a finance homework

1. A firm currently currently purchases the Economic Order Quantity (Q*) of a particular item from its supplier. The supplier is offering a 3% discount if the firm will buy in lots of 1,000 instead.
The firm expects to sell 5,000 units of the item per year. It’s cost is $50 per unit and the cost to place an order is about $20 per order. The annual carrying costs are 30% of the inventory value.
Calculate the firm’s net savings from taking the discount.
Enter your result rounded to the nearest integer. Do not include a dollar sign.

Net savings from taking the discount = Reduction in purchase price – TIC discount quantity + TIC optimal quantity

A firm uses the EOQ model to determine its optimal reorder quantity.The firm sells 93,910 units per year, and there is a 9 day lag between ordering and receiving new inventory.What is the order point (also known as reorder point)?Assume a 365 day year, round to the nearest integer, enter with no punctuation.

3. 3. Refer to the firm’s financial statements. If the firm adopts a more stringent collections policy, it expects to reduce DSO to 28 days, without having a significant effect on sales. What will be the firms average accounts receivable balance under the new policy?
Round your result to the nearest integer, and enter it with no punctuation of any kind.
DSO = accounts receivable / (annual credit sales / 365)
Assume all sales are credit sales.

Answer: 3,500

A firm buys inventory from suppliers that offer terms of 4/17 net 35. The firm does not currently take the offered discount. What is the “nominal annual cost” to the firm of not taking the discount?
Enter your result rounded to the nearest integer %. Assume a 365 day year.
Answer
Please me yours! If different!

Continue to pay on day 30.

Borrow from the bank and pay on day 30.

Borrow from the bank and pay on day 10 to get the discount.

4. Unlike the Baumol model, the Miller-Orr model of cash management assumes that the firm’s net cash flows are known and constant
False or true
5. A firm has marginal tax rates as follows:

Federal tax rate

31%

State tax rate

The firm in considering purchasing a corporate commercial paper issue with a before-tax return of 7% for its marketable securities portfolio. Calculate the after-tax return for the commercial paper.
6. Relative to short-term debt, the use of long-term debt usually results in __________.
Check all that are correct.
Answer

Lower interest costs

Higher interest costs

Lower profitability

Higher profitability

Lower risk

Higher risk

Check all of the following that are correct for a firm that holds safety stocks (above the EOQ optimal quantity).
Answer

Carrying costs are higher.

Transactions costs are higher.

Total inventory costs (TIC) is higher.

The time period between reorders decreases.

A firm sells $360,000 of goods per year on credit, on terms of 2/15 net 35. If 39% of customers take the discount and pay in 15 days, and the remainder pay the full invoice amount in 35 days, what is the firm’s DSO (day’s sales outstanding)?
Round your result to the nearest integer
7. Which of the following it not a typical characteristic of marketable securities?
Answer

High rate of return

Safe from default risk

Highly liquid

Short-term to reduce “interest rate” risk

Suppose a firm’s supplier offer terms of 2/10 net 30. The firm often pays its invoices on day 20, and does not qualify for the discount as a result. What effect does this early payment have on the cost to the firm of not taking the offered discount?
Answer

decreases the cost of foregoing the discount

no effect on the cost of foregoing the discount

increases the cost of foregoing the discount

A firm sells $335,876 of goods per year on credit. If customers take an average of 31 days to pay, what is the firm’s average accounts receivable balance? (Assume a 365 day year).
Round your answer to the nearest integer.Enter the result without any punctuation (i.e. dollar sign or commas).
8. A firm buys $273,750 per year from suppliers that offer terms of 1/10 net 30. The firm does not currently take the offered discount. If the firm can borrow against a line of credit at the bank at an interest rate of 15%, it should:
Assume a 365 day year.
Answer

Continue to pay on day 30.

Borrow from the bank and pay on day 30.

Borrow from the bank and pay on day 10 to get the discount.

9. firm is considering borrowing $50,000 from its bank for 60 days to meet working capital needs. The bank offers a loan with a stated rate of 11% and discount interest. The bank uses a 360 day year to calculate interest. Calculate the APR for the loan. Enter the result in percentage format with one decimal place. For example, enter 4.5%
10. A firm with a high level of “cash and marketable securities” on its balance sheet is most likely to be using the _______ net operating working capital policy.
Answer PLEASE ENTER YOURS!

restricted

relaxed

moderate

11. A firm’s cash conversion cycle has increased by 10 days over the last year. Check all the items below that could account for the observed increase.
Answer

the firm’s customers pay more quickly than in the past

the firm’s customers pay more slowly than in the past

the firm’s inventory sells more quickly than in the past

the firm’s inventory sells more slowly than in the past

the firm pays its supplier’s more quickly than in the past

the firm pays its supplier’s more slowly than in the past

Working Capital Management
FIN 340
Prof. David S. Allen
Northern Arizona University

The Basic Questions
What is the appropriate amount of current assets to carry, both in total and specific accounts?
How should current assets be financed?
These two questions constitute the firm’s working capital policy.

Terminology
Working capital is defined as current assets.
Net working capital is current asset minus current liabilities.
The typical financial managers spends the majority of his/her time on working capital issues, rather than on long-term issues such as capital budgeting, capital structure, and dividend policy.

Additional Terminology
Net operating working capital (NOWC)
=operating current assets – operating current liabilities
=cash + receivables + inventories – payables – accruals
Working capital management
The process of setting the working capital policy, and implementing it on a day-to-day basis.

Alternative Net Operating Working Capital Policies
Basic issue: How much current assets are needed to support the anticipated sales?

Alternative Current Asset Policies
Basic issue: How much current assets are needed to support the anticipated sales?

Alternative Current Asset Policies
Under conditions of certainty in sales, manufacturing time, and collections, firms would hold the least possible amount of current assets.
Why?
All assets must be financed, and financing costs money, reducing profitability at any given level of sales.

Alternative Current Asset Policies
Under conditions of uncertainty in sales, manufacturing time, and collections, firms would hold more than the minimum possible amount of current assets.
Why?
Safety stocks are needed to meet unanticipated variations in demand and manufacturing time.

Alternative Current Asset Policies
There is a risk-return tradeoff in determining the amount of current assets to hold:
Fewer current assets reduces financing costs, and so increases profits, but…
It increases the probability of losing sales due to stock outs and/or a restrictive credit policy.
So, the firm has a balancing act to perform between profitability and risk.

Alternative Short-Term Financing Policies
Net operating working capital = NOWC
= operating current assets – operating current liabilities
=(cash + receivables + inventories) – (payables + accruals)
Virtually all firms experience changes in NOWC due to:
Seasonality in sales, or
Cyclicality in the economy
NOWC has two components:
A permanent level, i.e. the minimum amount the firm always has, and
A temporary level which varies with seasonality and cyclicality.
How the firm finances these components is known as the firm’s short-term financing policy.

Maturity Matching Approach
The firm attempts to match the maturity of the financing with the expected life of the asset being financed.

Aggressive Approach
Finance all fixed assets and a portion of permanent NOWC with long-term capital. Finance the remaining portion of permanent NOWC and all temporary NWC with short-term debt (which tends to be less expensive, thereby increasing profits).

Conservative Approach
Finance all fixed assets, all permanent NOWC, and a portion of temporary NOWC with long-term capital. At times, the firm has more financing than needed, and “stores” the excess in marketable securities. Safer, but less profitable.

Short-Term Financing
Advantages of short-term financing
Short-term loans can be obtained much faster than long-term credit.
If the financing need is seasonal, the firm may not want long-term funds since:
Floatation (issuance) costs are higher for long-term debt.
Long-term loans sometimes contain prepayment penalties.
Long-term loans always contain “restrictive covenants.”
The yield curve is normally upward sloping, i.e. long-term interest rates are higher than short-term interest rates.

Short-Term Financing
Disadvantages of short-term financing
Short-term credit is more risky because:
Loans must be refinanced (rolled over) more often, and the rate on the new loan could increase substantially.
The lender may be unwilling to renew the loan if the firm’s financial condition has weakened or if the credit markets have become tighter.

Cash Conversion Cycle
In a typical manufacturing firm, the cycle goes something like this:
The firm buys raw materials from its suppliers on credit, then applies labor (accrued wages) to convert it into the finished product.
The finished product is sold to customers on credit.
The firm pays its suppliers and employees.
The firm receives payment from its customers.
So, cash is paid out before inflows are realized.

Cash Conversion Cycle
Inventory conversion period
= inventory / (COGS / 365)
Many published sources use sales in place of COGS.
Receivables collection period = receivables / (annual sales / 365)
Payables deferral period = payables / (COGS / 365)

Cash Conversion Cycle
Cash conversion cycle =
inventory conversion period
+ receivables collection period
– payables deferral period
Measures the number of days between paying out cash to suppliers and employees, and receiving cash from customers.
The longer the CCC, the greater the amount of outside financing the firm will need. This increases financing costs and reduces profitability.
Financing needed for purchases = CCC * (COGS/365)

Shortening the CCC
Goal is to reduce the CCC as much as possible without hurting operations or alienating customers and/or suppliers.
Reduce inventory conversion period by processing and selling goods more quickly.
Reduce receivables collection period by speeding up collections.
Lengthen the payables deferral period by slowing down the firm’s own payments to suppliers.

Current Asset Strategies
0
50
100
150
200
250
300
350
400
0
200
400
600
800
1000
1200
Sales
Current Assets
Relaxed
Moderate
Restricted
Current Assets
Turnover
To Support
of Current
$1000 in Sales
Assets
Relaxed
353
2.8
Moderate
220
4.5
Restricted
163
6.1

Cash and Marketable Securities Management
Prof. David S. Allen

The Need for Cash
Firms hold cash for at least three reasons:
Transactions balance: The firm’s day-to-day operations require cash for wages, inventories, rent, utilities, etc.
Precautionary balance: If the forecast of cash inflows and outflows used to create the cash budget proves to be wrong, the firm needs a safety stock of cash.
Speculative motive: The firm may hold extra cash in order to quickly take advantage of opportunities that may come along.
http://www.zacks.com/research/report.php?type=abs&t=MSFT

The Need for Cash
In addition, firms may hold cash because:
They have a bank loan outstanding that requires a compensating (minimum) cash balance.
This requirement helps ensure that the firm always has some minimum level of liquidity to meet its day-to-day needs.
They need a temporary “parking place” for the proceeds of a long-term debt issue.
These proceeds may be used later to build a new factory, for example.

The Need for Cash
Disadvantages of holding cash:

Cash earns a low rate of return, which reduces potential profitability.
Since cash is an asset on the left-hand side of the balance sheet, there must be a corresponding source of financing on the right-hand side, with an associated cost of capital that likely exceeds the return earned by the cash.

The Need for Cash
Recall in the cash budget that we assumed a target cash balance for the firm. Some cash budgets also use a minimum and maximum cash balance, in addition to a target in between. Where do these numbers come from?
Subjective estimates from management, based on experience.
Quantitative models such as Baumol, or Miller-Orr, to be examined later.
Bank required compensating balances.

The Tradeoff
In a typical cash management model, firms are usually assumed to hold cash (which earns no interest) and marketable securities (interest bearing, short-term securities) to meet their payment needs.
To move funds between the two, a transaction costs must be incurred.
The transaction cost includes direct costs such as a brokerage fee to sell a security, as well as indirect costs such as administrative time and effort.

The Tradeoff
If the firm holds a large cash balance, it incurs an opportunity cost (i.e. loses interest that could be earned on marketable securities).
However, the large cash balance results in less frequent liquidations (sales) of marketable securities, which lowers the firm’s transactions costs.
If the firm holds a small cash balance, the firm earns more interest on marketable securities.
However, a small cash balance results in more frequent liquidations of marketable securities, which raises the firm’s transactions costs.

The Tradeoff
So, the firm must strike a balance between transactions costs and opportunity costs (i.e. between cash and marketable securities). It seeks to find the cash balance at which the sum of these two costs is minimized.

Characteristics of Marketable Securities
Marketable securities are by definition those that can be resold from one investor to another in a “secondary” market.
While many securities fit this general definition, in the area of cash management there are several characteristics that are considered of primary importance.
Perhaps the most important is safety of principal, followed closely by liquidity.
Firms that invest excess cash on a temporary basis want to be assured that the full amount of original principal will be available at a later date when needed for some other purpose.
Liquidity is needed to ensure that the funds are available immediately when the need presents itself.

Characteristics of Marketable Securities
When choosing among alternative marketable securities, the cash manager must make tradeoffs that affect the rate of return earned. These tradeoffs include:
More or less quality: There is a direct relationship between the rate of return that is promised on marketable securities, and the likelihood of default.
Safer securities promise lower returns, and risky securities promise higher returns.
Note, however, that “promised” returns and “realized” returns can be different. Riskier securities may default, leaving the investor with little or no return.

http://www.ambest.com/ratings/methodology/commercialpaper

http://www.dbrs.com/about/ratingScales

http://www.rbcpa.com/Moody%27s_ratings_and_definitions

Characteristics of Marketable Securities
More or less quality (cont’d)
The safest securities are those backed by the U.S. government.
Examples include Treasury bills, notes, and bonds, and bank Certificates of Deposit.
Riskier securities include corporate securities, such as commercial paper, notes, and bonds.

Characteristics of Marketable Securities
More or less liquidity: Liquidity refers the ability to quickly sell a security at its true value.
The degree of liquidity of an asset is largely a function of how many buyers are available, and how well developed is the secondary market for the asset.
Some assets, such as U.S. Treasury bills, are very liquid.
Others, such as real estate, are much less liquid.
Since lack of liquidity is a source of risk, less liquid investments tend to promise higher returns, all else the same.

Characteristics of Marketable Securities
More or less time to maturity: If a firm ties its excess money up for a long period of time in a securities investment, then it faces the risk of not being able to use the money for some other opportunity that may come along.
This implies that long-term investments are riskier than short-term investments.
Note that this type of risk is not the same as default (quality) risk.
In general, for a given level of default risk, long-term investments promise a higher rate of return than short-term investments.
http://bonds.yahoo.com/rates.html

The Baumol Model
Baumol developed a model of cash management that recognizes the tradeoff between foregone interest (from holding too much cash in non-interest bearing accounts) and transactions costs (from liquidating marketable securities).
He did this by applying an existing inventory management model (Economic Order Quantitiy, EOQ) to cash balances.
The Baumol model makes a number of simplifying assumptions (inherited from the EOQ model):
The firm’s annual demand for cash is known (perhaps derived from the cash budget), and constant over time.
The cost to move funds from the marketable securities account to the cash account in fixed, i.e. independent of the amount transferred.

The Baumol Model
Note that these assumptions are often violated in practice.
As a result, the model’s main attractions are its ease of application and straightforward portrayal of the foregone interest (i.e. holding cost) versus transaction cost tradeoff.
The firm begins with its optimal cash balance (to be determined by the model), which is then used up until it runs out of funds.
At that time the firm again liquidates marketable securities to return its cash balance to its original value.

Baumol Model Cash Balances

The Baumol Model
The total costs of a given starting cash balance, C, is given by:
total costs = holding costs + transactions costs
= (C/2)k + (T/C)F
where:
C = cash raised by selling marketable securities or borrowing (i.e. the beginning cash balance)
F = fixed transaction cost of moving cash to/from mkt. sec.
T = total annual cash needs
k = opportunity cost of holding cash (return on marketable securities)

The Baumol Model
The goal is to find the value for C (amount transferred from marketable securities to the cash account) that minimizes total costs:

The Baumol Model
Minimizing the total cost, with respect to C results in:

The firm liquidates (or borrows) C* each time its cash balance hits zero.

Example
A firm has annual cash needs of T = $360,000.
The cost to transfer funds from its marketable securities account to its cash account is F = $30.
The opportunity cost of cash (i.e. the rate of interest it loses by not leaving the funds in its marketable securities account is k = 5%.

Example (cont’d)
To minimize the total cost of its cash holdings, the firm should transfer cash from its marketable securities account to its cash account in the amount:

Note that in practice, the firm may find it beneficial to round the amount to the nearest $1,000.
The total annual cost of its cash holdings would be:
TC = (C/2)k + (T/C)F = (20,785/2).05 + (360,000/20,785)30 = $1,039
(Note: these values correspond to the charts presented above).

The Miller-Orr Model
Miller and Orr developed a model that attempts to overcome some of the shortcomings of the Baumol model.
They assume that the firm’s daily cash flow is random.
It may increase or decrease on any given day.
They set an upper and lower limit on the firm’s cash balance.
If the balance hits the lower limit, the firm needs cash and will liquidate marketable securities.
If the balance hits the upper limit, the firm has excess cash, and will invest the excess in marketable securities.
In either case, the firm will transfer funds in an amount that returns its cash balance to a target level.

The Miller-Orr Model
H = upper limit
Z = target cash balance
L = lower limit, set by firm’s management
s2 = variance of daily cash flow
k = daily opportunity cost (= annual rate / 365)
F = fixed transaction cost
The target balance (Z) and upper limit (H) are:
Z = [3F s2 /4k]1/3 + L
H = 3[3F s2 /4k]1/3 + L = 3Z – 2L

Example
A firm wants to determine the optimal range for its cash balance.
Its management has decided that the firm needs at least $10,000 cash on hand each day in order to meet its daily cash needs (L = $10,000).
The firm has recorded its daily cash flows over the past year, and will use them to estimate the variance of daily cash flows:

The Miller-Orr Model
The variance was calculated using the =var(first cell : last cell) function in Excel.
Using the Miller-Orr model, the firm has determined its target cash balance (Z), and upper limit (H):

The Miller-Orr Model
Whenever its cash balance falls below $10,000, it will liquidate enough marketable securities to bring the cash balance back up to $16,997.21.
Whenever its cash balance rises above $30,991.63, it will purchase enough marketable securities to bring the cash balance back down to $16,997.21.
A typical cash balance over a year might look like this:

Marketable Securities Management
If firms are going to use marketable securities as a temporary storage place for excess cash balances, then the firm should establish written investment objectives and guidelines.
These help to ensure that the cash manager’s actions are within permissible bounds.

Developing Investment Objectives
Written investment objectives are needed in order to judge the appropriateness of any specific marketable security.
They also helps demonstrate to senior management that the cash manager is carrying out his/her duties with due diligence.

Developing Investment Objectives
A given investment is not inherently good or bad. Instead, each involves a particular tradeoff between:
More or less liquidity.
More of less quality.
More or less time to maturity.
Without written objectives, it is hard to know which side of a given tradeoff to emphasize.

Factors Influencing Investment Objectives
Cash management decisions should not constrain operational decisions.
Normally, it should be the other way around.
Cash investment management objectives should reflect the firm’s business plan. That is, the firm should build a cash budget first, then a set of investment objectives to fit the plan. Sensitivity analysis can help set boundaries for the investment objectives.

Factors Influencing Investment Objectives
Other issues that can affect investment objectives:
Regulatory requirements.
Alternative sources for satisfying unexpected cash needs.
The probability of unexpected cash needs.
Plans for business acquisition or internal capacity expansion.

Factors Influencing Investment Objectives
Tax status – has a major impact on investment objectives
The firm needs to know its marginal tax rate in order to compare yields on taxable and tax-exempt investments.
The firm must compare the after-tax return from alternative investments:
Returnafter-tax = Returnbefore-tax(1 – firm’s marginal tax rate)

Taxation of Interest Income
The marginal tax rate is the tax rate for the next dollar of income.
It varies by type of investment, and is the sum of the applicable federal and state tax rates.
Issuer
Federal Tax on interest income
State Tax on interest income
U.S. Treasury
Yes
No
Municipal government
No
No
Corporation
Yes
Yes

The Role of Investment Management
Is the portfolio being viewed as a profit center?
Recall that the principal purpose is to provide a safe, temporary parking place for excess funds.
Is management relying on the return to meet earnings goals?
Shareholders might question why the firm is using its investment portfolio, rather than its operations, to meet earnings goals.

The Role of Investment Management
If management emphasizes a preset level of returns, then the portfolio manager might engage in activities that are sub-optimal, such as:
Using maturities longer than the anticipated storage period.
Using lower quality issues.
Using less liquid issues.
If the portfolio manager’s compensation is tied to the return realized, then a higher risk strategy is likely to result.

How Objectives Are Expressed
Qualitative objectives provide guidance.
Some examples:
To ensure the availability of cash on a schedule consistent with the firm’s cash flow forecast.
To maintain complete portfolio liquidity at all times.
To hold only highly rated issues.
To invest primarily in tax-exempt (or taxable, depending on the marginal tax rate) issues.

How Objectives Are Expressed
If quantitative returns are specified, they should be relative to a benchmark rather than in absolute terms, e.g. 50 basis points above the average yield on 3 month t-bills during the period.
(Note: 100 basis points = 1%, so 50 basis points = 0.5%)
Other components of objectives:
Are targets to be met absolutely, or worked towards?
What is the time horizon for accomplishing and evaluating the goals?

Investment Guidelines
Spell out specific parameters that will guide and restrict the latitude of the portfolio manager.
For each purchase of marketable securities, they specify:
Maximum maturity.
Maximum average maturity over all investments.
Minimum quality standards.
Tax considerations.
Prohibited assets.
Diversification standards.

Management Controls and Reporting
Procedures are needed to monitor the marketable securities investment process.
The firm needs to specify responsibilities, the chain of reporting, and the division of duties.
A monthly report should detail: positions, market value, original cost, and expected cash flow.
A quarterly report should give a comparison of actual performance relative to objectives.

–
5,000.00
10,000.00
15,000.00
20,000.00
25,000.00
1
7
13
19
25
31
37
43
49
55
61
67
73
79
85
Day
Cash Balance

–
500.00
1,000.00
1,500.00
2,000.00
2,500.00
–
10,000.00
20,000.00
30,000.00
40,000.00
50,000.00
Cash Transferred
Costs
Holding Costs
Transactions Costs
Total Costs

k
)T)(F(2
C
*

785,20$
.05
)000,360)(30(2
C
*


Inputs:
L$10,000.00

2
2,085,784.83
k5%
F$30.00
Outputs:
Z$16,997.21
H$30,991.63

0
5000
10000
15000
20000
25000
30000
35000
0
100
200
300
400
Day
Cash Balance

Managing Accounts Receivable
FIN 340
Prof. David Allen

Managing Account Receivable
The firm faces a tradeoff between costs (slow payers and bad debts) and benefits (attracting sales).

Credit Policy
Credit period
Length of time buyers are given to pay for purchases
e.g. net 30
Often determined by competitive situation
Discounts
e.g. 2/10 net 30
Provides an incentive for customers to pay early
Reduces DSO, and thus the amount of financing for receivables.

Credit Policy
Credit standards
Required financial strength customers need to qualify for credit.
Collection policy
How tough or lax is the firm in trying to collect on slow-paying accounts?
Dunning letters
Collection agency

Setting the Credit Period and Standards
Credit period
Often determined by competitive situation
Setting credit standards
Firm needs a method to determine likelihood of payment, i.e. credit quality.
an external credit report (D&B, TRW)
An internally generated credit score (similar to Altman Z)
Five C’s
Character
Capacity
Capital (net worth)
Collateral
Conditions

Setting the Credit Period and Standards
Business credit information is available at:

https://www.dnb.com/product/birsampl.htm
The D&B PAYDEX® Score: D&B’s unique dollar-weighted numerical indicator of how a firm paid its bills over the past year, based on trade experiences reported to D&B by various vendors. The D&B PAYDEX Score ranges from 1 to 100, with higher scores indicating better payment performance.

Setting the Credit Period and Standards
Key to the D&B Rating

Collection Policy
The firm needs a procedure for dealing with past due accounts.
Dunning letters
Collection agency

Other Factors Influencing Credit Policy
Profit potential
Interest on past due accounts may be a significant source of profit
Legal considerations
Robinson-Patman Act – makes it illegal to offer more favorable credit terms to one customer (or class of customers) than another, unless the differences are cost-justified.

Basic Objectives:
Managing delinquencies: The older an account becomes, the more difficult it is to collect. So, we need to manage accounts so that few become delinquent, and to identify those that will become a problem as early as possible.
Managing credit risk: The goal here is to minimize the company’s losses on accounts that will not be fully collected. Continued business with the account is unlikely.
Forecasting: As a part of its ongoing cash budgeting process, the firm needs to forecast the cash flows from the accounts receivable (AR) portfolio, and to estimate bad debt losses.

Measuring Accounts Receivable Performance
Individual accounts are monitored for compliance with payments standards in order to initiate appropriate actions when customers delay payment beyond agreed upon terms.
On the aggregate level, monitoring is important in setting overall policy guidelines with respect to risk and return and in forecasting cash flows and bad debt losses.

Days Sales Outstanding
In our earlier coverage of ratio analysis, we used the “days sales outstanding” (DSO, also known as average collection period or average age of receivables) to measure the average length of time it takes to collect accounts receivable.
It can be shown that the DSO is biased when the firm’s sales are seasonal or cyclical in nature.

Days Sales Outstanding
DSO = accounts receivable / average daily sales
So, for annual data,
DSO = accounts receivable / (annual sales / 365)
If we are measuring DSO before year-end, we need to adjust the equation as follows:
DSOsub-period =
accounts receivable / (sub-period sales / days in sub-period)
For example, if we measure DSO at the end of each quarter, then:
DSOquarterly = accounts receivable / (quarterly sales / 91)
where 91 = approx. number of days in one quarter

Aging Schedule
The aging schedule is one of the primary tools used to measure accounts receivable performance.
It shows accounts receivable in dollar or percentage terms, as a function of age of invoice and month of sale.

DSO and Aging Schedule – Assumptions
In this example, we assume that customer payment behavior is constant, and sales are flat.

DSO and Aging Schedule – Flat Sales

DSO and Aging Schedule – Flat Sales
Here we are assuming that customers do not change their payment behavior over time. The percentages paid each month, relative to the sale date, do not vary.
Note that in every case the DSO is the same, regardless of the month, or whether we used quarterly sales or year-to-date sales figures.

DSO and Aging Schedule – Assumptions
In this example, we assume that customer payment behavior is constant, and sales are seasonal.

DSO and Aging Schedule – Seasonal Sales

DSO and Aging Schedule – Seasonal Sales
Note that DSO is changing over time, even though the customers’ payment behavior is not.
So, DSO cannot be used to accurately monitor receivables if the firm’s sales are seasonal or cyclical.

DSO and Aging Schedule – Seasonal Sales
So, as sales increase, the DSO is an upwards biased measure of the true payment behavior of the firm’s customers (i.e. DSO overestimates collection time).
Likewise, as sales decrease, the DSO is a downwards biased measure of the true payment behavior of the firm’s customers (i.e. DSO underestimates collection time).

Payment Patterns Approach to Monitoring AR
In the previous section, we showed that the DSO measure is biased when sales are changing over the measurement period, even if our customers do not change their payment behaviors.
We will now introduce a technique know as the “payments pattern approach” that allows us to more accurately determine trends in the payment behavior of our customers.

Payment Patterns Approach to Monitoring AR
In the example below, we do not make the assumption that we know the payment behavior of our customers. Instead, we let the data tell us what is happening.
The table below reports the credit sales by month and the collections received for that month’s sales.

Payment Patterns Approach to Monitoring AR
Next, we subtract the amount received from the sales to determine the remaining balance by month:

Payment Patterns Approach to Monitoring AR
Divide each figure by the sales for that month to convert to percentages:

Payment Patterns Approach to Monitoring AR
Then, measure the time as months since the sale, rather than by the name of the month:

Payment Patterns Approach to Monitoring AR
By examining either table above, we can see that the firm’s customers pay slowly in the Oct – Dec quarter, and most quickly in the Apr – Jun quarter.

Payment Patterns Approach to Monitoring AR
The Payment Patterns Approach shows the percentage of credit sales in each period (usually a month) that are outstanding at the end of each subsequent period.
It is not subject to bias when sales are seasonal, and is useful for projecting receivables and collections in preparing a cash budget.

Managing Credit Risk
Typically, the most important element is controlling the risk of non-payment.
In international trade, there is also foreign exchange risk and country risk.

Guarantees and Letters of Credit
A guarantee may be obtained is situations where the buyer’s credit quality is insufficient. The guarantee may be from the firm’s parent, or some type of government agency that has a stake in the buyer’s success.
A letter of credit is an obligation of a bank to remit funds when clearly pre-specified terms and conditions are met. It is issued by the buyer’s bank, and facilitates trade when the seller is located in another country.

Credit Insurance And Factoring
Credit Insurance
The selling firm submits a list of buyers, and typical amounts outstanding to the credit insurer. The insurer replies with a maximum insurable amount for each buyer and a price for the policy.
The agreement also details the deductible amount and coinsurance of credit losses above a predetermined level.
If an invoice becomes past due by more than a preset number of days, it is submitted to the insurer, who pays the face value to the seller (less deductibles and coinsurance).
The insurer is then responsible for collecting the account.

Credit Insurance And Factoring
Credit insurance is often used by small to medium sized firms that are uncomfortable with their credit exposure to a number of large buyers.
For the process to be economically feasible, the credit insurer must be superior in evaluating credit risk, and or have some diversification or economies of scale.
European companies use credit insurance much more than those in the U.S., in large part due to the lack of available credit information.

Factoring
Involves the sale or transfer of title of accounts receivable to a factoring company, which is usually a subsidiary of a financial services company or bank.
The factor provides the credit and collection functions.
Options:
With or without recourse: With recourse means the seller is liable if the factor cannot collect on an account. Most factoring is without recourse.
With or without notification: With notification means that the buyer knows that its account has been factored and is required to remit directly to the factor. Most factoring is on a notification basis.

Factoring
Maturity or discount factoring:
With maturity factoring, funds are available to the seller on the average collection date.
With discount factoring, funds are remitted to the seller sooner than the average collection date. Most users choose discount factoring to speed up cash receipts.
Pricing: usually a fixed percentage (about 1%) of the invoice is the commission.
With discount factoring, the interest rate is often the prime rate plus 2% or 3%. In addition, there is also a reserve of about 3% to 5% for returns, disputes, etc.

Factoring
Advantages:
Having the factor perform the credit and collection function is very useful for companies without expertise in this area.
Small companies are often not well diversified in their receivables exposure. Factoring mitigates this exposure.
For firms with highly seasonal sales, the ability to accelerate cash flows is very beneficial.
The factor performs a useful accounting function for the selling firm.

Factoring
Disadvantages:
Factoring can be much more expensive for the seller than bank borrowing or credit insurance.
Since the factor controls the credit and collection function, the seller may lose the ability to enhance revenues through adopting more lenient credit and collection procedures.
Since the factor will not accept all credits, or may place a limit on its exposure to certain buyers, the seller is still stuck with performing the credit and collection function on some of its customers.

Collections Policy
Issues:
Promptness: Delinquent accounts tend to perform much worst if not attended to properly.
Cost/benefits: Certain accounts may not respond to a particular form of collection procedure.
It is important to understand which procedures make economic sense at a given stage in the collection process.

Collections Policy
Internal Strategies
It is important at an early stage to distinguish those accounts that are actually delinquent from those delays that are caused by some dispute over the merchandise being invoiced.
It is prudent for the credit grantor to confirm in writing that the goods as ordered were in fact received before initiating collections efforts.
Most companies begin with relatively mild reminders so as not to agitate customers that are, in the longer-term, profitable.
As the delinquency increases, the long-term revenue potential of the customer diminishes.

Collections Policy
External Strategies
Collection Agencies
The usual agency charges 30-50% of the collected amount as its fee.
If the seller has an ongoing relationship with the collection agency, the charges may be based on the historical recovery rate.
Adjustment Bureaus
Usually organized by a given industry group to aid its members in the collection of bad debts.

Analyzing Proposed Changes in Credit Policy
The cost to finance (carry) the additional receivables is:
(DSO)(Sales per day)(variable cost ratio)(cost of funds)

Analyzing Proposed Changes in Credit Policy
Wahoo Corp. sells to its customers on terms on net 30. It is considering relaxing its credit terms to 2/10 net 30 in order to attract more sales.
In addition, the firm will reduce its spending on credit analysis and collection.
The firm’s marketing department believes that this change in policy will result in a 5% increase in gross sales.
Under the current policy, 70% of customers pay in 30 days.
Under the current policy, 30% of customers pay in 50 days, or 20 days late.
Under the proposed policy, 20% of customers are expected to take the offered discount, and pay in 10 days.
Under the proposed policy, 60% of customers are expected to forego the discount, and pay in 30 days.
Under the proposed policy, 20% of customers are expected to forego the discount, and pay in 50 days, or 20 days late.
Under the currrent policy, the firm spends $5,000 per year on credit analysis and collection efforts.
Under the proposed policy, the firm expects to reduce spending to $3,000 per year on credit analysis and collection efforts.
Complete the spreadsheet below to determine the effect on the firm’s profitability of the proposed change.

Analyzing Proposed Changes in Credit Policy

Analyzing Proposed Changes in Credit Policy
Profits increase under the proposed system, so the firm would adopt it.

SALES DATA AND PAYMENT BEHAVIOR
% of sales paid in month of sale50%
% of sales paid 1 month after sale30%
% of sales paid 2 months after sale20%
Amounts still outstanding
Month
Monthly
Sales
At end of month1 month later2 months later
November100$ 50$ 20$ -$
December100$ 50$ 20$ -$
January100$ 50$ 20$ -$
February100$ 50$ 20$ -$
March100$ 50$ 20$ -$
April100$ 50$ 20$ -$
May100$ 50$ 20$ -$
June100$ 50$ 20$ -$
July100$ 50$ 20$ -$
August100$ 50$ 20$ -$
September100$ 50$ 20$ -$
October100$ 50$ 20$ -$
November100$ 50$ 20$ -$
December100$ 50$ 20$ -$
AGING SCHEDULE – DOLLARS
Month
Accounts
Receivable
at Month End
Amount current
at month end
Amount past
due 1 to 30 days
at month end
January70$ 50$ 20$
February70$ 50$ 20$
March70$ 50$ 20$
April70$ 50$ 20$
May70$ 50$ 20$
June70$ 50$ 20$
July70$ 50$ 20$
August70$ 50$ 20$
September70$ 50$ 20$
October70$ 50$ 20$
November70$ 50$ 20$
December70$ 50$ 20$
AGING SCHEDULE – PERCENT
Month
Accounts
Receivable
at Month End
Percent current
at month end
Percent past
due 1 to 30 days
at month end
January70$ 71.4%28.6%
February70$ 71.4%28.6%
March70$ 71.4%28.6%
April70$ 71.4%28.6%
May70$ 71.4%28.6%
June70$ 71.4%28.6%
July70$ 71.4%28.6%
August70$ 71.4%28.6%
September70$ 71.4%28.6%
October70$ 71.4%28.6%
November70$ 71.4%28.6%
December70$ 71.4%28.6%
DSO CALCULATIONS
Based on Quarterly Sales Data
Based on Year-to-Date
Sales Data
Month
Monthly
Sales
Receivables
Outstanding At
End of Month
ADS = quarterly
sales / 91DSOADSDSO
January100$ 70$
February100$ 70$
March100$ 70$ 3.30$ 21.2 days3.30$ 21.2 days
April100$ 70$
May100$ 70$
June100$ 70$ 3.30$ 21.2 days3.30$ 21.2 days
July100$ 70$
August100$ 70$
September100$ 70$ 3.30$ 21.2 days3.30$ 21.2 days
October100$ 70$
November100$ 70$
December100$ 70$ 3.30$ 21.2 days3.30$ 21.2 days
SALES DATA AND PAYMENT BEHAVIOR
% of sales paid in month of sale50%
% of sales paid 1 month after sale30%
% of sales paid 2 months after sale20%
Amounts still outstanding
Month
Monthly
Sales
At end of
month
1 month
later
2 months
later
November100$ 50$ 20$ -$
December100$ 50$ 20$ -$
January100$ 50$ 20$ -$
February120$ 60$ 24$ -$
March140$ 70$ 28$ -$
April120$ 60$ 24$ -$
May100$ 50$ 20$ -$
June80$ 40$ 16$ -$
July100$ 50$ 20$ -$
August100$ 50$ 20$ -$
September100$ 50$ 20$ -$
October150$ 75$ 30$ -$
November150$ 75$ 30$ -$
December150$ 75$ 30$ -$
AGING SCHEDULE – DOLLARS
Month
Accounts
Receivable
at Month End
Amount
current at
month end
Amount
past due 1
to 30 days
at month
end
January70$ 50$ 20$
February80$ 60$ 20$
March94$ 70$ 24$
April88$ 60$ 28$
May74$ 50$ 24$
June60$ 40$ 20$
July66$ 50$ 16$
August70$ 50$ 20$
September70$ 50$ 20$
October95$ 75$ 20$
November105$ 75$ 30$
December105$ 75$ 30$
AGING SCHEDULE – PERCENT
Month
Accounts
Receivable
at Month End
Percent
current at
month end
Percent
past due 1
to 30 days
at month
end
January70$ 71.4%28.6%
February80$ 75.0%25.0%
March94$ 74.5%25.5%
April88$ 68.2%31.8%
May74$ 67.6%32.4%
June60$ 66.7%33.3%
July66$ 75.8%24.2%
August70$ 71.4%28.6%
September70$ 71.4%28.6%
October95$ 78.9%21.1%
November105$ 71.4%28.6%
December105$ 71.4%28.6%
DSO CALCULATION
Based on Quarterly
Sales Data
Based on Year-to-Date
Sales Data
Month
Monthly
Sales
Receivables
Outstanding
At End of
Month
ADS =
quarterly
sales / 91DSOADSDSO
January100$ 50$
February120$ 80$
March140$ 94$ 3.96$ 23.8 days3.96$ 23.8 days
April120$ 88$
May100$ 74$
June80$ 60$ 3.30$ 18.2 days3.63$ 16.5 days
July100$ 66$
August100$ 70$
September100$ 70$ 3.30$ 21.2 days3.52$ 19.9 days
October150$ 95$
November150$ 105$
December150$ 105$ 4.95$ 21.2 days3.87$ 27.1 days
Amount Collected in Month
Month
Credit
Sales
OctNovDecJanFebMarAprMayJunJulAugSepOctNovDecJanFebMar
Oct1,000 300 300 200 200
Nov1,000 300 300 200 200
Dec1,000 300 300 200 200
Jan1,200 480 420 240 60
Feb1,400 560 490 280 70
Mar1,600 640 560 320 80
Apr1,600 800 560 240 –
May1,600 800 560 240 –
Jun1,600 800 560 240 –
Jul1,400 630 420 210 140
Aug1,200 540 360 180 120
Sep1,000 450 300 150 100
Oct1,200 360 360 240 240
Nov1,200 360 360 240 240
Dec1,200 360 360 240 240
Amount Still Outstanding at End of Month
Month
Credit
Sales
OctNovDecJanFebMarAprMayJunJulAugSepOctNovDecJanFebMar
Oct1,000 700 400 200 –
Nov1,000 700 400 200 –
Dec1,000 700 400 200 –
Jan1,200 720 300 60 –
Feb1,400 840 350 70 –
Mar1,600 960 400 80 –
Apr1,600 800 240 – –
May1,600 800 240 – –
Jun1,600 800 240 – –
Jul1,400 770 350 140 –
Aug1,200 660 300 120 –
Sep1,000 550 250 100 –
Oct1,200 840 480 240 –
Nov1,200 840 480 240 –
Dec1,200 840 480 240 –
Amount Still Outstanding at End of Month
Month
Credit
Sales
OctNovDecJanFebMarAprMayJunJulAugSepOctNovDecJanFebMar
Oct1,000 70%40%20%0%
Nov1,000 70%40%20%0%
Dec1,000 70%40%20%0%
Jan1,200 60%25%5%0%
Feb1,400 60%25%5%0%
Mar1,600 60%25%5%0%
Apr1,600 50%15%0%0%
May1,600 50%15%0%0%
Jun1,600 50%15%0%0%
Jul1,400 55%25%10%0%
Aug1,200 55%25%10%0%
Sep1,000 55%25%10%0%
Oct1,200 70%40%20%0%
Nov1,200 70%40%20%0%
Dec1,200 70%40%20%0%
Amount Outstanding at End of Month
Month
Credit
Sales
Month of
Sale
1 Month
After
Sale
2 Months
After
Sale
3 Months
After
Sale
Oct1,000 70%40%20%0%
Nov1,000 70%40%20%0%
Dec1,000 70%40%20%0%
Jan1,200 60%25%5%0%
Feb1,400 60%25%5%0%
Mar1,600 60%25%5%0%
Apr1,600 50%15%0%0%
May1,600 50%15%0%0%
Jun1,600 50%15%0%0%
Jul1,400 55%25%10%0%
Aug1,200 55%25%10%0%
Sep1,000 55%25%10%0%
Oct1,200 70%40%20%0%
Nov1,200 70%40%20%0%
Dec1,200 70%40%20%0%
Avg. still outstanding61%29%11%0%
Amount Collected by Month
Month
Credit
Sales
Month of
Sale
1 Month
After
Sale
2 Months
After
Sale
3 Months
After
Sale
Oct1,000 30%30%20%20%
Nov1,000 30%30%20%20%
Dec1,000 30%30%20%20%
Jan1,200 40%35%20%5%
Feb1,400 40%35%20%5%
Mar1,600 40%35%20%5%
Apr1,600 50%35%15%0%
May1,600 50%35%15%0%
Jun1,600 50%35%15%0%
Jul1,400 45%30%15%10%
Aug1,200 45%30%15%10%
Sep1,000 45%30%15%10%
Oct1,200 30%30%20%20%
Nov1,200 30%30%20%20%
Dec1,200 30%30%20%20%
Avg. collected39%32%18%11%
Inputs:
Current
Policy
Proposed
Policy
Annual sales365,000$ 383,250$
Variable cost ratio65%65%
Cost of funds (financing cost)12%12%
Discount for early payment0%2%
Early payment period10 days
Percent of customers taking discount20%
Full amount due in30 30 days
Percent of customers paying full amount on time70%60%
Age of invoices for customers paying late50 50 days
Percent of customers paying late30%20%
Days per year365 365
Annual credit analysis and collection expense5,000$ 3,000$
Bad debt losses as percent of gross sales3%2%
Income tax rate30%30%
Outputs:
Current
Policy
Proposed
Policy
Days sales outstanding 36.00 30.00
Gross sales365,000 383,250
Less discounts- 1,533
= Net sales365,000 381,717
Less variable production costs237,250 249,113
= Profit before credit cost and taxes127,750 132,605
Less credit related costs:
Cost of carrying receivables2,808 2,457
Credit analysis and collection expenses5,000 3,000
Bad debt losses10,950 7,665
=Profit before taxes108,992 119,483
Less taxes32,698 35,845
=Net income76,294 83,638
Change in net income7,343

Inventory Management
FIN 340
Prof. David S. Allen
Northern Arizona University

Types of Inventory
Raw materials inventory:
Factors of production that will be used in a later stage of production or assembly.
Work-in-progress inventory:
Partially assembled or completed goods.
Finished goods inventory:
Items ready for distribution or sale.

Types of Inventory
Independent items: Have demand unrelated to the requirements for other items, e.g. finished goods.
Independent items lend themselves to analysis by quantitative techniques.
Dependent items: Derive their demand from the need for other items or finished products, e.g. raw materials or work-in-progress.
The demand for the end product is used to infer demand for its components, subcomponents, and raw materials, This is combined with the existing inventory balances to establish a net requirement.

Benefits of Holding Inventory
For finished goods, most marketing analyses suggest that product availability is the most important factor in customer satisfaction.
The ability to order in larger lot sizes can create economies of scale in pricing, handling, and setups.
In manufacturing, inventory decouples supply and demand. It makes possible longer production runs and more flexibility in the manufacturing process.
Inventory also can enhance firm liquidity. In periods of high cash flows, the firm can invest excess cash in building up inventory. When cash flows are lower, the firm can sell off excess inventory without replacing it in order to generate cash.

Costs of Holding Inventory
Ordering costs: The fixed and variable costs resulting from the placement and processing of an order.
These include freight, labor, and handling charges. They are generally assumed to be proportional to the number of orders placed. In a production setting, these correspond to setup costs, i.e. the costs associated with delays and costs in resetting machinery to accommodate a different item.

Costs of Holding Inventory
Carrying costs:
Cost of capital
Storage costs
Deterioration and obsolescence costs
Insurance costs
Handling costs
Carrying costs are usually assumed to be proportional to the average inventory level. They are often split into financing costs (the first item above) and holding costs (all others above).

Costs of Holding Inventory
Approx. annual cost as percentage of inventory value
Carrying costs
Cost of capital 12.0%
Storage and handling 0.5%
Insurance 0.5%
Property taxes 1.0%
Depreciation and obsolescence 12.0%
Total 26%
Ordering, shipping, and receiving costs
Cost of placing orders, including production and set-up costs Varies
Shipping and handling 2.5%

Cost of stock-outs
Loss of sales Varies
Loss of customer goodwill Varies
Disruption of production schedules Varies

Factors Influencing Inventory Management
Effective inventory management is complicated by a number of factors:
Uncertainty: The inability to perfectly anticipate supply and demand.
Problems with cost and benefit assessments: Costs and benefits are difficult to quantify.
Variety in product: Perishability, value, demand, and interaction with other products are difficult to model.
Constraints: Limitations on financing, storage, and supply can lead to suboptimal decisions.

Inventory Management Systems
Early inventory management focused on quantitative approaches to determining optimal order sizes, such of EOQ.
This was followed by techniques that focused more on order timing, such as materials requirements planning (MRP). These two focuses have had varying degrees of success.
More recently, the focus has been on “stockless” or just-in-time (JIT) systems, which emphasize minimal inventory levels.

Inventory Management Systems
An important reason for holding inventory is the inability of the company to synchronize delivery with demand.
The traditional western inventory system is thus a “just-in-case” type.
Large safety stocks are held to cover the uncertainty of demand because of long and variable lead time or because of lumpiness in the production process.
Much of the inventory management revolves around what to do because of this lead time.

Inventory Management Systems
Just-in-time is a philosophy for managing inventory that seeks to identify and eliminate waste and bottlenecks in the supply chain.
By holding little or no inventory, problems become apparent, and demand a solution.

Just-in-Time
JIT requires at least eight factors to be effective:
short distances between buyer and supplier
dependable quality
small supplier network
dependable transportation
manufacturing flexibility
small lot sizes
effective receiving and materials-handling facilities
strong management commitment

The EOQ Inventory Model
Two costs associated with inventory:
Carrying costs
Ordering costs
Carrying costs increase as inventory levels increase.
However, ordering costs decline as the inventory level increases.
The firm attempts to minimize the total cost.
Total inventory cost = carrying cost + ordering cost

The EOQ Inventory Model
Note that the EOQ model applies to individual inventory items, not aggregate inventory.

The EOQ Inventory Model
S = annual demand for item in units
Q = number of items per order
So, average inventory = Q/2
C = carrying cost as proportion of inventory value
P = price (i.e. cost) per unit
The total annual carrying cost is then:
TCC = (C)(P)(Q/2)
F = fixed cost to place an order
N = number of orders placed per year
So, total annual ordering cost is:
TOC = F(S/Q)

The EOQ Inventory Model
Total Inventory Cost
TIC = TCC + TOC
= (C)(P)(Q/2) + (F)(S/Q)
So, as the order quantity Q increases, the first term increases, but the second term decreases.

The EOQ Inventory Model
To find the cost-minimizing order quantity, Q*, we apply calculus to the TIC equation:
TIC = (C)(P)(Q/2) + (F)(S/Q)
Solving, we find:
Q* = [2FS/(CP)]1/2
A consequence of this equation is that Q* increases with the square root of annual sales, S. So, the firm’s inventory turnover is assumed to increase as sales increase.

The EOQ Inventory Model

EOQ With Safety Stocks
Safety stocks are used to:
Meet demand in the event that it is larger than expected.
Meet demand if new orders take longer to receive than expected.

EOQ With Safety Stocks

EOQ With Safety Stocks
With safety stocks, the average inventory is higher than without them:
Avg. inventory = Q*/2 + safety stock

EOQ With Quantity Discounts
If the firm’s suppliers offer a discount for larger orders (larger than Q*), the firm will need to compare the reduction in purchase price with the additional TIC from holding a larger than optimal quantity:
Reduction in purchase price
+ TIC discount quantity
– TIC optimal quantity
= net savings from taking the discount
Let Q’ = discount quantity, D = discount percent
Net savings from taking the discount
= (D)(P)(S)
-(Q’ / 2)(C)(P)(1-D) + (F)(S/Q’)
+(Q* / 2)(C)(P)+ (F)(S/Q*)

Short-term Financing
FIN 340
Prof. David S. Allen
Northern Arizona University

Introduction
The firm must decide the mix of short-term debt, long-term debt, and equity used to finance its assets.
We will examine various sources of short-term financing, and their costs:
Accruals
Accounts payable
Banks loans
Commercial paper

Accruals
Arise from the fact that firms do not pay their employees on a daily basis.
Typically paid weekly, biweekly, or semi-monthly.
Also arise from accumulation of taxes payable.
“Free” source of financing
Arises spontaneously
Firm has little control over the level of accruals:
Pay schedule is usually determined by industry norms.
Tax payment schedule is set by law.

Accounts payable (trade credit)
Firms generally buy from other firms on credit.
Spontaneous source of financing.
Small firms often don’t qualify for other forms of financing, so trade credit becomes its largest source of non-equity capital.
Accounts payable
= (avg. payment period) x (avg. daily purchases)

Accounts payable (trade credit)
Cost of Trade Credit
If a firms buys on credit with discount terms, e.g. 2/10 net 30
For a $100 purchase
“True” price = $98
For a finance charge of $2, the buyer can obtain another (30-10)=20 days of credit
Cost of foregoing the discount

Accounts payable (trade credit)
Cost of foregoing the discount
Can be reduced by “stretching accounts payable”
But, may cause problems with suppliers
Decision Criteria
If the firm has an alternative source of financing, such as a bank line of credit, that is less expensive than the supplier provided “cost of foregoing the discount”, it should borrow from the bank and take the discount by paying earlier.

Accounts payable (trade credit)
Components of Trade Credit: Free versus Costly
Free trade credit = credit received during the discount period
Costly trade credit = credit beyond the discount period
Firms should always use the free component, but should use the costly component only if it has a lower cost than other available alternatives.

Short-Term Bank Loans
Non-spontaneous source of financing
Second in importance, after trade credit, as a source of short-term financing for non-financial firms.
Maturity
Most are for a year or less
Many are 90 day notes
Bank may refuse to renew if the borrower’s financial condition has deteriorated.

Short-Term Bank Loans
Promissory Note
Specifies:
Amount borrowed
Interest rate
Repayment schedule (lump sum or annuity)
Collateral
Others terms
Proceeds are deposited in the borrowers checking account.

Short-Term Bank Loans
Compensating Balances
Banks sometimes require borrowers to maintain an average (or even minimum) checking account balance equal to 10% to 20% of the loan principal.
The result is to increase the effective interest rate on the loan, since interest is paid on the full loan amount, but only a portion is usable.

Short-Term Bank Loans
Informal Line of Credit
An informal agreement between a firm and its bank indicating the maximum credit the bank will extend to the borrower.
Revolving Credit Agreement
A formal line of credit, and legal obligation of the bank.
Firm must pay a commitment fee on the unused portion, usually in monthly installments.
Interest is paid on the amount actually borrowed.
Interest rate is usually pegged to the prime rate or some other short-term rate (e.g. t-bill rate).
Clean-up clause: requires the borrower to reduce the loan balance to zero at least once per year (not permanent capital).

The Cost of Bank Loans
Rates are higher for riskier borrowers, and for smaller loans, due to the fixed cost of making and servicing loans.

Prime rate= 3.25% in November 2009.
Available only to bank’s most creditworthy customers.
Others pay “prime plus” some specified percentage points.

The Cost of Bank Loans
Promissory note elements:
Interest only
Interest paid during life of loan
Principal repaid at maturity
Amortized
Also known as an “installment loan.”
Each payment is part interest, and part principal.
Collateral
May be inventory, or receivables.
UCC-1 and Security Agreement filing with state to evidence collateral.
Prevents borrower from using same collateral on a different loan.
Specifies conditions under which collateral can be seized.

The Cost of Bank Loans
Promissory note elements:
Loan guarantees: for small corporations, the larger stockholders will have to personally guarantee the loan.
Nominal (stated) interest rate:
Fixed rate
Floating rate: typical for most loans of more than $25,000
360 versus 365 day year
Frequency of interest payments: usually calculated daily, but paid monthly
Maturity:
Long-term loans always have a stated maturity date
Short-term loans may be outstanding (rolled over) for a long time.

The Cost of Bank Loans
Promissory note elements:
Discount interest: interest is paid in advance, reducing the usable loan amount, and thus increasing the effective interest rate.
Other cost elements:
Compensating balance
Commitment fee
Key-person insurance: bank may require key persons to carry life insurance to pay off the loan in the event of their death.

The Cost of Bank Loans
Annual percentage rate = APR (as defined in Truth in Lending Act)
= effective periodic rate annualized without recognizing the effects of compounding.
= effective periodic rate * number of interest periods in a year
The APR is calculate as:

The Cost of Bank Loans
Effective annual rate = EAR (a.k.a. Effective Annual Yield or EAY, defined in Truth in Savings Act)
= effective periodic rate annualized to incorporate the effects of compounding.
= (1 + effective periodic rate)number of interest periods in a year – 1
The EAR overcomes the problems noted above for the APR, but is not required reporting for loans. It is used, however, in reporting rates earned on savings.

The Cost of Bank Loans
Consider a loan of $100,000 at a nominal (stated) rate of 8%, with a 360 day year (used by most banks).
Regular (Simple) Interest
Interest rate per day = nominal rate / 360
= .08 / 360 = 0.0002222222
So, the interest on a three month (90 day) loan would be:
Interest = (loan period)(daily rate)(amount borrowed)
= (90 days)(0.0002222222 / day)($100,000) = $2,000.00
APR = (2,000 / 100,000)(365 / 90) = 0.08111 = 8.111%
EAR = (1 + 2,000 / 100,000)365/90 – 1 = .08362 = 8.362%

The Cost of Bank Loans
Consider a loan of $100,000 at a nominal (stated) rate of 8%, with a 360 day year (used by most banks).
Discount Interest
Interest rate per day = nominal rate / 360
= .08 / 360 = 0.0002222222
So, the interest on a three month (90 day) loan would be:
Interest = (loan period)(daily rate)(amount borrowed)
= (90 days)(0.0002222222 / day)($100,000) = $2,000.00
This $2,000 is subtracted from the loan amount, and the borrower has use of only $98,000.
APR = (2,000 / 98,000)(365/90) = 0.08277 = 8.277%
EAR = (1 + 2,000 / 98,000)365/90 – 1 = .08538 = 8.538%

The Cost of Bank Loans
Consider a loan of $100,000 at a nominal (stated) rate of 8%, with a 360 day year (used by most banks).
Compensating Balance and Simple Interest
Interest rate per day = nominal rate / 360
= .08 / 360 = 0.0002222222
So, the interest on a three month (90 day) loan would be:
Interest = (loan period)(daily rate)(amount borrowed)
= (90 days)(0.0002222222 / day)($100,000) = $2,000.00
Compensating balance = 20% = $20,000
APR = (2,000 / 80,000)(365/90) = 0.10139 = 10.139%
EAR = (1 + 2,000 / 80,000)365/90 – 1 = .10533 = 10.533%

Choosing A Bank
Willingness to Assume Risks
Depends on
Personalities of bank officers
Characteristics of its deposit liabilities
Geographic and industry diversification of lending portfolio
Advice and Counsel
Bank lending officer may have valuable knowledge and experience that could be used by borrowing firms.
Loyalty to Customers
Will the bank work with customers experiencing difficulties, or call its loans?

Choosing A Bank
Specialization
Some large banks have departments that specialize in certain types of loans, e.g. agricultural.
Lending officer will understand the market better, and be more receptive to borrowers.
Maximum Loan Size
Maximum loan to any one customer is limited to 15% of capital stock plus retained earnings.
So, large firms will need to work with larger banks.

Commercial Paper
Short term, unsecured promissory note issued by large, creditworthy firms.
Sold to other businesses, insurance companies, mutual funds, and banks.
Maturity and Cost
Must be less than 271 days, to avoid SEC registration.
Interest cost is below prime rate, but above T-bill rate.
Use of Commercial Paper
Usually restricted to firms with net worth of $100,000,000 or more, and annual borrowings of $10,000,000 or more.

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Suppose a firm decides to minimize its holdings of current assets, relative to sales. Which statements are true?

Answer

1.	The firm’s expected profits will decrease.
2.	The firm’s expected profits will increase.
3.	The risk of the firm’s profits will decrease.
4.	The risk of the firm’s profits will increase.

2. A firm uses the EOQ model to detemine its optimal order quantity, but is considering adding a safety stock of 1,000 units to meet unexpected demand, or to cover demand during variations in lead time. Check all of the statements that are correct if it starts holding safety stocks.

Answer

a.	The firm’s annual total carrying cost (TCC) will increase.
b.	The firm’s annual total ordering cost (TOC) will decrease.
c.	The firm’s annual total inventory cost (TIC) will increase.

3. Match the term in the left column with the description in the right column.

credit period length of time customers are given to pay for purchases

discount reduction in amount owed if invoice is paid early

credit standard required financial strength of acceptable credit customer

collection policy procedures followed to collect past-due accounts

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