Unit 5: Managing Current Assets

Question 1

Working Capital Overview

(Definition, time horizon, and permanent working capital)

Answer 1

• Working capital finance concerns the optimal mix and use of current assets and the means to acquire them, notably current liabilities.
• Working capital policy applies to short term decisions, while capital structure finance applies to long-term decisions.
• Permanent working capital is the minimum level of assets maintained by a firm.
  
  • Increases as firm growths.
  • Usually financed with long-term debt.
• Temporary WC fluctuates seasonally

Question 2

WC: Conservative vs Aggressive

Answer 2

• Working capital policy ( Conservative vs Aggressive )
  
  • A firm adopts a conservative working capital policy seeks to minimize liquidity risk by increasing working capital.
    
    • The firm seeks to ensure that adequate cash, inventory, and supplies are available and payables are minimized.
    • The firm foregoes potentially higher returns from investing in long-term assets and instead keeps that additional working capital available.
    • This policy is reflected in a higher current ratio (current assets + current liabilities) and acid-test ratio (Quick assets + current liabilities).
  • A firm adopts an aggressive working capital policy seeks to increase profitability while accepting reduced liquidity and a higher risk of short-term cash flow problems.
    
    • Lower current ratio and acid-test ratio.
  • Carrying excessive current assets such as inventories increase costs (storage, spoilage and opportunity cost).
  • The optimal level of current assets varies with the industry in which a firm operates.

Question 3

Managing the level of cash

(Three motives for holding cash, optimal level of cash with EOQ)

Answer 3

• Managing the level of cash
  
  • Transactional (as a medium of exchange)
  • Precautionary (provide a reserve for contingencies)
  • Speculative (to take advantage of unexpected opportunities)
• Optimal level of cash
  
  • Cash does not earn return, so only the amount needed to satisfy current obligations as they come should be kept.
  • The expected return on available investment projects must exceed the return on investments of comparable risk:
    
    • EOQ approach (originally developed for inventory mgmt.)
      
      • Q = square ( 2bT/ i )
      • Where
        
        • Q = optimal cash level
        • B = fixed cost per transaction
        • T = total demand for cash for the period
        • I = interest rate on marketable securities (remember to transform to the relevant period)

Question 4

Forecasting Future Cash Flows

(Calculations based on Cash/Credit Sales for cash receipts)

(Calculations based on budgeted purchases and sales for cash payments)

Answer 4

Calculations start with cash budget.

>> Cash receipts are based on projeted sales, credit terms, ans estimated collection rates.

>> Cash payments are based on budgeted purchase sales (sales serves as base to payroll, and operating expenses) , total sales and interest expenses.

(like in CMA 1)

Question 5

Speeding Up Cash Collections

(Benefit of improved float time)

(Lockbox system)

(Concentration banking)

Answer 5

• The period from when a payor mails a check until funds are available in the payee’s bank is called float. Firms use various strategies to decrease the float time for receipts.
• Annual benefit of improved float time:
  
  • (Daily cash receipts * days of reduced float)*opportunity cost of funds MINUS any eventual cost (the cost period has to match the opportunity cost horizon of benefit)
• Lockbox system is a popular means of speeding up cash receipts
  
  • Customer submit payments to a mailbox rather than firm’s offices.
    
    • Bank personnel remove the envelopes from the mailbox and deposit the checks to the firm’s account directly
  • The bank generally charges a flat fee for this
• Concentration banking is another means of speeding up cash receipts
  
  • Customers submit payments to local branch office >> into local bank account >> firm’s principal bank.
• Transfer of funds by wire speeds up cash management. ETF = electronic funds transfer.

Question 6

Slowing cash payments

Answer 6

• To increase payment flow, a firm may send checks to its vendors without being certain it has sufficient funds to cover them all.
  
  • For these situations banks offer overdraft protection. The bank guarantees to cover (with a fee) any shortage with a transfer from the firm’s master account.
• Other methods
  
  • Zero balance accounts = are checking accounts in which a balance of zero is maintained by automatically transferring funds from a master account in an amount only large enough to cover checks presented for payment.
  • Centralizing accounts payable.
  • Controlled disbursement accounts.

Question 7

Compensating balance

Answer 7

• A compensating balance is the minimum amount that a bank requires a firm to keep frozen in its accounts. Compensating balances are non-interest bearing and are mean to compensate the bank for various services rendered, such as unlimited check writing. These balances incur opportunity costs because they are unavailable for investment purposes.

Question 8

Marketable Securities: Treasuries, Federal Agency and Repos

(MUNICIPAL BONDS ARE NOT INCLUDED SINCE THEY ARE LONG TERM)

Answer 8

• US treasury obligations are the safest investment, exempt from state and local taxation (but subject to federal income tax) and highly liquid.
  
  • T-bills have maturity < 1 year. They have no coupon rate and are sold at discount. Often held as a substitute for cash since there is no default risk.
  • T-notes have maturities from 1 – 10 years. There is semiannual interest payment.
  • T-bonds have maturity of >10y. They also provide _{semiannual interest.}
• Federal agency securities are backed by 1) full faith and credit of the US or 2) only by the issuing agency.
• Repurchase agreements (REPOs) are means for dealers in government securities to finance their portfolios
  
  • When a firm buys a REPO, it is temporarily purchasing some of the dealers government securities. The dealer agrees to repurchase them at a later time for a specific price.
  • In essence, the dealer provided a secured, short-term loan.
  • Maturities vary from overnight to a few days.

Question 9

MS: Bankers acceptance, Commercial Paper, CDs

Answer 9

• Banker’s acceptance are drafts - guarantee of payment vs other firm - drawn by a nonfinancial firm on deposits at a bank
  
  • The drawer (firm) then sells the draft to an investor (holder).
  • One advantage is that the acceptance by the bank is a guarantee of payment at maturity
    
    • The payee can rely on creditworthiness of the banker rather than the drawer.
  • A second advantage is because they are highly marketable due to bank’s prestige.
• Commercial paper consists of unsecured, short-term notes issued by large companies that are very good credit risks.

Commercial paper usually consists of secured and unsecured large amount promissory notes of large corporations. Not ideal for small companies.

• Certificates of Deposits (CD) are a form of savings deposit that cannot be withdrawn before maturity without a high penalty and is usually issued by a bank.
  
  • CDs often yield a lower return than commercial paper and bankers acceptance because they are less risky.
  • Negotiable CDs can be sold in the secondary market.

Question 10

MS: Eurodollars and Money Market

Answer 10

• Eurodollars are time deposits of US dollars in banks located abroad.
• Money market mututal funds invest in short term, low risk securities.
  
  • In addition to paying interest, these funds allow investors to write checks on their balances (you invest money in the fund, and you can write checks against these funds for another purpose)

Question 11

Efficient portfolios & Maturity Matching

Answer 11

• Efficient portfolios:
  
  • A feasible portfolio that offers the highest expected return for a given risk or the least risk for a given expected return is called an efficient portfolio.
  • An indifference curve (x = risk, y = return) represents combinations of portfolios having equal utility for the investor.
    
    • The steeper the slope of the curve the more risk adverse (requires marginally more return for a given additional amount of risk)
    • The higher the curve, the greater is the investor level of utility.
    • Along the curve each point provides the same utility for a risk adverse investor.
  • The investment in securities should be based on expected net cash flows and cash flow uncertainty evaluations.
    
    • Portfolios should be arranged so the maturity of funds coincide with the need of funds so it provides maximal returns and flexibility.
      
      • Maturity matching ensures that securities will not have to be sold unexpectedly
    • If its cash flows are relatively uncertain, a securities marketability and market risk are important factors to be considered. Transaction costs are also a consideration.
    • When cash flows are relatively certain, the maturity date becomes the most important concern.

Question 12

Hedging

(Natural Hedge and Future Contracts: Long VS Short Hedge)

Answer 12

• The purchase or sale of a derivative or other instrument is a hedge if it is expected to reduce the risk of adverse price movements.
• A natural hedge is a method of reducing financial risk by investing in two different items whose performance tends to cancel each other. However, natural hedgers are not perfect in that they do not eliminate risk.
  
  • Buying insurance is a natural hedge.
  • Pair trading or buying long and short positions of highly correlated stocks, can be an effective method of hedging securities.
  • Investing in both stocks and bonds is sometimes viewed as a natural hedge.
• Future contracts are used to hedge commodities. They are agreements to buy or sell assets at a fixed price that are to be delivered and paid for later.
  
  • Long hedgers are future contracts that are purchased to protect against price increases. AND VICEVERSA.
  • Because commodities can be sold and bought on margin considerable leverage is involved.

Question 13

Mesaures of Risk / Security vs Porfilio Risk

(E(R) , SD, Security vs Portfolio Risk)

Answer 13

• Measures of risk
  
  • The expected rate of return (R) on an investment is determined by using an expected value calculation.
    
    • E(R) = SUM (RiPi)
  • One way to measure the risk is the standard deviation (variance) of the dx of the returns.
    
    • Large standard deviation reflects a broadly dispersed probability dx.
• Security vs Portfolio Risk
  
  • Risk and return should be evaluated in the portfolio level (not individual stock).
  • Diversification effects ensures that the average risk is lower than the average of the standard deviations because returns are imperfectly correlated.

Question 14

Correlation and Covariance

Answer 14

• Correlation
  
  • Correlation coefficient (r) measures the degree to which any two variables e.g. two stocks in a portfolio, are related. It has a range from 1 to -1.
    
    • Perfect positive means that securities move always together.
    • Perfect negative means that securities move always in opposite direction.
    • Given perfect negative correlation, risk would in theory, be eliminated.
    • In practice there is no such thing (usually around .5, thus reducing risk but not eliminating it).
• Covariance
  
  • The correlation coefficient of two securities can be combined with their standard deviation to arrive at their covariance. A measure of their mutual volatility.
    
    • Covariance:

Correlation coefficient * SD1 * SD2

Question 15

Ris​k and Diversification (Specific Risk vs Market Risk)

Answer 15

• Risk and diversification
  
  • Specific risk (also called diversifiable, unsystematic, residual or unique risk) is linked to an investee’s operations. CAN BE ELIMINATED WITH DIVERSIFICATION
    
    • In principle, diversifiable risk should continue to decrease as the number of different securities held increases (in practice works for 20-30 stocks).
  • Market risk also called undiversifiable risk or systematic risk, is the risk of the stock market as a whole and is affected by overall economy climate.

Question 16

Beta

Answer 16

• Beta
  
  • Sensitivity to movements by the overall market.
  • An avg-risk stock has a beta of 1 because its returns are perfectly positively related with those on the market portfolio.
  • A beta of less than 1 means that the security is less volatile than the market. (AND VICE VERSA)
• Beta coefficient is the slop of the regression lien for the returns of an individual security (dependent variable) and the overall market return (independent variable).
• Beta of a portfolio is a weighted average of the betas of the individual securities.
  
  • A particular stock’s beta is influenced by
    
    • D/E ratio (financial leverage)
    • Operating leverage (fixed to variable costs ratio).
    • The characteristics of the industry

Question 17

CAPM

and VAR

Answer 17

• CAPM
• Quantifies the required return on an equity security by relating the security’s risk to the average return available in the market.
• Based on the principles that investors should be compensated in two ways for their investment: time value for money an risk.
  
  • Time value is captured on the risk free rate Rm (e.g. treasuries).
  • The risk component consists of:
    
    • The market risk premium: return provided by the market above the risk free (Rm – Rf) weighted by
    • Security systematic risk, called beta (B).
• VAR​
  
  • VaR is a technique that employs a normal dx (bell curve) to determine the maximum potential gain or loss within a certain period at a given level of confidence.
  • Cash flow risk and earnings risk are identical in application to VAR.

Question 18

Receivables MGMT: Overview

(Cash Conversion Cycle and Operating Cycle)

Answer 18

• Also referred as trade credit policy
• Market factors influencing the level of receivables include the cost of borrowing and the opportunity for repeat sales
  
  • Low gross margin per unit and operating at full capacity are reasons not to ease credit terms.
• The optimal credit policy does not seek merely to maximize sales, but should also consider the impacts on bad debt and negative effects on cashflow. Thus the firm must balance default risk (bad debt experience) and sales maximization.
• Default risk is the probability that a particular customer will be unwilling or unable to pay a debt.
  
  • To manage (not necessarily minimize) default risk, firms often require written agreements to be signed by the customer (outlining the terms of credit and consequences of nonpayment).
  • Firms often use credit scoring.
• Cash conversion cycle is the time that passes, on average, between the firms purchase of inventory and the collection of cash from a customer on the sale of that inventory .
  
  • The operating cycle is the cash cycle plus the time between the purchase and payment. (operating cycle starts before at purchase).
• Aging schedule (columns with time ranges of payment and rows with ranges of balances), of accounts receivable is then combined with collection probabilities (for each time range times probability of uncollectible) to get to estimated uncollectible.

Question 19

Basic Receivables Term

(2/10, net 30)

(average collection period)

(Avg accounts receivable)

Answer 19

• Basic Receivables Terms
  
  • The most common credit term offered are 2/10, net 30. This convention means that the customer may either deduct 2% of the invoice amount if paid in less than 10 days or must pay the entire balance by the 30^th day.
  • The average collection period (or average days of sales outstanding) equals days of sales outstanding in receivables is the average number of sales that pass between the time of a sale and payment.
  • Average accounts receivable equals :
    
    • 1 .Begin + end balance average divided by 2.
    • 2. Daily credit sales * average collection period
    • 3. Net credit sales * (average collection period / days in year) = 2
    • 4. Net credit sales / accounts receivable turnover

Accounts receivable turnover = net credit sales / avg accounts receivable

Basic Receivables Terms

• • The most common credit term offered are 2/10, net 30. This convention means that the customer may either deduct 2% of the invoice amount if paid in less than 10 days or must pay the entire balance by the 30^th day.
    
    • The average collection period (or average days of sales outstanding) equals days of sales outstanding in receivables is the average number of sales that pass between the time of a sale and payment.
    • Average accounts receivable equals begin + end balance average divided by 2.

Accounts receivable turnover = accounts receivable / net credit sales

Question 20

Assessing the impact of a change in credit terms

(Contribution margin gain minus Cost of Change in Credit)

Answer 20

• Amounts of receivable are an opportunity cost. A key aspect of any change in credit terms is balancing the competitive need to offer credit with the opportunity cost incurred.
• Increased investment in receivables is calculated with this formula:
  
  • IIR = Incremental variable costs * Incremental average collection period / days in year
• Cost of change in credit terms is calculated as:
  
  • Change in credit (CC): IIR * opportunity cost of funds (usually anchored in money market instrument)
• Benefit or loss is:
  
  • Incremental contribution margin (increase in sales * contribution margin ratio)

MINUS CC

• The upper limit of a company’s credit period is the operating cycle of the purchaser. If the credit period is longer than the purchaser operating cycle, the seller is in effect financing more than just the purchaser inventory needs.

Question 21

Factoring

Answer 21

• Factoring is a transfer of receivables to a third party who assumes the responsibility of collection.
• Factor receives a high financing fee plus a fee for collection, and is usually more efficient since it is specialized.
• Credit card sales are a common form of factoring. The retailer gets immediate cash but pays a fee.

Question 22

Pledging

Answer 22

• A pledge is the use of receivables as collateral for a loan. The borrower agrees to use collection of receivables to pay the loan.
  
  • Upon default lender can sell the receivables to recover loan proceeds.
  • PLEDGE IS NOT REFLECTED IN ACCOUNTS SINCE IT IS A RELATIVELY INFORMAL AGREEMENT.

Question 23

Costs Related To Inventory

(Purchase + Carrying+Ordering+StockOut)

Answer 23

• Purchase costs – includes shipping costs (investment in inventory) and handling.
• Carrying costs:
  
  • Storage
  • Insurance
  • Security
  • Taxes
  • Depreciation or rent from from facilities
  • Interest
  • Spoilage and obsolescence
  • Opportunity costs of funds invested: Purchase cost (per unit) * Capital Cost

CARRYING COSTS ARE CALCULATED USING AVG INVENTORY.

• Ordering costs: costs of placing order (labor required to inspect goods while receiving, cost of preparing purchase orders, cost to process the supplier invoice and related payment process cost) and is independent of nrs ordered.
• Stockout costs: are the opportunity cost of missing a customer order. Can also include the costs of expediting a special shipment necessitated by insufficient inventory in hand.

Question 24

Safety stock

(Check calculation too)

Answer 24

• To protect against the risk of stockouts, a safety stock is held.
  
  • It increases carrying costs
  • Hard to access level linked to demand and supply swings.
  • Cost is determined by carrying cost of the safety stock plus the expected stockout cost.

Question 25

Relationship between inventory costs

Answer 25

* Relationships * Order cost decreases on avg with qty ordered * Purchase cost is usually constant * Carrying costs increases on avg with qty ordered. * Implications of Relations * Stockout costs can be minimized only by incurring high carrying costs. (less probable stockout situations). * Carrying costs can be minimized only by incurring the high fixed costs of placing an many small orders. (less need of carrying high amounts) * Ordering costs can be minimized only by the cost of storing large quantities. (less need of orders)

Question 26

JIT

Answer 26

* **JIT** is an inventory system where inventory is treated as non-value adding activity. Materials arrive at the time they are needed * **All materials (and linked carrying costs)** are reduced or entirely eliminated. Binding agreements with suppliers assure so. * **Is a pull or demand driven system.** Therefore, finished goods inventories are also eliminated.

Question 27

KANBAN

Answer 27

* **Kanban** system also improves inventory flow. * **Kanban** means ticket. Tickets (also described as cards or markers) control the flow of production or parts. * **A basic Kanban** includes a **withdrawal Kanban** that states the qty of that a later process should withdraw from its predecessor, **a production Kanban** that states the output of the preceding process, and a **vendor Kanban** that tells how much a vendor how much, where and when to devlier.

Question 28

**Inventory replenishment Models** **(Leadtime, reorder point, cost of carrying safety stock)**

Answer 28

* **Lead time** is the time between placing an order with a supplier and the receipt of goods. * When lead time is known and demand is uniform, goods can be timed to arrive just as inventory on hands is exhausted. * **Reorder point** can be calculated as follows: * **(Average demand \* leadtime) + Safety Stock (IN JIT , no safety stock is needed)** * Determining the appropriate level of safety stocks involves a probabilistic calculation. * Balances the variability of demand with the acceptable risk of stockout costs. * **Cost of carrying safety stock** consists of two components: * **Expected stock out cost (expected stock out \* unit cost of stock out)** ## Footnote **+ carrying cost (safety stock level \* units carrying costs)**

Question 29

Determining the Order Qty | (Formula and Relations)

Answer 29

* **Determining the Order Quantity** * **Concern is not with peak level of inventory but rather the size of the order to fulfill demand** and is determined by: * **Economic order of quantity (EOQ) = square (2ad/k)****, where:** * **a = fixed cost per purchase** * **d = periodic demand in units** * **k = carrying costs per unit** * **Assumptions of the model:** * **Demand is uniform** * **Carrying costs are constant** * **The same qty is ordered at each reorder point** * Purchasing costs are unaffected by the qty ordered * Sales are perfectly predictable * Lead times are known with certainty * Deliveries are consistent * Adequate inventory is maintained to avoid stockouts. * A change in any of the variables changes the EOQ equation.