corporate finance summary

8/20/2019 Corporate Finance Summary

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Chapter 1: Introduction to Corporate Finance

1.1.Corporate Finance and the Financial Manager The financial manager coordinates the activities of the treasurer and the controller. The controller’soffice handles cost and financial accounting, tax payments, and management information systems.The treasurer’s office is responsible for managing the firm’s cash and credit, its financial planning, and

its capital expenditure.

A financial manager must be concerned with three basic types of questions:- Capital budgeting what are the long-term investments

The process of identifying investment opportunities. The value of the cash flow generated byan asset exceeds the cost of that asset.

• !i"e #how much cash do we expect to receive$• Timing # when are we going to receive this$• %is& # how li&ely will we receive it$

- 'apital !tructure Where do we get the financial aid from(s the specific mixture of long-term debt and equity the firm uses to finance its operations. Thegoal is to decide if one structure is better than the other

• )ow much should the firm borrow, by finding the best mixture #this will effect both theris& and the value of the firm$

• *hat are the least expensive sources of funds for the firm• The financial manager has to decide exactly how and where to raise money

- *or&ing 'apital +anagement How are you going to manage everyday financial activities All the short-term assets and liabilities such as money owed to suppliers

+anaging the firm’s wor&ing capital is a day-to-day activity that ensures that the firm hassufficient resources to continue its operations and avoid costly interruptions.

• )ow much cash and inventory should we &eep on hand• !hould we sell on credit *hat terms To who• )ow will we obtain needed short-term financing

1.2.Forms of Business OrganizationThree legal forms of business organi"ations:

• Sole Proprietorship A business owned by a single individual wned by one person, least regulated form, easy to start, all the profits to owner T theowner has unlimited liability for business debts #personal assets for payment$. All businessincome is taxed as personal income. The life of a sole proprietorship it limited to the owner’slife span. There are limitations which ma&es it hard for a business to grow because ofinsufficient capital.

• Partnership A business formed by two or more individuals or entities.

(t is similar to a proprietorship except that there are two or more owners. General partnership: all the partners share in gains or losses, and all have unlimited

liability for all partnership debts. The way partnership gains and losses are divided is

described partnership agreement. #ownership of a general partnership is not easilytransferred since it requires that a new partnership is formed.$

Limited partnership: one or more general partners will run the business and have unlimitedliability, but there will be one or more limited partners who will not actively participate in thebusiness. A limited partner’s liability for business debt is limited to the amount that partnercontributes in the partnership.#a limited partner’s interest can be sold without dissolvingthe partnership$

• Corporation A business created as a distinct legal entity composed of one or more

individuals or entities A corporation is a legal /person0 separate and distinct from its owners.(t can borrow money and own property, can sue and be sued, can enter into contracts, it canown stoc& in another company.

1orming a corporation involves preparing articles of incorporation and a set of bylaws( rulesdescribing how the corporation regulates its existence$


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o Advantages ownership can be easily transferred #the life of the corporation is notlimited$, the stoc&holders #owners$ have limited liability for corporate debt #they canonly loose the investment$ it can sell shares

o !isadvantages because it is a legal person, it must pay taxes #dividends is alsotaxed double taxation" at the corporate level when they are earned and at personallevel when they are paid out$

22' 3 limited liability company’s goal is to operate and be taxed li&e a partnership butretain limited liability for owners #hybrid of partnership and corporation$

(%! 3 (nternal %evue !ervice will consider 22' as a corporation, thereby sub4ecting it todouble taxation, unless it means certain specific criteria

Another names for corporations: #oint stoc$ companies% public limited companies% limited liabilitycompanies.

1..!he "oal of financial Management A fundamental question to as&: from the stoc$holders& point of view% what is a good financialmanagement decision'

The goal of financial management is to maximi"e the current value per share of the existingstoc&

+aximi"e the mar&et value for the existing owners’ equity The financial manager best serves the owners of the business by identifying goods and

services that add value to the firm because they are desired and valued in the freemar&etplace

'orporate finance is the study of the relationship between business decisions and the value of the stoc& in the business

the act 5!arbox’ is intended to protect investors from corporate abuses.• %equires that each company’s annual report must have an assessment of the company’s

internal control structure and financial reporting

• They must declare that the annual report does not contain any false statements• The annual report must list any deficiencies ininternal controls

(t ma&es management responsible for the accuracy of the company’s financial statements +any public firms have chosen to /go dar&0 #the shares are no longer traded on the stoc&

exchange mar&ets$ #A(+ - Alternative (nvestment +ar&et$

1.#.!he $genc% Pro&lem and Control of the CorporationThe relationship between stoc&holders and the management is called an agency relationship

• $genc% pro&lem: the possibility of conflict of interest between the stoc&holders andmanagement of a firm

Agency cost refers to the costs of the conflict of interest between stoc&holders and management.These cost can be indirect or direct. An indirect agency cost is a lost opportunity 6irect agency costs come in two forms:

'orporate expenditure #benefits management, cost the stoc&holders$ 7xpense that arise from the need to monitor management actions

+anagement may tend to overemphasi"e organi"ational survival to protect 4ob security. Also,management may disli&e outside interference, so independence and corporate self-sufficiently may beimportant goals.

*hether managers will act in the stoc&holders’ interest depends on 8 factors9. Are managers goals aligned with stoc&holders goals #this uestion relates to the way

managers are compensated)o +anagerial compensation is usually tied to financial performance in general and often

to share value in particular.o etter performers within the firm will tend to get promoted. +anagers who are

successful in pursuing stoc&holder goals can reap enormous rewards


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8. 'an managers be replaced if they do not pursue stoc&holders goals (this uestion relates tocontrol of the firm)

o 'ontrol of the firm ultimately rest with stoc&holderso *roxy fight is an important mechanism by which unhappy stoc&holders can act to

replace existing management. #proxy is the authority to vote someone else’s stoc&$o Another way that managers can be replaced is by ta&eover. Avoiding a ta&eover by

another firm gives management another incentive to act in the stoc&holders’ interest

Sta'eholder : someone other than a stoc&holder or creditor who potentially has a claim on the cashflows of the firm #employees, customers, supplies etc$. !uch groups will also attempt to exert controlover the firm, perhaps to the detriment of owners

1.(.Financial Mar'ets and the Corporation A financial mar&et is 4ust a way to bring buyers and sellers together.1inancial mar&ets function as both primary and secondary mar&ets for debt and equity securities.

primary mar$ets refers to the original sale of securities by governments and corporationso the corporation is the seller, and the transaction raises money for the corporation.o Two types of primary mar&et transactions: public offerings #selling securities to the

general public$ and private placements #a negotiated sale involving a specific buyer$o ublic offerings of debt and equity must be registered with the !ecurities and

7xchange 'ommission #!7'$. registration requires the firm to disclose a great deal of information before selling any securities

o 6ebt and equity are often sold privately to large financial institutions such as lifeinsurance companies or mutual funds, to avoid regulatory requirements and theexpenses.

+econdary mar$ets are those in which these securities are bought and sold after the originalof sale

o ne owner or creditor selling to another #transferring ownership of corporatesecurities$

o (nvestors are much more willing to purchase securities in a primary transaction whenthey &now that those securities can later be resold if desired.o Two &inds of mar&ets: auction and dealer #buy and sell for themselves, their own ris&$

mar&ets 6ealer mar&ets in stoc& and long-term debt are called over,the,counter ( T'$mar&ets #refers to old over the counter buying securities$ An auction mar&et or exchange has a physical location #dealer mar&ets not$ in an auction mar&et to match buyers and sellers. (n a dealer mar&et, the dealersearch for buyers and sellers

;

2isting!toc&s that trade on an organi"ed exchange are said to be listed on that exchange. To be listed firmsmust meet certain minimum criteria. These differ from one exchange to another.

Chapter 2)Financial Statements and Cash Flo*.

2.1 !he Balance Sheet

*rite-off by a companyThe value of the company’s assets that has been declined #%educing net income$. (t is the reduction of

taxable income as recognition of certain expenses required to produce the income.!he Balance Sheet


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1inancial statements showing a firm’s accounting value on a particular date.9. *hat a 1irm’s owns 9. #Assets$ left side8. *hat a 1irms owes 8. #2iabilities$ right side>. The difference between the two >. #7quity$ right side

1. + $ssets

Assets are items of 7conomic ?alue. The assets are classified as either current or fixed.1ixed #2ong 2ife$@. -angible truc& or a computer . ntangible: trademar& or patent

'urrent #2ife B 9 year$C. *ill convert to cash within 98 months: inventory, cash, and accounts receivable.

2. , -ia&ilitiesThe liabilities are either current or long-term.'urrent #2ife B 9 year$

D. )ave to be paid within 98 months: accounts payable2ong-Term

E. ;ot due in the coming year: a loan that needs to be due in five years./ond and bondholders is where companies borrow money from for the long term.

3. , /uit% 0Shareholders) Common or O*ners /uit%3The differences between Assets and 2iabilities

!he Balance Sheet Identit% Assets F 2iabilities G !hareholders’ 7quity

4et 5or'ing Capital 'urrent assets - 'urrent liabilities.This is positive in a healthy firm. This means that cash that will become available exceeds the cashthat must be paid over the same period. !o basically you are able to pay off your debts.

-i/uidit%

The speed and ease with which an asset can be converted to cash.• 2iquid Assets: 7ase of conversion

An asset that can be easily sold has a high liquidity without losing significant loss of value for examplecurrent assets.

• (lliquid Assets: 2oss of value An asset that cannot be quic&ly converted to cash without a price reduction for example fixed assetsli&e tangible things. (ntangible things will never convert to cash but are very valuable.

o The more liquid a business is, the less li&ely it is to experience financial distress meaningbeing in difficulty in paying debts or buying needed assets.

6ownside is that liquid assets are less profitable to hold: cash holdings #4ust sit there, noearnings$. Therefore there is a trade-off between advantages of liquidity and forgone profits.

%esidual portion: the amount left after the creditors are paid. This amount is for the equity holders.

Shareholders /uit% Assets 3 2iabilities

1inancial 2everage: the more debt a firm has, the greater is its degree of financial leverage.(t increases the potential shareholders’ reward, but it also increases the potential distress andbusiness failure #because you invest your assets$.

"$$P: Henerally Accepted Accounting rinciplesThe common set of standards and procedures by which audited financial statements are prepared.

The firm’s assets are boo& values #carried on the boo&s$ which mean that the balance sheet will showthe historical cost of the asset, not the cost of what it would be worth today.


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'urrent Assets’ boo& value and mar&et value might be somewhat similar since they are converted intocash over a relative short span of time. 1or fixed assets this would be a purely coincidence.

alance sheet is important for:+upplier si"e of accounts payable*otential creditor examine the liquidity and degree of financial leverage

0anager can trac& things li&e cash and inventory on hand.

Ieep in mind that the balance sheet does not show the value of the firm. Things li&e a goodmanagement team, good reputation, and talented employees are not on there.

Accounting ?alue F in the boo&s #historical value$+ar&et ?alue F right now, this moment value. #+ore interestingJ$

2.2 !he Income Statement

Income Statement1inancial statement summari"ing a firm’s performance over a period of time #a quarter or year$.

%evenues - 7xpenses F (ncomeThe income statement starts off with the revenues and expenses of the company, followed by otherfinancial expenses li&e interest paid or taxes.

7nd the statement with 1et ncome (bottom line$. ften expressed 0PS3 earnings per share. 7arnings per share F ;et incomeKTotal !hares utstanding 6ividends per shareF Total 6ividendsKTotal !hares utstanding

$ddition to retained earningsThe differences between net income and cash dividend. This amount is added to the cumulativeretained earnings account.

+atching rinciple is first determining revenues and then match the revenues with the cost associatedwith producing them.The revenue is reali"ed at the time of sales. The cost at the time of production.)owever, the actual cash outflows may have occurred at some different time.

This means that the revenues and expenses are shown on the income statement may not beall representative of the actual cash inflows and outflows.

4oncash Items7xpenses charged against revenues that do not directly affect cash flow, such as depreciation.

*hen a company purchased a new asset and writes it off over a five year period, then everyyear an amount will be depreciation. !his is 6ust an accounting num&er) not real cash7 ecause the company already paid for it when it purchased the asset.

6ifferences between accounting income and cash flow: Accounting (ncome is the financial figure that you get after deducting all business expenses from

sales.'ash 1low is the mechanism by which you see net cash generated or absorbed in business fromdifferent activities.

!ime and Costs(n the long run, all business costs are variable(n a relative short time hori"on, some cost are 7ffectively fixed 3 they must be paid no matter what#property, taxes etc.$

2.# Cash Flo*

Cash Flo*The difference between the number of dollars that came in and the number that went out.

Cash Flo* Identit% 'ash flow from assets #'1A$F 'ash flow to creditors #'1'$ G 'ash flow to stoc&holders #'1!$


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The cash flow from a firm’s assets is equal to the cash flow paid to suppliers of capital to the firm.

Cash flo* from assetsThe total of cash flow to creditors and cash flow to stoc&holders, consisting of the following:

9. perating 'ash 1low cash results from day to day activities of producing and selling.8. 'apital spending net spending on fixed assets.

>. 'hange in ;et *or&ing 'apital net change in current assets relative to currentliabilities.

1. Operating Cash Flo* 0OCF3'ash generated from a firm’s normal business activities.

2 !o not include depreciation #not cash outflow$ and interest #financing expense$.8 !o include taxes.

7arnings before (nterest and Taxes #7(T$


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!ources of 'ash A firm’s activities that generate cash

!elling products, assets or a security !ecrease in Assets 3 ncrease in Liabilities

ses of 'ash

A firm’s activities in which cash is spend. Also called applications of cash uying assets #inventoryKaccounts receivable$, payments #debtsKnotes payable$ ncrease in Assets 3 !ecrease in Liabilities

+tatement of Cash 4low A firm’s financial statement that summari"es the sources and uses of cash over a specified period> 'ategories:

- perating activities- 1inancing activities- (nvestment activities

.2 Standardized financial statements

6ue to the fact that you need to have the same standards to ma&e statements, you use standardi"ingfinancial statements #by wor&ing with percentage instead of dollars$

CommonSize Statement A standardi"ed financial statement presenting all items in percentage terms. #easy to compare$

alance sheet items percentage of assets (ncome statements percentage of sales

CommonBase Statement A standardi"ed financial statement presenting all items relative to a certain base year amount

Com&ined CommonSize and CommonBase Statements

The reason for doing this is that as total assets grow, most of the other accounts must grow as well.y first forming the common-si"e statements, we eliminate the effect of this overall growth

. ;atio $nal%sis

Financial ratios%elationship determined from a firm’s financial information and used for comparison purposes.

Another way of avoiding the problems involved in comparing companies of different si"es is tocalculate and compare

After calculating you are left with percentages, multiples, or time periods

1inancial ratios are grouped in the following categories

9. !hort-term solvency, or liquidity, ratios8. 2ong-term solvency, or financial leverage, ratios>. Asset management, or turnover, ratios@. rofitability ratios. +ar&et value ratio’s

!hort Term !olvency, or 2iquidity, +easures The ratios are intended to provide information about a firm’s liquidity, and these ratios are

sometimes called liuidity measures. 2iquidity ratios are particularly interesting to short-term creditors

1. Current ;atiothe current ratio is a measure of short-term liquidity. The unit of measurement in either in dollars or

times. To a creditor the higher the 'urrent %atio, the better


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To a firm a high current ratio indicates liquidity, but is may also indicate an inefficientuse of cash and other short-term assets

A current ratio of less than 9 would mean that net wor&ing capital is negative, which is unhealthy for acompany

'urrent ratio F 'urrent AssetsK'urrent 2iabilities

2. !he erage A problem with T(7 ratio is that it is based on 7(T, which is not really a measure of cash available topay interest, since depreciation has been deducted out. ecause interest is definitely a cash outflow#to creditors$ one way to define the cash coverage ratio is:

'ash 'overage %atio F #7(T G 6epreciation$K(nterest7(T plus depreciation is often called 7(T6# 7arnings before interest, taxes, and depreciation$(t is a measure of the firm’s ability to generate cash from operations, and it is frequently used as a

measure of cash flow available to meet financial obligations. Asset +anagement, or Turnover, +easures


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The measures in this section are sometimes called asset utili9ation ratios. They are intended to describe how efficiently or intensively a firm uses its assets to generate

sales.

1. In>entor% !urno>er and =a%s Sales in In>entor% An indicator of how fast we can sell our products

(nventory Turnover F 'ost of Hoods !oldK(nventory 6ays’ sales in (nventory F >CK(nventory Turnover

2. ;ecei>a&les !urno>er and =a%s Sales in ;ecei>a&le An indicator of how fast we can collect our sales #also possible for payable turnover$

%eceivables turnover F !alesKAccounts %eceivables 6ays’ sales in %eceivables F >CK%eceivables Turnover

This ratio is frequently called average collection period #'A$

. $sset !urno>er ;atios!everal 5big picture’ ratios.

;*' turnover F !alesK;*'This ratio measures how much 5wor&’ we get out of our wor&ing capital #a high value is preferred$

1ixed asset turnover F !alesK;et fixed assets1or every dollar in fixed assets, M is generated in sales

Total asset turnover F !alesKTotal Assets1or every dollar in assets M is generated in sales

rofitability +easured (ntended to measure how efficiently a firm uses its assets and manages its operations #focus

on net income$

1. Profit Margin All other things being equal, a relatively high profit margin is obviously desirable #low expense ratiosrelative to sales$

rofit +argin F ;et (ncomeK!ales A low profit margin does not have to be bad for a company /our prices are so low that we lose moneyon everything we sell, but we ma&e it up in volume’

2. ;eturn on $ssets 0;O$3(t is a measure of profit per dollar of assets.

%eturn on Assets F ;et (ncomeKTotal Assets

. ;eturn on /uit% 0;O3 A measure of how the stoc&holders fared during the year. ecause benefiting shareholders is our goal,%7 is the true bottom-line measure of performance.

%eturn on 7quity F ;et incomeKTotal 7quity

%A en %7 are accounting rates of return. These measures should properly be called returnon boo$ assets and return on euity #%7 is sometimes called return on net worth$

+ar&et ?alue +easures The mar&et price per share of stoc&, is not necessary contained in the financial statements.

These measures can be calculated directly only for publicly traded companies 7arnings per share #7!$ F ;et (ncomeK!hares utstanding

1. Price?arnings ;atio(t measures how much investors are willing to pay per dollar of current earnings #the higher, the morepotential growth the company has$

7 ratio F rice per !hareK7arnings per share if the firm had no or almost no earnings, its 7 would also be quite large.


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*5G ratio " *5 ratio3expected future earnings growth rates. The idea behind this ratio is thatwhether a 7 ratio is high or low depends on expected future growth. #high 7H ratiossuggest that the 7 is too high relative to growth$

2. Price?Sales ;atio!ometimes, companies will have negative earnings for extended periods, to their 7 ratios are not

very meaningful *rice,sales ratio rice-!ales ratio F rice per shareK!ales per share

*hether a particular price-sales ratio is high or low depends on the industry involved.

3. Mar'etto&oo' ;atio(t compares the mar&et value of the firm’s investments to their cost. # a value less than 9 could meanthat the company has not been successful overall in creating value for its stoc&holders.

+ar&et-to-boo& ratio F +ar&et value per shareKoo& value per share1otice that boo$ value per share is total euity divided by the number of shares outstanding

ecause boo& value is an accounting number, it reflects historical costs.

Another ratio, called -obin&s : ratio, is much li&e the mar&et-to-boo& ratio. Tobin’s L F mar&et value of assetsK%eplacements cost of assets Tobin’s L F mar&et value of equityNdebtK%eplacements cost of assets

The L ratio is superior to the mar&et-to-boo& ratio because it focuses on what the firm is worth todayrelative to what it would cost to replace it today.

)igh L F attractive investment opportunitiesKcompetitive advantage +ar&et-to-boo& ratio focuses on historical costs, which are less relevant L ratios are difficult to calculate with accuracy.

.# !he =u Pont Identit%

%A and %7, the difference between these two profitability measures is a reflection of the use offinancial debt financing, or financial leverage.

A closer loo& at %7

%eturn on 7quity F ;et (ncomeKTotal 7quity

%eturn on equity F net income x !ales x Assets!ales Assets 7quity

%7 F %A x 7quity multiplier F %A x #9G 6ebt-7quity %atio$

%7 F profit margin x total asset turnover x equity multiplier

=u Pont Identit%opular expression brea&ing %7 into three parts:

9. operating efficiency #as measured by profit margin$8. asset use efficiency #as measured by total asset turnover$>. financial leverage #as measured by the equity multiplier$

*ea&ness in either operating or asset use efficiency #or both$ will show up in a diminishedreturn on assets, which will translate into a lower %7

%7 could be leveraged up by increasing the amount of debt in the firm #however, this alsoincreases interest expense, which reduces profit margins, and reduces %7$

(f a company’s equity value declines sharply, its equity multiplier rises higher %7

An 7xpanded 6u ont Analysis6u pont can increase its %7 by increasing sales and also by reducing one or more of these costs.Figure .1 Page @A Fundamentals of Corporate Finance

.( sing Financial Statement Information


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*hy evaluate 1inancial !tatementsThe primary reason for loo&ing at accounting information is that we don’t have mar&et valueinformation.

(f there is a conflict between accounting and mar&et data, mar&et data should be givenprecedence

Internal ses +anagers and employees are frequently evaluated and compensated on the basis of

accounting measures of performance such as profit margin and return on equity.#erformance evaluation$

)istorical financial statement information is useful for generating pro4ections about the future.

ternal ses 1inancial statements are imported for short-term and long-term creditors and potential

investors #parties outside the firm$ 1inancial statements are a prime source of information about a firm’s financial health 1inancial statements are useful in evaluating our main competitor 1inancial statement information would be essential in identifying potential targets and deciding

what to offer

'hoosing a enchmar&

!ime !rend $nal%sis +anagement by exception 3 a deteriorating time trend may not be bad, but it does merit

investigation.

Peer "roup $nal%sisThe second means of establishing a benchmar& is to identify firms similar in the sense that theycompete in the same mar&ets, have similar assets, and operate in similar ways. #identify a peer group)

+tandard ndustrial Classification (+C) code

a .!. government code used to classify a firm by its type of business operations. There are four-digit codes. 1irms with the same !(' code are assumed to be similar o The first digit in a !(' code established the general type of business. (;


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The technique to use this is the percentage of sales approach.

Firms financial polic%Which directly affect its future profitability% need for external financing% and opportunities for growth.

(nvestment in new assets Capital /udgeting Arises from investment opportunities and capital budgeting decision.

1inancial leverage +tructure *olicy The amount of borrowing to finance its investments. 'ash !ividend policy

Amount which is necessary to pay shareholders 2iquidity and wor&ing capital 1et Wor$ Capital !ecision

In>estment and financing policies interact.

Proper Prior Planning Pre>ents Poor Performance

Financial Planning formulates the way in which financial goals are to be achieved. *hat is tobe done in the future (t leads to long time implements.

The goal is to increase the mar&et value of the owners 5equity. (f this happens then growth willusually result. (t is a desirable consequence of good decisions ma&ing.

• The short-range time period: 98 months• The long-range time period: 8- years

Planning Eorizon: The long-range time period on which the financial planning processfocuses.

t is the first dimension of the planning process that must be established. $ggregation: the process by which smaller investment proposals of each of a firm’s

operational units are added up and treated as one big pro4ect. t is the second dimension of the planning process that needs to be determined.

A company always needs to be aware of different future scenarios: #> years planning hori"on$1. 5orst Case

6isaster planning, loo&ing pessimistic towards the future, it would require details about costcutting and liquidation.

2. 4ormal Case%equires most li&ely the assumptions about the company and economy.

. Best Caseptimistic, new products and expansion, financial details to fund the expansion.

'yclical usiness: businesses with sales that are strongly affected by the overall state ofeconomy or business cycles.

*hat will planning accomplish- amining Interactions 0*here *ill the financing &e o&tained fromD3

The lin& between investment proposals and its available financing choices.

- ploring Options 0*hat is the impact of a ne* in>estmentD36evelop, analy"e and compare different scenarios.- $>oiding Surprises 0*hat ma% happen to the firmD3

The actions of a firm when things go seriously wrong. Hoal is to avoid surprises and developcontingency plans.

- nsuring Feasi&ilit% and Internal Consistenc%!pecific goals. 1inancial planning is a way of finding out 4ust what is possible 3 and, byimplication, what is not possible.

#.2 Financial planning models

A financial plan is based on future assumptions which generate predicted values for variables.

- !ales 1orecastThe sales forecast will be used as the driver which means that the user will supply this valueand all other values will be based on this forecast.


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The forecast will be given as the growth rate in sales and cannot always be perfect because of the uncertain future state of economy evaluate alternative scenarios.

- 1orma #As a matter of form$ !tatementsThe pro forma’s are the output from the financial planning model and includes a forecast:

• alance sheet

• (ncome statement• 'ash flows

The financial statements are the form we use to summari"e the different events pro4ected for thefuture. (pro forma statements 3 pro forma the output from the financial planning model )

- Asset requirementsThis shows the pro4ected capital spending. (t indicates the minimum amount a company must invest inorder to participate in an activity #changes is total fixed assets and net wor&ing capital$ Affect thecapital budget.

- 1inancial requirements'ontains the financial agreements about the dividend and debt policy, raise cash by selling newshares or by borrowing.

- The lug After the firm has a sales forecast and an estimate of the required spending on assets, the balancesheet will no longer balance. ecause new financing may be necessary to cover all of the pro4ectedcapital spending, a financial 5plug’ variable must be selected

The plug is the designated source or sources of external financial needed #71;$ to deal withany shortfall #or surplus$ in financing and thereby bring the balance sheet into balance.

- 7conomic AssumptionsThe plan will have to state explicitly the economic environment in which the firm expects to reside over the life of the plan. Also, assumptions of the level of interest rates and the firm’s tax rate have to bemade.

$ simple Financial Planning Model

The way the liabilities and owners’ equity change depends on the firm’s financing policy and itsdividend policy. Hrowth in assets requires that the firm decide on how to finance that growth. This is astrictly managerial decision.

#. !he Percentage of Sales $pproach

The amount of long-term borrowing is something set by management, therefore it does not directlyincrease at the same rate as sales.

Percentage of sales approach: a financial planning method in which accounts are varieddepending on a firm’s predicted sales level

The (ncome !tatement

=i>idend pa%out ratio: the amount of cash paid out to shareholders divides by net income 6ividend payout ratio F cash dividendsK;et income;etention ;atio: the addition to retained earning divided by net income. Also called the plowbac$ ratio.#equal to 9 3 the dividend payout ratio$

%etention ratio F addition to retained earningsK;et income

The alance !heetCapital intensit% ratio: a firm’s total assets divided by its sales, or the amount of assets needed togenerate O9 in sales. #the higher the ratio, the more capital intensive the firm is$

'apital intensity ratio F total assetsKsales

2ong-term debt, common stoc&, and paid in surplus, are not applicable to the balance sheet since theywon’t change automatically with a change is sales. *e initially assume no change and simply write in

the original amounts.

)ow to finance: 7xternal 1inancial ;eeded #71;$


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- !hort-term borrowingP- 2ong-term borrowingP %- ;ew equity

The choice is up to management.

'apacity sage

1ull-capacity sales F current salesKcapacity usage in percentage %atio of fixed assets to sales F 1ixed AssetsK1ull-capacity sales

#.# ternal Financing and "ro*th

All other things staying the same, the higher the rate of growth in sales or assets, the greaterwill be the need for external financing.

Again, growth is simply a convenient means of examining the interactions between theinvestment and financing decisions

71; and Hrowth

The need for new assets grows at amuch faster rate than the addition toretained earnings, so the internalfinancing provided by addition toretained earnings rapidly disappears. whether a firm runs a cash surplusor deficit depends on growth.

1inancial olicy and Hrowth

- !he internal gro*th rateThe maximum growth rate a firm can achieve without external financing of any &ind

(nternal growth rate F %A x b9 3 %A x b

/ " plowbac$ 3 retention ratio.

- !he Sustaina&le "ro*th ;ateThe maximum growth rate a firm can achieve without external equity financing while maintaining a

constant debt-equity ratio. (no increase in financial leverage) !ustainable Hrowth rate F %7 x b

9 3 %7 x b

- =eterminants of "ro*th %7 F profit margin = Total asset turnover = 7quity multiplier

%7 will increase the sustainable growth rate by ma&ing the top bigger and the bottom smaller.(ncreasing the plowbac& ratio will have the same effect

A firm’s ability to sustain growth depends explicitly on the following factors: *rofit margin an increase will increase the firm’s ability to generate funds internally and

thereby increase its sustainable growth. !ividend policy a decrease in the percentage of net income paid out as dividends will

increase the retention ratio. This increase internally generated equity and thus increasessustainable growth


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4inancial policy an increase in the debt-equity ratio increases the firm’s financial leverage.ecause this ma&es additional debt financing available, it increases the sustainablegrowth rate

-otal asset turnover an increase in the firm’s total asset turnover increases the salesgenerated for each dollar in assets. This decreases the firm’s need for new assets assales grow and thereby increases the sustainable growth rate. #increasing total asset

turnover is the same thing as decreasing capital intensity$

The sustainable growth rate shows the relationship between the firms four ma4or areas of concerns:- (ts operating efficiency as measured by profit margin- (ts asset use efficiency as measured by total asset turnover - (ts dividend policy as measured by the retention ratio- (ts financial policy as measured by the debt-equity ratio.

f sales are to grow at a rate higher than the sustainable growth rate% the firm must increase its profitmargin% increase total asset turnover% increase financial leverage% increase earnings retention% or sellnew shares.

If a firm does not *ish to sell ne* e/uit% and its profit margin) di>idend polic%) financial polic%)and total asset turno>er 0or capital intensit%3 are all fied) then there is onl% one possi&le

gro*th rate.

Chapter 1A)Short!erm Finance and Planning

!hort-term financial management is often called wor$ing capital management .

1A.1 !racing Cash and 4et 5or'ing Capital

Current assets'ash and other assets that are expected to convert to cash within a year.

They are on the balance sheet in order of their accounting liquidity 3 the ease with which they

can be converted to cash and the time it ta&es to convert them. Cash% cash euivalents% mar$etable securities% accounts receivable% and inventories

Current liabilitiesbligations that are expected to require cash payment within one year #or operating period$

Accounts payable% expenses payable (wages @ taxes)% and notes payable

;et wor&ing capital G fixed assets F 2ong-term debt G equity ;et wor&ing capital F #cash G other current assets$ 3 liabilities 'ash F 2ong-term debt G equity G current liabilities 3 current assets other than cash 3 fixed

assets #cash"L-! 7 5 7 CL CA (other than cash) 4A)

Those activities that increase cash are called sources of cash

Those activities that decrease cash are called uses of cash

1A.2 !he Operating C%cle and the Cash C%cle

The primary concern in short-term finance is the firm’s short-run operating and financing activitiesThe activities create patterns of cash inflows and cash outflows

6efining the perating and 'ash 'ycles- !he operating C%cle

The length of time it ta&es to acquire inventory, sell it, and collect for it. perating 'ycle F (nventory period G Accounts receivable period

6efinitions: Operating C%cle: the period between the acquisition of inventory and the collection of cash

from receivables. In>entor% period: the time it ta&es to acquire and sell inventory


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$ccounts recei>a&le period: the time between sale of inventory and collection of thereceivable

The operating cycle describes how a product moves through the current asset account.

- !he Cash C%cleThe number of days that pass before we collect the cash from a sale, measured from when we

actually pay for the inventory 'ash cycle F perating cycle 3 Accounts payable period

6efinitions: $ccounts pa%a&le period: the time between receipt of inventory and payment for it Cash C%cle: the time between cash disbursement and cash collection

Cash flow time line A graphical representation of the operating cycle and the cash cycle

a gap between short-term inflows and outflows can be filled either by borrowing or by holdinga liquidity reserve in the form of cash or mar&etable securities.

The gap can be shorted by changing the inventory, receivable, and payable periods.

The perating 'ycle and the 1irm’s rgani"ational 'hart!a&le 1A.1) Page (A# Fundamentals of Corporate Finance

'alculating the perating and 'ash 'ycles- !he Operating C%cle (nventory turnover F 'ost of Hoods !oldKAverage (nventory (nventory period F >CK(nventory turnover

%eceivables turnover F 'redit salesKAverage Accounts %eceivable %eceivables period F >CK%eceivables Turnover

Receivables period is also called the days’ sales in receivables or the averagecollecting period.

- The Cash Cycle Payables turnover = Cost of Goods Sold/Averae payables

Payable period = 3!"/Payables turnover

* note: average is the beginning and ending divided by2.

18.3 Some Aspects of Short-Term Financial Policy

#he short$ter% &nancial policy that a &r% adopts 'ill be re(ected in at least t'o'ays)

-he si9e of the firm&s investment in current assets this is usually measured relative to the

firm’s level of total operating revenues. A flexible short-term financial policy would maintain arelatively high ratio of current assets to sales. A restrictive short-term financial policy wouldentail a low ratio of current assets to sale.

-he financing of current assets this measured as the proportion of short-term debt and long-term debt used to finance current assets. A restrictive short-term financial policy means a highproportion of short-term debt relative to long-term financing, and a flexible policy means lessshort-term debt and more long-term debt

The si"e of the firm’s (nvestment in 'urrent AssetsFlei&le shortterm policies, such actions as:

• Ieeping large balances of cash and mar&etable securities (costly)• +a&ing large investments in inventory• Hranting liberal credit terms, which results in a high level of accounts receivable. (stimulates

sales)


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;estricti>e shortterm policies% has actions which are exactly the opposite.(t probably reduces future sales to levels below those that would be achieved under flexible policies.

Carr%ing costs: (high in a restrictive policy)'osts that rise with increases in the level of investment in current assets.

'arrying costs are the opportunity costs associated with current assets.

The rate on return on current assets is very low when compared to other assets.

Shortage costs: (high in a flexible policy)'osts that fall with increases in the level of investment in current assets

!hortage costs are incurred when the investment in current assets is low (f a firm runs out of cash, it will be forced to sell mar&etable securities. #if this is not possible

cash,out it may borrow or default on an obligation A firm may lose customers if it runs out of inventory or if it cannot extend credit to customers

(n general, two &inds of shortage costs: -rading% or order% costs order costs are the costs of placing an order for more cash or more

inventory Costs related to lac$ of safety reserves these are costs of lost sales, lost customer goodwill,

and disruption of production schedules.

Alternative financing policy for 'urrent Assets

- $n Ideal Case(n an ideal economy, short-term assets can always be financed with short-term debt, and long-termassets can always be financed with long-term debt and equity. ;et *or&ing 'apital is always "ero.(sawtooth pattern)

- =ifferent Policies for Financing Current $ssets(n the real world, it is not li&ely that current assets will ever drop to "ero. A growing firm can be thought of as having a total asset requirement consisting of the current assetsand long-term assets needed to run the business efficiently. The total asset requirement may exhibitchange over time for many reasons, li&e:

#9$ A general growth trend#8$ !easonal variation around the trend#>$ npredictable day to day and month-to-month fluctuations.

A firm might consider two strategies to meet its cyclical needs: The firm could &eep a relatively large pool of mar&etable securities. As the need for inventory

and other current assets began to rise, the firm would sell of mar&etable securities and use thecash to purchase whatever is needed. nce the inventory was sold and inventory holdingsbegin to decline, the firm would reinvest in mar&etable securities. (policy 4)

The firm could &eep relatively little in mar&etable securities. As the need for inventory andother assets began to rise, the firm would simply borrow the needed cash on a short-termbasis. The firm would repay the loans as the need for assets cycled bac& down (policy 8)

n the flexible case% the firm finances internally% using it own cash and

mar$etable securities. n the restrictive case% the firm finances the variationexternally% borrowing the needed funds on a short,term basis

*hich financing olicy is the estThere is no definitive answer. !everal considerations must be included in a proper analysis


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*1+ Cash reserves the flexible financing policy implies surplus cash and little short-termborrowing. This policy reduces the probability that a firm will experience financial distress.1irms may not have to worry as much about meeting recurring, short-run obligations.)owever, investments in cash and mar&etable securities are "ero net present valueinvestments at best.

*2+ 0aturity hedging most firms attempt to match the maturities of assets and liabilities. They

finance inventories with short-term ban& loans and fixed assets with long-term financing. 1irmstend to avoid financing long-lived assets with short-term borrowing. This type of maturitymismatching would necessitate frequent refinancing and is inherently ris&y because short-terminterest rates are more volatile than longer-term rates

*3+ 8elative interest rates short-term interest rates are usually lower than long-term rates ,thisimplies that it is, on average, more costly to rely on long-term borrowing as compared to short-term borrowing.

1A.# !he cash Budget

Cash budget : # primary tool in short,run financial planning)a forecast of cash receipts and disbursements for the next planning period

!ales and 'ash 'ollections 'ash 'ollections F eginning accounts receivable G #day’s or receivable$KQR = sales

S B= days for a uarterly cash budget 7nding %eceivables F eginning receivables G !ales - 'ollections

!a&le 1A.2 Page (# Fundamentals of Corporate Finance

ecause beginning receivables are all collected along with half of sales, ending receivablesfor a particular quarter will be the other half of sales.

'ollections are a source of cash, other sources include: asset sales, investment income, andreceipts from planned long-term financing.

'ash utflows

The cash disbursement, or payments. 1our asic categories#9$ *ayments of account payable these are payments for goods or services rendered bysuppliers, such as raw materials. Henerally, these payments will be made sometime afterpurchases.

#8$ Wages% taxes% and other expenses this category includes all other regular costs of doingbusiness that require actual expenditures. 7.g. depreciation, it requires no cash outflow and isnot included as a regular cost of business. #wages, taxes etc. routinely 8R percent of sales$

#>$ Capital expenditures these payments of cash for long-lived assets.#@$ Long,term financing expenses: this category includes, for example, interest payments on long-

term debt outstanding and dividend payments to shareholders. 'ash alanceThe predicted net cash flow is the difference between cash collections and cash disbursements.

!a&le 1A. G 1A.# G 1A.( page ((G(@ Fundamentals of Corporate finance

Chapter 2H) Credit and In>entor% Management

2H.1 Credit and ;ecei>a&les

Granting credit is ma&ing an investment in a customer 3 an investment tied to the sale of a product orservice. This stimulates sales. )owever:

- There is the chance that the customer will not pay- The firm has to bear the costs of carrying the receivables.

Therefore, the credit policy decision involves a trade-off between the benefits of increased sales andthe costs of granting credit.

-rade credit are receivables which include credit to other firms #when credit is granted.$'redit granted consumers are called consumer credit


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'omponents of 'redit olicy(f a firm decides to grant credit to customers, then it must establish procedures for extending creditand collecting. 'omponents of credit policy:

#9$ !erms of Sale: the terms of sale establish how the firm proposes to sell its goods andservices. A basic decision is whether the firm will require cash or will extend credit. (f the firm

does grant credit to a customer, the terms of sale will specify the credit period, the cashdiscount and discount period, and the type of credit instrument#8$ Credit anal%sis: in granting credit, a firm determines how much effort to expend trying to

distinguish between customers who will pay and the customers who will not pay. The firms usea number of devices and procedures to determine the probability that customers will not payPthese are called credit analysis

#>$ Collection polic%: after credit has been granted, the firm has the potential problem ofcollecting cash, for which it must establish a collection policy.

The 'ash 1lows from Hranting 'redit

The 'ash flow of Hranting 'reditne way to reduce the receivables period is to speed up the chec& mailing, processing, and clearing.

The (nvestment in %eceivablesThe investment in accounts receivable for any firm depends on the amount of credit sales and the

average collection period #A'$. Accounts receivable F average daily sales = A'Thus, a firm’s investment in accounts receivable depends on factors that influence credit sales andcollections.

2H.2 !erms of the Sale

The term of sale are made up of three distinct elements:#9$ The period for which credit is granted#8$ The cash discount and the discount period#>$ The type of credit instrument

The asic 1orm

Terms such as 8K9R, net CR mean

customers haveCR days from the invoice date to pay the fullamountP however, if payment is made within 9R days, a 8 percent cash discount can be ta&en.'redit terms are interpreted in the following way:

B ta&e this discount off the invoice priceSKBif you pay in this many daysSBelse pay the full invoice amount in this many daysS

The 'redit eriodCredit Period: The length of time for which credit is granted

(t varies from industry, however it is almost always between >R and 98R days. (f a cash discount is offered, then the credit period has two components: the net credit period

#length of time the customer has to pay$ and the cash discount period #the time during whichthe discount is available$

- In>oice dateThe invoice date is the beginning of the credit period.


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An in>oice is a bill for goods or serviced provided by the seller to the purchaser. (t is usuallythe shipping date or the billing date, not the date on which the buyer receives the goods or thebill.

The term of sale might be %H, receipt of goods. (n this case, the credit period starts whenthe customer receives the order.

*ith 7+ #end of the month$ dating, all sales made during a particular month are assumed to

be made at the end of the month. #++ is middle of the month$ !easonal dating is sometimes used to encourage sales of seasonal products during off-

season #e.g. suntan oil$

- -ength of the Credit Periodtwo important factors that influence the length of the credit period are the buyer&s inventory period andoperating cycle. The shorter these are, the shorter the credit period will be.

The operating cycle has two components: the ( and %. The buyers inventory period is the time it ta&es the buyer to acquire inventory, process it, and

sell it. #credit period we offer$ The buyers receivable period is the time it then ta&es the buyer to collect on sale. y extending credit, we finance a portion of our buyer’s operating cycle and thereby shorten

that buyer’s cash cycle. (f our credit period exceeds the buyer’s inventory period we also finance part of the buyers

receivables. The length of the buyer’s operating cycle is often cited as an appropriate upper limit to the

credit period.

;umber of factors that influence the credit period:#9$ *erishability and collateral value perishable items have relatively rapid turnover and relatively

low collateral value. 'redit terms are thus shorter for such goods.#8$ Consumer demand products that are well established generally have more rapid turnover.

;ewer or slow-moving products will often have longer credit periods associated with them toentice buyers. Also, sellers may choose to extend much longer credit periods for off-seasonsales.

#>$ Cost% profitability and standardi9ation relatively inexpensive goods tend to have shorter creditperiods. The same is true for relatively standardi"ed goods and raw materials. These al tendto have lower mar&ups, and higher turnover rates, both of which lead to shorter credit periods.#exception: Auto dealers$

#@$ Credit ris$ the greater the credit ris& of the buyer, the shorter the credit period is li&ely to be.#$ +i9e of the account if an account is small, the credit period may be shorter because small

accounts cost more to manage, and the customers are less important#C$ Competition when the seller is in a highly competitive mar&et, longer credit periods may be

offered as a way of attracting customers#D$ Customer type a single seller might offer different credit terms to different buyers. !ellers

often have both wholesale and retail customers, and they frequently quote different terms ofthe two types.

'ash 6iscountCash discount: a discount given to induce prompt payment. Also sales discount 6iscounts are offered to speed up the collection of receivables the effect of %educing the

amount of credit being offered, against the cost of the discount Another reason for discounts is that they are a way of charging higher prices to customers that

have had credit extended to them. # a convenient way of charging for the credit granted tocustomers$

- Cost of the CreditTo see why the discount is important we must calculate the cost to the buyer of not paying early.

#9$ *e must find the interest rate that the buyer is effectively paying for the trade credit.7.H. 8K9R net >R the order cost O9RRR

Then the interest rate is 8RKQERF 8.R@RE

)ow many period are there in a year F >CK8RF 9E.8The $; 5ffective Annual 8ate is:


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7A%F [email protected] 3 9 F @@.C.

- !rade =iscounts(s some circumstances, the discount is not really an incentive for early payment but is instead atrade discount a discount routinely given to some type of buyer

The credit period and discount period are effectively the same and there is no reward for

paying before the due date.

- !he Cash =iscount and the $CPTo the extent that a cash discount encourages customers to pay early, it will shorten the receivablesperiod and, all other things being equal, reduce the firm’s investment in receivables.

A' FAverage 'ollection eriod. ;ew A' F .. pays in .. days = .. 6ays G .. pays in .. days = ..6ays

7.H. R. = 9R days G R. = >R days F 8R 6ays

(f the firm’s annual sales are O9 million before discount O9 millionK>C F @9.RQC%eceivables will fall with @9.RQC = 9R F [email protected]

- Credit InstrumentsCredit instruments ? the evidence of indebtedness.

• pen account the only formal instrument of credit is the invoice, which is sent with theshipment of goods. The customer must sign as evidence that the goods have been received

• *romissory note a basic ( and might be used when the order is large, when there is nocash discount involved, or when the firm anticipates a problem in collections. They caneliminate possible controversies later about the existence of debt.

• Commercial draft calling the customer to pay a specific amount by a specified date #beforethe goods are delivered$

• +ight draft immediate payments are required• -ime draft immediate payments are not required• -rade acceptance when the draft is presenter and the buyers accept it #promise to pay in the

future$• /an$er&s acceptance if the ban& accepts the draft, meaning that the ban& is guaranteeing

payment

2H. $nal%zing Credit Polic%

Hranting credit ma&es sense only if the ;! from doing so is positive

'redit olicy 7ffects1ive basis factors to consider

#9$ 8evenue effects if the firm grants credit, then there will be a delay in revenue collections assome customers ta&e advantage of the credit offered and pay later. however, the firm may beable to charge a higher price if it grants credit and it may be able to increase the quantity sold.Total revenues may thus increase

#8$ Cost effects although the firm may experience delayed revenues if it grants credit, it will stillincur the costs of sales immediately. *hether the firm sells for cash or credit, it will still have toacquire or produce the merchandise #and pay for it$

#>$ -he cost of debt when the firm grants credit, it must arrange to finance the resultingreceivables. As a result, the firm’s cost of short-term borrowing is a factor in the decision togrant credit

#@$ -he probability of nonpayment if the firm grants credit, some percentage of the credit buyerswill not pay. This can happen, of course, if the firm sells for cash

#$ -ime cash account when the firm offers a cash discount as part of its credit terms, somecustomers will choose to pay early to ta&e advantage of the discount

7valuating a proposed 'redit olicy Frice per unitv F variable cost per unitL F current quantity sold per month


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The factor may have full responsibility for credit chec&ing, authori"ation, and collection.!maller firms may find such an arrangement cheaper than running a credit department.

Captive finance company A wholly owned subsidiarity that handles the credit function for the parent company (large firms do thisoften)

To separate the production and financing of the firm’s products for management, financing,and reporting. This may allow the firm to achieve a lower overall cost of debt than could beobtained if production and financing were commingled

2H.J In>entor% Management

oth credit policy and inventory policy are used to drive sales, and the two must be coordinated toensure that the process of acquiring inventory, selling it, and collecting on the sale proceeds smoothly.

nventory will often exceed 6? percent of assets.

The 1inancial +anager and (nventory olicy(nventory management has become an increasingly important specialty in its own right, and financialmanagement will often only have input into the decision.

(nventory Types1or a manufacturer, inventory is normally classified into one of three categories

- 8aw material what the firms uses as a starting point in its production process- Wor$,in,progress unfinished products. )ow big this portion of inventory is depends in large

part on the length of the production process- 4inished goods products ready to ship or sell

Ieep in mind three things concerning inventory types:#9$ The names for the different types can be a little misleading #one firms raw materials are

another firms finished goods.#8$ The various types of inventory can be quite different in terms of their liquidity #how easy to turn

into cash$#>$ The demand of inventory item that becomes a part of another item is usually termed derived

or dependent demand because the firm’s need for these inventory types depends on its needfor finished items. #opposite is independent)

(nventory costsCarrying costs represent all of the direct and opportunity cost of &eeping inventory on hand. Theseinclude:

#9$ !hortage and trac&ing costs#8$ (nsurance and taxes#>$ 2osses due to obsolescence, deterioration, or theft#@$ The opportunity cost of capital on the invested amount

-he sum of these costs can be ranging roughly from >= to E= percent of inventory value per year.

The other type of cost associated with inventory is shortage costs. These costs are associated withhaving inadequate inventory on hand.

• 8estoc$ing costs the cost of placing an order with suppliers or the costs of setting up aproduction run.

• Costs related to safety reserves opportunity losses such as lost sales and loss of customergoodwill that result from having inadequate inventory

A basic trade-off exists in inventory management because carrying costs increase with inventorylevels, whereas shortage or restoc&ing cost decline with inventory levels.

The basic goal of inventory management is to minimi"e the sum of these two costs.

2H.A In>entor% Management !echni/ues

The goal of inventory management is usually framed as cost minimi"ation.


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The A' Approach(t is a simple approach to inventory management in which the basic idea is to divide inventory intothree groups. The underlying rationale is that a small portion of inventory in terms of quantity mightrepresent a large portion in terms of inventory value.

The 7conomic rder Luantity +odel #7L$the 7L model is the best-&nown approach for explicitly establishing an optimal inventory level. (nventory carrying cost rise and restoc&ing costs decrease as inventory levels increase. +inimum cost point is at LX #figure 2H. page @@$ The total amount of inventory the firm needs in a given year is dictated by sales. Therefore,

the actual cost of inventory is not included.

- !he carr%ing costs'arrying cost are normally assumed to be directly proportional to inventory levels

Total carrying costs F average inventory = 'arrying cost per unitLK8 = ''

- !he Shortage costs

*e will assume that the firm never actually runs short on inventory, so that costs relating to safety arenot important

%estoc&ing costs are normally assumed to be fixed Total restoc&ing costs F fixed cost per order = number of orders

1 = #TKL$

- !he !otal Costs Total costs F 'arrying costs G %estoc&ing costs

#LK8$ = '' G 1 = #TKL$ur goal is to find the value L, the restoc&ing quantity, that minimi"es cost

'arrying costs F %estoc&ing costs#LXK8$ = '' F 1 = #TKLX$

LXU8 F #8T = 1$K''LX F Y#8T = 1$K''

5conomic rder :uantity (5:)

The restoc&ing quantity that minimi"es the total inventory costs.

7xtensions to the 7L modelThus far, we have assumed that a company will let its inventory run down to "ero and then reorder. (nreality, a company will wish to reorder before its inventory goes down to "ero for two reasons:

• y always having at least some inventory on hand, the firm minimi"es the ris& of a stoc& outand the resulting losses of sales and customers

• *hen a firm does reorder, there will be some time lag before the inventory arrives.

- Safet% Stoc's A safety stoc$ is the minimum level of inventory that a firm &eeps on hand. (nventories are reorderedwhenever the level of inventory falls to the safety stoc& level

- ;eorder PointsThe reorder points are the times at which the firm will actually place its inventory orders. This simplyoccur some fixed number of days before inventories are pro4ected to reach "ero.

!afety stoc&s and reorder points together results in a generali"ed 7L model in which thefirm orders in advance of anticipated needs and also &eeps a safety stoc& of inventory

+anaging 6erived-6emand (nventories6emand for some inventory types is derived from or dependent on other inventory needs.

+aterials required planning and 4ust-in-time inventory management are two methods formanaging demand-dependent inventories


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- Materials ;e/uired planning 0M;P3 A set of procedures used to determine inventory levels for demand-dependent inventory types such aswor&-in-progress and raw materials.

roduction and inventory specialists have developed computer-based systems #+%$ forordering andKor scheduling production of demand-dependent types of inventory

7specially important for complicated products for which a variety of components are neededto create the finished products

- Kustintime In>entor% 0KI!3 A system for managing demand-dependent inventories that minimi"es inventory holdings.

+inimi"e inventory +aximi"ing turnover (t requires a high degree of cooperation among suppliers 7ach large manufacturer tends to have its own $eiretsu Z(T systems are sometimes called $anban systems #$anban is a signal to a supplier to send

more inventory$ A Z(T system is an important part of a larger production planning process

corporate finance summary

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