I’m working on a finance discussion question and need an explanation and answer to help me learn.
Working capital management involves managing the firm’s liquidity, which—in turn—involves managing the firm’s investments in current assets and in the use of current liabilities.
Explain the determinants of net working capital and the cash conversion cycle. How can these strategies be used in Saudi Arabian companies? Why is working capital so important to a firm when the presence of credit and leverage tend to be utilized more? What advantage does a highly liquid firm have over a highly leveraged firm? Explain.Foundations of Finance
Tenth Edition
Chapter 15
Working-Capital Management
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Learning Objectives
15.1 Describe the risk-return trade-off involved in managing
working capital.
15.2 Describe the determinants of net working capital.
15.3 Compute the firm’s cash conversion cycle.
15.4 Estimate the cost of short-term credit.
15.5 Identify the primary sources of short-term credit.
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Working Capital
• Gross working capital
– The firm’s total investment in current assets.
• Net working capital
– The difference between the firm’s current assets and its
current liabilities.
• This chapter focuses on net working capital.
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Short-Term Sources of Financing
• Include current liabilities, i.e., all forms of financing that
have maturities of 1 year or less.
• Two issues to consider
– How much short-term financing should the firm use?
– What specific sources of short-term financing should
the firm select?
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How Much Short-Term Financing
Should a Firm Use?
• This question is addressed by hedging principle of
working-capital management.
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What Specific Sources of Short-Term
Financing Should the Firm Select?
• Three basic factors influence the decision:
– The effective cost of credit
– The availability of credit in the amount needed and for
the period that financing is required
– The influence of a particular credit source on the cost
and availability of other sources of financing
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Managing Current Assets and
Liabilities
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Current Assets
• A firm’s current assets are assets that are expected to be
converted to cash within 1 year, such as cash and
marketable securities, accounts receivable, inventories.
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The Risk-Return Trade-Off
• Holding more current assets will reduce the risk of
illiquidity.
• However, liquid assets like cash and marketable securities
earn relatively less compared to other assets. Thus, larger
amounts of liquid investments will reduce overall rate of
return.
• The trade-off: Increased liquidity must be traded off
against the firm’s reduction in return on investment.
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Use of Current versus Long-Term
Debt
• Other things remaining the same, the greater the firm’s
reliance on short-term debt or current liabilities in financing
its assets, the greater the risk of illiquidity.
• The trade-off: A firm can reduce its risk of illiquidity
through the use of long-term debt at the expense of a
reduction in its return on invested funds. This trade-off
involves an increased risk of illiquidity versus increased
profitability.
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The Advantages of Current
Liabilities: Return
• Flexibility
– Current liabilities can be used to match the timing of a
firm’s needs for short-term financing. Example:
Obtaining seasonal financing versus long-term
financing for short-term needs.
• Interest Cost
– Interest rates on short-term debt are lower than on longterm debt.
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The Disadvantages of Current
Liabilities: Risk
• Risk of illiquidity can increase for two reasons:
– Short-term debt must be repaid or rolled over more
often.
– Uncertainty of interest costs from year to year.
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Determining the Appropriate Level
of Working Capital
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The Appropriate Level of Working
Capital
• Managing working capital involves interrelated decisions
regarding investments in current assets and use of
current liabilities.
• Hedging principle or principle of self-liquidating debt
provides a guide to the maintenance of appropriate level
of liquidity.
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The Hedging Principle
• The hedging principle involves matching the cash-flowgenerating characteristics of an asset with the maturity of
the source of financing used to finance its acquisition.
• Thus, a seasonal need for inventories should be financed
with a short-term loan or current liability.
• On the other hand, investment in equipment that is
expected to last for a long time should be financed with
long-term debt.
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Figure 15.1 The Hedging Principle
Illustrated
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Permanent and Temporary Assets
• Permanent investments
– Investments that the firm expects to hold for a period
longer than one year
• Temporary investments
– Current assets that will be liquidated and not replaced
within the current year
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Sources of Financing
• Total assets will be equal to sum of temporary, permanent,
and spontaneous sources of financing.
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Temporary and Permanent Sources
• Temporary sources of financing consist of current liabilities
such as short-term secured and unsecured notes payable.
• Permanent sources of financing include intermediate-term
loans, long-term debt, preferred stock, and common
equity.
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Spontaneous Sources of Financing
• Spontaneous sources of financing arise spontaneously
in the firm’s day-to-day operations.
– Trade credit is often made available spontaneously
or on demand from the firm’s suppliers when the firm
orders its supplies or more inventory of products to
sell. Trade credit appears on balance sheet as
accounts payable.
– Wages and salaries payable, accrued interest, and
accrued taxes also provide valuable sources of
spontaneous financing.
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Table 15.1 The Hedging Principle Applied
to Working-Capital Management (1 of 2)
A firm’s asset needs that are not financed by spontaneous sources of financing
should be financed in accordance with the following “matching rule”—permanentasset investments are financed with permanent sources, and temporary-asset
investments are financed with temporary sources of financing.
Classification of a Firm’s
Investments in Assets
Definitions and Examples
Temporary investments
Definition: Current assets that will be liquidated and not
replaced within the year.
Blank
Examples: Seasonal expansions in inventories and
accounts receivable.
Permanent investments
Definition: Current and long-term asset investments that
the firm expects to hold for a period longer than 1 year.
Blank
Examples: Minimum levels of inventory and accounts
receivable the firm maintains throughout the year as well
as its investments in plant and equipment.
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Table 15.1 The Hedging Principle Applied
to Working-Capital Management (2 of 2)
Classification of a Firm’s
Sources of Financing
Definitions and Examples
Spontaneous financing
Definition: Financing that arises more or less
automatically in response to the purchase of an asset.
Blank
Examples: Trade credit that accompanies the purchase of
inventories and other types of accounts payable created by
the purchase of services (for example, wages payable).
Temporary financing
Definition: Current liabilities other than spontaneous
sources of financing.
Blank
Examples: Notes payable and revolving credit
agreements that must be repaid in a period less than 1
year.
Permanent financing
Definition: Long-term liabilities not due and payable within
the year and equity financing.
Blank
Examples: Term loans, notes, and bonds as well as
preferred and common equity.
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Using the Cash Conversion Cycle
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The Cash Conversion Cycle
• A firm can minimize its working capital by speeding up
collection on sales, increasing inventory turns, and slowing
down the disbursement of cash. This is captured by the
cash conversion cycle (CCC).
Cash conversion cycle (CCC) = days of sales outstanding
(DSO) + days of sales in inventory (DSI) − days of payables
outstanding (DPO)
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Table 15.2 The Determinants of Dell
Computer Corporation’s Cash
Conversion Cycle for 1995–2012
Cash conversion cycle (CCC) = days of sales outstanding
(DSO) + days of sales in inventory (DSI) − days of payables
outstanding (DPO)
Blank
1995
2000
2005
2012
Days of sales outstanding (DSO)
50.04
33.14
35.59
63.09
Days of sales in inventory (DSI)
37.36
5.79
4.65
11.58
Days of payables outstanding (DPO)
40.58
62.07
79.41
97.06
Cash conversion cycle (CCC)
46.81
(23.14)
(39.17) (22.39)
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Estimating the Cost of Short-Term
Credit Using the Approximate
Cost-of-Credit Formula
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Cost of Short-Term Credit
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APR Example
• A company plans to borrow $1,000 for 90 days. At
maturity, the company will repay the $1,000 principal
amount plus $30 interest. What is the APR?
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Annual Percentage Yield (APY)
• APR does not consider compound interest. To account for
the influence of compounding, we must calculate APY or
annual percentage yield.
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APY Example
• In the previous example,
– # of compounding periods
– Rate = 12%
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APR or APY?
• Because the differences between APR and APY are
usually small, we can use the simple interest values
of APR to compute the cost of short-term credit.
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Evaluating Sources of Short-Term
Credit
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Sources of Short-Term Credit
• Short-term credit sources can be classified into two basic
groups:
– Unsecured sources
– Secured sources
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Unsecured Loans
• Unsecured loans include all of those sources that have
as their security only the lender’s faith in the ability of
the borrower to repay the funds when due.
• Major sources:
– Accrued wages and taxes, trade credit, unsecured
bank loans, and commercial paper
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Secured Loans
• Involve the pledge of specific assets as collateral in the
event the borrower defaults in payment of principal or
interest
• Primary suppliers
– Commercial banks, finance companies, and factors
• Principal sources of collateral
– Accounts receivable and inventories
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Unsecured Sources: Accrued Wages
and Taxes
• Because employees are paid periodically (biweekly or
monthly), firms accrue a wage-payable account that is, in
essence, a loan from their employees.
• Similarly, if taxes are deferred or paid periodically, the firm
has the use of the tax money.
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Unsecured Sources: Trade Credit
• Trade credit arises spontaneously with the firm’s
purchases. Often, the credit terms offered with trade credit
involve a cash discount for early payment.
• For example, the terms
means a 2 percent discount is offered for payment within
10 days, or the full amount is due in 30 days.
• In this case, a 2 percent penalty is incurred for not paying
within 10 days.
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Table 15.3 The Rates of Interest on
Selected Trade Credit Terms
Credit Terms
2 over 10, net 60
2 over 10, net 90
3 over 20, net 60
6 over 10, net 90
Effective Rates
14.69%
9.18
27.84
28.72
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Effective Cost of Passing Up a
Discount
• Ex.: Terms
• The equivalent APR of this discount is:
• The effective cost of delaying payment for 20 days is
36.73 percent.
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Unsecured Sources: Bank Credit
• Commercial banks provide unsecured short-term credit
in two forms:
– Lines of credit
– Transaction loans (notes payable)
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Line of Credit
• Informal agreement between a borrower and a bank about
the maximum amount of credit the bank will provide the
borrower at any one time.
• There is no legal commitment on the part of the bank to
provide the stated credit.
• Banks usually require that the borrower maintain a
minimum balance in the bank throughout the loan period
(known as compensating balance).
• Interest rate on a line of credit tends to be floating.
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Revolving Credit
• Revolving credit is a variant of the line of credit form of
financing.
• A legal obligation is involved.
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Transaction Loans
• A transaction loan is made for a specific purpose. This is
the type of loan that most individuals associate with bank
credit and is obtained by signing a promissory note.
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Unsecured Sources: Commercial
Paper
• The largest and most credit-worthy companies are able to
use commercial paper—a short-term promise to pay that is
sold in the market for short-term debt securities.
• Maturity: Usually 6 months or less.
• Interest Rate: Slightly lower
than the prime rate on commercial loans.
• New issues of commercial paper are placed directly or
dealer placed.
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Commercial Paper: Advantages
• Interest rates
– Rates are generally lower than rates on bank loans.
• Compensating-balance requirement
– No minimum balance requirements are associated
with commercial paper.
• Amount of credit
– A firm with very large credit needs is provided with a
single source for all its short-term financing.
• Prestige
– Signifies credit status
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Secured Sources of Loans
• Secured loans have assets of the firm pledged as
collateral. If there is a default, the lender has first claim
to the pledged assets. Because of its liquidity, accounts
receivable is regarded as the prime source for collateral.
• Accounts-Receivable Loans
– Pledging Accounts Receivable
– Factoring Accounts Receivable
• Inventory Loans
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Pledging Accounts Receivable (1 of 2)
• Borrower pledges accounts receivable as collateral for a
loan obtained from either a commercial bank or a finance
company.
• The amount of the loan is stated as a percentage of the
face value of the receivables pledged.
• If the firm pledges a general line, then all of the accounts
are pledged as security (simple and inexpensive).
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Pledging Accounts Receivable (2 of 2)
• If the firm pledges specific invoices, each invoice must be
evaluated for creditworthiness (more expensive).
• Credit Terms: Interest rate is 2 percent to 5 percent
higher than the bank’s prime rate. In addition, handling
fee of 1 percent to 2 percent of the face value of
receivables is charged.
• Although pledging offers considerable flexibility to the
borrower and provides financing on a continuous basis,
the cost of using pledging as a source of short-term
financing is relatively high compared to other sources.
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Factoring Accounts Receivable
• Factoring accounts receivable involves the outright sale
of a firm’s accounts to a financial institution called a
factor.
• A factor is a firm (such as commercial financing firm or a
commercial bank) that acquires the receivables of other
firms. The factor bears the risk of collection in exchange
for a fee of 1 percent to 3 percent of the value of all
receivables factored.
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Secured Sources: Inventory Loans
• These are loans secured by inventories.
• The amount of the loan that can be obtained depends on
the marketability and perishability of the inventory.
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Types of Inventory Loans (1 of 2)
• Floating or Blanket Lien Agreement
– The borrower gives the lender a lien against all its
inventories.
• Chattel Mortgage Agreement
– The inventory is identified and the borrower retains
title to the inventory but cannot sell the items without
the lender’s consent.
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Types of Inventory Loans (2 of 2)
• Field-Warehouse Agreement
– Inventories used as collateral are physically separated
from the firm’s other inventories and are placed under
the control of a third-party field-warehousing firm.
• Terminal-Warehouse Agreement
– Inventories pledged as collateral are transported to a
public warehouse that is physically removed from the
borrower’s premises.
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Key Terms (1 of 3)
• Chattel mortgage agreement
• Commercial paper
• Compensating balance
• Factor
• Factoring accounts receivable
• Field-warehouse agreement
• Floating lien agreement
• Gross working capital
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Key Terms (2 of 3)
• Hedging principle
• Inventory loans
• Line of credit
• Net working capital
• Operating net working capital
• Permanent investments
• Pledging accounts receivable
• Revolving credit agreement
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Key Terms (3 of 3)
• Secured loans
• Temporary investments
• Terminal-warehouse agreement
• Trade credit
• Transaction loan
• Unsecured loans
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Foundations of Finance
Tenth Edition
Chapter 17
Cash, Receivables, and Inventory
Management
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Learning Objectives
17.1 Understand the problems inherent in managing the
firm’s cash balances.
17.2 Evaluate the costs and benefits associated with
managing a firm’s credit policies.
17.3 Understand the financial costs and benefits of
managing firm’s investment in inventory.
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Managing the Firm’s Investment in
Cash and Marketable Securities
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Cash and Marketable Securities
• Cash refers to currency and coins plus demand deposit
accounts.
• Marketable securities includes security investments the
firm can quickly convert to cash balances.
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Why a Company Holds Cash
• Cash flow process
– Two typical sources of cash: external and internal
– Irregular increases or decreases in the firm’s cash
holdings can come from several sources:
▪ Sale of securities (stocks and bonds)
▪ Nonmarketable-debt contracts
▪ Payment of dividend, interest, tax bills
▪ Share repurchases
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Figure 17.1 The Cash Generation and
Disposition Process
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Three Motives for Holding Cash
• Transactions motive
– Balances held to meet cash needs that arise in the
ordinary course of doing business
• Precautionary motive
– Precautionary balance as a buffer
– Maintain balances to satisfy possible, but as yet
unknown, needs
• Speculative motive
– To take advantage of potential profit-making situations
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Cash Management Objectives and
Decisions
• Cash management program must minimize the firm’s risk
of insolvency.
• Insolvency—The situation in which the firm is unable to
meet its maturing liabilities on time.
• A company is technically insolvent when it lacks the
necessary liquidity to make prompt payment on its current
debt obligations.
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The Cash Balance Trade-Off
• A large cash balance will help minimize the chance of
insolvency, but it penalizes the company’s profitability.
• A smaller cash balance will increase the chance of
insolvency, but it will free up excess cash for investment
and enhance profitability.
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Cash Management Objectives (1 of 2)
• Two prime objectives
– Enough cash must be on hand to meet disbursal needs
in the course of doing business.
– Investment in idle cash balances must be reduced to a
minimum.
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Cash Management Objectives (2 of 2)
• Two conditions would allow the firm to operate for
extended periods with cash balances near or at zero:
– Completely accurate forecast of net cash flows over
the planning horizon
– Perfect synchronization of cash receipts and
disbursements
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Cash Management Decisions
• What can be done to speed up cash collections and slow
down or better control cash outflows?
• What should be the composition of a marketable securities
portfolio?
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Collection and Disbursement
Procedures
• The efficiency of firm’s cash management program can be
improved by accelerating cash receipts.
• There are three main delays—referred to as floats—as
shown in Figure 17.2.
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Figure 17.2 Ordinary Cash Collection
System
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Float and Managing Cash Inflow
(1 of 2)
• Float—The time from when a check is written until the
actual recipient can draw upon or use the funds:
– Mail float
– Processing float
– Availability float
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Float and Managing Cash Inflow
(2 of 2)
• Mail float
– Time lapse from the moment a customer mails a
remittance check until the firm begins to process it
• Processing float
– The time required for the firm to process remittance
checks before they can be deposited in the bank
• Availability float
– The time it takes the bank to give the firm credit for the
customer’s payment
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Benefit of Float Reduction
• The financial benefit of float reduction can be calculated as
follows:
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Float Reduction Example
• If a company with daily sales of $45,062,466 could invest
in marketable securities to yield 4 percent annually and
could eliminate 1 day of float, what would be the annual
savings?
= $45,062,466 × 0.04 = $1,802,499
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Managing the Cash Outflow
• Goal: To increase company’s float by slowing down the
disbursement process.
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The Composition of a MarketableSecurities Portfolio
• The general selection criteria for proper marketablesecurities mix include the following:
– Financial risk
– Interest rate risk
– Liquidity
– Taxability
– Yields
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Financial Risk
• Refers to the uncertainty of expected returns from a
security attributable to possible changes in the financial
capacity of the security issuer to make future payments to
the security owner.
• If the chance of default on the terms of the instrument is
high, then the financial risk is said to be high.
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Interest Rate Risk
• Interest rate risk refers to the uncertainty of expected
return from a financial instrument attributable to changes in
interest rates.
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Table 17.1 Market Price Effect of Rise
in Interest Rates
Item
Original price
Three-Year
Instrument
Twenty-Year
Instrument
$1,000.00
$1,000.00
964.82
821.00
35.18
$ 170.00
Price after 1 year
Decline in price
$
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Liquidity
• Liquidity refers to the ability to convert a security into cash.
• Should an unforeseen event require that a significant
amount of cash be immediately available, then a sizable
portion of the portfolio might have to be sold. Manager
should prefer securities that can be sold at or near its
prevailing market price.
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Taxability
• The tax treatment of the income a firm receives from its
security investments does not affect the ultimate mix of the
marketable-securities portfolio as much as the criteria
mentioned earlier since interest income from most
instruments is taxable at the federal level.
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Yields
• Yield is affected by previous factors of financial risk,
interest rates, liquidity, and taxability.
• The yield criterion involves an evaluation of the risks and
benefits inherent in all of these factors. For example, if a
given risk is assumed, such as lack of liquidity, a higher
yield may be expected on the illiquid instrument.
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Table 17.2 Comparing After-Tax Yields
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Marketable-Security Alternatives
• Money market securities generally have short-term
maturity and are highly marketable.
• Five key attributes of marketable securities
– Denominations in which securities are available
– Maturities that are offered
– Basis used
– Liquidity of the instrument
– Taxability of the investment returns
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Examples of Marketable Securities
(1 of 3)
• U.S. Treasury bills
– Direct obligations of the U.S. government sold by the
U.S. Treasury on a regular basis
• Federal agency securities
– Debt obligations of corporations and agencies that
have been created to effect various lending programs
of the U.S. government
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Examples of Marketable Securities
(2 of 3)
• Banker’s acceptances
– Draft (order to pay) drawn on a specific bank by an
exporter in order to obtain payment for goods shipped
to a customer who maintains an account with that
specific bank
• Negotiable certificates of deposit
– Marketable receipt for funds that have been deposited
in a bank for a fixed period
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Examples of Marketable Securities
(3 of 3)
• Commercial paper
– Short-term unsecured promissory notes sold by large
businesses
• Repurchase agreements
– Legal contracts that involve the actual sale of securities
by a borrower to the lender, with a commitment on the
part of the borrower to repurchase the securities at the
contract price plus a stated interest charge
• Money market mutual funds
– Pooling of the funds of large number of small savers
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Table 17.3 Features of Selected
Money-Market Instruments (1 of 7)
Instruments
Denominations
Maturities
Basis
Liquidity
Taxability
U.S. Treasury
bills—direct
obligations of
the U.S.
government
$1,000 and
increments of
$1,000
91 days,
182 days,
and 4
weeks
Discount
Excellent
secondary
market
Exempt
from state
and local
income
taxes
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Table 17.3 Features of Selected
Money-Market Instruments (2 of 7)
Instruments
Denominations
Federal agency Wide variation;
securities—
from $1,000 to
obligations of
$1 million
corporations
and agencies
created to
affect the
federal
government’s
lending
programs
Maturities
Basis
Liquidity
Taxability
5 days (Farm
Credit
consolidated
discount
notes) to
more than 10
years
Discount
or
coupon;
usually
on
coupon
Good for
issues of
“big five”
agencies
Generally
exempt at
local level;
FNMA
issues are
not exempt
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Table 17.3 Features of Selected
Money-Market Instruments (3 of 7)
Instruments
Denominations
Maturities
Basis
Liquidity
Bankers’
acceptance—
drafts
accepted for
future
payment by
commercial
banks
No set size;
typically range
from $25,000 to
$1 million
Predominantly
from 30 to 180
days
Discount Good for
acceptances
of large
“moneymarket”
banks
Taxability
Taxed at all
levels of
government
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Table 17.3 Features of Selected
Money-Market Instruments (4 of 7)
Instruments
Denominations
Maturities
Basis
Liquidity
Taxability
Negotiable
certificates of
deposit—
marketable
receipts for
funds
deposited in a
bank for a
fixed time
period
$25,000 to $10
million
1 to 18
months
Accrued
interest
Fair to
good
Taxed at all
levels of
government
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Table 17.3 Features of Selected
Money-Market Instruments (5 of 7)
Instruments
Denominations
Maturities
Commercial
paper—shortterm
unsecured
promissory
notes
$5,000 to $5
3 to 270
million; $1,000 and days
$5,000 multiples
above the initial
offering size are
sometimes
available.
Basis
Liquidity
Taxability
Discount
Poor; no
active
secondary
market in
usual
sense
Taxed at all
levels of
government
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Table 17.3 Features of Selected
Money-Market Instruments (6 of 7)
Instruments
Denominations
Maturities
Basis
Liquidity
Taxability
Repurchase
agreements—
legal contracts
between a
borrower
(security seller)
and lender
(security buyer).
The borrower
will repurchase
at the contract
price plus an
interest charge.
Typical sizes
are $500,000 or
more.
According
to terms of
contract
Not
applicable
Fixed by the Taxed at all
agreement; levels of
that is,
government
borrower
will
repurchase
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Table 17.3 Features of Selected
Money-Market Instruments (7 of 7)
Instruments
Denominations
Maturities
Basis
Money-market
mutual funds—
holders of
diversified
portfolios of
short-term,
high-grade
debt
instruments
Some require
Shares can Net asset
an initial
be sold at
value
investment as
any time.
small as $1,000.
Liquidity
Taxability
Good;
provided by
the fund
itself
Taxed at all
levels of
government
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Managing the Firm’s Investment in
Accounts Receivable
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Accounts Receivable Management
• Accounts receivable is less liquid compared to cash and
marketable securities. Account receivables typically
comprise more than 25 percent of a firm’s assets.
• Size of investment in accounts receivable is determined by
several factors:
– The percentage of credit sales to total sales
– The level of sales
– Credit and collection policies
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Figure 17.3 Determinants of
Investment in Accounts Receivable
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Terms of Sale—A Decision Variable
• Identify the possible discount for early payment, the
discount period, and the total credit period.
–
– Thus a customer can deduct a percent if paid within b
days, otherwise it must be paid within c days.
▪ Example
Discount of 2 percent if paid
within 10 days; otherwise due in 45 days.
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The Type of Customer—A Decision
Variable
• This involves determining the type of customer who
qualifies for trade credit.
• Need to consider the costs of credit investigation,
collection costs, default costs.
• May use credit scoring or a numerical evaluation of each
applicant to determine their short-run financial well-being.
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Collection Effort—A Decision
Variable
• The probability of default increases with the age of the
account. Thus, eliminating past-due receivables is key.
One common way of evaluating the situation is with ratio
analysis—average collection period, ratio of receivables to
assets, ratio of credit sales to receivables, ratio of bad debt
to sales.
• A direct trade-off exists between collection expenses and
lost goodwill on one hand and noncollection of accounts on
the other.
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Managing the Firm’s Investment in
Inventory
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Inventory Management
• Inventory management involves the control of the assets
that are produced to be sold in the normal course of the
firm’s operations.
• The purpose of carrying inventory is to make each function
of the business independent of every other function—so
that delays or shutdowns in one area do not affect the
production and sale of the final product.
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The Inventory Trade-Off
• Risk: If inventory level is low, it is possible that there will
be delays in production and customer delivery.
• Return: Low inventory will reduce storage and handling
costs and release funds tied up in inventory. Thus it will
increase returns.
• Similarly, high levels of inventory will reduce delays but
increase costs.
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Types of Inventory
• Raw-materials inventory
– Basic materials purchased to be used in the firm’s
production operations
• Work-in-process inventory
– Partially finished goods requiring additional work before
they become finished goods
• Finished-goods inventory
– Goods on which production has been completed but
are not yet sold
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Inventory Management Techniques
• Effective inventory management is directly related to the
size of the investment in inventory.
• Effective management is essential to the goal of
maximization of shareholder wealth.
• To control the investment in inventory, management must
solve two problems:
– The order quantity problem
– The order point problem
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The Order Quantity Problem
• Involves determining the optimal order size for an
inventory item given its expected usage, carrying costs,
and ordering costs.
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Total Inventory Costs (1 of 2)
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Total Inventory Costs (2 of 2)
• Economic order quantity (EOQ) attempts to determine the
order size that will minimize total inventory costs.
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Figure 17.4 Inventory Level and the
Replenishment Cycle
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Figure 17.5 Total Costs and EOQ
Determination
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Assumptions of the EOQ Model
• Constant or uniform demand
• A constant unit price
• Constant carrying costs
• Constant ordering costs
• Instantaneous delivery
• Independent orders
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The Order Point Problem (1 of 3)
• The two most limiting assumptions in EOQ—constant
demand and instantaneous delivery—are dealt with
through the inclusion of safety stock.
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The Order Point Problem (2 of 3)
• Safety stock
– Inventory held to accommodate any unusually large
and unexpected usage during delivery time
• Order point problem
– The decision about how much safety stock to hold or
how low the inventory should be depleted before it is
ordered
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The Order Point Problem (3 of 3)
• Delivery-time stock—Inventory needed between the
order date and the receipt of the inventory ordered.
• The order point is reached when inventory falls to a level
equal to the delivery-time stock plus the safety stock. See
Figure 17.6.
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Figure 17.6 Order Point Determination
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Just-in-Time Inventory System
• The goal is to operate with the lowest average level of
inventory possible.
• Within the EOQ model, the basics are to
– Reduce ordering costs
– Reduce safety stocks
• This is achieved by attempts to receive continuous flow of
deliveries of component parts.
• The result is to actually have about 2 to 4 hours’ worth of
inventory on hand.
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Inflation and EOQ
• Inflation affects the EOQ model in two ways:
– Anticipatory buying—buying in anticipation of a price
increase to secure the goods at a lower cost.
– Increased carrying costs—as inflation pushes up
interest rates, the costs of carrying inventory increases.
As “C” increases, the optimal EOQ declines in the EOQ
model.
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Key Terms (1 of 2)
• Anticipatory buying
• Cash
• Credit scoring
• Delivery-time stock
• Finished-goods inventory
• Float
• Insolvency
• Inventory management
• Just-in-time inventory control system
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Key Terms (2 of 2)
• Marketable securities
• Order point problem
• Order quantity problem
• Raw-materials inventory
• Safety stock
• Terms of sale
• Work-in-process inventory
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Copyright
This work is protected by United States copyright laws and is
provided solely for the use of instructors in teaching their
courses and assessing student learning. Dissemination or sale of
any part of this work (including on the World Wide Web) will
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and materials from it should never be made available to students
except by instructors using the accompanying text in their
classes. All recipients of this work are expected to abide by these
restrictions and to honor the intended pedagogical purposes and
the needs of other instructors who rely on these materials.
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