Financing Working Capital

 Another source of risk for the borrower is that


interest rates are more unstable in the short term
than in the long term
 The risk will be compounded if floating rate short term
debt is used.
 Thus, a company must balance profitability and
risk in reaching a decision on how the funding of
current and fixed assets is divided between long-
term and short-term sources of funds.

May 27, 2020 Lecture7_Working Capital Management 17


Financing Working Capital
 There are three types of funding policies
 Matching (or “asset permanence”) funding policy
 Conservative funding policy
 Aggressive funding policy
 Matching funding policy
 Financing current assets with short-term funds, while
financing permanent current assets and fixed assets
with long term funds
 The maturity of funds roughly matches the maturity of
the different types of assets.

May 27, 2020 Lecture7_Working Capital Management 18


Financing Working Capital:
Matching
Tshs
Temp. C.A.
S-T
(FCA) Loans

Perm C.A. L-T Fin:


Stock,
Bonds,
Fixed Assets Spon. C.L.

Years
Note: Lower dashed line would be more aggressive.
May 27, 2020 Lecture7_Working Capital Management 19
Financing Working Capital
 Conservative Funding Policy
 Uses long-term funds to finance not only
fixed assets and permanent current assets,
but some fluctuating current assets as well.
 As there is less reliance on short-term funding,
the risk of such a policy is lower.
 The higher cost of long-term finance means that
profitability is reduced as well.
May 27, 2020 Lecture7_Working Capital Management 20
Financing Working Capital:
Conservative
Tshs Marketable (Long-term finance reinvested short-term)
securities
Zero S-T
Debt
FCA
L-T Fin:
Perm C.A. Stock,
Bonds,
Spon. C.L.
Fixed Assets
Years
May 27, 2020 Lecture7_Working Capital Management 21
Financing Working Capital
 Aggressive Funding Policy
 Uses short term funds to finance not only
fluctuating current assets, but some
permanent current assets as well.
 Carries the greatest risk to solvency, but also
offers the highest profitability.

May 27, 2020 Lecture7_Working Capital Management 22


Financing Working Capital
 Aggressive Funding Policy
 Uses short term funds to finance not only
fluctuating current assets, but some
permanent current assets as well.
 Carries the greatest risk to solvency, but also
offers the highest profitability.

May 27, 2020 Lecture7_Working Capital Management 23


Financing Working Capital:
Aggressive
Tshs
Temp. C.A.

FCA S-T
Loans
Perm C.A.
L-T Fin:
Stock,
Fixed Assets Bonds,
Spon.
C.L.
Years
Note: Lower dashed line would be more aggressive.
May 27, 2020 Lecture7_Working Capital Management 24
Working Capital and the Cash
Conversion Cycle (CCC)
 The general concept of liquidity requirements (cf the
peddler effect) has been applied to more complex
businesses, and it is useful when analysing the
effectiveness of a firm’s working management process
 This gives rise to the concept of the cash conversion
cycle (CCC) - the length of time from the payment for
the purchase of the raw materials to the collection of
accounts receivable generally by the sale of the final
product

May 27, 2020 Lecture7_Working Capital Management 25


Working Capital and the Cash
Conversion Cycle (CCC)
 CCC is the period of time between the outlay on
raw materials and the inflow of cash from the sale
of finished goods
 Represents the number of days of sales for which
financing is needed
 Represents the interaction between the components of
working capital and the flow of cash within a company
 Can be used to determine the amount of cash
needed for any sales level

May 27, 2020 Lecture7_Working Capital Management 26


Working Capital and the Cash
Conversion Cycle (CCC)
 The CCC involves five basic steps:
1. A firm orders and receives materials it
needs to produce the product.
2. Labour will be used to convert the
materials into finished products
3. The finished products are sold (on credit)
creating receivables (not immediate cash)

May 27, 2020 Lecture7_Working Capital Management 27


Working Capital and the Cash
Conversion Cycle (CCC)
 CCC Steps (Cont)
4. At some point during the cycle, the firm has
to pay off its accounts payable and accrued
wages
5. The cycle is completed when the firm’s
receivables have been collected

May 27, 2020 Lecture7_Working Capital Management 28


Working Capital and the Cash
Conversion Cycle (CCC)
 The length of the CCC affects the amount of
investment required to be made in working capital
 the greater will be the amount of investment required to
be made in working capital
 The length of the CCC depends on the length of:
 The Inventory conversion period (ICP)
 The debtor (or receivable) collection period (RCP)
 The creditor (or payable) deferral period (PDP)

May 27, 2020 Lecture7_Working Capital Management 29


Working Capital and the Cash
Conversion Cycle (CCC)
 The Inventory conversion period (ICP)
 the average time taken to use up raw materials,
added to the average time taken to convert raw
materials into finished goods
 ICP is calculated by dividing inventory by
sales per day:
 ICP = Inventory/sales per day
 = Inventory/(annual sales/360)

May 27, 2020 Lecture7_Working Capital Management 30


Working Capital and the Cash
Conversion Cycle (CCC)
 The receivable collection period (RCP)
 the average time taken by credit customers to
settle their accounts (Collection of cash following
sale)
 Also called the days sales outstanding (DSO) and is
calculated as receivables/Sales per day
 RCP = DSO = Receivables/sales per day
 = Receivables/(sales/360)

May 27, 2020 Lecture7_Working Capital Management 31


Working Capital and the Cash
Conversion Cycle (CCC)
 The Payable deferral period (PDP)
 the average time taken by a company to
settle accounts with its suppliers
 i.e. The average length of time between the
purchase of materials and labour and the
payment of cash for them
 For example, the firm might on average have 30
days to pay for labour and materials

May 27, 2020 Lecture7_Working Capital Management 32


Working Capital and the Cash
Conversion Cycle (CCC)
 The length of the CCC nets out the 3: (i.e.
ICC, RCP, PDP)
 CCC equals the length of time between the firm’s
actual cash expenditure to pay for productive
resources (material and labour) and its own cash
receipts from the sale of products
 The length of time between paying for labour and
materials and collecting on receivables.
 Measures the average length of time cash is tied up
in current assets.
 CCC = ICP + RCP - PDP
May 27, 2020 Lecture7_Working Capital Management 33
The Cash Conversion Cycle
Cash balance

PDP

R/Ms WIP Finished RCP


Stock goods

Time
0 t1 t2 t3 t3
May 27, 2020 Lecture7_Working Capital Management 34
The Cash Conversion Cycle
 Goods ordered at time 0
 Goods received at time t1
 Length between 0 and t1 depends on lead time
 Production starts sometime after t1 and ends sometime before
t3
 Payment for purchases made at time t2
 Length between t1 and t2 depends on credit terms received from suppliers and their
collection efficiency
 Goods sold at time t3
 Money for goods sold received at time t4
 Length between t3 and t4 depends on credit terms given to customers and efficiency
of collection

May 27, 2020 Lecture7_Working Capital Management 35


The Cash Conversion Cycle
 The CCC shows the relationship between:
 The inventory conversion period (t1 – t3 which
depends on company’s production efficiency)
 The debtor deferral period or receivables
collection period (t3 – t4 which depends on
company’s collection efficiency and policy)
 The creditor deferral period or payables deferral
period (t1 – t2 which depends on suppliers’
credit terms and collection efficiency)

May 27, 2020 Lecture7_Working Capital Management 36


The Cash Conversion Cycle
Inventory Receivables Payables
CCC = conversion + collection – deferral
period period period
Payables
Days per year Days sales
CCC = Inv. turnover + outstanding – deferral
period

May 27, 2020 Lecture7_Working Capital Management 37


The cash conversion cycle model

Finished goods Sold

ICP RCP
(72 days) (24 days)

PDP
(30 days) CCC
(72 + 24 – 30 = 66 days)

R/M Received Cash paid for R/M purchased on credit A/R Collected
Days

May 27, 2020 Lecture7_Working Capital Management 38


Working Capital and the Cash
Conversion Cycle (CCC)

 Approximating the ICP, RCP and PDP by using


financial ratios of stock turnover, debtors’ ratio
and creditors’ ratio, the length of the CCC is
given by:
 CCC = (stock turnover) + (debtors’ ratio) -
(creditors’ ratio)

May 27, 2020 Lecture7_Working Capital Management 39


Working Capital Investment and
Financing Policies
 Working capital policy involves two basic
questions:
1. What is the appropriate level for current
assets, both in total and by specific
accounts?
2. How should current assets be financed?

May 27, 2020 Lecture7_Working Capital Management 40


Accounts Receivables
 Credit vs. Cash sales
 Benefits vs. costs of credit sales
 Credit policy
 Who to grant credit and how much
 Credit terms
 Collection of accounts receivables

May 27, 2020 Lecture7_Working Capital Management 41


Accounts Receivables
 Examples:
 Malingumu, a kiosk owner, buys all his merchandise from
Halimoja Wholesalers. Due to the long standing
relationship Halimoja offers Malingumu 30 days credit
which has recently been reviewed to 2/10 net-30.
Normally, Malingumu has been settling his accounts in 35
days without a penalty. Malingumu has an average credit
history and believes that a short-term line of credit from a
bank will attract interest in the 23% - 26% per annum
region. He is therefore resigned to take up the cash
discount. Is he making the right choice?

May 27, 2020 Lecture7_Working Capital Management 42


Accounts Receivables
 Examples:
For the past few years Fabio Company has been making credit sales on ‘net-30’
terms. Annual credit sales currently stand at Shs. 72 million and it takes an
average of 60 days to collect receivables. To speed up collection, the company
is considering offering terms of 2/10, net 30. It anticipates that credit
customers taking advantage of the discount will represent 40% of the sales
volume and average collection period will be shortened by 25 days. However
the change will not affect the volume of credit sales. Assuming a year with 360
days and 12% as cost of capital for Fabio:
 Should the new credit policy be adopted?
 For each of the following variable, determine the level that is needed for the
new credit policy to break-even:
 The average collection period
 Proportion of sales for customers taking up the discount
 Credit sales (assume a net profit margin of 5%)s

May 27, 2020 Lecture7_Working Capital Management 43


Accounts Receivables
 Examples:
Banka Matata Ltd (BML) sells printer cartridges and does not extend credit to its
customers. A study commissioned last month revealed that, by offering credit
and keeping the price unchanged, BML can increase sales by 40 percent – all
new credit customers – while half of the current sales will migrate to credit
sales. The cost per unit, however, will increase on average by Shs. 100
reflecting the expenses associated with accounts receivable. The probability of
a customer making a payment on a credit sale is 96 percent. Currently BML
sells 10,000 cartridges at shs. 9600 per unit and the cost is shs 8600 per unit.
 Should BML extend credit to its customers?
 How much should the price change for the credit extension plan to break
even?
 How much should the probability of credit customer making repayment be for
the credit extension plan to break even?

May 27, 2020 Lecture7_Working Capital Management 44


Inventory Management
 Significant amounts of WC can be invested
in stocks of raw materials, work-in-progress
and finished goods
 Stocks of RMs and WIP can act as a buffer
between different stages of the production
process and so ensure its smooth operation
 Stocks of FGs allow the sales department of a
company to satisfy customer demand without
unreasonable delay and potential loss of sales

May 27, 2020 Lecture7_Working Capital Management 45


Inventory Management
 The benefits of holding stocks must be weighed
against any costs incurred in order to determine
the optimal stock levels.
 The optimal stock held depends on
 holding costs (such as insurance, rent and utility
charges)
 replacement costs, including the cost of obsolescence
 the cost of the stock itself
 the opportunity cost of cash tied up in stock

May 27, 2020 Lecture7_Working Capital Management 46


Inventory Management
 The classical stock management model is the
Economic Order Quantity (EOQ)
 It establishes an optimum level of stock by:
 balancing the cost of holding stock against the cost of ordering
fresh supplies
 Using the optimal level of stock as the basis of a minimum cost of
procurement policy
 The EOQ model assumes for the period under
consideration, costs and activity are constant and
known with certainty.
 Because these steady-state assumptions are made, it is also called
a deterministic model
 It makes no allowance for the existence of buffer stocks

May 27, 2020 Lecture7_Working Capital Management 47


Inventory Management
 If a constant rate of stock consumption is
assumed:
 holding costs will increase as average stock levels and
order quantities increase;
 ordering costs will decrease as order quantity
increases and the number of orders falls.
 The EOQ occurs when the total costs, which is
the sum of the holding cost and the ordering
cost, is at a minimum.
 Total Cost = Total holding cost + Total ordering cost

May 27, 2020 Lecture7_Working Capital Management 48


Inventory Management
 Algebraically, the cost equation is:
TC = [(Q x H)/2 + (D x O)/Q]
Where:
H = holding cost per unit
D = annual demand in units per year
O = ordering cost per order
Q = order quantity in units
 The relationship is shown in the following figure

May 27, 2020 Lecture7_Working Capital Management 49


Inventory Management
 The minimal cost occurs when holding cost and
ordering cost are equal, as can be shown by
differentiating the total cost equation with respect
to Q and setting to zero.
 Putting holding cost equal to ordering cost and
rearranging gives:
 Q = [(2 x O x D)/H]½
 Q is now the order quantity which
minimizes the sum of HC and OC
May 27, 2020 Lecture7_Working Capital Management 50
The EOQ
Cost Total cost
Tshs
Holding cost

Ordering cost

Order Quantity
0 Q*

May 27, 2020 Lecture7_Working Capital Management 51


The Management of Cash
 Cash management is part of a wider task of
treasury management
 It is concerned with optimizing the amount
of cash available to the company, by:
 maximizing the interest earned by spare funds
not required immediately, and
 reducing any losses caused by delays in the
transmission of funds.
May 27, 2020 Lecture7_Working Capital Management 52
The Management of Cash (Cont..)

 Holding cash to meet short-term needs


carries the opportunity cost of the return
which could have been earned if the cash
had been invested or put to productive use.
 However, choosing to reduce this
opportunity cost by operating with very
small cash balances will increase the risk of
being unable to meet debts as they fall due.
May 27, 2020 Lecture7_Working Capital Management 53
Reasons/Motives for Holding Cash

 Cash doesn’t earn a profit, so why hold it?


 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

May 27, 2020 Lecture7_Working Capital Management 54


Why manage Cash?
 The goals of managing cash:
 To meet 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

May 27, 2020 Lecture7_Working Capital Management 55


Optimum Cash Levels
 The optimum cash level will vary between companies and
over time
 For a given company, the optimum amount of cash to
hold will depend upon:
 forecasts of the future cash inflows and outflows of the company
 the efficiency with which the cash flows of the company are
managed
 the availability to the company of liquid assets
 the company’s borrowing capacity
 the company’s tolerance of risk.

May 27, 2020 Lecture7_Working Capital Management 56


Management of Cash Flows
 Cash flows should be efficiently managed. How?
 Debts should be collected in line with agreed credit terms
 Cash should be banked as soon a possible
 To reduce the interest charged on amounts outstanding on
agreed overdraft accounts
 To increase the interest earned on cash deposited
 Available credit offered by suppliers should be used to the
full and payments made as late as possible as long as the
benefit of this course of action is greater than the net
benefit to be derived from accepting any discounts
offered for early payments

May 27, 2020 Lecture7_Working Capital Management 57


Cash management techniques
 Simple Cash management techniques fall
into five categories:
 Cash flow synchronization
 Using float
 Accelerating collections
 getting available funds to where they are
needed
 controlling disbursements.
May 27, 2020 Lecture7_Working Capital Management 58
Cash management techniques

 Cash flow synchronization


 A situation in which inflows coincide with
outflows, thereby permitting a firm to hold
low transactions balances
 This can be achieved by firms correctly
forecasting their cash inflows and outflows
 i.e. it is determined in the market place, varying
as conditions change

May 27, 2020 Lecture7_Working Capital Management 59


Cash management techniques

 Using float
 Float is the term used to the amount of
money tied up in the period between the
initiation of payment and the point at which
money appears in the company’s bank
account.
 It is the difference between the balance
shown in a firm’s (or individual’s) checkbook
and the balance on the bank’s records

May 27, 2020 Lecture7_Working Capital Management 60


Cash management techniques
 Float is due to:
 Transmission delay – time taken for a payment to
pass from payer to payee (i.e. payment float)
 Lodgement delay – the delay in banking payments
received (i.e. processing float)
 Clearance delay – the time taken by a bank to clear
a presented instruction to pay (i.e. clearance float)
 Thus there are three types of float:
 Disbursement float
 Collection float
 Net float outflows
May 27, 2020 Lecture7_Working Capital Management 61
Cash management techniques
 Float can be reduced by minimizing lodgement delay
and simplifying and speeding up the banking of cash.
 Steps to keep float to a minimum:
 Use a lockbox.
 Insist on wire transfers from customers.
 Synchronize inflows and outflows.
 Use a remote disbursement account.
 Increase forecast accuracy to reduce need for “safety stock”
of cash.
 Hold marketable securities (also reduces need for “safety
stock”).
 Negotiate a line of credit (also reduces need for “safety
stock”). outflows

May 27, 2020 Lecture7_Working Capital Management 62


Cash Management Models

 There are some models which can assist


the financial manager in determining his
firm’s optimum cash balance
 The deterministic model (e.g. Baumol model)
 Stochastic models (e.g. Miller-Orr model)

May 27, 2020 Lecture7_Working Capital Management 63


The Baumol Model
 The model is based on a number of assumptions:
 The firm has a steady demand for cash over some
period of time (i.e. cash usage is linear over time)
 All of the firm’s receipts (from debtors, etc.) are put
straight into an interest yielding deposit or marketable
securities.
 The firm gets cash during this time by drawing down
the deposit or selling marketable securities
 Cash is always replenished to the maximum required
when the balance reaches zero
 There could be a cushion for buffer stocks of cash or if there
is an extended lead time

May 27, 2020 Lecture7_Working Capital Management 64


The Baumol Model
 The model assumes the following cash
pattern:
Amount of Cash

C/2

Time

May 27, 2020 Lecture7_Working Capital Management 65


The Baumol Model
 The model derives the amount of money to
withdraw from the deposit so that the cost
of withdrawal are optimally balanced with
those of interest, etc forgone by holding
cash

May 27, 2020 Lecture7_Working Capital Management 66


The Baumol Model (Cont..)
 The model can be stated as:
2WP
C 
 Where: H
 C = the optimum amount of cash to be withdrawn each time
 W = the cost of making each withdrawal (a cost independent of the
size of the withdrawal)
 P = the planned payments for the forthcoming time period
 H = the interest forgone on the cash withdrawal (i.e. the interest
rate of the deposit)

May 27, 2020 Lecture7_Working Capital Management 67


The Miller-Orr Model
 Merton Miller and Daniel Orr expanded the Baumol
model by incorporating a stochastic generating
process for periodic changes in cash balances
 In contrast to the deterministic assumptions of the
Baumol model
 With the Miller-Orr model, the changes in cash
balances over a given period are assumed to be
random in both size and direction

May 27, 2020 Lecture7_Working Capital Management 68


The Miller-Orr Model (Cont..)
Cash balance
Upper control limit
h

Z Return point

Lower control limit

Time
May 27, 2020 t1 t
Lecture7_Working Capital2Management 69
Miller - Orr Model (Cont..)
 The model specifies two control limits
 h - an upper bound and zero - a lower bound
 Note: The minimum bound can be set at some amount
higher than zero and h and Z would move up in the figure
 When the cash balance touches the upper bound h -
z of marketable securities are bought and the new
balance becomes z
 When the cash balance touches zero, z marketable
securities are sold and the new balance becomes z

May 27, 2020 Lecture7_Working Capital Management 70


The Miller-Orr Model (Cont..)
 As long as the cash balance fluctuates somewhere
between the upper and lower limits, no action is
taken
 Note that the minimum bound can be set at some
amount higher than zero, and h and z would move up in
the figure
 The solution for the optimal values of h and z
depend on:
 the fixed costs,
 the opportunity costs, and
 The degree of likely fluctuation in cash balances
May 27, 2020 Lecture7_Working Capital Management 71
The Miller-Orr Model (Cont..)
 The optimal value of z is:
3b 2
z  3
4i
 Where:
 b = fixed cost associated with a security transaction
 2 = variance of daily net cash flows
 i = interest rate per day on marketable securities

May 27, 2020 Lecture7_Working Capital Management 72


The Miller-Orr Model (Cont..)
 The optimal value of h is 3z
 With these control limits set, the model minimizes
the total costs (fixed and opportunity) of cash
management
 Note that the critical assumption is that cash flows
are random.
 Thus the average cash balance cannot be determined
exactly in advance, but it is approximately (z + h)/3.

May 27, 2020 Lecture7_Working Capital Management 73


Alternative Current Assets
Financing Policies
 Current assets financing requirements
depend on:
 The nature of business
 Some businesses experience seasonal and/or
cyclical fluctuations while others don’t
 The financial strength of the company
 The performance of the economy

May 27, 2020 Lecture7_Working Capital Management 74


Alternative Current Assets
Financing Policies
 Advantages of short-term financing:
 Speed
 a short-term loan can be obtained much faster than long-
term credit
 Flexibility
 if its needs for funds are seasonal or cyclical, a firm may
not want to commit itself to long-term debt
 Cost
 Under normal conditions interest rates are generally lower
on short-term than long-term loans

May 27, 2020 Lecture7_Working Capital Management 75


Alternative Current Assets
Financing Policies
 The main disadvantages of short-term
financing is RISK
 although short-term debt is often less expensive
than long-term debt, short-term credit subjects the
firm to more risk than does long-term financing.
 Why?
 If a firm borrows on a long-term basis, its interest
costs will be relatively stable over time, but if it
uses short-term credit, its interest expense will
fluctuate widely at times going quite high.

May 27, 2020 Lecture7_Working Capital Management 76


Alternative Current Assets
Financing Policies
 Why short-term funds are riskier? (cont..)
 If a firm borrows heavily on a short-term
basis, it may find itself unable to repay this
debt, and it may be in such a weak financial
position that the lender will not extend the
loan which may end up forcing a firm into
bankruptcy.

May 27, 2020 Lecture7_Working Capital Management 77


Alternatives for Short-term
Finance
 There are 4 sources of short-term finance:
 Accruals
 Accounts payable (Trade credit)
 Bank loans
 Commercial paper.

May 27, 2020 Lecture7_Working Capital Management 78


Alternatives for Short-term
Finance
 Accruals:
 Continuously recurring short-term liabilities,
especially accrued wages and accrued taxes
 Usually, they increase automatically, or
spontaneously, as a firm’s operations
expand
 It is a “free” debt because no explicit
interest is paid on funds raised through
accruals
May 27, 2020 Lecture7_Working Capital Management 79
Alternatives for Short-term
Finance
 Accounts payable (Trade credit):
 Interfirm debt arising from credit sales and
recorded as an account receivable by the seller and
as an accounts payable by the buyer.
 The cost of trade credit is calculated as:
 APC = [DP/(1 - D%)] [360/(DCO - DP)]
 Where:
 APC = Approximate percentage cost
 DP = Discount period
 D% = Discount percent
 DCO = Days credit outstanding
May 27, 2020 Lecture7_Working Capital Management 80
Alternatives for Short-term
Finance
 Trade credit can be divided into two
components:
 Free trade credit - credit received during the
discount period
 Costly trade credit - credit in excess of the
free trade credit and whose cost is an
implicit one based on the foregone
discounts

May 27, 2020 Lecture7_Working Capital Management 81


Alternatives for Short-term
Finance
 Short-term bank loans
 Considerations:
 Maturity - the bulk of bank lending is on a short-
term basis.
 Promissory notes - When a bank loan is approved,
normally it is executed by signing a document
specifying:
 the amount borrowed
 the percentage interest rate
 the repayment schedule
 any collateral for security
 any other agreed terms and conditions
May 27, 2020 Lecture7_Working Capital Management 82
Alternatives for Short-term
Finance
 Basic types of Short-term bank loans
 Line of credit
 arrangement to which a bank agrees to lend up
to a specified maximum amount of funds during
a designated period
 Revolving credit agreement
 a formal committed line of credit extended by a
bank or other lending institution

May 27, 2020 Lecture7_Working Capital Management 83


Alternatives for Short-term
Finance
 The cost of bank loans
 Prime rate
 interest rate banks charge their most
creditworthy customers.
 Interest on bank loans are calculated in
three ways:
 Simple interest
 Discount interest
 Add-on interest

May 27, 2020 Lecture7_Working Capital Management 84


Alternatives for Short-term
Finance
 The cost of bank loans: Simple interest
 Borrower receives the face value of the loan
and repays the principal and interest at
maturity
 Computation: for a period of one year or
more
 EAI = Interest/amount received
 Where EAI = Effective annual interest

May 27, 2020 Lecture7_Working Capital Management 85


Alternatives for Short-term
Finance
 The cost of bank loans: Simple interest
(Cont..)
 For a period of one or more years, the
nominal rate equals the effective rate
 For a period less than one year the effective
rate is calculated as:
 EAI = (1+kNom/m)m - 1.0
 Where kNom is the nominal or quoted rate and m
is the number of loan periods per year (i.e.
360/loan period)
May 27, 2020 Lecture7_Working Capital Management 86
Alternatives for Short-term
Finance
 The cost of bank loans: Simple interest
with compensating balance
 A minimum balance that a firm must
maintain with a commercial bank (generally
equal to 10% to 20% of the amount of
loans outstanding
 Face value = Funds required /[1.0 - CB (fraction)]
 EARSimple CB = Interest/Amount received
 Alternatively:
 EARSimple CB = Nominal rate (%)/[1.0 - CB (fraction)]
May 27, 2020 Lecture7_Working Capital Management 87
Alternatives for Short-term
Finance
 The cost of bank loans: Discount interest
with compensating balance:
 Face value = FR/[1.0 - NR (fraction) - CB
(fraction)]
 Where: FR = Funds received; NR
(fraction) = nominal rate as a fraction;
CB (fraction = compensating balance
as a fraction
 EARDiscount CB = NR (%)/[1.0 - NR (fract.) - CB
(fract)] - 1.0
May 27, 2020 Lecture7_Working Capital Management 88
Alternatives for Short-term
Finance
 The cost of bank loans: Discount interest
 In a discount interest loan, the bank
deducts the interest in advance (discounts
the loan). Thus the borrower receives less
than the face value of the loan
 Interest calculated on the face amount of a
loan but is paid in advance
 If the discount loan is for a period of less
than one year, its effective annual rate is
found as follows:
 EAIDiscount = [(1.0 + interest)/(Face value - interest)]m - 1.0
May 27, 2020 Lecture7_Working Capital Management 89
Alternatives for Short-term
Finance
 The cost of bank loans: Add-on interest
 Interest that is calculated and added

to funds received to determine the


face amount of an installment loan
 AEARAdd-on = [Interest /(Amount received/2)]
 Where: AEARAdd-on =Approximate effective annual
rate (add-on)

May 27, 2020 Lecture7_Working Capital Management 90


Alternatives for Short-term
Finance
 Commercial Paper
 short-term (up to 270 days) unsecured debt
(promissory notes) issued by large firms
 High quality hence usually carry low interest
rate
 somewhat below the prime rate
 The rate of commercial paper fluctuates
with supply and demand conditions
 i.e. it is determined in the market place, varying
as conditions change

May 27, 2020 Lecture7_Working Capital Management 91