Class Notes for Managerial Finance I
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1 Class Notes for Managerial Finance I These notes are a compilation from: 1. Class Notes Supplement to Modern Corporate Finance Theory and Practice by Donald R. Chambers and Nelson J. Lacy. I gratefully acknowledge the permission of Hayden-McNeil Publishing Inc and professors Chambers and Lacey to use and reproduce these materials. 2. Material by the author. Copyright in each is reserved to the author. Working Capital Management Associated Readings: 4 th Edition Chapter 16, 5 th Edition Chapter 17 Key Terms working capital working capital management net working capital cash management ratio analysis economic order quantity {EOQ} just-in-time Miller-Orr model information signaling money market securities Andrew Hall Class Notes to Managerial Finance. Page 1
2 Summary of Chapter Each of us has to budget and make sure we have cash available when we need it. Our incomings should equal our outgoings and even if we have an overdraft facility we need to make sure that we stay within our arrangement or our checks will be returned and out credit will be compromised. The same is true of Corporations who must manage their available cash to ensure that they can pay their bills when due. Companies lend money to customers who take credit and companies need a systematic approach to deciding whether to extend credit. Companies also lend money by placing cash in Bank Accounts, Certificates of Deposit, Bonds and other Marketable securities. If a large amount of cash has been raised by your corporation by, for example, issuing a new bond: then it may be desirable to invest this cash to provide a return to the corporation. The cash will be needed in due course so it will help to have a strategy for releasing the cash. This section looks at the models that are available to help the managers of the firm to make these decisions. Class Outline I. Accounts Receivable Management: To whom should the firm extend credit anyone who asks? Or should the firm be more discriminatory? We analyze the credit decision in two parts: A. The One-Off Customer: First we assume that the credit is a one off decision and work on the basis that there will only be one sale, ever. The one-off credit decision is a simple gamble in which we put down the cost of the goods sold and the payoff will be the net profit on the goods sold. There are assumed to be only two states of nature: we will be paid or we will not be paid: this means that P(Non-Payment) = 1 P(Payment) OR P(Payment) = 1 P(Non-Payment) The expected return from the gamble can be expressed as: E( R) = 1, ( ) i= 1, nr i = i nr i * Prob E R = * = NetProfit * P (Payment) CostOfGoodsSold * P (Non-Payment) Prob i or substituting 1 P(Payment) for P(Non-Payment) ( ) = NetProfit * (Payment) CostOfGoodsSold *[ 1 (Payment)] E R P P i Andrew Hall Class Notes to Managerial Finance. Page 2
3 Class Application #1: The One-Off Credit Decision: Helena Diskettes is looking at the decision to extend credit to a new customer who just placed an order for 2,000 boxes of diskettes. Helena sells each box for $25, and the cost of each box to the firm is $19. What probability of payment would make you indifferent to extending the credit? Note you will be indifferent to extending the credit if the expected return is $0.00! Answer: A few matters to sort out first. The customer cost would be $38,000 {2,000 B. The Repeat Customer: Then we assume that the customer will be a repeat customer and we calculate an NPV for the project by subtracting costs of providing credit from benefits: NPV = {Prob. of Payment*Customer Value} - {(1-Prob. of Payment)*Cost} where customer value = profitability of the account. Class Application #2: The Credit Decision: Helena Diskettes is looking at the decision to extend credit to a new customer who just placed an order for 2,000 boxes of diskettes. Helena sells each box for $25, and the cost of each box to the firm is $19. Your credit check on the customer tells you that the chance that the customer will pay their bill is 75%. You know that should the relationship with the customer work out well, chances are very good that they will place a similar order every year. Determine the credit decision using formula (16.6). Use a discount rate of 15% Answer: A few matters to sort out first. The customer cost would be $38,000 {2,000 boxes times $19 cost per box}, while the customer value per year $12,000 {2,000 boxes times the $6 profit per box}. However, the total customer value would be the present value of $12,000 per year, and assuming a perpetuity would be $80,000 {$12,000.15}. NPV = {.75 $80,000} - {.25 $38,000} = $50, Andrew Hall Class Notes to Managerial Finance. Page 3
4 Class Application #3: The Credit Decision: Returning to Helena Diskettes, and the decision on the customer. Using the information in Class Application #2, find the probability of payment that would make Helena indifferent to handing out the credit. Answer: Substitute x for the probability of payment in formula (16.6), set the equation equal to zero, and solve for x: {x $80,000} - {(1-x ) $38,000} = $0 x = Andrew Hall Class Notes to Managerial Finance. Page 4
5 II. Terms of Credit: Once the decision to extend credit has been determined, the firm must set its credit terms. Credit terms are usually separated into two parts; the credit period and the credit discount, for example 2/10; net 30. This means that the firm provides an incentive for the customer to pay quickly; in this case a 2% discount if the bill is paid within 10 days, else the full amount is due in 30 days. Interestingly, customers who take no discount and pay when due effectively borrow money to be repaid on the last payment date. The length of this loan is the number of days (called the GAP) from the last day of discount to the last day payment is due. Class Application #4: Terms of Credit and The Implicit Interest rate On The Loan: Helena Diskettes sets their credit terms to be 2/15; net 30. Determine the interest rate implied by these credit terms. Answer: This problem is an application to time value of money, and the equation (3.10) 1 that solves for the interest rate: FV n n r = 1. The present value in this case is the PV payment net of the discount, and the future value is the payment without the discount. The length of the loan is the GAP, 20 days, or.055 years, in this case. Note also that you have information for PV and FV because you know the size of the order, $50,000, and you know the discount is 2% so payment with discount is $49, $ 50, r = 1 = or a whopping 44.4%. With an interest rate this high, the $49,000 customer has a great incentive to pay early. Note that by lengthening the GAP, say by changing the credit terms to 2/15; net 60, you reduce the implied interest rate to approximately 18%. III. Managing Liquidity: Liquidity management is a tradeoff between too much liquidity and not enough liquidity. The EOQ Model calculates an optimal liquidity or a precise balance of this trade-off. The figure below presents this tradeoff where the costs are represented by storage costs (holding cash) and ordering costs (turning interestbearing securities into cash. The EOQ model searches for the point where total costs are minimized. Note that this is the point where storage costs are equal to ordering costs Andrew Hall Class Notes to Managerial Finance. Page 5
6 Class Application #5: Cash Management Using The EOQ Model: Kramer Industries experiences regular cash outflows of $50,000 per day as it expands its chain of Kosmo Coffee Shops around the country. To obtain needed cash, the firm must sell marketable securities and incur a transactions cost of $100. Further, the firm earns no interest on its cash balance while it earns 6% after tax and risk on its marketable securities. Using the EOQ model, find the optimal order amount Answer: EOQ = {(2*$18,250,000*$100) (.06)}.5 = $246,664 Kramer will place $18,250,000 $246,664 = 74 orders per year The annual order cost will be $ = $7,400 The annual storage cost will be ($246,664 2) (.06) = $7,400 Class Application #6: Cash Management Using The EOQ Model: Abnormal Growths Inc. is consuming cash at a rate of $10,000 per day. Selling securities to obtain additional cash costs a fee of $250 each time. The interest rate is 10%. a. Determine the optimal order amount (the EOQ) b. How many orders will be placed each year? c. What will be the total annual order costs? d. What will be the average cash balance size? e. What will be the annual storage costs? f. How much money would the firm be losing if they replenished cash everyday with $10,000? g. What if interest rates were 5% instead of 10%? Answer: EOQ = {(2*$18,250,000*$100) (.06)}.5 = $246, Andrew Hall Class Notes to Managerial Finance. Page 6
7 IV. Marketable Securities Management: Many firms keep liquid assets in near cash form in order to earn a return. However, a tradeoff exists between low risk and liquidity against the return earned. Some of the common types of marketable securities are: TBills: No credit risk, no state income tax. Commercial Paper: Low credit risk, taxable. CD s: Low credit risk, taxable. Class Application #7: Calculating Rates Of Return On Alternative Marketable Securities: A particular Massachusetts firm has marketable securities balances of $10 million, and will invest this money over one year. The firm can choose only among the following securities for investment. Calculate the after-tax rate of return on each, and make a recommendation. The firm pays federal tax at the rate of 34%, and state tax at the rate of 6%. 1. TBills, Yield = 6%, Probability of Default = 0% 2. CD s, Yield = 10.1%, Probability of Default = 3% 3. Municipal Bond (Mass), Yield =6%, Probability of Default = 1% Answer: First get all bond yields on an after tax basis: l: ATY =.06 (1-.06) = CD: ATY =.101 (1-.40) = Municipal ATY =.06 (1-.00) =.0600 Next, After Risk Yield = Before Risk Yield (1-Prob. Of Default) 1. TBill: ARY =.0564 (1-.00) = CD: ARY =.0606 (1-.03) = Municipal ARY =.0600 (1-.01) = Andrew Hall Class Notes to Managerial Finance. Page 7
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