Working Capital Policy

Working Capital Policy
Learning Objectives
Understand the importance of working capital. The liquidity-profitability trade-off. Determining the optimal level of current assets. The risk and return implications of alternative approaches to working capital financing policy.
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The Importance of Managing and Accumulating Working Capital Working capital is the amount of the firms current assets: cash, accounts receivable, marketable securities, inventory and prepaid expenses. Managing the level and financing of working capital is necessary:
to keep costs under control (e.g. storage of inventory) to keep risk levels at an appropriate level (e.g. liquidity)
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Managing Current Assets & Liabilities
Net Working Capital

= Current Assets - Current Liabilities
Determining the Correct level of Working Capital

Balance Risk & Return Benefits of Working Capital
Higher Liquidity (Lowers Risk) Lower Returns - $$ invested in lower returning securities rather than production.
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Costs of Working Capital
Example: Risk-Return Trade-off

Compare the 2 following companies
Marketable Securities Other Current Assets Fixed Assets Total Assets Firm 1 0 200 800 1000 Firm 1 ST Debt 100 LT Debt 400 Common Stock 500 Total Liabilities&Equity 1000
Operating Earnings Interest Earned EBT Taxes (40%) Net Income Current Ratio
Firm 1 150 0 150 -60 90 2
Current Ratio = Current Assets Current Liabilities = 200 100 = 2

5

Marketable Securities Other Current Assets Fixed Assets Total Assets Firm 1 0 200 800 1000 Firm 1 ST Debt 100 LT Debt 400 Common Stock 500 Total Liabilities&Equity 1000
Operating Earnings Interest Earned EBT Taxes (40%) Net Income
Firm 1 150 0 150 -60 90
Return on Assets = =
Net Income Assets 90 1000
= .09 = 9%
Current Ratio ROA 2 9%
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Marketable Securities Other Current Assets Fixed Assets Total Assets Firm 1 0 200 800 1000 Firm 2 200 200 800 1200 Firm 1 ST Debt 100 LT Debt 400 Common Stock 500 Total Liabilities&Equity 1000 Firm 2 100 400 700 1200
Operating Earnings Interest Earned EBT Taxes (40%) Net Income Current Ratio ROA
Firm 1 150 0 150 -60 90 2 9%
Firm 2 150 8 158 -63 95
Firm 2: $200 Marketable Securities Financed with Common Stock 200 x 4% = $8 interest earned

Firm 1 150 0 150 -60 90 2 9%
Firm 2 150 8 158 -63 95 4
Current Ratio = CA CL = =4
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400 100

Firm 1 150 0 150 -60 90 2 9%
Firm 2 150 8 158 -63 95 4 7.9%
Return on Assets = =
NI Assets
95 1200
=.079 = 7.9%
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Firm 1 150 0 150 -60 90 2 9%
Firm 2 150 8 158 -63 95 4 7.9%
Firm 1
Higher ROA Less Liquid Riskier
Firm 2
Lower ROA More Liquid Less Risky
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Variation in assets over time

Total Assets
$5M
}
Assume ZERO Long-term Growth
Fixed Assets
Time
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Total Assets
$7M $5M
Permanent Current Assets Fixed Assets
Time
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Total Assets
$10M
Temporary Current Assets
$7M $5M
Permanent Current Assets

Fixed Assets
Time
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Different Approaches to Financing
Conservative Approach
Finance all fixed assets, permanent current assets, and some temporary with LT debt or equity. ST financing is used for the remaining temp. current assets. Lower risk, lower return
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Financing Current Assets: Conservative Approach

Total Assets
$10M
Long-term Sources
Short-term Sources Temporary Current Assets
$7M $5M

Fixed Assets
Time
15
Moderate Approach (Maturity Matching)

Finance fixed assets and permanent current assets with LT funds and temporary current assets with ST funds. Moderate risk, moderate return 16
Financing Current Assets: Moderate Approach

Total Assets
$10M
$7M $5M
Long-term Sources
Time
17
Financing Current Assets: Moderate Approach

Total Assets
$10M
$7M $5M
Long-term Sources
Short-term Sources Temporary Current Assets
Fixed Assets
Time
18
Moderate Approach (Maturity Matching)

Finance fixed assets and permanent current assets with LT funds and temporary current assets with ST funds. Moderate risk, moderate return
Aggressive Approach
Finance all temporary current assets, permanent current assets, and some fixed assets with ST debt. LT financing is used for the remaining fixed assets. Higher risk, higher return 19
Financing Current Assets: Aggressive Approach

Total Assets Short-term Sources
$10M
$7M $5M
Long-term Sources
Time
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Managing (WARM, SOFT) Cash
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How much cash should a firm keep on hand?
Managers must keep enough cash to make payments when needed. (Minimum balance) But since cash is a non-earning asset, managers should invest excess returns and keep just the amount of cash that is necessary. (Maximum balance)
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The size of the minimum cash balance depends on:
How quickly and cheaply a firm can raise cash when needed. How accurately managers can predict cash requirements. How much precautionary cash the managers need for emergencies.
Link to Dun & Bradstreet
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The firms maximum cash balance depends on:
Available (short-term) investment opportunities
Expected return on investment opportunities (opportunity cost) Transaction cost of withdrawing cash and making an investment
Link to Bureau of Economic Analysis
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e.g. money market funds, CDs, commercial paper
If high expected return, firms are quick to invest excess cash
Choosing the Optimum Cash Balance

Cash Balances in a Typical Month
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Days of the Month
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Invest Excess Cash
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Days of the Month
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Sell Securities to obtain cash
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Days of the Month
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The Miller - Orr Model
The Miller-Orr Model provides a formula for determining the optimum cash balance, the point at which to sell securities (lower limit) and when to invest excess cash (upper limit). Depends on:
transaction costs of buying or selling securities variability of daily cash return on short-term investments
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The Miller-Orr Model - Target Cash Balance (Z)

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Z=
3 x TC x V +L 4xr
where: TC = transaction cost of buying or selling securities V = variance of daily cash flows r = return on short-term investments L = minimum cash requirement
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Example: Suppose that short-term securities
yield 5% per year (r) and it costs the firm $50 each time it buys or sells securities (TC). The variance of cash flows is $100,000 (V) and your bank requires $1,000 minimum checking account balance (L).
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Example
3
Z= 3 x 50 x 100,000 + $1,000 4 x .05/365
= $3,014 + $1,000 = $4,014
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The Miller-Orr Mode - Upper Limit
The upper limit for the cash account (H) is determined by the equation: H = 3Z - 2L where: Z = Target cash balance L = Lower limit In the previous example: H = 3 ($4,014) - 2($1,000) = $10,042
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Forecasting Cash Needs - Cash Budget
Used to determine monthly needs and surpluses for cash during the planning period Examines timing of cash inflows and outflows i.e. when checks are written and when deposits are made. Payments to suppliers are typically made some time after shipment is received. Receipts from credit customers are received some time after sale is recorded.
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Cash Budget - Problem

Rocky Mountain Climbing, Inc. (RMC) has the following information: Previous Sales November 2007 December 2007 Forecast Sales January 2008 February 2008 March 2008 April 2008 120,000 260,000 140,000 140,000
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130,000 125,000

Rocky Mountain Climbing, Inc. (RMC) has the following information: Previous Sales: November 2007 130,000 December 2007 125,000 Forecast sales for: January 2008 120,000 February 2008 260,000 March 2008 140,000 April 2008 140,000 Collections : 30% of customers pay cash 50% pay in month after sale 20% pay 2 months after sale
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Other information for RMC Cash Budget:
Purchases of inventory are 75% of sales and are made 2 months before sale and are paid for 1 month after delivery Other expenses Taxes $14,000 per month $10,000 due in March
Cash Balance (Dec. 31, 2007) = $28,000 Minimum balance required by bank = $25,000 (ST borrowing rate = 6% annually) 37
Steps in the Cash Budget
Forecast of monthly collections and other cash inflows Forecast of purchases and other cash outflows Summarize the effect on net monthly cash flows and determine borrowing needs or surpluses.
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Cash Budget - Collections
In each month RMC will collect cash from sales that have occurred in that month and in the preceding two months. In January, sales are 120,000
Collections:
30% x $120,000 (January sales) 50% x $125,000 (December sales) 20% x $130,000 (November sales)
= 36,000 = 62,500 = 26,000
Total cash collected in January
=$124,500
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Sales made in January will not be fully collected until March.
Collection of January Sales

Nov Sales 130,000 Dec 125,000 Jan 120,000 36,000 120,000 x .30
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Feb 260,000
Mar 140,000

Nov Sales 130,000 Dec 125,000 Jan 120,000 36,000 120,000 x .30 Feb 260,000 60,000 Mar 140,000
120,000 x .50
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Nov Sales 130,000 Dec 125,000 Jan 120,000 36,000 120,000 x .30 Feb 260,000 60,000 Mar 140,000 24,000
120,000 x .50
120,000 x .20
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Calculate collections for other months.
Cash Budget RMC, Inc. Dec Jan 125,000 120,000
36,000 62,500 26,000 124,500
Nov Sales 130,000 Collections: Month of Sale (30%) First Month (50%) 2nd Month (20%) Total Collections
Feb 260,000 78,000 60,000 25,000 163,000
Mar 140,000 42,000 130,000 24,000 196,000

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Cash Budget Purchases/Payments

Purchases are made 2 months prior to sale and are paid for 1 month later.
Payments for January Purchases
Nov Sales 130,000 90,000 Dec 125,000 Jan 120,000 Feb 260,000 Mar 140,000
75% of January Sales Purchased in November

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Purchases are made 2 months prior to sale and are paid for 1 month later.
Payments for January Purchases
Nov Sales 130,000 90,000 Dec 125,000 90,000 Jan 120,000 Feb 260,000 Mar 140,000
75% of January Sales Purchased in November, Paid for in December

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Calculate payments for all months. Note that in order to do a cash budget, you will need forecasts of sales for April.
Nov Sales 130,000 Purchases Payments
Cash Budget RMC, Inc. Dec Jan Feb 125,000 120,000 260,000 195,000 105,000 105,000 195,000 105,000
Mar 140,000
Apr 140,000
105,000
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Cash Collections Material Payments
Cash Budget RMC, Inc. Jan 124,500 195,000
Feb 163,000 105,000
Mar 196,000 105,000
Summary of Previous Calculations
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Cash Collections Material Payments Other Payments: Other Expenses Tax Payments
Cash Budget RMC, Inc. Jan 124,500 195,000 14,000 0
Feb 163,000 105,000 14,000 0
Mar 196,000 105,000 14,000 10,000
Remaining Cash Outflows
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Cash Collections Material Payments Other Payments: Rent Other Expenses Tax Payments Net Monthly Change
Cash Budget RMC, Inc. Jan 124,500 195,000 2,000 12,000 0 (84,500)
Feb 163,000 105,000 2,000 12,000 0 44,000
Mar 196,000 105,000 2,000 12,000 10,000 67,000
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Analysis of Borrowing Needs

Cash Budget RMC, Inc. Jan Net Monthly Change (84,500) Beginning Cash Balance 28,000 Ending Cash (No Borrow) Needed (Borrowing) Loan Repayment Interest Cost Ending Cash Balance Cumulative Borrowing
Feb 44,000
Mar 67,000
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Cash Budget RMC, Inc. Jan Net Monthly Change (84,500) Beginning Cash Balance 28,000 Ending Cash (No Borrow) (56,500) Needed (Borrowing) Loan Repayment Interest Cost Ending Cash Balance Cumulative Borrowing
Feb 44,000
Mar 67,000
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Cash Budget RMC, Inc. Jan Feb Mar Net Monthly Change (84,500) 44,000 67,000 Beginning Cash Balance 28,000 Ending Cash (No Borrow) (56,500) Needed (Borrowing) Target Ending Balance Loan Repayment Interest Cost Ending Cash Balance 25,000 Cumulative Borrowing
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Cash Budget RMC, Inc. Jan Feb Mar Net Monthly Change (84,500) 44,000 67,000 Beginning Cash Balance 28,000 Ending Cash (No Borrow) (56,500) Needed (Borrowing) 81,500 Loan Repayment 0 Interest Cost 0 Ending Cash Balance 25,000 Borrowing Required to Cumulative Borrowing cover Minimum Balance and Deficit
56,500+25,000
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Cash Budget RMC, Inc. Jan Net Monthly Change (84,500) Beginning Cash Balance 28,000 Ending Cash (No Borrow) (56,500) Needed (Borrowing) 81,500 Loan Repayment 0 Interest Cost 0 Ending Cash Balance 25,000 Cumulative Borrowing 81,500
Feb 44,000
Mar 67,000
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Feb 44,000 25,000 69,000
Mar 67,000
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Feb 44,000 25,000 69,000 0 408 25,000
Mar 67,000
Interest Incurred on Prior Month Borrowing
81,500 x .005
56

Feb 44,000 25,000 69,000 0 43,592 408 25,000
Mar 67,000
Amount that can be repaid from monthly surplus 69,000 - 408 - 25,000=$43,592
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Cash Budget RMC, Inc. Jan Net Monthly Change (84,500) Beginning Cash Balance 28,000 Ending Cash (No Borrow) (56,500) Needed (Borrowing) 81,500 Loan Repayment 0 Interest Cost 0 Ending Cash Balance 25,000 Cumulative Borrowing 81,500 New Loan Balance
Feb 44,000 25,000 69,000 0 43,592 408 25,000 37,908
Mar 67,000
81,500 - 43,592=$37,908
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Feb 44,000 25,000 69,000 0 43,592 408 25,000 37,908
Mar 67,000 25,000 92,000
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Feb 44,000 25,000 69,000 0 43,592 408 25,000 37,908
Mar 67,000 25,000 92,000 0 190
Interest Incurred on Prior Month Borrowing
37,908 x .005
60

Feb 44,000 25,000 69,000 0 43,592 408 25,000 37,908
Mar 67,000 25,000 92,000 0 37,908 190
Repay Outstanding Loan Balance

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Feb 44,000 25,000 69,000 0 43,592 408 25,000 37,908
Mar 67,000 25,000 92,000 0 37,908 190 53,902 0
Ending Cash Balance
$53,902-$25,000=$28,902 Surplus
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Cash Budget RMC, Inc. Jan 25,000 81,500
Ending Cash Balance Cumulative Borrowing
Feb 25,000 37,908
Mar 53,902 0
RMC needs to raise $81,500 in short-term debt in January, would probably take out a short-term bank loan. In March RMC has a 28,902 surplus. It would probably invest in marketable securities at this point in time.
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Managing Cash Inflows and Outflows
Generally managers try to increase the amount of cash flowing into a business during any given time period. They also try to slow down cash outflows. Collect early and Pay late (but not too late).
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Managing Cash Flows
Can increase cash inflows (or speed them up) by:

Increasing cash sales Increasing credit sales collections
Can decrease cash outflows (or slow them down) by:

Cutting costs Taking full advantage of time allowed to pay obligations
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Managing Cash Flows
Can speed up inflows by:
Can slow down cash outflows by:

Delaying the payment of bills Using remote disbursement banks
Tightening up credit policy (as long as savings from reduced bad debts and collection costs exceed sales that may be lost) Obtaining computerized fund transfers from customers Using collection centers Using a lockbox system
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Accounts Receivable and Inventory
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Learning Objectives
How and why firms manage accounts receivable and inventory. Computation of optimum levels of accounts receivable and inventory. Alternative inventory management approaches. How firms make credit decisions and create collection policies.
68
Why do firms accumulate accounts receivable and inventory?
Given that accounts receivable and inventory are assets that do not provide an explicit rate of return, it is important to understand why firms might still want to have these investments. Granting credit is often an essential business practice and can enhance sales. (But also will increase costs.) Holding adequate inventory is necessary to avoid loss of sales due to stock-outs.
69
Finding the Optimum Level of Accounts Receivable
Firms managers must review the firms credit policies and evaluate the impact of any proposed changes in policies based on the NPV of incremental cash flows due to the change. This is similar to the method we used in determining the best capital budgeting projects to undertake.
Link to Hoovers Online
70
Accounts Receivable Management

The terms of sale are generally stated in the form X / Y, n Z This means that the customer can deduct X percentage if the account is paid within Y days; otherwise, the account must be paid within Z days. Example: 2/10 n 30
The company offers a 2% discount if account paid in 10 days. Balance due in 30 days.
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Effects of Tightening Credit Policy
Raise credit standards
Shorten net due period
Fewer credit customers (could reduce sales) Lower accounts receivable
Reduce discount percentage Shorten discount period

Same as above
Fewer credit customers (could reduce sales) Accounts paid sooner Lower accounts receivable Fewer credit customers (could reduce sales) Fewer take the discount
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Average Collection Period (ACP)
Old Policy; 2/10, n30

35% of customers pay in 10 days 62% of customers pay in 30 days 3% of customers pay in 100 days ACP=(.35x10)+(.62x30)+(.03x100)=25.1 days 35%of customers pay in 10 days 60% of customers pay in 40 days 5% of customers pay in 100 days ACP=(.35x10)+(.60x40)+(.05x100)=32.5 days
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New Policy; 2/10, n40

Analysis of Accts. Receivable Changes
Develop pro forma financial statements for each policy under consideration. Use the pro formas to estimate incremental cash flows by comparing forecasts to current policy cash flows. Use the incremental cash flows to estimate the NPV of each policy change. Choose the policy change that maximizes the value of the firm (highest NPV).
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Example: ABC Corporation is considering a credit policy change from offering no credit to offering 30 days credit with no discount (n 30). Why might they do this? -Increase sales -Increase market share What costs will the firm incur as a result? -Cost of carrying accounts receivable -Potential increase in bad debts -Credit analysis and collection costs
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Assume the Net Incremental Cash Flows associated with ABCs new credit policy are as follows: External financing (Init. Investment) = $28,000 t=0
Increase in sales t=1,2... Increase in COGS Increase in Bad Debts increase in Other Expenses Increase in Interest Expense Increase in Taxes Total Incr. Operating Cash Flow = $30,000 = $15,000 = $3,000 = $5,000 = $500 = $2,600 = $3,900/yr.
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Calculate the NPV of the change (k = 12%): PV of the expected inflows of $3,900 per year from t = 0 to infinity (perpetuity) = $3,900 / .12 = $32,500
NPV = PV of inflows - initial investment = $32,500 - $28,000 = $4,500 Since NPV > 0, ABC should undertake the credit policy change, assuming that the assumptions are valid and that the projected cash flows are accurate.
77
How Firms Make Credit Decisions
The Five Cs of Credit: Character is the borrowers willingness to pay based on past payment patterns. Capacity is the borrowers ability to pay based on forecasts of future cash flows. Capital is how much wealth the borrower has to fall back on. Collateral is what the lender gets if the borrower fails to pay. Conditions faced by the borrower in the business marketplace are also considered.
Link to Credit Scoring
78
Methods of Collection
Most firms use some of the following:

Send reminder letters. Make telephone calls. Hire collection agencies. Sue the customer. Settle for a reduced amount. Write off the bill as a loss. Sell accounts receivable to factors.
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Inventory Management
Typically, inventory accounts for about four to five percent of a firm's assets. In order to effectively manage the investment in inventory, two problems must be dealt with: how much to order and how often to order. The economic order quantity (EOQ) model attempts to determine the order size that will minimize total inventory costs.
80
Determining Optimal Inventory

Economic Order Quantity (EOQ)
Total Total Inventory = Carrying + Costs Costs Total Ordering Costs
Link to Bloomberg.com
81
The EOQ Model assumes the firm orders a fixed amount Q at equal intervals.
Inventory Level (units) Order Quantity Q
Time
82
The EOQ Model

Inventory Level (units) Average Inventory = Order Quantity Q 2 2
Order Quantity Q
Time
83
Total Total Inventory = Carrying + Costs Costs Total Inventory = Costs
Total Ordering Costs
OQ S ) CC + ( OQ ) OC 2
Where: OQ = Order Size (order quantity) S = Annual Sales Volume CC = Carrying Cost per Unit OC = Ordering Cost per Order
84
Ordering Costs = ( S )OC OQ
Cost ($)
Ordering Costs
Order Size (units)
85
Ordering Costs = ( S )OC OQ Carrying Costs = ( OQ ) CC 2
Cost ($)
Carrying Costs
Order Size (units)

86
Ordering Costs = ( S )OC OQ Carrying Costs = ( OQ ) CC 2 Total Costs = Carrying Costs + Order Costs
Cost ($)
Order Size (units)
87
Determining Optimal Inventory The economic order quantity that minimizes the total costs of inventory.
2 x S x OC CC
EOQ =
88

Example: Awesome Autos expects to sell 1,200 new automobiles in the next year. It currently costs $26 per order placed with the manufacturer. Carrying costs amount to $75 per auto. How many autos should they order each time they place an order? 2(1200)26 = 75 2 x S x OC EOQ = CC = 28.84 29 cars
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Example: Awesome Autos expects to sell 1,200 new automobiles in the next year. It currently costs $26 per order placed with the manufacturer. Carrying costs amount to $75 per auto. How many autos should they order each time they place an order?
EOQ autos in each order
Place 1,200/ 29 = 41.4 orders each year

90
Inventory Management with Safety Stock- Order before inventory is at zero.

Inventory Level (units) Inventory Order Point
EOQ Depleted Stock During Delivery Safety Stock Actual Delivery Time Time
91
Inventory Level (units)
Order Quantity Q
Time
92
ABC Inventory Classification System
Tool to reduce inventory carrying costs: classify different types of inventory according to value.
Example: Class A: Expensive items are assigned a serial number and are checked daily. Replaced only as sold. Class B: Moderately priced items are assigned a serial number but are checked less often (monthly) and managed according to EOQ. Class C: Small inexpensive items. Check inventory annually and reorder by visual check.
93
Just In Time Inventory Control (JIT)

Developed in Japan. Reduce raw material inventory carrying costs by making deals with suppliers that require them to deliver the raw materials as needed. Carrying costs are passed on to suppliers. Can result in higher costs if delivery is delayed: shut down of whole production line.
94
Short Term Financing
95
Learning Objectives
The need for short-term financing. The advantages and disadvantages of shortterm financing. Three types of short-term financing. Computation of the cost of trade credit, commercial paper, and bank loans. How to use accounts receivable and inventory as collateral for short-term loans.
96
Why Do Firms Need Short-term Financing?
Profits may not be sufficient to keep up with growth-related financing needs. Firms may prefer to borrow now for their needs rather than wait until they have saved enough. Short-term financing instead of long-term sources of financing due to:
easier availability usually lower cost
97
Sources of Short-term Financing
Short-term loans.
borrowing from banks and other financial institutions for one year or less.
Trade credit.
borrowing from suppliers
Commercial paper.
only available to large credit- worthy businesses.
98
Types of short-term loans:
Promissory note
A legal IOU that spells out the terms of the loan agreement, usually the loan amount, the term of the loan and the interest rate. Often requires that loan be repaid in full with interest at the end of the loan period.
Self-liquidating loan
The proceeds of the loan are used to acquire assets that generate cash to repay the loan (e.g. inventory).
99
Types of short-term loans:
Line of Credit
Revolving credit agreement
The borrowing limit that a bank sets for a firm. May include many promissory notes that the firm has taken out at different times and with overlapping payment periods. Usually informal agreement and may change over time
Formal agreement with bank to extend credit to a firm for a period of time (can be more than one year).
100
Trade Credit
Trade credit is the act of obtaining funds by delaying payment to suppliers. Even though it is obtained by simply delaying payment, it is not always free. The cost of trade credit may be some interest charge that the supplier charges on the unpaid balance. More often, it is in the form of a lost discount that would be given to firms who pay earlier. Credit has a cost. That cost may be passed along to the customer as higher prices, borne by the seller as lower profits, or some of both.
101
Estimation of Cost of Short-Term Credit

Calculation is easiest if the loan is for a one year period: Effective Interest Rate is used to determine the cost of the credit to be able to compare differing terms.
Effective Interest you pay = Interest Rate Amount you get to use
Example: You borrow $10,000 from a bank and must pay $1,000 interest at the end of the year Your effective rate is the same as the stated rate = $1,000/$10,000 = .10 = 10%
102
Variations in Loan Terms
A discount loan requires that interest be paid up front when the loan is given. This changes the effective cost in the previous example since you only get to use: ($10,000 - $1,000) = $9,000. Effective cost = $1,000/$9,000 = .1111 = 11.11%.
103
Variations in Loan Terms
Sometimes lenders require that a minimum amount, called a compensating balance be kept in your bank account. If your compensating balance requirement is $500, then the amount you can use is reduced by that amount. Effective cost for a $10,000 simple interest 10% loan with a $500 compensating balance = $1,000/($10,000-$500) = .1053 = 10.53%.
104
Cost of Short-Term Credit For Periods Less Than One Year

When loans are for less than one year, we must convert the cost to annual terms for comparison. e.g. A 1 month $10,000 loan requires that interest of $90 be paid: the monthly rate = 90/10,000 = .0090 = .9%.
Use the following formula to equate:

Effective Annual = Rate
(1 +
$ Interest $ you get to use
(Periods/yr) -1
105
$10,000 loan for 1 month with monthly interest equal to $90. What is the effective annual interest rate? Effective annual rate = (1.009)12 - 1 = .1135 =11.35%
Link to CNNfn
106
What if the loan is a discount loan? Must pay the interest up front so that reduces the dollars available to use. $10,000 loan with .9%monthly interest:
Effective annual rate
90 K= 1+ 10,000 - 90
) -1 = .1146
107
12
k = 11.46%
Sources of Short Term Credit
Cost of Trade Credit

Typically receive a discount if you pay early. Stated as: 2/10, net 60
Purchaser receives a 2% discount if payment is made within 10 days of the invoice date, otherwise payment is due within 60 days of the invoice date.
The cost is the form of the lost discount.

108
Cost of Trade Credit 2/10 net 60
Assume your purchase is $100 list. If you take the discount, you pay $98. If you dont take the discount, you pay $100. Therefore, you are paying $2 for the privilege of borrowing $98 for the additional 50 days. (Note: the first 10 days are free in this example).
109
Cost of Trade Credit 2/10 net 60

The formula for cost of trade credit is similar to the previous equations. The exponent is the number of times per year the firm can take 50 days of credit. The cost of trade credit for this example: [1 +(2/98)])7.3 -1 = .1589 = 15.89%.
Cost = of Credit
1+
Discount % 100-Discount%
365 days to pay - disc. pd.
) -1
110
Computing the Cost of Trade Credit Another Example
Effective Annual Cost, k, of Passing Up a Discount; 2/10, n40

K = (1+
2 100 - 2
365 40 10
)
-1 = .2786
k = 27.86%
111
Commercial Paper
Commercial paper is quoted on a discount basis so discount yield must be converted to effective annual interest rate for comparison. Compute the discount from face value (D)
Compute the price = Par - D Compute Effective Annual Rate = (par/price)(365/DTG) - 1
D = (Discount yield x par x DTG)/360 DTG = days to go (to maturity)
112
Cost of Commercial Paper Example
$1 million issue of 90 day c.p. quoted at 4% discount yield. Step 1: Calculate D = .04 x $1 mill. x 90 360 = $10,000
Step 2: Calculate price
= $1,000,000 - $10,000 = $990,000

(365/90)
Step 3: Calculate effective rate
= (1,000,000 / 990,000) = 4.16%
-1
113
Accounts Receivable as Collateral
A pledge is a promise that the borrowing firm will pay the lender any payments received from the accounts receivable collateral in the event of default. Since accounts receivable fluctuate over time, the lender may require certain safeguards to ensure that the value of the collateral does not go below the balance of the loan. Accounts receivable can also be sold outright. This is known as factoring.
114
Inventory as Collateral
A major problem with inventory financing is valuing the inventory. For this reason, lenders will generally make a loan in the amount of only a fraction of the value of the inventory. The fraction will differ depending on the type of inventory.
115
Inventory as Collateral
Blanket Lien: A general claim against the borrowers inventory if there is a default Trust Receipt: A legal document that identifies specific inventory as security for a loan Warehousing: Inventory pledged as collateral is removed from the control of the borrower (either in an on-site or public warehouse)
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Working Capital Policy

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Working Capital Policy

Managing Current Assets & Liabilities

Net Working Capital

Determining the Correct level of Working Capital

Costs of Working Capital

Example: Risk-Return Trade-off

Firm 1 150 0 150 -60 90 2

Current Ratio = Current Assets Current Liabilities = 200 100 = 2

Example: Risk-Return Trade-off

Operating Earnings Interest Earned EBT Taxes (40%) Net Income

Firm 1 150 0 150 -60 90

Net Income Assets 90 1000

Example: Risk-Return Trade-off

Firm 1 150 0 150 -60 90 2 9%

Firm 2 150 8 158 -63 95

Example: Risk-Return Trade-off

Firm 1 150 0 150 -60 90 2 9%

Firm 2 150 8 158 -63 95 4

Example: Risk-Return Trade-off

Firm 1 150 0 150 -60 90 2 9%

Firm 2 150 8 158 -63 95 4 7.9%

Example: Risk-Return Trade-off

Firm 1 150 0 150 -60 90 2 9%

Firm 2 150 8 158 -63 95 4 7.9%

Variation in assets over time

Variation in assets over time

Permanent Current Assets Fixed Assets

Variation in assets over time

Permanent Current Assets

Different Approaches to Financing

Financing Current Assets: Conservative Approach

Short-term Sources Temporary Current Assets

Permanent Current Assets

Different Approaches to Financing

Moderate Approach (Maturity Matching)

Financing Current Assets: Moderate Approach

Permanent Current Assets Fixed Assets

Financing Current Assets: Moderate Approach

Short-term Sources Temporary Current Assets

Permanent Current Assets

Different Approaches to Financing

Moderate Approach (Maturity Matching)

Financing Current Assets: Aggressive Approach

Temporary Current Assets

Permanent Current Assets Fixed Assets

Managing (WARM, SOFT) Cash

How much cash should a firm keep on hand?

The size of the minimum cash balance depends on:

The firms maximum cash balance depends on:

Available (short-term) investment opportunities

e.g. money market funds, CDs, commercial paper

If high expected return, firms are quick to invest excess cash

Choosing the Optimum Cash Balance

Choosing the Optimum Cash Balance

Choosing the Optimum Cash Balance

Sell Securities to obtain cash

The Miller - Orr Model

The Miller-Orr Model - Target Cash Balance (Z)

The Miller-Orr Model - Target Cash Balance (Z)

The Miller-Orr Model - Target Cash Balance (Z)

= $3,014 + $1,000 = $4,014

The Miller-Orr Mode - Upper Limit

Forecasting Cash Needs - Cash Budget