PRINCIPLES  OF  WORKING  CAPITAL  MANAGEMENT  

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Contents  •  Meaning  &  need  for  inves/ng  in  current  assets  •  Gross  working  Capital  and  Net  Working  Capital  •  Concept  of  opera/ng  cycle  &  its  rela/on  to  Working  capital  •  Working  capital  financing  

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Introduc;on  

•  Tradi/onally,  working  capital  has  been  defined  as  the  firm’s  investment  in  current  assets.  Current  assets  are  required  for  day-­‐to-­‐day  opera/ons  of  the  firm.  

•  The  assets  keep  changing  from  one  form  to  another  from  viz.  Stocks,  Receivables  and  Cash.  

•  Working  capital  decisions  are  very  important  as  they  affect  the  liquidity  of  the  business.  

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Features  of  Working  capital  decisions  

•  Working  capital  decisions  are  typically  •  Short-­‐term  financial  decisions,  i.e.,  working  capital  decisions  typically  affect  the  cash  flows  of  the  firm  for  a  shorter  /me  frame,  extending  normally  up  to  a  maximum  of  one  year  

•  The  concepts  of  risk  and  3me  value  of  money  are  less  per0nent  to  working  capital  decision-­‐making  

•  They  are  modified  from  3me  to  3me  unlike  capital  budge/ng  decisions,  which  are  one-­‐/me  and  irreversible  

•  Concept  of  working  capital  is  dynamic  as  market  condi/ons  with  respect  to  credit,  stocking  etc.  change  more  frequently  

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Concepts  of  Working  Capital    

Gross  working  capital  (GWC)    

•  GWC  refers  to  the  firm’s  total  investment  in  current  assets  

•  Current  assets  are  the  assets  which  can  be  converted  into  cash  within  an  accoun/ng  year   (or  opera/ng  cycle)  and   include  cash,  debtors,   (accounts  receivable  or  book  debts)  bills  receivable  and  stock  (inventory).  

•  It  is  termed  as  managers’  concept  of  working  capital.  

•  It   denotes   the   liquidity   posi/on  of   the  firm.  Other   factors   remaining   the  same,  the  higher  the  GWC  of  a  firm,  the  bePer  its  liquidity  posi/on.    

•  Increasing  GWC  affects  profitability  adversely  as  more  funds  get  /ed  up  in  current  assets  that  have  low/zero  yield.  

1. Gross Working Capital (GWC) 2. Net Working Capital (NWC)

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Concepts  of  Working  Capital  

Net  working  capital  (NWC)  •  NWC   refers   to   the   difference   between   current   assets   and  

current  liabili/es.    •  Current  liabili/es  (CL)  are  those  claims  of  outsiders  which  are  

expected   to  mature   for   payment   within   an   accoun/ng   year  and   include   creditors   (accounts   payable),   bills   payable,   and  outstanding  expenses.    

•  NWC  can  be  posi/ve  or  nega/ve.      •  Posi/ve  NWC  =  CA  >  CL  •  Nega/ve  NWC  =  CA  <  CL  

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Factors  influencing  Working  Capital  decisions  

Time  –  Opera/ng  &  

Cash  conversion  Cycle  

Working  Capital  Policy  

of  the  company    

Ac/vity-­‐    Units  produced  /  Sold  /  held  &  Costs  

Current  assets  to  total  assets  ra;o  for  different  industries  

 Industries     Current  assets  to  total  assets  (%)    

IT   80-­‐85  

Trading   75–80  

Pharma   65–70    

Engineering   60–65    

Metals     45–50    

Paper   40–45  

Shipping     15–20    

Nature  of  business  

Manufacturing  policy   Credit  policy   Opera/ng  efficiency   Infla/on  

Market  &  demand   Technology  

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Opera;ng  Cycle  

Opera/ng  cycle  is  the  /me  dura/on  required  to  convert  1.  resources  into  inventories    2.  inventories  into  sales  (either  cash  or  credit  sales)  3.  Credit  sales  into  cash.      

The  opera/ng  cycle  of  a  manufacturing  company  involves  following  phases:  1.   Acquisi;on  of  resources  such  as  raw  material,  labour,  power  and  fuel  etc.  2.   Manufacture  of  the  product  which  includes  conversion  of  raw  material  into  

work-­‐in-­‐progress  into  finished  goods.  3.   Sale  of  the  product  either  for  cash  or  on  credit.  Credit  sales  create  account  

receivable  for  collec/on.  

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Opera;ng  cycle  The  length  of  the  opera/ng  cycle  of  a  manufacturing  firm  is  the  sum  of:  

•  Inventory  conversion  period  (ICP).  •  Debtors  (Account  receivable)  conversion  period  (DCP).    

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Gross  Opera;ng  Cycle  (GOC)  

•  The   firm’s   gross   opera/ng   cycle   (GOC)   can   be  determined   as   inventory   conversion   period   (ICP)  plus  debtors  conversion  period  (DCP).  Thus,  GOC  is  given  as  follows:  

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Inventory  conversion  period  (ICP)  

Inventory  conversion  period  is  the  total  /me  needed  for  producing  and  selling  the  product.  Typically,  it  includes:  

RMCP =RawmaterialInventoryX360

Rawmaterialconsumed

WIPCP = Work − In− processInventoryX360Costof production

FGCP = FinishedGoodsInventoryX360Costof goodssold

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Debtors  (receivables)  conversion  period  (DCP)  

•  Debtors  conversion  period  (DCP)   is   the  average  /me   taken   to   convert   debtors   into   cash.   DCP  represents   the   average   collec/on   period.   It   is  calculated  as  follows:  

Debtors Conversion Period (DCP) = Sundry DebtorsX360AnnualCredit Sales

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Creditors  (payables)  deferral  period  (CDP)  

•  Creditors(payables)  deferral  period   (CDP)   is   the  average   /me   taken   by   the   firm   in   paying   its  suppliers  (creditors).  CDP  is  given  as  follows:  

Creditors Deferral Period (CDP) = SundryCreditorsX360AnnualCredit Purchases

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Cash Conversion or Net Operating Cycle

•  Net   opera/ng   cycle   (NOC)   is   the   difference   between  gross  opera/ng  cycle  and  payables  deferral  period.  

•  Net   opera/ng   cycle   is   also   referred   to   as   cash  conversion  cycle.  

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Operating & Cash conversion cycle Example: Following information has been extracted from the financial statement of a manufacturing firm. Compute the operating cycle for the firm assuming that the information given is for one full year period

(figures  in  Rs.  Crore)  

Average  Creditors  outstanding   15  

Raw  material  purchases   90  

Average  debtors  outstanding   6  

Raw  material  consumed   60  

Cost  of  produc/on   145  

Cost  of  goods  sold   157.5  

Sales   200  

Inventory  of  raw  material   5.75  

Work  –  in  -­‐  progress   6.75  

Finished  goods   4.80  

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Solu;on:  

a)  RMCP  =    Raw  material  Inventory  X  360  

 Raw  material  consumed  

5.75    X  360    60  

=  34.50  days  

b)  WIPCP  =   WIP  Inventory  X  360    

Cost  of  produc;on  

6.75  X  360    

145  =  16.76  days  

c)  FGCP  =     Finished  goods  Inventory  X  360    

Cost  of  Goods  Sold  

4.80  X  360    

157.50  =  10.97  days  

d)  DCP  =   Ave.  Sundry  Debtors  X  360    

Credit  sales  

6  X  360    

200  =  10.80  days  

Gross  Opera;ng  Cycle   =  73.03  days  

e)  CDF  =   Ave.  Sundry  Creditors  X  360    

Credit  purchases  

15  X  360    90  

=  60  days  

Net  Opera;ng  Cycle  or  Cash  Conversion  Cycle   =  13.03  days  

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Cash conversion cycle of some companies Company   Industry   DCP  

(days)  ICP  

(days)  CDP  (days)  

CCC  or  NOC  

ACC  (  2007)   Cement   15.35   50.65   99.39   -­‐33.39  

Ambuja  Cements  (2007)   Cement   9.50   61.63   93.25   -­‐22.12  

Tata  Motors  (2008)   Auto   14.47   36.76   70.36   -­‐19.13  

Ashok  Leyland  (2008)   Auto   17.32   61.93   65.41   13.84  

Wipro  (2008)   Comp.  Sojware   75.37   12.14   0.00   87.51  

TCS  (2008)   Comp.  Sojware   73.78   0.47   34.15   40.10  

Infosys  (2008)   Comp.  Sojware   72.15   0.00   13.97   58.18  

HUL  (2008)   Personal  care   11.83   79.29   116.83   -­‐25.71  

Colgate  (2008)   Personal  care   2.27   23.91   88.81   -­‐62.63  

SAIL  (2008)   Steel   27.98   87.80   37.23   78.55  

Tata  Steel  (2008)   Steel   10.09   87.98   109.54   -­‐11.47  

Source: FM text book by Jonathan Berk

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Es;ma;ng  Working  capital  

•  Current  assets  holding  period    •  To   es/mate   working   capital   requirements   on   the   basis   of   average  

holding  period  of  current  assets  and  rela/ng  them  to  costs  based  on  the   company’s   experience   in   the   previous   years.   This   method   is  essen/ally  based  on  the  opera/ng  cycle  concept.  

•  Ra3o  of  sales    •  To  es/mate  working  capital   requirements  as  a   ra/o  of   sales  on   the  

assump/on  that  current  assets  change  with  sales.  •  Ra3o  of  fixed  investment    

•  To  es/mate  working  capital   requirements  as  a  percentage  of  fixed  investment.  

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Permanent  and  variable  Working  capital  

•  Permanent   or   fixed   working  capital  •  A   minimum   level   of   current  assets,  which   is   con/nuously  required  by  a  firm  to  carry  on  its   business   opera/ons,   is  referred   to   as   permanent   or  fixed  working  capital.  

•  F luc tua;ng   o r   var i ab le  working  capital    •  The   extra   working   capital  needed   to   support   the  changing   produc/on   and  sales   ac/vi/es   of   the   firm   is  referred   to   as   fluctua/ng   or  variable  working  capital.    

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Key  decisions  in  Working  Capital  Management  

•  Current  Assets  to  Fixed  Assets  Ra;o    •  Liquidity  vs.  Profitability:  Risk–Return  Trade-­‐off    •  The  Cost  Trade-­‐off    

Alterna3ve  current  asset  policies   Cost  Trade-­‐off  

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Working  Capital  Finance  Policies  

•  The  working  capital  financing  policy  may  have  a  significant  impact  on  the  profitability–liquidity  posi/on  of  the  firm.    These  policies  could  be    •  Long  term  •  Short  term  •  Spontaneous  

•  Theore/cally,  the  policies  of  working  capital  financing  can  be  categorized  as:      •  Matching  •  Conserva/ve  •  Aggressive  

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Matching   Aggressive   Conserva;ve  

Long  term  finances   Rs.  100  Cr   Rs.  85  Cr   Rs  115  Cr  

Poten/al  Short  term  finances  

Rs.  15  Cr   Rs.  30  Cr  

Nil.  However,  any  requirement  over  and  above  Rs  115  cr  will  

need  short  term  funding  

Working  Capital  Finance  Policies  Expected  Financing  requirement:  -­‐  Permanent  long  term  requirement:  Rs  100  crores  (  Fixed  &  Current  asset)  -­‐  Expected  fluctua/on  +  or  –  15%  -  To use combination of long term and short term finances  

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Matching  financing  plan  

Conserva3ve  financing  plan  

Aggressive  financing  plan  

Short  term   Long  term  

Cost  advantage   Less  risky  

Flexibility   Long  process  

Liquid  but  risky   Predictability  

Short vs. Long term finances

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Case  Study  Strong  Cement  Company  Ltd  has  an  installed  capacity  of  producing  1.25  lakh  tons  of  cement   per   annum;   its   present   capacity   u;lisa;on   is   80   per   cent.   The   major   raw  material   to  manufacture  cement   is   limestone  which   is  obtained  from  the  company's  own  mechanised  mine  located  near  the  plant.  The  company  produces  cement  in  200  kg  bags.  From  the  informa;on  given  below,  determine  the  net  working  capital  (NWC)  requirement  of  the  company  for  the  current  year.  

Cost  structure  per  bag  of  cement  (es;mated)      Gypsum      Limestone      Coal      Packing  material      Direct  labour      Factory  overheads  (including  deprecia;on  of  Rs  10)      Administra;ve  overheads      Selling  overheads  Total  cost      Profit  margin    Selling  price          Add:  Sale  tax  (10  per  cent  of  selling  price)    Invoice  price  to  consumers  

Rs  25  15  30  10  50  30  20      25  205      45  250      25  275  

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Addi;onal  informa;on:  

1)  Desired   holding   period   of   raw  materials:   Gypsum   -­‐   3months;   Limestone   -­‐  1month;  Coal  -­‐  2.5  months  and  Packing  material  -­‐  1.5  months  

2)  The   product   is   in   process   for   a   period   of   0.5  month   (assume   full   units   of  materials,  namely  gypsum  limestone  and  coal  are  required  in  the  beginning;  other  conversion  costs  are  to  be  taken  at  50  per  cent).  

3)  Finished  goods  are  in  stock  for  a  period  of  1  month  before  they  are  sold.  4)  Debtors  are  extended  credit  for  a  period  3  months.  5)  Average  ;me   lag   in  payment  of  wages   is   approximately   0.5  month  and  of  

overheads,  1  month.  6)  Average  ;me  lag  in  payment  of  sales  tax  is  1.5  months.  7)  The  credit  period  extended  by  various  suppliers  are:          Gypsum  -­‐  2  months;  Coal  -­‐  1  month  and  Packing  material  -­‐  0.5  month  

1)  Minimum  desired  cash  balance  is  Rs.  25  lakh.  

   

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SOLUTION  

Statement  showing  determina;on  of  net  working  capital  of  Strong  Cement  Company  Ltd  

Current  assets:      Minimum  desired  cash  balance      Raw  materials:      Gypsum  (5  lakh  bags*  ×  Rs  25  ×  3/12)      Limestone  (5  lakh  bags*  ×  Rs  15  ×  1/12)      Coal  (5  lakh  bags  ×  Rs  30  ×  2.5/12)      Packing  material  (5  lakh  bags  ×  Rs  10  ×  1.5/12)      Work-­‐in-­‐process:  (5  lakh  bags  ×  Rs  105  ×  0.5/12)              —  Raw  material  cost  100  per  cent  (Rs  25  +  Rs  15  +  Rs  30)              —  Other  conversion  costs  (Rs  50  +  Rs  20  cash  factory                          overheads)  ×  0.5        Finished  goods  (5  lakh  bags  ×  Rs  170**  ×  1/12)      Debtors  (5  lakh  bags  ×  Rs  220**  ×  3/12)  Total  

               

Rs  70    

   35  105  

 Rs  25,00,000  

 31,25,000  6,25,000  31,25,000  6,25,000  21,87,500  

       

70,83,333  2,75,00,000  4,67,70,833  

 

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Current  liabili;es:      Creditors:      Gypsum  (5  lakh  bags  ×  Rs  25  ×  2/12)      Coal  (5  lakh  bags  ×  Rs  30  ×  1/12)      Packing  material  (5  lakh  bags  ×  Rs  10  ×  1/24)      Wages  (5  lakh  bags  ×  Rs  50  ×  1/24)      Overheads  (5  lakh  bags  ×  Rs  65  ×  1/12)      Sales  tax  (5  lakh  bags  ×  Rs  25  ×  1.5/12)  Total  NWC  

             

   

20,83,333  12,50,000  2,08,333  10,41,667  27,08,333  

     15,62,500        88,54,166  3,79,16,667  

*1.25  lakh  tons  ×  0.8  =  1  lakh  ton/200  kgs  =  5,00,000  bags  **(Total  cost,  Rs  205  –  Deprecia;on,  Rs  10  –  selling  overheads,  Rs  25)  ***(Cash  cost,  Rs  195  +  sale  tax,  Rs  25)  

RECEIVABLES  MANAGEMENT  

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LEARNING  OBJECTIVES  

•  Establishing  a  sound  credit  policy  •  Op/mum  credit  policy  •  Explain  the  credit  policy  variables  •  The  nature  and  costs  /  benefits  of  factoring  

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INTRODUCTION  •  Trade  credit  happens  when  a  firm  sells   its  products  or  services   on   credit   and   does   not   receive   cash  immediately  

•  Impact  of  Credit  sale  •  Increase  in  sales  -­‐  Marke/ng  tool  •  Maximisa/on  of  sales  Vs.  incremental  profit  

•  produc/on  and  selling  costs  •  administra/on  costs  •  bad-­‐debt  losses  

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Purpose  &  features  of  Credit  Policy  •  Purpose  of  Credit  policy  is  to  determine  

•  Investment  in  receivables  to  op;mise  returns,  which  includes  •  volume  of  credit  sales,  collec/on  period,  type  of  customer…  

•  Features  Credit  policy  •  Credit  standards:    

•  Basis  &  type  of  corpora/ons  to  whom  credit  will  be  allowed  •  Credit  sales  as  a  %  of  total  sales  •  Average  days  of  credit  •  Maximum  amount  of  exposure  to  a  single  customer  /client  …  80-­‐20  principle  

•  Credit  terms:  •  Credit  terms  for  specific  customers  

•  Collec/on  efforts:  •  Process  for  collec/on  •  Provisioning  policy  for  aged  debts  

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Op;mum  Credit  Policy  

Credit  policy  aims  at  maximising  the  value  of  the  firm.  Credit  policy  is  op/mum  when,  IRR  =  RRR  Steps  in  achieving  op/mum  credit  policy  are:  •  Es/ma/on  of  incremental  profit  (  contribu/on)  •  Es/ma/on  of  incremental  investment  in  receivable  •  Es/ma/on  of  incremental  rate  of  return  (IRR)    •  Comparison  of  incremental  rate  of  return  with  required  rate  of  

return  (RRR)  

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Illustration: Delta Company has current sales of Rs 30 Crore (or 3000 lakh). To increase the sales, the company is considering a more liberal credit policy. The current average collection period of the company is 25 days. If the collection period is extended, sales increase in the following manner.

Credit  policy  

Increase  in  collec;on  period  

Increase  in  sales  

X   15  days   Rs.  12  lakh  Y   25  days   Rs.  27  lakh  Z   35  days   Rs.  47  lakh  

The company is selling its product at Rs 10 each. Average cost per unit at the current level is Rs 8 and variable cost per unit Rs 6. If the company required a return of 12 per cent on its investment. Which credit policy is desirable?

Cost  calcula3ons:      Average  cost  (Rs)   8  Unit  variable  cost  (Rs)   6  Price  (Rs)   10  Total  cost  of  sales  (Rs  lakh)   2,400  Total  variable  cost  (Rs  lakh)   1,800  Total  fixed  cost  (Rs  lakh)   600  

Solution: Need to find out a)  Incremental investment in Receivables b)  Incremental rate of return (contribution /

Incremental investment In AR)

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    Current     Policy   Policy   Policy       policy   X   Y   Z  

Exis/ng  Credit  period   25   25   25   25  

Add:  Change  to  the  exis;ng  credit  period  (days)   15   25   35  

A.  New  Credit  period  (days)   25   40   50   60  

B.  Annual  sales  (Rs  lakh)   3,000   3,012   3,027   3,047  C.  Inc.  sales  (Rs  lakh),  [B  -­‐  3,000]   -­‐   12   27   47  

D.  Inc.  contribu;on  (Rs  lakh),  [C  x  (10-­‐6)/10]   -­‐   4.8   10.8  

E.  Cost  of  sales    (Rs  lakh),  [B/10  x  6  +  600]   2,400   2,407   2,416   2,428  

F.  Investment  in  receivables  at  cost  (Rs  lakh),              [E/360  x  A]   167   267   336   405  

G.  Inc.  receivable  invt.  at  cost  (Rs  lakh),  [F  -­‐  167]   -­‐   100   168   238  

H.  Incremental  rate  of  return  (%),  [D/G]   -­‐   4.8%   6.4%   7.9%  I.      Required  rate  of  return  (%)   -­‐   12%   12%   12%  

Conclusion: The revised credit policy would be acceptable if the IRR = or > RRR.

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    Current     Policy   Policy   Policy       policy   X   Y   Z  

Exis/ng  Credit  period   25   25   25   25  

Add:  Change  to  the  exis;ng  credit  period  (days)   15   25   35  

A.  New  Credit  period  (days)   25   40   50   60  

B.  Annual  sales  (Rs  lakh)   3,000   3,012   3,027   3,047  C.  Inc.  sales  (Rs  lakh),  [B  -­‐  3,000]   -­‐   12   27   47  

D.  Inc.  contribu;on  (Rs  lakh),  [C  x  (10-­‐6)/10]   -­‐   4.8   10.8   18.8  

E.  Cost  of  sales    (Rs  lakh),  [B/10  x  6  +  600]   2,400   2,407   2,416   2,428  

F.  Investment  in  receivables  at  cost  (Rs  lakh),              [E/360  x  A]   167   267   336   405  

G.  Inc.  receivable  invt.  at  cost  (Rs  lakh),  [F  -­‐  167]   -­‐   100   168   238  

H.  Incremental  rate  of  return  (%),  [D/G]   -­‐   4.8%   6.4%   7.9%  I.      Required  rate  of  return  (%)   -­‐   12%   12%   12%  

Conclusion: The revised credit policy would be acceptable if the IRR = or > RRR.

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Factoring  •  Factoring  can  be  defined  as  ‘a  contract  between  the  suppliers  of  goods/services  and  the  ‘Factor’.  Under  this  contract  the  Factor  takes  over  (  or  ‘buys’)  the  debtors  of  the  suppliers.  The  main  feature  of  Factoring  are:  •  Factor  performs  a  few  or  all  of  the  following  func/ons  

•  Finance  the  supplier,  including  loans  and  advance  payments  

•  Maintenance  of  receivables  accounts  of  the  supplier  

•  Collec/on  of  receivables  which  he  has  taken  over  

•  Protec/on  against  default  in  payment  by  debtors  

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Factoring  and  Bills  Discoun;ng  

1.  Bills   discoun/ng   is   a   sort   of   borrowing   while   factoring   is   the  efficient  and  specialized  management  of  book  debts  along  with  enhancement  of  the  client’s  liquidity.  

2.  The   client   has   to   undertake   the   collec/on   of   book   debt.   Bill  discoun/ng  is  always  ‘with  recourse’,  and  as  such,  the  client  is  not  protected  from  bad-­‐debts.  

3.  Bills   discoun/ng   is   not   a   convenient   method   for   companies  having   large   number   of   buyers  with   small   amounts   since   it   is  quite  inconvenient  to  draw  a  large  number  of  bills.  

38

Types  of  Factoring  

•  Full  service  non-­‐recourse  •  Full  service  recourse  factoring  •  Bulk/agency  factoring  •  Non-­‐no/fica/on  factoring  

39

Benefits  of  Factoring  

•  Factoring   provides   specialized   service   in   credit  management,   and   thus,   helps   the   firm’s  management   to   concentrate   on   i ts   core  competencies  viz.  manufacturing  and  marke/ng.  

•  Factoring   helps   the   firm   to   save   cost   of   credit  administra/on   due   to   the   scale   of   economics   and  specializa/on.  

CASH  MANAGEMENT  

Contents  

•  Need  for  cash  management  •  Cash  planning  -­‐  budgets  &  Forecasts  

41

Cash  Management  

•  Cash  management  is  concerned  with  the  managing  of:  •  cash  flows  into  and  out  of  the  firm,  •  cash  flows  within  the  firm,  and  •  Financing  deficit  or  inves/ng  surplus  cash  

42

Facets  of  Cash  Management  

•  Cash  planning      •  Op/mum  cash  level      •  Inves/ng  surplus  cash    

43

Cash  Planning  

•  Cash  planning  is  a  technique  to  plan  and  control  the  use  of  cash.      

•  Cash  Forecas0ng  and  Budge0ng  •  Cash  budget  is  the  most  significant  device  to  plan  for  and  control  cash  receipts  and  payments.  

•  Cash  forecasts  are  needed  to  prepare  cash  budgets.  

44

Short  term  Cash  Forecasts  

•  The  important  func/ons  of  short-­‐term  cash  forecasts  •  To  determine  opera/ng  cash  requirements  

•  To  an/cipate  short-­‐term  financing  

•  To  manage  investment  of  surplus  cash.  

•  Short-­‐term  Forecas/ng  Methods  •  The  receipt  and  disbursements  method  

•  The  adjusted  net  income  method  

45

Long-­‐term  Cash  Forecas;ng  

•  The  major  uses  of  the  long-­‐term  cash  forecasts  are:  •  It   indicates   as   company’s   future   financial   needs,   especially   for   its  

working  capital  requirements.  

•  It   helps   to   evaluate   proposed   capital   projects.   It   pinpoints   the   cash  required  to  finance  these  projects  as  well  as  the  cash  to  be  generated  by  the  company  to  support  them.  

•  It   helps   to   improve   corporate   planning.   Long-­‐term   cash   forecasts  compel   each   division   to   plan   for   future   and   to   formulate   projects  carefully.  

46

Op;mum  Cash  Balance  

• Op/mum  Cash  Balance  under  Certainty:  Baumol’s  Model  

• Op/mum  Cash  Balance  under  Uncertainty:  The  Miller–Orr  Model  

47

Baumol’s  Model–Assump;ons:  

•  The   firm   is   able   to   forecast   its   cash   needs   with  certainty.  

•  The   firm’s   cash   payments   occur   uniformly   over   a  period  of  /me.  

•  From  1  and  2  therefore,  firm  knows  how  much  of  cash  it  has  to  hold  at  any  one  point  of  /me.  

•  The  opportunity  cost  of  holding  cash   is  known  and   it  does  not  change  over  /me.  

•  The   firm   will   incur   the   same   transac/on   cost  whenever  it  converts  securi/es  to  cash.  

48

Baumol’s  Model  •  The   firm   incurs   a   holding   cost   for   keeping   the   cash   balance.   It   is   an  

opportunity   cost;   that   is,   the   return   foregone   on   the   marketable  securi/es.   If   the   opportunity   cost   is   k,   then   the   firm’s   holding   cost   for  maintaining  an  average  cash  balance  is  as  follows:  

•  The  firm  incurs  a  conversion  or  transac;on  cost  whenever  it  converts  its  marketable   securi/es   to   cash.   Total   number   of   transac/ons   during   the  year  will   be   total   funds   requirement,  T,   divided   by   the   cash   balance,  C,  i.e.,   T/C.   The   per   transac/on   cost   is   assumed   to   be   constant.   If   per  transac/on  cost  is  c,  then  the  total  transac/on  cost  will  be:  

•  The  total  annual  cost  of  the  demand  for  cash  will  be:      

•  The   op/mum   cash   balance,   C*,   is   obtained   when   the   total   cost   is  minimum.  The  formula  for  the  op/mum  cash  balance  is  as  follows:  

Holding cost = ( / 2)k C

Transaction cost = ( / )c T C

* 2cTCk

=

Total cost = ( / 2) ( / )k C c T C+

49

Illustra;on:  Baumol’s  Model  ABC  limited  es/mates  its  total  cash  requirement  as  Rs  20  cr.  next  year.  The  company’s  opportunity  cost  of  funds  is  16%  per  annum.  The  company  will  have  to  incur  Rs  150  per  transac/on  when  it  converts  its  short-­‐term  securi/es  to  cash.  Determine  the  op/mum  cash  balance.  How  much  is  the  total  annual  cost  of  the  demand  for  the  op/mum  cash  balance?  How  many  deposits  will  have  to  be  made  during  the  year?  

Given,  T  =  total  cash  requirement  for  the  yr  =  Rs  20  cr  C=  cost  of  conversion  =  Rs  150  per  transac/on  k  =  Holding  cost  =  16%  per  annum  Therefore,  the  op/mum  cash  balance  C*  =  

* 2cTCk

=

C *= 2(150)(200000000)0.16

C*= 2(150)(200000000)0.16

C*= 612,372

Total  Cost  =  Rs  97980  made  up  of    a.  Cost  of  conversion  =  T  /  C*  X  ‘c’  =  20,00,00,000  /  612372  X  150  =  Rs.  48990    b.  Holding  cost  =  (C*  /  2)  X  k  =  612372/2  X  0.16  =  Rs  48990      

50

The  Miller–Orr  Model  

•  The  MO  model  provides  for    •  two   control   limits–the   upper   control   limit   and   the   lower   control  

limit    •  a  return  point  

•  If  the  firm’s  cash  flows  fluctuate  randomly  and  hit  the  upper  limit,   then   it   buys   sufficient   marketable   securi/es   to   come  back  to  a  normal  level  of  cash  balance  (the  return  point).  

•  Similarly,   when   the   firm’s   cash   flows   hit   the   lower   limit,   it  sells  sufficient  marketable  securi/es  to  bring  the  cash  balance  back  to  the  normal  level  (the  return  point).  

51

Miller-Orr model 52

The  Miller-­‐Orr  Model  •  The  difference  between  the  upper  limit  and  the  lower  limit  depends  on  the  following  factors:  •    the  transac/on  cost  (c)  •    the  interest  rate,  (i)    •    the  standard  devia/on  (s)  of  net  cash  flows.  

•  The  formula  for  determining  the  distance  between  upper  and  lower  control  limits  (called  Z)  is  as  follows:  

1/ 3(Upper Limit – Lower Limit) = (3/ 4 × Transaction Cost × Cash Flow Variance / Interest Rate) Upper Limit = Lower Limit + 3 Return Point = Lower Limit + The net effect is that the firms hold the average the cash balance equal to: Average C

ZZ

ash Balance = Lower Limit + 4/3Z

53

54

Illustra;on:  Miller  -­‐Orr  Model  XYZ  company  has  a  policy  of  maintaining  a  minimum  cash  balance  of  Rs  50  lakh.  The  standard  devia/on  of  the  company’s  daily  cash  flows  is  Rs  20  lakh.  The  annual  interest  rate  is  15  per  cent.  The  transac/on  cost  of  buying  and  selling  securi/es  is  Rs  150  per  transac/on.  Determine  XYZ’s  upper  control  limit,  return  point  and  average  cash  balance  as  per  the  Miller-­‐Orr  model.  Solu/on:  Upper  Control  Limit  =  Lower  limit  +  3Z  Data  given  Lower  limit  =  Rs  50  lakh  3Z  =  to  be  found  out  Z  =  difference  (in  Rs  or  $)  between  upper  control  limit  and  lower  control  limit    Formula  to  find  out  Z          Upper  limit  =  50,00,000+(3  X  10,30,714)  =  Rs  80,92,141    Return  point  =  Lower  limit  +  z  =  50,00,000  +  10,30,714  =  Rs  60,30,714  Average  cash  balance  =  Lower  limit  +  4/3  Z  =  50,00,000  +  (4/3  X  10,30,714)  

                   =  63,74,285  

= (3 / 4 X Transaction Cost X Cash Flow Variance / Interest Rate)1/3

= [3/4 X 150 X 20,00,0002 / (0.15 /365)]1/3

= 10,30,714

Inves;ng  surplus  cash  in  Marketable  securi;es  

•  Selec/ng  Investment  Opportuni/es:  •  Safety  •  Time  to  maturity  •  Marketability  

55

Short-­‐term  Investment  Opportuni;es:  

•  Treasury  bills    •  Commercial  papers    •  Cer/ficates  of  deposits    •  Bank  deposits    •  Inter-­‐corporate  deposits    •  Money  market  mutual  funds  

56

Appendix  

57

Features  of  Instruments  of  Collec;on  in  India  

58

Clearing  

•  The  clearing  process  refers  to  the  exchange  by  banks  of  instruments  drawn  on  them,  through  a  clearinghouse.    

•  Instruments  like  cheques,  demand  drajs,  interest  and  dividend  warrants  and  refund  orders  can  go  through  clearing.    

•  Documentary  bills,  or  promissory  notes  do  not  go  through  clearing.  

•  The  clearing  process  has  been  highly  automated  in  a  number  of  countries.  

59

The  Receipt  and  Disbursements  Method  

•  The  virtues  of  the  receipt  and  payment  methods  are:  •  It  gives  a  complete  picture  of  all  the  items  of  expected  cash  flows.  

•  It  is  a  sound  tool  of  managing  daily  cash  opera/ons.  

•  This  method,  however,  suffers  from  the  following  limita/ons:  •  Its  reliability  is  reduced  because  of  the  uncertainty  of  cash  forecasts.  

For  example,  collec/ons  may  be  delayed,  or  unan/cipated  demands  may  cause  large  disbursements.  

•  It  fails  to  highlight  the  significant  movements  in  the  working  capital  items.  

60

The  Adjusted  Net  Income  Method  

•  The  benefits  of  the  adjusted  net  income  method  are:  •  It  highlights  the  movements  in  the  working  capital  items,  and  thus  helps  

to  keep  a  control  on  a  firm’s  working  capital.  

•  It  helps  in  an/cipa/ng  a  firm’s  financial  requirements.  

•  The  major  limita/on  of  this  method  is:  •  It  fails  to  trace  cash  flows,  and  therefore,  its  u/lity  in  controlling  daily  

cash  opera/ons  is  limited.  

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Managing  Cash  Collec;ons  and  Disbursements  

•  Accelera/ng  Cash  Collec/ons  •  Decentralised  Collec/ons  •  Lock-­‐box  System  

•  Controlling  Disbursements  •  Disbursement  or  Payment  Float  

62

Controlling  Disbursements  •  Delaying  disbursement  results  in  maximum  availability  of  funds.  

However,   the   firms   that   delay   in   making   payments   may  endanger  its  credit  standing.  

•  While,   for   accelerated   collec/ons   a   decentralized   collec/on  procedure   may   be   followed,   for   a   proper   control   of  disbursements,  a  centralized  system  may  be  advantageous.  

•  Some   firms   use   the   technique   of   ‘playing   the   float’   to  maximize  the  availability  of  funds.  When  the  firm’s  actual  bank  balance  is  greater  than  the  balance  shown  in  the  firm’s  books,  the  difference  is  called  disbursement  or  payment  float.  

63