WCM

Working Capital
Management
Chapter 14 Capital Management
Copyright 2008 John Wiley & Sons
Quick Links
Working Capital Basics
Working Capital Accounts and Tradeoffs
The Operating and Cash Conversion Cycles
Working Capital Investment Strategies
Working Capital Tradeoffs
Accounts Receivable
Inventory Management
Cash Management and Budgeting
Financing Working Capital
Basics
Investment in Long Term Projects Based on
1.
2.
3.
4.
Judgments about future cash flows

The uncertainty of those cash flows
The opportunity costs of the funds to be invested
Risk Plays a very vital role
Management of Short Term Assets

1.
2.
Decisions are made in similar ways, but over much

shorter time horizons
Operating cycle become more important

Basic Definitions of Working Capital Terminology
Working capital is the capital that managers can
immediately put to work to generate the benefits

of capital investment.
Focus more on cash flows of current assets and
less on the time value of money.
Deals with the management of current assets and
their financing also known as
current capital/ circulating capital/ gross
capital

Current assets are cash and other assets that the
firm expects to convert into cash in a year or less.

Current liabilities (or short-term liabilities) are
obligations that the firm expects to pay off in a

year or less.
Working capital is the funds invested in a
companys cash account, account receivables,

inventory, and other current assets (also called
gross working capital).

Working capital, sometimes called gross
working capital, simply refers to current assets

used in operations.
Net operating working capital (NOWC) is
defined as current operating assets minus current

operating liabilities.
NOWC= CA (excluding cash) CA (excluding debt)

Net working capital (NWC) refers to the
difference between current assets and current

liabilities. NWC is important because it is a
measure of liquidity and represents the net shortterm investment the firm keeps in the business.
Working capital management involves making
decisions regarding the use and sources of

current assets.

Working capital efficiency refers to the length of
time between when a working capital asset is

acquired and when it is converted into cash.
Liquidity is the ability of a company to convert
assetsreal or financialinto cash quickly

without suffering a financial loss.

Dell
In the late 1980s, was a struggling company
Struggling with the management of working capital
Michel Dell and executives of the companies took
series of decisions to improve that

Focus on customers with predictable purchasing patterns
Collected data of the targeted customers and their
technological need
Moved to real time pricing
Set sales incentives
Moved to just in time inventory system

What is Working Capital Management?
Working capital management involves two key
issues:
1. What is the appropriate amount and mix of

current assets for the firm to hold?
2. How should these current assets be
financed?
10

How much should a firm invest in current assets?
That depends on factors:
The type of business and product

2. The length of the operating cycle
3. Customs, traditions, and industry practices
4. The degree of uncertainty of the business
1.
11

Current Asset Composition for a Sample of Firms
12
Mattel, Inc.s Current Assets by Quarter, June

2000 through September 2002
13

Factors affecting the composition of working capital
Nature of business
Nature of raw material used
Process technology used
Nature of finished good
Degree of competition in the market
Paying habits of the customers
Degree of synchronization among cash flows
Easy availability of working capital
Management policy of the firm
14
Exhibit 14.1: Dell Financial

Statements
15
Working Capital Accounts

and Tradeoffs
The various working capital accounts are:
Cash: This account includes cash and marketable
securities like treasury securities. The higher the cash

balance the better the ability of the firm to meet its
short-term financial obligations.
Receivables: These represent the amount owed
by customers who have taken advantage of the

firms trade credit policy.
16
Working Capital Accounts

and Tradeoffs
The various working capital accounts are:
Inventory: Firms maintain inventory of raw
materials, work in process, and finished goods.

Payables: The payables balance represents the
amount owed to the firms vendors and suppliers

on materials purchased on credit.
17
Operating and Cash

Conversion Cycles
Cash conversion cycle
The cash conversion cycle begins when the firm
invests cash to purchase the raw materials that

would be used to produce the goods that the firm
manufactures. It ends not with the finished goods
being sold to customers and the cash collected on
the sales; but when you take into account the time
taken by the firm to pay for its purchases.
Exhibit 14.2 shows the graphical representation
of the cash conversion cycle.
18
Exhibit 14.2: The Cash

Conversion Cycle
19
Operating and Cash

Conversion Cycles
When managing working capital accounts,
financial managers want to do the following:

Delay paying accounts payable as long as
possible without suffering any penalties.

Maintain minimal raw material inventories
without causing manufacturing delays.

Use as little labor as possible to manufacture
the product while producing a quality product.

20
Operating and Cash

Conversion Cycles
Maintain minimal finished goods inventories
without losing sales.

Offer customers the most attractive credit
terms possible on trade credit to maximize

sales while minimizing the risk of nonpayment.
Collect cash payments on accounts
receivable as fast as possible to close the
loop.
21
Operating and Cash

Conversion Cycles
With the financial managers goal is to maximize
the value of the firm, each of the decisions above

is intended to shorten the cash conversion cycle
and improve the firms liquidity.
22
Operating and Cash

Conversion Cycles
Cash conversion timelines
Two tools to measure the working capital
management efficiency are the operating cycle

and the cash conversion cycle.
The operating cycle begins when the firm uses its
cash to purchase raw materials and ends when

the firm collects cash payments on its credit
sales. Two measuresDays sales outstanding
and Days Sales in Inventoryhelp determine the
operating cycle.
23
Exhibit 14.3: Timeline for

Operating and Cash
Conversion Cycles
24
Operating and Cash

Conversion Cycles
Days of Sales in Inventory (DSI) shows how long
the firm keeps its inventory before selling it. It is

the ratio of the inventory balance to the daily cost
of goods sold.
The quicker a firm can move out its raw materials
as finished goods, the shorter the duration when

the firm holds it inventory, and the more efficient it
is in managing its inventory.
25
Operating and Cash

Conversion Cycles
Days sales outstanding (DSO) estimates how
long it takes on average for the firm to collect its

outstanding accounts receivable balance.
This ratio also called the Average Collection
Period (ACP).
An efficient firm with good working capital
management should have a low average

collection period compared to its industry.
26
Operating and Cash

Conversion Cycles
The operating cycle is calculated by summing the
Days Sales Outstanding and the Days Sales in

Inventory.
Operating Cycle = DSI + DSO
27
(14.1)
Operating and Cash

Conversion Cycles
Operating cycle example
Using the information provided in Exhibit 14.1 find
the operating cycle of Dell.
365 days
365
DSI =
=
= 4.57 days
Inventory turnover
$45,958/$576
365 days
365
DSO=
=
=35.59 days
Accounts rec. turnover $55,908/$5,452
Operating cycle = DSO + DSI = 35.59 + 4.57 = 40.16 days
28
Operating and Cash

Conversion Cycles
Formulas
29
Operating and Cash

Conversion Cycles
The cash conversion cycle is related to the
operating cycle, but it does not start until the firm

actually pays for its inventory. That is, the cash
conversion cycle is the length of time between the
cash outflow for materials and the cash inflow
from sales.
To measure the cash conversion cycle we need
another measure called the days payables

outstanding.
30
Operating and Cash

Conversion Cycles
Days Payables Outstanding (DPO) tells how long
a firm takes to pay off its suppliers for the cost of

inventory.
The cash conversion cycle is calculated as:
Cash Conversion Cycle=DSO+DSI-DPO (14.2)

or
Cash Conversion Cycle=Operating Cycle-DPO (14.3)
31
Operating and Cash

Conversion Cycles
Cash conversion timelines example
In the previous example find the cash conversion
cycle of Dell.
365 days
DPO =
Accounts payable turnover
365
=
= 84.64 days
$45,958/$10,657
Cash conversion cycle = 40.16 - 84.64 = -44.48
32
Exhibit 14.4: Selected

Financial Ratios for Dell, Inc.
33
Exhibit 14.5: Kernel Mills

Financial Statements
34
Working Capital Investment

Strategies
Financial managers use two types of strategies
for current assets investments: flexible and

restrictive.
The flexible strategy has a high percent of current
assets to sales, whereas a restrictive policy has a

low percent of current assets to sales.
35

Strategies
The flexible strategy calls for management to
invest large amounts in cash, marketable

securities, and inventory.
The strategy also promotes a liberal trade credit
policy for customers, which results in high levels

of accounts receivable.
The flexible strategy is perceived be a low-risk
and low-return course of action for management

to follow.
36

Strategies
The advantage of this policy is the large working
capital balances the firm holds.

The strategys downside is the high carrying cost
associated with owning a high level of inventory

and providing liberal credit terms for its customers.
37

Strategies
The higher carrying costs result for two reasons:
The investment in the low return current
assets deprives the higher returns that

management could earn on longer-term
assets like plant and equipment.
Higher amounts of inventory results in higher
warehousing and storage costs.
38

Strategies
Current assets are kept to a minimum in the
restrictive strategy.
The firm barely invests in cash and inventory and
has tight terms of sale intended to curb credit

sales and accounts receivable.
The restrictive strategy is a high-risk high-return
alternative to the flexible strategy.
39

Strategies
The high risk comes in the form of shortage costs
which can be either financial or operating.

Financial shortage costs arise mainly from
illiquidity shortage of cash and a lack of

marketable securities to sell for cash.
If there are unpaid bills that are due, the firm will
be forced to use expensive external emergency

borrowing.
40

Strategies
If funding cannot be secured, default occurs on
some current liability and the firm runs the risk of

being forced into bankruptcy by creditors.
Operating shortage costs result from lost
production and sales.

If the firm does not hold enough raw materials in
inventory, time may be wasted by a halt in

production.
41

Strategies
If the firm runs out of finished goods, sales may
also be lost, and customer dissatisfaction may

arise.
Restrictive sale policies such as allowing no credit
sales will also result in lost sales.

Overall, operating shortage costs can be
substantial, especially if the product markets are

competitive.
42

The optimal current asset investment strategy will
depend on the relative magnitudes of carrying

costs versus shortage costs. This conflict is often
referred to as the working capital trade-off.
Financial managers need to balance shortage costs
against carrying costs to find an optimal strategy.

If carrying costs are larger than shortage costs,
then the firm will maximize value by adopting a

more restrictive strategy.
43

On the other hand, if shortage costs dominate
carrying costs, the firm will need to move towards

a more flexible policy.
Overall, management will try to find the level of
current assets that minimizes the sum of the

carrying costs and shortage costs.
44
Cash Management
Cash forecasting
is analyzing how much and when cash is
needed,
How much and when to generate it
Cash forecasting requires pulling together and
consolidating the short-term projections that relate to
cash inflows and outflows. These cash flows may be a
part of your capital budget, production plans, sales
forecasts, or collection on accounts.
45
Cash Management
Points to Focus
How Companies manage their holding of cash
and marketable securities

How Cash is collected and paid out
How much cash the firm should hold
How companies raised short term loans
Avenues of investment of surplus cash
46
Cash Management and

Budgeting
Reasons for Holding Cash
Two reasons exist for holding a cash balance.
First, it facilitates transactions with suppliers,

customers and employees (transactions balance)
The amount depends on:
1. The size of the transactions made by the firm
2. The firms operating cycle, which determines its
cash outflow and inflow, depending on the firms
production process, purchasing policies, and
collection policies.
47
Cash Management and

Budgeting
Reasons for Holding Cash
The second reason for holding cash is simply that
most banks require firms to hold minimum cash

balances in exchange for the services they
provide, loans and other services
(compensating balance)
48
Cash Management and

Budgeting
Precautionary balance, just in case transactions
needs exceed the transactions balance.

Speculative balance, this is the amount of cash or
securities that can be easily turned into cash, above

what is needed for transactions and precaution.
49
Cash Management and

Budgeting
Costs Associated with Cash
Holding cost- cost to holding assets in the form of
cash is an opportunity costwhat the cash could have

earned if invested in another asset.
Transactions costs- are the fees, commissions, or
other costs associated with selling assets or borrowing
to get cash; they are analogous to the ordering costs
for inventory.
50
Cash Collection and

Disbursement
Payment through cheque

Creation of Float
Suppose that the United Carbon Company has
$1 million on demand deposit with its bank.

It now pays one of its suppliers by writing and
mailing a check for $200,000.
51
Cash Collection and

Disbursement
Float sounds like a marvelous invention, but

unfortunately it can also work in reverse.
Suppose that in addition to paying its supplier,
United Carbon receives a check for $100,000
from a customer
52
Cash Collection and

Disbursement
company gains as a result of the payment float
and loses as a result of the availability float.

The difference is often termed the net float. In
our example, the net
53 float is $100,000.
Cash Management and

Budgeting
As a manager
You can increase your available cash balance
by increasing your net float.

This means that you want to ensure that
checks paid in by customers are cleared
rapidly and those paid to suppliers are cleared
slowly.
This game is often called playing the float.
54
Cash Management and

Budgeting
Managing Float
Float is the child of delay.
Delays that help the payer hurt the recipient
Recipients try to speed up collections.
Payers try to slow down disbursements.
55
Cash Management and

Budgeting
Cash Collection and Disbursement
Collection time, or float, is the time between when
a customer makes a payment and when the cash

becomes available to the firm.
Collection time can be broken down into three
components.
First is delivery time, or mailing time. When a
customer mails payment, it may take several days

before that payment arrives.
56
Cash Management and

Budgeting
Cash Collection
Second is processing delay. Once the payment is
received, it must be opened, examined, accounted

for, and deposited at the firms bank.
Finally, there is a delay between the time of the
deposit and the time the cash is available for

withdrawal.
57
58
Cash Management and

Budgeting
Cash Collection
Payments in cash at the point of sale reduce the
collection time to zero. Payments by checks or

credit cards at the point of sale eliminates the mail
time but not the processing time.
59
Cash Management and

Budgeting
Lockboxes
A lockbox system allows geographically dispersed
customers to send their payments to a post office

box close to them.
With a concentration account, a post office box is
replaced by a local branch which receives the
mailings, processes the payments, and makes the
deposits. Often concentration banking is combined with a
lock-box system.
Either approach will reduce the collection time to
an extent but there is a cost associated with it.

60
Cash Management and

Budgeting
Lockboxes
61
Cash Management and

Budgeting
Lockboxes
Setting up a lockbox system requires the answers
to questions:
1.
2.
3.
How many lockboxes?

Where to locate the lockboxes to cut down on mail
time?
Where to direct which customers to send their
payments?
Recent advances in lockbox systems

1.
2.
3.
4.
Lockbox networks
Image-based processing
Mail interception
Nonbank lockbox systems
62
Cash Management and

Budgeting
Electronic funds transfers
Another increasingly popular means of reducing
cash collection time is through the use of

electronic funds transfers. Such payments reduce
cash collection times in every phase.
First, mailing time is eliminated.
Second, processing time is reduced or eliminated
since no data entry is necessary.

Finally, electronic funds transfers typically have
little or no delay in funds availability.

63
Cash Management and

Budgeting
Controlling Disbursements
Speeding up collections is not the only way to
increase the net float. You can also do so by
slowing down disbursements.
Increase the mailing time
Increase the cheque processing time
Some firms maintains disbursement accounts in
different parts of the country. The computer looks up

each suppliers zip code and automatically produces a
check on the most distant bank.
64
Cash Management and

Budgeting
Controlling Disbursements
United Carbon could open a zerobalance account with
a regional bank that receives almost all check

deliveries in the form of a single, early-morning
delivery
The cash manager at United Carbon know early in the
day exactly how much money will be paid out that day.
The cash manager then arranges for this sum to be
transferred from the companys concentration account

to the disbursement account.
65
Ex. of Lock-Box/Concentration
Banking
On this basis, the lock box would increase collected balance by

150 items per day * $1,200 per item * (1.2 + .8) days saved = $360,000
Invested at .02 percent per day, $360,000 gives a daily return of

.0002 * $360,000 = $72
Suppose that the bank charges $.26 per check
That works out to 150 *.26 = $39 per day
Net Saving $72 - $ 39 = $33 per day
66
Cash Management and

Budgeting
How many collection points do you need if you use
a lock-box system or concentration banking?
Of course, you can always find this out by working
through all possible combinations, but it may be simpler
to solve the problem by linear programming. Many
banks offer linear programming models to solve the
problem of locating lock boxes
67
Cash Management and

Budgeting
Electronic Funds Transfer
Real-time gross settlement (RTGS) system
Most developed countries now operate RTGS systems
for large-value payments.
Advantages
Record keeping and routine transactions are easy
to automate when money moves electronically.
The marginal cost of transactions is very low.
Float is drastically reduced.
68
Cash Management and

Budgeting
International Cash Management
Cash management in domestic firms is childs play
compared with that in large multinational corporations
operating in dozens of countries, each with its own
currency, banking system, and legal structure
Regional Banking System
Principal Bank
69
Cash Management and

Budgeting
Paying for Bank Services
Much of the work of cash management like
processing checks,
transferring funds,
running lock boxes,
helping keep track of the companys accounts
handling payments
receipts in foreign currency
is done by banks. All these services have to be paid for.
Direct Fee or need to maintains minimum average
balance in an interest-free deposit
70
Cash Management and

Budgeting
HOW MUCH CASH SHOULD THE FIRM HOLD?
Cash pay no interest
So why do individuals and corporations hold billions of
dollars in cash and demand deposits?

Why, for example, dont you take all your cash and
invest it in interest-bearing securities?

The answer is - cash gives you more liquidity than
securities.
In equilibrium the marginal value of this liquidity is
equal to the marginal value of the interest on Treasury

bills.
71
Cash Management and

Budgeting
production managers must make a similar trade-off
why firms carry inventories of raw materials
they could simply buy materials day by day, as
needed. But then they would pay higher prices for

ordering in small lots, and they would risk production
delays if the materials were not delivered on time. That
is why they order more than the firms immediate
needs
cost to holding inventories
Therefore production managers try to strike a sensible
balance between the costs of holding too little

72
inventory and those of holding
too much.
Cash Management and

Budgeting
It is exactly the same with cash
If you keep too small a proportion of your funds in the
bank, you will need to make repeated sales of

securities every time you want to pay your bills.
On the other hand, if you keep excessive cash in the
bank, you are losing interest.
73
Cash Management and

Budgeting
The Inventory Decision
Carrying Cost & Order Cost
These two costs are the kernel of the inventory
problem. Ex
Everymans Bookstore experiences a steady demand
for Principles of Corporate Finance from customers
who find that it makes a serviceable doorstop. An
increase in order size increases the average number
of books in inventory, and therefore the carrying cost
rises. However, as the store increases its order size,
the number of orders falls, so that the order costs
Chapter 14 decline.
Capital Management
74
Cash Management and

Budgeting
The Inventory Decision
75
Cash Management and

Budgeting
The Extension to Cash Balances
William Baumol was the first to point out that this
simple inventory model can tell us something about

the management of cash balances
Deciding
on the firms cash holding is exactly

analogous to the problem of optimum order size faced
by Everymans Bookstore.
The order cost is the fixed administrative expense of
each sale of Treasury bills.

The main carrying cost of holding this cash is the
interest that the firm is losing.

76
Cash Management and

Budgeting
The Cash Management Trade-off
Suppose that the interest rate is 8 percent per year, or
roughly 8/365 = .022 percent per day. Then the daily

interest earned by $1 million is .00022 * 1,000,000 =
$220. Even at a cost of $50 per transaction, which is
generously high, it pays to buy Treasury bills today
and sell them tomorrow rather than to leave $1 million
idle overnight.
77
Cash Management and

Budgeting
Ex
We want to have on hand the amount of cash that
minimizes the sum of the costs of making transactions

to get the cash (selling securities or borrowing) and
the opportunity cost of holding more cash than we
need.
78
Cash Management and

Budgeting
Baumol Model
The Baumol Model is based on the Economic Order
Quantity (EOQ) model developed for inventory

management.
EOQ model determines the amount of cash that
minimizes the sum

transactions cost.
of
79
the
holding cost
and
Cash Management and

Budgeting
Baumol Model
The holding cost includes the costs of administration
(keeping track of the cash) and the opportunity cost of

not investing the cash elsewhere.
The transaction cost is the cost of getting more cash
either through selling marketable securities or

through borrowing.
80
Cash Management and

Budgeting
Baumol Model - Ex
Suppose each time our cash balance is zero we
generate $100,000 (borrowing or selling securities).

Further suppose that our opportunity
cost for holding cash is 5%
Our holding costs are the product of the average cash
balance and the opportunity cost.
81
Cash Management and

Budgeting
Baumol Model - Ex
Now
suppose we need $1,000,000 cash for

transactions over a given period. If we need
$1,000,000 in total and we get $100,000 cash at a
time, we need to make 10 transactions during the
period.
82
Cash Management and

Budgeting
Baumol Model - Ex
Total cost = $2,500 + 2,000 = $4,500
Will cash infusions of $100,000 at a time produce

the lowest cost of getting cash?
Can we can control the amount of cash infusions?
the number which will affects both the holding cost
and the transactions cost
83
Cash Management and

Budgeting
Baumol Model - Ex
The holding cost is a function of the amount of the
cash infusion Q
The transactions cost is also a function of the amount
of cash infusion:
84
Cash Management and

Budgeting
Baumol Model - Ex
Total cost = Holding cost + Transaction cost
Setting the first derivative equal to zero
85
Baumol Model- Ex
Solving for the level of Q that minimizes the total cost,
Q*,
In our example, K = $200 per transaction, S = $1,000,000,

k = 5%, and
86
Baumol Model- Ex
We can check our work by looking at the total costs of
cash for levels of Q on either side of Q* = $89,443.

If Q = $100,000,
If Q = $50,000
If Q = $89,443,
87
Cash Management and

Budgeting
Costs of Cash for Different Levels of Cash Infusions
88
Cash Management and

Budgeting
Miller-Orr Model
The Baumol Model assumes that cash is used
uniformly throughout the period whereas the Miller-Orr

Model recognizes that cash flows vary throughout the
period in an unpredictable manner.
89
Cash Management and

Budgeting
Miller-Orr Model
Miller-Orr model takes account of changes in the need
for cash, and thus focuses on three key levels of

inventory:
the lower limit, below which inventory does not fall
the return point, the level of inventory that is the
target if either the lower or upper limit is reached

the upper limit, above which inventory does not rise
90
Cash Management and

Budgeting
Miller-Orr Model
Based on (a) how much needs are expected to vary
each day, (b) the cost of a transaction, and (c) the

opportunity cost of cash expressed on a daily basis,
this model tells us:
The level of cash at which a new cash infusion is
needed (lower limit)

The
upper limit of cash (invest in marketable

securities)
91
Cash Management and

Budgeting
Miller-Orr Model
The return point and the upper limit are determined by
the model as the levels necessary to minimize costs of

cash, considering
Daily swings in cash needs
The transactions cost
The opportunity cost of cash
92
Cash Management and

Budgeting
Miller-Orr Model
The Miller-Orr model provides us with a few decision
rules:
Our cash balance can be any level between the
upper and lower limit.

There is a cash balance (the return point) that we
aim for if our cash balance exceeds the upper limit

or if our cash balance is below the lower limit
93
Cash Management and

Budgeting
Miller-Orr Model
The return point is a function of:
The lower limit (Safety Stock)
the cost per transactions
the opportunity cost of holding cash (per day)
the variability of daily cash flows, which we
measure as the variance of daily cash flows
94
Cash Management and

Budgeting
Miller-Orr Model
Upper Limit
95
Cash Management and

Budgeting
Illustration of the Miller-Orr Model: Cash Balance per
Day with the Application of Control Limits
96
Cash Management and

Budgeting
Hindrance to Boumal and Miller-Orr Model
Seasonality
Global Nature of Business
Keeping cash in different currencies
Restrictions
on transferring currencies across
borders
Laws in many countries requiring holdings in that
countrys domestic currency

The risk that the value of the foreign currency may
change, relative to your domestic currency.

97
Cash Management and

Budgeting
Funda of Cash Management
Have enough cash on hand to meet immediate needs,
but not too much.

Get cash from those who owe it to you as soon as
possible and pay it out to those you owe as late as

possible.
The Baumol and Miller-Orr models help firms manage
cash to satisfy the first goal. But the second goal
requires methods that speed up in-coming cash and
slow down outgoing cash.
98
Cash Management and

Budgeting
Investment of Cash Short Term Money Market
Marketable Securities (safety and liquidity)
Default risk
Purchasing power risk
Interest rate risk
Reinvestment rate risk
Liquidity risk
99
Cash Management and

Budgeting
Money Market Securities
Certificate of Deposit-
Debt issued by banks sold in large denominations.

This debt has maturities ranging generally up to one
year. Because this debt is issued by banks, but
exceeds the amount for deposit guarantees by bank
insurance, there is some default risk.
100
Cash Management and

Budgeting
Commercial Paper-
Debt issued by large corporations that is sold in large

denominations and generally matures in thirty days.
While the debt is unsecured credit and is issued by
corporations, there is some default risk, though this is
minimized by the back-up lines of credit at
commercial banks.
101
Cash Management and

Budgeting
Eurodollar Deposits -
Loans and certificates of deposits of non-U.S. banks

that are denominated in the U.S. dollar. These debts
are generally large denominations with maturities up
to six months. Like loans and certificates of U.S.
banks, there is some default risk.
102
Cash Management and

Budgeting
Treasury Bills -
Securities issued by the Government that have

maturities of one month, three months, and six
months and maximum of 365 days (less than a year).
These securities are considered default-free and are
readily marketable.
103
Accounts Receivables
Whenever a firm sells a product, the seller spells
out the terms and conditions of the sale in a

document called the terms of sale.
The simplest offer is cash on delivery (COD)that
is, no credit is offered.

By allowing customers to pay some time after they
receive the goods or services, you are granting
credit, which we refer to as trade credit.
The majority of a firms investment in current assets,
is tied up in accounts 104
receivable and inventory
Because accounts receivable and inventory
are a use of funds, tying up funds in these

investments has an associated cost
This cost must be considered alongside the
benefits from the enhanced sales of goods and
services.
management decisions involving extending
credit (i.e., accounts receivable)
105
Costs of Credit
The firm granting the credit is forgoing the use
of the funds for a periodso there is an
opportunity cost associated with giving credit
The cost of administering and collecting the
accounts
The risk of bad debts
Discounting cost
106
Reasons for Extending Credit
To stimulate sales
Extending credit is both a financial and a
marketing decision
Benefit from extending credit
= Contribution margin Change in sales
Cost of Discount
= Discount percentage Credit sales using discount
107
Costs of Discounting
Lets first assume that Discount (of 2%) does not
change its sales prices. And lets assume that

Discounts sales will increase by $100,000 to
$1,100,000, with 30% paying within ten days and
the rest paying within thirty days.
The benefit from this discount is the increased
contribution toward before tax profit of $100,000
20% = $20,000. (20% is contribution margin)
The cost of the discount is the forgone profit of
2% on 30% of the $1.1 million sales, or $6,600.
108
When credit is part of the sale, the terms of sale
spell out the credit agreement between the buyer

and seller.
The agreement specifies when the cash payment
is due and the amount of any discount if early
payment is made. Trade credit, which is shortterm financing, is typically made with a discount
for early payment rather an explicit interest
charge.
109
The Implicit Cost of Trade Credit to the Customer
Trade credit is often stated in terms of a rate
of discount, a discount period, and a net

period when payment in full is due.
If the credit terms are stated as 2/10, net 30,
this means that the customer can take a 2%

discount from the invoice price if they pay
within ten days, otherwise the full price is due
within thirty days.
110
Ex
If you purchase an item that costs $100, you would
either pay $98 within the first ten days after purchase
or the full $100 price if you pay after ten days.
Credit period=365/20 Days
The flip-side of this trade credit is that the firm granting

credit has an effective return on credit of 44.58% per
year.
111
Financial managers must realize that trade credit
is a loan from the supplier and it is usually a very

costly form of credit.
We can find the effective annual rate (EAR) for
trade credit using the following formula:
Discount
EAR= 1+
Discounted
price
112
365 / days credit
-1 (14.4)
Accounts Receivables Example
A firm offers terms of sale of 3/10, net 40. What is
the effective annual rate for this offer?
Effective annual rate = (1 + 3/97)365/30 1
= 1.030912.1667 1
= 1.4486 1
= 0.4486, or 44.86%
113
Credit and Collection Policies
Firm considers the tradeoff between the costs
of accounts receivable
The opportunity cost of investing in receivables
The cost of administering the receivables
The cost of delinquent accounts (bad debts)
The benefits of accounts receivablethe expected
increase in profits and the return received from its
trade credit
114
Aging Accounts Receivables
A common tool that credit managers use is called
an aging schedule.
The aging schedule shows the breakdown of the
firms accounts receivable by their date of sale;

how long has the account not been paid in days.
Its purpose is to identify and then track delinquent
accounts and to see that they are paid.
115
Aging Accounts Receivables
Aging schedules are also an important financial
tool for analyzing the quality of a companys

receivables.
The aging schedule reveals patterns of
delinquency and shows where collection efforts

should be concentrated. Exhibit 14.6 shows aging
schedules for three different firms.
116
Exhibit 14.6: Aging

Schedule of Accounts
Receivable
117
Credit Policies
Credit terms should somehow balance the marketing
needs (increased sales) and the costs of these
receivables
Customers cash flow patterns.
The terms competitors are offering.
The equitability of credit terms among customers
118
Evaluation of Creditworthiness
The four Cs as they apply to the analysis of a
customers creditworthiness are:
a)
Capacity
b)
Character
c)
Collateral
d)
Conditions
119
Evaluation of Creditworthiness
Firms use the following sources of information
to assess the creditworthiness of customers:
1. Prior experience with the customer.
2. The credit rating assigned by rating agencies and
reports on the customer, such as those of Dun &
Bradstreet and TRW.
3. Contact with the customers bank or other
creditors.
4. Analysis of the customers financial condition.
120
Inventory management is largely a function of
operations management, not financial

management.
Manufacturing companies generally carry three
types of inventory: raw materials, work in process,

and finished goods.
121
Investment in inventoryraw goods, work in
progress, or finished goodsare costly.

Capital invested in inventory provides no direct
return. On the other hand, running out of raw

materials can cause manufacturing to shut down
at great cost to the firm, and shortage of finished
goods can mean lost sales. (Reasons for holding
inventory)
The level of inventory at which the marginal

benefits
122
equal the marginal cost is the owners wealth
Economic Order Quantity
The economic order quantity (EOQ)
mathematically determines the minimum total
inventory cost taking into account reorder costs
and inventory carrying costs.
The optimal order size strikes the balance
between these two costs.
EOQ is calculated as:
EOQ
2 Reorder costs Sales per period

(14.5)
Carrying costs
123
Economic Order Quantity Example
Best Buy sells Hewlett-Packard color printers at the
rate of 2,200 units per year. The total cost of
placing an order is $750. and it costs $120 per year
to carry a printer in inventory. Using the EOQ
formula, what is the optimal order size?
2 $750 2,200
EOQ
165.83, or 166 printers per order
$120
124
Just-in-Time Inventory Management
In this system the exact day-by-day, or even hour-
by-hour raw material needs are delivered by the

suppliers, who deliver the goods just in time for
them to be used on the production line.
A big advantage in this system is that there are
essentially no raw inventory costs and no chance

of obsolescence or loss to theft.
125
Just-in-Time Inventory Management
On the other hand, if the supplier fails to make the
needed deliveries, then production shuts down.

If the system works for a firm, it cuts down their
investment in working capital dramatically.
126

Working Capital
Permanent working capital is that investment
necessary to satisfy the continual demands of

operations.
Temporary working capital is the difference
between actual working capital and permanent
working capital. It arises from seasonal
fluctuations in a firms business.
127
Mattel, Inc.s Current Assets by Quarter, June

2000 through September 2002
128

Strategies for Financing Working Capital
Exhibit 14.7 shows the three basic strategies that
a firm can follow to finance its working capital

and fixed assets. Each of the three panels show:
1. The total long-term financing needed,
which consists of long-term debt and
equity.
2. The seasonal needs for working capital
that fluctuates with the level of sales.
129
Exhibit 14.7: Working

Capital Financing Strategies
130
Financing Strategies Aggressive

Approach
131
Financing Strategies Conservative

Approach
132
Financing Strategies Moderate

Approach (Maturity Matching)
133

The matching maturity strategy is shown in panel
(a) of Exhibit 14.7.

All working capital is funded with short-term
borrowing and, as the level of sales varies,

seasonally, short-term borrowing fluctuates
between some minimum and maximum level.
All fixed assets are funded with long-term
financing.
134

The matching of maturities is one of the most
basic techniques used by financial managers to

reduce risk when financing assets.
The long-term financing strategy is shown in
panel (b) in Exhibit 14.7.

This strategy relies on long-term debt to finance
both capital assets and working capital.
135

This strategy reduces the risk of funding current
assets because there is no need to worry about

refinancing assets since all funding is long term.
Panel (c) in Exhibit 14.7 shows the aggressive
funding strategy where all working capital and a

portion of fixed assets are funded with short-term
debt.
136

While this lowers the cost under some interest-
rate scenarios, it forces the firm to continually

refinance the funding of the long-term assets in a
changing interest rate environment.
137

Financing Working Capital in Practice
Nearly all financial managers try to match the
maturities of assets and liabilities when funding

the firm. That is, short-term assets are funded
with short-term financing and long-term assets
are funded with long-term financing.
Most financial managers like to fund some of
their currents assets with long-term debt as

shown in panel (b) of Exhibit 14.7, so-called
permanent working capital.
138

Financing Working Capital in Practice
In recent years, a number of large, well-known
firms of the highest credit standing have been

funding some of their long-term fixed assets with
short-term debt sold in the commercial paper
market.
139

Sources of Short-term Financing
Accounts payable (trade credit), bank loans, and
commercial paper are common sources of shortterm financing.

Accounts payable constitute 35 percent of total
current liabilities for all publicly traded

manufacturing firms.
140

The buyer needs to figure out whether it makes
financial sense to pay early and take advantage

of the discount or to wait and pay in full when the
account is due.
Short-term bank loans account for 20% of total
current liabilities for all publicly traded
manufacturing firms.
141

If the firm backs the loan with an asset, the loan
is defined as secured; otherwise, the loan is

unsecured.
Secured loans allow the borrower to borrow at a
lower interest rate, all else being equal.

An informal line of credit is a verbal agreement
between the firm and the bank, allowing the firm

to borrow up to an agreed-upon upper limit.
142

In exchange for providing the line of credit, a
bank may require that the firm holds a

compensating balance with them.
A formal line of credit is also known as revolving
credit. Under this type of agreement, the bank

has a legal obligation to lend to the firm an
amount of money up to a preset limit. The firm
pays a yearly fee, in addition to the interest
expense on the amount they borrow.
143

Commercial paper is a promissory note issued by
large financially secure firms, which have high

credit ratings.
Commercial paper is not secured which means
that the issuer is not pledging any assets to the

lender in the event of default.
However, most commercial paper is backed by a
credit line from a commercial bank.

144

Therefore the default rate on commercial paper is
very low, resulting in an interest rate that is

usually lower than what a bank would charge on
a direct loan.
For medium-size and small businesses,
accounts-receivable financing is an important

source of funds.
145

A company can secure a bank loan by pledging
the firms accounts receivable as security.

A second way for a business to finance itself with
accounts receivables, called factoring, is to sell

the receivables to a factor at a discount.
The firm who sold the receivables has no further
legal obligation to the factor.
146
Effective Cost of
Borrowing/period
Effective Annual Rate (EAR) on the borrowing
Interest earned
on investment of
one $
147
Financing Working Capital- Cost of

Financing
Single Payment Interest
A single payment loan is a specified amount
borrowed at the beginning of the loan period;
it is repaid plus interest at the end of the
period.
Suppose you borrow $100,000 for six months,
with an interest rate of 6% for this six-month
period.
APR = 6%*2 = 12%
148

Discount Interest
A discount loan is a loan in which the proceedsthe

funds you have available to useare a portion of the
stated loan amount. The interest is paid up front,
deducted from the funds at the beginning of the loan.
Suppose you borrow $200,000 from a bank for four months. If this is
a discount loan with a rate of 5%, you have available for your
use 95% of the loan amount, or $190,000.
APR = 5%*3 = 15%
149
150
All associated
cost
(Interest/fee)
Compensating Balance
Let r is the effective cost per period, i represent the

stated interest rate per compounding period on the
face value of the loan, and b represent the
compensating balance as a percentage of the loan
face value. Then,
Disc. %
r
Discounted Pr ice %
Effective Cost of
Borrowing per period
151
Per
Period

Compensating Balance
Suppose you borrow $500,000 from the bank for three months, with
a nominal annual rate of 12% (compounded every three months),
and the bank requires you to maintain a compensating balance for
10% of the loan. Then,
The stated quarterly rate (i) is: i =0.12/4= 0.03 or 3% for a 3 month
period
The effective cost for a three month period is: r = 0.03/(1 0.10)=
0.0333 or 3.33% per period
The effective annual cost of this financing is:
EAR = (1 + 0.0333)^4 1 = 0.1400 or 14% per year
152

Other Costs
Loan origination fee, which covers the lenders
costs of credit checks and legal fees to make the
loan available to you.
A lender may also charge a commitment fee, which
is compensation for the promise to make a loan
since the bank stands ready to lend the funds
whether used or not.
All these fees increase the cost of financing.

153

Other Costs
Suppose you arrange to borrow $50,000 from the bank for three
months with a single payment loan at a rate of 2.5% for three
months.
APR= 2.5%*4=10%
The effective annual cost of this credit is:
EAR = (1 + 0.025)^4 1 = 0.1038 or 10.38% per year
If the bank charges a loan origination fee of $500, taken as a
discount from the amount loaned, the effective cost of same
loan is:
r =costs/funds available= 0.025($50,000) + $500/($50,000 $500)=
0.0354 or 3.54% per period
154
EAR = (1 + 0.0354)^4 1 = 1.1493
1 = 0.1493 or 14.93% per

Question
Does it makes a difference whether the fees are paid
at the beginning of the period or the end of the period
Consider a one-year loan of $10,000 with single
payment interest of 5%.
If there were no fees, the effective cost of credit is 5%
per year.
155

Suppose there is a fee of $300 associated with this loan. If the
fees are paid at the beginning, you are effectively borrowing
$10,000 less the fee, or $9,700.
The effective cost is:
r =($500 + $300)/$9,700 = 0.0825 or 8.25%
Suppose instead that the $300 fee is paid at the end of the loan
period. You then have $10,000 to use during the entire year,
so the effective cost is:
r =($500 + $300)/$10,000 = 0.0800 or 8.00%
Paying the fee up-front effectively increases the cost of financing
compared to paying the same fee at the end of the loan period.
156

Bank Financing
Letter of Credit
A letter of credit is a written promise by a bank to
make a loan if specific conditions are met.
A letter of credit may be either revocable or irrevocable. If

revocable, the bank can cancel the letter of credit; if
irrevocable, the bank is committed to making the
loan.
The cost of a letter of credit comprises two parts: a
commitment fee for writing the letter of credit and the
157 it is made. The
interest on the loan once
loan typically
Comparing Forms of Bank

Financing
What the alternative ways of stating the costs for bank credit
do to the borrowers cash flows and the effective cost of
financing.
Alternative 1 :
Alternative 2 :
Alternative 3 :
Alternative 4 :
A loan with 10% single payment interest.

A loan with a 10% discount.
A loan with 10% single payment interest and a
20% compensating balance.
A $150,000 line of credit, where any borrowings
have a single payment interest of 10% and there
is a 1% fee for any unused line of credit.
If you need to borrow $100,000 for one year, which of these

alternatives has the lowest effective cost of financing?
158
Comparing Forms of Bank

Financing
Hint
Loan Amount Required = $100,000
Loan Amount to Borrow
Loan Amount - (discount % or cost) * Loan Amount = $100,000
Loan Amount = $100,000/(1-discount % or cost)
159

Add-on Interest
The total interest is added to the principal amount of

the loan and interest is paid on both the amount
borrowed and the interest to be paid on the loan.
Consider a loan of $1,000 for five years with 10% add-on

interest and the loan is to be paid off in five year-end payments.
Restated Loan
Present value = $1,000
Number of payments = 5
Amount of each payment = $300 = ($1000+$500)/5
and
$1,000 = $300(present value of an annuity for T = 5 and r = ?)
160

Unsecured and Secured Financing
A loan that is backed by specific property is a
secured loan. A loan that is backed only by the general
credit of the borrower is an unsecured loan.
161

Bank Financing
Single Payment Loan
Bank loans are represented in the form of a
promissory note, which specifies the amount of the
loan, the maturity date, and any interest
Line of Credit
A line of credit is an agreement wherein a bank will
make available to a firm, a loan up to a specific limit
the lineif the firm requests these funds. The bank
extends this line of credit for a specified period,
typically one year.
162

Bank Financing
Uncommitted Line of Credit
In an uncommitted line of credit, the bank makes a
verbal agreement to lend funds up to the line within
the specified period, but is not legally bound to do so
Committed Line of Credit
In a committed line of credit, the bank makes a
written agreement to lend funds and is legally
bound
to do so under the terms of the line of
credit.
163

Bank Financing
Revolving Credit
A revolving credit agreement is similar to a line of
credit agreement, but is usually for a longer period
two to three years. The borrower can borrow and
repay the credit many times within this period in a
series of short-term notes.
The cost of the revolving credit comprises two parts:

(1) the commitment fee or compensating balance,
(2) the interest on any borrowings under the agreement.
164

In addition to trade credit and bank loans, there are

loans that become marketable
loans that can be bought and
sold on the open market. Two short-term financing
arrangements that create a money market security
short-term securities that can be bought or sold
in financial markets by investorsare commercial
paper and bankers acceptances.
165

SECURED FINANCING
Secured financing is backed by some specific asset
or assets of the borrower.
A borrowers assets used in this way are referred to
as collateral.
The collateral acts as a back-up source of
funds for the lender if the borrower fails to abide by
the terms of the loan.
The collateral for short-term financing arrangements are

usually current assetsmarketable securities,
accounts receivable, or inventory
166

Accounts Receivable
There are three types of financing arrangements that

use accounts receivable as
security assignment
factoring
securitizing
167

ACTUAL COSTS OF SHORT-TERM FINANCING
The cost of short-term financing is a function of many

factors, including
prevailing interest rates
creditworthiness of borrower (credit rating)
length of maturity of borrowing
level of seniority
collateral
backup line of credit
168

Repurchase Agreements
A repurchase agreement, commonly referred to as a
repo, is the sale of a security with a commitment by
the seller to buy the same security back from the
purchaser at a specified price at a designated future
date.
The price at which the seller must subsequently
repurchase the security is called the repurchase
price and the date that the security must be
repurchased is called the repurchase date.
169

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Working Capital

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons

Copyright 2008 John Wiley & Sons

Judgments about future cash flows

Management of Short Term Assets

Decisions are made in similar ways, but over much

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons

Working Capital Basics

immediately put to work to generate the benefits

Copyright 2008 John Wiley & Sons

Working Capital Basics

firm expects to convert into cash in a year or less.

obligations that the firm expects to pay off in a

companys cash account, account receivables,

Copyright 2008 John Wiley & Sons

Working Capital Basics

working capital, simply refers to current assets

defined as current operating assets minus current

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons

Working Capital Basics

difference between current assets and current

decisions regarding the use and sources of

Copyright 2008 John Wiley & Sons

Working Capital Basics

time between when a working capital asset is

assetsreal or financialinto cash quickly

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons

Working Capital Basics

series of decisions to improve that

Copyright 2008 John Wiley & Sons

Working Capital Basics

1. What is the appropriate amount and mix of

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons

Working Capital Basics

The type of business and product

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons

Working Capital Basics

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons

Mattel, Inc.s Current Assets by Quarter, June

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons

Working Capital Basics

Copyright 2008 John Wiley & Sons

Exhibit 14.1: Dell Financial

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons

Working Capital Accounts

securities like treasury securities. The higher the cash

Receivables: These represent the amount owed

by customers who have taken advantage of the

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons

Working Capital Accounts

materials, work in process, and finished goods.

amount owed to the firms vendors and suppliers

Chapter 14 Capital Management

Copyright 2008 John Wiley & Sons