12-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Twelve Current Investment Decisions

12-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan 12.1The Investments Involved 12.2 The Operating Cycle and the Cash Cycle 12.3 Some Aspects of Short-term Financial Policy 12.4 The Cash Budget 12.5 A Short-term Financial Plan Summary and Conclusions Chapter Organisation

12-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Chapter Objectives Understand the components of the operating cycle and the cash cycle. Explain the key issues in a firm’s short-term financial policy. Understand and apply the inventory model. Prepare a cash budget.

12-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Current Investment Decisions Involve the administration of the company’s current assets (cash and marketable securities, receivables and inventory), and the financing needed to support these assets. Problems in using discounted cash flow techniques to evaluate these decisions: –identification of all relevant cash inflows and outflows –determining the size and timing of these cash flows –determining the correct discount rate.

12-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Current Asset Relationships

12-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Operating and Cash Cycles Operating cycle—the time period between the acquisition of inventory and the collection of cash from receivables. Operating cycle = Inventory period + A/cs receivable period Cash cycle—the time period between the outlay of cash for purchases and the collection of cash from receivables. Cash cycle = Operating cycle – A/cs payable period

12-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cycle Components Inventory period—the time it takes to acquire and sell inventory. Accounts receivable period—the time between sale of inventory and collection of the receivable. Accounts payable period—the time between the receipt of inventory and payment for it.

12-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Flow Time Line Accounts receivable period Cash received Time Inventory sold Inventory purchased Inventory period Accounts payable period Cash paid for inventory Operating cycle Cash cycle

12-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Operating Cycle The following information has been provided for Overcredit Co.: Sales for the year were $510,000 (assume all credit) and the cost of goods sold was $350,000. Calculate the operating cycle and cash cycle.

12-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Operating Cycle a) Find the inventory period:

12-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Operating Cycle b) Find the accounts receivable period:

12-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Operating Cycle

12-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Cash Cycle a) Find the payables period:

12-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Cash Cycle To more fully interpret the operating and cash cycles, a benchmark can be used. E.g. The figures could be compared to past time periods for the firm or they could be compared to competitors.

12-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Short-term Financial Policy Size of investments in current assets − Flexible policy—maintain a high ratio of current assets to sales − Restrictive policy—maintain a low ratio of current assets to sales. Financing of current assets − Flexible policy—less short-term debt and more long-term debt − Restrictive policy—more short-term debt and less long-term debt

12-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Size of the Firm’s Investment in Current Assets The size of the firm’s investment in current assets is determined by its short-term financial policies. Flexible policy actions include: –keeping large cash and securities balances –keeping large amounts of inventory –granting liberal credit terms. Restrictive policy actions include: –keeping low cash and securities balances –keeping small amounts of inventory –allowing few or no credit sales.

12-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Costs of Investments Need to manage the trade-off between carrying costs and shortage costs. Carrying costs increase with the level of investment in current assets, and include the costs of maintaining economic value and opportunity costs. Shortage costs decrease with increases in the level of investment in current assets, and include trading costs and the costs related to being short of the current asset. For example, sales lost as a result of a shortage of finished goods inventory.

12-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Costs of Investments More generally, there are two kinds of shortage costs: –Trading or order costs—are the costs of placing an order for more cash (e.g. brokerage costs) or more inventory (production set-up costs). –Costs related to safety reserves—are costs of lost sales, lost customer goodwill, and disruption of production schedule.

12-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Carrying and Shortage Costs Short-term financial policy: the optimal investment in current assets

12-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Carrying and Shortage Costs Flexible policy

12-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Carrying and Shortage Costs Restrictive policy

12-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan The Inventory Model The economic quantity (EOQ) is the optimal quantity of inventory ordered that minimises the costs of purchasing and holding the inventory. Where TC = total costX = order size EOQ = economic order qtyA = acquisition costs Y = total demandC = carrying costs P = price per unit

12-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—EOQ Smile Camera Shop sells 10,000 rolls of film per year, each with a wholesale price of $3.20. The cost of processing each order placed is $10.00 and carrying costs are 20 cents per roll per year. Calculate the EOQ.

12-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan EOQ Example With Quantity Discounts Smile Camera Shop is offered a 2-cent-per-roll discount if 2,000–3,500 rolls of film are ordered, and a 3-cent-per-roll discount if more than 3,500 rolls are ordered at a time. Determine the optimal order quantity.

12-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan EOQ Example With Quantity Discounts (continued) Calculate the total cost for each quantity: Smile Camera Shop would be better off purchasing in lots of 2,000 to reduce the total cost.

12-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Stock Out Costs Costs of stock outs are the profits lost because the firm is out of a particular product. Lead time is the time it takes from placing an order to the receipt of the inventory. Safety stock is the additional inventory held when demand is uncertain so as to reduce the probability of a stock out.

12-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan EOQ Example Under Uncertainty Smile Camera Shop’s EOQ (with quantity discounts) is 2000 rolls of film and five orders are placed each year. Determine the reorder point if it takes 30 days to fill an order, a safety stock of 100 is desired and daily usage is 30 rolls.

12-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Qty Time Reorder points Safety stock EOQ Example Under Uncertainty

12-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Just-in-Time (JIT) Just-in-time (JIT) is a system for managing demand- dependent inventories that minimises inventory holdings. JIT simply means that the purchaser receives the goods just in time to use the goods in the production process (e.g. a motor vehicle manufacturer) which in turn reduces the carrying cost of inventory. Acquisition costs are also minimised as next period’s production requirements are always known to the supplier.

12-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Budget A forecast of cash receipts and disbursements over the next short-term planning period. Primary tool in short-term financial planning. Helps determine when the firm should experience cash surpluses and when it will need to borrow to cover working-capital costs. Allows a firm to plan ahead and begin the search for financing before the money is actually needed.

12-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Cash Budget Projected sales for the first six months of 2006: Jan.$ Apr.$ Feb.$ May$ Mar.$ Jun.$ Analysis of collection of accounts receivable: –collected in month of sale20% –collected in month following sale60% –collected in second month following sale20% Actual sales for November and December were $ and $ respectively.

12-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Example—Cash Budget (continued) Wages and other expenses are 30 per cent of total monthly sales. Purchases are 50 per cent of the month’s estimated sales, all paid for in the month of purchase. Monthly interest payments are $ (interest rate is 1.5 per cent per month). An annual dividend of $ is payable in March. The beginning cash balance is $ The minimum cash balance is $

12-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Collections

12-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Disbursements

12-35 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Cash Budget

12-36 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Short-term Financial Planning

12-37 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 4e, by Ross, Thompson, Christensen, Westerfield & Jordan Summary and Conclusions Decisions about current assets are interdependent. A firm needs to establish its level of cash while considering the amount of inventory it should purchase and the level of accounts receivable. The objective of managing current assets is to find the optimal trade-off between carrying costs and shortage costs. The level of inventory that should be purchased to minimise carrying and shortage costs is called the economic order quantity (EOQ). The cash budget tells the financial manager what borrowing is required or what lending will be possible in the short-run.