Principles of

Chapter 9 Corporate Finance

Tenth Edition

Working Capital
Management

Slides by
Matthew Will

Copyright © 2011 by the McGraw-Hill

Companies, Inc. All rights reserved.
McGraw-Hill/Irwin
 12-2

Before-Class Assignment (Day 12)

1. A firm has sales of $860,000 and cost of goods sold of $490,000.
The firm had a beginning inventory of $98,000 and an ending
inventory of $112,000. What is the length of the inventory period?
2. A firm has sales of $498,000 and cost of goods sold of $221,000.
At the beginning of the year, inventory was $36,400. At the end of
the year, the inventory balance was $31,800. What is the inventory
turnover rate?
3. A firm has sales of $710,000. The cost of goods sold is equal to
57 percent of sales. The firm has average inventory of $23,940.
How many days on average does it take the firm to sell its
inventory?
4. A company has sales of $626,000. The cost of goods sold is
equal to 68 percent of sales. The beginning accounts receivable
balance is $75,534 and the ending accounts receivable balance is
$76,209. How long on average does it take the firm to collect its
receivables?
 12-3

After-Class Assignment (Day 12)

1. A firm has an inventory turnover rate of 16, a receivables
turnover rate of 21, and a payables turnover rate of 11. How long is
the operating cycle?
2. A company sells its inventory in 87 days on average. Its average
customer charges their purchases on a credit card and payment
are received in 10 days. A company takes 56 days on average to
pay for its purchases. Given this information, what is the length of
D&M's cash cycle?
3. A company has an inventory turnover rate of 13, an accounts
payable period of 44 days, and an accounts receivable period of 35
days. What is the length of the cash cycle?
4. A company has an inventory turnover of 16 and an accounts
receivable turnover of 10. The accounts payable period is 51 days.
What is the length of the cash cycle?
 12-4

After-Class Assignment (Day 12) (cont)

5. A company currently has an operating cycle of 76 days. The firm
is analyzing some operational changes that are expected to
decrease the accounts receivable period by 3 days and decrease
the inventory period by 8 days. The accounts payable turnover rate
is expected to increase from 7 to 9 times per year. If all of these
changes are adopted, what will the firm's new operating cycle be?

6. A company has an inventory period of 33 days, an accounts

payable period of 41 days and an accounts receivable period of 27
days. Management is considering offering a 5 percent discount if its
credit customers pay for their purchases within 10 days. If the new
discount is offered the accounts receivable period is expected to
decline by 13 days. If the new discount is offered, the cash cycle
will change from _____ days to _____ days.
 12-5

After-Class Assignment (Day 12) (cont)

7. A firm currently has a 36-day cash cycle. Assume the firm
changes its operations such that it decreases its receivables period
by 3 days, increases its inventory period by 2 days, and decreases
its payables period by 3 days. What will the length of the cash cycle
be after these changes?

8. For its most recent year a company had Sales (all on credit) of
$830,000 and Cost of Goods Sold of $525,000. At the beginning of
the year its Accounts Receivable were $80,000, its Accounts
Payable were $125,000 and its Inventory was $100,000. At the end
of the year its Accounts Receivable were $86,000, its Accounts
Payable were $105,000 and its Inventory was $110,000. Calculate
cash cycle operations.
 12-6

Topics Covered
1. Inventories Management
2. Receivables Management
3. Cash Management
4. Marketable Securities Management
5. Sources of Short Term Borrowing
 12-7

Working Capital = 479-

Current assets and liabilities for U.S.
manufacturing firms (1st qtr. 2009)…$ billions
Currenty Assets Current Liabilities

Cash 273 Short-term loans 182

Other shirt-term financial
investments 147 Accounts payable 408

Accounts receivable 601 Accrued income taxes 27

Current payments due on
Inventories 626 long-term debt 131

Other current asets 348 Other current liabilities 768

Total 1996
1996 Total 1517
1517
 12-8

Working Capital
Current assets as a percentage of total assets in different
industries. Figures are the mean percentages for companies in
the S&P Composite Index in 2008.
 12-9

1. Inventory Management
➢ Components of Inventory ➢ Expense of inventory:
– Raw materials – Carrying cost
– Work in process – Order cost / Restocking costs
– Finished goods

➢ Goal = Minimize amount of cash tied up in inventory

➢ Tools used to minimize inventory

– Just-in-time
– Lean manufacturing
– Economic order quantity model (EOQ)
 12-10

Inventories
➢ As the firm increases its order size, the
number of orders falls and therefore the order
costs decline. However, an increase in order
size also increases the average amount in
inventory, so that the carrying cost of
inventory rises. The trick is to strike a
balance between these two costs.
 12-11

Carrying costs
Q
Inventory, thousands of units

Inventory
10

Average
5
Inventory

0 2 4 6 8

Weeks
 12-12

Carrying costs
Beginning
Inventory

= Q / 2 (units)

Ending Carrying cost per unit = CC ($/unit)

Inventory

=> Carrying cost = Q / 2 x CC

 12-13

Carrying costs
Beginning
Inventory

= 10,000 / 2 = 5,000 units

Ending Carrying cost per unit =

Inventory $0.75 / unit / year

=> Carrying cost = 5,000 x $0.75 = $3,750 / year

 12-14

Order costs
T: Annual sales (units)
Q: number of units for each order (units / order)
=> Number of orders is T/Q (orders)
F: Fixed cost on each order ($ / order)

=> Order costs = F x ( T / Q )

 12-15

Order costs
Example:
During a year, Company A has annual sales of 600 pairs of
shoes. Company A orders 100 pairs for each order. How many
times that company A orders per year?
Assume that fixed cost on each order is $20 / order. What is
order costs?

Number of orders = 600 / 100 = 6 orders

=> Total order costs = $20 x 6 = $120
 12-16

Economic order quantity

Determination of optimal order size
Inventory costs, dollars

Total costs
Carrying
costs

Total order costs

Optimal Order size

order size
Số sp lưu trong kho
 12-17

Economic order quantity

Economic Order Quantity - Order size that
minimizes total inventory costs.

Số lượng sản phẩm lưu trong kho tối ưu (units /

order)
2 x annual sales x cost per order
Economic Order Quantity =
carrying cost
 12-18

EOQ example
During a year, Company A has annual sales of 600 pairs of
shoes. Company A orders 100 pairs for each order. Assume that
fixed cost on each order is $20 / order. Carrying cost is $3 / unit /
year.
What is economic order quantity?
 12-19

Example – Inventory management

A company uses (bán) 400,000 tons of

stone per year. The carrying costs (chi phí
lưu kho) are $100/ton. The cost per order
(chi phí đặt hàng) is $500 (500 $ / order).
Calculate the economic order quantity (Số
tấn đá lưu trong kho tối ưu) per order.
 12-20

Example – Inventory management

 12-21

Example – Inventory management

A company uses 400,000 tons of stone

per year. The carrying costs are $100/ton.
The cost per order is $500. Calculate the
economic order quantity per order, the
optimal number of orders per year, the
optimal annual order costs, the optimal
carrying costs and the total costs of
optimal inventory.
 12-22

Example – Inventory management

 12-23

Example – Inventory management

A company expects to sell 2,430 printers

next year. Annual carrying cost is $50 per
printer, and ordering cost is $30 ($/order).
The company operates 360 days a year.
Calculate the EOQ, number of times per
year the company reorder, the total
annual cost if the EOQ quantity is
ordered, the length of an order cycle.
 12-24

Example – Inventory management

12-25
12-26
12-27
 12-28

2. Credit management
1. How long are you going to give customers to pay their bills? Are you
prepared to offer a cash discount for prompt payment?
2. Do you require some formal IOU from the buyer or do you just ask
him to sign a receipt?
3. How do you determine which customers are likely to pay their bills?
4. How much credit are you prepared to extend to each customer? Do
you play it safe by turning down any doubtful prospects? Or do you
accept the risk of a few bad debts as part of the cost of building a
large regular clientele?
5. How do you collect the money when it becomes due? What do you
do about reluctant payers or deadbeats?
 12-29

2. Credit management
Terms of Sale – Credit, discount, and payment
terms offered on a sale.
Credit analysis – There are a number of ways
to find out whether customers are likely to pay
their debts.
Collection policy – The final step in credit
management is to collect payment.
 12-30

2. Credit management
Terms of Sale - Credit, discount, and payment
terms offered on a sale.

Example: 2/10 net 30

2 - percent discount for early payment

10 - number of days that the discount is
available
net 30 - number of days before payment is due
 12-31

Terms of sale example

Terms: 2/10, net 30, receivables amount = $1,000
What does it mean?
• Option 1: If the customer pays during 10 days => $980
• Option 2: If the customer pays during 30 days => $1,000

What will an intelligent customer’s decision?

Lend $980 in 20 days and pay interest of $20 on $980.
Interest rate = $20 / $980 = 2.0408%
Effective annual rate = (1+2.0408%) ^ (365/20) – 1 = 44.6%
 12-32

Terms of Sale
➢ A firm that buys on credit is in effect borrowing
from its supplier. It saves cash today but will
have to pay later. This, of course, is an implicit
loan from the supplier.
➢ We can calculate the implicit cost of this loan
Hàm ý lãi suất vay trong chính sách bán hàng
Effective annual rate

(
= 1 + discount
)
discounted price
365 / extra days credit
- 1
 12-33

Terms of Sale
Example - On a $100 sale, with terms 5/10 net
60, what is the implied interest rate on the credit
given?

Effective annual rate

(
= 1+ discount
discounted price
)365/extra days credit
-1
= (1 + )
5 365/50
95 - 1 = .454, or 45.4%
 12-34

Example – Receivales management

A supplier offers you credit terms of 2/15,

net 45. What is the cost of forgoing the
discount on a $218,400 purchase?
 12-35

Example – Receivales management

 12-36

Credit Agreements
➢ Terminology
– open account
– promissory note
– commercial draft
– sight draft
– time draft
– trade acceptance
– banker’s acceptance
– irrevocable letter of credit
– conditional sale
 12-37

Credit Analysis
Credit Analysis - Procedure to determine the
likelihood a customer will pay its bills.
➢ Credit agencies, such as Dun & Bradstreet
provide reports on the credit worthiness of a
potential customer.
➢ Financial ratios can be calculated to help
determine a customer’s ability to pay its bills.
 12-38

The Credit Decision

Credit Policy - Standards set to determine the
amount and nature of credit to extend to
customers.
Credit Scoring – What your lender won’t tell you.
➢ Extending credit gives you the probability of
making a profit, not the guarantee. There is still
a chance of default.
➢ Denying credit guarantees neither profit or loss.
 12-39

The Credit Decision

➢ Based on the probability of payoffs, the
expected profit can be expressed as:

p x PV(Rev - Cost) - (1 - p) x PV(cost)

The break even probability of collection is:

PV(Cost)
p =
PV(Rev)
 12-40

The Credit Decision

The credit decision and its probable payoffs

Payoff = Rev - Cost

Customer pays = p

Offer credit

Customer defaults = 1-p

Payoff = - Cost

Refuse credit
Payoff = 0
 Credit Decision’s Example
12-41

Company A is considering to grant credit for a customer X. On

each nondelinquent sale, company A receives:
• PV (Revenue): $1,200
• PV (Cost): $1,000
Calculate the break-even probability.

=> Break-even p = 1,000 / 1,200 = 5/6

Credit Decision’s Example
12-42

Expected profit = 5/6 x $200 + 1/6 x ($1,000) = 0

Customer pays = 5/6 Payoff = $200

Offer credit

Customer defaults = 1/6

Payoff = -$1,000

Refuse credit
Payoff = 0
 Credit Decision’s Example
12-43

Expected profit = 0.8 x $200 + 0.2 x ($1,000) = - $40

Customer pays = 0.8

Payoff = $200

Offer credit

Customer defaults = 0.2

Payoff = -$1,000

Refuse credit
Payoff = 0
 Credit Decision’s Example
12-44

Expected profit on initial order = 0.8 x $200 + 0.2 x ($1,000) = - $40

Expected profit on repeat order = 0.95 x $200 + 0.05 x ($1,000) = $140
Total expected profit = - $40 + 0.8 x $140 = $72
Customer pays = 0.95
Payoff = $200
Offer credit

Payoff = $200 Payoff = -$1,000

Customer pays = Customer defaults = 0.05
0.8
0 Refuse credit
Offer credit
Customer Payoff = -$1,000
defaults = 0.2

Refuse credit Payoff = 0

 12-45

Example – Payables management

Ms. Nhu has ordered goods with a value

of $800. The production cost is $600.
Under what conditions should you extend
credit if there is no possibility of repeat
orders?
 12-46

Example – Payables management

 12-47

Example – Payables management

The default rate (XS ko trả tiền) of a firm'

new customers has been running at 10%.
The average sale for each new customer
amounts to $800, generating a profit of
$100 and a 40% chance of a repeat order
next year. The default rate on repeat
orders is only 2%. If the interest rate is
9%, what is the expected profit from each
new customer?
 12-48

Example – Payables management

 12-49

Example – Payables management

A firm is currently experiencing a bad debt

ratio of 4%. Terry is convinced that, with
looser credit controls, this ratio will
increase to 8%; however, she expects
sales to increase by 10% as a result. The
cost of goods sold is 80% of the selling
price. Per $100 of current sales, what is a
firm 's expected profit under the proposed
credit standards?
 12-50

Example – Payables management

 12-51

Example – Payables management

A firm is currently experiencing a bad debt

ratio of 6%. The manager convinced that,
with tighter credit controls, he can reduce
this ratio to 2%; however, he expects
sales to drop by 8% as a result. The cost
of goods sold is 75% of the selling price.
Per $100 of current sales, what is the
manager's expected profit under the
proposed credit standards?
 12-52

Example – Payables management

 12-53

Collection Policy
Collection Policy - Procedures to collect and
monitor receivables.
Aging Schedule - Classification of accounts
receivable by time outstanding.
Factoring - Arrangement whereby a financial
institution buys a company's accounts
receivable and collects the debt.
 12-54

Collection Policy
Sample aging schedule for accounts receivable

Customer' s Less than More than

1 - 2 months 2 - 3 months Total Owed
Name 1 month 3 months
A 10,000 0 0 0 10,000
B 8,000 3,000 0 0 11,000
* * * * * *
* * * * * *
* * * * * *
Z 5,000 4,000 6,000 15,000 30,000
Total $200,000 $40,000 $15,000 $43,000 $298,000
 12-55

3. Cash Management
➢Cash does not pay interest
– Move money from cash accounts into
short term securities
– “Sweep programs”
– Concentration banking
– Lock-box system
 12-56

3. Cash Management
How purchases are paid. Percentage of total by payment type for
2007.
 12-57

3. Cash Management
➢ Electronic Funds Transfer (EFT)
➢ Automated Clearinghouse (ACH)
➢ International cash management
➢ Compensating balances
 12-58

4. Marketable Securities

Microsoft 2008 cash investments

Investment Amount
Money market mutual funds $1,044 million
Commercial paper 787
Certificates of deposit 1,580
US Govt and agency securities 4,200
Foreign govt bonds 3,466
Mortgage backed securities 3,628
Corporate notes and bonds 5,013
Municipal securities 761
Other 520
Total 20,999
 12-59

Money Market Investments

MATURITIES Basis for

Investment Borrower When Issued Marketability Calculating Interest Comments
4 weeks, 3 Excellent
months, or 6 secondary
Treasury bills U.S. government months market Discount Auctioned weekly
Benchmark bills by
Federal agency FHLB, "Fannie Mae," Very good regular auction;
benchmark bills and Sallie Mae," Freddie Overnight to 360 secondary discount notes sold
discount notes Mac," etc. days market Discount through dealers

Tax-anticipation notes
(TANs), revenue
anticipation notes
Municipalities, Good Usually interest- (RANs), bond
Tax-exempt states, school 3 months to 1 secondary bearing with interest anticipation notes
municipal notes districts, etc. year market at maturity (BANs), etc.
Tax-exempt variable- Municipalities, Good Long-term bonds with
rate demand notes states, universities, secondary put options to demand
(VRDNs) etc. 10-40 years market Variable interest rate repayment
 12-60

Money Market Investments

MATURITIES Basis for
Investment Borrower When Issued Marketability Calculating Interest Comments
Non-negotiable time
deposits and Usually 1 to 3
negotiable months; also Fair secondary
certificates of Commercial banks, longer-maturity market for Interest-bearing with
deposit (CDs) savings and loans variable-rate CDs negotiable CDs interest at maturity Receipt for time deposit
Industrial firms,
finance companies, Maximum 270 Dealers or Unsecured promissory
and bank holding days; usually issuer will note; may be placed
Commercial paper companies; also less than 10 repurchase through dealer or
(CP) municipalities years paper Usually discount directly with investor
Largely finance Minimum 270
companies and days;usually Dealers will Unsecured promissory
Medium-term notes banks; also industrial less than 10 repurchase Interest-bearing; note placed through
(MTNs) firms years notes usually fixed rate dealer
Demand to pay that has
Bankers' Major commercial Fair secondary been accepted by a
acceptances (Bas) banks 1-6 months market Discount bank

Overnight to Repurchase price set

about 3 months; higher than selling Sales of government
Dealers in U.S. also open repos price; difference securities by dealer with
Repurchase government (continuing No secondary quoted as repo simultaneous agreement
agreements (repos) securities contracts) market interest rate to repurchase.
 12-61

5. Sources of Short Term Borrowing

➢Bank loan (features)

– Commitment
– Maturity
– Rate of interest
➢Syndicated loans
➢Loan sales and CDOs
➢Secured loans
➢Commercial paper
➢Medium term notes