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Fundamentals of Managing Finance Chap 12

# The cost of idle funds in transit it takes five days

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Unformatted text preview: resent idle funds that cannot be used elsewhere, money that has an opportunity cost determined by the firm’s cost of capital. The Cost of Idle Funds in Transit It takes five days on average for customers’ checks, averaging \$50,000 per day, to reach a company. Once received, the money is invested to earn interest until required for payments to suppliers. Deposits, averaging \$40,000 per day, are made to cover the company’s checks one day before they clear. The company has a cost of capital of 12%. Question: What is the annual cost of these idle funds? Solution steps: 1. Multiply the number of idle days by the average daily cash flow to obtain the total sum of idle money: Idle money (5 days \$50,000) \$290,000 (1 day \$40,000) 2. Multiply the total idle money by the cost of capital: \$290,000 12% \$34,800 Answer: The annual cost of idle funds is \$34,800. \$290,000 is tied up in transit and cannot be used elsewhere, requiring the firm to raise another \$290,000 at an annual cost of \$34,800. FIGURE 12.3 Operating cash flow into and out from a company. Customers mail checks to the firm, and the money is then used to make payments to suppliers. Chapter 12 Investing in Permanent Working Capital Assets 295 SERVING FINANCE’S CUSTOMERS No Missed Cash Deliveries at Corning, Incorporated NET Present Value More information about the use of lockboxes can be found at the National Check Fraud Center website: www.ckfraud.org/ lockbox.html lock box—a post office box to which customers mail their payments concentration banking—the practice of instructing customers to mail payments to a local bank which then forwards the payment electronically electronic funds transfer— the computerized exchange of money between bank accounts NET Present Value A company offering a wide range of electronic funds transfer services is NPSGlobal at: www.npsglobal.com The Treasury Division of Corning, Incorporated, the large multinational glass and ceramic products manufacturer, evaluates its performance in meeting its customers’ requirements with a set of measurements the company calls Key Results Indicators (KRIs). For the Cash Management group, one KRI is the number of times Treasury fails to deliver the exact amount of cash needed by a company unit where and when required. Corning Treasury’s goal is to have a KRI of zero—no missed cash deliveries. Because idle funds in transit are costly, financial managers attempt to reduce receivables float by accelerating collections and reduce idle “in-bank” funds by delaying disbursements. Accelerating collections translates to speeding up or eliminating the mail. One way to do this is by instructing customers to mail payments to a lock box, a post office box used only for customer checks. A messenger from the company’s commercial bank empties the lock box at regular intervals and takes the checks directly to the bank for deposit; the checks avoid the delay of being delivered to the company which then has to take them to the bank. Companies doing business in widely spread locations often also use concentration banking, in which customers mail their checks to a local lock box. There they are picked up by a local bank which then “concentrates” the funds by forwarding them electronically to the company’s bank. With concentration banking, the time mail takes to travel long distances is avoided since all mail delivery is local. Another way is to request that customers make payments by electronic funds transfer in which money is transferred directly from the customer’s bank to the company, thereby avoiding the mail altogether (and increasing the liklihood of being paid). At first glance it would seem that customers would balk at such a system since they benefit from keeping their money for the period of float. However, in addition to eliminating receivables float in its entirety, direct electronic transfer eliminates the majority of the costs of a mail-based system: invoicing, paper, postage, handling, reconciliation of accounts, and the cost of rework when an error occurs. In many cases, the savings to both parties exceeds the cost of the float and can be shared between the parties. A decrease in funds in transit is a permanent reduction to the firm’s working capital needs and is analyzed using the perpetuity technique introduced earlier in this chapter. Interestingly, the change shows up on the accounting books not as a decrease to cash, but as a decrease in the accounts receivable balance since money owed the company is being collected more rapidly. Example Accelerating Collections A company receives cash inflows of \$1,000,000 per day from customers scattered across North America. For an annual fee of \$300,000, its bank has proposed to implement a lock box/concentration banking system which would cut receivables float from an average of five days to two days. The company’s cost of capital is 12% and it is in the 35% tax bracket. 296 Part IV Adding Value Question: What is the value of the proposed system? Should it be implemented? Solution steps: 1. Calculate the rece...
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