1. Copyright © 2006 McGraw Hill Ryerson Limited19-1 prepared by: Sujata Madan McGill University Fundamentals of Corporate Finance Third Canadian Edition

2. Copyright © 2006 McGraw Hill Ryerson Limited19-2 Chapter 19 Working Capital Management and Short Term Planning Working Capital Links Between Long-Term and Short-Term Financing Tracing Changes in Cash and Working Capital Cash Budgeting A Short-Term Financing Plan Sources of Short-Term Financing The Cost of Bank Loans

3. Copyright © 2006 McGraw Hill Ryerson Limited19-3 Working Capital Terminology  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.

4. Copyright © 2006 McGraw Hill Ryerson Limited19-4 Working Capital A Simple Cycle of Operations: CASH RAW MATERIALS INVENTORY FINISHED GOODS INVENTORY RECEIVABLES

5. Copyright © 2006 McGraw Hill Ryerson Limited19-5 Average Inventory Working Capital The Cash Conversion Cycle Inventory Period = Annual Cost of Goods Sold/365 Average A/R Accounts Receivable Period = Annual Sales/365 Average Accounts Payable Accounts Payable Period = Annual Cost of Goods Sold/365

6. Copyright © 2006 McGraw Hill Ryerson Limited19-6 Working Capital Example: Canadian non-financial enterprises 1. How long on average does it take Canadian non-financial firms to produce and sell their product? 2. How long does it take to collect bills? 3. How long does it take to pay bills? 4. What is the cash conversion cycle?

7. Copyright © 2006 McGraw Hill Ryerson Limited19-7 Average Inventory Working Capital Example: Canadian non-financial enterprises Inventory Period = Annual Cost of Goods Sold/365 (218,896+222,513)/2 2,104,620/365 = = 38.3 days

8. Copyright © 2006 McGraw Hill Ryerson Limited19-8 Average Accounts Receivable Working Capital Example: Canadian non-financial enterprises Receivables Period = Annual Sales/365 (264,622+264,733)/2 2,144,891/365 = = 45.1 days

9. Copyright © 2006 McGraw Hill Ryerson Limited19-9 Average Accounts Payable Working Capital Example: Canadian non-financial enterprises Payables Period = Annual Cost of Goods Sold/365 (318,058+325,240)/2 2,104,620/365 = = 55.8 days

10. Copyright © 2006 McGraw Hill Ryerson Limited19-10 Working Capital Example: Canadian non-financial enterprises Cash Conversion Cycle = Inventory Period + Receivables Period - Accounts Payable Period = 38.3 + 45.1 - 55.8 = 27.6 days

11. Copyright © 2006 McGraw Hill Ryerson Limited19-11 Working Capital The Working Capital Trade-Off  Working capital can be managed.  There are costs and benefits associated with the firm’s investment in working capital.  Carrying costs  Shortage costs  An important job of the financial manager is to find the level of current assets that minimizes the sum of carrying costs and shortage costs.

12. Copyright © 2006 McGraw Hill Ryerson Limited19-12 Links Between Long-Term and Short-Term Financing Total Capital Requirement Trend

13. Copyright © 2006 McGraw Hill Ryerson Limited19-13 Tracing Changes in Cash and Working Capital Example: Dynamic Mattress Company

14. Copyright © 2006 McGraw Hill Ryerson Limited19-14 Tracing Changes in Cash and Working Capital Example: Dynamic Mattress Company

15. Copyright © 2006 McGraw Hill Ryerson Limited19-15 Cash Budgeting Creating a Cash Budget 1. Forecast the sources of cash. 2. Forecast the uses of cash. 3. Calculate whether the firm is facing a cash shortage or surplus. T he financial plan then sets out a strategy for investing a cash surplus or for financing a deficit.

16. Copyright © 2006 McGraw Hill Ryerson Limited19-16 Cash Budgeting Example: Dynamic Mattress  The managers have forecasted that quarterly sales for 2002 will be:  A ssume 20% of each quarter’s sales are collected in the next quarter. Quarter1 st 2 nd 3 rd 4 th Sales ($ millions)87.578.5116131

17. Copyright © 2006 McGraw Hill Ryerson Limited19-17 Cash Budgeting Example: Dynamic Mattress  DMC’s collections on its sales would be as follows: Quarter1 st 2 nd 3 rd 4 th Sales ($ millions)87.578.5116131 70.080% collected now: 17.5 62.8 20% in next period:15.715.023.2 92.8104.8

18. Copyright © 2006 McGraw Hill Ryerson Limited19-18 Cash Budgeting Example: Dynamic Mattress  Dynamic Mattress’s collections on accounts receivables:

19. Copyright © 2006 McGraw Hill Ryerson Limited19-19 Cash Budgeting Example: Dynamic Mattress  Dynamic Mattress’s forecast uses of cash:  Payment of accounts payable  Labor, administration, and other expenses  Capital expenditures  Taxes, interest, and dividend payments

20. Copyright © 2006 McGraw Hill Ryerson Limited19-20 Cash Budgeting Example: Dynamic Mattress  Dynamic Mattress’s cash budget:

21. Copyright © 2006 McGraw Hill Ryerson Limited19-21 Cash Budgeting Example: Dynamic Mattress  Dynamic Mattress’s short-term financing requirement:

22. Copyright © 2006 McGraw Hill Ryerson Limited19-22 A Short-Term Financing Plan Example: Dynamic Mattress

23. Copyright © 2006 McGraw Hill Ryerson Limited19-23 A Short-Term Financing Plan Evaluating the Plan  Short-term financial plans are developed by trial and error.  You lay out one plan, and iterate on it with different assumptions about the financing and investment alternatives.  You continue until you can think of no further improvements.

24. Copyright © 2006 McGraw Hill Ryerson Limited19-24 Sources of Short-Term Financing Alternative Sources of Financing  Bank Loans  A bank loan is an unsecured loan.  A line of credit is an agreement by a bank that a company may borrow at any time up to an established limit.

25. Copyright © 2006 McGraw Hill Ryerson Limited19-25 Sources of Short-Term Financing Alternative Sources of Financing  Commercial Paper  Commercial paper is a short-term unsecured note issued by a firm.  Commercial paper is issued by large, well- known companies which regularly need to borrow large amounts of cash.

26. Copyright © 2006 McGraw Hill Ryerson Limited19-26 Sources of Short-Term Financing Alternative Sources of Financing  Banker’s Acceptance  A banker’s acceptance is a firm’s time draft that has been accepted by a bank.  This means the bank guarantees payment of the amount stated on the draft when it matures.

27. Copyright © 2006 McGraw Hill Ryerson Limited19-27 Sources of Short-Term Financing Alternative Sources of Financing  Secured Loans  Sometimes a company will offer assets as security.  A/R financing  Inventory financing

28. Copyright © 2006 McGraw Hill Ryerson Limited19-28 The Cost of Bank Loans Comparing Rates Annual Interest Rate = Amount of Loan x Number of Periods in the Year Simple Interest Quoted Annual Interest Rate EAR = m 1+-1 () m Effective Annual Rate

29. Copyright © 2006 McGraw Hill Ryerson Limited19-29 Summary of Chapter 19  Short-term financial planning is concerned with the management of the firm’s short-term or current assets.  The difference between current assets and current liabilities is called net working capital.  The cash conversion cycle is the length of time between the firm’s payment for materials and the date it gets paid by its customers.

30. Copyright © 2006 McGraw Hill Ryerson Limited19-30 Summary of Chapter 19  A firm’s short-term financial planning is determined by the amount of long-term capital it raises.  The starting point for short-term financial planning is forecasting the sources and uses of cash.  Most firms take a middle of the road approach, investing cash surpluses during part of the year and borrowing during the rest of the year.