Working Capital Management Chapter 30 Principles of Corporate Finance Ninth Edition Working Capital Management Slides by Matthew Will McGraw Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved

Topics Covered Inventories Credit Management Cash Marketable Securities

Working Capital Current assets and liabilities for U.S. manufacturing firms (2nd qtr. 2006)…$ billions

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

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. 22

Managing Inventories Inventory 60 30 Inventory, thousands of units Average Inventory 0 3 6 9 12 Weeks

Inventories Determination of optimal order size Total costs Carrying costs Inventory costs, dollars Total order costs Order size Optimal order size 24

Inventories Economic Order Quantity - Order size that minimizes total inventory costs. 23

Inventories Just-in-time inventory management Managing inventories of cash Upper limit Cash Balance Return point Lower limit Time 26

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. 25

Working Capital Net Working Capital - Current assets minus current liabilities. Often called working capital. Cash Conversion Cycle - Period between firm’s 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. 3

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 3

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 5

Terms of Sale Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given? 7

Credit Agreements Terminology open account promissory note commercial draft sight draft time draft trade acceptance banker’s acceptance irrevocable letter of credit conditional sale 8

Credit Analysis Numerical Credit Scoring categories The customer’s character The customer’s capacity to pay The customer’s capital The collateral provided by the customer The condition of the customer’s business 10

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 customer’s ability to pay its bills. 9

The Credit Decision Credit Policy - Standards set to determine the amount and nature of credit to extend to customers. Credit Scoring – What your lender won’t 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. 17

The Credit Decision The credit decision and its probable payoffs Payoff = Rev - Cost Payoff = - Cost Customer pays = p Customer defaults = 1-p Payoff = 0 Offer credit Refuse credit 20

The Credit Decision Based on the probability of payoffs, the expected profit can be expressed as: The break even probability of collection is: 23

Collection Policy Collection Policy - Procedures to collect and monitor receivables. Aging Schedule - Classification of accounts receivable by time outstanding. 24

Factoring volume (millions) Total factoring volume measured in millions of Euros Factoring volume (millions)

Collection Policy Sample aging schedule for accounts receivable 25

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

How purchases are paid. Percentage of total by payment type for 2004. Cash How purchases are paid. Percentage of total by payment type for 2004.

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

Payment Methods % of firms using

Marketable Securities Microsoft 2006 cash investments

Money Market Investments

Money Market Investments

Short Term Assets $ billion Short term assets held by US non-financial corporations (2nd quarter 2006) $ billion

Web Resources Web Links www.decisioneering.com www.jaxworks.com 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