Principles of Working Capital Management.ppt

April 4, 2018 | Author: Pavan Koundinya | Category: Factoring (Finance), Clearing (Finance), Credit (Finance), Working Capital, Inventory


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PRINCIPLES  OF  WORKING  CAPITAL   MANAGEMENT  2 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   3 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.   •  •   working  capital  decisions   typically  affect  the  cash  flows  of  the  firm  for  a  shorter  /me   frame.  change  more  frequently   .  stocking  etc.4 Features  of  Working  capital  decisions   •  Working  capital  decisions  are  typically   •  Short-­‐term  financial  decisions.  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.e.  i..  which  are  one-­‐/me  and  irreversible   •  Concept  of  working  capital  is  dynamic  as  market  condi/ons  with   respect  to  credit.  the  higher  the  GWC  of  a  firm.5 Concepts  of  Working  Capital     1.  (accounts   receivable  or  book  debts)  bills  receivable  and  stock  (inventory).  the  bePer  its  liquidity  posi/on.   It  is  termed  as  managers’  concept  of  working  capital.   Other   factors   remaining   the   same.  Gross Working Capital (GWC) 2.     Increasing   GWC   affects   profitability   adversely   as   more   funds   get   /ed   up   in   current  assets  that  have  low/zero  yield.   •  •  •  .  Net Working Capital (NWC) 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.   It   denotes   the   liquidity   posi/on   of   the   firm.   bills   payable.   and   outstanding  expenses.     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).6 Concepts  of  Working  Capital   Net  working  capital  (NWC)   •  •  •  NWC   refers   to   the   difference   between   current   assets   and   current  liabili/es.     NWC  can  be  posi/ve  or  nega/ve.       •  •  Posi/ve  NWC  =  CA  >  CL   Nega/ve  NWC  =  CA  <  CL   . 7 Factors  influencing  Working  Capital  decisions   Time  –   Opera/ng  &   Cash  conversion   Cycle   Ac/vity-­‐     Units   produced  /   Sold  /  held  &   Costs   Working   Capital  Policy   of  the   company     Current  assets  to  total  assets  ra.o  for   different  industries    Industries     IT   Trading   Pharma   Engineering   Metals     Paper   Shipping     Current  assets  to   total  assets  (%)     80-­‐85   75–80   65–70     60–65     45–50     40–45   15–20     Nature  of  business   Market  &  demand   Technology   Manufacturing  policy   Credit  policy   Opera/ng  efficiency   Infla/on   .   Acquisi.  power  and  fuel  etc.   .  2.  inventories  into  sales  (either  cash  or  credit  sales)   3.  resources  into  inventories     2.  Credit  sales  into  cash.       The  opera/ng  cycle  of  a  manufacturing  company  involves  following   phases:   1.   Sale  of  the  product  either  for  cash  or  on  credit.  Credit  sales  create  account   receivable  for  collec/on.  3.on  of  resources  such  as  raw  material.  labour.   Manufacture  of  the  product  which  includes  conversion  of  raw  material  into   work-­‐in-­‐progress  into  finished  goods.ng  Cycle   Opera/ng  cycle  is  the  /me  dura/on  required  to  convert   1.8 Opera. ng  cycle   The  length  of  the  opera/ng  cycle  of  a  manufacturing   firm  is  the  sum  of:   •  •  Inventory  conversion  period  (ICP).9 Opera.   Debtors  (Account  receivable)  conversion  period  (DCP).     . 10 Gross  Opera.  GOC  is   given  as  follows:   .  Thus.ng  Cycle  (GOC)   •  The   firm’s   gross   opera/ng   cycle   (GOC)   can   be   determined   as   inventory   conversion   period   (ICP)   plus  debtors  conversion  period  (DCP).  Typically.11 Inventory  conversion  period  (ICP)   Inventory  conversion  period  is  the  total  /me  needed  for  producing  and   selling  the  product.  it  includes:   Rawmaterial Inventory X 360 RMCP = Rawmaterial consumed Work − In − process Inventory X 360 WIPCP = Cost of  production Finished Goods Inventory X 360 FGCP = Cost of goods sold . 12 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:   Sundry Debtors X 360 Debtors Conversion Period ( DCP ) = Annual Credit Sales . 13 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:   SundryCreditorsX 360 Creditors Deferral Period (CDP) = Annual Credit Purchases .   .   •  Net   opera/ng   cycle   is   also   referred   to   as   cash   conversion  cycle.14 Cash Conversion or Net Operating Cycle •  Net   opera/ng   cycle   (NOC)   is   the   difference   between   gross  opera/ng  cycle  and  payables  deferral  period. Compute the operating cycle for the firm assuming that the information given is for one full year period (figures  in  Rs.15 Operating & Cash conversion cycle Example: Following information has been extracted from the financial statement of a manufacturing firm.75   4.5   200   5.  Crore)   Average  Creditors  outstanding   Raw  material  purchases   Average  debtors  outstanding   Raw  material  consumed   Cost  of  produc/on   Cost  of  goods  sold   Sales   Inventory  of  raw  material   Work  –  in  -­‐  progress   Finished  goods   15   90   6   60   145   157.75   6.80   . 03  days   Gross  Opera.ng  Cycle  or  Cash  Conversion  Cycle   .80  X  360     157.on   Finished  goods  Inventory  X  360     Cost  of  Goods  Sold   Ave.50  days   =  16.80  days   =  73.03  days   =  60  days   =  13.  Sundry  Debtors  X  360     Credit  sales   5.16 Solu.on:   a)  RMCP  =     b)  WIPCP  =   c)  FGCP  =     d)  DCP  =   Raw  material  Inventory  X  360     Raw  material  consumed   WIP  Inventory  X  360     Cost  of  produc.76  days   =  10.  Sundry  Creditors  X  360     Credit  purchases   15  X  360     90   Net  Opera.97  days   =  10.75  X  360     145   4.ng  Cycle   e)  CDF  =   Ave.75    X  360     60   6.50   6  X  360     200   =  34. 37   73.63   78.18   -­‐25.76   61.50   14.97   116.47   .93   12.14   0.65   61.  Sojware   Comp.15   11.54   CCC  or   NOC   -­‐33.36   65.55   -­‐11.  Sojware   Comp.39   -­‐22.47   17.78   72.41   0.81   37.15   13.63   36.98   CDP   (days)   99.83   2.51   40.47   0.98   10.32   75.00   79.  Sojware   Personal  care   Personal  care   Steel   Steel   DCP   (days)   15.12   -­‐19.17 Cash conversion cycle of some companies Company   ACC  (  2007)   Ambuja  Cements  (2007)   Tata  Motors  (2008)   Ashok  Leyland  (2008)   Wipro  (2008)   TCS  (2008)   Infosys  (2008)   HUL  (2008)   Colgate  (2008)   SAIL  (2008)   Tata  Steel  (2008)   Source: FM text book by Jonathan Berk Industry   Cement   Cement   Auto   Auto   Comp.83   88.27   27.29   23.84   87.39   93.35   9.00   34.10   58.91   87.23   109.13   13.25   70.09   ICP   (days)   50.80   87.71   -­‐62.   This   method   is   essen/ally  based  on  the  opera/ng  cycle  concept.18 Es.   .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.ma.   To   es/mate   working   capital   requirements   as   a   ra/o   of   sales   on   the   assump/on  that  current  assets  change  with  sales.   To   es/mate   working   capital   requirements   as   a   percentage   of   fixed   •  Ra3o  of  sales     •  •  Ra3o  of  fixed  investment     •  investment.   is   referred   to   as   permanent   or   fixed  working  capital.     .19 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. n g   o r   v a r i a b l e   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.   F l u c t u a .  Profitability:  Risk–Return  Trade-­‐off     The  Cost  Trade-­‐off     Alterna3ve  current  asset  policies   Cost  Trade-­‐off   .20 Key  decisions  in  Working  Capital  Management   •  •  •  Current  Assets  to  Fixed  Assets  Ra.o     Liquidity  vs.    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   .21 Working  Capital  Finance  Policies   •  The  working  capital  financing  policy  may  have  a   significant  impact  on  the  profitability–liquidity   posi/on  of  the  firm.  However.  15  Cr   Rs.  85  Cr   Conserva.  30  Cr   .ve   Rs  115  Cr   Nil.  100  Cr   Aggressive   Rs.   any  requirement   over  and  above   Rs  115  cr  will   need  short  term   funding   Rs.22 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   Matching   Long  term   finances   Poten/al   Short  term   finances   Rs. Long term finances Short  term   Cost  advantage   Flexibility   Liquid  but  risky   Long  term   Less  risky   Long  process   Predictability   Conserva3ve  financing  plan   Aggressive  financing  plan   Matching  financing  plan   .23 Short vs. 25  lakh  tons  of   cement   per   annum.on  of  Rs  10)      Administra.   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.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   .lisa.   Cost  structure  per  bag  of  cement  (es.   its   present   capacity   u.on   given   below.mated)      Gypsum      Limestone      Coal      Packing  material      Direct  labour      Factory  overheads  (including  deprecia.   From   the   informa.   determine   the   net   working   capital   (NWC)   requirement  of  the  company  for  the  current  year.on   is   80   per   cent.24 Case  Study   Strong  Cement  Company  Ltd  has  an  installed  capacity  of  producing  1.   4)  Debtors  are  extended  credit  for  a  period  3  months.   other  conversion  costs  are  to  be  taken  at  50  per  cent).   Limestone   -­‐   1month.5  months.25 Addi.   6)  Average  .  Coal  -­‐  2.on:   1)  Desired   holding   period   of   raw   materials:   Gypsum   -­‐   3months.  25  lakh.me   lag   in   payment   of   wages   is   approximately   0.5  month   1)  Minimum  desired  cash  balance  is  Rs.   3)  Finished  goods  are  in  stock  for  a  period  of  1  month  before  they  are  sold.   5)  Average   .onal  informa.me  lag  in  payment  of  sales  tax  is  1.  namely  gypsum  limestone  and  coal  are  required  in  the  beginning.5   month   and   of   overheads.5  months  and  Packing  material  -­‐  1.5  months   2)  The   product   is   in   process   for   a   period   of   0.  Coal  -­‐  1  month  and  Packing  material  -­‐  0.  1  month.   7)  The  credit  period  extended  by  various  suppliers  are:          Gypsum  -­‐  2  months.5   month   (assume   full   units   of   materials.       . 70.500           70.5/12)              —  Raw  material  cost  100  per  cent  (Rs  25  +  Rs  15  +  Rs  30)              —  Other  conversion  costs  (Rs  50  +  Rs  20  cash  factory                          overheads)  ×  0.25.5/12)      Work-­‐in-­‐process:  (5  lakh  bags  ×  Rs  105  ×  0.25.833     .25.000   21.000   31.00.83.26 SOLUTION   Statement  showing  determina.87.000     31.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         Finished  goods  (5  lakh  bags  ×  Rs  170**  ×  1/12)      Debtors  (5  lakh  bags  ×  Rs  220**  ×  3/12)   Total                   Rs  70        35   105     Rs  25.75.67.000   6.000   6.00.000   4.5/12)      Packing  material  (5  lakh  bags  ×  Rs  10  ×  1.25.333   2. 500        88.00.  Rs  10  –  selling  overheads.16.79.on.08.54.41.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  ×  1.333   12.5/12)   Total   NWC                     20.8  =  1  lakh  ton/200  kgs  =  5.000  bags   **(Total  cost.  Rs  195  +  sale  tax.62.667   *1.  Rs  205  –  Deprecia.08.333   10.27 Current  liabili.166   3.333        15.000   2.667   27.83.50.25  lakh  tons  ×  0.  Rs  25)   ***(Cash  cost.  Rs  25)   . RECEIVABLES  MANAGEMENT   . 29 LEARNING  OBJECTIVES   •  •  •  •  Establishing  a  sound  credit  policy   Op/mum  credit  policy   Explain  the  credit  policy  variables   The  nature  and  costs  /  benefits  of  factoring   .  incremental  profit   •  •  •  produc/on  and  selling  costs   administra/on  costs   bad-­‐debt  losses   .30 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.  collec/on  period.  type  of  customer…   •  Credit  terms:   •  Credit  terms  for  specific  customers   •  Collec/on  efforts:   •  Process  for  collec/on   •  Provisioning  policy  for  aged  debts   .  which  includes   •  volume  of  credit  sales.31 Purpose  &  features  of  Credit  Policy   •  Purpose  of  Credit  policy  is  to  determine   •  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   •  Investment  in  receivables  to  op.mise  returns. mum  Credit  Policy   Credit  policy  aims  at  maximising  the  value  of  the  firm.  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)   .  Credit  policy  is   op/mum  when.32 Op.  12  lakh   cost per unit Rs 6. The current average collection period of the company is 25 days. the company is considering a more liberal credit policy. Which credit policy is Z   35  days   Rs.on  period   sales   the current level is Rs 8 and variable X   15  days   Rs. To increase the sales.800   600   .400   1.  47  lakh   desirable? Solution: Need to find out a)  Incremental investment in Receivables b)  Incremental rate of return (contribution / Incremental investment In AR) Cost  calcula3ons:   Average  cost  (Rs)   Unit  variable  cost  (Rs)   Price  (Rs)   Total  cost  of  sales  (Rs  lakh)   Total  variable  cost  (Rs  lakh)   Total  fixed  cost  (Rs  lakh)     8   6   10   2. If the collection period is extended. If the company Y   25  days   Rs.33 Illustration: Delta Company has current sales of Rs 30 Crore (or 3000 lakh).  27  lakh   required a return of 12 per cent on its investment. Average cost per unit at policy   collec. The company is selling its product at Credit   Increase  in   Increase  in   Rs 10 each. sales increase in the following manner.      Required  rate  of  return  (%)   25   3.  receivable  invt.  sales  (Rs  lakh).416   336   168   6.000   -­‐   -­‐   2.  Annual  sales  (Rs  lakh)   C.  Investment  in  receivables  at  cost  (Rs  lakh).  [F  -­‐  167]   H.8   2.  Inc.  Inc.  at  cost  (Rs  lakh).8%   12%   Policy   Y   25   25   50   3.ng  credit  period  (days)   A.407   267   100   4.  contribu.047   47   2.34   Current       policy   Exis/ng  Credit  period   Add:  Change  to  the  exis.4%   12%   Policy   Z   25   35   60   3.  [D/G]   I.  [B  -­‐  3.on  (Rs  lakh).  Inc.              [E/360  x  A]   G.  Cost  of  sales    (Rs  lakh).027   27   10.012   12   4.428   405   238   7.  New  Credit  period  (days)   B.9%   12%   Conclusion: The revised credit policy would be acceptable if the IRR = or > RRR.000]   D.400   167   -­‐   -­‐   -­‐   25   Policy   X   25   15   40   3.  [C  x  (10-­‐6)/10]   E.  [B/10  x  6  +  600]   F. .8   2.  Incremental  rate  of  return  (%). 027   27   10.              [E/360  x  A]   G.  contribu.  [C  x  (10-­‐6)/10]   E.  receivable  invt.  [B  -­‐  3.  Inc.      Required  rate  of  return  (%)   25   3.  New  Credit  period  (days)   B.  Investment  in  receivables  at  cost  (Rs  lakh).  [B/10  x  6  +  600]   F.4%   12%   Policy   Z   25   35   60   3.  at  cost  (Rs  lakh).400   167   -­‐   -­‐   -­‐   25   Policy   X   25   15   40   3.8%   12%   Policy   Y   25   25   50   3.8   2.ng  credit  period  (days)   A.  sales  (Rs  lakh).  Cost  of  sales    (Rs  lakh).047   47   18.428   405   238   7.9%   12%   Conclusion: The revised credit policy would be acceptable if the IRR = or > RRR.  Inc.000   -­‐   -­‐   2.416   336   168   6. .407   267   100   4.  [F  -­‐  167]   H.  Annual  sales  (Rs  lakh)   C.000]   D.012   12   4.  Incremental  rate  of  return  (%).8   2.  [D/G]   I.35   Current       policy   Exis/ng  Credit  period   Add:  Change  to  the  exis.on  (Rs  lakh).8   2.  Inc. 36 Factoring   •  Factoring  can  be  defined  as  ‘a  contract  between  the   suppliers  of  goods/services  and  the  ‘Factor’.  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   .  The  main  feature  of  Factoring  are:   •  •  •  •  •  Factor  performs  a  few  or  all  of  the  following  func/ons   Finance  the  supplier.  Under  this   contract  the  Factor  takes  over  (  or  ‘buys’)  the  debtors  of   the  suppliers.   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.  the  client  is   not  protected  from  bad-­‐debts.   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.  3.  .  and  as  such.ng   1.37 Factoring  and  Bills  Discoun.   Bill   discoun/ng  is  always  ‘with  recourse’. 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   its   core   competencies  viz.   Factoring   helps   the   firm   to   save   cost   of   credit   administra/on   due   to   the   scale   of   economics   and   specializa/on.   •  .  manufacturing  and  marke/ng. CASH  MANAGEMENT   . 41 Contents   •  •  Need  for  cash  management   Cash  planning  -­‐  budgets  &  Forecasts   . 42 Cash  Management   •  Cash  management  is  concerned  with  the  managing  of:   •  •  •  cash  flows  into  and  out  of  the  firm.  and   Financing  deficit  or  inves/ng  surplus  cash   .   cash  flows  within  the  firm. 43 Facets  of  Cash  Management   •  •  •  Cash  planning       Op/mum  cash  level       Inves/ng  surplus  cash     .   Cash  forecasts  are  needed  to  prepare  cash  budgets.44 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.   The  receipt  and  disbursements  method   The  adjusted  net  income  method   •  Short-­‐term  Forecas/ng  Methods   •  •  .45 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. ng   •  The  major  uses  of  the  long-­‐term  cash  forecasts  are:   •  It   indicates   as   company’s   future   financial   needs.   It   helps   to   improve   corporate   planning.   Long-­‐term   cash   forecasts   compel   each   division   to   plan   for   future   and   to   formulate   projects   carefully.   •  •  .   especially   for   its   working  capital  requirements.46 Long-­‐term  Cash  Forecas.   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   evaluate   proposed   capital   projects. 47 Op.mum  Cash  Balance   Op/mum  Cash  Balance  under  Certainty:  Baumol’s   Model   •  Op/mum  Cash  Balance  under  Uncertainty:  The  Miller– Orr  Model   •  . 48 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.   49 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:   Holding cost = k (C / 2) 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:   •  •  Transaction cost = c(T / C ) The  total  annual  cost  of  the  demand  for  cash  will  be:   Total cost = k (C / 2) + c(T / C ) 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:   2cT C* = k     •  Illustra;on:  Baumol’s  Model   50 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*  =   C* = C*= C* = 2cT k 2(150)(200000000) 0.16 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         Similarly.51 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.   .   it   sells  sufficient  marketable  securi/es  to  bring  the  cash  balance   back  to  the  normal  level  (the  return  point).   then   it   buys   sufficient   marketable   securi/es   to   come   back  to  a  normal  level  of  cash  balance  (the  return  point).   when   the   firm’s   cash   flows   hit   the   lower   limit. 52 Miller-Orr model . 53 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 + 3Z Return Point = Lower Limit + Z The net effect is that the firms hold the average the cash balance equal to: Average Cash Balance = Lower Limit + 4/3Z . on:  Miller  -­‐Orr  Model   54 XYZ  company  has  a  policy  of  maintaining  a  minimum  cash  balance  of  Rs  50  lakh.30.  The  annual  interest  rate   is  15  per  cent.141     Return  point  =  Lower  limit  +  z  =  50.  The  transac/on  cost  of  buying  and  selling  securi/es  is  Rs  150  per   transac/on.000  +  10.00.   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   = (3/ 4 X Transaction Cost X Cash Flow Variance / Interest Rate)1/3   = [3/4 X 150 X 20.714   Average  cash  balance  =  Lower  limit  +  4/3  Z  =  50.15 /365)]1/3     = 10.00.714  =  Rs  60.  The   standard  devia/on  of  the  company’s  daily  cash  flows  is  Rs  20  lakh.30.Illustra.92.285   .00.714   Upper  limit  =  50.30.74.714)  =  Rs  80.714)                      =  63.  Determine  XYZ’s  upper  control  limit.  return  point  and  average  cash  balance  as   per  the  Miller-­‐Orr  model.00.0002 / (0.30.000  +  (4/3  X  10.30.000+(3  X  10. ng  surplus  cash  in  Marketable   securi.Inves.es   •  55 Selec/ng  Investment  Opportuni/es:   •  •  •  Safety   Time  to  maturity   Marketability   . es:   •  •  •  •  •  •  56 Treasury  bills     Commercial  papers     Cer/ficates  of  deposits     Bank  deposits     Inter-­‐corporate  deposits     Money  market  mutual  funds   .Short-­‐term  Investment   Opportuni. 57 Appendix   . Features  of  Instruments  of  Collec.on   in  India   58 .  through  a  clearinghouse.   The  clearing  process  has  been  highly  automated  in  a   number  of  countries.     Instruments  like  cheques.  demand  drajs.   .  interest  and   dividend  warrants  and  refund  orders  can  go  through   clearing.  or  promissory  notes  do  not  go  through   clearing.59 Clearing   •  •  •  •  The  clearing  process  refers  to  the  exchange  by  banks  of   instruments  drawn  on  them.     Documentary  bills.  or  unan/cipated  demands   may  cause  large  disbursements.  however.   It  is  a  sound  tool  of  managing  daily  cash  opera/ons.  suffers  from  the  following  limita/ons:   •  •  .   For  example.   It  fails  to  highlight  the  significant  movements  in  the  working  capital   items.The  Receipt  and  Disbursements   Method   •  60 The  virtues  of  the  receipt  and  payment  methods  are:   •  •  It  gives  a  complete  picture  of  all  the  items  of  expected  cash  flows.   •  This  method.  collec/ons  may  be  delayed.   Its  reliability  is  reduced  because  of  the  uncertainty  of  cash  forecasts.  and  thus  helps   to  keep  a  control  on  a  firm’s  working  capital.61 The  Adjusted  Net  Income  Method   •  The  benefits  of  the  adjusted  net  income  method  are:   •  It  highlights  the  movements  in  the  working  capital  items.   •  •  The  major  limita/on  of  this  method  is:   •  It  fails  to  trace  cash  flows.  its  u/lity  in  controlling  daily   cash  opera/ons  is  limited.   It  helps  in  an/cipa/ng  a  firm’s  financial  requirements.   .  and  therefore. 62 Managing  Cash  Collec.ons  and   Disbursements   •  Accelera/ng  Cash  Collec/ons   •  •  Decentralised  Collec/ons   Lock-­‐box  System   Disbursement  or  Payment  Float   •  Controlling  Disbursements   •  .   the  difference  is  called  disbursement  or  payment  float.   Some   firms   use   the   technique   of   ‘playing   the   float’   to   maximize   the   availability   of   funds.   the   firms   that   delay   in   making   payments   may   endanger  its  credit  standing.   While.   However.   When   the   firm’s   actual   bank   balance  is  greater  than  the  balance  shown  in  the  firm’s  books.  a  centralized  system  may  be  advantageous.63 Controlling  Disbursements   •  Delaying   disbursement   results   in   maximum   availability   of   funds.   for   a   proper   control   of   disbursements.   •  •  .   for   accelerated   collec/ons   a   decentralized   collec/on   procedure   may   be   followed.
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