financial management week 13.1
TRANSCRIPT
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Working Capital Management
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Working-Capital Management
Current Assets
Cash, marketable securities, inventory,
accounts receivable.
Long-Term Assets
Equipment, buildings, land.
Which earn higher rates of return?
Which help avoid risk of illiquidity?
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Working-Capital Management
CurrentAssets Cash, marketable securities, inventory,
accounts receivable.
Long-TermAssets Equipment, buildings, land.
Risk-Return Trade-off:Current assets earn low returns, buthelp reduce therisk of illiquidity.
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Working-Capital Management
Current Liabilities
Short-term notes, accrued expenses,
accounts payable.
Long-Term Debt and Equity
Bonds, preferred stock, common stock.
Which are more expensivefor the firm?
Which help avoid risk of illiquidity?
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Working-Capital Management
CurrentLiabilities Short-term notes, accrued expenses,
accounts payable.
Long-Term Debt and Equity Bonds, preferred stock, common stock.
Risk-Return Trade-off:Current liabilities are less expensive,but increase therisk of illiquidity.
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Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt
Preferred Stock
Common Stock
To illustrate, lets finance all current assets
with current liabilities,
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Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt
Preferred Stock
Common Stock
To illustrate, lets finance all current assets
with current liabilities, and finance all
fixed assets with long-term financing.
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Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt
Preferred StockCommon Stock
Suppose we use long-termfinancing tofinance some of our current assets.
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Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt
Preferred StockCommon Stock
Suppose we use long-termfinancing tofinance some of our current assets.
This strategy would be less risky, but more
expensive!
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Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt
Preferred Stock
Common Stock
Suppose we use current liabilitiesto financesome of our fixed assets.
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Balance Sheet
Current Assets Current Liabilities
Fixed Assets Long-Term Debt
Preferred Stock
Common Stock
Suppose we use current liabilities to financesome of our fixed assets.
This strategy would be less expensive, but
more risky!
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Inventory Management
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Inventory Management
Purchasing
Production scheduling
Efficient servicing of customer demands
Inventories provide flexibility for the firm in:
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Appropriate
Level of Inventories
Employ a cost-benefit analysis
Compare the benefitsof economies of production,
purchasing, and product marketing against thecostof the additional investment in inventories.
How does a firm determine the
appropriate level of inventories?
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How Much to Order?
Forecast usage
Ordering cost
Carrying cost
The optimal quantity to order depends on:
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Total Inventory Costs
C: Carrying costs per unit per period
O: Ordering costs per order
S: Total usage during the period
Total inventory costs (T) =C(Q / 2) + O(S/ Q)
TIME
Q / 2
QAverageInventory
INVENTORY
(inunits)
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Total Inventory Costs
EOQ (Q*) represents the minimum pointin total inventory costs.
Total Inventory Costs
Total Carrying Costs
Total Ordering Costs
Q* Order Size (Q)
Costs
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Economic Order Quantity
The EOQor
optimalquantity(Q*)
is:
The quantity of an inventory item to order sothat total inventory costs are minimized over
the firms planning period.
Q* = 2 (O) (S)C
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Example of the
Economic Order Quantity
Basket Wonders is attempting to determine the economic
order quantity for fabric used in the production of
baskets.
10,000 yards of fabric were used at a constant rate last
period.
Each order represents an ordering cost of $200.
Carrying costs are $1 per yard over the 100-day planningperiod.
What is the economic order quantity?
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Economic Order Quantity
We will solve for the economic order quantitygiven that ordering costs are $200 per order,total usage over the period was 10,000 units,
and carrying costs are $1 per yard (unit).
Q* = 2 ($200) (10,000)$1
Q* = 2,000 Units
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When to Order?
Order Point -- The quantity to which inventory must fall
in order to signal that an order must be placed toreplenish an item.
Order Point (OP) = Lead time X Daily usage
Issues to consider:
Lead Time -- The length of time between the
placement of an order for an inventory item andwhen the item is received in inventory.
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Example of When to Order
Julie Miller ofBasket Wonders has determined that ittakes only 2 days to receive the order of fabric after the
placement of the order.
When should Julie order more fabric?
Lead time = 2 days
Daily usage = 10,000 yards / 100 days= 100 yards per day
Order Point = 2 days x100 yards per day=200 yards
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Example of When to Order
0 18 20 38 40Lead
Time
200
2000
OrderPointU
NITS
DAYS
Economic Order Quantity (Q*)
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Order Point Problem
Average EOQinventory 2
= + safety stock
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Safety Stock
Our previous example assumed certaindemand and lead
time. When demand and/or lead time are uncertain, then
the order point is:
Order Point =
(Avg.lead time xAvg.daily usage) + Safety stock
Safety Stock-- Inventory stock held in reserve as acushion against uncertain demand (or usage) and
replenishment lead time.
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Order Point
with Safety Stock
0 18 20 38
400
2000
OrderPoint
UNITS
DAYS
2200
Safety Stock200
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How Much Safety Stock?
Amount of uncertainty in inventory demand
Amount of uncertainty in the lead time
Cost of running out of inventory
Cost of carrying inventory
What is the proper amount of safetystock?
Depends on the:
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The cash conversion cycle focuses on the timebetween payments made for materials and laborand payments received from sales:
Cash Inventory Receivables Payablesconversion = conversion + collection - deferral .
cycle period period period
Cash Conversion Cycle
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Cash Conversion Cycle
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CCC = +
CCC = + 45.6 30
CCC = 75.7 + 45.6 30
CCC = 91.3 days.
Days per yearInv. turnover
Payablesdeferralperiod
Days salesoutstanding
3654.82
Cash Conversion Cycle
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Accounts Receivable
Management
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Accounts Receivable
Management
Size of I nvestment in Accounts Receivable
Percent of Credit Sales to Total Sales
Level of Sales Terms of Sale
Quality of Customer
Collection Efforts
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Accounts Receivable
Management
Terms of Sale
Quoted as a/b net c, which means
deduct a%if paid within bdays,otherwise pay within cdays.
Example: 3/30 net 60means
deduct 3% if paid within 30 days,otherwise pay the entire amount
within 60 days.
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Accounts Receivable
Management
Terms of Sale
Annualized opportunity cost offoregoing a discount:
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x
Accounts Receivable
Management
Terms of Sale
Annualized opportunity cost offoregoing a discount:
a 360*
1 - a c - b
*or 365
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a 360
1 - a c - bx
Accounts Receivable Management
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a 360
1 - a c - b
Opportunity cost of foregoing 3/30 net 60:
x
Accounts Receivable Management
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a 360
1 - a c - b
opportunity cost of foregoing 3/30 net 60:
.03 360
1 - .03 60 - 30x
x
Accounts Receivable Management
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a 360
1 - a c - b
opportunity cost of foregoing 3/30 net 60:
.03 360
1 - .03 60 - 30
= 37.11%
x
x
Accounts Receivable Management
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Accounts Receivable Management
It means oportunity cost 3% discount is
37.11% (annualy).
It is the opportunity cost if we forgo the cash
discount.
Then, we can assume it is a financing costsimilar to the interest on a loan.
Compare that cost with the cost of a bank loan.
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Accounts Receivable Management
Should choose the cheapest source of funding.
The cost of trade credit depends on credit
terms.
The higher the discount percentage offered, the
greater the cost of forgoing the discount.
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Accounts Receivable Management
2/10 net 30
0.02/(1-0.02) x 365/(30-10) = 0.020 x 18,25 =
0.365 or 36,5 % pa
Then, we compare with benchmark, say bank
rate. If the banks rate is 22%, we should take
the discount
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Account Receivables Management
Marginal/Incremental Analysis
Step 1. Estimate changes in profit
Step 2. Estimate additional cost in account
receivables and inventory
Step 3. Estimate cost of discount (if there is a
change in cash discount)
Step 4. Compare incremental income withincremental cost
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Account Receivables Management
Dennis Corporation credit sales is $8,000,000. It is collected
within 30 days. Bad debt at this moment is $240,000 and
opportunity cost is 15%. He calculates that variabel cost is
75% of sales price.
Dennis is considering to relax the credit standard from 1/30,net 60 become 1/45, net 60. He believes that the new credit
standard will generate new credit sales become $9,000,000 and
half of his customer will take the new cash discount. He also
considers that bad debt of new credit standard will increase.He assumes 6% of new credit sales is bad debt. Furthermore,
He estimates new investment in inventory level is about
$25,000.
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Account Receivables Management
Relevan Information from Dennis Corp. New credit sales $9,000,000
Previous credit sales $8,000,000
Contribution margin (assumed for 1 unit) 25% (pricevar.cost)
New bad debt level 6%
New DSO 45 days
Previous DSO 30 days
Rate of return 15%
New cash discount 1%
Percentage of customers taking 50%
new cash discount
Additional investment in inventory $25,000
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Account Receivables Management
Step 1. Estimate changes in profit
Changes in Profit = (Increase in sales x contribution margin)
increase in sales x new bad debt level)
= ($1,000,000 x 0,25)($1,000,000 x 0.06)
= $190,000
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Account Receivables Management
Step 2. Estimate additional cost in account receivables and
inventory
Add.cost in A/R and inv = (Add. A/R + add. Inv.) x rate of return
Add. A/R = (New sales x new DSO)(Previous sales x previous DSO)Add. A/R =(9,000,000 x 45/360)(8,000,000 x 30/360) = 458,340
Add.cost in A/R and Inv. = (458,340 + 25,000) x 0.15 = 72,501
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Account Receivables Management
Step 3. Estimate cost of discount (if there is a change in
cash discount) Cost of disc. = (New sales level x new cash disc. x % of customer taking new
disc.)(previous sales level x prev. cash disc. X % of customer taking
prev.disc.)
Cost of disc. = ($9,000,000 x 0.01 x 0.50)($8,000,000 x 0.01 x 0)
= $45,000
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Account Receivables Management
Step 4. Compare incremental income with
incremental cost
Step 1(Step 2 + Step 3)
=$190,000($72,501 + $45,000) = $72,499 Conclusion: Dennis should take new credit standard
as new incremental income higher than incremental
cost.