Quiz 5

Working Capital
Policy
Chapter 17
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.
2
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)
3
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)
Costs of Working Capital
Lower Returns - $$ invested in lower returning

securities rather than production.
4
Example: Risk-Return Trade-off

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

Current Liabilities
= 200
100
= 2
5

Fixed Assets
Total Assets
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Current Ratio
ROA
Firm 1
0
200
800
1000
Firm 1
150
0
150
-60
90
Firm 1
ST Debt
100
LT Debt
400
Common Stock
500
Total Liabilities&Equity
1000
Return on Assets =
=
90
1000
= .09 = 9%
2
9%
Net Income
Assets

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

Fixed Assets
Total Assets
Firm 1
0
200
800
1000
Firm 2
200
200
800
1200
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Firm 1
150
0
150
-60
90
Firm 2
150
8
158
-63
95
Current Ratio
ROA
2
9%
Firm 1
ST Debt
100
LT Debt
400
Common Stock
500
Current Ratio = CA
CL
=
=4
8
400
100
Firm 2
100
400
700
1200

Fixed Assets
Total Assets
Firm 1
0
200
800
1000
Firm 2
200
200
800
1200
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Firm 1
150
0
150
-60
90
Firm 2
150
8
158
-63
95
2
9%
4
7.9%
Current Ratio
ROA
Firm 1
ST Debt
100
LT Debt
400
Common Stock
500
Return on Assets =
=
Firm 2
100
400
700
1200
NI
Assets
95
1200
=.079 = 7.9%
9

Fixed Assets
Total Assets
Firm 1
0
200
800
1000
Firm 2
200
200
800
1200
Operating Earnings
Interest Earned
EBT
Taxes (40%)
Net Income
Firm 1
150
0
150
-60
90
Firm 2
150
8
158
-63
95
2
9%
4
7.9%
Current Ratio
ROA
Firm 1
ST Debt
100
LT Debt
400
Common Stock
500
Firm 2
100
400
700
1200
Firm 1
Firm 2
Higher ROA
Less Liquid
Riskier
Lower ROA
More Liquid
Less Risky
10
Variation in assets over time

Total Assets
$5M
Fixed
Assets
Time
11
Assume ZERO Long-term Growth

Total Assets
$7M
$5M
Permanent
Current Assets
Fixed
Assets
Time
12

Total Assets
$10M
Temporary Current Assets
$7M
$5M
Permanent
Current Assets
Fixed
Assets
Time
13
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
14
Financing Current Assets:

Total Assets
Short-term
Sources
$10M
$7M
$5M
Long-term
Sources
Permanent
Current Assets
Fixed
Assets
Time
15
Financing
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.
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

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

Moderate Approach
Total Assets
Short-term
Sources
$10M
$5M
Long-term
Sources
$7M
Permanent
Current Assets
Fixed
Assets
Time
18
Financing
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.
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.
19
LT financing is used for the remaining fixed assets.

Aggressive Approach
Total Assets
$10M
Short-term
Sources
$7M
$5M
Long-term Sources
Permanent
Current Assets
Fixed
Assets
Time
20
Managing (WARM, SOFT) Cash

Chapter 18
21
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)
23
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
24
The firms maximum

cash balance depends
on:
Available (short-term) investment

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

paper
Expected return on investment

opportunities (opportunity cost)
If high expected return, firms are quick to

invest excess cash
Transaction cost of withdrawing cash

and making an investment
Link to Bureau of Economic Analysis
25
Choosing the Optimum

Cash Balance
Dollars in the Cash Account
Cash Balances in a Typical Month
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Days of26the Month

Cash Balance

Invest Excess
Cash
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Days of27the Month

Cash Balance
Sell Securities to
obtain cash
| | | | | | | | | | | | | | | | | | | | | | | | | | | |
Days of28the Month
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
29
The Miller-Orr Model

- Target Cash Balance
(Z)
3
3 x TC x V
Z=
+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
30

(Z)
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).
31

(Z)
Example
3
Z = 3 x 50 x 100,000
+ $1,000
4 x .05/365
= $3,014 + $1,000 = $4,014
32
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
33
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
34
Cash Budget - Problem

Rocky Mountain Climbing, Inc. (RMC) has the
following information:
Previous Sales
November 2007
December 2007
130,000
125,000
January 2008
February 2008
March 2008
April 2008
120,000
260,000
140,000
140,000
Forecast Sales
35

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
36

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
$14,000 per month
Taxes
$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.
38
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)

= 36,000
50% x $125,000 (December sales) = 62,500
20% x $130,000 (November sales) = 26,000
Total cash collected in January

=$124,500
39

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
Feb
Mar
260,000
140,000
36,000
120,000
120,000xx.30
.30
40

Nov
Sales 130,000
Dec
125,000
Jan
120,000
36,000
120,000
120,000xx.30
.30
Feb
Mar
260,000
60,000
140,000
120,000
120,000xx.50
.50
41

Nov
Sales 130,000
Dec
125,000
Jan
120,000
36,000
120,000
120,000xx.30
.30
Feb
Mar
260,000
60,000
120,000
120,000xx.50
.50
140,000
24,000
120,000
120,000xx.20
.20
42

Calculate collections for other months.
Cash Budget
RMC, Inc.
Nov
Dec
Jan
Feb
Mar
Sales
130,000
125,000
120,000
260,000 140,000
Collections:
Month of Sale (30%)
36,000
78,000
42,000
First Month (50%)
62,500
60,000 130,000
2nd Month (20%)
26,000
25,000
24,000
Total Collections
124,500
163,000 196,000
43
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
Mar
260,000
140,000
75%
75%of
ofJanuary
JanuarySales
SalesPurchased
Purchasedinin
November
November
44

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
Mar
260,000
140,000
75%
75%of
ofJanuary
JanuarySales
SalesPurchased
Purchasedinin
November,
November,Paid
Paidfor
forininDecember
December
45

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
125,000
120,000
195,000
105,000
195,000
Feb
Mar
260,000 140,000
105,000
105,000 105,000
46
Apr
140,000
Cash Collections
Material Payments
Cash Budget
RMC, Inc.
Jan
124,500
195,000
Feb
163,000
105,000
Summary
Summaryof
of Previous
PreviousCalculations
Calculations
47
Mar
196,000
105,000
Cash Collections
Material Payments
Other Payments:
Other Expenses
Tax Payments
Cash Budget
RMC, Inc.
Jan
124,500
195,000
Feb
163,000
105,000
Mar
196,000
105,000
14,000
0
14,000
0
14,000
10,000
Remaining
RemainingCash
Cash Outflows
Outflows
48
Cash Collections
Material Payments
Other Payments:
Rent
Other Expenses
Tax Payments
Net Monthly Change
Cash Budget
RMC, Inc.
Jan
124,500
195,000
Feb
163,000
105,000
Mar
196,000
105,000
2,000
12,000
0
(84,500)
2,000
12,000
0
44,000
2,000
12,000
10,000
67,000
49
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
50
Mar
67,000

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
Loan Repayment
Interest Cost
Ending Cash Balance
Feb
44,000
51
Mar
67,000

Cash Budget
RMC, Inc.
Jan
Feb
Mar
Net Monthly Change
(84,500)
44,000
67,000
28,000
(56,500)
Needed (Borrowing)
Target
TargetEnding
EndingBalance
Balance
Loan Repayment
Interest Cost
Ending Cash Balance
25,000
52

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
Feb
44,000
Mar
67,000
Borrowing
BorrowingRequired
Requiredto
to
cover
coverMinimum
MinimumBalance
Balance
and
andDeficit
Deficit
56,500+25,000
53

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
81,500
Feb
44,000
54
Mar
67,000

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
81,500
Feb
44,000
25,000
69,000
55
Mar
67,000

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
81,500
Feb
44,000
25,000
69,000
0
Mar
67,000
408
25,000
Interest
InterestIncurred
Incurredon
onPrior
Prior
Month
MonthBorrowing
Borrowing
81,500 x .00556

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
Mar
67,000
Amount
Amount that
that can
can be
be repaid
repaidfrom
from
monthly
monthlysurplus
surplus
57
69,000 - 408 - 25,000=$43,592

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
37,908
New
NewLoan
LoanBalance
Balance
81,500 - 43,592=$37,908
58
Mar
67,000

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
37,908
59
Mar
67,000
25,000
92,000

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
37,908
Interest
InterestIncurred
Incurredon
onPrior
Prior
Month
MonthBorrowing
Borrowing
37,908 x .005
60
Mar
67,000
25,000
92,000
0
190

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
81,500
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
RepayOutstanding
OutstandingLoan
Loan
Balance
Balance
61

Cash Budget
RMC, Inc.
Jan
Net Monthly Change
(84,500)
28,000
(56,500)
Needed (Borrowing)
81,500
Loan Repayment
0
Interest Cost
0
Ending Cash Balance
25,000
81,500
Feb
44,000
25,000
69,000
0
43,592
408
25,000
37,908
Ending
EndingCash
CashBalance
Balance
$53,902-$25,000=$28,902 Surplus
62
Mar
67,000
25,000
92,000
0
37,908
190
53,902
0
Ending Cash Balance

Cash Budget
RMC, Inc.
Jan
25,000
81,500
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.
63
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).
64
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
65
Managing Cash Flows
Can speed up inflows by:
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
Can slow down cash outflows by:

Delaying the payment of bills
Using remote disbursement banks
66
Accounts Receivable
and Inventory
Chapter 19
67
Learning Objectives
How and why firms manage

accounts receivable and
inventory.
Computation of optimum levels of
inventory.
Alternative inventory
management approaches.
How firms make credit decisions
68
Why do firms accumulate

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 Link
projects
undertake.
to Hooversto
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.
71
Effects of Tightening
Credit Policy
Raise credit standards
Fewer credit customers (could reduce

sales)
Lower accounts receivable
Shorten net due period

sales)
Accounts paid sooner
Lower accounts receivable
Reduce discount percentage

sales)
Fewer take the discount
72
Shorten discount period
Average Collection
Period (ACP)
Old Policy; 2/10, n30
35% of customers pay in 10 days

ACP=(.35x10)+(.62x30)+(.03x100)=25.1
days
New Policy; 2/10, n40
35%of customers pay in 10 days

ACP=(.35x10)+(.60x40)+(.05x100)=32.5
73
days
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).
74
Analysis of Accts.
Receivable Changes
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
75
Analysis of Accts.
Receivable Changes
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
$3,900/yr.
= $30,000
=
=
=
=
=
=
76
$15,000
$3,000
$5,000
$500
$2,600
Analysis of Accts.
Receivable Changes
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 77
assumptions are
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.
79
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 + (
)
OC
2
OQ
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
85
Order Size (units)

OQ
Cost
($)
Carrying Costs = ( OQ ) CC
2
Carrying Costs
Order Size (units)

86

OQ
Carrying Costs = ( OQ ) CC
2
Total Costs = Carrying Costs + Order Costs
Cost
($)
Order Size (units)

87
The economic order quantity that
minimizes the total costs of
inventory.
EOQ =
2 x S x OC
CC
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
89

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
93
inventory annually and reorder by visual
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
Chapter 20
95
Learning Objectives
The need for short-term financing.

The advantages and disadvantages of
short-term 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 longterm 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
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
Revolving credit agreement
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

Year
$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

Year
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
k = 11.46%
12
) -1 = .1146
107
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
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
Discount %
1 + 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
2
K = (1+ 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)
D = (Discount yield x par x DTG)/360
DTG = days to go (to maturity)
Compute the price = Par - D

Compute Effective Annual Rate
= (par/price)(365/DTG) - 1
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
Step 3: Calculate effective rate
= (1,000,000 / 990,000)
= 4.16%
(365/90)
113
-1
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)
116

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Working Capital

Understand the importance of

The Importance of Managing

Net Working Capital

Determining the Correct level of

Higher Liquidity (Lowers Risk)

Costs of Working Capital

Lower Returns - $$ invested in lower returning

Example: Risk-Return Trade-off

Current Ratio = Current Assets

Example: Risk-Return Trade-off

Example: Risk-Return Trade-off

Example: Risk-Return Trade-off

Example: Risk-Return Trade-off

Example: Risk-Return Trade-off

Variation in assets over time

Variation in assets over time

Variation in assets over time

Financing Current Assets:

Temporary Current Assets

Moderate Approach (Maturity Matching)

Financing Current Assets:

Financing Current Assets:

Temporary Current Assets

Moderate Approach (Maturity Matching)

Financing Current Assets:

Managing (WARM, SOFT) Cash

How much cash should

Managers must keep enough cash

The size of the

How quickly and cheaply a firm

The firms maximum

Available (short-term) investment

e.g. money market funds, CDs, commercial

Expected return on investment

If high expected return, firms are quick to

Transaction cost of withdrawing cash

Choosing the Optimum

Cash Balances in a Typical Month

Choosing the Optimum

Cash Balances in a Typical Month

Choosing the Optimum

Cash Balances in a Typical Month

The Miller - Orr Model

The Miller-Orr Model provides a

The Miller-Orr Model

The Miller-Orr Model

The Miller-Orr Model

The Miller-Orr Mode

The upper limit for the cash account

Used to determine monthly needs and

Cash Budget - Problem

Cash Budget - Problem

Cash Budget - Problem

Steps in the Cash

Forecast of monthly collections

Cash Budget Collections

In each month RMC will collect cash from

In January, sales are 120,000

30% x $120,000 (January sales)

Total cash collected in January

Cash Budget Collections