chapter 19 working capital management. chapter outline 19.1 overview of working capital 19.2 trade...
TRANSCRIPT
Chapter 19
Working Capital Management
Chapter Outline
19.1 Overview of Working Capital19.2 Trade Credit19.3 Receivables Management19.4 Payables Management19.5 Inventory Management19.6 Cash Management
Learning Objectives
Understand the cash cycle of the firm and why managing working capital is important
Use trade credit to the firm’s advantage Make decisions on extending credit and
adjusting credit terms
Learning Objectives (cont’d)
Manage accounts payable Know the costs and benefits of holding
additional inventory Contrast the different instruments available to
a financial manager for investing cash balances
19.1 Overview of Working Capital
Main Components of Net Working Capital Cash Inventory Receivables Payables
19.1 Overview of Working Capital
Cash Cycle Operating Cycle
The average length of time between when a firm originally purchases its inventory and when it receives the cash back from selling its product
Cash Cycle The length of time between when the firm pays cash to
purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory
19.1 Overview of Working Capital
Cash Cycle Cash Conversion Cycle (CCC)
CCC = Inventory Days + A/R Days – A/P Days (19.1)where:
InventoryInventory Days =
Average Daily Cost of Goods Sold
Accounts ReceivableAccounts Receivable Days =
Average Daily Sales
Accounts PayableAccounts Payable Days =
Average Daily Cost of Goods Sold
Figure 19.1 The Cash and OperatingCycle for a Firm
Example 19.1 Calculating the CCC
Problem: The following information is from Dell’s 2009 Income
Statement and Balance Sheet (numbers are $ millions). Use it to compute Dell’s cash conversion cycle.
Sales 52,902
Cost of Goods Sold 43,641
Accounts Receivable 5,837
Inventory 1,051
Accounts Payable 11,373
Example 19.1 Calculating the CCC
Solution:Plan: The CCC is defined in Eq. 19.1 as Inventory Days + Accounts
Receivable Days – Accounts Payable Days. Thus, we need to compute each of the three ratios in the CCC. In order to do that, we need to convert Sales and COGS into their average daily amounts simply by dividing the total given for the year by 365 days in a year.
Example 19.1 Calculating the CCC
Execute: Average Daily Sales = Sales/365 Days = 52,902/365 = 144.94 Average Daily COGS = COGS/365 Days = 43,641/365 = 119.56
Dell’s CCC = 8.79 + 40.27 −95.12= − 46.06
Inventory 1051Inventory Days 8.79
Average Daily Cost of Goods Sold 119.56
Accounts Receivable 5837Accounts Receivable Days 40.27
Average Daily Sales 144.94
Accounts PayableAccounts Payable Days
Average Da
11,373
95.12ily Cost of Goods Sold 119.56
Example 19.1 Calculating the CCC
Evaluate: Dell actually has a negative cash conversion cycle, meaning
that it generally receives cash for its computers before it pays its suppliers for the parts in the computer. Dell is able to do this because it primarily sells directly to the consumer, so it charges your credit card as soon as you place the order. Dell’s direct sales generate basically no receivables, so Dell’s accounts receivables are due to sales to businesses, educational institutions and retail outlets. Once you place your order, Dell places orders for the parts for your computer with its suppliers. Because of Dell’s size and bargaining power, its suppliers allow it to wait more than 95 days before paying them!
Example 19.1a Calculating the CCC
Problem: Given the following information from Elite PC’s
2010 income statement and balance sheet (numbers are in $ millions), calculate the company’s cash conversion cycle (CCC) and use it to evaluate the company’s efficiency:
Sales 66,467Cost of Goods Sold 54,226Accounts Receivable 5,160Inventory 643Accounts payable 10,234
Example 19.1a Calculating the CCC
Solution:Plan: The CCC is defined in Eq. 19.1 as Inventory Days + Accounts
Receivable Days – Accounts Payable Days. Thus, we need to compute each of the three ratios in the CCC. In order to do that, we need to convert Sales and COGS into their average daily amounts simply by dividing the total given for the year by 365 days in a year.
Example 19.1a Calculating the CCC
Execute: Average Daily Sales = Sales/365 Days = 66,467/365 =
182.10 Average Daily COGS = COGS/365 Days = 54,226/365 =
148.56
Example 19.1a Calculating the CCC
Execute (cont'd): Inventory Days = Inventory/Average Daily Cost of Goods Sold
=
643/148.56= 4.33
Accounts Receivable Days = A/R/Average Daily Sales =
5,160/182.10= 28.34
Accounts Payable Days = A/P/Average Daily Cost of Goods Sold =
10,234/148.56= 68.89
So, Elite’s CCC = 4.33+28.34 – 68.89 = -36.22!
Example 19.1a Calculating the CCC
Evaluate: Elite PC actually has a negative cash conversion cycle,
meaning that it generally receives cash for its computers before it pays its suppliers for the parts in the computer. Elite PC is able to do this because it sells directly to the consumer, so that it charges your credit card as soon as you place the order. Once you place your order, Elite PC places orders for the parts for your computer with its suppliers. Elite PC is paid by the credit card company about 28 days after you place your order. Because of Elite’s size and bargaining power, its suppliers allow it to wait about 69 days before paying them.
Table 19.1 Working Capital in Various Industries (Fiscal Year End 2009)
19.1 Overview of Working Capital
Firm Value and Working Capital Any reduction in working capital requirements
generates a positive free cash flow that the firm can distribute immediately to shareholders
Example 19.2 The Value of Working Capital Management
Problem: The projected net income and free cash flows next year for
Emerald City Paints are given in the following table in $ thousands:
Net Income 20,000
+Depreciation +5,000
-Capital Expenditures -5,000
- Increase in Working Capital -1,000
=Free Cash Flow 19,000
Example 19.2 The Value of Working Capital Management
Problem (cont'd): Emerald City expects capital expenditures and
depreciation to continue to offset each other and for both net income and increase in working capital to grow at 4% per year. Emerald City’s cost of capital is 12%. If Emerald City were able reduce its annual increase in working capital by 20% by managing its working capital more efficiently without adversely affecting any other part of the business, what would be the effect on Emerald City’s value?
Example 19.2 The Value of Working Capital Management
Solution:Plan: A 20% decrease in required working capital increases would
reduce the starting point from $1,000,000 per year to $800,000 per year. The working capital increases would still grow at 4% per year, but each increase would then be 20% smaller because of the 20% smaller starting point.
Example 19.2 The Value of Working Capital Management
Plan (cont'd): We can value Emerald City using the formula for a
growing perpetuity from Chapter 4 (Eq. 4.7):
As shown in the table, we can get to Emerald City’s free cash flow as:
Net Income + Depreciation – Capital Expenditures – Increases in Working Capital.
1CFPV
r g
Example 19.2 The Value of Working Capital Management
Execute: Currently, Emerald City’s value is:
If they can manage their working capital more efficiently, the value will be:
20,000,000 5,000,000 5,000,000 1,000,000237,500,000
.12 .04
20,000,000 5,000,000 5,000,000 800,000240,000,000
.12 .04
Example 19.2 The Value of Working Capital Management
Evaluate: Although the change will not affect Emerald City’s earnings
(net income), it will increase the free cash flow available to shareholders, increasing the value of the firm by $2.5 million.
Example 19.2a The Value of Working Capital Management
Problem: The projected net income and free cash flows next year for
River City Games are given in the following table in $ thousands:
Net Income 120,000
+Depreciation +80,000
-Capital Expenditures -95,000
- Increase in Working Capital -40,000
=Free Cash Flow 65,000
Example 19.2a The Value of Working Capital Management
Problem (cont'd): River City expects capital expenditures and
depreciation to continue to offset each other and for both net income and increase in working capital to grow at 6% per year. River City’s cost of capital is 8%. If River City were able reduce its annual increase in working capital by 10% by managing its working capital more efficiently without adversely affecting any other part of the business, what would be the effect on River City’s value?
Example 19.2a The Value of Working Capital Management
Solution:Plan: A 10% decrease in required working capital increases would
reduce the starting point from $40,000,000 per year to $36,000,000 per year. The working capital increases would still grow at 6% per year, but each increase would then be 10% smaller because of the 10% smaller starting point.
Example 19.2a The Value of Working Capital Management
Plan (cont'd): We can value River City using the formula for a
growing perpetuity from Chapter 4 (Eq. 4.7):
As shown in the table, we can get to River City’s free cash flow as:
Net Income + Depreciation – Capital Expenditures – Increases in Working Capital.
1CFPV
r g
Example 19.2a The Value of Working Capital Management
Execute: Currently, River City’s value is:
If they can manage their working capital more efficiently, the value will be:
000,000,250,306.08.
000,000,40000,000,95000,000,80000,000,120
000,000,450,306.08.
000,000,36000,000,95000,000,80000,000,120
Example 19.2a The Value of Working Capital Management
Evaluate: Although the change will not affect River City’s earnings (net
income), it will increase the free cash flow available to shareholders, increasing the value of the firm by $200 million.
19.2 Trade Credit
Trade Credit The difference between receivables and payables
that is the net amount of a firm’s capital consumed as a result of those credit transactions
The credit that a firm extends to its customers
19.2 Trade Credit
Trade Credit Terms Example: 2/10, Net 30
Cash Discount In this example, a 2% cash discount is taken if paid by
during the discount period Discount Period
In this example, 10 days Credit Period
The total length of time credit is extended to the buyer. In this example, 30 days
19.2 Trade Credit
19.2 Trade Credit
Trade Credit and Market Frictions Cost of Trade Credit
EAR = (1 + r)n – 1
Example 19.3 Estimating the Effective Cost of Trade Credit
Problem: Your firm purchases goods from its supplier on terms of 1/15,
net 40. What is the effective annual cost to your firm if it chooses not to take advantage of the trade discount offered?
Example 19.3 Estimating the Effective Cost of Trade Credit
Solution:Plan: Using a $100 purchase as an example: 1/15, net
40 means that you get a 1% discount if you pay within 15 days, or you can pay the full amount within 40 days. 1% of $100 is a $1 discount, so you can either pay $99 in 15 days, or $100 in 40 days. The difference is 25 days, so you need to compute the interest rate over the 25 days and then compute the EAR associated with that 25-day interest rate.
Example 19.3 Estimating the Effective Cost of Trade Credit
Execute: $1/$99 = 0.0101, or 1.01% interest for 25 days. There are
365/25 = 14.6 25-day periods in a year. Thus, your effective annual rate is (1.0101)14.6-1 = 0.158, or 15.8%
Example 19.3 Estimating the Effective Cost of Trade Credit
Evaluate: If you really need to take the full 40 days to produce the
cash to pay, you would be better off borrowing the $99 from the bank at a lower rate and taking advantage of the discount.
Example 19.3a Trade Credit
Problem: Your corporation, Vitamin Soda, purchases goods from a
supplier at 2/10 net 40. If your business requires the entire 40 days to pay back your supplier, would it be better to take a loan from the bank after the discount or just pay the EAR given by the trade credit?
Example 19.3a Trade Credit
Solution:Plan: Using a $200 purchase as an example: 2/10, net
40 means that you get a 2% discount if you pay within 10 days, or you can pay the full amount within 40 days. 2% of $200 is a $4 discount, so you can either pay $196 in 10 days, or $200 in 40 days. The difference is 30 days, so you need to compute the interest rate over the 30 days and then compute the EAR associated with that 30-day interest rate.
Example 19.3a Trade Credit
Execute: $4/$196 = 0.0204, or 2.04% interest for 30 days. There are
365/30 = 12.17 thirty-day periods in a year. Thus, your effective annual rate is (1.0204)12.17-1 =.2786, or 27.86%
Example 19.3a Trade Credit
Evaluate: If you really need to take the full 40 days to produce the
cash to pay, you would be better off borrowing the $196 from the bank at a lower rate and taking advantage of the discount.
Example 19.3b Estimating the Effective Cost of Trade Credit
Problem: Your firm purchases goods from its supplier on terms of 2/10,
net 45. What is the effective annual cost to your firm if it chooses not to take advantage of the trade discount offered?
Example 19.3b Estimating the Effective Cost of Trade Credit
Solution:Plan: Using a $100 purchase as an example: 2/10, net
45 means that you get a 2% discount if you pay within 10 days, or you can pay the full amount within 45 days. 2% of $100 is a $2 discount, so you can either pay $98 in 10 days, or $100 in 45 days. The difference is 35 days, so you need to compute the interest rate over the 35 days and then compute the EAR associated with that 35-day interest rate.
Example 19.3b Estimating the Effective Cost of Trade Credit
Execute: $2/$98 = 0.0204, or 2.04% interest for 35 days. There are
365/35 = 10.4 35-day periods in a year. Thus, your effective annual rate is (1.0204)10.4-1 = 0.234, or 23.4%
Example 19.3b Estimating the Effective Cost of Trade Credit
Evaluate: If you really need to take the full 45 days to produce the
cash to pay, you would be better off borrowing the $98 from the bank at a lower rate and taking advantage of the discount.
19.2 Trade Credit
Trade Credit and Market Frictions Benefits of Trade Credit
It is simple and convenient to use, and it has lower transaction costs than alternative sources of funds
It is a flexible source of funds, and can be used as needed
It is sometimes the only source of funding available to a firm
19.2 Trade Credit
Trade Credit and Market Frictions Trade Credit Versus Standard Loans
Firms offer trade credit because: Providing financing at below-market rates is an indirect way
to lower prices for only certain customers A supplier may have an ongoing business relationship with
its customer, it may have more information about the credit quality of the customer than a traditional outside lender such as a bank would have
If the buyer defaults, the supplier may be able to seize the inventory as collateral
19.2 Trade Credit
Managing Float Collection Float
Mail Float Processing Float Availability Float
Disbursement Float Electronic Check Processing
Check Clearing for the 21st Century Act (Check 21)
Figure 19.2 Collection Float
19.3 Receivables Management
Determining Credit Policy Establishing a credit policy involves three
steps: 1. Establishing credit standards2. Establishing credit terms3. Establishing a collection policy
19.3 Receivables Management
Determining Credit Policy 5 C’s of Credit
Character Capacity Capital Collateral Conditions
Example 19.4 Evaluating a Change in Credit Policy
Problem: Your company currently sells its product with a 1% discount
to customers who pay cash immediately. Otherwise the full price is due within 30 days. Half of your customers take advantage of the discount. You are considering dropping the discount so that your new terms would just be net 30. If you do that, you expect to lose some customers who were only willing to pay the discounted price, but the rest will simply switch to taking the full 30 days to pay. Altogether, you estimate that you will sell 20 fewer units per month (compared to 500 units currently). Your variable cost per unit is $60 and your price per unit is $100. If your required return is 1% per month, should you switch your policy?
Example 19.4 Evaluating a Change in Credit Policy
Solution:Plan: To decide whether to change your policy, compute
the NPV of the change. It costs you $30,000 to make the 500 units. You receive payment for half of the units immediately at a price of $99 per unit (1% discount). The other half comes in 30 days at a price of $100 per unit. At that point, you are starting over again with the next set of product. Thus, you can think of your cash flows in any 30-day period as:
Example 19.4 Evaluating a Change in Credit Policy
Plan (cont'd):
Example 19.4 Evaluating a Change in Credit Policy
Plan (cont'd):
Example 19.4 Evaluating a Change in Credit Policy
Execute:
So the NPV of the switch will be:
$1,891,200- $1,969,750=-$78,550.
25,000 5,2505,250 1,969,750
.0148,000 28,800
28,800 1,891,200.01
current
new
NPV
NPV
Example 19.4 Evaluating a Change in Credit Policy
Evaluate: You shouldn’t make the switch because you will lose too
many customers, even though your remaining customers will be paying the full price. The Valuation Principle helps us weigh this tradeoff—the present value of the costs outweighs the present value of the benefits, so the decision is not a good one.
Example 19.4a Evaluating a Change in Credit Policy
Problem: Your company currently sells its product with a 2% discount
to customers who pay cash immediately. Otherwise the full price is due within 30 days. Sixty percent of your customers take advantage of the discount. You are considering dropping the discount so that your new terms would just be net 30. If you do that, you expect to lose some customers who were only willing to pay the discounted price, but the rest will simply switch to taking the full 30 days to pay. Altogether, you estimate that you will sell 20 fewer units per month (compared to 1,000 units currently). Your variable cost per unit is $90 and your price per unit is $150. If your required return is 0.5% per month, should you switch your policy?
Example 19.4a Evaluating a Change in Credit Policy
Solution:Plan: To decide whether to change your policy, compute
the NPV of the change. It costs you $90,000 to make the 1,000 units. You receive payment for sixty percent of the units immediately at a price of $147 per unit (2% discount). The other forty percent comes in 30 days at a price of $150 per unit. At that point, you are starting over again with the next set of product. Thus, you can think of your cash flows in any 30-day period as:
Example 19.4a Evaluating a Change in Credit Policy
Plan (cont'd):
Cash flows under the current policy Now 30 days
Produce first set of 1000 units at $90 apiece -90,000
Customers pay for 750 units at $147 apiece 88,200
Customers pay for 250 units at $150 apiece 60,000
Produce next set of 1000 units at $90 apiece -90,000
Customers pay for 750 units at $147 apiece 88,200
-1,800 60,000 - 1800
Example 19.4a Evaluating a Change in Credit Policy
Plan (cont'd):
Cash flows under the alternative policy Now 30 days
Produce first set of 980 units at $90 apiece -88,200
Customers pay for 980 units at $150 apiece 147,000
Produce next set of 1000 units at $90 apiece -88,200
-88,200 147,000 – 88,200
Example 19.4a Evaluating a Change in Credit Policy
Execute:
So the NPV of the switch will be :
$11,671,800-11,638,200=$33,600
800,671,11005.0
200,88000,147200,88NPV
200,638,11005.0
800,1000,60800,1NPV
new
current
Example 19.4a Evaluating a Change in Credit Policy
Evaluate: You should make the switch because you will collect enough
more from all customers to make up for the loss of customers. The Valuation Principle helps us weigh this tradeoff—the present value of the benefits outweighs the present value of the costs, so the decision is a good one.
19.3 Receivables Management
Monitoring Accounts Receivable Accounts Receivable Days
The average number of days that it takes a firm to collect on its sales
Aging Schedule Categorizes accounts by the number of days they have
been on the firm’s books Can be prepared using either the number of accounts or
the dollar amount of the accounts receivable outstanding
19.3 Receivables Management
Monitoring Accounts Receivable Payments Patterns
Provides information on the percentage of monthly sales that the firm collects in each month after the sale
Table 19.2 Aging Schedules
Example 19.5 Aging Schedules
Problem: Financial Training Systems (FTS) bills its accounts on terms of
3/10, net 30. The firm’s accounts receivable include $100,000 that has been outstanding for 10 or fewer days, $300,000 outstanding for 11 to 30 days, $100,000 outstanding for 31 to 40 days, $20,000 outstanding for 41 to 50 days, $10,000 outstanding for 51 to 60 days, and $2,000 outstanding for more than 60 days. Prepare an aging schedule for FTS.
Example 19.5 Aging Schedules
Solution:Plan: An aging schedule shows the amount and percent of total
accounts receivable outstanding for different lengths outstanding. With the available information, we can calculate the aging schedule based on dollar amounts outstanding.
Example 19.5 Aging Schedules
Execute:
Example 19.5 Aging Schedules
Evaluate: FTS does not have an excessive percent outstanding at the
long-end of the table (only 6% of their accounts receivable are more than 40 days outstanding).
Example 19.5a Aging Schedules
Problem: Bubba’s Bikes bills its accounts on terms of 2/10, net 30. The
firm’s accounts receivable include $5,000 that has been outstanding for 10 or fewer days, $3,000 outstanding for 11 to 30 days, $2,000 outstanding for 31 to 40 days, $1,500 outstanding for 41 to 50 days, $1,000 outstanding for 51 to 60 days, and $500 outstanding for more than 60 days. Prepare an aging schedule for Bubba’s.
Example 19.5a Aging Schedules
Solution:Plan: An aging schedule shows the amount and percent of total
accounts receivable outstanding for different lengths outstanding. With the available information, we can calculate the aging schedule based on dollar amounts outstanding.
Example 19.5a Aging Schedules
Execute:
Days Outstanding
Amount Outstanding ($)
Percentage Outstanding (%)
1-10 5000 38.46%
11-30 3000 23.08%
31-40 2000 15.38%
41-50 1500 11.54%
51-60 1000 7.69%
60+ 500 3.85%
13000 100.00%
Example 19.5a Aging Schedules
Evaluate: Bubba’s has an excessive percent outstanding at the long-
end of the table (23.08% of their accounts receivable are more than 40 days outstanding).
19.4 Payables Management
Determining Accounts Payable Days Outstanding Firms should monitor their accounts payable to
ensure that they are making their payments at an optimal time
Example 19.6 Accounts Payable Management
Problem: The Rowd Company has an average accounts payable
balance of $250,000. Its average daily cost of goods sold is $14,000, and it receives terms of 2/15, net 40, from its suppliers. Rowd chooses to forgo the discount. Is the firm managing its accounts payable well?
Example 19.6 Accounts Payable Management
Solution:Plan: Given Rowd’s AP balance and its daily COGS, we
can compute the average number of days it takes to pay its vendors by dividing the average balance by the daily costs. Given the terms from its suppliers, Rowd should either be paying on the 15th day (the last possible day to get the discount), or on the 40th day (the last possible day to pay). There is no benefit to paying at any other time.
Example 19.6 Accounts Payable Management
Execute: Rowd’s accounts payable days outstanding is
$250,000/$14,000 = 17.9 days. If Rowd made payment three days earlier, it could take advantage of the 2% discount. If for some reason it chooses to forgo the discount, it should not be paying the full amount until the fortieth day.
Example 19.6 Accounts Payable Management
Evaluate: The firm is not managing its accounts payable well. The
earlier it pays, the sooner the cash leaves Rowd. Thus, the only reason to pay before the 40th day is to receive the discount by paying before the fifteenth day. Paying on the eighteenth day not only misses the discount, but costs the firm 22 days (40 - 18) use of its cash.
Example 19.6a Accounts Payable Management
Problem: Bugs Bunny Baked Chicken (BBBC) has an average accounts
payable balance of $300,000. Its average daily cost of goods sold is $15,000, and it receives terms of 2/15, net 35, from its suppliers. BBBC chooses to forgo the discount. Is the firm managing its accounts payable well?
Example 19.6a Accounts Payable Management
Solution:Plan: Given BBBC’s AP balance and its daily COGS, we
can compute the average number of days it takes to pay its vendors by dividing the average balance by the daily costs. Given the terms from its suppliers, BBBC should either be paying on the 15th day (the last possible day to get the discount), or on the 35th day (the last possible day to pay). There is no benefit to paying at any other time.
Example 19.6a Accounts Payable Management
Execute BBBC’s accounts payable days outstanding is
$300,000/$15,000 = 20 days. If BBBC made payment five days earlier, it could take advantage of the 2% discount. If for some reason it chooses to forgo the discount, it should not be paying the full amount until the thirty fifth day.
Example 19.6a Accounts Payable Management
Evaluate The firm is not managing its accounts payable well. The
earlier it pays, the sooner the cash leaves BBBC. Thus, the only reason to pay before the 35th day is to receive the discount by paying before the 15th day. Paying on the 20th day not only misses the discount, but costs the firm 15 days (35-20) use of its cash.
Example 19.6b Accounts Payable Management
Problem: The HOH Company has an average accounts payable
balance of $750,000. Its average daily cost of goods sold is $50,000, and it receives terms of 2/10, net 45, from its suppliers. HOH chooses to forgo the discount. Is the firm managing its accounts payable well?
Example 19.6b Accounts Payable Management
Solution:Plan: Given HOH’s AP balance and its daily COGS, we
can compute the average number of days it takes to pay its vendors by dividing the average balance by the daily costs. Given the terms from its suppliers, HOH should either be paying on the 10th day (the last possible day to get the discount), or on the 45th day (the last possible day to pay). There is no benefit to paying at any other time.
Example 19.6b Accounts Payable Management
Execute: HOH’s accounts payable days outstanding is
$750,000/$50,000 = 15.0 days. If HOH made payment five days earlier, it could take advantage of the 2% discount. If for some reason it chooses to forgo the discount, it should not be paying the full amount until the 45th day.
Example 19.6b Accounts Payable Management
Evaluate: The firm is not managing its accounts payable well. The
earlier it pays, the sooner the cash leaves HOH. Thus, the only reason to pay before the 45th day is to receive the discount by paying before the 10th day. Paying on the 15th day not only misses the discount, but costs the firm 30 days (45 - 15) use of its cash.
19.4 Payables Management
Stretching Accounts Payable When a firm ignores a payment due period and
pays later COD
Cash On Delivery CBD
Cash Before Delivery
Example 19.7 Cost of Trade Credit with Stretched Accounts Payable
Problem: What is the effective annual cost of credit
terms of 1/15, net 40, if the firm stretches the accounts payable to 60 days?
Example 19.7 Cost of Trade Credit with Stretched Accounts Payable
Solution:Plan: First, we need to compute the interest rate per
period. The 1% discount means that on a $100 purchase, you can either pay $99 in the discount period, or keep the $99 and pay $100 later. Thus, you pay $1 interest on the $99. If you pay on time, then this $1 in interest is over the 25 day period between the 15th day and the 40th day. If you stretch, then this $1 in interest is over the 45 day period between the 15th day and the 60th day.
Example 19.7 Cost of Trade Credit with Stretched Accounts Payable
Execute: The interest rate per period is $1/$99 = 1.01%. If the firm
delays payment until the sixtieth day, it has use of the funds for 45 days beyond the discount period. There are 365/45 = 8.11 45-day periods in one year. Thus the effective annual cost is (1.0101)8.11 – 1 = 0.0849, or 8.49%.
Example 19.7 Cost of Trade Credit with Stretched Accounts Payable
Evaluate: Paying on time corresponds to a 25-day credit period and
there are 365/25 = 14.6 25-day periods in a year. Thus, if it pays on the 40th day, the effective annual cost is (1.0101)14.6-1=.1580, or 15.8%. By stretching its payables, the firm substantially reduces its effective cost of credit.
Example 19.7a Cost of Trade Credit with Stretched Accounts Payable
Problem: What is the effective annual cost of credit terms of 2/10, net
30, if the firm stretches the accounts payable to 60 days?
Example 19.7a Cost of Trade Credit with Stretched Accounts Payable
Solution:Plan: First, we need to compute the interest rate per
period. The 2% discount means that on a $100 purchase, you can either pay $98 in the discount period, or keep the $98 and pay $100 later. Thus, you pay $2 interest on the $98. If you pay on time, then this $2 in interest is over the 20 day period between the 10th day and the 30th day. If you stretch, then this $2 in interest is over the 50 day period between the 10th day and the 60th day.
Example 19.7a Cost of Trade Credit with Stretched Accounts Payable
Execute: The interest rate per period is $2/$98 = 2.04%. If the firm
delays payment until the sixtieth day, it has use of the funds for 50 days beyond the discount period. There are 365/50 = 7.3 50-day periods in one year. Thus the effective annual cost is (1.0204)7.3 – 1 =0.1588, or 15.88%.
Example 19.7a Cost of Trade Credit with Stretched Accounts Payable
Evaluate: Paying on time corresponds to a 20-day credit period and
there are 365/20 = 18.25 20-day periods in a year. Thus, if it pays on the 30th day, the effective annual cost is (1.0204)18.25-1=0.4456, or 44.56%. By stretching its payables, the firm substantially reduces its effective cost of credit.
19.5 Inventory Management
Benefits of Holding Inventory Inventory helps minimize the risk that the firm will
not be able to obtain an input it needs for production and helps avoid stock-outs
Factors such as seasonality in demand mean that customer purchases do not perfectly match the most efficient production cycle
19.5 Inventory Management
Costs of Holding Inventory Acquisition Costs Order Costs Carrying Costs
19.5 Inventory Management
Costs of Holding Inventory “Just-In-Time” (JIT) Inventory Management
When a firm acquires inventory precisely when needed so that its inventory balance is always zero, or very close to it
19.6 Cash Management
Motivation for Holding Cash Transactions Balance
To meet its day-to-day needs Precautionary Balance
To compensate for the uncertainty associated with its cash flows
Compensating Balance To satisfy bank requirements
19.6 Cash Management
Alternative Investments There are several short-term securities that firms
with excess cash can invest in
Table 19.3 Money Market Investment Options
Chapter Quiz
1. How does working capital impact a firm’s value?2. What are the three factors that determine the
collection float? 3. What is the difference between accounts
receivable days and an aging schedule?4. What is the optimal time for a firm to pay its
accounts payable?5. What are the direct costs of holding inventory?6. List three reasons why a firm holds cash.