1. Current Assets Management14
Current Assets
Management

2. 14.1
Cash Management

3. Reasons for Holding Cash
Transaction balance – A cash balance associated with payments and collections; the balance necessary for day-to-day operations.
Precautionary balance – A cash balance held in reserve for random, unforeseen fluctuations in cash inflows and outflows.
Speculative balance – A cash balance held to enable the firm to take advantage of any bargain purchases that might arise.

4. Types of Float
Float – The difference between the book balance ( the cash balance in the firm’s book ) and the available balance ( the cash balance recorded at the bank ).
Disbursement float
Generated when a firm writes checks
Available balance > book balance
Collection float
Generated when a firm received checks
Available balance < book balance
Net float = disbursement float + collection float
If net float is positive, available balance > book balance
A Firm should be concerned with its net float and available balance more than with its book balance.

5. Float Management
Total collection or disbursement times can be broken down into three parts:
Mailing time
Processing delay
Availability delay
Speeding up cash collections involves reducing one or more of these components. Slowing down cash disbursement involves increasing one of them.

6. Measuring Float
The size of float depends on both the amount and the time delay involved.
Example:
Suppose you mail a check each month for $12,000 and it takes 3 days to reach its destination, 2 day to process, and 1 day before the bank makes the cash available. What is the average daily float?
(3+2+1)($12,000)/30 = $2,400

7. Cost of Float
The basic cost of collection float to the firm is the opportunity cost of not being able to use the cash.
Example:
The company receives an average of $20,000 in checks per day. The delay in clearing is typically 4 days. The current interest rate is 0.02% per day. What is the highest daily fee the company should be willing to pay to eliminate its float entirely?
Collection float = 4($20,000) = $80,000
Maximum daily charge = $80,000(0.0002) = $16

8. Cash Collection Some methods to speed up cash collection Lockboxes
Concentration banking system
Wire transfers

9. Cash Collection: Example
The company is considering a lockbox system which will reduce the collection time by 2 days. The daily interest rate is 0.016%. The average number of daily payments to each lockbox is 8,500 and average size of payment is $108. If the bank charges a fee of $225 per day, should the lockbox project be accepted?
Average daily collections = $108(8,500) = $918,000
PV = 2($918,000) = $1,836,000
PV of cost = $225/ = $1,406,250
NPV = –$1,406, ,836,000 = $429,750
The NPV is positive, so the lockbox project should be accepted.

10. Cash Disbursements
Slowing down disbursements can increase disbursement float, but it may cause ethical problems.
Controlling disbursements
Zero-balance account
Controlled disbursement account

11. Investing Idle Cash
Because of seasonal and cyclical activities, to help finance planned expenditures, or as a contingency reserve, firms temporarily hold a cash surplus.
The money market offers a variety of possible short-term financial assets for the idle cash.

12. The Target Cash Balance
The target cash balance involves a trade-off between the carrying costs and the trading costs.
The carrying costs
The opportunity costs of holding cash
The trading costs
The costs associated with buying and selling marketable securities

13. The BAT Model
The Baumol-Allais-Tobin (BAT) model is a classic, simple and most stripped-down sensible model for determining the optimal cash position.
Where
C* – Optimal cash balance
F - Fixed cost of making a securities trade
T - Total amount of new cash needed for transactions during the relevant period (usually 1 year)
R - Opportunity cost of holding cash, equal to the interest rate on marketable securities.
Its chief weakness is that it assumes steady, certain cash outflows.

14. The BAT Model: Example Annual interest rate = 6%
Fixed order cost = $25
Total cash needed = $8,500
C* = [(2T × F)/R]1/2 = [2($8,500)($25)/0.06]1/2
= $2,661.45

15. Implications of the BAT Model
The greater the interest rate, the lower is the target cash balance.
The greater the order cost, the higher is the target cash balance.

16. The Miller-Orr Model
The Miller-Orr model assume that the cash balance fluctuates up and down randomly and that the average change is zero.
Management set the lower limit, L.
If the cash balance is between L and U* (the upper limit), no transaction is made.
The advantage of the model is that it considers the effect of uncertainty.

17. The Miller-Orr Model where C* – Optimal cash balance
L – Lower control limit of cash balance
s2 – The variance of net daily cash flows
U* - Upper control limit of cash balance

18. The Miller-Orr Model: Example
The firm has a fixed cost associated with buying and selling marketable securities of $40. The interest rate is currently 0.021% per day. The firm has estimated that the standard deviation of its daily net cash flow is $70. Management has set a lower limit of $1,500 on cash holdings.
C* = L + (3/4 × F × 2 / R]1/3
= $1,500 + [3/4($40)($70)2/ ]1/3
= $2,387.90

19. Implications of Miller-Orr Model
The greater the interest rate, the lower the target cash balance.
The greater the order cost, the higher the target cash balance.
The greater the uncertainty is, the greater the difference between the target balance and the minimum balance.
The greater the uncertainty is, the higher the upper limit and the higher the average cash balance.

20. 14.2
Credit Management

21. Credit Management Granting credit normally increases sales.
Granting credit has both direct and indirect costs.
Chance that customers will not pay
Costs of carrying the receivables
The credit policy involves a trade-off between the benefits of increased sales and the costs of granting credit.

22. Components of Credit Policy
Terms of sale
The credit period
The cash discount and discount period
The type of credit instrument
Credit analysis
Determining the probability that customers will not pay
Collection policy
The firm’s toughness or laxity in following up on slow-paying accounts.

23. Terms of Sale Example: 2/10, net 60 General Form:
2% cash discount from the full price if payment is made in 10 days
Full amount due in 60 days form the invoice date
General Form:
<take this discount off the invoice price> / <if you pay in this many days>, <else pay the full invoice amount in this many days>

24. The Credit Period
The basic length of time for which credit is granted.
If a cash discount is offered, the credit period has two components.
The net credit period – the length of time the customer has to pay
The cash discount period – the time during which the discount is available
Factors influencing the length of credit period
The shorter the buyer’s inventory period, the shorter the credit period.
The shorter the operating cycle, the shorter the credit period.

25. Cash Discounts
Cash discount is a discount in the price of goods given to encourage early payment.
Although the cash discounts are rather small, if you calculate the cost to the buyer of not paying early, you will find the interest rate that the buyer is effectively paying for the trade credit is extremely high.
The company benefits when customers forgo discounts.

26. Credit instruments Open account Promissory note Commercial draft
Sight draft
Time draft
Trade acceptance
Banker’s acceptance
Conditional sales contract

27. Credit Policy Analysis
The NPV of granting credit depends on five factors.
Revenue effects
Cost effects
The cost of debt
The probability of nonpayment
The cash discount

28. Evaluating a Proposed Credit Policy: Example
A company currently has a cash only policy. It is considering a switch to a net 30 policy. Currently, the price per unit is $290 and cost per unit is $230. The company currently sells 1,105 units per month. Under the proposed policy, the company expects to sell 1,125 units per month. The price per unit will be $295 and the cost per unit will be $234. If the required monthly return is 0.95% per month, what is the NPV of the switch? Should the company offer credit terms of net 30?

29. Evaluating a Proposed Credit Policy: Example
Cash flow from old policy = ($290 – 230)(1,105)
= $66,300
 Cash flow from new policy = ($295 – 234)(1,125)
= $68,625
Incremental cash flow = $68,625-66,300 = $2,325
 NPV of switching= –[($290)(1,105) + (1,105)($234 – 230) + ($234)(1,125 – 1,120)] + ($2,325/0.0095) = –$84,813.16
Since the NPV is negative, the company should not offer the credit terms of net 30.

30. Optimal Credit Policy
The optimal amount of credit the firm should offer depends on the competitive conditions under which the firm operates.
These conditions will determine the carrying costs associated with granting credit and the opportunity costs of the lost sales resulting from refusing to offer credit.
The optimal credit policy minimizes the sum of carrying costs and opportunity costs.

31. Credit Analysis
The process of deciding whether or not to grant credit to a particular customer.
Two steps:
Gathering relevant information
Determining creditworthiness

32. Credit Information Financial statements
Credit reports about the customer’s payment history with other firms
Banks
The customer’ payment history with the firm

33. Determining Creditworthiness
Credit evaluation - Five C’s of credit
Character – the customer’s willingness to meet credit obligations
Capacity – the customer’s ability to meet credit obligations out of operating cash flows
Capital – the customer’s financial reserves
Collateral – an asset pledged in the case of default
Conditions – General economic conditions in the customer’s line of business
Credit scoring

34. One-Time Sale NPV = -v + (1 - )P / (1 + R) where
v - variable cost per unit
 - probability of default
P – price per unit
R – the required return on receivables per month
It makes sense to grant credit to almost everyone once, as long as the variable cost is low relative to the price.

35. One-Time Sale: Example
Your company is considering granting credit to a new customer. The variable cost per unit is $20; the current price is $60; the probability of default is 25%; and the monthly required return is 1%.
NPV = -$20 + (1-0.25)(60)/(1.01) = $24.55
The break-even probability
0 = (1 - )(60)/(1.01)
 = 66.33%

36. Repeat Business NPV = -v + (1-)(P – v)/R Example:
If a customer defaults once, credit can’t be granted again.

37. Collection Policy Monitor the age of accounts receivable
Keeping track of ACP though time
The aging schedule
Deal with past-due-accounts
Delinquency letter
Telephone call
Collection agency
Legal action

38. 14.3
Inventory Management

39. Inventory Management
Inventory management involves determining how much inventory to hold, when to place order, and how many units to order at a time.
Other functional areas will share decision-making authority regarding inventory.

40. Types of Inventory Manufacturer Things to remember Raw material
Work-in-progress
Finished goods
Things to remember
One’s raw material may be another’s finished goods.
Different types of inventory can be different in terms of liquidity.
The demand for finished goods is independent.

41. Inventory Costs Carrying costs Shortage costs
Storage and tracking costs
Insurance and taxes
Losses due to obsolescence, deterioration, or theft
The opportunity cost of capital on the invested amount
Shortage costs
Restocking costs
Costs related to safety reserves
Inventory management involves a trade-off between the carrying costs and shortage costs.

42. The ABC Approach
An inventory management technique to divide inventory into three or more groups.
The underlying rationale is that a small portion of inventory in terms of quantity might represent a large portion in terms of inventory value.

43. The EOQ Model
The Economic Order Quantity Model is a formula for determining the order quantity that will minimize total inventory cost.
Total carrying costs = (Average inventory)(Carrying cost per unit) = (Q/2)(CC)
Total restocking costs = (Fixed cost per order)(Number of orders) = F(T/Q)
Total Costs = Carrying cost + Restocking cost = (Q/2)(CC) + F(T/Q)

44. The EOQ Model (Q/2)(CC) = F(T/Q) Carrying costs = Restocking costs
The EOQ is:
Example: Carrying cost is $1 per unit; fixed order cost is $5 per order; the firm sells 120,000 units per year.
Q*= [2(120,000)($5)/$1]1/2 = 1, units

45. Extensions to the EOQ Model
Safety stocks - The firm reorders when inventory reaches a minimum level.
Reorder points - When there are lags in delivery or production times, the firm reorders when inventory reaches the reorder point.
By combining safety stocks and reorder points, the firm maintains a buffer against unforeseen events.

46. Managing Derived-demand Inventories
Materials Requirements Planning (MRP)
Once finished goods inventory levels are set, it is possible to determine what levels of work-in-process inventories must exist to meet the need for finished goods. From there, it is possible to calculate the quantity of raw materials that must be on hand.
Just-in-Time (JIT) Inventory
A system of inventory control in which a manufacturer coordinates production with suppliers so that raw materials or components arrive just as they are needed in the production process.