Learning Objectives

Explain working capital and the cash conversion

Cash and Working cycle.
Capital Management
22 Describe motives for holding cash.
Describe and apply popular cash management
techniques.
Describe the mechanics of different types of short-
term borrowings and evaluate their costs.
Describe the applications of Electronic Data
Corporate Financial Management 2e
Interchange.
Emery Finnerty Stowe
© Prentice Hall, 2004

Working Capital Management and

Chapter Outline the Principles of Finance
22.1 Overview of Working Capital Management Time Value of Money
22.2 Cash Conversion Cycle Incremental Benefits
Risk-Return Trade-Off
22.3 Cash Management
Options
22.4 Short-Term Financing Capital Market Efficiency
22.5 Electronic Data Interchange (EDI) Behavioral
Comparative Advantage
Two-Sided Transactions

Considerations in Working
Working Capital Management
Capital Management
Working capital Sales impact
= current assets – current liabilities Liquidity
Relations with stakeholders
Working capital management refers to n suppliers
choosing the levels and mix of: n customers
n cash, marketable securities, receivables and
inventories. Short-term financing mix
n different types of short-term financing. n profitability
n risk considerations

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 Working Capital Management Maturity Matching Approach

Maturity matching approach Hedge risk by matching the maturities of

Conservative approach assets and liabilities.
Aggressive approach Permanent current assets are financed with
long-term financing, while temporary
current assets are financed with short-term
financing.
There are no excess funds.

Maturity Matching Approach Conservative Approach

Temporary Current Assets
$ Short Term Long-term funds are used to finance both
Financing permanent as well as some temporary short-
term assets.
ets
ent Ass
ent Curr When there are excess funds, they are
Perman Long invested in marketable securities.
Term
Fixed Assets
Financing

Time

Conservative Approach Aggressive Approach

Temporary Current Assets Short Term
$ Financing Use less long-term and more short-term
financing than the conservative approach.
Assets
urrent
Pe rmanent C
Marketable securities
Long
Term
Fixed Assets Financing

Time

2
 Aggressive Approach Cost and Risk Considerations
Temporary Current Assets
$ Short Term Yield curve is usually upward sloping.
Financing
Short-term rates are more volatile than long-
ssets
rrent A term rates.
ent Cu
Perman
Firm's ability to obtain needed short-term
Long financing.
Fixed Assets
Term
Financing

Time

Cash Conversion Cycle Cash Conversion Cycle

Purchase Sale on Collect Acct.
The cash conversion cycle is the length of time Inventory Credit Receivable
between payment of accounts payable and the
receipt of cash from accounts receivable. Inventory Conversion Period Receivables Collection
Period

Time
Payables Cash Conversion Cycle
Deferral Period

Payment of
Accts. Payable

Cash Conversion Cycle Inventory Conversion Period

Cash Inventory Receivables Payables The inventory conversion period is the length of
conversion = conversion + collection − deferral time from the purchase of inventory to the time
the sales are made on credit.
cycle period period period

Inventory
Inventory 365
conversion = =
Cost of Sales/365 Inventory turnover
period

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 Receivables Collection Period Payables Deferral Period

The receivables collection period is the The payables deferral period is the average
average number of days it takes to collect length of time between the purchase of
on accounts receivable. materials and labor and the payment of cash
n Equal to days sales outstanding (DSO) for the same.
Payables
Receivables deferral =
Receivables 365
collection = = period
Sales/365 Receivables turnover Accounts payable + Wages, benefits, payroll taxes payable
period
(Cost of sales + Selling, general and administra tive expenses)/ 365

Cash Conversion Cycle Inventory Conversion Period

Given the following information about Vision
Inventory
Opticals, compute the firm’s cash conversion cycle. Inventory 365
conversion = =
Cost of Sales/365 Inventory turnover
period
Inventory $19,000
Accounts Receivable $21,000
Accounts Payable $5,600 Inventory
$19,000
Wages, Benefits, Payroll Taxes $9,000 conversion = = 74.57 days
Sales $227,000 $93,000/365
period
Cost of Sales $93,000
Selling & Other Expenses $22,000

Receivables Collection Period Payables Deferral Period

Receivables Payables
Receivables 365 deferral =
collection = =
Sales/365 Receivables turnover period
period Accounts payable + Wages, benefits, payroll taxes payable
(Cost of sales + Selling, general and administrative expenses)/365

Receivables
$21,000 $5,600 + $9,000
collection = = 33.77 days = = 46.34 days
($93,000 + $22,000) / 365
$227,000/365
period

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 Cash Conversion Cycle Cash Management

Cash Inventory Receivables Payables How much liquidity (cash plus marketable
conversion = conversion + collection − deferral securities) should the firm have?
cycle period period period What should be the relative proportions of
cash and marketable securities?
Cash
conversion = 74.57 days + 33.77 days − 46.34 days
cycle
= 62 days

Short-Term Investment
Demands for Cash
Alternatives
Transactions demand U.S. Treasury securities
n T-bills, T-notes, and T-bonds
Precautionary demand
U.S. federal agency securities
Speculative demand Negotiable certificates of deposit
Compensating balances Short-term tax-exempt municipals
Bankers acceptances
Commercial paper
Preferred stock & money market preferred stock

Transactions Demand Models Costs of Holding Cash

Costs in dollars of
holding cash Trading costs increase when the firm
Baumol Model must sell securities to meet cash needs.
n Deterministic model.
Total cost of holding cash
n Future cash requirements and disbursements are
known with perfect certainty Opportunity
Costs
Miller-Orr Model
The investment income
n Stochastic model. foregone when holding cash.
n Daily cash flows vary according to a normal
probability distribution with known variance Trading costs
C* Size of cash balance

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 The Baumol Model The Baumol Model
T = Annual transactions volume in dollars T = Annual transactions volume in dollars
b = Fixed cost of selling securities to raise cash b = Fixed cost of selling securities to raise cash
i =Annual interest rate i = Annual interest rate
C = Size of each deposit As we transfer $C each
C = Size of each deposit
period we incur a
If we start with $C, spend at a trading cost of b each
constant rate each period and C
C period. If we need T in
replace our cash with $C when total over the planning
we run out of cash, our C period we will pay $b,
C T times.
C average cash balance will be 2
2 C
2
The opportunity cost
of holding C is C × i The trading cost is T × b
2 2 1 2 3 Time C
1 2 3 Time

The Baumol Model The Baumol Model

C T The optimal cash balance is found where the opportunity
Total cost = i +b costs equals the trading costs.
2 C
Opportunity Costs = Trading Costs
C
Opportunity Costs i × C T
2 i =b
2 C
2bT Multiply both sides by C
C* =
i 2bT
C2 C2 =
Trading costs b ×
T i = bT
2 i
C
C* Size of cash balance
2bT
The optimal cash balance is found where the opportunity costs equals C* =
the trading costs. i

Baumol Model Baumol Model

Subsonic Speaker Systems (SSS) has annual Total transactions cost = bT/C = $10,350
transactions of $9 million. The fixed cost of
Annual opportunity cost = iC/2 = $10,350
converting securities into cash is $264.50 per
conversion. The annual opportunity cost of funds is Total cost = $20,700
9%. Number of deposits per year = T/C = 39.13
What is the optimal deposit size? Average cash balance = C/2 = $115,000
2bT 2 × $264.50 × $9,000,000
C* = = = $230,000
i 0.09

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 The Miller-Orr Model Miller-Orr Model

The firm allows its cash balance to wander randomly Let

between upper and lower control limits.
$ When the cash balance reaches the upper control limit UCL, n σ = the standard deviation of the net cash flows
cash is invested elsewhere to get us to the return point RP.
n b = fixed cost of converting securities into cash
UCL
n i = annual opportunity cost of holding cash
When the cash balance
Purchase reaches the lower n LCL = lower control limit (i.e. the minimum
securities control limit, LCL,
investments are sold cash balance)
RP to raise cash to get n Z = the amount of securities converted into cash
Sell
securities
us up to the target
LCL cash balance. when the cash balance hits the LCL

Time

Miller-Orr Model Miller-Orr Model

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 3bσ 2  The daily standard deviation of SSS’s net cash flows
Z =  is $40,000. The fixed cost of converting securities
 4i  into cash is $264.50 per conversion. The annual
opportunity cost of funds is 9%. (Use 9% / 365 for
Return Point = LCL + Z the daily interest rate.) SSS has set a lower control
limit (LCL) of $100,000.
UCL = LCL + 3Z = RP + 2Z What would SSS’s upper control limit (UCL) and
return point (RP) be according to the Miller-Orr
Average Cash Balance = LCL + (4/3)Z Model?
What is SSS’s average cash balance?

Other Factors in Cash

Miller-Orr Model
Management
13 13
 3bσ 2   3 × $264.50 × $40,0002  Compensating balance requirements
Z =  =  = $108,781
 4i   4 × (0.09 / 365)  Optimal amount of marketable securities
n transaction costs
Return Point = LCL + Z = $100,000 + $108,781 = $208,781 n maturity
n risk
UCL = LCL+3Z = $100,000 + 3×$108,781 = $426,343
n yield
= RP+2Z = $208,781 + 2 ×$108,781 = $ 426,343
Special tax situations
Average Cash Balance = LCL + (4/3)Z = $245,041

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 Float Float Management Techniques

Float is the difference between the available (or Wire transfers

collected) balance at the bank and the firm’s book
Zero balance accounts (ZBAs)
or ledger balance.
Disbursement float occurs when the firm writes a Controlled disbursing
check but the check has not yet cleared the Centralized processing of payables
banking system. Lockboxes
Collection float occurs when a check has been
deposited but the funds are not yet credited to the
firm’s bank account.

Lockbox Systems Lockbox Systems

Discount Music Stores is evaluating a lockbox
system which will reduce float by 3 days. The
lockbox system costs $15,000 per year. The
firm’s daily collections average $150,000, and
its opportunity cost of funds is 6% per year.
Should the firm utilize this lockbox system?
Funds freed up due to a reduction in float =
(3 days)($150,000 per day) or $450,000.
Annual value of float reduction =
$450,000(6%) = $27,000.
After deducting the $15,000 cost of the
lockbox system, the firm nets $12,000
before taxes.

Short-Term Financing Cost of Trade Credit

Trade Credit Discount Music Stores buys its inventory on “3/10,

net 30” terms. What is the cost of not taking the
Secured and Unsecured Bank Loans
discount?
Commercial Paper Suppose DMS buys $1,000,000 worth of inventory; if they forgo
the 3% discount to pay on day 30 they are borrowing $970,000
for 20 days and paying $30,000 interest:

+$970,000 –$1,000,000

0 10 30

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 Cost of Trade Credit: APY Cost of Trade Credit: APR
+$970,000 –$1,000,000
+$970,000 –$1,000,000

0 10 30
0 10 30
$1,000,000
$970,000 =
(1 + r ) 20 365 $1,000
(1 + r ) 20 365 =  $30,000   365 
$970 APR =   
 $970,000   20 days 
365
 $1,000  20 APR = 56.44%
r =  − 1 = 0.7435 = 74.35%
 $970 

Cost of Trade Credit: APY vs. APR Effective Use of Trade Credit

365 Advantages:
 Discount %  Total Period − Discount Period n Readily available
APY = 1 +  −1
 100% − Discount %  n Informal
n Flexible

n Stretching payments

 Discount %  365  Disadvantages

APR = 
100% − Discount %   Total Period - Discount Period  n High cost of discounts foregone
n Stretching of payments can hurt reputation

Bank Loans Cost of Bank Loans

Short-term unsecured loans Prime rate + “spread”

n Transaction loan LIBOR + “spread”
n Line of credit
Compensating balances
n Revolving credit agreement

Term loans
n Bullet maturity
n Balloon payment

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 Compensating Balance Compensating Balance
Requirements Requirements
Let  Interest charges - Interest received   1 
APR =   
n P = amount of loan  Loan amount - compensating balance   f 
n f = loan term
 rPf − yBf   1 
n r = interest rate on loan =  
n B = incremental cash balance as a result of  P − B  f 
compensating balance requirements
n y = interest earned (if any) on compensating balances
Interest charges = rPf
Interest received = yBf

Compensating Balance Compensating Balance

Requirements Requirements
Custom Controls is considering a 1-year loan  rPf − yBf  1 
APR =   f 
of $150,000 at an interest rate of 14%. Due to  P−B  
compensating balance requirements, Custom
Controls will have to maintain a deposit
balance of $20,000 which it would not have  0.14 × $150,000 − 0.06 × $20,000  1
APR =   1
otherwise maintained at the lending bank. The  $150,000 − $20,000  
deposit will earn 6% per year. = 15.23%
What is the APR of this loan?
Without the 6% yield on the compensating balance,
the APR = 16.15%

A Comparison of Single Payment

Discount Loans
Loans
The interest charge is deducted in advance for Ole Tools Inc. needs to borrow $5,000 for 6 months.
discount loans. Four single payment loan alternatives are available as
Let shown below. In each case, the interest rate is 15% per
year. Compute the APR and APY of each alternative.
r = interest rate on the loan
f = the term of the loan Loan Interest Payment Compensating
P = the principal amount Balance
A in arrears No
The APR of a discount loan is given by: B in arrears Yes (10%)
 rPf   1  r C in advance No
APR =    = D in advance Yes (10%)
 P − rPf   f  1 − fr

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 A Comparison of Single Payment
Loans A Comparison of Single Payment Loans
Loan CF0 CF1 APR
Interest charge on the loan is
 375   1 
$5,000× (.15) ×(0.5 years) or $375. A $5,000 ($5,375) APR =     = 15%
n For loans A & B, this amount is added to the  $5,000   .5 
repayment at loan maturity.  375   1 
n For discount loans (loans C & D), this amount B $4,500 ($4,875) APR =     = 16.67%
 $4,500   .5 
is deducted from the loan amount at loan
initiation.  $375   1 
C $4,625 ($5,000) APR =  $4,625   .5  = 16.22%
Compensating balances (for loans B & D),   
is  $375   1 
$5,000×0.10 = $500. D $4,125 ($4,500) APR =  $4,125   .5  = 18.18%
  

A Comparison of Single Payment Loans

A Comparison of Single Payment Loans

Loan CF0 CF1 APR APY 2

Loan CF0 CF1 APR APY
 $5,375 
A $5,000 ($5,375) 15.00% 15.56% =   −1 A $5,000 ($5,375) 15.00% 15.56%
 $5,000 
2 B $4,500 ($4,875) 16.67% 17.36%
 $4,875 
B $4,500 ($4,875) 16.67% 17.36% =   −1
 $4,500  C $4,625 ($5,000) 16.22% 16.87%
2
 $5,000 
C $4,625 ($5,000) 16.22% 16.87% =   −1 D $4,125 ($4,500) 18.18% 19.01%
 $4,625 
2
 $4,500 
D $4,125 ($4,500) 18.18% 19.01% =   −1
 $4,125 

Discounted Installment Loans Discounted Installment Loans

Sheridan Systems borrows $12,000 for 3
months at 15%. The interest is paid in
advance, and Sheridan will pay the loan in 3
monthly installments of $3,000 at the end of
the first two months and $6,000 at the end of
the third month.
Compute the APY and APR of this loan.
The interest cost of this loan is
($12,000)(15%)(3/12 years) or $450.
Since the interest is deducted in advance,
Sheridan will get $12,000 - $450 or $11,550
at loan initiation.

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 Discounted Installment Loans Commercial Paper

+$11,550 Commercial paper is a negotiable business IOU

–$3,000 –$3,000
0 1 2 3
$3,000 $3,000 $6,000
$11,550 = + +
1+ r (1 + r ) 2 (1 + r ) 3
r = 1.72% per month
APR = 12 × 0.0172 = 20.6%
APR = (1.0172)12 − 1 = 22.68%
–$6,000
note.
It is sold by the largest, most creditworthy firms
on a discount basis.
Maturity is set to less than 270 days.
n Registration with the SEC is not required.
40% of commercial paper is sold through dealers.
n Commission of about 0.125% on an annualized basis.

Factors Affecting the Short-Term Electronic Data Interchange

Financing Mix (EDI)
Cost of the source of funds EDI is computer-based exchange of information.
Desired level of current assets Benefits to firms from using EDI:
n reduced processing time
Seasonal component of current assets n lower personnel and material costs
Flotation costs n reduced costs due to errors
Restricted access to sources of long-term n lower investments in inventories
n better service
capital
n competitive pricing
Bankruptcy costs
Firm's choice of risk level

Electronic Data Interchange

In North America, the standards are set by ANSI

n American National Standards Institute
Electronic Funds Transfer (EFT)
n Transfer of funds between banks
Financial EDI (FEDI)
n Exchange of information between banks and customers:
n account balances, checks cleared, lockbox information

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