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WORKING CAPITAL
Short-Term Finance
What Is (Net) Working Capital?
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Current Assets – Current Liabilities
What Does It Mean to be Current?
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Convertible to cash with a year
What Are Current Assets?
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Cash Very liquid short-term securities - like T-
bills, repurchase agreements, and commercial paper – are usually included here
Marketable securities Less liquid and longer-term investments
made out of current assets Inventory Accounts receivable
What Are Current Liabilities?
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Accounts payable Accruals of wages and salaries All payments on long-term debt that are
payable within a year
What Is Non-Cash Working Capital?
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Remove cash and marketable securities from current assets Cash and marketable securities are held for
reasons beyond just working capita They also pay interest, reducing their
opportunity cost to something much closer to zero than can reasonably be expected from non-cash working capital
Remove debt as well – it gets counted in cost of capital
Inventory+receivables-payables-accruals
What Is the Pitfall in Thinking About Non-Cash Working Capital?
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Increases in inventory and receivables bleed cash out of the firm
Increases in payables and accruals yield cash for the firm
What Are the Economics of Non-Cash Working Capital?
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Non-cash working capital is a derived demand You need it because of projects You often need it before the project is
generating cash flow It is subject to
Economies of scale Economies of scope
What Is the Non-Cash Working Capital Tradeoff?
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Non-cash working capital is subtracted out of the present value of the project
Thus, present value and non-cash working capital are traded off The higher present value is traded off with
the higher risk due to potential loss of customers, and higher default risk
What Are the Cons of the Tradeoff Between Cash and Non-Cash Working Capital?
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Holding less cash: Is less of an issue if the firm has access to
ready outside financing Is harder if the economy tanks Increases uncertainty about meeting debt
obligations
What Are the Pros of the Tradeoff Between Cash and Non-Cash Working Capital?
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Holding less cash: Makes it easier to satisfy the customer out
of inventory Makes it easier to entice the customer with
easy credit
Is There An Optimal Level of Non-Cash Working Capital?
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Probably, but there are a lot of difficulties getting the data to figure out the tradeoff
What Industries Use the Most and Least Non-Cash Working Capital?
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Most: Shoes, textiles, office equipment,
homebuilding, auto manufacturing Least:
Advertising, cable TV, restaurants, hotels/gaming, railroads
What Are the Benefits of Holding Inventory?
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Raw materials Works in progress Finished items
More if it takes time to fill an order More if the product line is diverse More if competitors are ready with
substitutes
What Are the Costs of Holding Inventory?
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Foregone interest Increases with the size of inventory Increased with interest rates
Carrying costs Storage Tracking
What Is EOQ (Economic Order Quantity)?
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A solution to a simple optimization problem for minimizing the costs of inventory EOQ = sqrt(2 x demand x ordering cost/carrying
cost) This yields a graph of inventory that looks like a
series of “capital N’s” through time A cushion can be added above zero inventory for
safety Similar to the Baumol model for cash
(presented later)
What Are the Weaknesses of Using EOQ?
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It assumes constant demand It assumes that inventories can be
replenished without a time delay It assumes that ordering costs do not
depend on the size of the order (i.e., there are no volume discounts)
How Can Optimal Inventories Be Determined?
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Ideally you want to measure the change in the value of the firm due to a marginal change in inventory This is difficult in practice
Most firms look at similar firms for guidance
What Industries Hold the Most and Least Inventory?
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Most: Pharmacies, textiles, aerospace, apparel,
homebuilding Least
Healthcare information systems, medical services, telecommunications, hotels/gaming, restaurants
How Does Trade Credit Relate to Non-Cash Working Capital?
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Leads to an accounts receivable Product is shipped, leading to a need to
replenish inventory Payment may not be made immediately This can create cash flow problems
What Are the Costs of Offering Trade Credit?
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Default risk Interest foregone on the revenue
What Are the Benefits of Offering Trade Credit?
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Locks in a sale that the buyer can afford out of cash flows but not out of cash on hand
It’s also more of an additional general enticement to the buyer While trade credit is being “sold” to the
prospective buyer you are keeping them on the line for the item you actually want to sell
How Do You Decide Whether or Not to Offer Trade Credit?
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Present value analysis
How Do We Evaluate Trade Credit Policy?
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Similar to inventory policy? The problem is too murky to be solved
directly. So we ask: Does it increase the value of the firm? Is it consistent with what similar firms are
offering?
How To Construct a Scoring System for Offering Trade Credit?
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Define characteristics associated with default
Obtain data legally Weight the data in a way consistent with
the default risk Test fly the system Put it into practice
How Are Terms of Trade Credit Expressed?
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a/b net c a% discount Lasting for b days The full undiscounted amount due within c
days
How Do You Figure Out the Rate You Are Offering?
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[1+discount/(1-discount)}^(365/discount length) = 1+effective rate
If the customer delays payment, they are effectively increasing the discount length – and reducing your interest rate
Who Has the Most and Least Accounts Receivable?
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Most Telecommunications, newspapers, energy,
semiconductors, petroleum Least
Restaurants, industrial services, healthcare information services, tobacco, trailers and RVs
What About Accepting Trade Credit?
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This creates an accounts payable It also tends to increase cash flows The costs and benefits of this are the
opposite of extending trade credit, but … Don’t forget that the interest you pay is
deductible, while the interest you receive is not – so they are not quite mirror images of each other
Who Accepts Trade Credit?
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Surprisingly, the same industries that extend lots of trade credit also tend to accept a lot of it Restaurants and tobacco firms use little of
both Defense and auto firms use a lot of both The biggest exploiters of longer payables
and shorter receivables are auto firms
What About Cash?
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Cash Money in accounts bearing rates lower
than the risk-free rate Short-term securities
Why Hold Operating Cash?
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Transactions motive Precautionary motive Compensating balances
This is what you hold in the bank to get access to lines of credit and other services
What Determines Cash Holdings?
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Size Sophistication of the firm’s finances Availability of investments Most U.S. firms hold 1-2% of revenues as
cash
What Is the Baumol Model?
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Similar to the EOQ for inventory Optimal cash balances = sqrt[(2 x
annual cash usage x cost per security sale)/(interest rate)]
What Is the Miller-Orr Model?
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Firm sets upper and lower limits on cash, and it only buys or sells securities when it reaches these thresholds. This requires us To assume a minimum balance To know the variance of cash flows
Spread = 3[(3/4)(transactions cost x variance/interest rate)]^(1/3)
How Does Holding Cash Affect the Firm’s Value?
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Holding operating cash is much like holding non-cash working capital It reduces the flow of cash that can be paid
out to investors
How Can Cash Be Reduced?
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Float managing Increase your disbursement float and
decrease your processing float Better banking
Lockboxes Concentration banking Have the bank control disbursements so
they are made immediately after deposits
What Near-Cash Investments Are Possible?
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In order of increasing risk and return (there is usually a less than 1% difference in this group) Treasury bills Repurchase agreements
On T-Bills On non-mortgage securities On mortgage-backed securities
Commercial paper From financial institutions From non-financial instititutions
How to Choose Between Cash and Near-Cash?
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Benefits of near-cash Earn interest
Costs of near-cash Transactions costs Default risk (admittedly, this is minimal)
Choosing to park some cash in near-cash is an investment decision whose hurdle rate is the risk-free rate You need to be able to beat this after
transactions costs and default risk
When Can Investments In Cash and Near-Cash Reduce Firm Value?
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Not earning the market rate This is not much of a problem in the U.S. This can be a big problem with overseas
investments where local markets may be overregulated or too thin to offer reasonable risk-free rates
Lousy management The value of cash will be discounted in the
market if the firm has few viable projects Cash is a payment that has not been
made to equity yet Thus, hording cash is the same as being
underleveraged
Are There Good Reasons to Hold Lots of Cash?
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High growth industries High volatility industries Industries in which viable projects appear
unexpectedly
What About Riskier Investments In the Short-Term?
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Pros Higher returns You can take advantage of undervalued
securities issued by other firms Strategic investment
Push other firms decisions in your direction It’s the nature of some businesses
Cons Higher risk Higher transactions costs
Who Holds Cash?
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Most Coal, copper, air transport, autos, steel
Least Retail building supply, water utilities,
pharmacies, groceries, retail Cash holdings are positively associated
with revenue growth and negatively associated with revenue