learning objectives cash and working capital management

8/14/2019 Learning Objectives Cash and Working Capital Management

1/12

Prentice Hall, 2004

2222

Corporate Financial Management 2e

Emery Finnerty Stowe

Cash and Working

Capital Management

Learning Objectives

Explain working capital and the cash conversion

cycle.Describe motives for holding cash.

Describe and apply popular cash management

techniques.

Describe the mechanics of different types of short-

term borrowings and evaluate their costs.

Describe the applications of Electronic Data

Interchange.

Chapter Outline

22.1 Overview of Working Capital Management

22.2 Cash Conversion Cycle

22.3 Cash Management

22.4 Short-Term Financing

22.5 Electronic Data Interchange (EDI)

Working Capital Management and

the Principles of Finance

Time Value of Money

Incremental Benefits

Risk-Return Trade-Off

Options

Capital Market Efficiency

Behavioral

Comparative Advantage

Two-Sided Transactions

Working Capital Management

Working capital= current assets current liabilities

Working capital management refers tochoosing the levels and mix of:

n cash, marketable securities, receivables andinventories.

n different types of short-term financing.

Considerations in Working

Capital Management

Sales impact

Liquidity

Relations with stakeholders

n suppliers

n customers

Short-term financing mix

n profitability

n risk considerations


2/12

Working Capital Management

Maturity matching approach

Conservative approach

Aggressive approach

Maturity Matching Approach

Hedge risk by matching the maturities of

assets and liabilities.Permanent current assets are financed with

long-term financing, while temporary

current assets are financed with short-term

financing.

There are no excess funds.

Maturity Matching Approach

Temporary Current Assets

Time

$

PermanentC

urrentAsset

s

FixedAssets

Long

Term

Financing

Short Term

Financing

Conservative Approach

Long-term funds are used to finance both

permanent as well as some temporary short-

term assets.

When there are excess funds, they are

invested in marketable securities.

Conservative Approach


Time

$

Permanent

CurrentA

ssets

FixedAssets

Marketable securitiesLong

Term

Financing

Short TermFinancing

Aggressive Approach

Use less long-term and more short-termfinancing than the conservative approach.


3/12

Aggressive Approach


Time

$

Permanent

CurrentA

ssets

FixedAssets Long

Term

Financing

Short Term

Financing

Cost and Risk Considerations

Yield curve is usually upward sloping.

Short-term rates are more volatile than long-term rates.

Firm's ability to obtain needed short-term

financing.

Cash Conversion Cycle

The cash conversion cycle is the length of time

between payment of accounts payable and the

receipt of cash from accounts receivable.


Purchase

InventorySale on

Credit

Collect Acct.Receivable

Payment of

Accts. Payable

Inventory Conversion Period


Time

Payables

Deferral Period

Receivables Collection

Period


period

deferralPayables

period

collectionsReceivable

period

conversionInventory

cycle

conversionCash

+=


The inventory conversion period is the length oftime from the purchase of inventory to the timethe sales are made on credit.

turnoverInventory

365

Sales/365ofCost

Inventory

period

conversion

Inventory

==


4/12

Receivables Collection Period

The receivables collection period is the

average number of days it takes to collecton accounts receivable.

n Equal to days sales outstanding (DSO)

turnoversReceivable

365

Sales/365

sReceivable

period

collection

sReceivable

==

Payables Deferral Period

The payables deferral period is the average

length of time between the purchase ofmaterials and labor and the payment of cash

for the same.

365expenses)/tiveadministraandgeneralSelling,salesof(Cost

payabletaxespayrollbenefits,Wages,payableAccounts

period

deferral

Payables

++

=


Given the following information about Vision

Opticals, compute the firms cash conversion cycle.

InventoryAccounts ReceivableAccounts PayableWages, Benefits, Payroll Taxes

SalesCost of SalesSelling & Other Expenses

$19,000$21,000

$5,600$9,000

$227,000$93,000$22,000


turnoverInventory

365

Sales/365ofCost

Inventory

period

conversion

Inventory

==

days74.57

5$93,000/36

$19,000

period

conversion

Inventory

==

Receivables Collection Period

turnoversReceivable

365

Sales/365

sReceivable

period

collection

sReceivable

==

days77.3365$227,000/3

$21,000

period

collection

sReceivable

==

Payables Deferral Period

days34.46365/)000,22$000,93($

000,9$600,5$

365expenses)/tiveadministraandgeneralSelling,salesof(Cost

payabletaxespayrollbenefits,Wages,payableAccounts

period

deferral

Payables

=+

+=

++

=


5/12


perioddeferral

Payables

periodcollection

sReceivable

periodconversion

Inventory

cycleconversion

Cash

+=

days34.46days77.33days57.74

cycle

conversion

Cash

+=

days62=

Cash Management

How much liquidity (cash plus marketable

securities) should the firm have?What should be the relative proportions of

cash and marketable securities?

Demands for Cash

Transactions demand

Precautionary demand

Speculative demand

Compensating balances

Short-Term Investment

Alternatives

U.S. Treasury securities

n T-bills, T-notes, and T-bonds

U.S. federal agency securities

Negotiable certificates of deposit

Short-term tax-exempt municipals

Bankers acceptances

Commercial paper

Preferred stock & money market preferred stock

Transactions Demand Models

Baumol Modeln Deterministic model.

n Future cash requirements and disbursements are

known with perfect certainty

Miller-Orr Model

n Stochastic model.

nDaily cash flows vary according to a normal

probability distribution with known variance

Costs of Holding Cash

Opportunity

Costs

Trading costs

Total cost of holding cash

C*

Costs in dollars of

holding cash

Size of cash balance

The investment income

foregone when holding cash.

Trading costs increase when the firmmust sell securities to meet cash needs.


6/12

The Baumol Model

T= Annual transactions volume in dollars

b = Fixed cost of selling securities to raise cash

i =Annual interest rateC= Size of each deposit

Time

C

If we start with $C, spend at a

constant rate each period and

replace our cash with $Cwhen

we run out of cash, our

average cash balance will be2

C

2

C

1 2 3

The opportunity cost

of holding is2

Ci

C2

The Baumol Model

Time

C

2

C

1 2 3The trading cost is b

C

T

T= Annual transactions volume in dollars

b = Fixed cost of selling securities to raise cash

i = Annual interest rateC= Size of each deposit As we transfer $Ceach

period we incur a

trading cost ofb each

period. If we need Tin

total over the planning

period we will pay $b,

times.C

T

The Baumol Model

C* Size of cash balance

C2costTotal

Tb

Ci +=

Opportunity Costs2

Ci

C

TbTrading costs

The optimal cash balance is found where the opportunity costs equals

the trading costs.

i

bTC

2* =

The Baumol Model

Opportunity Costs = Trading Costs

C

Tb

Ci =

2

The optimal cash balance is found where the opportunity

costs equals the trading costs.

i

bTC

2* =

Multiply both sides by C

bTC

i =2

2

i

bTC

22 =

Baumol Model

Subsonic Speaker Systems (SSS) has annualtransactions of $9 million. The fixed cost of

converting securities into cash is $264.50 per

conversion. The annual opportunity cost of funds is

9%.

What is the optimal deposit size?

i

bTC

2* =09.0

000,000,9$50.264$2 = 000,230$=

Baumol Model

Total transactions cost = bT/C= $10,350Annual opportunity cost = iC/2 = $10,350

Total cost = $20,700

Number of deposits per year = T/C= 39.13

Average cash balance = C/2 = $115,000


7/12

The Miller-Orr Model

The firm allows its cash balance to wander randomlybetween upper and lower control limits.

$

Time

UCL

RP

LCL

When the cash balance reaches the upper control limit UCL,cash is invested elsewhere to get us to the return pointRP.

When the cash balance

reaches the lowercontrol limit,LCL,investments are sold

to raise cash to getus up to the target

cash balance.

Purchase

securities

Sell

securities

Miller-Orr Model

Let

n = the standard deviation of the net cash flowsn b = fixed cost of converting securities into cash

n i = annual opportunity cost of holding cash

nLCL = lower control limit (i.e. the minimum

cash balance)

nZ= the amount of securities converted into cash

when the cash balance hits theLCL

Miller-Orr Model

312

4

3

=

i

bZ

Return Point =LCL +Z

UCL =LCL + 3Z = RP + 2Z

Average Cash Balance = LCL + (4/3)Z

Miller-Orr Model

The daily standard deviation of SSSs net cash flowsis $40,000. The fixed cost of converting securitiesinto cash is $264.50 per conversion. The annualopportunity cost of funds is 9%. (Use 9% / 365 forthe daily interest rate.) SSS has set a lower controllimit (LCL) of $100,000.

What would SSSs upper control limit (UCL) andreturn point (RP) be according to the Miller-Orr

Model?What is SSSs average cash balance?

Miller-Orr Model

312

4

3

=i

bZ

Return Point =LCL +Z = $100,000 + $108,781 = $208,781

UCL =LCL+3Z = $100,000 + 3$108,781 = $426,343

=RP+2Z = $208,781 + 2 $108,781 = $ 426,343

Average Cash Balance = LCL + (4/3)Z = $245,041

312

)365/09.0(4

000,40$50.264$3

= 781,108$=

Other Factors in Cash

Management

Compensating balance requirementsOptimal amount of marketable securities

n transaction costs

n maturity

n risk

n yield

Special tax situations


8/12

Float

Float is the difference between the available (or

collected) balance at the bank and the firms bookor ledger balance.

Disbursement float occurs when the firm writes a

check but the check has not yet cleared the

banking system.

Collection float occurs when a check has been

deposited but the funds are not yet credited to the

firms bank account.

Float Management Techniques

Wire transfers

Zero balance accounts (ZBAs)

Controlled disbursing

Centralized processing of payables

Lockboxes

Lockbox Systems

Discount Music Stores is evaluating a lockbox

system which will reduce float by 3 days. The

lockbox system costs $15,000 per year. The

firms daily collections average $150,000, and

its opportunity cost of funds is 6% per year.

Should the firm utilize this lockbox system?

Lockbox Systems

Funds freed up due to a reduction in float =

(3 days)($150,000 per day) or $450,000.

Annual value of float reduction =

$450,000(6%) = $27,000.

After deducting the $15,000 cost of the

lockbox system, the firm nets $12,000

before taxes.

Short-Term Financing

Trade CreditSecured and Unsecured Bank Loans

Commercial Paper

Cost of Trade Credit

Discount Music Stores buys its inventory on 3/10,net 30 terms. What is the cost of not taking the

discount?

0 10 30

+$970,000 $1,000,000

Suppose DMS buys $1,000,000 worth of inventory; if they forgo

the 3% discount to pay on day 30 they are borrowing $970,000

for 20 days and paying $30,000 interest:


9/12

Cost of Trade Credit: APY

36520)1(

000,000,1$000,970$

r+=

970$

000,1$)1( 36520 =+ r

%35.747435.01970$

000,1$ 20365

==

=r

0 10 30

+$970,000 $1,000,000

Cost of Trade Credit: APR

0 10 30

+$970,000 $1,000,000

=days20

365

000,970$

$30,000APR

%44.56=APR

Cost of Trade Credit: APY vs. APR

1%Discount%100

%Discount1

PeriodDiscountPeriodTotal

365

+=

APY

=

PeriodDiscount-PeriodTotal

365

%Discount%100

%DiscountAPR

Effective Use of Trade Credit

Advantages:

n Readily available

n Informal

n Flexible

n Stretching payments

Disadvantages

n High cost of discounts foregonen Stretching of payments can hurt reputation

Bank Loans

Short-term unsecured loansn Transaction loan

n Line of credit

n Revolving credit agreement

Term loans

n Bullet maturity

n Balloon payment

Cost of Bank Loans

Prime rate + spreadLIBOR + spread

Compensating balances


10/121

Compensating Balance

Requirements

Let

n P = amount of loann f= loan term

n r= interest rate on loan

n B = incremental cash balance as a result of

compensating balance requirements

n y = interest earned (if any) on compensating balances

Interest charges = rPf

Interest received =yBf


Requirements

=

f-

-APR

1

balancengcompensatiamountLoan

receivedInterestchargesInterest

=fBP

yBfrPf 1


Requirements

Custom Controls is considering a 1-year loan

of $150,000 at an interest rate of 14%. Due to

compensating balance requirements, Custom

Controls will have to maintain a deposit

balance of $20,000 which it would not have

otherwise maintained at the lending bank. The

deposit will earn 6% per year.What is the APR of this loan?


Requirements

Without the 6% yield on the compensating balance,

the APR = 16.15%

=fBP

yBfrPfAPR

1

=

1

1

000,20$000,150$

000,20$06.0000,150$14.0APR

= 15.23%

Discount Loans

The interest charge is deducted in advance fordiscount loans.

Let

r= interest rate on the loan

f= the term of the loan

P = the principal amount

The APR of a discount loan is given by:

fr

r

frPfP

rPfAPR

=

=1

1

A Comparison of Single Payment

Loans

Ole Tools Inc. needs to borrow $5,000 for 6 months.Four single payment loan alternatives are available as

shown below. In each case, the interest rate is 15% per

year. Compute the APR and APY of each alternative.

Loan Interest Payment CompensatingBalance

ABCD

in arrearsin arrears

in advancein advance

NoYes (10%)

NoYes (10%)


11/121

A Comparison of Single Payment

Loans

Interest charge on the loan is

$5,000 (.15) (0.5 years) or $375.n For loans A & B, this amount is added to the

repayment at loan maturity.

n For discount loans (loans C & D), this amountis deducted from the loan amount at loaninitiation.

Compensating balances (for loans B & D),is

$5,0000.10 = $500.

A Comparison of Single Payment Loans

A

B

C

D

$5,000

$4,500

$4,625

$4,125

($5,375)

($4,875)

($5,000)

($4,500)

%22.165.

1

625,4$

375$=

=APR

Loan CF0 CF1 APR

%155.1

000,5$375 ==

APR

%67.165.

1

500,4$

375=

=APR

%18.185.

1

125,4$

375$=

=APR


A

B

C

D

$5,000

$4,500

$4,625

$4,125

($5,375)

($4,875)

($5,000)

($4,500)

Loan CF0 CF1 APR

15.00%

16.67%

16.22%

18.18%

APY

15.56%

17.36%

16.87%

19.01%

1000,5$

375,5$2

=

1500,4$

875,4$2

=

1625,4$

000,5$2

=

1125,4$

500,4$2

=


Loan CF0 CF1 APR APY

A

B

C

D

$5,000

$4,500

$4,625

$4,125

($5,375)

($4,875)

($5,000)

($4,500)

15.00%

16.67%

16.22%

18.18%

15.56%

17.36%

16.87%

19.01%

Discounted Installment Loans

Sheridan Systems borrows $12,000 for 3months at 15%. The interest is paid in

advance, and Sheridan will pay the loan in 3

monthly installments of $3,000 at the end of

the first two months and $6,000 at the end of

the third month.

Compute the APY and APR of this loan.


The interest cost of this loan is($12,000)(15%)(3/12 years) or $450.

Since the interest is deducted in advance,

Sheridan will get $12,000 - $450 or $11,550

at loan initiation.


12/12


0 1 3

$6,000

32 )1(

000,6$

)1(

000,3$

1

000,3$550,11$

rrr ++

++

+=

monthper%72.1=r

2

$3,000+$11,550 $3,000

%6.200172.012 ==APR

%68.221)0172.1( 12 ==APR

Commercial Paper

Commercial paper is a negotiable business IOU

note.It is sold by the largest, most creditworthy firms

on a discount basis.

Maturity is set to less than 270 days.

n Registration with the SEC is not required.

40% of commercial paper is sold through dealers.

n Commission of about 0.125% on an annualized basis.

Factors Affecting the Short-Term

Financing Mix

Cost of the source of funds

Desired level of current assets

Seasonal component of current assets

Flotation costs

Restricted access to sources of long-term

capital

Bankruptcy costs

Firm's choice of risk level

Electronic Data Interchange

(EDI)

EDI is computer-based exchange of information.

Benefits to firms from using EDI:

n reduced processing time

n lower personnel and material costs

n reduced costs due to errors

n lower investments in inventories

n better service

n competitive pricing

Electronic Data Interchange

In North America, the standards are set by ANSIn American National Standards Institute

Electronic Funds Transfer (EFT)

n Transfer of funds between banks

Financial EDI (FEDI)

n Exchange of information between banks and customers:

n account balances, checks cleared, lockbox information

learning objectives cash and working capital management

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