Week 12 Finance 1 Lecture Notes PDF

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Week 12 Finance 1 Lecture Notes Working Capital Management Management of Short-Term Assets  Short-terms assets have lives of days, weeks or months.  They include: o Inventory o Liquid Assets o Accounts Receivable  Despite their short lives and their small size, relative to large long-term capital investments, the investment in short-term assets still requires a commitment of capital. Therefore, like all investments they should generate an appropriate return.  Moreover, the investment in short-term assets is often a necessity of business as the firm needs to generate business and meet its ‘cash flow’ requirements.  Inventory: o Manufacturer: raw material, work in progress and finished goods o Retailer: merchandise  Liquid Assets: o All companies: cash – “cash is king” o Others (larger): bills of exchange and over-night deposits are good substitutes or cash (highly liquid) and can provide higher returns. o All companies: short-term liabilities are also an important source of liquid funds. For example, bank overdrafts provide ‘at call’, ‘revolving’ line of credit used by many businesses to smooth cash flow requirements.  Accounts Receivable: o Most companies: short-term credit is extended to customers when goods are sold on invoice.  In the perfect markets world (no fees, no taxes, no delays and full information), there is no need to be concerned about short-term assets. o There’s no need to hold raw materials because they can be instantly ordered and delivered. o There’s no need to hold liquid assets because all assets are liquid. o And by saying that all assets are liquid, account receivables are also liquid and can easily be converted into cash – albeit at their present value.  Therefore, if we are to consider the management of short-term assets, we cannot start in the frictionless world as we have done in most topics examined to date.  What frictions exist: o There are delays and uncertainties:  Raw materials take time to deliver. Failure to have the required materials may delay or stop the production process, which can be very costly in terms of lost production and fixed costs.  Customers may require stock immediately. Failure to have the stock results in lost sales and potential loss of customers.  Wages, interest and accounts payable must be paid and require access to cash. If you delay paying wages, employees will be unhappy at best. If you delay paying your interest, penalties may apply and it may

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increase the cost of future borrowings. If you do not pay your accounts payable, you may have no other option than to purchase goods C.O.D. (cash on delivery) in the future. o There are legal, administrative and ‘discounting’ costs.  Converting accounts receivable to cash can be costly. Can have high fees and can have relatively large discounts applied (price received relative to book value) because of costs associated with obtaining information about the creditors in accounts receivable. While this topic is also a topic for ‘management accounting’ and ‘operations research’, it is a finance topic because it involves investment and we can apply basic financial tools to analyse these investments. Primarily – NPV o There are cash inflows and outflows o There is an opportunity cost of funds o Decisions that have a positive NPV increase value. o When we have ‘mutually exclusive’ decisions, the one with the largest NPV maximises firm value. o The same principle applies to negative NPV investments where the investments are ‘mutually inclusive’ – you cannot have one without the other.

Overview of Inventory Management  Three main types of inventory o Raw Materials: yet to enter the production process o Work in Progress: in but not out of the production process o Finished Goods: finished but not sold  They can be a major asset o For example, in 2010 financials, they constituted 34%, 21% and 29% of shortterm assets for Boral, BHP and Paperlinx, respectively.  Inventory has costs o Acquisition Costs: ordering, freight and quantity discounts forgone. o Carrying Costs: Cost of capital, storage, insurance, deterioration and obsolescence, and price movement o Stock-Out Costs: no stock, no sale and potential to lose customers  Optimising these costs is a balance between having too much inventory and not enough inventory. Liquidity Management  Liquid Assets o “comprise cash and those assets that can be converted into cash in a very short time, and whose cash value can be predicted with a low degree of error”, Peirson et al. (2015).  Types include: o At call deposits o Short-term marketable securities such as bills of exchange and commercial paper. We priced bills in Week 2.  Liquidity Management

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o Size and composition of liquid assets and liabilities. o Note that as liquidity relates to an ability to access ‘cash’, access to lines of credit such as overdrafts are also important. Treasury Management o Central area or department that manages funding, liquidity and other financial risks such as interest rate and exchange rate movements. By centralising, Treasury can o match funding inflows and outflows o raise appropriate levels of funding o ensure sufficient liquidity for the whole organisation. Note that the liquidity required by the whole organisation will be less than that of the individual business units. o manage and hedge risk o provide economies of scale, lower administration costs per dollar of assets and, potentially, lower interest rates. o provides a high-level skill set with a unique perspective on the organisation that may not be possessed in the individual business units. An example of the value of treasury management: o Division A has a cash outflow of $150,000 o Division B has a cash inflow of $50,000 o Assuming that interest rate on borrowed funds is 15% p.a. while the interest rate on savings is 12% p.a.: o Interest cost from independent operations over a week would be,  I = -150,000 x 0.15 x 7/365 + 50,000 x 0.12 x 7/365  = -$316.44 o Interest cost from centralisation over a week would be,  I = -100,000 x 0.15 x 7/365  = -$287.67 Motives o Transactions: even with perfect certainty, cash inflows do not necessarily match outflows, hence businesses hold liquid assets to meet cash flow requirements o Precautionary: in an uncertain world, liquid assets are required to cover unexpected costs and opportunities. However, the amount required will depend on whether alternative sources of liquidity are available, e.g. access to an overdraft. o Speculative: if interests rates increase, the value of longer dated debt securities decreases more than similar shorter dated debt securities. Therefore, if one is speculating that interest will increase and prices will fall, then they buy short-dated (liquid) debt securities. o Not surprisingly, the first of these is considered the most dominant motive for liquidity management. Major Issues o If you do not have access to sufficient cash, damage to the business can be untold. Question:

If a property developer cannot pay his sub-contractors (tradesman) because of an inability to access cash, how will the sub-contractors react and how will this affect the value of his development? o If you have a large cash balance, is the business using resources efficiently? Question:  Why have large cash balances that only earn 4% p.a. when your debt costs 7% p.a? o Obviously, if you had to have one of these problems, the second is preferred. A failure to ensure sufficient cash balance is an acute problem that can severely damage a business. Holding excessive cash balances, while detrimental to value, can be solved over time. 

Accounts Receivable Management  Account Receivable: o “represent money owed to a company from the sale, on credit, of goods or services in the normal course of business”. Peirson et al. (2015). o The offering of credit to other businesses (trade credit) or individuals (consumer credit), relates to the company’s ‘credit and collection policies’. o The credit policy involves answering the following:  Is the company prepared to offer credit?  If credit is to be offered, want standards will be applied in the decision to grant credit to a customer?  How much credit should a customer be granted?  What credit terms will be offered? o The collection policy involves answering the following:  How to encourage payment?  How and when to enforce payment?  When to write-off bad debts? (accounting practice may not match reality).  Benefits and Costs of Granting Credit o Benefit:  Increased sales o Costs:  Opportunity cost of investment  Ties up funds that could be invested elsewhere.  Bad debts and delinquent accounts  Some customers will not pay accounts in a timely manner while others will simply not pay at all.  Administration  Staffing, stationery, postage and other costs associated with pursuing delinquent accounts prior to them becoming bad debts.  Additional Investment  With higher sales, you could expect higher inventory amounts  Credit Policy

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o Do you work on cash sales only (may not be possible) or do you extend credit to your clients? o If you extend credit:  Is credit worthiness assessed?  How is credit worthiness assessed?  What credit terms are offered? o For example, what would the following businesses do in regards to their credit policy?  A mechanic  An anaesthetist  A computer supplier Selection of Creditworthy Customers o Extend credit to all customers.  Increases size and probability of bad debts.  Consider credit limit o Extend credit to all ‘good’ customers.  Requires knowledge of customers and may result in forgone sales to new customers  Consider credit limit o Extend credit to customers that are credit worthy or who have a good credit history.  Information required from customer (their financials) or credit record company that collects information on individuals and companies.  Consider credit limit Decision Tree o A technique that applies probabilities to expected cash flows to determine the decision with the highest expected payoff.

Example o Company B wants to buy $1000 worth of goods from Company A. o The goods cost $700 to manufacture. o Company A’s cost of capital is 2% per month o And…

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Grant Credit Immediately (no investigation) E[Cost] = E[Bad Debt] + E[Cost of Capital] + E[Collection Cost] o = 700x0.07 + 700x0.02x2 + 5 o = 82

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Refuse Credit Immediately E[Cost] = Lost Margin x Probability of Payment o = 300x0.93 o = 279

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Investigate and Grant Credit o E[Cost] = E[Bad Debt] + E[Cost of Capital] + E[Collection Cost]  Low Risk, E[C] = 700x0.0 + 700x0.02x1 + 2 = 16  High Risk, E[C] = 700x0.4 + 700x0.02x7 + 20 = 398  New Cust. E[C] = 700x0.2 + 700x0.02x2 + 8 = 190

Investigate and Refuse Credit

 o E[Cost] = Lost Margin x Probability of Payment  Low Risk, E[C] = 300x1.00 = 300  High Risk, E[C] = 300x0.60 = 180  New Cust. E[C] = 300x0.80 = 240

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Expected Cost of Investigating o For each customer type, select action with lowest E[Cost] o Total E[Cost] = prob. cust. type x E[Cost] + Investigation Cost  = 0.8x16 + 0.15x180 + 0.05 x 190 + 2  = 51.30

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Credit Terms: o Specify the credit period and may include a discount for accounts that are paid early o Typical Terms

 n30  2/10, n30  3.5/10, 2.5/30 o Why offer a discount?  Pricing  Manage Credit Risk  Reduce bad debts  Reduce amount of accounts receivables; you are financing someone else 

The cost of credit

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Example, INV = $1,000 with terms of 2/10 n30. o Pay day 30

o Pay day 100 (stretching the account)

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Collection Policy o “A company that never has a bad debt almost certainly has a sub-optimal credit policy – that is if a more lenient policy were adopted, then the increase in sales would more than offset the losses imposed by a few bad debts”, Peirson et al. (2015) o What matters?  Size ($10, $100, $1000, $10000, $100000, …)  Timing (days in arrears, 1, 10, 20, 30, 60, 90, 180, …)  Customer (small, medium or big)  Costs (administration, legal and enforcement) o Actions  Reminders, Telephone Calls, Personal Letters, Legal Action, … o Ultimately, there is a trade-off of costs and benefits. Evaluation of Alternative Credit and Collection Policies

o Example:  By extending credit to customers, sales are expected to increase $20,000, although associated costs are $16,000.  Credit terms are n60 and all new sales are paid at day 60.  No bad debts, no administrative costs but r = 2% per month.

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Example cont. o Now credit terms are 2.5/30, n60 o 75% of customers take advantage of discount  CF1 = 0.75 x 20,000 x (1 – 0.025) = 14,625  CF2 = 0.25 x 20,000 = 5,000...