financial management week 13.1

8/14/2019 Financial Management Week 13.1

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Working Capital Management


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Working-Capital Management

Current Assets

Cash, marketable securities, inventory,

accounts receivable.

Long-Term Assets

Equipment, buildings, land.

Which earn higher rates of return?

Which help avoid risk of illiquidity?


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CurrentAssets Cash, marketable securities, inventory,

accounts receivable.

Long-TermAssets Equipment, buildings, land.

Risk-Return Trade-off:Current assets earn low returns, buthelp reduce therisk of illiquidity.


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Current Liabilities

Short-term notes, accrued expenses,

accounts payable.

Long-Term Debt and Equity

Bonds, preferred stock, common stock.

Which are more expensivefor the firm?

Which help avoid risk of illiquidity?


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CurrentLiabilities Short-term notes, accrued expenses,

accounts payable.

Long-Term Debt and Equity Bonds, preferred stock, common stock.

Risk-Return Trade-off:Current liabilities are less expensive,but increase therisk of illiquidity.


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Balance Sheet

Current Assets Current Liabilities

Fixed Assets Long-Term Debt

Preferred Stock

Common Stock

To illustrate, lets finance all current assets

with current liabilities,


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Balance Sheet



Preferred Stock

Common Stock

To illustrate, lets finance all current assets

with current liabilities, and finance all

fixed assets with long-term financing.


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Balance Sheet



Preferred StockCommon Stock

Suppose we use long-termfinancing tofinance some of our current assets.


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Balance Sheet



Preferred StockCommon Stock

Suppose we use long-termfinancing tofinance some of our current assets.

This strategy would be less risky, but more

expensive!


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Balance Sheet



Preferred Stock

Common Stock

Suppose we use current liabilitiesto financesome of our fixed assets.


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Balance Sheet



Preferred Stock

Common Stock

Suppose we use current liabilities to financesome of our fixed assets.

This strategy would be less expensive, but

more risky!


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Inventory Management


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Inventory Management

Purchasing

Production scheduling

Efficient servicing of customer demands

Inventories provide flexibility for the firm in:


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Appropriate

Level of Inventories

Employ a cost-benefit analysis

Compare the benefitsof economies of production,

purchasing, and product marketing against thecostof the additional investment in inventories.

How does a firm determine the

appropriate level of inventories?


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How Much to Order?

Forecast usage

Ordering cost

Carrying cost

The optimal quantity to order depends on:


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Total Inventory Costs

C: Carrying costs per unit per period

O: Ordering costs per order

S: Total usage during the period

Total inventory costs (T) =C(Q / 2) + O(S/ Q)

TIME

Q / 2

QAverageInventory

INVENTORY

(inunits)


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EOQ (Q*) represents the minimum pointin total inventory costs.


Total Carrying Costs

Total Ordering Costs

Q* Order Size (Q)

Costs


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Economic Order Quantity

The EOQor

optimalquantity(Q*)

is:

The quantity of an inventory item to order sothat total inventory costs are minimized over

the firms planning period.

Q* = 2 (O) (S)C


19/49

Example of the


Basket Wonders is attempting to determine the economic

order quantity for fabric used in the production of

baskets.

10,000 yards of fabric were used at a constant rate last

period.

Each order represents an ordering cost of $200.

Carrying costs are $1 per yard over the 100-day planningperiod.

What is the economic order quantity?


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We will solve for the economic order quantitygiven that ordering costs are $200 per order,total usage over the period was 10,000 units,

and carrying costs are $1 per yard (unit).

Q* = 2 ($200) (10,000)$1

Q* = 2,000 Units


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When to Order?

Order Point -- The quantity to which inventory must fall

in order to signal that an order must be placed toreplenish an item.

Order Point (OP) = Lead time X Daily usage

Issues to consider:

Lead Time -- The length of time between the

placement of an order for an inventory item andwhen the item is received in inventory.


22/49

Example of When to Order

Julie Miller ofBasket Wonders has determined that ittakes only 2 days to receive the order of fabric after the

placement of the order.

When should Julie order more fabric?

Lead time = 2 days

Daily usage = 10,000 yards / 100 days= 100 yards per day

Order Point = 2 days x100 yards per day=200 yards


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Example of When to Order

0 18 20 38 40Lead

Time

200

2000

OrderPointU

NITS

DAYS

Economic Order Quantity (Q*)


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Order Point Problem

Average EOQinventory 2

= + safety stock


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Safety Stock

Our previous example assumed certaindemand and lead

time. When demand and/or lead time are uncertain, then

the order point is:

Order Point =

(Avg.lead time xAvg.daily usage) + Safety stock

Safety Stock-- Inventory stock held in reserve as acushion against uncertain demand (or usage) and

replenishment lead time.


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Order Point

with Safety Stock

0 18 20 38

400

2000

OrderPoint

UNITS

DAYS

2200

Safety Stock200


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How Much Safety Stock?

Amount of uncertainty in inventory demand

Amount of uncertainty in the lead time

Cost of running out of inventory

Cost of carrying inventory

What is the proper amount of safetystock?

Depends on the:


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The cash conversion cycle focuses on the timebetween payments made for materials and laborand payments received from sales:

Cash Inventory Receivables Payablesconversion = conversion + collection - deferral .

cycle period period period

Cash Conversion Cycle


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CCC = +

CCC = + 45.6 30

CCC = 75.7 + 45.6 30

CCC = 91.3 days.

Days per yearInv. turnover

Payablesdeferralperiod

Days salesoutstanding

3654.82



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Accounts Receivable

Management


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Accounts Receivable

Management

Size of I nvestment in Accounts Receivable

Percent of Credit Sales to Total Sales

Level of Sales Terms of Sale

Quality of Customer

Collection Efforts


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Accounts Receivable

Management

Terms of Sale

Quoted as a/b net c, which means

deduct a%if paid within bdays,otherwise pay within cdays.

Example: 3/30 net 60means

deduct 3% if paid within 30 days,otherwise pay the entire amount

within 60 days.


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Accounts Receivable

Management

Terms of Sale

Annualized opportunity cost offoregoing a discount:


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x

Accounts Receivable

Management

Terms of Sale

Annualized opportunity cost offoregoing a discount:

a 360*

1 - a c - b

*or 365


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a 360

1 - a c - bx

Accounts Receivable Management


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a 360

1 - a c - b

Opportunity cost of foregoing 3/30 net 60:

x



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a 360

1 - a c - b

opportunity cost of foregoing 3/30 net 60:

.03 360

1 - .03 60 - 30x

x



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a 360

1 - a c - b

opportunity cost of foregoing 3/30 net 60:

.03 360

1 - .03 60 - 30

= 37.11%

x

x



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It means oportunity cost 3% discount is

37.11% (annualy).

It is the opportunity cost if we forgo the cash

discount.

Then, we can assume it is a financing costsimilar to the interest on a loan.

Compare that cost with the cost of a bank loan.


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Should choose the cheapest source of funding.

The cost of trade credit depends on credit

terms.

The higher the discount percentage offered, the

greater the cost of forgoing the discount.


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2/10 net 30

0.02/(1-0.02) x 365/(30-10) = 0.020 x 18,25 =

0.365 or 36,5 % pa

Then, we compare with benchmark, say bank

rate. If the banks rate is 22%, we should take

the discount


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Account Receivables Management

Marginal/Incremental Analysis

Step 1. Estimate changes in profit

Step 2. Estimate additional cost in account

receivables and inventory

Step 3. Estimate cost of discount (if there is a

change in cash discount)

Step 4. Compare incremental income withincremental cost


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Dennis Corporation credit sales is $8,000,000. It is collected

within 30 days. Bad debt at this moment is $240,000 and

opportunity cost is 15%. He calculates that variabel cost is

75% of sales price.

Dennis is considering to relax the credit standard from 1/30,net 60 become 1/45, net 60. He believes that the new credit

standard will generate new credit sales become $9,000,000 and

half of his customer will take the new cash discount. He also

considers that bad debt of new credit standard will increase.He assumes 6% of new credit sales is bad debt. Furthermore,

He estimates new investment in inventory level is about

$25,000.


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Relevan Information from Dennis Corp. New credit sales $9,000,000

Previous credit sales $8,000,000

Contribution margin (assumed for 1 unit) 25% (pricevar.cost)

New bad debt level 6%

New DSO 45 days

Previous DSO 30 days

Rate of return 15%

New cash discount 1%

Percentage of customers taking 50%

new cash discount

Additional investment in inventory $25,000


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Step 1. Estimate changes in profit

Changes in Profit = (Increase in sales x contribution margin)

increase in sales x new bad debt level)

= ($1,000,000 x 0,25)($1,000,000 x 0.06)

= $190,000


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Step 2. Estimate additional cost in account receivables and

inventory

Add.cost in A/R and inv = (Add. A/R + add. Inv.) x rate of return

Add. A/R = (New sales x new DSO)(Previous sales x previous DSO)Add. A/R =(9,000,000 x 45/360)(8,000,000 x 30/360) = 458,340

Add.cost in A/R and Inv. = (458,340 + 25,000) x 0.15 = 72,501


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Step 3. Estimate cost of discount (if there is a change in

cash discount) Cost of disc. = (New sales level x new cash disc. x % of customer taking new

disc.)(previous sales level x prev. cash disc. X % of customer taking

prev.disc.)

Cost of disc. = ($9,000,000 x 0.01 x 0.50)($8,000,000 x 0.01 x 0)

= $45,000


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Step 4. Compare incremental income with

incremental cost

Step 1(Step 2 + Step 3)

=$190,000($72,501 + $45,000) = $72,499 Conclusion: Dennis should take new credit standard

as new incremental income higher than incremental

cost.

financial management week 13.1

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