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Principles of Corporate Finance

Ninth Edition

Chapter 30
Working Capital Management

Slides by Matthew Will

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Topics Covered
Inventories Credit Management Cash Marketable Securities

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Working Capital
Current assets and liabilities for U.S. manufacturing firms (2nd qtr. 2006)$ billions
Currenty Assets Cash Other shirt-term financial investments Accounts receivable Inventories Other current asets Total 265 199 634 570 311 1979 Current Liabilities Short-term loans Accounts payable Accrued income taxes Current payments due on long-term debt Other current liabilities Total 138 436 65 104 723 1466

Net working capital (current assets-current liabilities) = $1979-1466=$513 billion.


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Inventory Management
Components of Inventory
Raw materials Work in process Finished goods

Goal = Minimize amount of cash tied up in inventory Tools used to minimize inventory
Just-in-time Lean manufacturing

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Inventories
As the firm increases its order size, the number of orders falls and therefore the order costs decline. However, an increase in order size also increases the average amount in inventory, so that the carrying cost of inventory rises. The trick is to strike a balance between these two costs.

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Managing Inventories

60 Inventory, thousands of units

Inventory

30

Average Inventory

6
Weeks

12

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Inventories
Determination of optimal order size
Inventory costs, dollars
Total costs Carrying costs

Total order costs Optimal order size Order size

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Inventories
Economic Order Quantity - Order size that minimizes total inventory costs.

Economic Order Quantity =

2 x annual sales x cost per order carrying cost

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Inventories
Just-in-time inventory management Managing inventories of cash
Upper limit

Cash Balance
Return point

Lower limit

Time
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Inventories
The optimal amount of short term securities sold to raise cash will be higher when annual cash outflows are higher and when the cost per sale of securities is higher. Conversely, the initial cash balance falls when the interest is higher.

Initial cash balance =

2 x annual cash outflows x cost per sale of securities interest rate

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Working Capital
Net Working Capital - Current assets minus current liabilities. Often called working capital. Cash Conversion Cycle - Period between firms payment for materials and collection on its sales. Carrying Costs - Costs of maintaining current assets, including opportunity cost of capital. Shortage Costs - Costs incurred from shortages in current assets.

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Terms of Sale
Terms of Sale - Credit, discount, and payment terms offered on a sale. Example - 5/10 net 30

5 - percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due

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Terms of Sale
A firm that buys on credit is in effect borrowing from its supplier. It saves cash today but will have to pay later. This, of course, is an implicit loan from the supplier. We can calculate the implicit cost of this loan

Effective annual rate = 1 +


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discount discounted price

365 / extra days credit

- 1

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Terms of Sale
Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?

Effective annual rate 1+ 1 +


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365/extra days credit discount discounted price 5 365/50 95

-1

- 1 = .454, or 45.4%
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Credit Agreements
Terminology
open account promissory note commercial draft sight draft time draft trade acceptance bankers acceptance irrevocable letter of credit conditional sale

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Credit Analysis
Numerical Credit Scoring categories
The customers character The customers capacity to pay The customers capital The collateral provided by the customer The condition of the customers business

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Credit Analysis
Credit Analysis - Procedure to determine the likelihood a customer will pay its bills. Credit agencies, such as Dun & Bradstreet provide reports on the credit worthiness of a potential customer. Financial ratios can be calculated to help determine a customers ability to pay its bills.

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The Credit Decision


Credit Policy - Standards set to determine the amount and nature of credit to extend to customers. Credit Scoring What your lender wont tell tell you.

Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default. Denying credit guarantees neither profit or loss.

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The Credit Decision


The credit decision and its probable payoffs

Customer pays = p

Payoff = Rev - Cost

Offer credit Customer defaults = 1-p Payoff = - Cost

Refuse credit Payoff = 0


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The Credit Decision


Based on the probability of payoffs, the expected profit can be expressed as:

p x PV(Rev - Cost) - (1 - p) x (PV(cost)


The break even probability of collection is:

PV(Cost) p = PV(Rev)
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Collection Policy
Collection Policy - Procedures to collect and monitor receivables. Aging Schedule - Classification of accounts receivable by time outstanding.

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Factoring
Total factoring volume measured in millions of Euros
1,200,000

Factoring volume (millions)

1,000,000

800,000

Rest of world
600,000

Europe Americas

400,000

200,000

0 1999 2000 2001 2002 2003 2004 2005 2006

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Collection Policy
Sample aging schedule for accounts receivable

Customer' s Less than More than 1 - 2 months 2 - 3 months Total Owed Name 1 month 3 months A 10,000 0 0 0 10,000 B 8,000 3,000 0 0 11,000 * * * * * * * * * * * * * * * * * * Z 5,000 4,000 6,000 15,000 30,000 Total $200,000 $40,000 $15,000 $43,000 $298,000

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Cash
Cash does not pay interest
Move money from cash accounts into short term securities Sweep programs MMDAs Concentration banking Lock-box system

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Cash
How purchases are paid. Percentage of total by payment type for 2004.
100% 80% 60% 40% 20% 0% Direct debits Credit transfers Credit/debit cards Checks

UK

Canada

Germany

Netherlands

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Switzerland

Sweden

France

USA

Italy

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Cash
Electronic Funds Transfer (EFT) Automated Clearinghouse (ACH) 2005 ACH transaction volume = $31.1 trillion International cash management Compensating balances

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Payment Methods
120

100

% of firms using

80

60

Receive payments
Make payments

40

20

0 Direct payments Direct deposits Wire transfers

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Marketable Securities
Microsoft 2006 cash investments

Investment Money market mutual funds Commercial paper Certificates of deposit US Govt and agency securities Foreign govt bonds Mortgage backed securities Corporate notes and bonds Municipal securities Other Total

Amount $723 million 3,242 364 4,904 6,034 4,285 7,605 4,008 383 31,548

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Money Market Investments


Investment Borrower MATURITIES When Issued 4 weeks, 3 months, or 6 months Marketability Excellent secondary market Very good secondary market Basis for Calculating Interest Comments

Treasury bills

U.S. government

Discount

Federal agency FHLB, "Fannie Mae," benchmark bills and Sallie Mae," Freddie Overnight to 360 discount notes Mac," etc. days

Discount

Auctioned weekly Benchmark bills by regular auction; discount notes sold through dealers Tax-anticipation notes (TANs), revenue anticipation notes (RANs), bond anticipation notes (BANs), etc. Long-term bonds with put options to demand repayment

Municipalities, Tax-exempt states, school municipal notes districts, etc. Tax-exempt variableMunicipalities, rate demand bond states, universities, (VRDBs) etc.

3 months to 1 year

10-40 years

Good secondary market Good secondary market

Usually interestbearing with interest at maturity

Variable interest rate

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Money Market Investments


Investment Non-negotiable time deposits and negotiable certificates of deposit (CDs) Borrower MATURITIES When Issued Marketability Basis for Calculating Interest Comments Usually 1 to 3 months; also Fair secondary longer-maturity market for Interest-bearing with variable-rate CDs negotiable CDs interest at maturity Receipt for time deposit Maximum 270 days; usually less than 10 years Minimum 270 days;usually less than 10 years Dealers or issuer will repurchase paper Dealers will repurchase notes Fair secondary market Unsecured promissory note; may be placed through dealer or directly with investor Unsecured promissory note placed through dealer Demand to pay that has been accepted by a bank

Commercial banks, savings and loans Industrial firms, finance companies, and bank holding Commercial paper companies; also (CP) municipalities Largely finance companies and Medium-term notes banks; also industrial (MTNs) firms Bankers' acceptances (Bas) Major commercial banks

Usually discount

Interest-bearing; usually fixed rate

1-6 months Overnight to about 3 months; also open repos (continuing contracts)

Discount

Repurchase agreements (repos)

Dealers in U.S. government securities

No secondary market

Repurchase price set higher than selling Sales of government price; difference securities by dealer with quoted as repo simultaneous agreement interest rate to repurchase.

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Short Term Assets


Short term assets held by US non-financial corporations (2nd quarter 2006)
600 500

$ billion

400 300 200 100


Money-market funds Cd s and time deposits Commercial paper Tax-exempt Treasury securities Agency securities Repos

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Web Resources
Click to access web sites Internet connection required

www.decisioneering.com www.jaxworks.com www.toolkit.cch.com www.bis.org www.federalreserve.gov www.ecb.int

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