20 — 1 Fundamentals of Corporate Finance Chapter

20 - 1 Fundamentals of Corporate Finance Chapter 20 Working Capital Management Sixth Edition Richard A. Brealey Stewart C. Myers Alan J. Marcus Slides by Matthew Will Mc. Graw Hill/Irwin Copyright © 2009 by The Mc. Graw-Hill Inc. All rights reserved 2009 by The Mc. Graw-Hill Companies, Inc. All rights reserved

20 - 2 Topics Covered w Accounts Receivable and Credit Policy w Inventory Management w Cash Management w Investing Idle Cash: The Money Market

20 - 3 A/R and Credit Policy w Credit Management Steps Establish terms of sale è What form of IOU will you require? è Perform a credit analysis è Create a credit policy è Develop a collection policy è

20 - 4 A/R and Credit Policy w Trade Credit è Bills awaiting payment from one company to another. w Consumer Credit è Bills awaiting payment from final customer to a company. w Terms of Sale è Credit, discount, and payment terms offered on a sale.

20 - 5 Terms of Sale Example - 5/10 net 30 5 - percent discount for early payment 10 - number of days that the discount is available net 30 - number of days before payment is due

20 - 6 Terms of Sale w 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. w We can calculate the implicit cost of this loan

20 - 7 Terms of Sale Example - On a $100 sale, with terms 5/10 net 60, what is the implied interest rate on the credit given?

20 - 8 Credit Agreements w Terminology open account è promissory note è commercial draft è sight draft è time draft è trade acceptance è banker’s acceptance è

20 - 9 Credit Analysis Open Account - Agreement whereby sales are made with no formal debt contract. Credit Analysis - Procedure to determine the likelihood a customer will pay its bills. w Credit agencies, such as Dun & Bradstreet provide reports on the credit worthiness of a potential customer. w Financial ratios can be calculated to help determine a customer’s ability to pay its bills.

20 - 10 Credit Analysis Numerical Credit Scoring categories The customer’s character è The customer’s capacity to pay è The customer’s capital è The collateral provided by the customer è The condition of the customer’s business è

20 - 11 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.

20 - 12 Credit Analysis Example - If the Altman Z score cut off for a credit worthy business is 2. 7 or higher, would we accept the following client?

20 - 13 Credit Analysis Example - If the Altman Z score cut off for a credit worthy business is 2. 7 or higher, would we accept the following client? A score above 2. 7 indicates good credit.

20 - 14 Credit Analysis w 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. è Undertake a full credit analysis for the doubtful orders only. è

20 - 15 Credit Analysis Return on Assets (%) 10 5 0 Failing Firms -5 Non-failinf Firms -10 -15 -20 4 3 2 Years Before Bankruptcy 1

20 - 16 Total Liabilities as a Percentage of Assets Credit Analysis 100 90 80 70 60 50 Failing firms 40 Non-failing firms 30 20 10 0 4 3 Years Before Bankruptcy 2 1

20 - 17 EBITDA as a Percentage of Total Liabilities Credit Analysis 40 35 30 25 20 15 Failing Firms 10 Non-failinf Firms 5 0 -5 -10 4 3 Years Before Bankruptcy 2 1

20 - 18 The Credit Decision Credit Policy - Standards set to determine the amount and nature of credit to extend to customers. Credit Scoring – What your lender won’t tell you. w Extending credit gives you the probability of making a profit, not the guarantee. There is still a chance of default. w Denying credit guarantees neither profit or loss.

20 - 19 The Credit Decision The credit decision and its probable payoffs Customer pays = p Payoff = Rev - Cost Offer credit Customer defaults = 1 -p Refuse credit Payoff = 0 Payoff = - Cost

20 - 20 The Credit Decision q Based on the probability of payoffs, the expected profit can be expressed as: q The break even probability of collection is:

20 - 21 The Credit Decision w Things to Remember in the Credit Decision 1. 2. 3. Maximize profit Concentrate on the dangerous accounts Look beyond the immediate order

20 - 22 Collection Policy - Procedures to collect and monitor receivables. Aging Schedule - Classification of accounts receivable by time outstanding.

20 - 23 Collection Policy Sample aging schedule for accounts receivable

20 - 24 Inventory Management w Components of Inventory è è è Raw materials Work in process Finished goods w Goal = Minimize amount of cash tied up in inventory w Tools used to minimize inventory è è Just-in-time Lean manufacturing

20 - 25 Inventories w As the firm increases its order size, the number of orders falls and therefore the order costs decline. However, an increase in order size also increases the average amount in inventory, so that the carrying cost of inventory rises. The trick is to strike a balance between these two costs.

20 - 26 Inventory, thousands of units Managing Inventories Inventory 60 Average Inventory 30 0 3 6 Weeks 9 12

20 - 27 Inventories Determination of optimal order size Inventory costs, dollars Total costs Carrying costs Total order costs Optimal order size Order size

20 - 28 Inventories Economic Order Quantity - Order size that minimizes total inventory costs.

20 - 29 Cash w Cash does not pay interest Move money from cash accounts into short term securities è “Sweep programs” è MMDAs è Concentration banking è Lock-box system è

20 - 30 Cash How purchases are paid. Percentage of total by payment type for 2005.

20 - 31 Cash w w Electronic Funds Transfer (EFT) Automated Clearinghouse (ACH) Fedwire CHIPS (Clearing House Interbank Payments System) w 2005 CHIPS / Fedwire transaction volume = $1, 000 trillion w International cash management w Compensating balances

20 - 32 Float w Time exists between the moment a check is written and the moment the funds are deposited in the recipient’s account. w 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.

20 - 33 Concentration Banking w Concentration Banking è System whereby customers make payments to a regional collection center, which then transfers funds to a principal bank. w Lock-box System è System whereby customers send payments to a post office box, and a local bank collects and processes checks.

20 - 34 Concentration Banking w Lock-box example è A lock box receives 150 payments per day, with an average size of $1, 200. The daily interest rate if. 02% and the lock box saves 1. 2 days in mailing time and. 8 days in processing time.

20 - 35 Concentration Banking w Lock-box example è A lock box receives 150 payments per day, with an average size of $1, 200. The daily interest rate if. 02% and the lock box saves 1. 2 days in mailing time and. 8 days in processing time.

20 - 36 Managing Float w Payers attempt to create delays in the check clearing process. w Recipients attempt to remove delays in the check clearing process. w Sources of delay Time it takes to mail check è Time for recipient to process check è Time for bank to clear check è

20 - 37 Managing Float Availability float Payment float Check mailed Mail float Check received Processing float Check clears Cash available to recipient Check deposited Check clears Check charged to payer’s account

20 - 38 Cash Balances w Money Market - market for short term financial assets. Treasury bills è commercial paper è certificates of deposit è repurchase agreements è w LIBOR

20 - 39 Web Resources www. federalreserve. gov www. ny. frb. org www. stls. frb. org www. nacha. org www. gtnews. com www. phoenixhecht. com www. simba. org www. treasuryandrisk. com www. intltreasurer. com www. nacm. org www. dnb. com www. equifax. com www. experian. com www. transunion. com www. myfico. com www. fairisaac. com www. jaxworks. com/calc 2. htm www. moodyskmv. com