Lecture04 - FIN2101 FIN2101 Business Finance II Module 4...

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Unformatted text preview: FIN2101 FIN2101 Business Finance II Module 4 Module 4 Working Capital Management (Week 1) Student Activities (Inventory) Student Activities (Inventory) Reading Text, Chapter 17 (pp. 632­8 only) Text Study Guide, Chapter 17 (part only) Study Book, Module 4.2 (pp. 4.4 to 4.12) Tutorial Work Tutorial Workbook, Self Assessment Activity 4.2 Text Study Guide, Chapter 17, T/F 7­10, MC 9 & 11­15, Problems 6, 7, 8 & 9 Student Activities (Cash) Student Activities (Cash) Reading Text, Chapter 16 Text Study Guide, Chapter 16 Study Book, Module 4.3 (pp. 4.12 to 4.20) Tutorial Work Tutorial Workbook, Self Assessment Activity 4.3 Text Study Guide, Chapter 16 Working Capital Management Working Capital Management Inventory Cash Accounts receivable Integrated approach required Inventory Inventory Manufacturer ­ raw materials, work­in­ progress, finished goods not sold. Wholesaler/retailer ­ goods in warehouse, goods on shelves. Objective Objective Balance the costs and benefits with the aim of COST MINIMISATION. Inventories should be increased as long as the resulting savings exceed the total cost of holding the additional inventory. Inventory Costs Inventory Costs Acquisition (ordering) costs Carrying (holding) costs Stockout costs Generally, there are carrying costs which increase with the size of the company’s order quantity and acquisition costs which decrease with the size of the order quantity. Economic Order Quantity Economic Order Quantity EOQ is the optimal order quantity for a particular inventory item, given its predicted usage, ordering cost and carrying cost. EOQ Model Assumptions EOQ Model Assumptions Constant and certain demand No quantity discounts available No lead time Constant ordering costs Constant carrying costs per unit of inventory EOQ Model EOQ Model EOQ 1 2 Time Periods 3 Inventory Policy Costs Inventory Policy Costs Total Cost = Ordering Cost + Carrying Cost = (Number of Orders × Cost per Order) + (Average Inventory × Carrying Cost per Unit) Inventory Policy Costs Inventory Policy Costs S Q Total cost = O × + C × Q 2 Total Costs Minimisation: S Q O × = C× Q 2 Economic Order Quantity (EOQ) Economic Order Quantity (EOQ) EOQ = 2 ×S× O C Inventory Policy Costs Inventory Policy Costs S Q Total cost = O × + C × Q 2 Total Inventory Costs Total Inventory Costs S Q TC = ( p × S) + O × + C × Q 2 Example 1 Example 1 DATA O = $30 S = 1 000 units p.a. p = $20 per unit C = $3 per unit p.a. Required: Calculate the EOQ and inventory policy costs associated with ordering in the EOQ. Example 1 Solution Example 1 Solution EOQ = = 2 ×S × O C 2 × 30 ×1 000 3 = 141.42 or 142 units S Q Total costs = O × + C × Q 2 1 000 142 = $30 × + $3 × 142 2 = $211.27 + $213.00 = $424.27 Flat Quantity Discounts Flat Quantity Discounts Where discounts are available, the supply price of an inventory item is relevant in determining our EOQ for that item. Example 2 Example 2 DISCOUNT 20 cents per unit if ordered in lots of 200, i.e. p = $19.80 per unit. Should the firm accept the quantity discount and order in lots of 200? Example 2 Solution Example 2 Solution Step 1 - Calculate the GAIN (p.a.) 1 000 units × $0.20 = $200 Step 2 - Determine New COSTS S Q Total costs = O × + C × Q 2 1 000 200 = $30 × + $3 × 200 2 = $150.00 + $300.00 = $450.00 Step 3 - Calculate Increase in Costs (p.a.) $450.00 - $424.27 = $25.73 Step 4 - Compare Gain to Cost Increase Gain of $200 > Incremental Costs of $25.73. Therefore ACCEPT discount & order in lots of 200 units. Alternative Approach Alternative Approach S Q TC = ( p × S) + O × + C × Q 2 TC142 = $20 424.27 TC 200 = $20 250.00 Variable Quantity Discounts Variable Quantity Discounts A supplier might offer discounts which vary according to the quantity ordered, eg: 0­99, $21 per unit 100­199, $20 per unit Work very carefully through Example 4.5 in Study Book. Variable Quantity Discounts Variable Quantity Discounts Calculate the optimal price­quantity combination for no discounts ­ EOQ. For each range, select the quantity nearest to the optimal quantity in step 1. Calculate the total inventory costs for each combination of price and quantity for each range to find the combination with the lowest cost. EOQ Model & Positive Lead Time EOQ Model & Positive Lead Time No lead time assumption is unrealistic. Model can be adjusted to incorporate a positive lead time. Figure 4.3 in Study Book. Example 4.2 in Study Book. EOQ Model & Positive Lead Time EOQ Model & Positive Lead Time & Safety Stock Can also relax the assumption of certain demand. Reorder point can be adjusted by adding a safety stock to allow for uncertainty in respect of demand. Figure 4.4 in Study Book. Example 4.3 in Study Book. Other Techniques Other Techniques ABC system Materials requirement planning (MRP) system Inventory divided into 3 groups, based on the dollar investment in each. Uses EOQ concepts to determine what to order, when to order, and what priorities to assign to ordering materials. Just­in­time (JIT) system Materials arrive at the exact time they are needed for production. Cash Management Cash Management Cash and short­term securities are the most liquid assets of the firm. Cash in a bank account is non­ productive. Cash Management Cash Management The Issue: What amount of liquid resources should a firm aim to have at a particular point in time? The Objective: Minimise the cash balance but be able to pay debts on time. Reasons for Holding Cash Reasons for Holding Cash Transactions Motive Safety Motive Speculative Motive Costs of Holding Cash Costs of Holding Cash Opportunity cost of foregone investment opportunities. Loss of purchasing power of our money. Cost of Holding Insufficient Cash Cost of Holding Insufficient Cash Loss of suppliers’ goodwill. Lost sales. Foregone suppliers’ discounts. Overdraft costs. Transaction costs. Cash Management Cash Management Efficient management of the firm’s operating and cash conversion cycles helps maintain a low level of cash and contributes to shareholder wealth maximisation. Operating Cycle Operating Cycle The time from the point when the firm begins to build inventory to the point when cash is collected from sale of the resulting finished product. OC = Average age of inventory (AAI) + average collection period (ACP) Cash Conversion Cycle Cash Conversion Cycle The amount of time the firm’s cash is tied up between payment for production inputs and receipt of payments from the sale of the resulting finished product. CCC = OC – Average payment period (APP) CCC = AAI + ACP ­ APP Managing the CCC Managing the CCC Ideally firms would like to have a negative CCC. Typically, firms have a positive CCC. Strategies for minimising CCC: Quick inventory turnover Collect receivables as quickly as possible Pay accounts payable as late as possible Text, pp. 589­92. Cash Management Techniques Cash Management Techniques Management can speed up collections and slow disbursements by taking advantage of the ‘float’ in the collection and payment system. Float refers to the funds that have been dispatched by a payer but are not yet in a form that can be spent by the payee. Delays in the transportation and processing of cheques generate float. Types of Float Types of Float Collection float is the amount of funds resulting from the delay between when the payer deducts a payment from its account and when the payee actually receives the funds. A delay in the receipt of funds. Disbursement float is the amount of funds resulting from the delay between when a firm deducts a payment from its account and the time when funds are actually withdrawn from the account. A delay in the actual withdrawal of funds. Components of Float Components of Float Mail float – time between when a payer mails the cheque and when it is received by the payee. Processing float – the time between receipt of a cheque by the payee and depositing it in an account. Clearing float – time between when a cheque is deposited in an account and when the funds actually become available. Managing Float Managing Float The payee firm’s objective is to minimise the collection float so that payments are available as quickly as possible. The payer firm’s objective is to slow down payments so as to increase the disbursement float. Strategies for speeding up collections and slowing down disbursements are discussed in the text (pp.595­7). Cash Management Models Cash Management Models As with inventory management, we have holding costs and transaction costs in respect of cash management. Total costs = holding costs + transaction costs. Objective of Cash Management Objective of Cash Management To balance the holding and transaction costs to minimise the total costs to gain the optimal cash balance. Baumol’s Model Baumol’s Model Assumptions certainty in respect of cash inflows, their regularity and size, as well as cash outflows transaction costs are a fixed amount, irrespective of the nature and/or size of the transaction Derived from EOQ Model Baumol’s Model Example Baumol’s Model Example DATA Demand = $20 000 Conversion cost = $30 Opportunity cost = 10% Required: Calculate the economic conversion (ECQ) and the costs associated with such a cash management policy. Example Solution Example Solution 2 × conversion cost × demand for cash ECQ = opportunity cost (in decimal form) 2 × $30 × $20 000 = 0.10 = $3 464 demand for cash Total cost = conversion cost × ECQ ECQ + opportunity cost × 2 $20 000 $3 464 = $30 × + 0.10 × $3 464 2 = $173.21 + $173.20 = $346.41 Miller­Orr Cash Management Miller­Orr Cash Management Model Emphasis on daily movements of cash. Cash balance will follow a random walk. Management moves between cash and short­ term investments. Management acts to restore the cash balance to a pre­determined return point. Miller­Orr Model Miller­Orr Model Difficult and costly to keep a tight control of cash balances on a day­to­day basis. Considered a sound alternative. Oriented to large organisations with a very large number of transactions on a daily basis. Miller­Orr Model (NO Overdraft) Miller­Orr Model (NO Overdraft) Return point = 3 3 × conversion cost × variance of daily net cash flows 4 × daily opportunity cost ( in decimal form ) Example (NO Overdraft) Example (NO Overdraft) Standard deviation of daily net cash flows = $3 000 Conversion cost = $25 (Fixed Cost) Opportunity cost = 10% p.a. Required: Calculate the return point and the upper and lower limits. Solution Solution 3 × $25 × $3 000 2 Return point = 3 0.10 4× 365 = $8 508 L = $0 U = 3 × return point = $25 524 Miller­Orr Model Miller­Orr Model (With Overdraft) Wright adjusted the model to allow for overdrafts. A firm’s desire to stay in overdraft presumes that it is cheaper to use the overdraft facility than it is to allow the cash account to be in credit. Yield on long­term investments > overdraft rate. Miller­Orr Model Miller­Orr Model (With Overdraft) Concerned with long­term investments. Move between cash and long­term investments. Miller­Orr Model (WITH Miller­Orr Model (WITH Overdraft) 3 × conversion cost × variance of daily net cash flows Return point = 3 4 × ( daily opportunity cost - daily overdraft rate ) Example (WITH Overdraft) Example (WITH Overdraft) Standard deviation of daily net cash flows = $3 000 Conversion cost = $200 (Fixed Cost) Opportunity cost = 10% p.a. Overdraft rate = 8% p.a. Required: Calculate the return point and the upper and lower limits. Solution Solution 3 × $200 × $3 000 Return point = 3 0.10 - 0.08 4× 365 2 = $29 098 U = $0 L = 3 ×return point below U = $87 294 below U = ( $87 294 ) Return point = $29 098 above L = ($58 196) Assumptions Assumptions Access to long­term investments. Constant yield on short­term investments. Immediate action can be taken when a control limit is reached. Fixed transaction costs. Conclusions on Miller­Orr Conclusions on Miller­Orr Felt to be useful for managers to help them determine what they should be doing as far as cash management is concerned. Nevertheless, a simplistic model based on unrealistic assumptions. Excess cash Excess cash make investment in marketable securities Two basic characteristics: a ready market/active secondary market safety of principal: safety/liquidity(maturity)/profitability Classifications of marketable securities Government issues Treasury notes, Commonwealth bonds, State government issues Non­government issues CDs, commercial bills and promissory notes Classifications of marketable securities Classifications of marketable securities 1.Treasury bills: it was issued by the treasury department enjoy some tax preferential tax treatment Sold at a discount Risk involved in the Treasury bills 1) No default /credit risk 2) Interest rate risk 3) Foreign exchange rate risk 4) Inflation risk 2. Federal agency issue 2. Federal agency issue Government National Mortgage Association(Ginnie Mae) Federal Home Loan Banks(FHLBs): discount securities Federal Farm Credit Bank (FFCBs):coupon securities 3. Large negotiable CD: Created by citibank to circumvent the Q Issued by large corporation and finance corporation 3. Bank acceptances 3. Bank acceptances Time draft drawn on and accepted by a bank Facilitate the import­export trade business 4.commercial paper Short­term unsecured promissory notes issued by large corporations and finance corporations General Motors Acceptance Corporation(GMAC) Low liquidity( no active secondary market) and high default risk ...
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This note was uploaded on 12/06/2011 for the course BUSINESS Finance taught by Professor Qilei during the Summer '11 term at Tianjin University.

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