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Unformatted text preview: FIN2101
Business Finance II 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
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
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
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
What amount of liquid resources should a firm aim to have at a particular point in time?
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
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
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
2 × conversion cost × demand for cash
opportunity cost (in decimal form)
2 × $30 × $20 000
= $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
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
3 × $25 × $3 000 2
Return point =
3 0.10 4× 365 = $8 508
L = $0
U = 3 × return point
= $25 524 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
(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
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
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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