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14Current AssetsManagement14.1Cash ManagementReasons for Holding CashTransaction balance A cash balance associated with payments and collections; the balance necessary for day-to-day operations.Precautionary balance A cash balance held in reserve for random, unforeseen fluctuations in cash inflows and outflows.Speculative balance A cash balance held to enable the firm to take advantage of any bargain purchases that might arise.

Types of FloatFloat The difference between the book balance ( the cash balance in the firms book ) and the available balance ( the cash balance recorded at the bank ).Disbursement floatGenerated when a firm writes checksAvailable balance > book balanceCollection floatGenerated when a firm received checksAvailable balance < book balance Net float = disbursement float + collection floatIf net float is positive, available balance > book balanceA Firm should be concerned with its net float and available balance more than with its book balance.Float ManagementTotal collection or disbursement times can be broken down into three parts:Mailing timeProcessing delayAvailability delaySpeeding up cash collections involves reducing one or more of these components. Slowing down cash disbursement involves increasing one of them.

Measuring FloatThe size of float depends on both the amount and the time delay involved.

Example:Suppose you mail a check each month for $12,000 and it takes 3 days to reach its destination, 2 day to process, and 1 day before the bank makes the cash available. What is the average daily float? (3+2+1)($12,000)/30 = $2,400

Cost of FloatThe basic cost of collection float to the firm is the opportunity cost of not being able to use the cash.

Example:The company receives an average of $20,000 in checks per day. The delay in clearing is typically 4 days. The current interest rate is 0.02% per day. What is the highest daily fee the company should be willing to pay to eliminate its float entirely?Collection float = 4($20,000) = $80,000Maximum daily charge = $80,000(0.0002) = $16

Cash CollectionSome methods to speed up cash collectionLockboxesConcentration banking systemWire transfersCash Collection: ExampleThe company is considering a lockbox system which will reduce the collection time by 2 days. The daily interest rate is 0.016%. The average number of daily payments to each lockbox is 8,500 and average size of payment is $108. If the bank charges a fee of $225 per day, should the lockbox project be accepted? Average daily collections = $108(8,500) = $918,000PV = 2($918,000) = $1,836,000PV of cost = $225/0.00016 = $1,406,250 NPV = $1,406,250 + 1,836,000 = $429,750The NPV is positive, so the lockbox project should be accepted.

Cash DisbursementsSlowing down disbursements can increase disbursement float, but it may cause ethical problems.Controlling disbursementsZero-balance accountControlled disbursement account

Investing Idle CashBecause of seasonal and cyclical activities, to help finance planned expenditures, or as a contingency reserve, firms temporarily hold a cash surplus.The money market offers a variety of possible short-term financial assets for the idle cash.The Target Cash BalanceThe target cash balance involves a trade-off between the carrying costs and the trading costs.The carrying costsThe opportunity costs of holding cashThe trading costs The costs associated with buying and selling marketable securities The BAT ModelThe Baumol-Allais-Tobin (BAT) model is a classic, simple and most stripped-down sensible model for determining the optimal cash position.

WhereC* Optimal cash balanceF - Fixed cost of making a securities tradeT - Total amount of new cash needed for transactions during the relevant period (usually 1 year)R - Opportunity cost of holding cash, equal to the interest rate on marketable securities.

Its chief weakness is that it assumes steady, certain cash outflows.

The BAT Model: ExampleAnnual interest rate = 6%Fixed order cost = $25Total cash needed = $8,500

C* = [(2T F)/R]1/2 = [2($8,500)($25)/0.06]1/2 = $2,661.45

Implications of the BAT ModelThe greater the interest rate, the lower is the target cash balance.The greater the order cost, the higher is the target cash balance.The Miller-Orr ModelThe Miller-Orr model assume that the cash balance fluctuates up and down randomly and that the average change is zero.Management set the lower limit, L.If the cash balance is between L and U* (the upper limit), no transaction is made. The advantage of the model is that it considers the effect of uncertainty.

The Miller-Orr Model

where C* Optimal cash balance L Lower control limit of cash balance s2 The variance of net daily cash flows

where U* - Upper control limit of cash balance

The Miller-Orr Model: ExampleThe firm has a fixed cost associated with buying and selling marketable securities of $40. The interest rate is currently 0.021% per day. The firm has estimated that the standard deviation of its daily net cash flow is $70. Management has set a lower limit of $1,500 on cash holdings. C* = L + (3/4 F 2 / R]1/3 = $1,500 + [3/4($40)($70)2/0.00021]1/3 = $2,387.90

Implications of Miller-Orr ModelThe greater the interest rate, the lower the target cash balance.The greater the order cost, the higher the target cash balance.The greater the uncertainty is, the greater the difference between the target balance and the minimum balance.The greater the uncertainty is, the higher the upper limit and the higher the average cash balance.14.2Credit ManagementCredit ManagementGranting credit normally increases sales.Granting credit has both direct and indirect costs.Chance that customers will not payCosts of carrying the receivablesThe credit policy involves a trade-off between the benefits of increased sales and the costs of granting credit.

Components of Credit PolicyTerms of saleThe credit periodThe cash discount and discount periodThe type of credit instrumentCredit analysis Determining the probability that customers will not payCollection policy The firms toughness or laxity in following up on slow-paying accounts.

Terms of SaleExample: 2/10, net 60 2% cash discount from the full price if payment is made in 10 daysFull amount due in 60 days form the invoice dateGeneral Form: / , The Credit Period The basic length of time for which credit is granted.If a cash discount is offered, the credit period has two components.The net credit period the length of time the customer has to payThe cash discount period the time during which the discount is availableFactors influencing the length of credit periodThe shorter the buyers inventory period, the shorter the credit period.The shorter the operating cycle, the shorter the credit period.

Cash DiscountsCash discount is a discount in the price of goods given to encourage early payment.Although the cash discounts are rather small, if you calculate the cost to the buyer of not paying early, you will find the interest rate that the buyer is effectively paying for the trade credit is extremely high.The company benefits when customers forgo discounts.

Credit instrumentsOpen account Promissory noteCommercial draftSight draftTime draftTrade acceptanceBankers acceptanceConditional sales contractCredit Policy AnalysisThe NPV of granting credit depends on five factors.Revenue effectsCost effectsThe cost of debtThe probability of nonpaymentThe cash discount Evaluating a Proposed Credit Policy: ExampleA company currently has a cash only policy. It is considering a switch to a net 30 policy. Currently, the price per unit is $290 and cost per unit is $230. The company currently sells 1,105 units per month. Under the proposed policy, the company expects to sell 1,125 units per month. The price per unit will be $295 and the cost per unit will be $234. If the required monthly return is 0.95% per month, what is the NPV of the switch? Should the company offer credit terms of net 30?

Evaluating a Proposed Credit Policy: ExampleCash flow from old policy = ($290 230)(1,105) = $66,300Cash flow from new policy = ($295 234)(1,125) = $68,625Incremental cash flow = $68,625-66,300 = $2,325NPV of switching= [($290)(1,105) + (1,105)($234 230) + ($234)(1,125 1,120)] + ($2,325/0.0095) = $84,813.16Since the NPV is negative, the company should not offer the credit terms of net 30.

Optimal Credit PolicyThe optimal amount of credit the firm should offer depends on the competitive conditions under which the firm operates.These conditions will determine the carrying costs associated with granting credit and the opportunity costs of the lost sales resulting from refusing to offer credit.The optimal credit policy minimizes the sum of carrying costs and opportunity costs.Credit AnalysisThe process of deciding whether or not to grant credit to a particular customer.Two steps:Gathering relevant informationDetermining creditworthiness

Credit InformationFinancial statementsCredit reports about the customers payment history with other firmsBanksThe customer payment history with the firm

Determining CreditworthinessCredit evaluation - Five Cs of creditCharacter the customers willingness to meet credit obligationsCapacity the customers ability to meet credit obligations out of operating cash flowsCapital the customers financial reservesCollateral an asset pledged in the case of defaultConditions General economic conditions in the customers line of businessCredit scoringOne-Time SaleNPV = -v + (1 - )P / (1 + R)where v - variable cost per unit - probability of defaultP price per unitR the required return on receivables per month

It makes sense to grant credit to almost everyone once, as long as the variable cost is low relative to the price.

One-Time Sale: ExampleYour company is considering granting credit to a new customer. The variable cost per unit is $20; the current price is $60; the probability of default is 25%; and the monthly required return is 1%.NPV = -$20 + (1-0.25)(60)/(1.01) = $24.55The break-even probability0 = -20 + (1 - )(60)/(1.01) = 66.33%

Repeat BusinessNPV = -v + (1-)(P v)/RExample: NPV = -$20 + (1-.25)(60 20)/0.01 = $2980

If a customer defaults once, credit cant be granted again.

Collection PolicyMonitor the age of accounts receivableKeeping track of ACP though timeThe aging schedule Deal with past-due-accountsDelinquency letterTelephone callCollection agencyLegal action

14.3Inventory ManagementInventory ManagementInventory management involves determining how much inventory to hold, when to place order, and how many units to order at a time.Other functional areas will share decision-making authority regarding inventory.

Types of InventoryManufacturerRaw materialWork-in-progressFinished goods Things to rememberOnes raw material may be anothers finished goods.Different types of inventory can be different in terms of liquidity.The demand for finished goods is independent.

Inventory CostsCarrying costsStorage and tracking costsInsurance and taxesLosses due to obsolescence, deterioration, or theftThe opportunity cost of capital on the invested amountShortage costsRestocking costsCosts related to safety reservesInventory management involves a trade-off between the carrying costs and shortage costs.

The ABC ApproachAn inventory management technique to divide inventory into three or more groups.The underlying rationale is that a small portion of inventory in terms of quantity might represent a large portion in terms of inventory value.

The EOQ ModelThe Economic Order Quantity Model is a formula for determining the order quantity that will minimize total inventory cost.Total carrying costs = (Average inventory)(Carrying cost per unit) = (Q/2)(CC)Total restocking costs = (Fixed cost per order)(Number of orders) = F(T/Q)Total Costs = Carrying cost + Restocking cost = (Q/2)(CC) + F(T/Q)

The EOQ ModelCarrying costs = Restocking costs (Q/2)(CC) = F(T/Q)The EOQ is:

Example: Carrying cost is $1 per unit; fixed order cost is $5 per order; the firm sells 120,000 units per year.Q*= [2(120,000)($5)/$1]1/2 = 1,095.45 units

Extensions to the EOQ ModelSafety stocks - The firm reorders when inventory reaches a minimum level.Reorder points - When there are lags in delivery or production times, the firm reorders when inventory reaches the reorder point.By combining safety stocks and reorder points, the firm maintains a buffer against unforeseen events. Managing Derived-demand InventoriesMaterials Requirements Planning (MRP)Once finished goods inventory levels are set, it is possible to determine what levels of work-in-process inventories must exist to meet the need for finished goods. From there, it is possible to calculate the quantity of raw materials that must be on hand.Just-in-Time (JIT) InventoryA system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials or components arrive just as they are needed in the production process.