IFM10 Ch21 Solutions Manual.docx

IFM10 Ch21 Solutions Manual.docx

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IFM10Ch21SolutionsManual

Chapter21

WorkingCapitalManagement

ANSWERSTOBEGINNING-OF-CHAPTERQUESTIONS

21-1TheCCCisdefinedasthenumberofdaysbetweenacompany’spayingforsomeproductorservicethatitsellsandthereceiptofcashfromthesaleoftheproductorservice.

Otherthingsheldconstant,itisbettertohaveashorterthanalongerCCC,becausethelowertheCCC,thelessthefirm’sinvestmentinworkingcapital.Withlessworkingcapital,totalcapitalrequirementdecline,causingthedollarcostofcapitaltodecline.Thisincreasesnetincomeandthevalueofthefirm.

AsshownintheBOCmodel,theillustrativecompany’sinventoryconversionperiodis28days,itsreceivablescollectionperiod（orDSO）is20days,anditspayablesdeferralperiodis28days,resultinginaCCCof20days.

Thecompanyhasa$380millioncostofgoodssold,or$380/360=$1.0556perday.Witha20dayCCC,itsaverageinvestmentinworkingcapitalis20（$1.0556）=$21.11million.Witha10%costofcapital,thecostofcarryingworkingcapitalis$2.11million.

IftheCCCcouldbereducedby5days,to15days,theaverageworkingcapitalbalancewouldbe15（$1.0556）=$15.83million,withacarryingcostof$1.58million.Thus,thesavingswouldbe$2.11million-$1.58million=$530,000.

ThekindsofactionsthatcompaniestaketoshortentheirCCC’sincludespeedingupthemanufacturingprocess,offeringdiscountsortighteningcredittermsandstandardstospeedupcollections,andnegotiatingbettercredittermsorpayingfromremotelocationstodeferpayments.Ofcourse,thecostsoftakingsuchactionsmustbebalancedagainstthebenefitsofthelowerCCC.

21-2Acashbudgetisaforecastofinflowsandoutflowsofcash,generallyonamonthlyordailybasis.Theprimarypurposeofthecashbudgetistoforecastwhenloanswillbeneededand/orwhensurplusfundsthatcanbeinvestedwillbeonhand.Acashbudgetisalsoveryusefulwhennegotiatingbankloans.

TheBOCmodelprovidesadetailedexampleofamonthlycashbudget.Itshowsthat,otherthingsheldconstant,shorteningtheCCCwillcausecashtocomeinfaster,thusincreasinginvestablefundsand/orreducingborrowingrequirements.

Achangeincreditpolicywillhaveseveraleffectsonthecashbudget.Atighteningwillprobablylowerthesalesforecast,whichwillreducebothcollectionsandpaymentsforpurchases,andpossiblyalsotaxespayable.Tighteningshouldalsoalterthepercentagesofsalescollectedduringeachmonth,increasingthepercentagesforthefirstandsecondmonthsandreducingthepercentageforthethirdmonth.Thosechangeswouldprobablylowertheneedforloans.However,alotdependsontheprofitabilityofsales,andifatighteningreducedsalessubstantially,thismightlowerprofitsandadverselyaffectcashflow.Ourconclusionisthatoneshouldnotjumptoquickconclusionsabouthowacreditpolicychangewillaffectoperations.Rather,athoroughanalysisisrequired.

NotealsothatachangeincreditpolicywouldaffecttheCCC.Atightningwouldleadtofasterpayments,whichwouldshortentheCCC,andaneasingwouldhavetheoppositeeffect.

21-3Freetradecreditisthecreditonegetsduringthediscountperiod,i.e.,creditonereceiveswhilestillbeingabletotakediscounts.Forexample,ifyoubuy$100ofgoodsundertermsof2/10,net30,youonlyhavetopay$98ifyoupaybythe10thday,soyouget$98offreecreditfor10days.Afterday10,youcangetanadditional20daysofcredit,butatacostofthe$2discountyoumustgiveup.Seethemodelfornumericalexamplesofthenominalandeffectivecostratesfordifferentsetsofcredittermsandactualpayments.Thereweshowthatstretchingpaymentslowerstheeffectivecostoftradecredit.However,stretchingpaymentsgivesoneareputationforbeingaslowpayer,andthatcanhaveasubstantialthoughnotquantifiablecost.

21-4Matchingmaturitiescausesthecashflowsfromanassettobesynchronizedwiththecashcostsrequiredonthecapitalusedtofinancetheassets.Ifthefirmwerefinancedonlywithdebt,andifthedebtwasamortized,thenthematchingwouldbequiteclose.However,firmsusebothdebtandequity,andtheequityhasnostatedmaturity.Similarly,assetshavevaryinglives,andthoselivescannotalwaysbedeterminedatthetimetheassetisbeingfinanced..Forexample,ifafirmspendsmoneyonadvertisingtobuilditsreputationasareliablesupplierofhighqualityproducts,andiftheadvertisingiseffective,then“goodwill”iscreated.Goodwillisclearlyanintangibleasset,regardlessofwhetherornotaccountantsshowitonthebalancesheet,andmoneymustberaisedandspenttocreatethegoodwill.Butwhatisthelifeofthatasset,hencehowcanonefinanceitwithamatchingmaturityclaim?

Ourconclusionisthatitmakessensetoconsiderthematchingmaturityconcept,andtoavoidfinancingabuildingwitha30yearlifewitha30dayloan.However,itwouldbedifficult,ingeneral,tomatchallassetandclaimmaturitiesperfectly.

Firmscanalsodeliberatelymismatchmaturitiesiftheythinkthatcapitalcostsarelikelytoriseorfallsharplyinthenearfuture.Forexample,ifinterestratesarecurrentlyquitehighandstockpriceslow,thenafirmmightfinancelongtermassetsadditionswithshorttermdebtonthetheorythatitcouldlaterrefinancetheshorttermdebtwithlongtermdebtonceratesfall.

21-5Anaggressivefinancingpolicygenerallyreferstoadeliberatemis-matchingofassetandclaimsmaturities.Theyieldcurveisnormallyupwardsloping,soshort-termratesarenormallylowerthanlong-termrates.Thus,firmscannormallyminimizecurrentinterestpaymentsbyusingprimarilyshort-termdebt.However,thiscanbeabigmistakeifinterestratesrise,inwhichcasethefirmwouldhavebeenbetterofflockinginlong-termratesbeforetheyrose.

Also,itisaggressivetouselotsofdebtandrelativelylittleequityinfinancing.Debtnormallycostslessthanequity,butequityfinancingissaferfromthefirm’sstandpoint.

Entrenched,oligolopisticfirmscangenerallyfinancewithwhatevertypeofcapitaltheirmanagementschoose,andmanagementsoftenchoosetofollowaconservativefinancingpolicysotheywon’thavetoworryasmuchastheywouldunderanaggressivepolicy.Firmsinhighlycompetitiveindustriesareoftenunderpressure,andduringhardtimescapitalsuppliersaremorewillingtolendmoney（secured,withtoughterms）thantobuythestockofashakycompany.Also,profitmarginsoffirmsinhighlycompetitiveindustriesmaypressurecompaniestoholddownallcosts,includingcapitalcosts,eventothepointwheretheirfinancingpoliciesputthefirmatrisk.

ANSWERSTOEND-OF-CHAPTERQUESTIONS

21-1a.Workingcapitalisafirm’sinvestmentinshort-termassets--cash,marketablesecurities,inventory,andaccountsreceivable.Networkingcapitaliscurrentassetsminuscurrentliabilities.Netoperatingworkingcapitalisoperatingcurrentassetsminusoperatingcurrentliabilities.

b.Theinventoryconversionperiodistheaveragelengthoftimeittakestoconvertmaterialsintofinishedgoodsandthentosellthem.Itiscalculatedbydividingtotalinventorybysalesperday.Thereceivablescollectionperiodistheaveragelengthoftimerequiredtoconvertafirm’sreceivablesintocash.Itiscalculatedbydividingaccountsreceivablebysalesperday.Thecashconversioncycleisthelengthoftimebetweenthefirm'sactualcashexpendituresonproductiveresources（materialsandlabor）anditsowncashreceiptsfromthesaleofproducts（thatis,thelengthoftimebetweenpayingforlaborandmaterialsandcollectingonreceivables.）Thus,thecashconversioncycleequalsthelengthoftimethefirmhasfundstiedupincurrentassets.Thepayablesdeferralperiodistheaveragelengthoftimebetweenafirm’spurchaseofmaterialsandlaborandthepaymentofcashforthem.Itiscalculatedbydividingaccountspayablebycreditpurchasesperday（COGS/365）.

c.ArelaxedNOWCpolicyreferstoapolicyunderwhichrelativelylargeamountsofcash,marketablesecurities,andinventoriesarecarriedandunderwhichsalesarestimulatedbyaliberalcreditpolicy,resultinginahighlevelofreceivables.

ArestrictedNOWCpolicyreferstoapolicyunderwhichholdingsofcash,securities,inventories,andreceivablesareminimized;whileamoderatecurrentassetinvestmentpolicyliesbetweentherelaxedandrestrictedpolicies.

AmoderateNOWCpolicymatchesassetandliabilitymaturities.Itisalsoreferredtoasthematuritymatching,or“self-liquidating”approach.

d.Transactionsbalanceisthecashbalanceassociatedwithpaymentsandcollections;thebalancenecessaryforday-to-dayoperations.Acompensatingbalanceisacheckingaccountbalancethatafirmmustmaintainwithabanktocompensatethebankforservicesrenderedorforgrantingaloan.Aprecautionarybalanceisacashbalanceheldinreserveforrandom,unforeseenfluctuationsincashinflowsandoutflows.

e.Acashbudgetisascheduleshowingcashflows（receipts,disbursements,andcashbalances）forafirmoveraspecifiedperiod.Thenetcashgainorlossfortheperiodiscalculatedastotalcollectionsfortheperiodlesstotalpaymentsforthesameperiodoftime.

Thetargetcashbalanceisthedesiredcashbalancethatafirmplanstomaintaininordertoconductbusiness.

f.Tradediscountsarepricereductionsthatsuppliersoffercustomersforearlypaymentofbills.

g.Anaccountreceivableiscreatedwhenagoodisshippedoraserviceisperformed,andpaymentforthatgoodisnotmadeonacashbasis,butonacreditbasis.

Dayssalesoutstanding（DSO