Corporate Finance

Term III, Sections E & F

Class Notes 11

Indian Institute of Management Calcutta

Prof Purusottam Sen

December 2017-March 2018
 The Operating Cycle and the Cash Cycle
Raw material
purchased Cash received
Finished goods sold

Order Stock
Placed Arrives

Inventory period Accounts receivable period

Accounts payable period Time

Firm receives invoice Cash paid for materials

Operating cycle

Cash cycle
 Cash Budgeting

• A cash budget is a primary tool of short-run financial planning.

• The idea is simple: Record the estimates of cash receipts and

disbursements.

– Cash Receipts
• Arise from sales, but we need to estimate when we actually
collect
– Cash Outflow
• Payments of Accounts Payable
• Wages, Taxes, and other Expenses
• Capital Expenditures

• Long-Term Financial Planning

 Example

• Sales estimates (in Rs. lacs)

– Q1 = 500; Q2 = 600; Q3 = 650; Q4 = 800; Q1 next year = 550

• Accounts receivable
– Beginning receivables = Rs. 250 lacs
– Average collection period = 30 days

• Accounts payable
– Purchases = 50% of next quarter’s sales
– Beginning payables = Rs.125 lacs
– Accounts payable period is 45 days

• Other expenses
– Wages, taxes and other expense are 30% of sales
– Interest and dividend payments are Rs.50 lacs
– A major capital expenditure of Rs.200 lacs is expected in the second
quarter

• The initial cash balance is Rs.80 lacs and the company maintains a
minimum balance of Rs.50 lacs
 Example

• ACP = 30 days, this implies that 2/3 of sales are collected in the quarter
made, and the remaining 1/3 are collected the following quarter.

• Beginning receivables of Rs.250 lacs will be collected in the first quarter.

Q1 Q2 Q3 Q4

Beginning Receivables 250 167 200 217

Sales 500 600 650 800
Cash Collections 583 567 633 750
Ending Receivables 167 200 217 267
 Example

• Payables period is 45 days, so half of the purchases will be paid for each
quarter, and the remaining will be paid the following quarter.

• Beginning payables = Rs.125 lacs

Q1 Q2 Q3 Q4
Payment of accounts 275 313 362 338
Wages, taxes and other expenses 150 180 195 240
Capital expenditures 200
Interest and dividend payments 50 50 50 50
Total cash disbursements 475 743 607 628
 Example

Q1 Q2 Q3 Q4
Total cash collections 583 567 633 750

Total cash disbursements 475 743 607 628

Net cash inflow 108 -176 26 122

Beginning Cash Balance 80 188 12 38

Net cash inflow 108 -176 26 122

Ending cash balance 188 12 38 160

Minimum cash balance -50 -50 -50 -50

Cumulative surplus (deficit) 138 -39 -12 110

 The Short-Term Financial Plan

The most common way to finance a temporary cash deficit is to arrange a

short-term loan.

 Unsecured Loans
– Line of credit (at the bank)
 Secured Loans
– Accounts receivable can be either assigned or factored.
– Inventory loans use inventory as collateral.
 Other Sources
– Banker’s acceptance
– Commercial paper
 Working Capital Financing – Other Sources

• Commercial Paper
• Needs to be rated by rating agency
• Maturity 15 – 364 days
• Privately placed with Fis
• Market determined interest
• Inter-corporate Loan
• Bill Discounting
• Discounting trade bills using Bill of Exchange
• Factoring
• Purchase of receivables (with or without recourse)
• Forfaiting
• Non recourse discounting of export receivables
 Carrying Costs and Shortage Costs
Total costs of
holding current Carrying costs
Rs Minimum
assets. * Opportunity costs of holding short
point term assets – such assets provide
lower ROI
* Maintenance of economic value of
current assets

Shortage costs
* Transactions costs for converting
marketable securities – if those
are available
* Possibility of defaults
* Loss of sales due to allowing no
credit sales

CA* Investment in Current

Assets (Rs)
Corporate Liquid Asset Holdings
 Alternative Financing Policies

• A flexible short-term finance policy means a low proportion of

short-term debt relative to long-term financing.

• A restrictive short-term finance policy means a high proportion of

short-term debt relative to long-term financing.

• In an ideal world, short-term assets are always financed with short-

term debt, and long-term assets are always financed with long-
term debt.
– In this world, net working capital is zero.
 Cumulative Fund Requirement

Rs

Cumulative fund requirement

Long Term
W/C
Capital
Expenditure Year 1 Year 2 Time
 Short Term Financing

Rs A
B
C

Cumulative fund requirement

Year 1 Year 2 Time

Lines A, B, and C show alternative amounts of long-term finance

Policy A: A permanent cash surplus (Flexible - ie., a low proportion of short term
debt to long term debt)
Policy B: Short-term surplus for part of year and borrower for remainder
Policy C: A permanent short-term borrower (Restrictive- ie., a high proportion of
short term debt to long term debt)
 Financing Options
Financing
POLICY A (Flexible)
Level

POLICY B

POLICY C (Restrictive)

Output

HIGH LOW

Liquidity POLICY A POLICY B POLICY C

Profitability POLICY C POLICY B POLICY A
Risk POLICY C POLICY B POLICY A
 Short Term Vs. Long Term Financing

 FINANCING 
Short Term Long Term

Short Moderate Low

Term Risk - Profit Risk-profit
ASSET
TYPE Long High Moderate
Term Risk-profit Risk-profit
Working Capital Financing – Turnover Method

• Based on The Nayak Committee

• Working Capital Requirement : 25% of turnover
• Promoter Contribution (Margin) : 5% of turnover
• Bank Finance : 20% of turnover
• Used for Small Trading Companies
Working Capital Financing – Cash Budget System

• Based on Net Cash Flow

• Cash Outflows (Business Expenditure) – Cash Inflows
(Operating as well as Capital inflows marked for
business uses)
• Eliminates requirement of Stock and Debtors for
assessment
• Applicable conditions incorporated in the loan
agreement
• Used for Service Sector Companies
 Working Capital Financing – Tandon Committee

 As per the current practice, the first step is to assess the level of
norms for holding such assets in various industry sectors
 The Tandon Committee had advised such norms – which have
subsequently been reviewed.
 For example, the norms for current assets in the paints and
varnishes industry is as follows:
− Raw Materials : 2.25 months
− Work-in-process : 0.50 months
− Finished Goods : 1.50 months
− Receivables : 2.00 months
 Working Capital Financing – Tandon Committee
• Method I : Borrowers to fund 25% of the net working capital
(Current Assets – Current Liabilities)
• Method II : Borrowers to fund 25% of Current Assets
• Method III : Borrowers fund 100% of Core Assets + 25% of the
Other Current Assets
The balance is funded by the bank

Note:
• Chore Committee has discarded Method III and recommended
Method II
• Method II is also known as Maximum Permissible Bank Finance
(MPF)
• Banks mainly use Method II for assessment of Working Capital
requirements though they are allowed to use their own methods.
Rate of interest is fixed by banks on the basis of their Prime
Lending Rate (PLR) + applicable spread
 Working Capital Financing – Example
Sometimes bank stipulations may reduce funding available :
MPBF
Stock 140.00
Debtors1 200.00
Other current assets 10.00
Total Current Assets 350.00
Less: Creditors 50.00
Net Current Assets 300.00
Less: 25% Margin on Current Assets 87.50
MPBF 212.50

1 debtors more than 90 days 20.00

Bank Stipulations may give rise to lower drawing power because of:
Margin stipulations
Disallowance of current assets other than stocks and debtors
Sub limits stipulation
No. of days stipulation (for debtors)
 Working Capital Financing – Example (contd)

For example the bank could stipulate the following:

Sub limit for debtors 100.00

Other current assets disallowed:
Debtors older than 90 days disallowed
Margin for stock 25%
Margin for debtors 35%

Thus the drawing power computed by the bank is as follows :

Stock 105.00
Debtors 100.00
Total 205.00
Less Creditors 50.00

155.00
Which is of course is less than what was computed earlier!