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Unformatted text preview: TBS 907- FINANCIAL STRATEGY MODULE 6 STRATEGIC FINANCIAL PLANNING OBJECTIVES Management of Short Term Assets Short term Financial Planning Working Capital Long Term and Short Term Financing Decisions Cash Budgeting A Short Term Financing Plan Cash/Liquidity Management Inventory Management Credit Management Short term Assets Introduction Both short-term and long-term assets require a commitment of resources by the company and, therefore, both forms of investment warrant careful analysis. The management of short-term assets is important, given that the typical company holds around one-third of its total assets in short-term assets. Short-Term Asset Management The analysis of short-term asset management assumes markets are not frictionless and perfectly competitive. Holding inventories and cash is not costless but delays in daily business can result if such short-term assets are mismanaged. Wealth maximisation remains the ultimate objective, but techniques other than net present value are often required. Managing Short-Term Assets and Liabilities Match maturity structure of assets and liabilities. Cash inflows from sale or use of assets can meet liabilities. If assets and liabilities are not matched well, company may not be able to meet obligations in timely fashion. Working Capital
Net Working Capital - Current assets minus current liabilities. Often called working capital. Cash Conversion Cycle - Period between firm's payment for materials and collection on its sales. Carrying Costs - Costs of maintaining current assets, including opportunity cost of capital. Shortage Costs - Costs incurred from shortages in current assets. Working Capital
Simple Cycle of operations
Cash Raw materials inventory Receivables Finished goods inventory Changes in Cash & W.C.
Example - Dynamic Mattress Company
Assets 2000 Current Assets 4 Cash 4 Mark Securities 0 Inventory 26 Accts Recv 25 Total Curr Assets 55 Fixed Assets Gross investment 56 less Depr 16 Net Fixed Assets 40 Total Assets 95 2001 5 5 5 25 30 65 70 20 50 115 Liabilities & Equity 2000 Current Liabilities Bank Loans 5 Accts Payable 20 Total Curr Liab 25 Long Term Debt 5 Net Worth 65 2001 0 27 27 12 76 Total Liab and owner' s equity 95 115 Changes in Cash & W.C.
Example - Dynamic Mattress Company
Income Statement Sales $350 Operating Costs 321 Depreciation 4 EBIT 25 Interest 1 Pretax income 24 . Tax at 50% 12 Net Income $12 Assume dividend = $1 mil R.E.=$11 mil Example Dynamic Mattress Company Changes in Cash & W.C.
Sources Issued long term debt 7 Reduced inventories 1 Increased accounts payable 7 Cash from operations Net income 12 Depreciation 4 Total Sources $31 Uses Repaid short term bank loan 5 Invested in fixed assets 14 Purchased marketable securities 5 Increased accounts receivable 5 Dividend 1 Total Uses $30 Increase in cash balance $1 Example - Dynamic Mattress Company Changes in Cash & W.C. Dynamic used cash as follows Paid $1 mil dividend. Repaid $5 mil short term bank loan Invested $14 mil Purchased $5 mil of marketable securities Accounts receivable expanded by $5 mil Motives for Holding Liquid Assets Transactions motive Perfect synchronisation of cash inflows and outflows is virtually impossible to achieve because the timing of a company's inflows depends on the actions of its customers. Therefore, liquid assets are held in order to finance transactions undertaken between cash inflows. Motives for Holding Liquid Assets (cont.) Precautionary motive Future cash inflows and outflows cannot be predicted with perfect certainty. Therefore, the possibility exists that extra cash will be needed to meet unexpected costs, or to take advantage of unexpected opportunities. Motives for Holding Liquid Assets (cont.) Speculative motive When interest rates increase, there is a fall in the market value of income-producing assets such as bonds. Individuals forecasting an increase in interest rates may, therefore, sell bonds and, instead, hold cash or bank deposits in order to avoid the resulting capital loss. Major Issues in Liquidity Management If cash payments exceed cash receipts: need to borrow to make payments (incur interest) postpone payment which may be disruptive to the business and damage its reputation If cash receipts exceed cash payments: company failing to maximise its resources if a large cash balance is maintained Major Issues in Liquidity Management (cont.) Ensure interest costs on short-term debt are not excessive. Consider the effects of bank charges. Liquidity management involves `balancing' several costs and benefits. Cash Budgeting A forecast of the amount and timing of the cash receipts and payments that will result from a company's operations over a period of time. Cash budgets assist in forecasting when payments exceed receipts (or vice versa). Forecasts can be on a daily, weekly or monthly basis. Cash Budgeting (cont.) Preparation Forecast cash receipts analysis of past sales performance projections of likely business and economic conditions estimate cash receipts from sales Forecast cash payments Compare actual results with forecast results on an ongoing basis. Cash Budgeting
Steps to preparing a cash budget
Step 1 - Forecast the sources of cash. Step 2 - Forecast uses of cash. Step 3 - Calculate whether the firm is facing a cash shortage or surplus. Example - Dynamic Mattress Company Dynamic forecasted sources of cash
Quarter Sales, $mil 1st 2nd 3rd 4th Cash Budgeting 87.50 78.50 116.00 131.00 AR ending balance = AR beginning balance + sales - collections Cash Budgeting
Example - Dynamic Mattress Company Dynamic collections on AR
Qtr 1st 30.0 87.5 2nd 3rd 4th 32.5 30.7 38.2 78.5 116.0 131.0 62.8 17.5 80.3 $30.7 92.8 15.7 108.5 $38.2 104.8 23.2 128.0 $41.2 1. Beginning receivables 2. Sales 3. Collections . Sales in current Qtr (80%) 70 . Sales in previous Qtr (20%) 15.0 Total collections 85.0 4. Receivables at end of period . (4 = 1 + 2 - 3) $32.5 Cash Budgeting
Example - Dynamic Mattress Company Dynamic forecasted uses of cash Payment of accounts payable Labor, administration, and other expenses Capital expenditures Taxes, interest, and dividend payments Cash Budgeting
Example - Dynamic Mattress Company Dynamic cash budget
Qtr 1st Sources of cash collections on AR other Total Sources Uses of cash payment of AP labor and admin expenses capital expenditures taxes, interest, & dividends Total uses of cash Net cash inflow (sources minus uses) 65.0 30.0 32.5 4.0 131.5 $46.5 60.0 30.0 1.3 4.0 95.3 $15.0 55.0 30.0 5.5 4.5 95.0 $26.0 50.0 30.0 8.0 5.0 93.0 $35.0 85.0 0.0 85.0 80.3 0.0 80.3 108.5 12.5 121.0 128.0 0.0 128.0 2nd 3rd 4th Cash Budgeting
Example - Dynamic Mattress Company Dynamic short term financing requirements
Cash at start of period + Net cash flow = Cash at end of period Min operating cash balance Cumulative short term financing required (minimum cash balance minus caash at end of period) 5 - 41.5 - 56.5 + 26 - 30.5 5 $35.5 - 30.5 + 35 + 4.5 5 - $.5 - 46.5 - 15 - 41.5 - 56.5 5 5 $46.5 $61.5 A Short Term Financing Plan
Example - Dynamic Mattress Company Dynamic forecasted deferrable expenses Quarter 1st 2nd 3rd 4th Amount Deferrable, $mil 52 48 44 40 A Short Term Financing Plan
Example Dynamic Mattress CompanyFinancing Plan
1st New borrowing 1. Bank loan 2. Stretching payables 3. Total Repayments 4. Bank loan 5. Stetched payables 6. Total 7. Net new borrowing 8. Plus securities sold 9. Less securities bought 10. Total cash raised Interest payments: 11. Bank loan 12. Stretching payables 13. Interest on securities sold 14. Net interest paid 16. Cash required for operations 17. Total cash required 38.0 3.5 41.5 0.0 0.0 0.0 41.5 5.0 0.0 46.5 0.0 0.0 0.0 0.0 46.5 46.5 2nd 0.0 19.7 19.7 0.0 3.6 3.5 16.2 0.0 0.0 16.2 1.0 0.2 0.1 1.2 15.0 16.2 3rd 0.0 0.0 0.0 4.3 19.7 24.0 -24.0 0.0 0.0 -24.0 1.0 1.0 0.1 2.0 -26.0 -24.0 4th 0.0 0.0 0.0 33.7 0.0 33.7 -33.7 0.0 0.4 -34.1 0.8 0.0 0.1 0.9 -35.0 -34.1 Cash Management Models Assuming Certainty: Baumol's
Model Holding cash is treated akin to holding inventory. Assumptions: Company has an initial cash balance. Cash payments are known and occur at a constant rate. Cash Management Models Assuming Certainty: Baumol's
Model (cont.) Assumptions Upon exhausting initial cash balance, company withdraws some interest-bearing liquid assets and converts them to cash. Upon exhausting this cash balance, further withdrawals of interest-bearing liquid assets are made and converted to cash. Withdrawal of funds from interest-bearing liquid assets involves a known transaction cost. Cash Management Models Assuming Certainty: Baumol's Model (cont.) Baumol's model shows that the optimal amount of each withdrawal of funds from liquid assets, W *, can be denoted by: W* = 2aT i where: T = total cash payments per year W* = amount of each withdrawal of funds from interest-bearing liquid assets a = the transaction cost of a withdrawal of funds i = annual interest rate on liquid assets Miller-Orr Model Assumes that, if left unmanaged, a company's cash balance would follow a random walk with zero drift. Cash balance is allowed to wander freely between an upper limit (U*) and a lower limit (L). If cash holdings reach U*, management intervenes by withdrawing U*-C* dollars to return the cash balance to the target level C*. If cash balance reaches L, management intervenes by injecting C* dollars to return the cash balance to the target level C*. Miller-Orr Model
Cash U* C* L X Y Time U* is the upper control limit. L is the lower control limit. The target cash balance is C*. As long as cash is between L and U*, no transaction is made. Miller-Orr Model
L = set by the firm 3 2 C = L+ F R 4 U = 3 C - 2 L 1 3 Avg. cash balance = ( 4 C - L ) /3 Example
Assume L = $0, F = $10, i = 0.5% per month and the standard deviation of monthly cash flows is $2 000.
3 $20002 C = $0 + $10 0.005 4 = $1 817 1 3 U = ( 3 $1 817 ) - ( 2 $0 ) Avg. cash balance = ( 4 $1 817 - $0) /3 = $2 423 = $5 451 Miller-Orr Model Implications Considers the effect of uncertainty (through 2 in net cash flows). The higher the 2, the greater the difference between C* and L. The higher the 2, the higher is the upper limit and the average cash balance. All things being equal: the greater the interest rate, the lower is the C*; the greater the order costs, the higher is the C*. Float Time exists between the moment a check is written and the moment the funds are deposited in the recipient's account. This time spread is called Float. Payment Float - Checks written by a company that have not yet cleared. Availability Float - Checks already deposited that have not yet cleared. INVENTORY MANAGEMENT Types of Inventory Raw materials Inventory that will form part of the completed product, but which has yet to enter the production process. Work in process Partially completed products which require additional processing before they become finished goods. Finished goods Completed products not yet sold (manufacturer) or merchandise on hand (retailer or wholesaler). Benefits and Costs of Holding High Levels of Inventory Benefits more likely to satisfy customer demand lower ordering costs Costs capital tied up storage costs insurance costs Inventory Costs: Retail and Wholesale Acquisition costs Relevant costs include: ordering costs freight and handling costs quantity discounts forgone Per unit of inventory, each of these costs will be lower, the larger the order placed. Inventory Costs: Retail and Wholesale (cont.) Carrying costs Relevant carrying costs include: opportunity cost of investment storage costs insurance premiums deterioration and obsolescence price movements The higher the inventory level held, the higher the carrying costs. Inventory Costs: Retail and Wholesale (cont.) Stockout costs Losses incurred when a company's inventory of a particular item is completely exhausted. Major benefit of holding inventory is the avoidance of stockout costs. Inventory Costs: Manufacturing Raw materials Shortage of raw materials for a manufacturer will disrupt the production process and result in under-utilisation of labour and equipment. Finished goods The acquisition costs include set-up costs for a production run. Carrying costs and stockout costs are similar to those faced by retailers and wholesalers. Inventory Management Under Certainty Economic Order Quantity Model:the optimal quantity of inventory ordered that minimises the cost of purchasing and holding the inventory. Assumptions: demand for product is constant (per unit of time) demand is known with certainty EOQ
Economic Order Quantity - Order size that minimizes total inventory costs. Economic Order Quantity = 2 x annual sales x cost per order carrying cost EOQ ( contd)
Determination of optimal order size
Inventory costs, dollars Total costs Carrying costs Total order costs Optimal order size Order size Inventory Management Under Uncertainty (cont.) With certainty, inventory ordered when inventory levels equal the demand during lead time. With uncertainty, an adjustment is necessary. Incorporating Uncertainty To incorporate uncertainty Quantity decision made as per EOQ. Add a safety stock to the reorder point. Safety stock Additional inventory held when demand is uncertain, to reduce the probability of stockouts. Determining Safety Stocks The level of safety stock can be calculated by: specifying an acceptable probability of a stockout occurring during lead time; or specifying an acceptable expected level of customer service. Inventory Management and the `Just-In-Time' system The `just-in-time' system is a way of organising the manufacture of goods such as motor vehicles, engines and power tools. It is based on the concept that raw materials, equipment and labour are each supplied only in amounts required, and at the times required, to perform the manufacturing task. Inventory Management and the `Just-In-Time' system (cont.) This synchronisation of delivery with demand reduces inventory levels, lead times and delivery quantities. The aim of the system is to achieve an improvement in overall efficiency, as well as a reduction in inventory costs. 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 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 Effective annual rate = 1 + ( discount discounted price ) 365 / extra days credit - 1 Terms of Sale
Example - On a $100 sale, with terms 2/10 net 20, what is the implied interest rate on the credit given? Effective annual rate = 1+ = (1 + ( 365/extra days credit discount discounted price 2 365/20 98 ) -1 ) - 1 = .446, or 44.6% Credit Policy Establishment of a credit policy (cont.): How much credit should a customer be granted? setting limits What credit terms will be offered? credit period discount period discount rate effective rate 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. Benefits and Costs of Granting Credit Benefits increased sales Costs opportunity cost of investment cost of bad debts and delinquent accounts cost of administration cost of additional investment Credit Analysis
Numerical Credit Scoring categories The customer's character The customer's capacity to pay The customer's capital The collateral provided by the customer The condition of the customer's business Credit Analysis
Multiple Discriminant Analysis - A technique used to develop a measurement of solvency, sometimes called a Z Score. Edward Altman developed a Z Score formula that was able to identify bankrupt firms approximately 95% of the time.
Altman Z Score formula NWC retained earnings EBIT shareholder' s equity sales + .85 + 3.1 + .42 + 1.0 total assets total assets total assets total liabilities total assets Z = .72 Credit Analysis Credit analysis is only worth while if the expected savings exceed the cost. Don't undertake a full credit analysis unless the order is big enough to justify it. Undertake a full credit analysis for the doubtful orders only. The Credit Decision
Credit Policy - Standards set to determine the amount and nature of credit to extend to customers. 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. The Credit Decision
The credit decision and its probable payoffs
Customer pays = p Payoff = Rev - Cost Offer credit Customer defaults = 1-p Payoff = - Cost Refuse credit Payoff = 0 Evaluation of Alternative Credit and Collection Policies Application of NPV method Benefits measured by the net increase in sales Costs include manufacturing, selling, collection, administration and bad debts Evaluation of Alternative Credit and Collection Policies (cont.) Pay attention to the timing of the cash flows. Net cash flows can be discounted at the required rate of return. Analysis undertaken for all credit/collection policies, with the policy generating the highest net present value being the preferred option. Collection and Credit Policies Discounts for early payment, late payments or failures to pay, together with any collection costs, all reduce the NPV of credit. Company's policies should be designed so that the costs of extending credit are outweighed by the benefits. 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) Collection Policy Collection policy refers to the efforts made to collect delinquent accounts either informally or by a debt collection agency. Procedures implemented: reminder notice personal letters and telephone calls personal visits legal action or debt collection agency Procedures adopted may have an impact on sales. Aging Schedule - Classification of accounts receivable by time outstanding. Factoring and Accounts Receivable Financing Factoring is the sale of a company's accounts receivable at a discount to a financial institution. The factoring company specialises in the administration and collection of accounts receivable and, therefore, may be able to provide these services at a lower cost than the selling company would be able to achieve through its own efforts. Factoring and Accounts Receivable Financing (cont.) Notification and Non-notification Agreements: The selling company's customers are notified that the agreement exists. The selling company's customers are not notified about the agreement. Non-recourse Factoring: The factoring company assumes the baddebt risk. Factoring and Accounts Receivable Financing (cont.) Accounts Receivable Financing: The company borrows funds and pledges its accounts receivable as security for the loan. Suppliers of this type of finance are usually finance companies. Generally, finance companies are prepared to lend up to 70 per cent of the total value of all acceptable accounts receivable. Unacceptable accounts receivable are those that have been outstanding for a lengthy period (e.g. 90 days where the credit policy is 30 days). Credit Insurance A company may obtain protection against bad-debt losses by taking out a credit insurance policy. These policies may take several forms: specific account policies whole turnover policies protracted default ...
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- Spring '09