IFM10 Ch21 Solutions Manual.docx
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IFM10 Ch21 Solutions Manual.docx
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IFM10Ch21SolutionsManual
Chapter21
WorkingCapitalManagement
ANSWERSTOBEGINNING-OF-CHAPTERQUESTIONS
21-1TheCCCisdefinedasthenumberofdaysbetweenacompany’spayingforsomeproductorservicethatitsellsandthereceiptofcashfromthesaleoftheproductorservice.
Otherthingsheldconstant,itisbettertohaveashorterthanalongerCCC,becausethelowertheCCC,thelessthefirm’sinvestmentinworkingcapital.Withlessworkingcapital,totalcapitalrequirementdecline,causingthedollarcostofcapitaltodecline.Thisincreasesnetincomeandthevalueofthefirm.
AsshownintheBOCmodel,theillustrativecompany’sinventoryconversionperiodis28days,itsreceivablescollectionperiod(orDSO)is20days,anditspayablesdeferralperiodis28days,resultinginaCCCof20days.
Thecompanyhasa$380millioncostofgoodssold,or$380/360=$1.0556perday.Witha20dayCCC,itsaverageinvestmentinworkingcapitalis20($1.0556)=$21.11million.Witha10%costofcapital,thecostofcarryingworkingcapitalis$2.11million.
IftheCCCcouldbereducedby5days,to15days,theaverageworkingcapitalbalancewouldbe15($1.0556)=$15.83million,withacarryingcostof$1.58million.Thus,thesavingswouldbe$2.11million-$1.58million=$530,000.
ThekindsofactionsthatcompaniestaketoshortentheirCCC’sincludespeedingupthemanufacturingprocess,offeringdiscountsortighteningcredittermsandstandardstospeedupcollections,andnegotiatingbettercredittermsorpayingfromremotelocationstodeferpayments.Ofcourse,thecostsoftakingsuchactionsmustbebalancedagainstthebenefitsofthelowerCCC.
21-2Acashbudgetisaforecastofinflowsandoutflowsofcash,generallyonamonthlyordailybasis.Theprimarypurposeofthecashbudgetistoforecastwhenloanswillbeneededand/orwhensurplusfundsthatcanbeinvestedwillbeonhand.Acashbudgetisalsoveryusefulwhennegotiatingbankloans.
TheBOCmodelprovidesadetailedexampleofamonthlycashbudget.Itshowsthat,otherthingsheldconstant,shorteningtheCCCwillcausecashtocomeinfaster,thusincreasinginvestablefundsand/orreducingborrowingrequirements.
Achangeincreditpolicywillhaveseveraleffectsonthecashbudget.Atighteningwillprobablylowerthesalesforecast,whichwillreducebothcollectionsandpaymentsforpurchases,andpossiblyalsotaxespayable.Tighteningshouldalsoalterthepercentagesofsalescollectedduringeachmonth,increasingthepercentagesforthefirstandsecondmonthsandreducingthepercentageforthethirdmonth.Thosechangeswouldprobablylowertheneedforloans.However,alotdependsontheprofitabilityofsales,andifatighteningreducedsalessubstantially,thismightlowerprofitsandadverselyaffectcashflow.Ourconclusionisthatoneshouldnotjumptoquickconclusionsabouthowacreditpolicychangewillaffectoperations.Rather,athoroughanalysisisrequired.
NotealsothatachangeincreditpolicywouldaffecttheCCC.Atightningwouldleadtofasterpayments,whichwouldshortentheCCC,andaneasingwouldhavetheoppositeeffect.
21-3Freetradecreditisthecreditonegetsduringthediscountperiod,i.e.,creditonereceiveswhilestillbeingabletotakediscounts.Forexample,ifyoubuy$100ofgoodsundertermsof2/10,net30,youonlyhavetopay$98ifyoupaybythe10thday,soyouget$98offreecreditfor10days.Afterday10,youcangetanadditional20daysofcredit,butatacostofthe$2discountyoumustgiveup.Seethemodelfornumericalexamplesofthenominalandeffectivecostratesfordifferentsetsofcredittermsandactualpayments.Thereweshowthatstretchingpaymentslowerstheeffectivecostoftradecredit.However,stretchingpaymentsgivesoneareputationforbeingaslowpayer,andthatcanhaveasubstantialthoughnotquantifiablecost.
21-4Matchingmaturitiescausesthecashflowsfromanassettobesynchronizedwiththecashcostsrequiredonthecapitalusedtofinancetheassets.Ifthefirmwerefinancedonlywithdebt,andifthedebtwasamortized,thenthematchingwouldbequiteclose.However,firmsusebothdebtandequity,andtheequityhasnostatedmaturity.Similarly,assetshavevaryinglives,andthoselivescannotalwaysbedeterminedatthetimetheassetisbeingfinanced..Forexample,ifafirmspendsmoneyonadvertisingtobuilditsreputationasareliablesupplierofhighqualityproducts,andiftheadvertisingiseffective,then“goodwill”iscreated.Goodwillisclearlyanintangibleasset,regardlessofwhetherornotaccountantsshowitonthebalancesheet,andmoneymustberaisedandspenttocreatethegoodwill.Butwhatisthelifeofthatasset,hencehowcanonefinanceitwithamatchingmaturityclaim?
Ourconclusionisthatitmakessensetoconsiderthematchingmaturityconcept,andtoavoidfinancingabuildingwitha30yearlifewitha30dayloan.However,itwouldbedifficult,ingeneral,tomatchallassetandclaimmaturitiesperfectly.
Firmscanalsodeliberatelymismatchmaturitiesiftheythinkthatcapitalcostsarelikelytoriseorfallsharplyinthenearfuture.Forexample,ifinterestratesarecurrentlyquitehighandstockpriceslow,thenafirmmightfinancelongtermassetsadditionswithshorttermdebtonthetheorythatitcouldlaterrefinancetheshorttermdebtwithlongtermdebtonceratesfall.
21-5Anaggressivefinancingpolicygenerallyreferstoadeliberatemis-matchingofassetandclaimsmaturities.Theyieldcurveisnormallyupwardsloping,soshort-termratesarenormallylowerthanlong-termrates.Thus,firmscannormallyminimizecurrentinterestpaymentsbyusingprimarilyshort-termdebt.However,thiscanbeabigmistakeifinterestratesrise,inwhichcasethefirmwouldhavebeenbetterofflockinginlong-termratesbeforetheyrose.
Also,itisaggressivetouselotsofdebtandrelativelylittleequityinfinancing.Debtnormallycostslessthanequity,butequityfinancingissaferfromthefirm’sstandpoint.
Entrenched,oligolopisticfirmscangenerallyfinancewithwhatevertypeofcapitaltheirmanagementschoose,andmanagementsoftenchoosetofollowaconservativefinancingpolicysotheywon’thavetoworryasmuchastheywouldunderanaggressivepolicy.Firmsinhighlycompetitiveindustriesareoftenunderpressure,andduringhardtimescapitalsuppliersaremorewillingtolendmoney(secured,withtoughterms)thantobuythestockofashakycompany.Also,profitmarginsoffirmsinhighlycompetitiveindustriesmaypressurecompaniestoholddownallcosts,includingcapitalcosts,eventothepointwheretheirfinancingpoliciesputthefirmatrisk.
ANSWERSTOEND-OF-CHAPTERQUESTIONS
21-1a.Workingcapitalisafirm’sinvestmentinshort-termassets--cash,marketablesecurities,inventory,andaccountsreceivable.Networkingcapitaliscurrentassetsminuscurrentliabilities.Netoperatingworkingcapitalisoperatingcurrentassetsminusoperatingcurrentliabilities.
b.Theinventoryconversionperiodistheaveragelengthoftimeittakestoconvertmaterialsintofinishedgoodsandthentosellthem.Itiscalculatedbydividingtotalinventorybysalesperday.Thereceivablescollectionperiodistheaveragelengthoftimerequiredtoconvertafirm’sreceivablesintocash.Itiscalculatedbydividingaccountsreceivablebysalesperday.Thecashconversioncycleisthelengthoftimebetweenthefirm'sactualcashexpendituresonproductiveresources(materialsandlabor)anditsowncashreceiptsfromthesaleofproducts(thatis,thelengthoftimebetweenpayingforlaborandmaterialsandcollectingonreceivables.)Thus,thecashconversioncycleequalsthelengthoftimethefirmhasfundstiedupincurrentassets.Thepayablesdeferralperiodistheaveragelengthoftimebetweenafirm’spurchaseofmaterialsandlaborandthepaymentofcashforthem.Itiscalculatedbydividingaccountspayablebycreditpurchasesperday(COGS/365).
c.ArelaxedNOWCpolicyreferstoapolicyunderwhichrelativelylargeamountsofcash,marketablesecurities,andinventoriesarecarriedandunderwhichsalesarestimulatedbyaliberalcreditpolicy,resultinginahighlevelofreceivables.
ArestrictedNOWCpolicyreferstoapolicyunderwhichholdingsofcash,securities,inventories,andreceivablesareminimized;whileamoderatecurrentassetinvestmentpolicyliesbetweentherelaxedandrestrictedpolicies.
AmoderateNOWCpolicymatchesassetandliabilitymaturities.Itisalsoreferredtoasthematuritymatching,or“self-liquidating”approach.
d.Transactionsbalanceisthecashbalanceassociatedwithpaymentsandcollections;thebalancenecessaryforday-to-dayoperations.Acompensatingbalanceisacheckingaccountbalancethatafirmmustmaintainwithabanktocompensatethebankforservicesrenderedorforgrantingaloan.Aprecautionarybalanceisacashbalanceheldinreserveforrandom,unforeseenfluctuationsincashinflowsandoutflows.
e.Acashbudgetisascheduleshowingcashflows(receipts,disbursements,andcashbalances)forafirmoveraspecifiedperiod.Thenetcashgainorlossfortheperiodiscalculatedastotalcollectionsfortheperiodlesstotalpaymentsforthesameperiodoftime.
Thetargetcashbalanceisthedesiredcashbalancethatafirmplanstomaintaininordertoconductbusiness.
f.Tradediscountsarepricereductionsthatsuppliersoffercustomersforearlypaymentofbills.
g.Anaccountreceivableiscreatedwhenagoodisshippedoraserviceisperformed,andpaymentforthatgoodisnotmadeonacashbasis,butonacreditbasis.
Dayssalesoutstanding(DSO
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