1. 1 Chapter 14 Working Capital Management and Policies McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Revisiting the Balance Sheet Model of the Firm Current assets – Most liquid – Less profitable than fixed assets – Represent net amount firm has to fund 14-2

3. Revisiting the Balance Sheet Model Net working capital = Current Assets – Current Liabilities – Firm’s objective is to fund the least amount of net working capital possible 14-3

4. Tracing Cash and Net Working Capital Operating Cycle is the time needed to – Acquire raw materials and turn into finished goods – Sell and receive payment for them 14-4

5. Operating Cycle 14-5

6. Cash Cycle Portion of operating cycle firm must finance Time between payment for inventory and sales receipts 14-6

7. Short Term Financial Policy Firms reduce net working capital needs – Manage need for current assets – Obtain current liabilities to fund current assets 14-7

8. Size of Current Assets Investment Two categories of carrying costs: 1) Opportunity costs with capital tied up in current assets 2) Explicit costs to maintain value of current assets 14-8

9. Financing Terms Consider Asset Demand Peaks and Valleys 14-9

10. Alternative Financial Policies for Current Assets Flexible financing policy Restrictive financing policy Compromise financing policy 14-10

11. Flexible Financing Long-Term Debt for Peak Asset Demand 14-11

12. Restrictive Financing : Long-Term Debt/Equity for Trough Asset Demand 14-12

13. Compromise Financing Seasonal Average Asset Demand Financed with Long-Term Debt/Equity 14-13

14. Short-Term Financial Plans Firms not using flexible financing will need to seek short-term solutions – Unsecured loans – Secured loans – Other short-term financing alternatives 14-14

15. Unsecured Loans Commercial loan from bank – Usually a line of credit – Fees can be explicit and implicit 14-15

16. Secured Loans Asset-based loans – Lenders charge lower interest rates – Real estate, accounts receivable, inventory used as collateral 14-16

17. Other Financing Sources Commercial paper Banker’s acceptances 14-17

18. Cash Management Clarification on terminology cash flow vs. cash account – Cash flows are good – Cash account is a current asset with high liquidity and low profitability 14-18

19. Reasons for Holding Cash Transaction facilitation Compensating balances Investment opportunities 14-19

20. Baumol Model Strength: Minimizes sum of opportunity costs and trading costs Weakness: Unrealistic assumptions 14-20

21. The Miller-Orr Model Assumes daily net cash flows normally distributed Allows for cash inflows and outflows 14-21

22. Other Factors Influencing Target Cash Balance Short-term borrowing for unexpected cash demands Declining trading costs Firm requirement to maintain compensating balances 14-22

23. Float Control: Collection and Disbursement of Cash Float – the period of time after check is written but not yet cleared and deposited 14-23

24. Float Control Three types of collection float – Mail – In-house processing – Availability 14-24

25. Delaying Disbursements Legal ways to increase disbursement float – Zero-balance account – Drafts 14-25

26. Ethical and Legal Questions Illegal practices – Using collected cash before receiving it – Continuing to use disbursed cash after check sent – Check kiting is drawing money against account with insufficient funds 14-26

27. Investing Idle Cash Most large firms invest in their own marketable securities Smaller firms invest in money-market fund or bank sweep account 14-27

28. Why Firms Have Excess Cash Seasonal fluctuations Preparation for a planned expenditure 14-28

29. What to Do with Surplus Cash Appropriate investments – Treasury bills – Federal Funds – Repurchase agreements – Commercial paper – Negotiable CDs – Banker’s acceptances 14-29

30. Credit Management Trade-off between the opportunity cost of lost sales, and the carrying costs of funding Accounts Receivable (AR) plus the expected costs of default on AR 14-30

31. Credit Policy: Terms of the Sale Credit terms include – Credit period – Cash discount – Description of the type of credit instrument 14-31

32. Credit Analysis Determination of the borrower’s ability and willingness to pay 5 C’s of credit: 1.Capacity 2.Character 3.Capital 4.Collateral 5.Conditions 14-32

33. Collection Policy Collecting past-due accounts from customers Typical procedure – Send delinquency letters – Initiate telephone calls – Employ collection agency – Legal action against the customer 14-33