Working Capital

Management
 Basic Definitions
Gross working capital:
Total current assets.
Net working capital:
Current assets - Current liabilities.
Net operating working capital (NOWC):
Operating CA – Operating CL =
(Cash + Inv. + A/R) – (Accruals + A/P)
(More…)

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 Definitions (Continued)
Working capital management:
Includes both establishing working capital
policy and then the day-to-day control of
cash, inventories, receivables, accruals, and
accounts payable.
Working capital policy:
The level of each current asset.
How current assets are financed.

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Cash and Liquidity
Management
 Cash Management
Cash management is concerned with the
managing of:
 Cash flows into and out of the firm,
Cash flows within the firm, and
Cash balances held by the firm at a
point of time by financing deficit or
investing surplus cash

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 Reasons for Holding Cash
Speculative motive – hold cash to take
advantage of unexpected opportunities
Precautionary motive – hold cash in case of
emergencies
Transaction motive – hold cash to pay the day-
to-day bills
Trade-off between opportunity cost of holding
cash relative to the transaction cost of
converting marketable securities to cash for
transactions
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 Understanding Float
Float – difference between cash balance
recorded in the cash account and the cash
balance recorded at the bank
Disbursement float
 Generated when a firm writes checks
 Available balance at bank – book balance > 0
Collection float
 Checks received increase book balance before the
bank credits the account
 Available balance at bank – book balance < 0
Net float = disbursement float + collection float
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 Example: Types of Float
You have $3000 in your checking account. You
just deposited $2000 and wrote a check for
$2500.
What is the disbursement float? $2,500
What is the collection float? -$2,000
What is the net float? $2,500 – $2,000 = $500
What is your book balance? $3000 + 2000 –
2500 = $2500
What is your available balance? $3000

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 Example: Measuring Float
Size of float depends on the dollar amount and the
time delay
Delay = mailing time + processing delay +
availability delay
Suppose you mail a check for $1000 and it takes 3
days to reach its destination, 1 day to process and 1
day before the bank makes the cash available
What is the average daily float (assuming 30-day
months)?
Method 1: (3+1+1)(1000)/30 = 166.67
Method 2: (5/30)(1000) + (25/30)(0) = 166.67

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 Example: Cost of Float
Cost of float – opportunity cost of not being able
to use the money
Suppose the average daily float is $3 million with
a weighted average delay of 5 days.
 What is the total amount unavailable to earn interest?
 5*3 million = 15 million
 What is the NPV of a project that could reduce the
delay by 3 days if the cost is $8 million?
 Immediate cash inflow = 3*3 million = 9 million
 NPV = 9 – 8 = $1 million

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 Payment Payment Payment Cash
Mailed Received Deposited Available

Mailing Time Processing Delay Availability Delay

Collection
Delay

One of the goals of float management is to try

to reduce the collection delay. There are several
techniques that can reduce various parts of the
delay.
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Example: Accelerating Collections – Part I
Your company does business nationally and currently all
checks are sent to the headquarters in Tampa, FL. You are
considering a lock-box system that will have checks
processed in Phoenix, St. Louis and Philadelphia. The
Tampa office will continue to process the checks it receives
in house.
 Collection time will be reduced by 2 days on average
 Daily interest rate on T-billls = .01%
 Average number of daily payments to each lockbox is
5000
 Average size of payment is $500
 The processing fee is $.10 per check plus $10 to wire
funds to a centralized bank at the end of each day.
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Example: Accelerating Collections – Part II
Benefits
Average daily collections = 3(5000)(500) = 7,500,000
Increased bank balance = 2(7,500,000) = 15,000,000

Costs
Daily cost = .1(15,000) + 3*10 = 1530
Present value of daily cost = 1530/.0001 = 15,300,000
NPV = 15,000,000 – 15,300,000 = -300,000
The company should not accept this lock-box
proposal

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 Cash Disbursements
Slowing down payments can increase
disbursement float – but it may not be
ethical or optimal to do this
Controlling disbursements
Zero-balance account
Controlled disbursement account

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 Investing Cash
Money market – financial instruments with an
original maturity of one year or less
Temporary Cash Surpluses
Seasonal or cyclical activities – buy marketable
securities with seasonal surpluses, convert
securities back to cash when deficits occur
Planned or possible expenditures – accumulate
marketable securities in anticipation of
upcoming expenses

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Figure 7.1

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 Optimum Cash Balance
Optimum Cash Balance under Certainty:
Baumol’s Model
Optimum Cash Balance under Uncertainty:
The Miller–Orr Model

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 Baumol’s Model–Assumptions:
The firm is able to forecast its cash needs
with certainty.
The firm’s cash payments occur uniformly
over a period of time.
The opportunity cost of holding cash is
known and it does not change over time.
The firm will incur the same transaction
cost whenever it converts securities to cash.

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 Baumol’s Model
 The firm incurs a holding cost for keeping the cash balance. It is an
opportunity cost; that is, the return foregone on the marketable securities.
If the opportunity cost is k, then the firm’s holding cost for maintaining an
average cash balance is as follows:
Holding cost = k (C / 2)
 The firm incurs a transaction cost whenever it converts its marketable
securities to cash. Total number of transactions during the year will be
total funds requirement, T, divided by the cash balance, C, i.e., T/C. The
per transaction cost is assumed to be constant. If per transaction cost is c,
then the total transaction cost will be:
Transaction cost = c(T / C )
 The total annual cost of the demand for cash will be:
Total cost = k (C / 2)  c(T / C )
 The optimum cash balance, C*, is obtained when the total cost is
minimum. The formula for the optimum cash balance is as follows:
2cT
C* 
k
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 Illustration–Baumol’s Model
Advani Chemical Limited estimates its total cash requirement as Rs 2 crore next
year. The company’s opportunity cost of funds is 15% per annum. The company
will have to incur Rs 150 per transaction when it converts its short-term securities to
cash. Determine the optimum cash balance. How much is the total annual cost of
the demand for the optimum cash balance? How many deposits will have to be
made during the year?
C*  2cT / k
2(150)( 20,000,000)
C*   Rs200,000
0.15

The annual cost will be:

Total cost = 150(2,00,000/2,00,000) + 0.15(2,00,000/2)
= 150(100) + 0.15(1,00,000) = 15,000 + 15,000 = Rs 30,000

During the year, the company will have to make 100 deposits, i.e. converting marketable securities to cash.

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 The Miller–Orr Model
The MO model provides for two control limits–the
upper control limit and the lower control limit as
well as a return point.
If the firm’s cash flows fluctuate randomly and hit
the upper limit, then it buys sufficient marketable
securities to come back to a normal level of cash
balance (the return point).
Similarly, when the firm’s cash flows wander and
hit the lower limit, it sells sufficient marketable
securities to bring the cash balance back to the
normal level (the return point).
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 The Miller-Orr Model
The difference between the upper limit and the lower
limit depends on the following factors:
 the transaction cost (c)
 the interest rate, (i)
 the standard deviation (s) of net cash flows.
The formula for determining the distance between upper
and lower control limits (called Z) is as follows:
(Upper Limit – Lower Limit) = (3/ 4 × Transaction Cost × Cash Flow Variance / Interest Rate)1 / 3
Upper Limit = Lower Limit + 3Z
Return Point = Lower Limit + Z
The net effect is that the firms hold the average the cash balance equal to:
Average Cash Balance = Lower Limit + 4/3Z

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Characteristics of Short-Term Securities
Maturity – firms often limit the maturity of
short-term investments to 90 days to avoid
loss of principal due to changing interest
rates
Default risk – avoid investing in marketable
securities with significant default risk
Marketability – ease of converting to cash
Taxability – consider different tax
characteristics when making a decision
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Credit and Inventory
Management
 Credit Management: Key Issues
Granting credit increases sales
Costs of granting credit
Chance that customers won’t pay
Financing receivables
Credit management examines the trade-off
between increased sales and the costs of
granting credit

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 Components of Credit Policy
Terms of sale
Credit period
Cash discount and discount period
Type of credit instrument
Credit analysis – distinguishing between “good”
customers that will pay and “bad” customers that
will default
Collection policy – effort expended on collecting
receivables

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 Credit Sale Check Mailed Check Deposited Cash
Available

Cash Collection

Accounts Receivable

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 Terms of Sale
Basic Form: 2/10 net 45
 2% discount if paid in 10 days
 Total amount due in 45 days if discount not
taken
Buy $500 worth of merchandise with the
credit terms given above
 Pay $500(1 - .02) = $490 if you pay in 10 days
 Pay $500 if you pay in 45 days

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 Example: Cash Discounts
Finding the implied interest rate when
customers do not take the discount
Credit terms of 2/10 net 45
Period rate = 2 / 98 = 2.0408%
Period = (45 – 10) = 35 days
365 / 35 = 10.4286 periods per year
EAR = (1.020408)10.4286 – 1 = 23.45%
The company benefits when customers
choose to forgo discounts
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 Credit Policy Effects
Revenue Effects
Delay in receiving cash from sales
May be able to increase price
May increase total sales
Cost Effects
Cost of the sale is still incurred even though the cash from
the sale has not been received
Cost of debt – must finance receivables
Probability of nonpayment – some percentage of
customers will not pay for products purchased
Cash discount – some customers will pay early and pay
less than the full sales price
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Example: Evaluating a Proposed Policy – Part I
Your company is evaluating a switch from a
cash only policy to a net 30 policy. The price
per unit is $100 and the variable cost per unit
is $40. The company currently sells 1000 units
per month. Under the proposed policy, the
company will sell 1050 units per month. The
required monthly return is 1.5%.
What is the NPV of the switch?
Should the company offer credit terms of net
30?
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Example: Evaluating a Proposed Policy – Part II
Incremental cash inflow
(100 – 40)(1050 – 1000) = 3000
Present value of incremental cash inflow
3000/.015 = 200,000
Cost of switching
100(1000) + 40(1050 – 1000) = 102,000
NPV of switching
200,000 – 102,000 = 98,000
Yes the company should switch
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 Total Cost of Granting Credit
Carrying costs
Required return on receivables
Losses from bad debts
Costs of managing credit and collections
Shortage costs
Lost sales due to a restrictive credit policy
Total cost curve
Sum of carrying costs and shortage costs
Optimal credit policy is where the total cost
curve is minimized
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 Figure 8.1
The Costs of Granting Credit

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 Credit Analysis
Process of deciding which customers receive
credit
Gathering information
 Financial statements
 Credit reports
 Banks
 Payment history with the firm
Determining Creditworthiness
 5 C’s of Credit
 Credit Scoring
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 Credit Information
Financial statements
Credit reports with customer’s payment
history to other firms
Banks
Payment history with the company

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 Five Cs of Credit
Character – willingness to meet financial
obligations
Capacity – ability to meet financial
obligations out of operating cash flows
Capital – financial reserves
Collateral – assets pledged as security
Conditions – general economic conditions
related to customer’s business

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 Collection Policy
Monitoring receivables
Keep an eye on average collection period relative
to your credit terms
Use an aging schedule to determine percentage
of payments that are being made late
Collection policy
Delinquency letter
Telephone call
Collection agency
Legal action

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 Inventory Management
Inventory can be a large percentage of a
firm’s assets
There can be significant costs associated
with carrying too much inventory
There can also be significant costs associated
with not carrying enough inventory
Inventory management tries to find the
optimal trade-off between carrying too much
inventory versus not enough

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 Types of Inventory
Manufacturing firm
Raw material – starting point in production
process
Work-in-progress - partially finished goods
requiring additional work before they become
finished goods
Finished goods – products ready to ship or sell
Remember that one firm’s “raw material” may be
another firm’s “finished good”
Different types of inventory can vary dramatically
in terms of liquidity
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 Inventory Costs
Carrying costs – range from 20 – 40% of inventory
value per year
Storage and tracking
Insurance and taxes
Losses due to obsolescence, deterioration or theft
Opportunity cost of capital
Shortage costs
Restocking costs
Lost sales or lost customers
Consider both types of costs and minimize the total
cost
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 Inventory Management - ABC
Classify inventory by cost, demand and need
Those items that have substantial shortage
costs should be maintained in larger quantities
than those with lower shortage costs
Generally maintain smaller quantities of
expensive items
Maintain a substantial supply of less expensive
basic materials

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 EOQ Model
The EOQ model minimizes the total inventory cost
Total carrying cost = (average inventory) x
(carrying cost per unit) = (Q/2)(CC)
Total restocking cost = (fixed cost per order) x
(number of orders) = F(T/Q)
Total Cost = Total carrying cost + total restocking
cost = (Q/2)(CC) + F(T/Q)

* 2TF
Q 
CC
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Figure 8.2

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 Example: EOQ
Consider an inventory item that has carrying
cost = $1.50 per unit. The fixed order cost is
$50 per order and the firm sells 100,000 units
per year.
What is the economic order quantity?

* 2(100,000)(50)
Q   2582
1.50
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 Extensions
Safety stocks
Minimum level of inventory kept on hand
Increases carrying costs
Reorder points
At what inventory level should you place an
order?
Need to account for delivery time
Derived-Demand Inventories
Materials Requirements Planning (MRP)
Just-in-Time Inventory

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 Extensions (cont.)
Derived-Demand Inventories: Sales depend on
consumer demand
Materials Requirements Planning (MRP): use
computer-based systems for ordering and/or
scheduling production of demand-dependent
inventories
Just-in-Time Inventory: design for inventory in
which parts, raw materials, and other work-in-
process is delivered exactly as needed for
production. The goal is to minimize inventory