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A B C D E F

Tab 1. Cash Conversion Cycle (Section 16.3)

Figure 16-4. GBM's Cash Conversion Cycle (Dollars in Millions)

Panel a. Target CCC: Based on Planned Conditions

Cash

Conversion

Cycle (CCC)

=

Planned

Inventory

Conversion

Period (ICP)

+

Credit Terms

Offered to Our

Customers

-

= 50.0 + 60.0 -

Target CCC = 70.0

Panel b. Actual CCC: Based on Financial Statements

Sales $1,216.7

COGS $1,013.9

Inventories $140.0

Receivables $445.0

Payables $115.0

Days/year 365

Actual CCC =Inventory

COGS/365+

Receivables

Sales/365-

=

$140

($1,013.9/365) +

$445

($1,216.7/365) -= 50.4 + 133.5 -

Actual CCC = 142.5

Chapter 16: Tool Kit for Working Capital Manage

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A B C D E F

Panel c. Actual versus Target components

ICP ACP

Actual - Target = 50.4 - 50.0 133.5 - 60.0

= 0.4 + 73.5 -% Difference = 0.8% 122.5%OK VERY BAD

Figure 16-5. Benefits from Reducing the CCC (Dollars in Millions)

Old (Actual)Inventory conversion period (ICP, days) 50.4

Average collection period (ACP, days) 133.5

Payable deferral period (PDP, days) -41.4

Cash Collection Cycle (CCC, days) 142.5

Reduction in CCC

Effects of the CCC Reduction

Annual sales $1,216.7

Costs of goods sold (COGS) $1,013.9

Inventory = Actual Old, New = new ICP(COGS/365) $140.0

Receivables = Actual Old, New = new ACP(Sales/365) 445.0Payables = Actual Old, New = new PDP(COGS/365) -115.0

Net operating WC = Inv + Receivables Payables $470.0

Reduction in NOWC

Reduction in interest expense @ 10%

Actual dataDays of Working Capital (DWC): NOWC/(Sales/365) 141.0

CCC: NOWC component Sales or COGS 365 142.5

GBM's inventories are in line with its plans, and it's paying its suppliers about on time,

PDP are OK. However, some of its customers are paying quite late, so its average coll

DSO) is 133.5 days even though all customers should pay on Day 60.

In the chapter's opening vignette, we discussed "Days of working capital." DWC is ess

same as the CCC except that the CCC uses the COGS when calculating both the ICP an

whereas DWC uses sales for all calculations. Here's the DWC calculation for GBM:

The CCC is slightly larger than the DWC because Sales > COGS, and Sales is always u

DWC, lowering the result if inventories exceed payables. We regard the CCC as being s

1

$3

$

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G

4/11/2010

Credit Terms

Our Supplier

Offers Us

40.0

Payables

COGS/365

$115

($1,013.9/365)41.4

ent

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G

PDP

41.4 - 40.0

1.43.5%OK

New (Target)35.0

40.0

-50.0

25.0

$1,216.7

$1,013.9

$97.2

133.3-138.9

$91.7

so the ICP and

ction period (or

entially the

d the PDP

ed in the denom

omewhat better

7.5

8.3

7.8

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A B C D E F G H I J K L M

Tab 2. The Cash Budget (Section 16.4)

Educational Procucts Corporation (EPC), Cash Budget (Millions)

Description of the scenarios.

Current

ig Disc'

hort net

Base case (Current).The company sells on terms of 2/10, net 60. 20% of customers pay in the 1st month and

take discounts, 70% pay on time in the 2nd month, and 10% either pay in the 3rd month or never pay and end

up as bad debts. Purchases are 60% of next month's sales, and payments for purchases are made the month

after the purchase. Lease payments and payments due on a new plant are shown on the cash budget.

Monthly gross sales are shown on the cash budget, and sales are adjusted for the 2% cash discount. The

Big discount. Change the credit terms to 4/10, net 30. The payment pattern shifts as follows: 70% pay 1stmonth, 20% pay 2nd month, 10% pay 3rd month or never. Sales rise by 10% over the base case. Bad debts

remain at zero. 4% discount is a price cut, stimulates sales. The nominal cost of add'l credit is 76%, which

4/11/2010

The cash budget shows expected cash flows over a given period. EPC uses a monthly cash budget for the

coming year plus a daily cash budget for the coming month. The monthly cash budget is used for planning

purposes, the daily budget for actual cash control. The following monthly cash budget examines the firm's

projected cash flows for the last 6 months of 2011.

One of EPC's primary concerns is negotiating a loan from its bank to cover any cash shortfall that might occur

during the year. The treasurer, who is responsible for developing the cash budget, sets up several scenarios

that vary mainly in terms of the credit policy and the state of the economy. Information about each scenario is

given below, and the scenario data are shown below the verbal descriptions. Also, on a screen to the right,

the cost of additional credit (beyond the discount period) is provided for each scenario.

Short net period. Change the credit terms to 2/10, net 30. The payment pattern shifts as follows: 50% pay in

1st month, 40% pay in 2nd month, 10% pay in 3rd month or never. Sales fall by 10% versus the base case. Bad

debts remain at zero. Reducing the net period turns off some potential customers, reduces sales. The nominal

cost of add'l credit is 37%, which is high enough to stimulate early payment.

Long net period. Change the credit terms to 1/10, net 90. The payment pattern shifts as follows: 5% pay 1st

month, 5% pay 2nd month, 90% pay 3rd month or never. Sales rise by 20% versus the base case because of

the long credit period, but many new customers are weak credits. Bad debts rise to 15%. The nominal cost of

add'l credit is only 4.61%, which leads to few customers taking discounts.

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Long net

ad econ

Data set up to create scenarios (Milions of Dollars)

Use Scenario Manager to Pick a Scenario

Active Scenario Shown in Tan

Part 1. Inputs for the Cash Budget

Base

Case

Base

Case

Big

Discou

nt

Short

net

period

Long

net

period

Terrible

econo

my

% customers who take discounts and pay in 1st month 20% 20% 70% 50% 5% 15%

% who don't take discount and pay in 2nd month 70% 70% 20% 40% 5% 40%

% who don't pay in 1st or 2nd month. Lates + bad debts 10% 10% 10% 10% 90% 45%

Total: Must equal 100% 100% 100% 100% 100% 100% 100%

Purchases as a % of next month's sales 60% 60% 60% 60% 60% 60%

Other payments $30 $30 $30 $30 $30 $35

Construction cost for new plant (Sept) $150 $150 $150 $150 $150 $200

Target cash balance $10 $10 $10 $10 $10 $10

Disc % for early pmt; reduces 1st month collections 2% 2% 4% 2% 1% 2%

Discount period 10 10 10 10 10 10

Net period 60 60 30 30 90 60

Bad debt % (BD%); reduces 3rd month payments 0% 0% 0% 0% 15% 10%

Sales % change from base-case forecast 0% 0% 10% -10% 20% -20%

1. EPC sells on terms of 2/10, net 60, meaning that it gives a discount to customers

who pay within 10 days, and non-discount customers have 60 days to pay.

2. All discount customers pay on the 10th day, and other customers pay on the 60th

or 90th day, or are bad debts and never pay. No one pays after the 3rd month.

c ve

Scenar

io

Shown

Terrible economy. Leave credit terms unchanged. Due to the economy, the firm has more late payers, more

bad debts, lower sales, and fewer discount customers.

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Figure 16-6. EPC's Cash Budget, July - December, 2011 (Dollars in Millions)

May June July August Sept Oct Nov Dec

Forecasted gross sales (manual inputs): $200.0 $250.0 $300.0 $400.0 $500.0 $350.0 $250.0 $200.0

Adjustment: % deviation from forecast 0% 0% 0% 0% 0% 0% 0% 0%

Adjusted gross sales forecast $200.0 $250.0 $300.0 $400.0 $500.0 $350.0 $250.0 $200.0

Collect ions on sales:

During sales' month: 0.2 (Sales)(1 discount %) $58.8 $78.4 $98.0 $68.6 $49.0 $39.2During 2nd month: 0.7 (prior month's sales) 175.0 210.0 280.0 350.0 245.0 175.0

Due in 3rd month: 0.1 (sales 2 months ago) 20.0 25.0 30.0 40.0 50.0 35.0

Less bad debts (BD% Sales 2 months ago) 0.0 0.0 0.0 0.0 0.0 0.0

Total collections $253.8 $313.4 $408.0 $458.6 $344.0 $249.2

Purchases: 60% of next month 's sales $180.0 $240.0 $300.0 $210.0 $150.0 $120.0 $120.0

Payments

Pmt for last month's purchases (30 days of credit) $180.0 $240.0 $300.0 $210.0 $150.0 $120.0

Wages and salaries 30.0 40.0 50.0 40.0 30.0 30.0

Lease payments 30.0 30.0 30.0 30.0 30.0 30.0

Other payments (interest on LT bonds, dividends, etc.) 30.0 30.0 30.0 30.0 30.0 30.0

Taxes 30.0 30.0

Payment for plant construction 150.0

Total payments $270.0 $340.0 $590.0 $310.0 $240.0 $240.0

Net cash f lows:

Assumed excess cash on hand at start of forecast period $0.0

Net cash flow (NCF): Total collections Total pmts -16.2 -26.6 -182.0 148.6 104.0 9.2

Cumulative NCF: Prior month cum plus this month's NCF -$16.2 -$42.8 -$224.8 -$76.2 $27.8 $37.0

Cash surplus (or loan requirement)

Target cash balance $10.0 $10.0 $10.0 $10.0 $10.0 $10.0Surplus cash or loan needed: Cum NCF Target cash -$26.2 -$52.8 -$234.8 -$86.2 $17.8 $27.0

Max required loan (most negative on Row 102)

Max investable funds (most positive on Row 102)

$234.8

$27.0

Base Case

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Max Loan Requirement

Base case $234.8

Big discount 103.5

Short net period 199.3

Long net period 550.7

Bad economy 470.9

% pay Max loan % bad Max loan % Sales Max Loan

late $234.8 debts $234.8 variation $234.8

0% $215 0% $235 -30% $311

15% $245 3% $257 -15% $273

30% $275 6% $280 0% $235

45% $305 9% $302 15% $197

60% $335 12% $325 30% $158

Graph scales are set for the Base Case. Lines won't show for some scenarios because max loan is out of displayed range.

Question: In the Base Case, suppose the credit manager did a bad job and the % of customers who paid late (3rdmonth rather than 2nd month) increased, and bad debts also rose. How would this affect the max loan required? Also,

from base-case values, how would changes in sales affect the max loan requirement?

$200

$240

$280

$320

0% 20% 40% 60%

Max Loan

% Late

Late Pay Effect

$230

$280

$330

0% 4% 8% 12%

Max Loan

% Bad Debts

Bad Debt Effect

$150

$200

$250

$300

-50%

Max

Loan

%

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Maximum Required Loan

BD% % Late Payers

$234.8 0% 15% 30% 45% 60%

0% $214.8 $244.8 $274.8 $304.8 $334.8

3% 237.3 267.3 297.3 327.3 357.36% 259.8 289.8 319.8 349.8 379.8

9% 282.3 312.3 342.3 372.3 402.312% 304.8 334.8 364.8 394.8 424.8

The higher the bad debt %, the larger the loan requirement. Similarly, the higher the % of late payers, the

larger the loan requirement. If EPC has high bad debts combined with a high % of late payers, it will have a

$200

$250

$300

$350

$400

$450

0% 2% 4% 6% 8% 10% 12%

Ma

xLoanRequired

% Bad Debts

Combined Effect: Bad Debts and Late

0% late

15% late

30% late

45% late

60% late

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4/11/2010

Tabl 3. Costs of Different Types of Short-Term Credit

Accruals and Accounts Payable (Trade Credit) (Section 16.9)

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Cost of Trade Credit

= x

100 Discount %

= x

= Periodic cost x Periods per year

= 0.02041 x 18.25

= 0.37245 = 37.24%

= (1 + Periodic rate)^No. of periods 1

= 0.44585 = 44.59%

Figure 16-7 Different Credit Terms and Their Associated Costs

Days in year: 365

Credit terms DiscountDiscount

period

Net

period

Nominal Effective

1/10, net 20 1% 10 20 36.87% 44.32%

1/10, net 30 1% 10 30 18.43% 20.13%

1/10, net 90 1% 10 90 4.61% 4.69%

2/10, net 20 2% 10 20 74.49% 109.05%

2/10, net 30 2% 10 30 37.24% 44.59%

3/15, net 45 3% 15 45 37.63% 44.86%

Traditional Bank Loan to Businesses

Simple Interest

Example: Borrow $10,000 for one year @ 5.25% simple interest, paid monthly.Amount borrowed $10,000.00

Stated annual rate 5.250%

Days per year 360

Stated rate per day: Nominal rate/Days per year 0.000145833

Interest cost per day (Daily rate x Amount borrowed) $1.46

Interest cost per 30-day month (Daily cost x 30) $43.75

1 0.02

365

Days credit out Discount period

3650.020

20

If a company allows its customers to pay after say 30 days, then it is extending 30 days of free credit. If it has

terms like 2/10, net 30, then it is extending 10 days of free credit and an additional 20 days of "non-free credit"

that has a cost equal to the 2% discount that is foregone. Firms should calculate the cost of the non-free

credit, compare it to the cost of funds from other sources such as banks, and then borrow from the source

with the lowest cost, other things equal.

Nominal cost of trade

Discount %

Example: 2/10, net 30

Effective cost of trade

Most short-term working capital bank loans to businesess are documented with a promissory note that

Cost of additional

credit

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Months per year 12

Effective interest rate per month (N=12,-PV,PMT,FV. Press I/Yr. Or use Rate function) 0.438%

Nominal interest rate per year. Nominal monthly rate x 12 5.25%

Effective interest rate per year. (1 + monthly rate)^12 1 5.38%

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Add-On Loan Rate

1-month 1-Year 2-Year

Amount borrowed $10,000.00 $10,000.00 $10,000.00

Stated annual rate 7.250% 7.250% 7.250%

Payments per year 12 12 12

Stated rate per month: Annual rate/12 0.604% 0.604% 0.604%

Months loan will be outstanding 1 12 24

Total interest: (Stated rate/month)(Borrowed)(no. of months) $60.42 $725.00 $1,450.00

Total loan: Amount borrowed + Total Interest $10,060.42 $10,725 $11,450.00

Monthly payment: Total loan / Months of loan $10,060.42 $893.75 $477.08

Rate/month: N=1,12, or 24, PV=-10000, PMT= varies. 0.604167% 1.093585% 1.112845%

Nominal APR = monthly rate 12 7.25% 13.12% 13.35%

EFF% = (1+monthly rate)^12 1 7.50% 13.94% 14.20%

Note that the nominal and effective interest rate increases as the term of the loan increases. More interest is

With a monthly payment add-on loan, the amount borrowed is multiplied by the stated interest rate to get the

If the loan is for more than a year, say 2 years, use the same procedures except use 24 rather than 12 for the

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SECTION 16.3SOLUTIONS TO SELF TEST

Inventory $20

Receivables $5

Payables $4

Sales $80

COGS $60

Inventory conversion period = 121.67

Average collection period = 22.81

Payables deferral period = 24.33

Cash conversion cycle = 120.15

A company has $20 million in inventory, $5 million in receivables, and $4 million in payables. Its

annual sales revenue is $80 million and its cost of goods sold is $60 million. What is its CCC?

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Sales $20

Old inventory turnover ratio 2.0

New inventory turnover ratio 2.5

Old inventory = Sales/Inv. turnover $10.00

New inventory = Sales/Inv. turnover $8.00

Increase in available free cash flow $2.00

A company has $20 million in sales and an inventory turnover ratio of 2.0. If it can reduce its

inventory and improve its inventory turnover ratio to 2.5 with no loss in sales, by how much will FCF

increase?

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Annual sales $730

DSO 35.0

Daily sales $2.00

Accounts receivables = DSO Daily Sales $70.00

A company has annual sales of $730 million. If its DSO is 35, what is its average accounts

receivables balance?

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Discount 2%

Dicount period 12

Days credit is outsta 28

Nominal annual

cost of credit = Cost per period

0.0204 22.8125

46.6%

Effective annualcost of credit = (1 + Cost per period) ^ 1

1.0204 ^ 22.8125 1

1.5855 1

58.5%

Number of periods

per year

Number of periodsper year

A company has credit terms of 2/12 net 28. What is the nominal annual cost of

trade credit? The effective annual cost?

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If a firm borrowed $500,000 at a rate of 10% simple interest with monthly interest

payments and a 365-day year, what would be the required interest payment for a 30-day

month?

Nominal rate 10%

Amount borrowed $500,000.00

Days/year 365

Rate/day = nominal rate / 365 = (fraction, not %) 0.000273973

Interest / month = Amount borrowed rate/day 30 = $4,109.59

If interest must be paid monthly, what would be the effective annual rate?

If interest had to be paid daily, the effective rate would be found as follows:

Effective rate = (1 + nom rate/365)^365 1.0 = 0.105155782 or 10.52%

However, interest must be paid monthly, so the effective rate is lower, found as follows:

Effective rate = (1 + nom rate/12)^12 1.0 = 0.104713067 or 10.47%

If this loan had been made on a 10% add-on basis, payable in 12 end-of-month

installments, what would be the monthly payments?

Find the total interest: 0.1 $500,000 = $50,000.00

Find the total amount of the loan: $500,000 + $50,000 = $550,000

Find the monthly payments: $550,000/12 = $45,833.33

What is the annual percentage rate?

APR: Find the rate that causes the PV of the monthly payment

stream to equal the amount borrowed. This is the nominal rate. 17.97%

What is the effective annual rate?

EFF%: =(1 + 0.1797/12)^12 1 =0.1953 or 19.53%paste function: =EFFECT(G37,12) 0.1953 or 19.53%

Simple interest loan

It would be easy to go wrong on this problem for two reasons. First, you must recognize that the monthly interest

payment will vary depending on how many days are in the month, and second, you must differentiate from daily

interest compounding and monthly compounding.

Add-on Loan

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