Working Capital

Short-Term Finance

What Is (Net) Working Capital?

Current Assets Current Liabilities

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What Does It Mean to be Current?

Convertible to cash with a year

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What Are Current Assets?

Cash
Very liquid short-term securities - like T-bills, repurchase agreements, and commercial paper are usually included here

Marketable securities
Less liquid and longer-term investments made out of current assets

Inventory Accounts receivable

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What Are Current Liabilities?

Accounts payable Accruals of wages and salaries All payments on long-term debt that are payable within a year

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What Is Non-Cash Working Capital?

Remove cash and marketable securities from current assets
Cash and marketable securities are held for reasons beyond just working capita They also pay interest, reducing their opportunity cost to something much closer to zero than can reasonably be expected from non-cash working capital

Remove debt as well it gets counted in cost of capital Inventory+receivables-payables-accruals

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What Is the Pitfall in Thinking About Non-Cash Working Capital?

Increases in inventory and receivables bleed cash out of the firm Increases in payables and accruals yield cash for the firm

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What Are the Economics of NonCash Working Capital?

Non-cash working capital is a derived demand
You need it because of projects You often need it before the project is generating cash flow

It is subject to
Economies of scale Economies of scope
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What Is the Non-Cash Working Capital Tradeoff?

Non-cash working capital is subtracted out of the present value of the project Thus, present value and non-cash working capital are traded off
The higher present value is traded off with the higher risk due to potential loss of customers, and higher default risk

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What Are the Cons of the Tradeoff Between Cash and Non-Cash Working Capital?
Holding less cash:
Is less of an issue if the firm has access to ready outside financing Is harder if the economy tanks Increases uncertainty about meeting debt obligations

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What Are the Pros of the Tradeoff Between Cash and Non-Cash Working Capital?
Holding less cash:
Makes it easier to satisfy the customer out of inventory Makes it easier to entice the customer with easy credit

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Is There An Optimal Level of NonCash Working Capital?

Probably, but there are a lot of difficulties getting the data to figure out the tradeoff

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What Industries Use the Most and Least Non-Cash Working Capital?
Most:
Shoes, textiles, office equipment, homebuilding, auto manufacturing

Least:
Advertising, cable TV, restaurants, hotels/gaming, railroads

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What Are the Benefits of Holding Inventory?

Raw materials Works in progress Finished items
More if it takes time to fill an order More if the product line is diverse More if competitors are ready with substitutes

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What Are the Costs of Holding Inventory?

Foregone interest
Increases with the size of inventory Increased with interest rates

Carrying costs
Storage Tracking

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What Is EOQ (Economic Order Quantity)?

A solution to a simple optimization problem for minimizing the costs of inventory
EOQ = sqrt(2 x demand x ordering cost/carrying cost) This yields a graph of inventory that looks like a series of capital Ns through time A cushion can be added above zero inventory for safety

Similar to the Baumol model for cash (presented later)

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What Are the Weaknesses of Using EOQ?

It assumes constant demand It assumes that inventories can be replenished without a time delay It assumes that ordering costs do not depend on the size of the order (i.e., there are no volume discounts)

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How Can Optimal Inventories Be Determined?

Ideally you want to measure the change in the value of the firm due to a marginal change in inventory
This is difficult in practice

Most firms look at similar firms for guidance

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What Industries Hold the Most and Least Inventory?

Most:
Pharmacies, textiles, aerospace, apparel, homebuilding

Least
Healthcare information systems, medical services, telecommunications, hotels/gaming, restaurants

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How Does Trade Credit Relate to Non-Cash Working Capital?

Leads to an accounts receivable
Product is shipped, leading to a need to replenish inventory Payment may not be made immediately This can create cash flow problems

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What Are the Costs of Offering Trade Credit?

Default risk Interest foregone on the revenue

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What Are the Benefits of Offering Trade Credit?

Locks in a sale that the buyer can afford out of cash flows but not out of cash on hand Its also more of an additional general enticement to the buyer
While trade credit is being sold to the prospective buyer you are keeping them on the line for the item you actually want to sell
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How Do You Decide Whether or Not to Offer Trade Credit?

Present value analysis

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How Do We Evaluate Trade Credit Policy?

Similar to inventory policy?
The problem is too murky to be solved directly. So we ask:
Does it increase the value of the firm? Is it consistent with what similar firms are offering?

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How To Construct a Scoring System for Offering Trade Credit?

Define characteristics associated with default Obtain data legally Weight the data in a way consistent with the default risk Test fly the system Put it into practice
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How Are Terms of Trade Credit Expressed?

a/b net c
a% discount Lasting for b days The full undiscounted amount due within c days

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How Do You Figure Out the Rate You Are Offering?

[1+discount/(1-discount)}^(365/discount length) = 1+effective rate If the customer delays payment, they are effectively increasing the discount length and reducing your interest rate

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Who Has the Most and Least Accounts Receivable?

Most
Telecommunications, newspapers, energy, semiconductors, petroleum

Least
Restaurants, industrial services, healthcare information services, tobacco, trailers and RVs

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What About Accepting Trade Credit?

This creates an accounts payable It also tends to increase cash flows The costs and benefits of this are the opposite of extending trade credit, but
Dont forget that the interest you pay is deductible, while the interest you receive is not so they are not quite mirror images of each other
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Who Accepts Trade Credit?

Surprisingly, the same industries that extend lots of trade credit also tend to accept a lot of it
Restaurants and tobacco firms use little of both Defense and auto firms use a lot of both The biggest exploiters of longer payables and shorter receivables are auto firms
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What About Cash?

Cash Money in accounts bearing rates lower than the risk-free rate Short-term securities

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Why Hold Operating Cash?

Transactions motive Precautionary motive Compensating balances
This is what you hold in the bank to get access to lines of credit and other services

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What Determines Cash Holdings?

Size Sophistication of the firms finances Availability of investments Most U.S. firms hold 1-2% of revenues as cash

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What Is the Baumol Model?

Similar to the EOQ for inventory Optimal cash balances = sqrt[(2 x annual cash usage x cost per security sale)/(interest rate)]

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What Is the Miller-Orr Model?

Firm sets upper and lower limits on cash, and it only buys or sells securities when it reaches these thresholds. This requires us
To assume a minimum balance To know the variance of cash flows

Spread = 3[(3/4)(transactions cost x variance/interest rate)]^(1/3)

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How Does Holding Cash Affect the Firms Value?

Holding operating cash is much like holding non-cash working capital
It reduces the flow of cash that can be paid out to investors

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How Can Cash Be Reduced?

Float managing
Increase your disbursement float and decrease your processing float

Better banking
Lockboxes Concentration banking Have the bank control disbursements so they are made immediately after deposits
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What Near-Cash Investments Are Possible?

In order of increasing risk and return (there is usually a less than 1% difference in this group) Treasury bills Repurchase agreements
On T-Bills On non-mortgage securities On mortgage-backed securities

Commercial paper
From financial institutions From non-financial instititutions
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How to Choose Between Cash and Near-Cash?

Benefits of near-cash
Earn interest

Costs of near-cash
Transactions costs Default risk (admittedly, this is minimal)

Choosing to park some cash in near-cash is an investment decision whose hurdle rate is the risk-free rate
You need to be able to beat this after transactions costs and default risk
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When Can Investments In Cash and Near-Cash Reduce Firm Value?

Not earning the market rate
This is not much of a problem in the U.S. This can be a big problem with overseas investments where local markets may be overregulated or too thin to offer reasonable risk-free rates

Lousy management
The value of cash will be discounted in the market if the firm has few viable projects

Cash is a payment that has not been made to equity yet

Thus, hording cash is the same as being underleveraged
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Are There Good Reasons to Hold Lots of Cash?

High growth industries High volatility industries Industries in which viable projects appear unexpectedly

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What About Riskier Investments In the Short-Term?

Pros
Higher returns You can take advantage of undervalued securities issued by other firms Strategic investment
Push other firms decisions in your direction

Its the nature of some businesses

Cons
Higher risk Higher transactions costs
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Who Holds Cash?

Most
Coal, copper, air transport, autos, steel

Least
Retail building supply, water utilities, pharmacies, groceries, retail

Cash holdings are positively associated with revenue growth and negatively associated with revenue

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