Chapter 13 Working Capital Management

Transcription

1 Chapter 13 Working Capital Management LEARNING OBJECTIVES 1. Model the cash conversion cycle and explain its components. (Slide 13-2) 2. Understand why the timing of accounts receivable is important and explain the components of credit policy. 3. Understand the float concept and its effect on cash flow and explain how to speed up receivables and slow down disbursements. 4. Explain inventory management techniques and calculate the economic order quantity (EOQ). 5. Account for working capital changes in capital budgeting decisions. IN A NUTSHELL In this chapter, the author covers various topics related to the efficient management of a firm s current assets such as cash, accounts receivable, and inventory. Since there is typically a time lag between when a firm places an order and pays for raw materials to when a product is manufactured, shipped out, and paid for, it is very important for a firm to keep track of how much is being tied up in these various assets, and for how long. Excessive investments tend to be wasteful. Therefore, the name of the game is to try and speed up collections and delay payments (without penalty) so as to have optimal use of one s funds. Accordingly, after explaining the various components of a firm s cash conversion cycle, the author discusses various techniques and steps that firms can avail of to manage their cash, receivables, and inventory. The chapter ends with a discussion of the importance of including working capital changes within the capital budgeting decision process. LECTURE OUTLINE 13.1 The Cash Conversion Cycle (Slides 13-3 to 13-12) In order to manage working capital efficiently, a firm has to be aware of how long it takes them, on average, to convert their goods and services into cash. This length of time is formally known as the cash conversion cycle. Equation 13.1 shows that the cash conversion cycle is made up of 3 separate cycles: 1. The production cycle: i.e. the time it takes to build and sell the product 2. The collection cycle: i.e. the time it takes to collect from customers (i.e. collecting accounts receivable) and 442

2 Chapter 13 n Working Capital Management The payment cycle: i.e. the time it takes to pay for supplies and labor, i.e. paying accounts payable). The production cycle and the collection cycle together make up the operating cycle, so the cash conversion cycle can also be calculated as follows: Cash conversion cycle = Operating cycle Payment cycle. Figure 13.1 provides an excellent illustration of these various cycles. The production cycle begins when a customer places an order and ends when the product is shipped out. The collection cycle begins when the order is filled and ends when payment is received. The payment cycle begins when labor is hired or raw materials are received to start production and ends when the firm pays for purchases, raw materials and other production costs. Since firms typically have to pay for production costs before they receive payment from their customers, a longer cash conversion cycle would tie up their finances and viceversa. It, therefore, makes sense to keep track of these various cycles and try to shorten the cash conversion cycle so as to free up much needed funds (A) Average production cycle: is calculated in 3 steps. First calculate average inventory as shown in Equation 13.2 Next, calculate the inventory turnover rate as follows: Cost of Goods sold Inventory turnover rate = 13.3 Average Inventory Lastly, calculate the average production cycle as follows:

3 444 Brooks n Financial Management: Core Concepts, 2e Production cycle= 365/ Inventory turnover rate (B) Average collection cycle: makes up the other leg of the operations cycle. It measures the number of days taken by a firm, on average, to collect its accounts receivables. To measure it we first calculate the average accounts receivable, i.e. Then we measure the accounts receivable turnover rate as follows: Finally, we calculate the average collection cycle, i.e. Average collection cycle = 365/A/R turnover rate (C) Average payment cycle: is also calculated with the same three steps, except that we use the average accounts payable and accounts payable turnover to do it (D) Putting it all together: The Cash Conversion Cycle: When we add a firm s production cycle to its accounts receivable cycle and deduct the number of days in its payment cycle, we get the cash conversion cycle i.e. the number of days between when a firm incurs an outflow to start production until it receives payment on a credit sale. So if a firm can shorten its production cycle or its collection cycle, or both, while keeping its payment cycle constant or lengthened, it can shorten the number of days that it would typically have to finance its operations for, thereby reducing its financing costs and increasing its profits. Thus, shortening the cash conversion cycle essentially requires the efficient management of receivables (credit policy), inventory, and payables. Example 1: Measuring the Cash Conversion Cycle Mark is has just been appointed as the chief financial officer of a mid-sized manufacturing company and is keen to measure t,he firm s cash conversion cycle, operating cycle, production cycle, collection cycle, and payment cycle, so as to see if any changes are warranted. He collects the necessary information for the most recent fiscal year, and puts together the table below: Cash sales $200,000 Credit sales $600,000 Total sales $800,000 Cost of goods sold $640,000 Ending Balance Beginning Balance Accounts receivable $40,000 $36,000 Inventory $10,000 $6,000 Accounts payable $ 9,000 $5,000

4 Chapter 13 n Working Capital Management 445 First, we calculate the average values of the 3 accounts: Average A/Rè ($36,000 + $40,000)/2 = $38,000 Average inventoryè $( )/2 = $8,000 Average A/P è ($ $5,000)/2 = $7,000 Next, we calculate the turnover rates of each A/R Turnover = Credit Sales/Avg. A/R è $600,000/$38,000 è Inventory Turnover = Cost of Goods Sold/Avg. Inv è $640,000/$8,000 = 80 A/P Turnover = Cost of Goods Sold/Avg. A/P = $640,000/$7,000 = Finally we calculate the collections cycle, the production cycle, and the payment cycle by dividing each of the turnover rates into 365 days, respectively. Collection cycle = 365/A/R Turnoverè 365/ è days Production cycle = 365/Inv. Turnoverè 365/80è 4.56 days Payment cycle = 365/A/P Turnoverè 365/91.43è 3.99 days So the firm s operation cycle = Collection cycle + Production cycle = = days Cash conversion cycle = Operating cycle payment cycle = è days. So on average, the firm has to finance its credit sales for about 24 days Managing Accounts Receivable and Setting Credit Policy (Slides to 13-24) The efficient management of accounts receivable is a critical step in shortening the cash conversion cycle. A firm s credit policy, if too lax can lead to increased defaults, and if too strict, can lead to lost sales. Thus, firms have to establish well-balanced credit and collection policies to efficiently manage working capital (A) Collecting accounts receivable: The timing of collecting payments from customers is hardly uniform. A certain percentage of customers always pay on time, while a small percentage is always late. Hence, firms have to analyze their historical collection patterns and accordingly plan for the future (B) Credit: A two- sided coin: One firm s accounts receivable is another firm s accounts payable. Also, the cash conversion cycle decreases with a shortening of the collection cycle but increases with a lengthening of the payment cycle, If a firms shortens it collection cycle by tightening its credit policy, its suppliers could do the same, which would negate the effectiveness of the strategy.

5 446 Brooks n Financial Management: Core Concepts, 2e It is imperative for firms to establish good credit policies regarding screening, payment terms, and collecting of over-due bills (C) Qualifying for credit. This often depends on the customer s background, business potential, and competitive pressures. There is usually a trade-off between paying the high screening costs and the lost cash flow due to defaults resulting from poor screening. Example 2: Evaluating credit screening cost Go-Green Golf Carts Inc. has developed an environmentally friendly golf cart, which costs $2500 to produce and will sell for $4,000.Market analysis shows that the firm will be able to sell 2000 carts per year, if it allows credit sales. However, there is a chance that 1% of the customers may default. If the firm does not offer credit terms, 40% of the sales will be lost. It has also been determined that if the firm offers credit only to credit-worthy customers by screening the buyers, the default rate will be zero, i.e. the 20 potential defaulters will be screened in advance. Should the firm proceed with credit sales and if so, should it screen the clients and at what cost? Profit earned on all-cash sales =.6*2000*($1500)=$1,800,000 Profit earned on credit sales (no screen) =(.99*2000*1500) (20*2500)è $2,920,000 i.e 99% of 2000 customers will pay and provide a $1500 profit, while 1% of 2000 or 20 customers will default causing a loss of $2500 each Additional profit generated by granting no-screen credit è 2,920,000-$1,800,000= $1,120,000 Benefits of screening = 20 *$2500 = $50,000 Maximum cost per customer for screen = $50,000/2000 = $25 Let s say the firm proceeds with the credit terms and successfully screens out the 20 bad credit clients at a cost of $25 per screen Profit = (1980*$1500) $25*2000=$2,920,000è the amount it would earn if all 2000 sales were on credit and 20 customers defaulted. If the credit screen costs more than $25 it would be better for them to merely grant credit and hope that the default rate is not >1%!! 13.2 (D) Setting Payment Policy: An important part of credit policy is to determine how many days of free credit to grant customers and whether or not to offer discounts for paying early, and if so, how much of a discount? Discounts, if high enough, tend to be mutually beneficial, since the seller frees up cash and the buyer pays less. Example 3: Cost of foregoing cash discounts Let s say that a firm grants it customers credit on terms of 1/10, net 45. You are one of the customers who have an invoice due of $10,000. You have a line of credit with your

6 Chapter 13 n Working Capital Management 447 bank that is at the rate of 9% per year on outstanding balances. Should you avail of the discount and pay on day 11 or wait until the 45 th day and make the full $10,000 payment? If you pay by Day 11, you will owe $10,000*(.99)= $9900 If you pay by Day 45, you will owe $10,000 You benefit by $100 for a 35 day period. If you could invest $9900 over a 35 day period and end up with more than $10,000, you would be better off holding off the payment and investing the money rather than taking the discount. The holding period return = $100/$9900 = 1.01% over a 35 day period The APR = HPR * 365/35= 1.01*10.428% è 10.53% The EAR = (1+HPR) 365/n -1 = (1.0101) 365/35-1 =11.05% Since you can borrow at 9% per year, it would be better to borrow the money, pay on Day 10, and take advantage of the discount Alternate method: Calculate the APR and EAR implied by the discount being offered using Equations and as follows: APR = (1%/(1-1%)) * (365/days between payment days) = (.01/.99)* (365/(45-10) è.0101* è.1053 or 10.53% EAR = (1+ (.01/.99) 365/35-1 = (1.0101) = 11.05% 13.2 (E) Collecting Overdue Debt: i.e. a firm s collection policy, involves sending collection notices, taking court action, and eventually writing off bad debts. The cost to the firm escalates at each step. Firms should carefully establish and monitor their credit policy involving screening, payment terms, and collection procedures so as to maximize benefits while minimizing costs The Float (Slides to 13-28) Float, which refers to the time it takes for a check to clear, is of two types. Disbursement float is the time lag between when a buyer writes a check to when the money leaves his or her account. Collection float is the time lag between when a seller deposits the check to when the funds are received in the account. Note: The collection float is part of the disbursement float, so if the seller or his bank can speed up collection it will automatically shorten the disbursement float.

7 448 Brooks n Financial Management: Core Concepts, 2e 13.3 (A) Speeding up the Collection (Shortening the Lag Time): Firms attempt to speed up collections in a variety of ways including: Lock boxes, which are post office boxes set up at convenient locations to allow for quick pick up and deposit of checks by the firm s bank. Electronic fund transfers (EFT) which occur directly from the buyers account. For example by accepting debit cards (B) Slowing Down Payment (Lengthening the Lag Time): is getting more difficult with the advent of Check 21 (electronic clearing of checks between banks) and acceptance of debit cards. One method that continues to be popular, though, is the widespread use of credit cards which allows for a month long float Inventory Management: Carrying Costs and Ordering Costs (Slides to 13-43) Managing inventory essentially involves the balancing of carrying costs (i.e. storage costs, handling costs, financing costs and costs due to spoilage and obsolescence) against ordering costs (i.e. delivery charges), which tend to offset each other. To keep carrying costs down requires more frequent orders of smaller sizes, but could result in lost sales due to stock-outs. Fewer, larger orders, lowers ordering costs, but requires carrying larger amounts of inventory. There are 4 cost-minimizing methods that firms can use to manage inventories efficiently: The ABC inventory management model; Stocking redundant inventory; the Economic Order Quantity method; and the Just in Time approach (A) ABC Inventory Management: involves categorizing inventory into 3 types: Large dollar or critical items (A-type); Moderate dollar or essential items (B-type), and small-dollar or non-essential items (C-type) as shown in Table Each type is monitored differently with respect to the frequency of taking stock and reordering (B) Redundant Inventory Items: involves maintaining back-up inventory of items that are currently not needed frequently, but could be used in emergencies and avoid higher costs due to stoppages.

8 Chapter 13 n Working Capital Management (C) Economic Order Quantity: is a method to determine the optimal size of each order by balancing ordering costs with carrying costs so as to minimize the total cost of inventory. The Trade- off between Ordering Costs and Carrying Costs: occurs because with larger order sizes, fewer orders are needed, reducing delivery costs, and the costs resulting from lost sales due to shortages. However, higher levels of inventory are held, thereby increasing costs associated with storage, handling, spoilage and obsolescence. Figure 13.7 illustrates this trade-off 13.4 (D) Measuring Ordering Costs: involves multiplying the number of orders placed per period by the cost of each order and delivery, as shown in Equation Where OC = cost per order; S=annual sales; and Q = order size. Example 4: Measuring ordering cost Nigel Enterprises sells 1,000,000 copies per year. Each order it places costs $40 for shipping and handling. How will the total annual ordering cost change if the order size changes from 1000 copies per order to copies per order. At 1000 copies per order: Total annual ordering cost = $40 X 1,000,000/1000 è $40,000 At copies per order: Total annual ordering cost = $40 X 1,000,000/10,000 è $4000 As order size increases, ordering cost decline due to fewer orders 13.4 (E) Measuring Carrying Costs: involves multiplying the carrying cost by the half the order quantity as shown in Equation below:

9 450 Brooks n Financial Management: Core Concepts, 2e The model assumes that inventory is used up at a constant rate each period so when it is at its half way point a new order is received, meaning that on average we are holding about half the inventory each period. Example 5: Measuring carrying cost Nigel Enterprises has determined that it costs them $0.10 to hold one copy in inventory each period. How much will the total carrying cost amount to with 1000 copies versus 10,000 copies being held in inventory. With 1000 copies in inventory Total annual carrying cost = $0.10* 1000/2 = $50 With 10,000 copies in inventory Total annual carrying cost = $0.10*5000 = $500 As order size increases carrying costs go up proportionately. To arrive at the optimal order quantity, we can use Equation 13.17, Example 6: Calculating EOQ With annual sales of 1,000,000 copies, carrying costs amounting to $0.10 per copy held and order costs amounting to $40 per order. What is Nigel Enterprises optimal order size? Please verify that your answer is correct. S = 1,000,000; OC = $40; CC = $0.10 EOQ = [(2* *$40)/0.1] 1/2 = 28, 285 (rounded to nearest whole number) With order size = 28,285, Total order cost = (1,000,000/28285)*$40 = $ Total carrying cost = 28285/2*0.1= $ Total inventory cost = $ Verification: With Q = 28,000 è OC = (1,000,000/28000)*$40 è $ è CCè 28000/2*.1è 1400 Total cost è >$ With Q = 29,000è OC= /29000)*40 è è CCè 1450 Total cost = $ >$ (F) Reorder Point and Safety Stock: Since inventory gets used up every day, and there is a lead time necessary to have additional supplies delivered, firms must determine a reorder point such that they don t have a stock-out. The reorder point = daily usage * days of lead time Once the inventory hits the re-order point, the next order is placed so that by time it is delivered, the firm would be just about out of inventory.

10 Chapter 13 n Working Capital Management 451 An additional protection measure is to build in some safety stock or buffer so as to be covered in case of delivery delays as follows: Average inventory = EOQ/2 + safety stock Example 7: Measuring re- order point and safety stock Calculate Nigel Enterprises Reorder point and safety stock assuming that deliveries take 4 days on average with a possibility of 2 day delays sometimes. EOQ = 28,285; daily usage rate = 1,000,000/365è 2740 Reorder point = 4*2740 = 10,960 (without safety stock) With safety stock built in we calculate average inventory asè Average inventory = EOQ/2 + safety stock Safety stock = 2 days usage = 2*2740 = 5480 So Nigel Enterprises should reorder when the inventory drops to 10, è 16,440 copies (G) Just in Time: is an inventory management system which tries to keep inventory at a minimum by following lean manufacturing practices, i.e. producing only what is required, when it is required and keeping finished goods in storage for as little time as possible. JIT inventory management, if practiced successfully would eliminate waste and improve productivity significantly The Effect of Working Capital on Capital Budgeting (Slide 13-44) Inventories and Daily Operations: When doing capital budgeting, as was explained earlier, we must take into account the initial investment required for working capital i.e. inventory and accounts receivable, as part of cash outflow at time 0. Moreover, if working capital fluctuates significantly each period, it must be taken into account, and at the end of the productive life of the project, it should be included as a cash inflow, to reflect the fact that the firm will be drawing down on the inventory and collecting the receivables, which already have been included as part of the cash outflow. Questions 1. Explain the three components of the cash conversion cycle. The three components of the cash conversion cycle are the production cycle, the collection cycle (also known as the accounts receivable cycle) and the payment cycle (also known as the accounts payable cycle). The production cycle is the time it takes to produce and sell a product or service. The collection cycle is the time it takes from the sale of the product or service until cash is collected from the sale. The payment

11 452 Brooks n Financial Management: Core Concepts, 2e cycle is the time between the order of supplies or raw materials and the payment to suppliers for these items. 2. Why should a company attempt to speed up its receivables and slow down its payables? Speeding up receivables or slowing down payments reduces the cash conversion cycle. The cash conversion cycle reflects the time a company must fund its operations. A shorter cash conversion cycle means less funding necessary for operations. 3. How can a company encourage its slow-paying customers to pay their outstanding bills? One way to encourage slow paying customers is to offer discounts for quicker payments. 4. What is credit screening? When would it be appropriate for a company to use credit screening? When would it be appropriate for a company to not use credit screening? A credit screen is a process to identify potential bad loans (non paying credit customers). It is appropriate to use a credit screen when the cost of the screen does not outweigh the benefits of the screen. That is, as long as the potential bad customers are eliminated from credit sales and good customers are not eliminated from credit sales, it is appropriate to use a cost effective credit screen. 5. Why is it often a good practice to simply write off a bad debt rather than pursue payment from a credit customer? It is expensive to try and collect all bad debts and when the cost of recovering the sales dollars is greater than the sales dollars it is better to simply write-off the bad debt and take the tax credit. 6. Should a company take all discounts offered by its suppliers? What criteria should be used when accepting or rejecting a discount on an invoice? Companies should only take those discounts where the implied interest rate is greater than what they can earn by keeping their funds until the payment date for the full amount of the invoice. The criterion is the average hurdle rate or cost of capital for the company (its borrowing rate from other lenders). 7. What is the float? Why does it take time between when you write a check and when the funds come out of the account? The float is the time between when a check is written and when the funds leave the account. The time lapse is due to the time the check is held and processed by the receiver of the check, the time the check travels from the receiver s bank to the issuer s bank, and any processing time at the issuer s bank. The time between banks is now less due to Check 21, the legislation that permits electronic transfer of funds between banks for checks. 8. When might it be detrimental to a company to have too many items in inventory? When might it be detrimental to have too few?

12 Chapter 13 n Working Capital Management 453 Too many inventory items may be costly for a company due to the cost of storing and maintaining inventories. Too few inventories may result in lost sales when a company is out of stock or production stoppages when replacement parts are not in stock. 9. What is an economic order quantity? What cost does it attempt to minimize? An economic order quantity is the optimal order size that minimizes the total inventory costs of an item. 10. Why might a company have extra inventory on hand above the amount suggested by the economic order quantity? Make a case for a redundant inventory item in a business setting. Extra inventory or safety stock is held by a company because orders can and do get delayed in shipping and the safety stock helps reduce the potential out of stock problems that result in down production time or lost sales. A redundant inventory item is an item not in use and being held just in case something happens to the inventory item it would replace. Anytime a part is difficult to replace (for a variety of reasons such as remote location of unit, or long lead time in producing replacement part) a redundant inventory item can be used to keep the production going and avoid costly delays. The Mars Rover is a good example of a remote location where it would be difficult if not impossible to replace a part and so it is important to have redundant parts on the Mars Rover should the front line item fail. 11. Why is it necessary to consider changes to working capital accounts as part of the capital budgeting decision? Working capital is a necessary component of a new product when inventory items such as bottles for bottled-water are used to deliver a new product to the customer. Without the increase in the working capital, capital budgeting projects cannot be completed. 12. What ire some potential pitfalls of poor short-term financial planning? Poor short-term planning can leave a company short of funds at a critical time. Lenders could view this as a systematic problem of the firm and choose not to loan funds at this critical time requiring the company to take drastic measures that hurt the long run viability of the company. It could even force a company into bankruptcy. Prepping for Exams 1. b 2. b 3. a 4. a 5. c 6. d 7. c 8. a 9. c

13 454 Brooks n Financial Management: Core Concepts, 2e 10. a Problems 1. Business operating cycle. Kolman Kampers has a production cycle of thirty-five days, a collection cycle of twenty-one days, and payment cycle of fourteen days. What are Kolman s business operating cycle and cash conversion cycle? If Kolman reduces the production cycle by one week what is the effect on the cash conversion cycle? If Kolman decreases the collection cycle by one week what is the effect on the cash conversion cycle? If Kolman increases the payment cycle by one week what is the effect on the cash conversion cycle? Operating Cycle = Production Cycle + Collection Cycle Operating Cycle = 35 Days + 21 Days = 56 Days Cash Conversion Cycle = Operating Cycle Payment Cycle Cash Conversion Cycle = 56 Days 14 Days = 42 Days Reducing Production Cycle by one week (7 days) reduces cash conversion cycle by one week (7 Days) to 35 days. Reducing Collection Cycle by one week (7 days) reduces cash conversion cycle by one week (7 Days) to 35 days. Increasing Payment by one week (7 days) reduces cash conversion cycle by one week (7 Days) to 35 days. 2. Business operation cycle. Stewart and Company currently has a production cycle of forty days, a collection cycle of twenty days, and a payment cycle of fifteen days. What are Stewart s current business operating cycle and cash conversion cycle? If Stewart and Company wants to reduce its cash conversion cycle to thirty-five days what action can it take? Operating Cycle = Production Cycle + Collection Cycle Operating Cycle = 40 Days + 20 Days = 60 Days Cash Conversion Cycle = Operating Cycle Payment Cycle Cash Conversion Cycle = 60 Days 15 Days = 45 Days Options on reducing the cash conversion cycle to 35 days: 1) reduce production cycle by 10 days 2) reduce collection cycle by 10 days 3) increase payment cycle by 10 days 4) combination of reductions to production cycle and collection cycle and increase of payment cycle totaling 10 days.

14 Chapter 13 n Working Capital Management 455 Use the following account information for problems 3 through Selected Income Statement Items for Rian Company Cash Sales $298,000 Credit Sales $672,000 Total Sales $970,000 Cost of goods sold $570, & 2008 Selected Balance Sheet Accounts of Rian Company 12/31/08 12/31/07 Change Accounts Receivable $38,000 $46,000 $8,000 Inventory $55,000 $59,000 $4,000 Accounts Payable $27,000 $25,000 $2, Average production cycle. Find the average production cycle for Rian Company. Average Inventory = (Beginning Inventory + Ending Inventory) / 2 Average Inventory for Rian Company = ($55,000 + $59,000) / 2 = $57,000 The second step is to determine how quickly we turn over the inventory. To do this, we take the cost of goods sold for the year, COGS, and divide by the average inventory: Inventory Turnover = COGS / Average Inventory Inventory Turnover for Rian Company = $570,000 / $57,000 = 10 times Average Production Cycle = Days in Year / Inventory Turnover Average Production Cycle = 365/10 = 36.5 Days 4. Average production cycle. For the coming year, Rian Company wants to reduce its average production cycle to thirty days. If the target-ending inventory for 2009 is $61,000, what cost of goods sold will the company need to reach its goal? Working backwards through the equations for average production cycle we have, Average Production Cycle = 365/x = 30 Days where x is the inventory turnover. X = Average Inventory = = COGS / [($55,000 + $59,000)/2] COGS = $57,000 = $693, Average collection cycle. What is the average collection cycle for Rian Company?

15 456 Brooks n Financial Management: Core Concepts, 2e First step is to calculate the Average A/R Average Accounts Receivable = (Beginning A/R + Ending A/R) / 2 Average A/R for Rian Company = ($38,000 + $46,000) / 2 = $42,000 Step two is to determine the Accounts Receivable turnover rate: Accounts Receivable Turnover Rate = Credit Sales / Average Accounts Receivable A/R Turnover for Rian Company = $672,000 / $42,000 = 16 times The third and final step is to estimate the collection cycle by dividing the number of days in a year by the Accounts Receivable turnover rate: Collection Cycle = 365 / Accounts Receivable Turnover Rate Rian s Collection Cycle = 365 / 16 = Days 6. Average collection cycle. Rian Company had a target of twenty days for the collection cycle for the year If total sales had remained at $970,000, how much of the sales revenue would have needed to be cash sales for the company to meet the collection goal? Working backwards to find credit sales we have, Collection Cycle = 20 Days = 365 / Average Receivable Turnover Average Receivable Turnover = 365 / 20 Days = Days Average Receivable Turnover = Days = Credit Sales / $42,000 Credit Sales = $42, = $766,500 Cash Sales = Total Sales Credit Sales = $970,000 $766,500 = $203, Average accounts payable cycle. Calculate Rian Company s average accounts payable cycle. Average Accounts Payable = (Beginning of the year A/P + End of Year A/P) / 2 Average A/P = ($27,000 + $25,000) / 2 = $26,000 The second step is to determine the Accounts Payable Turnover and here we use the COGS as the cost of production. Accounts Payable Turnover = COGS / Average A/P Rian s A/P Turnover = $570,000 / $26,000 = times The third and final step is to determine the number of days that Rian Company takes to pay its suppliers: Accounts Payable Cycle = 365 / Accounts Payable Turnover Rian s A/P Cycle = 365 / = days

16 Chapter 13 n Working Capital Management Average accounts payable cycle. Rian Company had a target of fifteen days for its payment (accounts payable) cycle. What would the ending balance in the accounts payable account need to be to reach this target (holding all other accounts the same)? Working backwards we have, Rian s A/P cycle = 15 days = 365 / Accounts Payable Turnover Accounts Payable Turnover = 365 / 15 days = days Accounts Payable Turnover = days = $570,000 / Average Accounts Payable Average Accounts Payable = $570,000 / = $23, Average Accounts Payable = $23, = [$25,000 + Ending A/P] / 2 Ending A/P = $23, $25,000 = $21, Cash flow of accounts receivable. Myers and Associates, a famous law office in California, bills it clients on the first of each month. Clients pay in the following fashion: 40% pay at the end of the first month, 30% pay at the end of the second month, 20% pay at the end of the third month, 5% pay at the end of the fourth month, and 5% default on their bills. Myers wants to know the anticipated cash flow for the first quarter of 2009 if the past billings and anticipated billings follow this same pattern. The actual and anticipated billings are as follows: End of January Anticipated Cash Flow from Billings = 5% of Oct + 20% of Nov + 30% of Dec + 40% of Jan = 0.05 $392, $323, $296, $340,000 = $19,600 + $64,600 + $88,800 + $136,000 = $309,000 End of February Anticipated Cash Flow from Billings = 5% of Nov + 20% of Dec + 30% of Jan + 40% of Feb = 0.05 $323, $296, $340, $360,000 = $16,150 + $59,200 + $102,000 + $144,000 = $321,350 End of March Anticipated Cash Flows 5% of Dec + 20% of Jan + 30% of Feb + 40% of Mar = 0.05 $296, $340, $360, $408,000 = $14,800 + $68,000 + $108,000 + $163,200 = $354,000

17 458 Brooks n Financial Management: Core Concepts, 2e 10. Cash flow of accounts receivable. Myers and Associates (from Problem 9) has hired a new accountant, who promises to increase the speed of payment by clients. The new collection times will be 60% at the end of the first month, 25% at the end of the second month, and 10% at the end of the third month. The uncollectible accounts will remain at 5%.What cash flow improvement will this change generate for the first quarter if the new system takes effect in January? Assume payments from the fourth quarter will stay on the old payment schedule. The new payment schedule only impacts January sales forward so, End of January Anticipated Cash Flow from Billings = 5% of Oct + 20% of Nov + 30% of Dec + 60% of Jan = 0.05 $392, $323, $296, $340,000 = $19,600 + $64,600 + $88,800 + $204,000 = $377,000 End of February Anticipated Cash Flow from Billings = 5% of Nov + 20% of Dec + 25% of Jan + 60% of Feb = 0.05 $323, $296, $340, $360,000 = $16,150 + $59,200 + $85,000 + $216,000 = $376,350 End of March Anticipated Cash Flows = 5% of Dec + 10% of Jan + 25% of Feb + 60% of Mar = 0.05 $296, $340, $360, $408,000 = $14,800 + $34,000 + $90,000 + $244,800 = $383, Credit screening. Tennindo Inc. is starting up its new, cost-efficient gaming system console, the yuu. Tennindo currently has 4,000 cash-paying customers and makes a profit of $60 per unit. Tennindo wants to expand its customer base by allowing customers to buy on credit. It estimates that credit sales will bring in an additional 1,200 customers per year but that there will also be a default rate on credit sales of 5%. It costs $260 to make a yuu, which retails for $320. If all customers (old and new) buy on credit, what is the cost of bad debt without credit screening? What is the most Tennindo would pay for credit screening that accurately identifies bad-debt customers prior to the sale? What are the increased profits by adding credit sales for customers with and without credit screening? Should Tennindo offer credit sales if credit screening costs $10 per customer? Cost of bad debt is 0.05 (4, ,200) $260 = $67,600 Maximum cost of Credit Screen: Old Profits = 4,000 $60 = $240,000 $240,000 = $60 5,200 Cost of Screen per Customer Cost per Customer = ($296,400 $240,000) / 5200 = $10.85

18 Chapter 13 n Working Capital Management 459 New Profits of firm without credit screen = 5, $ ,200 $260 = $296,400 $67,600 = $228,800 New Profits with Credit Screen = 5, $60 $5200 $10 = $296,400 $52,000 = $244,400 Tennindo should offer credit sales if credit screen costs $10 per customer 12. Credit screening. Screendoor Inc. is a credit-screening consulting firm. Screendoor advises Tennindo Inc. (from Problem 11) that it can offer a credit-screening device that is 90% accurate and costs $5.00 per customer to apply. Using the data in Problem 11, determine whether Tennindo should use Screendoor s credit-screening system. Profit with credit screening system: Profit = $60 5, $5.00 5,200 5, (1-0.90) $260 Profit = $296,400 $26, $260 = $296,400 $26,000 $6,760 Profit with Screendoor system = $263,640 Note, 26 customers are still bad debt customers ( (1 0.90)) but the profit is higher with credit screening, so they should go for it. 13. Credit terms. As manager of Fly-by-Night Airlines, you decide to allow customers 90 days to pay their bills. To encourage early payment, though, you allow them to reduce their bills by 1.5% if paid within the first 30 days. At what implied effective annual interest rate are you loaning money to your customers? What if you extend the discount to 60 days and allow full payment up to 180 days? Holding Period (60 Day) Return = $0.015 / $0.985 = or 1.523% Now what is % interest over 60 days stated on an annual basis? Effective Annual Rate = ( ) 365/60 1 = or 9.63% Holding Period (120 Day) Return = $0.015 / $0.985 = or 1.523% Now what is % interest over 120 days stated on an annual basis? Effective Annual Rate = ( ) 365/120 1 = or 4.70% 14. Credit terms. Find the effective annual rate of the following credit terms: a. 2% discount if paid within ten days or net within thirty days b. 1% discount if paid within thirty days or net within sixty days c. 0.5% discount if paid within fifteen days or net within forty-five days d. 1.0% discount if paid within twenty days or net within thirty days

19 460 Brooks n Financial Management: Core Concepts, 2e a. ( /0.98) 365/20 1 = or 44.59% b. ( /0.99) 365/30 1 = or 13.01% c. ( /0.995) 365/30 1 = or 6.29% d. ( /0.99) 365/10 1 = or 44.32% 15. Economic order quantity (EOQ). Tinnendo Inc. believes it will sell 4 million zenzens, an electronic game, this coming year (note that this figure is for annual sales). The inventory manager plans to order zen-zens forty times over the next year. The carrying cost is $0.03 per zen-zen per year. The order cost is $600 per order. What are the annual carrying cost, the annual ordering cost, and the optimal order quantity for the zen-zens? Verify your answer by calculating the new total inventory cost. Annual Carrying Cost = average inventory cost per unit per year Average inventory = (4,000,000 / 40) / 2 = 50,000 Annual Carrying Cost = 50,000 $0.03 = $1,500 Annual Ordering Costs = 40 $600 = $24,000 EOQ = [2 4,000,000 $600 / 0.03] 1/2 = 400,000 New Carrying Costs = 400,000 / 2 $0.03 = $6,000 New Ordering Costs = 4,000,000 / 400,000 $600 = $6,000 EOQ of 400,000 is optimal order quantity (carrying costs = ordering costs) and new TOTAL Annual Inventory Cost = $6,000 + $6,000 = $12, Economic order quantity (EOQ). It turns out that the marketing manager in Problem 15 has underestimated the zen-zen market. The zen-zens are a smash, and current estimates are that the company will sell 8 million of them per year. Should the inventory manager simply double the EOQ order quantity from Problem 15? Find the new EOQ and verify that it is the correct order quantity by finding the new carrying cost and new ordering cost. New EOQ = [2 8,000,000 $600 / $0.03] 1/2 = 565,685 New Ordering Costs = 8,000,000/ 565,685 $600 = $8,485 New Carrying Costs = 565,685 / 2 $0.03 = $8,485 (Note answers rounded to nearest whole unit and nearest dollar) The new EOQ is not double the EOQ in problem # Working capital and capital budgeting. Farbuck s Tea Shops is thinking about opening another tea shop. The incremental cash flow for the first five years is as follows:

20 Chapter 13 n Working Capital Management 461 Initial capital cost = $3,500,000 Operating cash flow for each year = $1,000,000 Recovery of capital assets after five years = $250,000 The hurdle rate for this project is 12%. If the initial cost of working capital is $500,000 for teapots, teacups, saucers, napkins, should Farbuck s open this new shop if it will be in business for only five years? What is the most it can invest in working capital and still have a positive net present value? Find the incremental cash flows by year CF 0 = $3,500,000 plus $500,000 outflow or -$4,000,000 CF 1 through CF 4 = $1,000,000 CF 5 = $1,000,000 plus $500,000 plus $250,000 or $1,750,000 NPV at 12% NPV = -$4,000,000 + $1,000,000 (1 1/ ) / $1,750,000 / NPV = -$4,000,000 + $3,037,349 + $992,997 = $30,346 And the project is a go! The most that Farbuck s Tea Shops could spend on working capital is as follows: For each additional dollar of current value they get $1/ in return or a net present cash outflow of $1 $ = $ If the current NPV is $30,346 they could spend another $30,346/ = $70,152 in working capital. Proof: NPV = -$4,070,152 + $1,000,000 (1 1/ ) / $1,820,152 / NPV = -$4,070,152 + $3,037,349 + $1,032,803 = $0 18. Working capital and capital budgeting. Working capital investment is 25% of the anticipated first year sales for Wally s Waffle House. The first-year sales are currently projected at $4,300,000. The incremental cash flow (not including working capital investment) is Initial cash flow = $13,7000,000 outflow Cash flow years 1 through 10 = $2,850,000 What is the internal rate of return of the ten-year project with working capital factored into the cash flow? What is the net present value at 15% weighted average cost of capital? What is the maximum investment in working capital for an acceptable project with a 15% weighted average cost of capital? IRR (using calculator) CF0 = -$13,700, $4,300,000 = -$14,775,000

21 462 Brooks n Financial Management: Core Concepts, 2e CO1 = $2,850,000 FO1 = 9 CO2 = $2,850, $4,300,000 = $3,925,000 IRR = 14.64% NPV = -$14,775,000 + $2,850,000 (1 1/ ) / $3,925,000 / NPV = -$14,775,000 + $13,599, $970, = -$205,786 And the project is a no-go! Wally s Waffle House must reduce its working capital to cover the net loss of $205,786. For each additional dollar of reduced spending on working capital they get $1/ in return or a net present cash outflow of $1 $ = $ If the current NPV is - $205,786 they need to reduce working capital spending by $205,786/ = $273,355 (you need to not round the $ to get this number). Current spending is $1,075,000 and therefore you will have to reduce current working capital to $801,645. If you can reduce working capital by $273,355 you have the following cash flow: CF0 = -$13,700, $4,300,000 + $273,355 = -$14,501,645 CO1 = $2,850,000 FO1 = 9 CO2 = $2,850, $4,300,000 $273,355 = $3,651,645 Then the NPV will be zero at 15% Proof: NPV = -$14,501,645 + $2,850,000 (1 1/ ) / $3,651,645 / NPV = -$14,501,645 + $13,599,014 + $902,631 = $0 Solutions to Advanced Problems for Spreadsheet Application 1. Cash flow timing for accounts receivable. Zenotech Incorporated Actual Forecast Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Sales in thousands of $ $ 3,866 $ 4,209 $ 3,113 $ 1,979 $ 1,543 $ 1,137 $ 1,010 $ 1,608 $ 1,974 $ 2,005 $ 2,608 $ 3,501 $ 4,070 $ 5,280 $ 3,547 $2,411 $1,604 $1,233 Collection Rates for Month: Less than $2 million Default 1.25% Discount 48.00% Net % 90 Days 7.50% 120 days 4.25% % Between $2 and $5 million Default 2.50% Discount 41.00% Net % 90 Days 9.00% 120 days 5.50% % Over $5 million Default 4.00% Discount 37.00% Net % 90 Days 11.00% 120 days 6.50% % Discount rate 1.50%

22 Chapter 13 n Working Capital Management 463 Collected so Start with Sept Sales: Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Anticipated Cash Flow $ 1,459 $ 1,121 $ 1,305 $ 1,684 $ 1,743 $ 2,112 $ 2,774 $ 3,459 $ 4,092 $ 4,183 $ 3,268 $ 2,433 Alternative Build the Collections by Month: Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Sales $ 3,113 $ 1,979 $ 1,543 $ 1,137 $ 1,010 $ 1,608 $ 1,974 $ 2,005 $ 2,608 $ 3,501 $ 4,070 $ 5,280 $ 3,547 $ 2,411 $1,604 Collection Month TOTAL January $ 1,459 $ 171 $ 148 $ 602 $ 538 February $ 1,121 $ 84 $ 116 $ 443 $ 478 March $ 1,305 $ 66 $ 85 $ 394 $ 760 April $ 1,684 $ 48 $ 76 $ 627 $ 933 May $ 1,743 $ 43 $ 121 $ 770 $ 810 June $ 2,112 $ 68 $ 148 $ 842 $ 1,053 July $ 2,774 $ 84 $ 180 $ 1,095 $ 1,414 August $ 3,459 $ 110 $ 235 $ 1,470 $ 1,644 September $ 4,092 $ 143 $ 315 $ 1,709 $ 1,924 October $ 4,183 $ 193 $ 366 $ 2,191 $ 1,432 November $ 3,268 $ 224 $ 581 $ 1,490 $ 974 December $ 2,433 $ 343 $ 319 $ 1,013 $ 758 $ 195 $ 217 $ 626 $ 133 $ 120 $ Economic order quantity. Exact Copies Information Paper In Reams 12,000,000 Cost To Order $ Carrying Cost $ 0.05 Annually TOTAL ANNUAL Order Frequency Quantity Ordered Number of Orders Annual Order Costs Annual Carry Costs INVENTORY COSTS Weekly 230, $ 23, $ 5, $ 29, Bi Weekly 461, $ 11, $ 11, $ 23, Monthly 1,000, $ 5, $ 25, $ 30, Bi-Monthly 2,000, $ 2, $ 50, $ 52, Quarterly 3,000, $ 1, $ 75, $ 76, EOQ Quantity Ordered Number of Orders Annual Order Costs Annual Carry Costs INVENTORY COSTS Optimal Order Size 464, $ 11, $ 11, $ 23,237.90

23 464 Brooks n Financial Management: Core Concepts, 2e Costs at Various Order sizes Quantity Ordered Number of Orders Annual Order Costs Annual Carry Costs INVENTORY COSTS 214, $ 25, $ 5, $ 30, , $ 22, $ 5, $ 28, , $ 20, $ 6, $ 27, , $ 18, $ 7, $ 25, , $ 17, $ 7, $ 25, , $ 15, $ 8, $ 24, , $ 14, $ 9, $ 23, , $ 13, $ 9, $ 23, , $ 13, $ 10, $ 23, , $ 12, $ 10, $ 23, , $ 11, $ 11, $ 23, , $ 11, $ 12, $ 23, , $ 10, $ 12, $ 23, , $ 10, $ 13, $ 23, , $ 9, $ 14, $ 23, , $ 9, $ 14, $ 23, , $ 8, $ 15, $ 24, , $ 8, $ 15, $ 24, , $ 8, $ 16, $ 24, , $ 7, $ 17, $ 25, , $ 7, $ 17, $ 25, $35, $30, $25, $20, $15, $10, Carrying Costs Ordering Costs TOTAL COSTS $5, $- 214, , , , , , , , , , , , , , , , , , , , , Solutions to Mini- Case Cranston Dispensers, Inc.: Part 1 This case is designed to offer a comprehensive review of working capital management and policy issues. Greatest emphasis is on the cash conversion cycle and associated computations, but collections and credit policy are covered conceptually and a related EOQ problem is included in the case questions.

24 Chapter 13 n Working Capital Management Determine Cranston s average production cycles for 2009 and Inventory Turnover = COGS/ Avg Inventory Production Cycle = 365/Inv Turnover ,568/ (( )/2) = /4.65 = 79 days ,172/ (( )/2)) = /4.83 = 76 days 2. Determine Cranston s average collection cycles for 2009 and Assume that all sales are credit sales. Receivable Turnover = Credit Sales/ Avg Acc. Rec. Collection cycle = 365/Receivables Turnover ,784/ (( )/2) = /5.55 = 66 days ,202/(( )/2) = /6.66=55 days 3. Determine Cranston s average payment cycles for 2009 and Payables turnover = COGS/Avg Acc Payable Payment cycle = 365/Payables Turnover ,568/ (( )/2) = /8.28 = 44 days ,172/ (( )/2) = /8.83 = Using your answers to Questions 1 through 3, determine Cranston s cash conversion cycles for 2009 and Business cycle = = 145 days Cash conversion cycle = = 101 days 2009 Business cycle = = 131 days Cash conversion cycle = = 90 days 5. Cranston now bills its customers on terms of net 45, meaning that payment is due on the forty-fifth day after the goods are shipped. Although most customers pay on time, some routinely stretch the payment period to sixty and even ninety days. What steps can Cranston take to encourage clients to pay on time? What is the potential risk of implementing penalties for late payment?

25 466 Brooks n Financial Management: Core Concepts, 2e Cranston has both carrot and stick approaches available. The first step should be a polite reminder call. The company could impose penalties on late payments; these penalties should be stiff enough that overdue accounts will not be viewed as a source of cheap credit. The company could also offer a discount for early payment. As a last resort, Cranston could require cash on delivery or refuse delivery to chronically latepaying customers. Penalties run the risk of alienating some customers who may choose to take their business elsewhere. Cranston would need to be especially careful not to lose very large accounts that are an important part of their business. 6. Suppose Cranston institutes a policy of granting a 1 % discount for payment within fifteen days with the full amount due in forty-five days (1/15, net 45). Half the customers take the discount; the other half takes an average of sixty days to pay. a.) What would be the length of Cranston s collection cycle under this new policy? The new collection period will be 15/2 + 60/2 = 47.5 days. Customers who forego the discount will apparently take another 15 days beyond the due date. b.) In dollars, how much would the policy have cost Cranston in 2010? Cranston would lose 1% on half of its sales, or $3,784/2.01 = $18.92 million before taxes. Since this amount would not be taxed, we can estimate the after-tax effect as $18.92 million ( /398.50) = approximately $13.24 million. c.) If this policy had been in effect during 2010, by how many days would the cash conversion cycle have been shortened? In 2010, the collection cycle was 66 days. The new policy would shorten the collection period, and the cash conversion cycle, by = 18.5 days. 7. An image-based lockbox system could accelerate Cranston s cash collections by three days. Cranston can earn an annual rate of 6% on the cash freed by accelerated collections. Using sales for 2010, what is the most Cranston should be willing to pay per year for the lockbox system? The lockbox system would free up 3 days sales or $3,784/365 3 = $31.10 million dollars. If Cranston can earn 6% on this money, the lockbox system would be advantageous at any cost less than $31.10 million.06 =$1.866 million per year. 8. One of Cranston s principal raw materials is plastic pellets, which it purchases in lots of 100 pounds at $0.35 per pound. Annual consumption is 8,000,000 pounds. Within a broad range of order sizes, ordering and shipping costs are $120 per order. Carrying costs are $1.50 per year per 100 pounds. Compute the Economic Order Quantity for plastic pellets. The pellets can only be ordered in whole lots of 100 pounds, so use 8,000,000/100 as S in Equation If Cranston used the EOQ model, how often would it order pellets? EOQ = (2 800, /1.50) 1/2 =11,314 lots per order. 800,000/ 11,314 = 71, so Cranston would be placing orders every five days.