fundamentals of corporate finance/3e,ch12

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Fundamentals of Corporate Finance 3eRoss, Thompson, Christensen, Westerfield and JordanSlides prepared by Sue Wright

12-1

Chapter Twelve

Current Investment Decisions


12-2

12.1 The Investments Involved

12.2 The Operating Cycle and the Cash Cycle

12.3 Some Aspects of Short-term Financial Policy

12.4 The Cash Budget

12.5 A Short-term Financial Plan

12.6 Summary and Conclusions

Chapter Organisation


12-3

Chapter Objectives

• Understand the components of the operating cycle and the cash cycle.

• Explain the key issues in a firm’s short-term financial policy.

• Understand and apply the inventory model.

• Prepare a cash budget.


12-4

Current Investment Decisions

• Involve the administration of the company’s current assets (cash and marketable securities, receivables and inventory), and the financing needed to support these assets.

• Problems in using discounted cash flow techniques to evaluate these decisions:

– identification of all relevant cash inflows and outflows– determining the size and timing of these cash flows– determining the correct discount rate.


12-5

Operating Cycle versus Cash Cycle

• Operating cycle—the time period between the acquisition of inventory and the collection of cash from receivables.Operating cycle = Inventory period + A/cs receivable period

• Cash cycle—the time period between the outlay of cash for purchases and the collection of cash from receivables.

Cash cycle = Operating cycle – A/cs payable period


12-6

Cash Flow Time Line

Accounts receivableperiod

Cashreceived

Time

Inventorysold

Inventorypurchased

Inventoryperiod

Accounts payable period

Cash paid for inventory

Operating cycle

Cash cycle


12-7

Example—Operating Cycle

The following information has been provided for Overcredit Co.:

Sales for the year were $510 000 (assume all credit) and the cost of goods sold was $350 000.

Calculate the operating cycle and cash cycle.


12-8

Example—Operating Cycle (continued)

days100times653

365

turnoverInventory

365periodInventory

times6532

00010200090000350

inventory Avg.

COGSturnoverInventory

.

.

a) Find the inventory period:


12-9


days 53.7 times6.8

365

t/osReceivable

365 period sReceivable

times6.8 2

000 78 000 72000 510

sreceivable Avg.

salesCredit t/osReceivable

b) Find the accounts receivable period:


12-10


days 153.7

53.7100

period sReceivableperiodInventory cycle Operating


12-11

Example—Cash Cycle

days254times736

365

turnoverPayables

365period Payables

times7362

0005500049000350

payables Avg.

COGS t/oPayables

. .

.

a) Find the payables period:


12-12

Example—Cash Cycle (continued)

days 99.5

54.2 153.7

period Payables cycle Operating cycleCash


12-13

Short-term Financial Policy

• Size of investments in current assets

-Flexible policy—maintain a high ratio of current assets to sales

-Restrictive policy—maintain a low ratio of current assets to sales

• Financing of current assets

- Flexible policy—less short-term debt and more long-term debt

- Restrictive policy—more short-term debt and less long-term debt


12-14

Short-term Financial Policy

• The size of the firm’s investment in current assets is determined by its short-term financial policies.

• Flexible policy actions include:– keeping large cash and securities balances– keeping large amounts of inventory– granting liberal credit terms.

• Restrictive policy actions include:– keeping low cash and securities balances– keeping small amounts of inventory– allowing few or no credit sales.


12-15

Costs of Investments

• Need to manage the trade-off between carrying costs and shortage costs.

• Carrying costs increase with the level of investment in current assets, and include the costs of maintaining economic value and opportunity costs.

• Shortage costs decrease with increases in the level of investment in current assets, and include trading costs and the costs related to being short of the current asset. For example, sales lost as a result of a shortage of finished goods inventory.


12-16

Carrying Costs and Shortage Costs


12-17



12-18



12-19

The Inventory Model

YA/C

C X/2 A Y/X YP TC

2EOQ

The economic quantity (EOQ) is the optimal quantity of inventory ordered that minimises the costs of purchasing and holding the inventory.

Where TC = total cost X = order size

EOQ = economic order qty A = acquisition costs

Y = total demand C = carrying costs

P = price per unit


12-20

Example—EOQ

Smile Camera Shop sells 10 000 rolls of film per year, each with a wholesale price of $3.20. The cost of processing each order placed is $10.00 and carrying costs are 20 cents per roll per year. Calculate the EOQ.

rolls 1000

$0.20

$10.00000 102

2EOQ

YA/C


12-21

EOQ Example With Quantity Discounts

Smile Camera Shop is offered a 2-cent-per-roll discount if 2000–3500 rolls of film are ordered, and a 3-cent-per-roll discount if more than 3500 rolls are ordered at a time. Determine the optimal order quantity.


12-22

EOQ Example With Quantity Discounts (continued)

080 $32

$0.20 500/2 3 $10 500 000/3 10 $3.17 000 10 units 500 3

050 $32

$0.20 000/2 2 $10 000 000/2 10 $3.18 000 10 units 000 2

200 $32

$0.20 000/2 1 $10 000 000/1 10 $3.20 000 10 units 000 1

Calculate the total cost for each quantity:

Smile Camera Shop would be better off purchasing in lots of 2000 to reduce the total cost.


12-23

Inventory Management Under Uncertainty

• Inventory management requires two decisions:– quantity to be ordered– reorder point

• Safety stock is the additional inventory held when demand is uncertain so as to reduce the probability of a stock out.

• Reorder point takes into account the lead time from placement of an order to receipt of the goods.


12-24

EOQ Example Under Uncertainty

Smile Camera Shop’s EOQ (with quantity discounts)

is 2000 rolls of film and five orders are placed each

year. Determine the reorder point if it takes 30 days

to fill an order, a safety stock of 100 is desired and

daily usage is 30 rolls.


12-25

Qty

2 100

1 000

100

Time

Reorder

points

EOQ Example Under Uncertainty

Safety stock

Reorder point


12-26

Cash Budget

• Forecast of cash receipts and disbursements over the next short-term planning period.

• Primary tool in short-term financial planning.• Helps determine when the firm should experience

cash surpluses and when it will need to borrow to cover working-capital costs.

• Allows a company to plan ahead and begin the search for financing before the money is actually needed.


12-27

Example—Cash Budget

• Projected sales for the first six months of 2004:

Jan. $130 000 Apr. $140 000

Feb. $125 000 May $155 000

Mar. $145 000 Jun. $145 000

• Analysis of collection of accounts receivable:– collected in month of sale 20%– collected in month following sale 60%– collected in second month following sale20%

• Actual sales for November and December were $125 000 and $120 000 respectively.


12-28

Example—Cash Budget (continued)

• Wages and other expenses are 30 per cent of total monthly sales.

• Purchases are 50 per cent of the month’s estimated sales, all paid for in the month of purchase.

• Monthly interest payments are $15 000 (interest rate is 1.5 per cent per month).

• An annual dividend of $60 000 is payable in March.• The beginning cash balance is $30 000.• The minimum cash balance is $20 000.


12-29

Cash Collections


12-30

Cash Disbursements


12-31

Cash Budget


12-32

Short-term Financial Planning

fundamentals of corporate finance/3e,ch12

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