Principles Used in Chapter 16

Principles Used in Chapter 16 • Principle 1: • The Risk-Return Trade-Off – We Won’t Take On Additional Risk Unless We Expect to Be Compensated with Additional Return.

Cash Flow Process • Two typical sources of cash: external and internal • Irregular increases or decreases in the firm’s cash holdings can come from several sources such as: • Sale of securities (stocks and bonds) • Nonmarketable-debt contracts • Payment of dividend, interest, tax bills • Share repurchases

Cash Flow Process • Other sources of cash reductions: • Acquisition of fixed assets • Purchase of inventory

Motives for Holding Cash • Three Motives: • Transactions Motive • Precautionary Motive • Speculative Motive

Transactions Motive • Balances held to meet cash needs that arise in the ordinary course of doing business.

Precautionary Motive • Buffer stock of liquid assets • Maintain balances to satisfy possible, but as yet unknown, needs

Speculative Motive • Cash held to take advantage of potential profit-making situations

Cash Management • Cash management program must minimize the firm’s risk of insolvency. • Insolvency – The situation in which the firm is unable to meet its maturing liabilities on time. • A company is technically insolvent in that it lacks the necessary liquidity to make prompt payment on its current debt obligations.

The Trade-off • A large cash balance will help minimize the chance of insolvency, but it penalizes the company’s profitability. • A smaller cash balance will increase the chance of insolvency, but it will free up excess cash for investment and enhance profitability.

Cash Management Objectives • Two prime objectives: • Enough cash must be on hand to meet disbursal needs in the course of doing business. • Investment in idle cash balances must be reduced to a minimum.

Cash Management Objectives • Two conditions would allow the firm to operate for extended periods with cash balances near or at zero: • Completely accurate forecast of net cash flows over the planning horizon. • Perfect synchronization of cash receipts and disbursements.

Cash Management Decisions • What can be done to speed up cash collections and slow down or better control cash outflows? • What should be the composition of a marketable securities portfolio?

Collection and Disbursement Procedures • Efficiency of firm’s cash management program can be improved: • By accelerating cash receipts • By improving the methods used to distribute cash

Speeding up Collection • What can be done to accelerate collection procedures? • Reduce Float • Lockbox System

Float and Managing Cash Inflow • Float – The time from when a check is written until the actual recipient can draw upon or use the funds. • Mail Float • Processing Float • Transit Float

Float and Managing Cash Inflow • Mail Float • Time lapse from the moment a customer mails a remittance check until the firm begins to process it. • Processing Float • The time required for the firm to process remittance checks before they can be deposited in the bank.

Float and Managing Cash Inflow • Transit Float • The time necessary for a deposited check to clear through the commercial banking system and become usable funds to the company • Disbursing Float • Availability of funds in the company’s bank account during the time the payment check is clearing through the banking system

Lockbox Arrangement • Commercial banking service where customers mail checks to a post office box (rather than company) to expedite cash collection • The bank providing the lock box service is authorized to open the box, collect the mail, process the checks, and deposit the checks directly into the company’s account.

Benefits of Lockbox Arrangement • Reduces mail and processing float and can reduce transit float • Funds deposited in this manner are usually available for company use in one business day or less • Elimination of clerical functions • Early knowledge of dishonored checks

Benefit of Float Reduction • The financial benefit of float reduction can be calculated with the following formula: • Sales per day X days of float reduction X assumed yield • Sales per day = Annual revenues / days in year

Management of Cash Outflow • Goal: to increase company’s float by slowing down the disbursement and collection process through: • Zero balance accounts • Payable-through drafts

Composition of Marketable-Securities Portfolio • General Selection Criteria for proper marketable securities mix: • Financial risk • Interest rate risk • Liquidity • Taxability • Yields

Financial Risk • Refers to the uncertainty of expected returns from a security attributable to possible changes in the financial capacity of the security issuer to make future payments to the security owner. • If the chance of default on the terms of the instrument is high, then the financial risk is said to be high.

Interest Rate Risk • Refers to the uncertainty of expected return from a financial instrument attributable to changes in interest rates.

Liquidity • Refers to the ability to transform a security into cash. • Should an unforeseen event require that a significant amount of cash be immediately available, then a sizable portion of the portfolio might have to be sold. Manager should prefer securities that can be sold at or near its prevailing market price.

Taxability • The tax treatment of the income a firm receives from its security investments does not affect the ultimate mix of the marketable-securities portfolio as much as the criteria mentioned earlier.

Yields • Affected by previous factors of financial risk, interest rates, liquidity and taxability. • The yield criterion involves an evaluation of the risks and benefits inherent in all of these factors. • For example: If a given risk is assumed, such as lack of liquidity, a higher yield may be expected on the nonliquid instrument.

Marketable Security Alternatives • Money market securities generally have short-term maturity and are highly marketable. • Characteristics of Marketable Securities in terms of five key attributes: • Denominations in which securities are available • Maturities that are offered • Basis used • Liquidity of the instrument • Taxability of the investment returns

Examples of Marketable Securities • U.S. Treasury Bills • Direct obligations of the U.S. government sold by the U.S. treasury on a regular basis. • Federal Agency Securities • Debt obligations of corporations and agencies that have been created to effect various lending programs of the U.S. government. • Banker’s Acceptances • Draft (order to pay) drawn on a specific bank by an exporter in order to obtain payment for goods shipped to a customer who maintains an account with that specific bank.

Examples of Marketable Securities • Negotiable Certificates of Deposit • Marketable receipt for funds that have been deposited in a bank for a fixed period. • Commercial Paper • Short-term unsecured promissory notes sold by large businesses. • Money market mutual funds • Pooling of the funds of a large number of small savers.

Examples of Marketable Securities • Repurchase agreements • Legal contracts that involve the actual sale of securities by a borrower to the lender, with a commitment on the part of the borrower to repurchase the securities at the contract price plus a stated interest charge.

Accounts Receivable Management • Accounts receivable is less liquid compared to cash and marketable securities. Account receivables typically comprise 25% of a firm’s assets. • Size of investment in accounts receivable is determined by: • The percentage of credit sales to total sales • The level of sales • Credit and collection policies

Credit and Collection Policy • Decision Variables: • The Terms of Sale • The Type of Customer • The Collection Effort

Terms of Sale • Identify the possible discount for early payment, the discount period, and the total credit period. • They are stated in the form a/b, net c • Thus a customer can deduct a% if paid within b days, otherwise it must be paid within c days. • Example 1/10, net 45  Discount of 2% if paid within 10 days; otherwise due in 45 days.

Type of Customer • This involves determining the type of customer who qualifies for trade credit. • Need to consider the costs of credit investigation, collection costs, default costs. • May use credit scoring or a numerical evaluation of each applicant to determine their short-run financial well-being.

Collection Efforts • The probability of default increases with the age of the account. Thus, eliminating past-due receivables is key. One common way of evaluating the situation is with ratio analysis – average collection period, ratio of receivables to assets, ratio of credit sales to receivables, ratio of bad debt to sales. • A direct trade-off exists between collection expenses and lost goodwill on one hand and noncollection of accounts on the other.

Inventory Management • Involves the control of the assets that are produced to be sold in the normal course of the firm’s operations. • The purpose of carrying inventory is to uncouple the operations of the firm – that is, to make each function of the business independent of each other function – so that delays or shutdowns in one area do not affect the production and sale of the final product.

The Trade-off • Risk: If inventory level is low, it is possible that there will be delays in production and customer delivery. • Return: But low inventory will reduce storage and handling costs and release funds tied up in inventory. Thus it will increase returns. • Similarly, high levels of inventory will reduce delays but increase costs.

Inventories • Raw materials • Basic materials purchased to be used in the firm’s production operations. • Work in process • Partially finished goods requiring additional work before they become finished goods. • Finished goods • Goods on which production has been completed but are not yet sold.

Inventory Management Techniques • Effective inventory management is directly related to the size of the investment in inventory. • Effective management is essential to the goal of maximization of shareholder wealth.

Inventory Management Techniques • To control the investment in inventory, management must solve two problems: • Order quantity problem • Order point problem

Order Quantity Problem • Involves determining the optimal order size for an inventory item given its expected usage, carrying costs, and ordering costs.

Total Inventory Costs • Total inventory costs = total carrying costs + total ordering costs • Total carrying costs = number of orders * carrying cost per order = Q/2 * C • Total ordering costs = number of orders * ordering cost per order = S/Q * O • Where • Q = inventory order size in units • C = Carrying cost per unit • S = total demand for units • O = Ordering cost per order

EOQ Assumptions • Constant or uniform demand • Constant unit price • Constant carrying costs • Constant ordering costs • Instantaneous delivery • Independent orders

Order Point Problem • The two most limiting assumptions in EOQ – constant demand and instantaneous delivery – are dealt with through the inclusion of safety stock.

Order Point Problem • Safety stock • Inventory held to accommodate any unusually large and unexpected usage during delivery time • Order point problem • The decision about how much safety stock to hold or how low should the inventory be depleted before it is ordered?

Determination of Order Point • Inventory Order Point = Delivery time stock + safety stock • Delivery-time stock – Inventory needed between the order date and the receipt of the inventory ordered. • The order point is reached when inventory falls to a level equal to thedelivery-time stock plus the safety stock. See figure 16-8.

Just-in-Time Inventory System • Aim is to operate with the lowest average level of inventory possible. • Within the EOQ model, the basics are to: • Reduce ordering costs • Reduce safety stocks • This is achieved by attempts to receive continuous flow of deliveries of component parts. • The result is to actually have about 2 to 4 hours worth of inventory on hand.

Inflation and EOQ • Inflation affects the EOQ Model in two ways: • Anticipatory buying – buying in anticipation of a price increase to secure the goods at a lower cost. • Increased carrying costs – as inflation pushes up interest rates, the costs of carrying inventory increases. As “C” increases, the optimal EOQ declines in the EOQ model.

Principles Used in Chapter 16