13W-Ch 22 Working Capital Mngmt

8/10/2019 13W-Ch 22 Working Capital Mngmt

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CHAPTER 22 Working Capital Management


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Cash conversion cycleThe cash conversion model focuses on thelength of time between when a company

makes payments to its creditors and when acompany receives payments from itscustomers.

CCC = + .Inventoryconversionperiod

Receivablescollectionperiod

Payablesdeferralperiod


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Cash doesnt earn a profit, so

why hold it?1. Transactions must have some cash to

operate.

2. Precaution safety stock. Reduced byline of credit and marketable securities.3. Compensating balances for loans and/or

services provided.

4. Speculation to take advantage ofbargains and to take discounts. Reducedby credit lines and marketable securities.


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What is the goal of cash

management?To meet above objectives, especiallyto have cash for transactions, yet not

have any excess cash.To minimize transactions balances inparticular, and also needs for cash tomeet other objectives.


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Ways to minimize cash holdingsUse a lockbox.Insist on wire transfers from customers.

Synchronize inflows and outflows.Use a remote disbursement account.Increase forecast accuracy to reduceneed for safety stock of cash.

Hold marketable securities (also reducesneed for safety stock). Negotiate a line of credit (also reducesneed for safety stock).


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What is float, and how is it affected

by the firms cash manager? Float is the difference between cash asshown on the firms books and on itsbanks books. If a firm with 4 days of net float writes andreceives $1 million of checks per day, itwould be able to operate with $4 millionless capital than if it had zero net float.


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Cash budget:

The primary cash management toolPurpose : Forecasts cash inflows,outflows, and ending cash balances.

Used to plan loans needed or fundsavailable to invest.Timing : Daily, weekly, or monthly,depending upon purpose of forecast.Monthly for annual planning, daily foractual cash management.


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Should depreciation be explicitly

included in the cash budget?No. Depreciation is a noncashcharge. Only cash payments andreceipts appear on cash budget.However, depreciation does affecttaxes, which appear in the cashbudget.


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What are some other potential

cash inflows besides collections?Proceeds from the sale of fixedassets.Proceeds from stock and bondsales.Interest earned.Court settlements.


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How could bad debts be worked

into the cash budget?Collections would be reduced by theamount of the bad debt losses.For example, if the firm had 3% baddebt losses, collections would totalonly 97% of sales.Lower collections would lead tohigher borrowing requirements.


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Types of inventory costsCarrying costs storage and handling costs,insurance, property taxes, depreciation, andobsolescence.

Ordering costs cost of placing orders,shipping, and handling costs.Costs of running short loss of sales orcustomer goodwill, and the disruption of

production schedules.Reducing the average amount of inventorygenerally reduces carrying costs, increasesordering costs, and may increase the costs of

running short.


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Elements of credit policy1. Credit Period How long to pay? Shorter

period reduces DSO and average A/R, but itmay discourage sales.

2. Cash Discounts Lowers price. Attracts newcustomers and reduces DSO.

3. Credit Standards Tighter standards tend toreduce sales, but reduce bad debt expense.

Fewer bad debts reduce DSO.4. Collection Policy How tough? Tougher

policy will reduce DSO but may damagecustomer relationships.


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Working capital financing policiesModerate Match the maturity of theassets with the maturity of the

financing. Aggressive Use short-term financingto finance permanent assets.

Conservative Use permanent capitalfor permanent assets and temporaryassets.


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Moderate financing policy

Years

Lower dashed line would be more aggressive.

$

Perm C.A.

Fixed Assets

Temp. C.A.

S-T

Loans

L-T Fin:Stock,

Bonds,Spon. C.L.


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Conservative financing policy

$

Years

Perm C.A.

Fixed Assets

Marketablesecurities Zero S-T

Debt

L-T Fin:Stock,Bonds,

Spon. C.L.


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Short-term credit Any debt scheduled for repayment within oneyear.Major sources of short-term credit

Accounts payable (trade credit)Bank loansCommercial loans

AccrualsFrom the firms perspective, S -T credit ismore risky than L-T debt.

Always a required payment around the corner.May have trouble rolling over loans.


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Advantages and disadvantages ofusing short-term financing

AdvantagesSpeed

FlexibilityLower cost than long-term debt

Disadvantages

Fluctuating interest expenseFirm may be at risk of default as a result oftemporary economic conditions


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Accrued liabilities

Continually recurring short-termliabilities, such as accrued wages ortaxes.Is there a cost to accrued liabilities?

They are free in the sense that no

explicit interest is charged.However, firms have little control overthe level of accrued liabilities.


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What is trade credit?

Trade credit is credit furnished by a firmssuppliers.

Trade credit is often the largest source ofshort-term credit, especially for smallfirms.Spontaneous, easy to get, but cost canbe high.


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The cost of trade credit

A firm buys $3,000,000 net ($3,030,303gross) on terms of 1/10, net 30.

The firm can forego discounts and pay onDay 40, without penalty.

Net daily purchases = $3,000,000 / 365= $8,219.18


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Breaking down net and grossexpenditures

Firm buys goods worth $3,000,000. Thatsthe cash price.

They must pay $30,303 more if they donttake discounts.Think of the extra $30,303 as a financingcost similar to the interest on a loan.

Want to compare that cost with the cost ofa bank loan.


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Breaking down trade credit

Payables level, if the firm takes discountsPayables = $8,219.18 (10) = $82,192

Payables level, if the firm takes no discountsPayables = $8,219.18 (40) = $328,767

Credit breakdownTotal trade credit $328,767Free trade credit - 82,192Costly trade credit $246,575


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Nominal cost of costly trade credit

The firm loses 0.01($3,030,303)= $30,303 of discounts to obtain

$246,575 in extra trade credit:k NOM = $30,303 / $246,575

= 0.1229 = 12.29%

The $30,303 is paid throughout theyear, so the effective cost of costlytrade credit is higher.


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Nominal trade credit cost formula

12.29%

0.1229 10-40

365 991

periodDisc.-takenDaysdays365

%Discount-1

%Discountk NOM


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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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Commercial paper (CP)Short-term notes issued by large, strongcompanies. B&B couldnt issue CP --itstoo small.CP trades in the market at rates justabove T-bill rate.CP is bought with surplus cash by banks

and other companies, then held as amarketable security for liquidity purposes.


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Bank loans

The firm can borrow $100,000 for 1year at an 8% nominal rate.

Interest may be set under one of thefollowing scenarios:

Simple annual interestDiscount interestDiscount interest with 10% compensatingbalanceInstallment loan, add-on, 12 months


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Must use the appropriate EARs toevaluate the alternative loan terms

Nominal (quoted) rate = 8% in all cases.We want to compare loan cost rates and

choose lowest cost loan.We must make comparison on EAR =Equivalent (or Effective) Annual Rate basis.


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Simple annual interest

Simple interest means no discount oradd-on.

Interest = 0.08($100,000) = $8,000

k NOM = EAR = $8,000 / $100,000 = 8.0%

For a 1-year simple interest loan, k NOM = EAR


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Discount interest

Deductible interest = 0.08 ($100,000)= $8,000

Usable funds = $100,000 - $8,000= $92,000

INPUTS

OUTPUT

N I/YR PMTPV FV

1

8.6957

0 -10092


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Raising necessary funds with adiscount interest loan

Under the current scenario, $100,000 isborrowed but $8,000 is forfeitedbecause it is a discount interest loan.Only $92,000 is available to the firm.If $100,000 of funds are required, thenthe amount of the loan should be:

Amt borrowed = Amt needed / (1 discount)= $100,000 / 0.92 = $108,696


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Discount interest loan with a10% compensating balance

$121,9510.1-0.08-1$100,000

balancecomp.-discount-1needed Amountborrowed Amount

Interest = 0.08 ($121,951) = $9,756

Effective cost = $9,756 / $100,000 = 9.756%


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Add-on interest on a 12-monthinstallment loan

Interest = 0.08 ($100,000) = $8,000Face 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, recognizethat the firm receives $100,000 and must makemonthly payments of $9,000. This constitutes anannuity.


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Installment loanFrom the calculator output below, we have:

k NOM = 12 (0.012043)

= 0.1445 = 14.45%

EAR = (1.012043) 12 1 = 15.45%

INPUTS

OUTPUT

N I/YR PMTPV FV

12

1.2043

-9 0100


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What is a secured loan?

In a secured loan, the borrower pledgesassets as collateral for the loan.

For short-term loans, the most commonlypledged assets are receivables andinventories.Securities are great collateral, butgenerally not available.

13W-Ch 22 Working Capital Mngmt

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