HARAMBEE UNIVERSITY COLLEGE

FINANCIAL MANAGEMENT II

Adama 2009
 UNIT ONE
WORKING CAPITAL MANAGEMENT

Decisions relating to working capital and short term financing are referred to as working
capital management.
management. These involve managing the relationship between a firm's short-
term assets and its short-term liabilities.
liabilities. The goal of working capital management is to
ensure that the firm is able to continue its operations and that it has sufficient cash flow to
satisfy both maturing short-term debt and upcoming operational expenses.

1.1 General Introduction

By definition, working capital management entails short term decisions - generally,

relating to the next one year period - which is "reversible". These decisions are therefore
not taken on the same basis as Capital Investment Decisions (NPV or related, as above)
rather they will be based on cash flows and / or profitability.

 One measure of cash flow is provided by the cash conversion cycle - the net
number of days from the outlay of cash for raw material to receiving payment
from the customer. As a management tool, this metric makes explicit the inter-
relatedness of decisions relating to inventories, accounts receivable and payable,
and cash. Because this number effectively corresponds to the time that the firm's
cash is tied up in operations and unavailable for other activities, management
generally aims at a low net count.

 In this context, the most useful measure of profitability is Return on capital

(ROC). The result is shown as a percentage, determined by dividing relevant
income for the 12 months by capital employed;
employed; Return on equity (ROE) shows
this result for the firm's shareholders. Firm value is enhanced when, and if, the
return on capital, which results from working capital management, exceeds the
cost of capital,
capital, which results from capital investment decisions as above. ROC
measures are therefore useful as a management tool, in that they link short-term
policy with long-term decision making. See Economic value added (EVA).

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1.2 Management of working capital

Guided by the above criteria, management will use a combination of policies and
techniques for the management of working capital. These policies aim at managing the
current assets (generally cash and cash equivalents,
equivalents, inventories and debtors)
debtors) and the
short term financing, such that cash flows and returns are acceptable.

1.2.1 Cash management.

management.

Identify the cash balance which allows for the business to meet day to day expenses, but
reduces cash holding costs.

1.2.2 Inventory management

Identify the level of inventory which allows for uninterrupted production but reduces the
investment in raw materials - and minimizes reordering costs - and hence increases cash
flow; see Supply chain management;
management; Just In Time (JIT); Economic order quantity (EOQ);
Economic production quantity

1.2.3 Debtors management

Identify the appropriate credit policy,

policy, i.e. credit terms which will attract customers, such
that any impact on cash flows and the cash conversion cycle will be offset by increased
revenue and hence Return on Capital (or vice versa);
versa); see Discounts and allowances.
allowances.

1.3 Short term financing.

financing.

Identify the appropriate source of financing, given the cash conversion cycle: the
inventory is ideally financed by credit granted by the supplier; however, it may be
necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through
"factoring".
factoring".

Funds invested in a company's cash, Accounts Receivable,

Receivable, Inventory,
Inventory, and other Current
Assets (gross working capital); usually refers to net working capital-that
capital-that is, current assets
minus Current Liabilities. Working capital finances the Cash Conversion Cycle of a

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business-the time required to convert raw materials into finished goods, finished goods
into sales, and accounts receivable into cash. These factors vary with the type of industry
and the scale of production, which varies in turn with seasonality and with sales
expansion and contraction. Internal sources of working capital include Retained Earnings
savings achieved through operating efficiencies and the allocation of Cash Flow from
sources like Depreciation or deferred taxes to working capital. External sources include
bank and other short-term borrowings, Trade Credit and term debt and Equity Financing
not channeled into long-term assets.

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 UNIT TWO
WORKING CAPITAL REQUIREMENT
 Definition
The amount of working capital a company determines it must maintain in order to
continue to meet its costs and expenses. The working capital requirement will be different
for each company, depending upon many factors such as how frequently the company
receives earnings and how high their expenses are.

2.1 Working Capital Estimating

Take time out to sort through all of your inventory and review services. This might mean
taking a trip your company's storage room and rummaging through items. Find out how
you can use items that are simply collecting dust, in order to increase profit.

Do you have employees with nothing to do? Make a list of long term goals for your
business (i.e. open a new store; start delivering to customers, etc.). Then create short term
goals that must be completed in order to reach each long term goal (i.e. research
communities in need of such services, purchase a company car, etc.). Break these short
term goals into weekly/daily tasks and make sure that you and your employees are aware
of what needs to be done, and always taking action.

After you've reviewed all inventory, including products, services, company vehicles, etc.,
and put it to good use, review what is left over and eliminate it. You can make money by
selling unused items and eliminating unwanted services. Unfortunately, the same goes for
employees. If you find that you have more employees than necessary to complete work, it
may be wiser to outsource what is necessary to another company

Any invoices that are more than 60 days old should be taken care of. By 30 days, have
staff begin to check and work on getting the money owed to you into the account.

Review all of the debts that you owe and set a schedule of when you pay each one.
Usually, the longer it takes to pay off a debt, the more interest it collects. Having an

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understanding of all debts and paying them on time will keep your business more
organized and keep you in control and aware of your finances.

A financial professional such as an accountant, attorney or a financial advisor, can help

you make financial decisions when you are overwhelmed. But it is important that you
trust this person and his/her judgment. Before choosing a financial advisor, look into their
client history and find out if they have had success with others. Ask other clients how
they feel about the financial advisor's services and ask whether or not they recommend
his/her services. But don't depend on your financial advisor for everything. Make sure
you can still capable of making your own financial decisions when necessary.

2.2 What Does "Net Working Capital" Mean?

To understand what we mean by "net working capital," let's break this phrase down into
its component parts:
Net.
Net. This means we look at cash tied up in short term operating assets such as accounts
receivable and inventory, offset by non-interest bearing current liabilities such as
accounts payable.
Working:
Working: This means that we want to focus on cash tied up in short term operating
assets. Thus, working capital excludes long term capital required for, say, investment in
Plant, Property and Equipment (PP&E).
Capital. This means that we want to calculate the amount of cash that a company has to
tie up in working capital in order to run its business.

More specifically, for industrial companies, "net working capital" equals cash tied up by
a company's short term operating assets, netted against short term operating liabilities.
For any year, then, we add and subtract the following to calculate a company's net
working capital:
Required cash:
cash: We usually assume that a company needs to have some cash on hand to
run its business. We can estimate that sum as a fixed amount of cash, or an amount as a
percentage of sales. Thus, we add required cash to calculate working capital.

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2.2.1 Accounts receivable (A/R)
Accounts Receivable equals money owed to a company for goods or services purchased
on credit. As A/R grows, then, a company needs to tie up cash in its business as it
effectively lends this money out. Thus, we add accounts receivable to calculate working
capital.

2.2.2 Inventory
Any company selling a physical product will have to tie up cash in raw materials, work-
in-progress and finished goods inventory. Thus, we add inventory to calculate working
capital.

2.2.3 Other current assets

A company may have to tie up cash in other current assets, such as insurance pre-
payments. Thus, we add other current assets to calculate working capital.

2.2.4 Accounts payable

Accounts Payable equal bills from suppliers for goods or services purchased on credit. A
company benefits from accounts payable just like consumers benefit from a charge card:
you enjoy the merchandise now, and pay later. Thus, we subtract accounts payable to
calculate working capital.

2.2.5 Deferred or Unearned Revenue

Some companies get paid in cash by their customers before those companies deliver a
promised product or service. As an example, you may have purchased a warranty for a
product, whereby you gave company cash in advance for a promised service: the ability
to have that product replaced or fixed in the event it became defective. Until the warranty
ends, the company has the obligation to provide this service to you, so it must recognize
this cash received as a liability. Thus, we subtract deferred revenue to calculate working
capital.

2.2.6 Other Non-interest Bearing Current Liabilities

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Various companies may have assorted non-interest bearing current liabilities such as
accrued wages, accrued expenses, accrued royalties, or "other accrued liabilities." These
non-interest bearing current liabilities generate cash as they increase. Thus, we subtract
other non-interest bearing current liabilities to calculate working capital.

In cases where working capital tends to be more volatile or trend in a particular direction,
"cash conversion cycle" analysis offers an intuitive way of thinking about, and projecting,
working capital. The cash conversion cycle quantifies the time between cash payment to
suppliers and cash receipt from customers.

The three components of the cash conversion cycle are as follows:

A. Days sales outstanding (DSO)-is the number of days between the sale of a product
and the receipt of a cash payment. The formula is: DSO = Days in year (360) / (Sales /
Average accounts receivable).
B. Days in inventory (DII). The number of days it takes for a company to convert its raw
material, work-in-progress and finished goods inventory into product sales. The formula
is: DII = Days in year (360) / (Cost of goods sold / Average inventory).
C. Days payables outstanding (DPO)-is the number of days between the purchase of an
input from a vendor and cash payment to that vendor. The formula is: DPO = Days in
year (360) / (Cost of goods sold / Average accounts payable).

2.3 Dimensions of Working Capital Management

In addition to long-term investment decisions viz. which project to take up for
investment? What is the appropriate amount of debt financing? What is the best dividend
policy for a firm? Agency management software can help a business to deal with many
questions related with customer relationship management and sales force automation
software.

Companies face many decisions involving investment in current assets and their firm?
What should be the level of investment in inventories and bills receivables? How much
cash or marketable securities should be held? What should be the level of credit
purchases and bills payable?

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To what extent should the current assets be financed through long-term funds? These
questions relate to the current assets and current liabilities of a firm, and belong to the
field of working capital management. Working capital management is thus concerned
with all the aspects of managing current assets and current liabilities.
Let us pinpoint its significant dimensions which require the attention of financial
executives.

2.4 Benefits of Working Capital Management

Even though interest rates are low, companies that can squeeze cash out of the order-to-
receipt process see big advantages over competitors with inefficient processes.
For companies that are relatively unsophisticated, that means overhauling operations to
speed up processes and eliminate mistakes that lead to delays. Improvements can be as
basic as reengineering billing procedures so that accurate bills go out the same day orders
are shipped, with all pertinent information included, in ways that fit smoothly into the
customer's A/P system -- which can reduce the number of payments that have to be
processed as exceptions, suggests Wright.

Sophisticated companies that have mastered the fundamentals of working capital should
take a broader approach; they should look for ways to speed up the whole supply chain,
Wright says. "Working capital is money the business process consumes. The longer the
process takes, the more money is consumed.

Trade finance is an important part of the business. It offers various aspects of managing
finances for the company. Trade finance helps to generate, manage and establish various
finance practices like working capital, factoring solutions, banking solutions, loans,
guarantees, discounting, etc. Various trade finance companies help to provide credit
finance, export finance, credit protection, invoice collection services, etc. Trade finance
companies help to reduce marketing cost and increase one's trade profitability. They also
help in increasing the sales by promoting the products, services or the website around the
world.

2.5 Financing of Working Capital

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Working capital financing is essential to any growing business. It helps keep your
business current and competitive in your market. If you have commercial real estate or
equipment that produces an income for your business, you can obtain working capital
financing that can help pay down credit lines or accounts payable, freeing up money for
growth opportunities. Before attempting to obtain this type of loan make sure that you
have established good business credit scores. These credit scores will make a big
difference when the lending institution is determining whether to give your business the
money that it needs to succeed.

Working capital financing can range anywhere from $100,000 to $2,000,000 and more.
The loan terms can range anywhere from 15 to 25 years. These loans typically are paid
back in installments with no large lump-sum payments required. This is also known as a
fully amortizing loan. Once acquired working capital financing can be used for acquiring
real estate, expanding a current facility, building a new office, purchasing new
equipment, operating expenses, or to buy out a current owner or shareholder.

All types of businesses are eligible for working capital financing. Service businesses,
manufacturers, distributors, retail stores, professionals, restaurants, and gas stations can
all benefit from these types of loans.
Ease the process of obtaining this financing by having your business credit scores in
place which our unique Business Finance Coach.

2.6 Financing a New Business

Your new business may need financing to cover the cost of equipment and other expenses
before sales generate enough cash to make the operation self-supporting. There are a
number of ways to obtain financing, and your choice among them will depend on your
situation. What you need to know? What is "angel”?

2.7 Alternative Strategies and Optimum Working Capital Policies

Many companies seek to differentiate themselves and achieve success primarily through
new technologies or unique product or service offerings. Companies that apply best
practices go beyond this by gaining competitive advantage through stronger and more

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efficient internal business processes. The role of cash management can vary greatly from
one company to the next, making an apples-to-apples benchmark comparison of how
corporations collect, disburse and invest cash an arduous task. Good to excellent
businesses frequently attempt to optimize their company's cash management function by
incorporating best practices to reduce external financing cost, lower bank charges,
minimize risk and manage long- and short-term liquidity.

These companies approach working capital management with a goal to lower costs and
free up resources for investment and growth. They take full advantage of myriad
opportunities to strengthen cash flow and cash budgeting, settle payments quickly, reduce
working capital liabilities, negotiate favorable payment terms with suppliers, establish
clear accountability in accounts payable and receivable, increase the value of collections
personnel, and gather better information to support strategic decision making for long
term opportunities .

Working capital optimization is inherently complex, as it touches many business

processes and people within an organization. It is a balancing act, and companies must
manage it carefully to ensure that they optimally employ their working capital and have
the critical resources they need to do things like fund product development, produce and
deliver their products, and provide high levels of customer service. The ability to impact
the bottom line through working capital optimization is tremendous.

2.8 Financing Decisions

We explore the consequences for corporate financial policy that arise when investors
exhibit inertial behavior. Develop a simple model to illustrate this idea, and present
supporting empirical evidence. Both individual and institutional investors tend to hang on
to shares granted them in mergers, with this tendency being much stronger for
individuals. Consistent with the model and with this cross-sectional pattern in inertia,
acquirers targeting firms with high institutional ownership experience more negative
announcement effects and greater announcement volume. Moreover, the results are
strongest when the overlap in target and acquirer institutional ownership is low and when
the demand curve for the acquirer's shares appears to be steep.

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 UNIT THREE
MANAGEMENT OF CASH

Objectives
Objectives
After finishing this unit you should be able to understand:
 the role of cash in current assets management.
 the overall cash management cycle.
 calculation of optimal cash balance.
 the techniques of cash management and cash planning.
 determination of optimum cash balance.

3.1 Introduction
Introduction
Once the firm has developed policies for the overall management of working capital, it
can turn its attention to the three primary assets that provide liquidity: cash, receivables,
and inventory.
In the financial sense, the term cash refers to all money items and sources that are
immediately available to help pay firms bills.

Cash is the medium of exchange that clients will accept in transactions related and
affected in business. Management of cash is of major importance in any business,
because cash is the only means of acquiring desired goods and services. A careful
scrutiny of cash operations is required because cash may be readily misappropriated.
Cash is the important current asset used widely in the operations of the business. Cash is
the basic input needed to keep, so as maintaining continuous operating condition in
business. Every firm is expected to maintain sufficient cash balance required for its
operations. Any surplus cash held will result as idleness of cash reducing the profitability
of the firm, while cash shortage leads to the disruption of the manufacturing process.
Thus, a major function of finance manager is to maintain a sound cash balance required
for business operations.

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Cash is the pure liquid asset widely used in the day-to-day operations of business. Cash
holding for the firm will serve three basic motives. They are, the first being transaction
motive, the second being precautionary motive and the third being the speculative
motive. Transaction motive has an objective of holding cash to meet the day-to-day
requirements like making payments to suppliers, purchase of materials, payment of
wages and salaries, and other operating expenses. Cash is also used in standing payments
like taxes, dividends and other payments. Precautionary motive of holding cash is to
meet the unexpected business expenses. Cash is held to meet contingencies in future like
emergencies. Speculative motive serve the objective of holding cash for investing in
profit-making ventures.

3.2 Cash Management Cycle

Once the financial manager has identified the firm’s policies on cash flow management,
he or she must face the problem of predicting the amounts and timing of future inflows
and outflows of cash. Cash management is concerned with the managing of cash
efficiently. Cash is the form of money, which is involved, with all operations of business
as inflows or outflows. Cash management can basically categorized into
(i) Cash outflow like, purchases, payment to expenses and services;
(ii) Cash inflows like, sales, other revenues; and
(iii) Cash balance held at any point of time.
A cash management cycle is used to explain the basic function of cash management. It
seeks to accomplish the objective of cost minimization by achieving liquidity and
profitability. Every business transaction resulting, as cash inflow will increase the cash
balance, while cash outflow transaction will decrease cash balance. Cash management
cycle is defined as “ the process of identifying various cash inflows and making them
available to business needs as cash outflows, maintaining the objective of liquidity and
profitability”. The following diagram explains the basic process of cash management
cycle.

Any firm can be successful with its cash management, when it is able to achieve the
following objectives:

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 1. Managing cash flows: The cash flows should be properly managed to avoid the
variance between planned events to actual event. Accelerating cash inflows and
decelerating cash outflows can achieve this.
2. Cash Planning: is the process of estimating cash inflows and outflows to project
cash surplus or deficit for future planning period. A cash budget is used to serve
this objective.
3. Investing supplies/Borrowing deficit: The surplus cash balance over and above
the minimum balance should be always is invested in the profitable ventures,
while the deficit balance should be arranged from various financing sources.
4. Optimum Cash Balance: It is always essential to determine appropriate cash
balance. The cost of excess of cash holding and also the danger of cash
deficiency should be matched to determine the optimum level of cash balance.

3.3 Cash Planning

The method that is used to plan and control the use of cash is known as cash planning. It
helps a firm in its future actions, by preparing estimated or projected cash statement for a
planning period. Forecast may be based on the present operations or on the anticipated
future operations. Cash planning may be done on daily, weekly, or monthly basis. The
period and frequency of the cash planning usually depend upon the size of the firm and
philosophy of management. Cash planning can be prepared based on the planning
period. Cash planning prepared for shorter period say, a year or less is called short-tem
plan or cash budget. On the other hand, a cash plan prepared for a period above one year
is called long-term plan or cash forecasting.

Cash budget is the most significant device to plan for and control cash receipts and
payment. A cash budget is a summary statement of the given firm’s expected cash
inflows and outflows over the projected period. It gives information on the timing and
magnitude of expected cash flows and the end balances over the planning period. This
information is vital for decision-makers to determine future cash needs, and plan for the
same accordingly. The time horizon of a cash budget may differ from firm to firm, and
industry-to-industry. Generally the cash budget time period will be monthly (suitable to

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the seasonal variations). Estimation of cash requirements and preparation of cash budget
should satisfy the following objectives:
 Identify the quantity and timing of cash inflows and outflows accurately.
 Provision of basic guidelines for various operations, so as to adhere to
organization plans.
 Anticipation of cash deficits or cash surplus, and arrange various alternative
course of actions.

Every firm essentially should hold adequate cash balance, but avoid idle cash balances.
The firm has to assess its needs for cash in order to achieve its business objectives. Cash
budget is the statement showing the cash requirement and replenishment, which will be
helpful identifying excess holding or shortage of cash balance. Cash budget serves the
following purposes:
 To coordinate the timing of cash needs. It identifies the time intervals when there
might either be a shortage and also the volume of deficit balance.
 It enables a firm to take advantages from the market conditions like, cash
discounts on accounts payables and receivables, pay obligations whenever they
are due, formulate efficient dividend policy and finance the capital requirements.
It is also helpful in quantifying seasonal requirements influencing the production
 It helps to arrange needed funds on the most favorable terms and prevents the
accumulation of excess funds.
 Scheduling, fluctuations of interest and inflation effects in the market.
 It pinpoints the periods during which the firm can have excess cash balance as a
surplus.

3.4 Preparation of Cash Budget and Illustration

The budget that is prepared by using operating and financial cash flows is called Cash
budget.
Cash flows generated using the cash operations of the firm are known as operating cash
flows, while the financial cash flows are concerned with long-term opportunities. Events
like sales, disposal of fixed assets come under operating cash inflows, and activities
resulting as purchase of raw materials, payment of expenses, maintenance expenses, and

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purchase of fixed assets are identifiable as operating cash outflows. Borrowing of funds,
sale of securities, receipt of interest or rent or any other revenue comes under the
financial cash inflows. Events like payment of income tax, repayment of loan amount,
repurchase of shares, payment of interest or dividends are categorized under financial
outflows.

The cash management strategies are intended to minimize the operating cash balance
requirements. This can be achieved by
(i) Stretching accounts payable without affecting the credit status of the firm,
(ii) Employing efficient inventory management, and
(iii) Accelerating collections of accounts receivables.
Some of the specific techniques for accelerating collection of receivables from customer
are ensuring prompt payment from customers, and early payment/conversion into cash.
The techniques of delay in payments include avoidance of early payment, centralized
disbursement and float.

Illustration:
Illustration: From the information given below construct a cash budget for six months
period starting form July 19Y1 till December.

Month and year Projected sales

April 19Y1 $ 120,000
May 19Y1 100,000
June 19Y1 80,000
July 19Y1 50,000
August 19Y1 60,000
September 19Y1 90,000
October 19Y1 150,000
November 19Y1 180,000
December 19Y1 200,000
January 19Y2 150,000

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Additional information:
a) Assume that opening cash balance as $ 20,000 and same balance has to be
maintained through out the planning period.
b) 80 percent of sales are on credit basis. 50 percent of the accounts receivables are
collected in one month, 30 percent during the second month of sale and remaining
during the third month of sale.
c) Material cost accounts for 30 percent of sales. Suppliers allow 45 days credit, and
materials to be procured one month in advance for production purpose.
d) Payroll expenses amounts to 20 percent of sales and carry a lag-in-payment period
of one month.
e) Production overheads accounts for 10 percent of sales, and carry a lag-in-payment
period of 60 days.
f) Production should be completed at least 30 days before the date of sale.
g) All the payments and earnings accrue uniformly through out the year.

Sol: Cash Budget for the Given Firm

For the period of 6 months starting from July 19Y1
Cash receipts July August September October November December
Cash sales (1) $10,000 $12,000 $18,000 $30,000 $36,000 $40,000
Collections (2) 75,200 5,5200 48,800 58,400 91,200 122,400
Miscellaneous

Total receipts $85,200 $ 67,200 $ 66,800 $ 88,400 $ 127,200 $ 162,400

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Cash payments
Payments to suppliers 16,500 22,500 36,000 49,500 57,000 52,500
Payroll 10,000 12,000 18,000 30,000 36,000 40,000
Overheads 8,000 5,000 6,000 9,000 15,000 18,000
Others

Total payments 34,500 39,500 60,000 88,500 108,000 110,500

Receipts less Payments 50,700 27,700 6,800 -100 19,200 51,900

Minimum balance 20,000 20,000 20,000 20,000 20,000 20,000

Ending balance 30,700 7,700 -13,200 -20,100 -800 31,900

Surplus/(deficit)
Decision Invest Invest Borrow Borrow Borrow Invest

Working notes:
1. Cash sales amounts to 20 percent of total sales
Month July August September October November December
Total Sales $50,000 $60,000 $90,000 $150,000 $180,000 $200,000
Cash sales $10000 $12000 $18000 $30000 $36000 $40000

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2. Credit collections from accounts receivables:
Total Sales Credit collection Total
1 Month 2 Month 3 month
May 19Y1* $ 48,000 $ 48,000
June 19Y1* 40,000 28,800 68,800
July 19Y1 32,000 24,000 19,200 75,200
August 19Y1 20,000 19,200 16,000 55,200
September 19Y1 24,000 12,000 12,800 48,800
October 19Y1 36,000 14,400 8,000 58,400
November 19Y1 60,000 21,600 9,600 91,200
December 19Y1 72,000 36,000 14,400 122,400
January 19Y2* 80,000 43,200 24,000 147,200
* Events out side the planning period.
Credit collection made for the planning period:
80 % of total sales are credit, and it is given that 50 % of credit sales (that means 40 % of
total sales will be collected during the 1 st month). Therefore the total sales collection will
be as follows:
Cash sales 20 % Given
First month collection 40 % 50 % of 80 %
Second month collection 24 % 30 % of 80 %.
Third month collection 16 % 20 % of 80 %
Total 100% -

Note: Total production cost is estimated as 60 percent of sales. Material cost to sales ratio
is given as 30 percent, payroll expenses given as 20 percent and production overhead
expenses is given as 10 percent of sales. Therefore, 50 percent of production cost
accounted for material cost, 30 percent for payroll expenses and remaining 20 percent for
production overheads.

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3. Material cost 30 percent of sales or 50 percent of production cost.
Month Sales Production cost Material cost Due month
April 19Y1 * $120,000 $ 60,000 $ 24,000
May 19Y1* 100,000 48,000 15,000
June 19Y1* 80,000 30,000 18,000 $ 19,500
July 19Y1 50,000 36,000 27,000 16,500
August 19Y1 60,000 54,000 45,000 22,500
September 19Y1 90,000 90,000 54,000 36,000
October 19Y1 150,000 108,000 60,000 49,500
November 19Y1 180,000 120,000 45,000 57,000
December 19Y1 200,000 90,000 - 52,500
January 19Y2* 150,000 - - 22,500

Once the cash budget has been prepared and appropriate net cash flow established, one
should ensure that there does not exist a significant deviations between projected cash
flows and actual cash flows. Better cash management improving control over cash
collection and disbursements can achieve this. Cash management objective can be
achieved by accelerating cash collection and decelerating cash payments to the possible
extent.
Cash management should always aims to achieve the following objectives:
 Liquidity:
By predicting cash surpluses or shortages, the firm achieves liquidity---sufficient money
in the bank to pay debts as they come due. Business units should satisfy the primary
objective of cash availability for all business needs.
 Safety:
Cash availability will always impose risk of loss; therefore the second objective of cash
management is to avoid the risk of loss, or thefts.
 Profitability:
Accurate cash forecasting achieves profits by allowing the firm to take profitable
discounts on purchases, invest surplus funds, or reduce the costs of maintaining idle cash
balances.

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Secondary and final objective of cash management is earn a highest possible return after
satisfying the above two objectives.

Cash budget always should the projects end result as surplus cash balance or deficit cash
balance. Therefore, finance manager should carefully plan well in advance for arranging
such balances with actual business situations. A surplus cash balance induces cash
idleness to the business reducing the profitability; therefore surplus cash balances should
be invested in the following alternatives:

 Investment in the bank, as term deposits that earn higher return of interest.
 Investment in capital market instruments like shares and bonds that provide
maximum returns.
 Investment in money market instruments that provide a higher return compared to
bank returns.
In the same way a deficit cash balance leads to cash shortage and makes the business
suffer from cash crisis. This may result as disruption of business activities, and financial
distress among the stakeholders. It is necessary to avoid such financial problems, which
can be done through successful borrowing techniques. The following are few events
advised to avoid such chaotic conditions:
 Disposal of investments: If the business unit has maintained any investments
with the surplus cash balances, can be used in financing the deficit balance by
disposing them.
 Bank overdrafts:
overdrafts: Making an arrangement with the bankers to have overdraft
facility, that is the most economical way of dealing with borrowing. Interest will
be chargeable on the outstanding amount at any time, and the bank may also
require payment of an overdraft at any time.
 Bank loans:
loans: Represent the formal agreement between the bank and the borrower,
that the bank will lend a specific sum for a specific period. Interest must be paid
on the whole of the sum for the duration of the loan.

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3.5 Determining the Optimum Cash Balance
Operating cash balance is the Liquidity position of any firm that maintained perfectly
after obtaining optimum cash balance. This is the balance that caters the needs of
business perfectly attaining both the objectives of cash management. The test of liquidity
is really the availability of cash to meet the firm’s obligation when they become due. The
optimum cash balance is maintained for the transaction purpose and additional amount
may be maintained as a buffer or safety balance. Firm maintaining limited cash balance
result as payment crisis, and excess cash balance held will decline the profitability of the
firm. Therefore, a tradeoff between the profitability and liquidity has to achieve using the
optimum cash balance technique. This can be explained through the following diagram.

Fig. I
Optimum Cash Balance

Total cost curve

Opportunity cost curve

Cost
Transaction cost curve

Optimum cash balance

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Cash Balance

From the above figure (Fig. I) it is clearly evidential that, increasing cash balance,
reduces transaction cost but increased the opportunity cost like interest charges, which
may reduced the profitability of the firm. That means the liquidity objective of the firm
is achieved but profitability declines. On contrary, limited cash balance held reduces the
opportunity cost but the transaction cost, like acquiring funds at the time of shortage,
increases. That means, profitability is achieved but not liquidity. Therefore, the
intersection point of transaction curve with opportunity cost curve, yields the desired
optimum cash balance, where the firm attains both the objectives.

3.6 Cash Management Models

A number of cash management models have been developed for managing cash balances.
All models assume that a business will have a certain amount of ready cash available, (in
the current account) for day-to-day operations. An additional amount is made available
in the form of bank deposits, marketable securities, as buffer cash balance.

3.6.1 Baumol Model and Illustration

Baumol model is similar to that of economic order quantity (EOQ model) used in the
inventory management. If cash resources are steadily used up by a constant daily
demand for cash, the model suggests that the optimum regular cash injections say ‘a’ into
the business can be determined as follows:

A=

Where Ad = Annual demand for the cash

Ct = Cost per transaction (purchase or sale or both of securities)
Ir = Interest rate for the said period
A = Optimum cash injection

Illustration:

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A JO COM. has annual demand of cash equal to $ 240,000 per annum. Investment
earnings rate is given as 12 percent per annum and the cost per transaction of investment
is $ 100 per sale/purchase. Calculate the optimum cash balance of the firm?

SOLUTION:

A=

Given Ad = $ 240,000
Ct = $ 100
Ir = 12 percent or 0.12
A =?

A= A = $ 20,000

According to the this model, low cash balance held without earning interest is considered
as best decision, at the time of increasing interest rates. The basic limitation of this
model is the unrealistic assumption of the constant cash demand. In practice the demand
for cash usually is fluctuating.

3.6.2 Miller-Orr Model and Illustration

Uncertainty of both cash receipts and cash payments are considered in Miller-Orr model.
This model is explained through the following diagram. The firms

Miller-Orr Cash Management Model Fig 7.3

UPPER LIMIT

CASH
BALANCE

LOWER LIMIT

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Using the upper limit and lower limit consider all receipts and payments. As per this
model, the lower limit is to be specified and upper limit can be determined using the
equation of spread between the upper limit and lower limit. The spread can be determined
using the following equation.
¾ transaction cost variance of cash flow 1/3

Spread =3 ------------------------------------------------------------
Interest rate

Illustration: A firm sets its minimum cash balance as $ 5,000 and estimates the
following:
Transaction cost per sale/purchase = $ 15
Standard deviation = $ 1,200 per day
Interest rate = 7.3 percent p.a. or 0.02 per day
Calculate the spread using Miller-Orr model?

Sol: ¾ transaction cost variance of cash flow 1/3

Spread =3 -----------------------------------------------------------
Interest rate

Transaction cost per sale/purchase = $ 15

Standard deviation = $ 1,200 per day
Interest rate = 7.3 percent p.a. or 0.02 per day

¾ $ 15 {$ 1,200  $ 1,200} 1/3

Spread =3 ---------------------------------------------------
0.02

Therefore Spread = 3 {81014113000}1/3

= 3  4,327
= $ 12,981

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Summary
Once the firm has developed policies for the overall management of working capital, it
can turn its attention to the three primary assets that provide liquidity: cash, receivables,
and inventory.
In the financial sense, the term cash refers to all money items and sources that are
immediately available to help pay firms bills.

Cash is the pure liquid asset every firm is expected to maintain for its day-to-day
activities. Cash holding for the firm will serve three basic motives and they are (a)
transaction motive; (b) precautionary motive, and (c) speculative motive. Transaction
motive of holding of cash is essential to meet day-to-day operational requirements.
Precautionary motive of holding of cash is to meet the requirements above the basic
requirements, which are unexpected business activities. Speculative motive of holding
cash is to explore the opportunities of business or opportunities outside the business.

Cash budget is prepared unsung the operating and financial cash flows. Cash flows
generated using the cash operations of the firms are knows as operating cash flows, the
latter consists of cash flows in the long-term opportunities.
Once the financial manager has identified the firm’s policies on cash flow management,
he or she must face the problem of predicting the amounts and timing of future inflows
and outflows of cash. Cash management is concerned with the managing of cash
efficiently.

Marketable securities are an outlet for surplus cash as liquid security/Assets. To be liquid
a security must have two basic characteristic that is, a ready market and safety of
principal. The selection criterions for marketable securities include the evaluation of
financial risk, interest rate risk, liquidity, taxability and yield among different financial
assets. The prominent marketable securities available for investment are: treasury bills,
negotiable certificates of deposits, commercial paper, bankers’ acceptance, inter-
corporate deposits, inter bank call money.

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 Self check questions
Part I
1. Discus how to prepare cash budget.
2. Explain briefly the Baumol cash management model.
3. What is the concept and importance of cash budget?
4. Explain briefly the process of constructing cash budget?
5. How can a firm reach the suitable level of optimum cash balance?
6. Discuss the miller-Orr model.
7. What are the conditions to be followed for managing cash effectively and efficiently?

Part II.

1. Tole & Job com. has an annual cash demand of $ 1 million. Transaction cost is given
as $ 200 per purchase or sale of securities. Interest on borrowings is given as 12
percent. Determine constant cash injections, using Baumol model.
2. His Investments Company has an annual cash demand of $ 408,000. Transaction cost
is given as $ 120 per purchase or sale of securities. Interest on borrowings is given as
9 percent. Determine constant cash injections, using Baumol model.
3. Darara plc has a monthly cash demand of $ 560,000. Transaction cost is given as $
180 per purchase or sale of securities. Interest on borrowings is given as 12 percent
per annum. Determine constant cash injections, using Baumol model.
4. Tsed COM. has a daily cash demand of $ 1000. Transaction cost is given as $ 80 per
purchase or sale of securities. Interest on borrowings is given as 7.3 percent per
annum. Determine constant cash injections, using Baumol model.
5. hazy plc sets its minimum cash balance as $ 1,000 and estimates the following:
Transaction cost per sale/purchase = $ 12
Standard deviation = $ 1,200 per day
Interest rate = 14.6 percent p.a. or 0.04 per day
Calculate the spread using Miller-Orr model?

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6. yahoo com. sets its minimum cash balance as $ 1,250 and estimates the following:
Transaction cost per sale/purchase = $ 25
Standard deviation = $ 200 per day
Interest rate = 12 percent p.a.
Calculate the spread using Miller-Orr model?
9. A firm sets its minimum cash balance as $ 5,000 and estimates the following:

Transaction cost per sale/purchase = $ 20

Standard deviation = $ 800 per day
Interest rate = 10 percent p.a.
Calculate the spread using Miller-Orr model?
10. A firm sets its minimum cash balance as $ 6,000 and estimates the following:
Transaction cost per sale/purchase = $ 32
Standard deviation = $ 750per day
Interest rate = 8 percent p.a.
Calculate the spread using Miller-Orr model?

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 UNIT FOUR
MANAGEMENT OF INVESTMENTS IN MARKETTABLE
SECURTY
4.1 Introduction
Managers are continually faced with decisions about which assets to invest in. In this
chapter, we will look at the different types of investment decisions the financial manager
faces. We will also discuss ways to estimate the benefits and costs associated with these
decisions.

The financial manager’s objective is to maximize owners’ wealth. To accomplish this, the
manager must evaluate investment opportunities and determine which ones will add
value to the firm. For example, consider three firms, Firms A, B and C, each having
identical assets and investment opportunities, but that:
■ Firm A’s management does not take advantage of its investment opportunities and
simply pays all of its earnings to its owners;
■ Firm B’s management only makes those investments necessary to replace deteriorating
plant and equipment, paying out any leftover earnings to its owners; and
■ Firm C’s management invests in all those opportunities that provide a return better than
what the owners could have earned if they had invested the funds themselves.
In the case of Firm A, the owners’ investment in the firm will not be as profitable as it
would be if the firm had taken advantage of better investment opportunities. By failing to
invest even to replace deteriorating plant and equipment, Firm A will eventually shrink
until it has no more assets. Firm B’s management is not taking advantage of all profitable
investments. This means that there are forgone opportunities, and owners’ wealth is not
maximized. But Firm C’s management is making all profitable investments and is thus
maximizing owners’ wealth. Firm C will continue to grow as long as there are profitable
investment opportunities and its management takes advantage of them.

In this chapter, we will describe the process of making investment decisions. We will
look at estimating how much a firm’s cash flows will change in the future as a result of
an investment decision. The main topic of this chapter, estimating cash flow, is an

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imprecise art at best. Therefore, after we describe in detail a method for estimating cash
flows, including two integrative examples, we will explain some ways in which managers
sometimes deviate from the ideal method in actual practice.

4.2 The Investment Problem

Firms continually invest funds in assets and these assets produce income and cash flows
that the firms can then either reinvest in more assets or pay to the owners. These assets
represent the firm’s capital. Capital is the firm’s total assets. It includes all tangible and
intangible assets.

These assets include physical assets (such as land, buildings, equipment, and machinery),
as well as assets that represent property rights (such as accounts receivable, securities,
patents, copyrights). When we refer to capital investment,
investment, we are referring to the firm’s
investment in its assets.

The term “capital” also has come to mean the funds used to finance the firm’s assets. In
this sense, capital consists of notes, bonds, stock, and short-term financing. We use the
term “capital structure” to refer to the mix of these different sources of capital used to
finance a firm’s assets.

The firm’s capital investment decision may be comprised of a number of distinct

decisions, each referred to as a project. A capital project is a set of assets that are
contingent on one another and are considered together.
For example, suppose a firm is considering the production of a new product.
This capital project would require the firm to acquire land, build facilities, and purchase
production equipment. And this project may also require the firm to increase its
investment in its working capital—inventory,
capital—inventory, cash, or accounts receivable. Working
capital is the collection of assets needed for day-to-day operations that support a firm’s
long-term investments.
The investment decisions of the firm are decisions concerning a firm’s capital
investment. When we refer to a particular decision that financial managers must make,
we are referring to a decision pertaining to a capital project.

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4.3 Capital Budgeting
Investment Decisions and Owners’ Wealth Maximization Managers must evaluate a
number of factors in making investment decisions.
Not only does the financial manager need to estimate how much the firm’s future cash
flows will change if it invests in a project, but the manager also must evaluate the
uncertainty associated with these future cash flows.
We already know that the value of the firm today is the present value of all its future cash
flows. But we need to understand better where these future cash flows come from. They
come from:
■ assets that are already in place, which are the assets accumulated as a result of all past
investment decisions, and
■ future investment opportunities.

The value of the firm is therefore, Future cash flows are discounted at a rate that
represents investors’ assessments of the uncertainty that these cash flows will flow in the
amounts and the timeframe expected. To evaluate the value of the firm, we need to
evaluate the risk of these future cash flows.

4.3.1 Cash flow risk

Cash flow risk comes from two basic sources:
■ Sales risk,
risk, which is the degree of uncertainty related to the number of units that will be
sold and the price of the good or service; and
■ Operating risk,
risk, which is the degree of uncertainty concerning operating cash flows that
arises from the particular mix of fixed and variable operating costs.
Sales risk is related to the economy and the market in which the firm’s goods and
services are sold. Operating risk, for the most part, is determined by the product or
service that the firm provides and is related to he sensitivity of operating cash flows to
changes in sales. We refer to the combination of these two risks as business risk.
risk.
A project’s business risk is reflected in the discount rate, which is the rate of return
required to compensate the suppliers of capital (bondholders and owners) for the amount

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of risk they bear. From the perspective of investors, the discount rate is the required rate
of return (RRR).
From the firm’s perspective, the discount rate is the cost of capital what it costs the firm
to raise a dollar of new capital.

Value of firm = Present value of all future cash flows= Present value of cash flows from
all assets in place+ Present value of cash flows from future investment opportunities

For example, suppose a firm invests in a new project. How does the investment affect the
firm’s value? If the project generates cash flows that just compensate the suppliers of
capital for the risk they bear on this project (that is, it earns the cost of capital), the value
of the firm does not change. If the project generates cash flows greater than needed to
compensate them for the risk they take on, it earns more than the cost of capital,
increasing the value of the firm. If the project generates cash flows less than needed, it
earns less than the cost of capital, decreasing the value of the firm.

How do we know whether the cash flows are more than or less than needed to
compensate for the risk that they will indeed need? If we discount all the cash flows at
the cost of capital, we can assess how this project affects the present value of the firm. If
the expected change in the value of the firm from an investment is:
■ positive, the project returns more than the cost of capital;
■ negative, the project returns less than the cost of capital;
■ zero, the project returns the cost of capital.
Capital budgeting is the process of identifying and selecting investments in long-lived
assets, or assets expected to produce benefits over more than one year.
Because a firm must continually evaluate possible investments, capital budgeting is an
ongoing process. However, before a firm begins thinking about capital budgeting, it must
first determine its corporate strategy—its
strategy—its broad set of objectives for future investment.
For example, the Quantum
Corporation’s goal is to “... be the leading mass storage company in the world....In order
for Quantum to achieve our goals, we must build and maintain leadership positions in all
of our businesses—in profitability, as well as in market share.”

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4.3.2 How does a firm achieve its corporate strategy?
By making investments in long-lived assets that will maximize owners’ wealth. Selecting
these projects is what capital budgeting is all about.

4.3.3 Stages in the Capital Budgeting Process

There are five stages in the capital budgeting process.
Stage 1: Investment screening and selection
Projects consistent with the corporate strategy are identified by production, marketing,
and research and development management of the firm. Once identified, projects are
evaluated and screened by estimating how they affect the future cash flows of the firm
and, hence, the value of the firm.

Stage 2: Capital budget proposal

A capital budget is proposed for the projects surviving the screening and selection
process. The budget lists the recommended projects and the dollar amount of investment
needed for each. This proposal may start as an estimate of expected revenues and costs,
but as the project analysis is refined, data from marketing, purchasing, engineering,
accounting, and finance functions are put together.

Stage 3: Budgeting approval and authorization

Projects included in the capital budget are authorized, allowing further fact gathering and
analysis, and approved, allowing expenditures for the projects. In some firms, the projects
are authorized and approved at the same time. In others, a project must first be
authorized, requiring more research before it can be formally approved. Formal
authorization and approval procedures are typically used on larger expenditures; smaller
expenditures are at the discretion of management.

Stage 4: Project tracking

After a project is approved, work on it begins. The manager reports periodically on its
expenditures, as well as on any revenues associated with it. This is referred to as project

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tracking,
tracking, the communication link between the decision makers and the operating
management of the firm. For example: tracking can identify cost overruns and uncover
the need for more marketing research.

4.4 Classifying Investment Projects

In this section, we discuss different ways managers classify capital investment projects.
One way of classifying projects is by project life, whether short-term or long-term. We do
this because in the case of long-term projects, the time value of money plays an important
role in long-term projects. Another way of classifying projects is by their risk. The riskier
the project’s future cash flows, the greater the role of the cost of capital in decision-
making. Still another way of classifying projects is by their dependence on other projects.
The relationship between a project’s cash flows and the cash flows of some other project
of the firm must be incorporated explicitly into the analysis since we want to analyze how
a project affects the total cash flows of the firm.

4.4 Classification According to Their Economic Life

An investment generally provides benefits over a limited period of time, referred to as its
economic life. The economic life or useful life of an asset is determined by:
■ physical deterioration;
■ obsolescence; or
■ the degree of competition in the market for a product.
The economic life is an estimate of the length of time that the asset will provide benefits
to the firm. After its useful life, the revenues generated by the asset tend to decline
rapidly and its expenses tend to increase.
Typically, an investment requires an immediate expenditure and provides benefits in the
form of cash flows received in the future. If benefits are received only within the current
period—within one year of making the investment—we refer to the investment as a
short-term investment.
investment. If these benefits are received beyond the current period, we refer
to the investment as a long-term investment and refer to the

Stage 5: Post-completion audit

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Following a period of time, perhaps two or three years after approval, projects are
reviewed to see whether they should be continued. This re-evaluation is referred to as a
post-completion audit.
audit. Thorough post-completion audits are typically performed on
selected projects, usually the largest projects in a given year’s budget for the firm or for
each division. Post-completion audits show the firm’s management how well the cash
flows realized corresponds with the cash flows forecasted several years earlier.
An investment project may comprise one or more capital expenditures. For example, a
new product may require investment in production equipment, a building, and
transportation equipment.
Short-term investment decisions involve, primarily, investments in current assets: cash,
marketable securities, accounts receivable, and inventory. The objective of investing in
short-term assets is the same as long-term assets: maximizing owners’ wealth.
Nevertheless, we consider them separately for two practical reasons:
1. Decisions about long-term assets are based on projections of cash flows far into the
future and require us to consider the time value of money.
2. Long-term assets do not figure into the daily operating needs of the firm.
Decisions regarding short-term investments, or current assets, are concerned with day-to-
day operations. And a firm needs some level of current assets to act as a cushion in case
of unusually poor operating periods when cash flows from operations are less than
expected.

Classification According to Their Risk

Suppose you are faced with two investments, A and B, each promising a $100 cash
inflow ten years from today. If A is riskier than B, what are they worth to you today? If
you do not like risk, you would consider A less valuable than B because the chance of
getting the $100 in ten years is less for A than for B. Therefore, valuing a project requires
considering the risk associated with its future cash flows.
The investment’s risk of return can be classified according to the nature of the project
represented by the investment:
■ Replacement projects:
projects: investments in the replacement of existing equipment or
facilities.

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■ Expansion projects:
projects: investments in projects that broaden existing product lines and
existing markets.
■ New products and markets:
markets: projects that involve introducing a new product or
entering into a new market.
■ Mandated projects:
projects: projects required by government laws or agency rules.
Replacement projects include the maintenance of existing assets to continue the current
level of operating activity. Projects that reduce costs, such as replacing old equipment or
improving the efficiency, are also considered replacement projects. To evaluate
replacement projects we need to compare the value of the firm with the replacement asset
to the value of the firm without that same replacement asset. What we’re really doing in
this comparison is looking at opportunity costs:
costs: what cash flows would have been if the
firm had stayed with the old asset.

There’s little risk in the cash flows from replacement projects. The firm is simply
replacing equipment or buildings already operating and producing cash flows. And the
firm typically has experience in managing similar new equipment.
Expansion projects, which are intended to enlarge a firm’s established product or market,
also involve little risk. However, investment projects that involve introducing new
products or entering into new markets are riskier because the firm has little or no
management experience in the new product or market.

A firm is forced or coerced into its mandated projects. These are government mandated
projects typically found in “heavy” industries, such as utilities, transportation, and
chemicals, all industries requiring a large portion of their assets in production activities.
Government agencies, such as the Occupational Health and Safety Agency (OSHA) or
the Environmental Protection Agency (EPA), may impose requirements that firms install
specific equipment or alter their activities (such as how they dispose of waste).
We can further classify mandated projects into two types: contingent and retroactive.
Suppose, as a steel manufacturer, we are required by law to include pollution control
devices on all smoke stacks. If we are considering a new plant, this mandated equipment
is really part of our new plant investment decision—the investment in pollution control
equipment is contingent on our building the new plant.

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On the other hand, if we are required by law to place pollution control devices on existing
smoke stacks, the law is retroactive. We do not have a choice. We must invest in the
equipment whether it increases the value of the firm or not. In this case we either select
from among possible equipment that satisfies the mandate, or we weigh the decision
whether to halt production in the offending plant.
Classification According to Their Dependence on Other Projects In addition to
considering the future cash flows generated by a project, a firm must consider how it
affects the assets already in place—the results of previous project decisions—as well as
other projects that may be undertaken.

Projects can be classified as follows according to the degree of dependence with other
projects: independent projects, mutually exclusive projects, contingent projects, and
complementary projects.
An independent project is one whose cash flows are not related to the cash flows of any
other project. Accepting or rejecting an independent project does not affect the
acceptance or rejection of other projects.
Projects are mutually exclusive if the acceptance of one precludes the acceptance of other
projects. For example, suppose a manufacturer is considering whether to replace its
production facilities with more modern equipment. The firm may solicit bids among the
different manufacturers of this equipment. The decision consists of comparing two
choices, either keeping its existing production facilities or replacing the facilities with the
modern equipment of one manufacturer. Because the firm cannot use more than one
production facility, it must evaluate each bid and choose the most attractive one. The
alternative production facilities are mutually exclusive projects: the firm can accept only
one bid.

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 UNIT FIVE
MANAGEMENT OF RECEIVABLES

Objectives
After completing this chapter you will be able to know the following concepts:
 elaborate the concept of receivables management
 examine discount policy and credit policy
 explain the role of accounts receivables in current assets
 explain the advantages of factoring services
 understand and analyze the tools and techniques of inventory
management.
 to know the concept of inventory control

5.1 Introduction
In addition to the management of cash and marketable securities, the financial manager
must be concerned with two other important areas of working capital. First, sales made
on credit involve the creation of receivables that must be converted to cash. Since the
cash is not firmly in hand until the money is collected, receivables represent an exposure
that must be analyzed and managed. Second, in order to have goods to sell, the firm must
maintain inventory. Until the goods are sold, they also represent an exposure that must be
managed.

Receivables are asset accounts representing amounts owed to the firm as a result of the
sale of goods or services in the ordinary course of business. The value these claims is
carried on the balance sheet under titles such as accounts receivable, trade receivables, or
customer receivables. A firm granting credit to its customers does not receive cash
immediately for its sales, but creates receivables, that the firm expected to collect in the
near future.

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Receivable arising out of credit sales has the following three characteristics features:
i. Involvement of risk in collection;
ii. Collection at latter period do have lower economic value and
iii. Problems of non-collection. Receivables constitute a substantial
portion in the current assets.
Receivables usually block the funds employed. The time interval between the date of
sale and the date of collection has to be financed out of working capital. Such funds have
to arrange from banks or other financing sources that consume additional interest
expenses. Thus, the receivables investment represents investment in credit sales that
increase profitability on one hand and additional investment cost (interest on additional
borrowings both on investment and extended period of repayment). Therefore, finance
manager will be anxious to:
a. Establish a credit policy in relation to normal credit period and determine and fix
individually the credit limit depending on the credibility of the customers.
b. Develop a system that will control the implementation of credit policy.
c. Prescribe the reporting procedures, which will monitor the efficiency of the
system.

Example 1:
A GIGI COMPANY has an investment in the credit sales as br 100,000 and the average
collection period allowed to the customers as 15 days. Find the amount of investment
gained and lost when the return on investment in the business is at 7 percent and
borrowings demand an interest at the rate of 4 percent per annum. The com. has a
proposal to expand its sales by extending the credit days from 15 days to 30 days. Does
the proposal worth accepting when increase in sales is expected as 5 percent? Ignore all
other expenses as constant.

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Solution:
Solution:

Existing situation: Average collection period = 15 days

Average investment in receivables = br 100,000
Total credit sales =?

Total credit sales = (Average investment X 360 days) / average collection period.

Therefore total credit sales = (br100, 000 X 360 days) / 15 days

Total credit sales = br 2,400,000

Profitability with the existing situation:

Return on investment (sales) = br 2,400,000 X 7 % = br 168,000
Less: Interest expenses on investment
Average receivables X 4 % 4,000
Net returns = br 164,000

Revision in the credit period:

Average collection period = 30 days
Total credit sales = br 2,400,000 + 5 % on br 2,400,000
= br 2,520,000
Average investment in receivables =?

Average receivables = (total credit sales X Average collection period) / 360 days

Average receivables = (br 2,520,000 X 30 days) / 360 days

Average receivables = br 210,000

Profitability with the existing situation:
Return on investment (sales) = br 2,520,000 X 7 % = br 176,400
Less: Interest expenses on investment
Average receivables X 4 % 8,400
Net returns = br 168,000

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Therefore, increment in the credit period has increased the net returns from br 164,000 to
br 168,000. So we conclude that the new application is more accepting.

5.2 Establishment of Credit Policy and Illustration

A major dictions area in working-capital management is the establishment of credit limits
for differing customers of the firm. There are two aspects of setting limits:
1. How two deal with numerous small accounts,
2. Larger accounts, where a balance sheet and income statement are available.
The numerous small accounts are probably best handled within overall credit policy that
services for a good balance between cash at risk and first year profit. The exact policy
varies with individual industries, but a simple rule of thumb might be that the first year
profit on an account should equal or exceed the maximum cash at risk at any one time.
The credit limits for large accounts is totally different approach should be taken for
establishing the credit limit for a large account. The first step is to require a credit
application from the potential customer that contains a balance sheet and income
statement for a recent period. Any firm’s investment in accounts receivables depends on
(a) the volume of credit sales,
(b) risk involved in collection; and
(c) collection period. Investment in receivables is expressed in terms of costs. The
volume of credit sales is a function of firm’s total sales and the percentage of credit sales
to total sales. Total sales depend on the market size, firm’s market share, product’s
quality, intensity of competition, and economic conditions prevailing in the market
environment. Finance manager usually have limited or no control over these variables.

Finance manager can affect the volume of credit sales and collection period and
consequently, investment in accounts receivables. This is possible through establishment
of credit policy, retaining the terms of credit under the control of the business. The terms
of credit policy is used to refer to the combination of three decision variables. They are:

5.2.1 Credit standards

This criterion will decide the type of customer to whom credit can be allowed with the
credit limit. Allowing credit to more slow-repaying customer will increase investment in

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receivables and vice-versa. Increase in investment may result in increase in risk of
default (non-collection of debt).

5.2.2 Credit Terms

It specifies duration of credit (in time) and terms of payments (discounts) by the
customer. Investment in accounts receivables will be high if customers are allowed
extended credit period in making payments, and decreases with reduction in credit period.
Alternatively offering a discount on early payments by the customer will reduce the
investments as well as the credit period. This is also referred as accelerating collection
policy.

5.2.3 Collection Efforts

Collection efforts will increase the expenses on investment by payment of charges of
collection incase of collection done by outsiders, and payroll expenses if done by internal
staff. Collection charges will depend on the collection period. Lower the collection
period lower will the collection charges and vice-versa.

Any credit policy before implementation has to be evaluated. An evaluation procedure

includes three stages. The first stage,
stage, of evaluation is the process of identifying
incremental revenue a firm may receive with extending the credit. Increased sales
multiplied by the profitability rate will give this value. Empirically,
Empirically, this can be
calculated as ∆ sales X net income ratio. The second stage is the analysis of additional
credit grant to the customers with risk of default. That means extension of credit to the
existing customers may increase the bad debt expenses. Therefore incremental revenue
with sales should also be analyzed with increment in expenditure as bad debts expenses.
Such additional expenses should be deducted from the net returns calculated in stage one.
Empirically, incremental expenses as bad debts can be calculated as ∆ sales X bad debts
ratio (percentage of bad debts). The third stage,
stage, increased sales will increase in
investment in the accounts receivables, thereby increase the interest expenses on the
borrowings. Incremental interest expenses should also be deducted from the incremental
revenue calculated from stage one. If the net revenue is positive then the credit policy
established would increase the wealth of the shareholders, and if the return is negative,

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the shareholders wealth will be decreased. Positive returns will always qualify for
acceptance decision while the negative returns will be rejected.
Exercise
What are credit policy and its establishment?
………………………………………………………………………………………………

Illustration:

Ato Tsega plc currently has annual sales of $ 5 millions will average collection period of
30 days allowed to customers. Plc plans to relax its credit policy as follows:

Credit policy % Change in sales % Change in bad Increase in credit

debts cost period
A $ 100,000 1.2 % 15 days
B $ 200,000 1.5 % 30 days
C $ 500,000 1.8 % 45 days
D $ 1,000,000 2.0 % 60 days

Profitability rate of the firm is given as 10 percent and firm can borrow at 6 percent
(interest cost). Which credit policy is advisable to the firm, including the existing policy?
Ignore tax affect and assume a year of 360 days.

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Solution:
Assessment of existing policy:
Volume of credit sales $5,000,000
Return on investment $ 5,000,000 X 10 % $500,000
Less : Incremental expenses
1) Bad debts *1 $0
2) Interest on additional investment *2 $2,500
Net return on investment $497,500
Average collection period is given as 30 days
Accounts receivables = Credit sales / Average collection period $41,666.67
*1 Bad debts expenses = (incremental sales X bad debts ratio)
*2 interest on additional investment = Increased investment on receivables X interest rate.

Assessment of Credit policy A:

Volume of credit sales $5,100,000
Return on investment $ 5,100,000 X 10 % $10,000
Less : Incremental expenses
1) Bad debts *1 ($1,200)
2) Interest on additional investment *2 ($13,250)
Net return on investment ($4,450)
Average collection period is given as 45 days
Accounts receivables = Credit sales / Average collection period $637,500
*1 Bad debts expenses = (incremental sales X bad debts ratio)
*2 interest on additional investment = Increased investment on receivables X interest rate

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Assessment of Credit policy B:
Volume of credit sales $5,200,000
Incremental sales $200,000
Incremental return $ 200,000 X 10 % $20,000
Less : Incremental expenses
1) Bad debts *1 ($3,000)
2) Interest on additional investment *2 ($27,000)
Net return on investment ($10,000)
Average collection period is given as 30 days
Accounts receivables = Credit sales / Average collection period $866,667
*1 Bad debts expenses = (incremental sales X bad debts ratio)
*2 interest on additional investment = Increased investment on receivables X interest rate

Assessment of Credit policy C:

Volume of credit sales $5,500,000
Incremental sales $500,000
Return on investment $ 5,000,000 X 10 % $50,000
Less : Incremental expenses
1) Bad debts *1 ($9,000)
2) Interest on additional investment *2 ($43,750)
Net return on investment ($2,750)
Average collection period is given as 30 days
Accounts receivables = Credit sales / Average collection period $1,145,833
*1 Bad debts expenses = (incremental sales X bad debts ratio)
*2 interest on additional investment = Increased investment on receivables X interest rate

Assessment of credit policy D:

Volume of credit sales $6,000,000
Incremental sales $1,000,000

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Return on investment $ 1,000,000 X 10 % $100,000
Less : Incremental expenses
1) Bad debts *1 $(20,000)
2) Interest on additional investment *2 $(65,000)
Net return on investment $15,000
Average collection period is given as 30 days
Accounts receivables = Credit sales / Average collection period $1,500,000
*1 Bad debts expenses = (incremental sales X bad debts ratio)
*2 interest on additional investment = Increased investment on receivables X interest rate

From the above solution it is clear that the credit policy D is more profitable when
compared to all other policies, as it is giving positive returns of $ 15,000 while all other
policies are giving negative policies. Therefore the plc should go for the credit policy D
for acceptance.

5.3 Implementing Credit Policy

Accomplishment of credit policy involves assessing credit merit of customers, controlling
credit limits, prompting action on the over dues and defaulters. Therefore, credit policy
can be implemented if the following events are satisfied:
1. Controlling credit limits is the second major component of implementing credit
policy. Once an extension of credit is granted, a close credit monitoring system
has to be adopted. Credit monitoring includes age of receivables, constructing of
ratios, preventing of credit limit extension, promptly invoicing clients. This is
also referred as post credit analysis.

2. Action in collection of over dues and defaulters. Longer the period of collection,
higher the probability of default. A follow-up system has to developed and
implemented in order to reduce the risk of default. Such procedures includes,
sending reminder letters, or phone calls, withholding additional supplies, debt
collection agencies support in collection, and finally instigating legal action.

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 3. Assessment of credit standards: Every customer should be carefully assessed
before a credit terms are extended. Information from various sources regarding
credit worthiness should be collected and analyzed. Some of the major sources
are trade references, bank references, credit agencies, credit associations and
reports from sales personnel. Assessment of credit standards in other words is
called as pre-credit analysis of customers.

5.4 Optimum Credit Policy

Before beginning detailed financial analysis, should check the financial statements for
adequacy of net working capital. Investment in credit sales will accumulate costs in the
form of bad debts losses, collection charges, and interest on additional borrowings. An
increase in investment in the accounts receivables increases such costs. A reduction in
the investment in accounts receivables reduces such costs but also decreases profitability
of firms as decrease in receivables means decrease in sales. An optimum credit policy is
one that maximizes value of the firm, by minimizing the associated costs of credit sales
and providing a incremental revenue to the business.

Optimum credit policy is a trade-off between the increased profitability and increased
cost can be arrived with an efficient credit policy. This can be explained with the
following diagram. From the figure below, it is clear that the firm’s credit policy has to
be determined at point ‘x’. This the point at which the trade-off occurs, where total of
opportunity costs of lost contribution and credit administration cost and bad debts losses
are minimum.

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Optimum Credit Policy Fig

Costs and Benefits

Y
Total cost curve

Profitability options

Liquidity options
Optimum Credit policy x-axis

 Credit policy

The point where operating profits are maximum and firms total cost on investment in
receivables is minimum is called Optimum credit policy. The point of intersection of
profitability slope and liquidity slope is the optimum point as the incremental return is
equal to incremental costs of funds employed. Thus, the point ‘x’ is considered as
optimum credit policy. Once the firm moves away from optimum point towards the Y-
axis, credit policy has to be hardened by reducing credit terms. If the intersection point
moves away from Y-axis and it has to be softened. A hard credit policy means reduction
of credit terms and soft credit policy means extension of additional credit terms.

5.5 Factoring Receivables

The firm’s receivables are a major component of its current assets. The approximate size
of the receivable is determined by a number of factors are the level of credit sales, the
credit policies established by the firm, and the terms of trade. Credit management is a
specialized activity, and involves a lot of time and efforts to the company. Collection of

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receivables poses a problem particularly from banks, financing receivables for a limited
period and the seller of goods and services has the bear the risk of default by client. As
an alternative, a firm assigns the task of collection to specialist organizations called
factoring organizations. Factoring is of both financial as well as management support to
a client. It is the process of selling receivables (especially aged debts) to the firms
specialized in collection and administering. Therefore a firm sells it debts to the
collecting firm will have cash received as advance and the risk involved in collections are
transferred to specialized clients.

The basic function of a factor includes finding the customer, and collects sales proceeds
and remits the same to the client. Other secondary function of factor includes:
Credit collection and protection:
protection: a factor performs all the actions related to the
collection of debts. In additions too the collection, factor also provides protection
from debts like partial or full protection from bad debts.
Financial assistance:
assistance: A factor has provides facilities like advancing the debts to
the clients. Thus factor provides various services like managing debts and
financing them for a return called as factor service commission with or without
reserve commission to cover bad debts losses.
Sales ledger administration:
administration: Full credit services are provided by factor to client,
like advising about credit extension or reduction, maintenance of accounts
receivables, information related to market trends, competitors, and so on.

The factoring facilities are categorized classified into two groups. They are (1) full
service non-recourse factoring and (2) full service recourse factoring. Full service non-
recourse factoring is the method under which, book debts are purchased by the factor,
assuming 100 percent credit risk. The full amounts of invoices have to be paid to client
in the event of debt becoming bad. Under full service recourse factoring, client is not
protected against the risk of bad debts. Factor does not provide any indemnity against
book debts on which a customer subsequently defaults. The client will have to refund the
money in case of non-collection of book debts.

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Self check Exercise
1. Discuss the concept and importance of the credit policy.
………………………………………………………………………………………………
2. Discuss factoring receivables with there secondary functions.
………………………………………………………………………………………………

Illustration:
Illustration: A Roza plc has annual sales of $ 20 millions. 80 percent of sales are on 60-
day credit. Average collection period is given as 75 days. Based on the past performance
bad debts costs are estimated as 1 percent on credit sales. The plc has credit collection
cost of $ 75,000 per annum. A factor offers 1.75 % service charges for collection of
receivables. Factor also provides finance facility of 80 percent of amount sold to him
within 10 days of sale. Interest cost on borrowings is given to you as 6 %. Should the
plc go for factoring service?

Solution:
Existing credit collection (without factoring)
Bad debts expenses @ 1 % on credit sales
1 % of ($20,000,000 X 80%) $ 160,000
Collection charges per annum (given) 75,000
Interest on receivables investment
Receivables X interest cost
[16000, 000 X 75 days) / 360 days] X 6 % 200,000
Total expenses $ 435,000

Factoring Services as an alternative of own collection policy:

Factor commission
[$16,000,000 X 1.75%] $ 280,000
Bad debts expenses 160,000
Interest expenses (same as above) 200,000

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 Total expenses $ 640,000
Less: savings on factoring service
Collection charges (not required) (75,000)
Interest saved on cash advance received from
Factor after 10 days of sale
[$16000, 000 X 65days) / 360 days] X 6 % (173,333)
Net expenses after benefits $ 391,667

It can be concluded that the total expenses with factoring services is lower than the
expenses with own collection policy, therefore it advisable to the firm to go for factor
service for collection of receivables.

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 UNIT SIX
INVENTORY MANAGEMENT

To manage its inventories effectively, a firm should use a systems approach to inventory
management. A system approach considers in a single model all the factors that affect the
inventory. The model, called a system, may have any number of subsystems tied together
to achieve a single goal. In the case of inventory systems, the goal is to minimize costs.
Inventories constitute the most significant part of current assets. Because of the larger
size of investments in current assets, considerable funds are committed on inventories. It
is essential for every firm to minimize such investments by avoiding unnecessary storing
costs, obsolescence costs, and purchasing costs. Business units that are unable to control
inventories investment, end-up with decrease in profitability in the long run. The primary
objective of inventory management is to ensure sufficient levels of inventories to
maintain an acceptable level of availability on demand, and minimizing the associated
holding and administrative costs.

Inventories for a manufacturing firm include raw materials, work-in-progress and

finished goods. Raw materials are the basic inputs that are converted into finished goods
through conversion process (manufacturing process). Raw materials inventories include
materials purchased and stored for future production needs. Work-in-progress
inventories are semi-completed goods. These goods represent partly completion of
conversion process and partly incompletion of conversion process. Hence these goods
are neither raw materials nor finished goods. Finished goods inventories are completed
goods in all aspects of manufacturing process and are ready for sale.

6.1 Objectives of Inventories Management

Since Inventories constitute the most significant part of current assets, Maintaining large
size of inventories increases investment in current assets, and also associated costs with
maintenance of inventories like storing cost, administrative cost, obsolescence cost and
wastage. Maintaining higher volume of inventories will facilitate successful production
cycle, with un-interrupted production procession. But higher inventories volume result in

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increasing indirect production costs like, storing costs, security costs, administration
expenses, and losses from obsolescence. On contrary, lower volumes of inventories may
result as decrease in indirect expenses on one hand and increases production costs on the
other as idle machine hours, idle labor hours and so on. Therefore firms’ should try to
achieve the dual objective of inventories management of continuous un-interrupted
production and minimum investment in inventories. In other words, an efficient
inventory management should always aim for the following objectives:
 Ensure a continuous supply of materials to facilitate un-interrupted
production.
 Maintain sufficient quantities of inventories in period of short supply and
un-anticipated price changes.
 Maintain sufficient volume of finished goods inventories for smooth sales
operations, and efficient customer services.
 Minimize the carrying cost of inventories.
 Control investments in inventories and maintain optimum level.

6.2 Inventory Management Techniques

The goal of managing inventories, the firms’ should be in consonance with the wealth
maximization principle. One can achieve this, by determining the optimum level of
inventory. An efficiently controlled inventory makes the firm flexible, and inefficiently
controlled inventories results in unbalanced inventories and inflexibility in production
and operational activities. A successful inventory management should always aim for
two basic conditions. The first being the identification of quantity to be ordered,
minimizing the investments in inventories. The second one is the using pattern of
inventory, which determines the timing interval for the replenishment of inventories. The
first one is called economic order quantity and the second one is re-order point.
point.

Economic order quantity is the inventory replenishment cycle and the major decision area
processed in the inventories management. A firm buying raw materials has to decide two
basic criteria influenced by purchasing decisions. They are (1) carrying costs of
inventory and (2) ordering cost of inventories. Determination of optimum inventories
level or quantity of inventory to be injected depends on the trade-off between inventory

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carrying cost and inventory ordering costs. Economic order quantity is that level of
inventory, which minimizes the total ordering costs, and also carrying costs.

Ordering cost of inventory is also called as purchasing costs of inventory. Costs that are
associated with purchasing activities are called as ordering costs. Usually costs like
material requisition, receiving, inspecting and pre-storing arrangements are part of
ordering costs. Ordering costs increases with increase in the number of purchases and
decreases on decrease in the number of purchases.

Carrying costs are cost of storing the raw materials and finished goods in the stores. The
costs incurred for maintaining a given level of inventory are called carrying costs or
storing costs. Carrying costs includes storing expenses, insurance, taxes, deterioration
and obsolescence of materials. Storage expenses also include expenses on warehousing,
handling and clerical staff maintenance expenses. Behavior of carrying costs is in
directly proportional to the inventory volume. Increase in the volume of inventories
increases carrying costs and vice-versa. Inventory carrying cost is always expected to
maintain on the assumption of average volume, as the events under the two extreme
points will give biased results. Inventory volume under at the time of beginning of the
year (BOY) will be maximum in volume thereby the inventory ratio will lower, while the
inventory volume during the end of year (EOY) will be low reducing the inventory ratio
The optimum size of inventory is commonly referred as economic order quantity. It is
that size of inventory where inventory carrying cost will be equal to the inventory
ordering costs. Before attaining this trade-off, inventory-carrying cost will be more than
ordering costs and after this, carrying cost will be less than the ordering costs. This can
be explained with the following figure more clearly.

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 Costs and Benefits
Optimum inventory cost Fig 8.3

Total cost curve

Inventory ordering cost curve

Inventory carrying cost curve

EOQ

Quantity

6.3 Determination of Economic order Quantity

The economic order quantity (EOQ) refers to the order size that will result in the lowest
total of order and carrying costs for an item of inventory. If a firm places unnecessary
orders, it will incur unneeded order costs.

Economic order quantity can be determined using three different approaches. Graphical
method is the first method, trial and error method is the second and order formula
approach is the third method. Graphical method is explained in the above paragraph.
Trial and error method is the analytical approach adopted to determine economic order
quantity of the given firm. This can be explained in detail using the following
illustration:
Illustration 5: A firm provides the following information related to its inventories
operations. Determine the economic order quantity using trial and error method.

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 Annual consumption of raw materials 10,000 units
Ordering cost per order placed $ 200
Inventory carrying cost per unit per annum 4 percent
Cost per unit $ 100.
Sol:
Estimation of economic order quantity (trial and error method)
Particulars
Total quantity per
annum 10,000 10,000 10,000 10,000 10,000 10,000 10,000
Cost per unit
purchased $100 $100 $100 $100 $100 $100 $100
Total purchasing
cost (a) $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000 $1,000,000
Number of orders 1 2 4 5 8 10 12
Ordering cost per
order $200 $200 $200 $200 $200 $200 $200
Total ordering cost
(b) $200 $400 $800 $1,000 $1,600 $2,000 $2,400
Quantity purchased
per order 10000 5000 2500 2000 1250 1000 833
Average inventory 5000 2500 1250 1000 625 500 417
Inventory carrying
cost per unit $4 $4 $4 $4 $4 $4 $4
Total inventory
carrying cost [c] $20,000 $10,000 $5,000 $4,000 $2,500 $2,000 $1,667

Total cost (a) + (b)

+ [c] $1,020,200 $1,010,400 $1,005,800 $1,005,000 $1,004,100 $1,004,000 $1,004,067
Economic ordering
quantity $1,004,000

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 (a) Total purchasing cost of inventory = quantity purchased X Unit cost price
(a) Total ordering cost of inventory = Number of orders X ordering cost
(b) Total inventory carrying cost = Average inventory X unit carrying cost per
annum.

Order formula Approach: Trial and error approach is time consuming and tedious
approach of determining economic order quantity. Order formula approach is the simple
method used in determining the economic order quantity. Under this method, economic
ordering quantity is determined using the following formula:

EOQ =

Where AC = Annual consumption of quantity

O = Ordering cost per single order placed
I = annual carrying cost per single unit of inventory
EOQ = Economic ordering quantity

Using the information from the illustration 5, EOQ can be determined as follows:
Given AC = 10,000 units
O = $ 200 per order placed
I = $ 4 per unit

EOQ =

EOQ =

EOQ = 1,000 units per order.

Usually suppliers encourage placing larger orders by offering discount. Firms will save
big margins on the purchase prices on accepting discount offers. Basic equation of
economic ordering quantity will not resolve this issue. Therefore the discount offer is to
analyze separately. Under this option, benefits on decrease in price should compare with
incremental costs of inventory. If the net benefit is positive discount offer will be
profitable, if it is negative discount offer will be not worth accepting.

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6.4 Reorder Point
An important question in any inventory management system is “when an order should be
placed so that the firm does not run out of goods?”
It is a level of inventory at which the firm places an order in the amount of he economic
order quantity if the firm places the order when the inventory reaches the order point, if
the firm places the order when the inventory reaches the order point, the new good will
arrive before the firm runs out of goods to sell.

Economic order quantity solves the problem of how much inventory level has to be
maintained, but when to order can be determined effectively by reorder point. The
reorder point is that inventory level at which an order should be placed to replenish the
inventory. To determine the reorder point under certainty one should know (a) lead time,
(b) average usage of inventory and (c) economic order quantity or quantity replenished.
Lead-time is the normal time taken to replenish inventory after placing an order of the
same inventory. Under certainty assumption, lead-time will not fluctuate. Average usage
of inventory is the quantity consumed by the production process. Therefore reorder point
can be calculated using the following formula:

Reorder point = Lead-time X Average usage on inventory (units)

Determination of reorder point under uncertainty assumptions differs with the certainty
model slightly. Uncertainty is the condition where, lead-time may fluctuate, or average
inventory consumption may vary or both. Reorder point under the uncertainty can be
determined as follows:

Reorder point = {Lead-time X Average usage}+ {safety stock}

Illustration:
Illustration:

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From the following information given below calculate the inventory reorder point both
under the certainty assumption and under uncertainty assumptions.

Given Economic order quantity 2,000 unity

Lead-time 1 week
Average consumption 400 units per week
Uncertainty condition
Lead-time 1 to 1½
1½ week
Average consumption 400 to 500 units

Solution:
Under Certainty assumption
Reorder point = Lead-time X Average usage on inventory (units)

Reorder point = 1 week X 400 units per week

Reorder point = 400 units

Under Certainty assumption (lead-time)

Reorder point = Lead-time X Average usage + safety stock

Reorder point = 1 week X 400 units per week + ½ week stock

Reorder point = 400 units + 200 units

Reorder point = 600 units

Under Certainty assumption (average consumption)

Reorder point = Lead-time X Average usage + safety stock
Reorder point = 1 week X 500 units per week +½
+½ week stock
Reorder point = 500 units + 250 units

Reorder point = 750 units

Under Certainty assumption (both)
Reorder point = Lead-time X Average usage +½
+½ week stock
Reorder point = 1 week X 400 units per week + 250 units
Reorder point = 650 units

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Reorder point with certainty option may vary slightly. The basic variation starts with
defining uncertainty, as a result arising due to inconsistency in lead-time and
consumption of materials in production. The following diagram explains the same.
Uncertainty will assume some amount of stock a fixed or unused called as buffer stock or
safety stock kept in reserve to meet the contingency needs.

6.5 Inventory Control

By holding inventories the firm is able to separate the process of purchasing, producing,
and selling. Usually a firm has to maintain multiple types of inventories. Control over
operations of such inventories will be quite difficult. Therefore a firm should be selective
in its approach in inventories controlling system. This selective approach is also called as
ABC analysis that tends to measure significance of each item of inventories in terms of
its value. Inventories with high vale (in terms of investment) are called as ‘A’ class items
and are expected to keep under tight control. Inventories with low value of investments
are expected to have limited or no control called as ‘C’ class items. Finally, inventories
with moderate investment are called as ‘B’ class items are kept under moderate control
measures.

ABC analysis concentrates on important items and is also know as control by importance
and exception [CIF]. As the items, are classified in the importance of their relative value,
this approach is also called as proportional value analysis [PVA]. The following steps
are involved in implementing ABC analysis:
 Classify the items of inventories; determine the expected usage in units and the
price per unit for each item.
 Determine the total value of each item by multiplying the expected units by the
unit price.
 Rank the items in accordance with the total value starting from the items with
highest total values.
 Compute the ratio (percentage) of number of units of each item to total units of all
items and the ratio of total value of each item to total value of all items.
 Combine items on the basis of their relative value to form ABC categories.

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Illustration 6: From the following information determine the inventory control measure
using ABC analysis.
Items of 1 2 3 4 5 6 7
inventory
Units 10,000 5,000 16,000 14,000 30,000 15,000 10,000
Unit price $ 30 $ 50 $5 $4 $2 $1 $0.50

Sol:
Construction of ABC Analysis of control measure
Item % OfCumulativ Unit Total % of TotalCumulatin
Number Units total e price cost cost g
1 10,000 0.10 0.10 $30 $300,000 0.3916 0.3916
2 5,000 0.05 0.15 $50 $250,000 0.3264 0.7180
3 16,000 0.16 0.31 $5 $80,000 0.1044 0.8225
4 14,000 0.14 0.45 $4 $56,000 0.0731 0.8956
5 30,000 0.30 0.75 $2 $60,000 0.0783 0.9739
6 15,000 0.15 0.90 $1 $15,000 0.0196 0.9935
7 10,000 0.10 1.00 $0.50 $5,000 0.0065 1.0000

Total 100,0001.00
100,0001.00 1.00 None $766,000 1.0000 1.0000

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Classification Quantity % of total total cost %
"A" class items
1 10,000 10 $300,000 39
2 15,000 15 $250,000 32
Total 25,000 25 550,000 71
"B" class
3 16,000 16 $80,000 11
4 14,000 14 $56,000 7
Total 30,000 30 136,000 18
"C" class
5 30,000 30 $60,000 8
6 15,000 15 $15,000 2
7 10,000 10 $5,000 1
Total 55,000 55 80,000 11

Activity
1. Discuss deeply inventory management and its objective.
………………………………………………………………………………………………
2. Express EOQ in different aspect
………………………………………………………………………………………………

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Summary
In addition to the management of cash and marketable securities, the financial manager
must be concerned with two other important areas of working capital. First, sales made
on credit involve the creation of receivables that must be converted to cash. Since the
cash is not firmly in hand until the money is collected, receivables represent an exposure
that must be analyzed and managed. Second, in order to have goods to sell, the firm must
maintain inventory. Until the goods are sold, they also represent an exposure that must be
managed.

The economic order quantity (EOQ) refers to the order size that will result in the lowest
total of order and carrying costs for an item of inventory. If a firm places unnecessary
orders, it will incur unneeded order costs.

An account receivable is created when a buyer is granted a certain length of time to delay
payment. This in simple terms called as the open account credit. The only evidence
supporting the debt is the sales invoice which accompanies the merchandise or service
and which the buyer signs to indicate the receipt. Allowing a customer to delay payments
represents an extremely important decision for the seller. In the event of failure from the
part of customer to repay or failure from the part of the seller to collect the due will result
in the form of loss of income.

Credit policy is established to determine which customer qualifies for the credit and
under with terms. The following are basic reasons, which help the firm as guidelines in
credit policy: Credit period, Discount, Discount period, Credit limit.

Credit information sources: Credit managers have access to customer information from
several important sources. First, most communities maintain credit associations. By
becoming a member of an association, the manager can attend meetings and meet other
people with similar interests and problems. Exchanging information among members is
common and a valuable information resource

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 Self check Exercises
Part I
1. Define the credit management policy applicable to accounts receivables.
2. Exemplify briefly the functions performed by the factor in collection of credit.
3. Describe the role and significance of inventory management in business.
4. Explain the concept of reorder point and its determinant under certainty.
5. What is economic order quantity?
6. Explain inventory management.
7. Briefly explain inventory control.

Part II
1. An xx plc desires to earn 10 percent required rate of return on its investments. Its
current credit terms are net 10. The total volume of sales of the plc is 12 millions per
annum. The plc collection period is 60 days. If the plc offers 2/10, net 30, 60 percent
of the customers will take the discount and the collection period will be reduced to 40
days. Should the credit terms be changed?
2. ABC com. has current sales of $ 3 million. To push the sales, the company is
considering a more liberal policy. Existing collection period of the firm is 30 days.
Each unit is sold at the price of $ 10. Average cost per unit at current level is $ 8 and
variable cost per unit is $ 6. Interest on additional borrowings will be 10 percent.
The proposes to implement one of the following policies:
Credit policy Revised collection period Incremental sales
A 45 days $ 500,000
B 60 days $ 1,000,000
C 75 days $ 2,000,000
Should the com. should go for new policies when the required rate of return is 12
percent.

3. Eyob com. has the current collection period of 60 days, and average investment in
receivables as $ 600,000. Calculate the amount of credit sales and receivables
turnover ratio?
4. Dige has an amount of $ 12 million credit sales. The current bad debts costs are
estimated as 1.5 percent and collection charges of $ 100,000 per annum. A factor

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 offers the following two proposals as an alternative of collection, advice which
proposal is suitable for Dige?
Suggestion I: 1.8 percent commission payable to full service recourse factoring.
Suggestion II: 2.5 percent commission payable to full service non-recourse
factoring.
5. A manufacturer has expected annual usage of product “560” of 50,000 units. The
cost of processing an order of purchases is $ 20, and carrying cost per unit for a year
is 50 cents. Lead-time on an order is 5 days and it is a practice to keep stock usage in
reserve for 2 days. Calculate (a) economic order quantity (b) reorder point.
6. A com. has $ 4 per year carrying cost on each unit of inventory and annual usage of
50,000 units. Ordering cost is $ 100 per order. Calculate economic ordering
quantity, total cost of inventory, annual ordering cost and annual carrying cost? If
the quantity is offered at a discount of 0.25 cents on purchases above 10,000 units,
will you accept the offer price?
7. A firm has estimated annual demand of 2,500 units with $ 400 as ordering cost and $
50 per unit as carrying cost. Safety stock is kept at 20 percent of economic ordering
quantity. Lead-time is 10 days. Determine (a) economic order quantity (b) safety
stock and (c) reorder point?
8. Dido requires materials of 3,000 units of product “X”. Each unit is priced $ 20, and
ordering cost per order placed will $ 30. If the annual carrying cost per unit is 2.5
percent per annum, calculate the economic order quantity? If the suppliers offer the
following discounts, what will be your decision?

Quantity purchased Discount rate

001 – 500 units none
500 – 1,000 units 0.5 %
1,000 – 2,000 units 1.0 %
2,000 – 3,000 units 2.0 %
3,000 and above 2.5 %

9. A disso is considering a selective inventory control measure for controlling

inventories. The following date is given to you:

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 Item Code Units Unit price
1 6,000 $ 4.00
2 61,200 $0.05
3 16,800 $ 2.10
4 3,000 $ 6.00
5 55,800 $0.20
6 22,680 $ 0.50
7 26,640 $ 0.65
8 14,760 $0.40
9 20,520 $ 0.40
10 90,000 $ 0.10
11 29,940 $.030
12 24,640 $ 0.50

Categorize the above items into ABC analysis groups?

10. Zewid is considering implementing ABC inventory control system for its inventories.
Assist the firm in constructing the ABC analysis graph.
Units Unit price
7,000 $ 10.00
8,000 $9.00
10,000 $ 2.00
6,000 $ 8.00
8,000 $1.00
2,000 $ 60
5,000 $ 0.40
4,000 $40.00

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 UNIT SEVEN
THE FINANCING DECISION

7.1 Introduction
The ultimate source of capital is, of course, the investor, but there are a number of ways
by which a business may Endeavour to obtain the finance it requires with the maximum
of certainty and the minimum of expense.
When seeking to capitalize a business, it is essential to know the amount of finance
required, and the type of undertaking and its relevant circumstances. However, it is
equally important that the search for funds should be made when the appeal is likely to
have the desired effect. It is necessary, therefore, to consider the various methods of
raising capital together with the conditions in which a business finds it expedient to apply
them.

Some investors are more flexible than others because they are not locked into a few
available sources of funds. Investors would like many financing alternatives in order to
minimize their cost of funds at any point in time. Unfortunately, not many firms are in
this enviable position through the duration of a business cycle.

At the time the financing decision is made, the investor is never sure if it is the right one.
Should the financing be long-term or short term, debt or equity, and so on? At each point
a decision is made until a final financing method is reached. In most cases the investor
will balance short-term versus long-term considerations against a composition of the
firm’s assets and the firm’s willingness to accept risk. The ratio of long-term financing to
short-term financing at any point will be greatly influenced by the term structure of
interest rates (The term structure of interest rates refers to the way in which the yield on a
security varies according to the term of the borrowing, that is the length of the time until
the debt will be repaid as shown by the yield curve. Normally, the longer the term of an
asset to maturity the higher the rate of interest paid on the asset.)

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7.2 Short Term Sources of Finance
The repayment term of short term financing is usually shorter than one year.
Creditworthiness is an important aspect which the entrepreneur or the venture must
satisfy before any short term financing will be granted. The following aspects are
considered when assessing creditworthiness.
Character: The reputation of honesty and reliability.
Capacity: The business sense of the borrower, the level of experience and business
history.
Circumstances: The general business circumstances in the industry and the economy.
Insurance Cover: The extent of the cover of insurable risks taken out by the borrower.
Guarantees: The lender may require the borrower to use assets to guarantee the loan.

7.2.1 Different Aspects of Short Term Finance

A. Trade creditors
This the basic source of finance and many entrepreneurs do not realise that by acquiring
items on credit they are obtaining short term finance. Credit just like any other source of
finance has interest element hidden which most are not able to recognise. The discount
may be offered to encourage early payment and the receiving company may not
advantage of the discount the cost arise.
Assume that a discount of 5% is offered for payment within 30 days. The cost of capital
for credit taken over these 30 days is:

Therefore it is not a cheap source of finance. On occasions, trade credit is used is used
because the buyer is not aware of the real costs involved- if he were, he might turn to
other sources of trade finance. However, other forms of capital are not always available,
and for a company that has borrowed as much as possible trade credit may be the only
choice left. This is an important source of capital for many small companies. A company
which provides credit to another is in fact putting itself in the position of a banker whose
advance takes the form not of cash but of goods for which payment will be deferred. This

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use of trade credit between companies is extremely important from both an industrial and
a national point of view.
B. Terms of Trade Credit
Terms of credit vary considerably from industry to industry. Theoretically, four main
factors are determined the length of credit allowed.
The economic nature of the product: products with a high sales turnover are sold on short
credit terms. If the seller is relying on a low profit margin and a high sales turnover, he
cannot afford to offer customers a long time to pay.
The financial circumstances of the seller: if the seller’s liquidity position is weak he will
find it difficult to allow very much credit and will prefer an early cash settlement. If the
credit term is used as part of sales promotion then, he may allow more credit days and use
other means for improving liquidity position.
The financial position of the buyer: if the buyer is in weak liquidity position he may
take long time to settle the balance. The seller may not be will to trade with such
customers, but where competition is stiff there is no choice other than accepting such risk
and improve on sales levels.
Cash discounts: when cash discounts are taken into account, the cost of capital can be
surprisingly high. The higher the cash discount being offered the smaller is the period of
trade discount likely to be taken.

Trade credits are also used as signaling effect on the performance of both the buyer and
the seller. Where the days allowed to customers are increasing, it may indicate that the
company is slipping in its debt collection and very soon may encounter cash flow
problem. More days to the customers also increase the risk of bad debts which will
reduce the profit levels of the company. On the other hand reducing credit days to
customers may result in loss of some customers as they will always seek a supplier
willing to offer more credit days.

For a company, as a buyer having increased credit days may indicate that the enterprise is
facing cash problems and is unable to settle their balance in good time, and this may
result in loss of business. Allowing cash discounts to pass is also a cost to the business as
outlined above. However, reducing the day’s payment to the supplier may also indicate

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that the company is not trusted by its suppliers. A company with a poor track record will
always face difficulties in negotiating for more days, hence the short payment period.
C. Factoring
Factoring involves raising funds on the security of the company’s debts, so that cash is
received earlier than if the company waited for the debtors to pay. Most factoring
companies offer these three services:
Sales ledger accounting, dispatching invoices and making sure bills are paid.
Credit management, including guarantees against bad debts is the provision of finance,
advancing clients up to 80% of the value of the debts that they are collecting.

I. Sales ledger administration

The factoring companies will takeover the administration of receivable department,
maintaining the sales records, credit control and the collection of receivables. It is
claimed that the factor will be able to obtain payment from customers more quickly than
if the company was to make collection on its own. The cost of this administrative service
is a fee based on total value of debts assigned to the factor. The fee rate is based on work
which is to be done and the risk level of bad debts.

II. Credit management

For a fee the factor can provide up to 100% protection against non payment of approved
sales. The factoring company will always assess the credit profile of an enterprise before
entering into such an agreement. As outlined above the risk level of the company’s debts
will be the main factor in determining the fee charge.

III. Provision of finance

This is the main product which most factoring companies offer. Factor companies
provide finance which is used to boost the working capital; of the business. The factoring
is not as cheap as may be the bank overdrafts and because the bank borrowing is also
flexible it is imperative that the company should approach the bank first. However,
factoring can be particularly useful when a company has exhausted its overdraft and is
not yet in position to raise new equity.

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D. Invoice Discounting
This is purely a financial arrangement which benefits the liquidity position of the
enterprise. Invoice discounting is the transferring of invoice to a finance house in
exchange with immediate cash. The company makes an offer to the finance house by
sending it the respective invoices and agreeing to guarantee payment of any debts that are
purchased. If the finance house accepts the offer, it makes immediate cash payment of
about 75%, which means that at a specified future date, say 90 days, the loan must be
repaid. The company is responsible for collecting the debt and for returning the amount
advanced, whenever the debt is collected.

E. Bank Overdraft
One of the most commonly used sources of short term of finance because of its cost and
flexibility. When borrowed funds are no longer required they can quickly and easily be
paid. It is also comparatively cheap because the risks to the lender are less than on the
long-term loans, and all the loan interests are allowable tax expenses. The bank issue
overdrafts with the right to call them in at short notice. Bank advances are, in fact payable
on demand. Normally the bank assures the borrower that he can rely on the overdraft not
being recalled for a certain period of time.

The borrower is required to use the overdraft to supplement the working capital shortfall.
As the bank overdraft is payable on demand it is not wise to use the money in purchasing
non current assets like machine. Financing of such assets should be made using long-term
finance such as finance lease and loans. Any plans that involve an overdraft or short term
loan should therefore refer closely to the company’s cash flow analysis so that it is quite
clear how long the funds will be needed and when they can be repaid.

Another purpose for which bank overdraft might typically be used to iron out seasonal
fluctuations in trade. The banks assist in providing temporary funds to finance production
on the assumption that the goods or products will be sold in a later season. Agriculture is
the obvious example of an industry where this type of borrowing is needed.

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F. Counter Trade
Counter trade is a method of financing trade, but goods rather than money are used to
fund the transaction. It is a form of barter. Goods are exchanged for the other goods. This
form of business for private enterprises is diminishing in local trading but for
international trade is still a popular way of funding the business activities.

Provides information about short term financing for businesses, it also provides some
examples of sources of short term financing.
What is Short Term Financing?

Short term financing is essentially to provide capital deficit businesses funds for a short
term period of a year or less.
What is short term financing for?
_________________________________
These funds are usually for businesses to run their day-to-day operations including
payment of wages to employees, inventory ordering and supplies

An example of short tern financing could be when a firm places an order for raw
materials, it pays with finance and anticipates recouping this finance by selling these
goods over the period of a year.
Difference between Short term and Long Term financing

In contrast long-term financing decisions are involved when a firm purchases a special
machine that will reduce operating costs over, say, the next five years.
Following from the earlier explanation that short term borrowing should be used for
working capital requirements for day to day operations of a business. Industries with
seasonal peaks and troughs and those engaged in international trade will be heavy users
of short term borrowing finance.

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7.2.2 Short Term Financing and Lenders
Lenders favor businesses that exhibit strong management, steady growth potential and
reliable projected cash flow (demonstrating the business ability to pay the monthly
interest payments on this line of credit from its projected.

However Lenders normally charge a higher base rate of interest for operating loans
reflecting this relatively weaker security position
Example of Short Term financing sources

There are many methods for which a firm can seek short terms financing some of these
include:

Overdrafts
Short-term loans
Bills of exchange
Promissory notes/commercial paper
Inventory loan
Letters of credit
Short term Eurocurrency advances
Factoring
Why Do Firms Need Short-term Financing?
________________________________________________
 Cash flow from operations may not be sufficient to keep up with growth-related
financing needs.
 Firms may prefer to borrow now for their inventory or other short term asset
needs rather than wait until they have saved enough.
 Firms prefer short-term financing instead of long-term sources of financing due
to:
• easier availability
• usually has lower cost (remember yield curve)

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 • matches need for short term assets, like inventory

7.2.3 Types of short-term loans

A. Line of Credit
• The borrowing limit that a bank sets for a firm after reviewing the cash
budget.
• The firm can borrow up to that amount of money without asking, since it
is pre-approved
• Usually informal agreement and may change over time
• Usually covers peak demand times, growth spurts, etc.
• Promissory note
 A legal IOU that spells out the terms of the loan agreement,
usually the loan amount, the term of the loan and the interest rate.
 Often requires that loan be repaid in full with interest at the end of
the loan period.
 Usually with a Bank or Financial Institution; occasionally with
suppliers or equipment manufacturers

B. Estimation of Cost of Short-Term Credit

 Calculation is easiest if the loan is for a one year period:
 Effective Interest Rate is used to determine the cost of the credit to be able to
compare differing terms.

Effective = Cost (interest + fees)

Interest Rate Amount you get to use

Example: You borrow $10,000 from a bank, at a stated rate of 10%, and must pay $1,000
interest at the end of the year. Your effective rate is the same as the stated rate:
$1,000/$10,000 = .10 = 10%

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7.3 Long term debt and lease
7.3.1 The Expanding Role of Debt
A lease of ten years or longer-Long-term leases are common in commercial real estate,
but unusual in residential real estate.
• Growth in corporate debt is attributed to:
– Rapid business expansion.
– Inflationary impact on the economy.
– Inadequate funds generated from the internal operations of business firms.
• Expansion of the U.S. economy has placed pressure on the Government to raise
capital.
– New set of rules have been developed for evaluating corporate bond
issues.
7.3.2 The Debt Contract
• Contract bond: the basic long-term debt instrument for most large U.S
corporations – basic items include:
– Par value: initial value of the bond.
• Principal or face value.
– Coupon rate: actual interest rate on the bond.
– Maturity date: repayment date of the principal.
• Bond indenture, a supplement to the bond agreement.
• Secured debts have specific assets pledged to bondholders in the event of default.
– These assets are seldom actually sold and distributed (proceeds).
– Terms used to denote collateralized or secured debts:
• Mortgage agreement: real property is pledged.
• After-acquired property clause: requires any new property to be
placed under the original mortgage.
– Greater the protection offered, lower the interest rate on the bond.
• Debt that is not secured by a claim to a specific asset.
– Debenture: unsecured long-term corporate bond.

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 • General claim against the corporation is common for defaults.
– Subordinated debenture
• Payment to the holder will occur only after the designated senior
debenture holders are
7.3.3 Methods of Repayment
• Does not always involve a lump-sum disbursement at the maturity date.
– Repayment of bonds can be done by:
• Simplest method - single-sum payment at maturity.
• Serial payments: paid off in installments over the life of the issue.
• Sinking-fund provision: semiannual/ annual contributions made
into a fund run by a trustee.
• Conversion: converting debt to common stock.
• Call feature: retire or force in debt issue before maturity.
Bond Prices, Yields, and Ratings
A. Bond Prices
• Financial managers must be sensitive to the bond market with regard to:
– Interest rate changes.
– Price movements.
• Market conditions will influence:
– Timing of new issues.
– Coupon rate offered.
– Maturity date.
• Bonds do not maintain stable long-term price patterns.
B. Bond Yields
• Three different ways; computed below:
– Example: par value: $1,000; payment: $100/ year; period: 10 years;
current price: $900.
• Coupon rate (nominal yield): interest rate / par value.
$100 = 10%
$1,000
• Current yield: in terms of the current price.

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 $100 = 11.11%
$900
• Yield to maturity: for bonds is held until maturity.
Interest rate approximate: 11.70% = payment of $100 for 10 years and a final
payment of $1,000.
C. Bond Ratings
• Two major bond rating agencies:
– Moody’s Investor Service.
– Standard and Poor’s.
• Ratings are based on a corporation’s:
– Ability to make interest payments.
– Consistency of performance.
– Size.
– Debt-equity ratio.
– Working capital position
7.3.5 Advantages of Debt
• Interest payments are tax-deductible.
• The financial obligation is clearly specified and of a fixed nature.
– Exception: floating rate bonds.
• In an inflationary economy, debt may be paid with ‘cheaper dollars.’
• The use of debt, up to a prudent point, may lower the cost of capital to the firm.
7.3.6 Leasing as a Form of Debt
• Leasing has the characteristics of a debt.
– A corporation contracts to lease and signs a non-cancelable, non-term
agreement.
– Companies are expected to fully divulge all information about leasing
obligations.
• Leasing was made official as a result of Statement of Financial Accounting
Standards (SFAS):
• Four conditions for identification include:

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 – The arrangement transfers ownership of the property to the lessee by the
end of the lease term.
– The lease contains a bargain purchase price at the end of the lease.
– The lease term is equal to 75% or more of the estimated life of the leased
property.
– The present value of the minimum lease payments equals 90% or more of
the fair value of the leased property at the inception of the lease.
• Does not meet the conditions of a capital lease.
• Usually short-term, cancelable at the option of the lessee.
• The lessor may provide for the maintenance and upkeep of the asset.
• Does not require a capitalization, or presentation, of a full obligation on the
balance sheet.
• Capital lease
– Requires treatment similar to a purchase-borrowing arrangement.
• Intangible asset is amortized, or written off, over the life of the
lease - annual expense deduction.
• Liability account is written off through regular amortization -
implied interest cost on the balance.
• Operating lease
– Requires annual expense deduction equal to the lease payment, with no
specific amortization.
7.3.7 Advantages of Leasing
• Takes care of lack sufficient funds or the credit capability issues to purchase assets.
• Obligation may be substantially less restrictive.
• May not require a down payment.
• Lessor’s expertise – may reduce negative effects of obsolescence.
• Lease on chattels have no such limitations for bankruptcy and reorganization
proceedings.
• Tax advantage factors include:
– Depreciation write-off or research related tax credits.

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 • Infusion of capital can occur if a firm chooses to engage in a sale-leaseback
arrangement.
– Allows the lessee to continue the usage of the asset.

UNIT EIGHT
INTERNATIONAL FINANCIAL MANAMGEMENT
Objectives
After completing this chapter, you will be able to:
 discuss what transaction costs are
 compare and contrast the different between direct terms vs. indirect terms
 discuss important topics in international financial management
 recognize the rules of thumb in international financial management

8.1 Introduction
Introduction

When money crosses international boundaries, individuals, businesses, and governments

must deal with special kinds of problems. Each country has its own national currency;
thus, a citizen of the United States must convert dollars to French francs before being
able to purchase goods or services in Paris. Most governments have imposed retractions
on the exchange of currencies, and these may affect business transactions. Governments
may be facing financial difficulties, such as balance of payments deficits, or may be
dealing with economic problem, such as inflation or high levels of unemployment. In
these cases, they may require detailed accounting for the flows of funds or may allow
only certain types of international transactions. They study of flows of funds between
individuals and organizations across national borders and the development of methods of
handling the flows more efficiently are properly within the scope of international finance.
Exchange rate: is the price of one currency in terms of another currency.
Direct (or Normal) quote: quote in domestic currency (e.g., a US bank gives a direct
quote for the British pound, denoted as £, as US$/one pound or US$/£, whereas a British
bank gives a direct quote for the US dollar as £/US$.)

Indirect (or Reciprocal) quote: the inverse of the direct quote.

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US (or American) Terms: direct quote used in doing business in the US (e.g., US$/£).

Euro: a new currency, introduced on January 4, 1999, issued by the EU. It will come into
common use in about three years.

Spot (exchange) rate: bank rate (guaranteed) for up to 48 hours.

Forward rate: contractually agreed to rate for a future exchange.
Bid rate: buy rate
Offer rate: sell rate
Spread = bid rate - offer rate
Cross rate - exchange rate computed from two other rates.
For example assume that, the US exchange rates for Belgium and the UK are as follows:
US $ equiv.
(US Terms)
Currency per US $
(European Terms)
Belgium (Spot) 0.0321 ($/BF) 31.1150 (BF/$)
Britain (Spot) 1.5901 ($/£) 0.6289 (£/$)
Suppose you subscribe to a journal produced in the UK and the bill for a given year is 50
£. The proper payment, if they will accept a personal check, is $81, determined as
follows:

From the table, the rate is 1.5901 US$/£. Thus, the exact payment in US$ is
(1.5901 US$/£) x (50 £) = 79.505 US$.
One should include an extra amount; say $1.50, to cover inconvenience and any
transactions costs that the publisher might encounter.

8.2 Transactions Costs

The spread (= bid rate - offer rate) is the profit to the currency dealer and is a transaction
cost to the other party. For example, suppose you must pay for the British journal in
British pounds.

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For example, one can assume the rate to sell as 1.5904 US$/£. Thus, it will cost you
(1.5904 US$/£) x (50 £) = 79.52 US$ to acquire the 50 £.

Note that there is not a great deal of difference here. However, if we were dealing in
millions of dollars or millions of pounds, then the difference would be quite large.
Furthermore, common sense suggests that if the publisher will accept a personal check,
which is very convenient for you and quite inconvenient for the publisher, then you
should add $1.50 (or so) to correct for exchange rate changes, transactions costs, and
convenience. Therefore, if you were paying in US$, you would remit $81. (Most
international businesses maintain offices in many countries exactly to make transactions
convenient for the buyer. For example, Oxford University Press, Cambridge University
Press, and Springer-Verlag (of Germany) all have offices in New York, and Kluwer
Academic Press (of the Netherlands) has an office in Boston.)

8.3 Cross Rates

Under the presumption of no transactions costs and efficient markets, we can calculate
the exchange rate between any two currencies. For example, it is provided that American-
terms rates for the Swiss Franc (SwF) and the German Deutsche mark (DM), which
yields the exchange rate for the SwF, in terms of the DM, as follows:

.840790 (SwF/DM) = 1.2685 (SwF/US$)

1.5087 (DM/US$)
Cross rates can be calculated due to a very simple form of efficiency in the currency
market, known as Triangular Arbitrage.

8.4 Triangular Arbitrage

Assume you can get exchange rates that are not in balance. For example, suppose one can
exchange dollars for Belgian francs at a rate of XBF/$
XBF/$ and Belgian francs for French
francs at the rate of XFF/BF
XFF/BF.. Let X$/FF
X$/FF be the exchange rate between US$ and FF. If the
product (XBF/$
(XBF/$)(X
)(XFF/BF
FF/BF)) is greater than X$/FF
X$/FF (ignoring transactions costs), then you
would make the swap and “best the market.” The net effect of your activity would be to
alter the market rates because you would influence supply and demand. The final effect,

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in a free (currency) exchange market, is to bring all of the exchange rates into balance.
Since there are three sides to this trade, it is called triangle arbitrage.
Graphically, triangle arbitrage is as follows:
US Currency Belgian Currency T (XBF/$
(XBF/$)) T
French Currency (XFF/$
(XFF/$)) T versus (XBF/$
(XBF/$)) T (XFF/BF
(XFF/BF))
If the currency market is efficient, then (XFF/$
(XFF/$)) T = (XBF/$
(XBF/$)) T (XFF/BF
(XFF/BF),
),
Whereupon, removing T, one has XFF/$
XFF/$ = (XBF/$
(XBF/$)(X
)(XFF/BF
FF/BF).
). Rearranging yields
XFF/BF = XFF/$
XFF/$ finally,
XBF/$.
BF/$.
Thus, this form of efficiency is what allows the computation of cross-rates. Note that this
form of currency market efficiency is time-independent, and pertains only to spot rates.

8.5 Direct Terms vs. Indirect Terms

Recall the definitions given above:
Direct (or Normal) quote: quote in domestic currency (e.g., a US bank gives a direct
quote for the British pound, denoted as £, as US$/one pound or US$/£.) Indirect (or
Reciprocal) quote: the inverse of the direct quote.

8.6 Exchange Rate Notation

The text denotes exchange rates with an ‘X’ and a subscript representing the units of the
quote. E.g., X£/$
X£/$ is the British pound price of a US dollar (measured in British pounds
per US dollar), and X$/£
X$/£ is the US dollar price of a British pound (measured in US
dollars per British pound). The text also uses ‘C’ to represent a generic currency, and a
‘b’ to represent the base currency. Furthermore, the text uses a superscript to denote time.
For example, the spot (i.e., the time 0) exchange rates for British pounds and US dollars
will be denoted X$/£ 0 and X£/$ 0.

8.7 Changes in Currency Values and Exchange Rate Quotes

Exchange rates are simply prices (of currencies in terms of other currencies), and like all
prices, they respond to changes in supply and demand. As the text notes, if the demand
for British pounds increases and the demand for dollars stays fixed, then X $/£ will rise
and X£/$
X£/$ will fall. The parallel with a commodity is complete. For example, if the
demand for loaves of bread increases while the supply stays fixed, then the price of a loaf

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of bread will increase, i.e., P$/loaf
P$/loaf will rise. Clearly, the US dollar price of the British
pound has fallen rather steadily. There are some interesting, and historically important,
segments to the graph. The dip and rise around 1930 reflects the differential effects of the
Great Depression. The steep drop in the late-1930s reflects the early years of World War
II (which the US did not enter until 1941). The flat segments reflect the rigidity
introduced by the Bretton Woods agreement (designed to stabilize the major currencies
after WWII). The general decline beginning in the late-1960s reflects the end of fixed
exchange rates and the post-WWII transition of economic power from Great Britain to
the US. This last decline results from an increasing demand for US$ and a decreasing
demand for British pounds that resulted as the US$ replaced the British pound as the
principal international currency. Note that the transition of economic (and military)
power from Great Britain to the US was nearly complete by 1945 (i.e., the end of WWII).
However, the rigidity of exchange rates introduced via the Bretton Woods Agreement
(see O’Brien, pages 32-33) masks the transition of economic power. Put differently, the
British pound was seriously over valued (relative to the US$). This is why the US
dropped the fixed exchange rate system in favor of floating (i.e., market determined)
exchange rates.

8.8 Siegel’s Paradox

As always, there is no paradox, just some funny algebra. Siegel’s “Paradox” refers to the
following fact: in general, if a currency C has appreciated (depreciated) against a base
currency by k%, then the base currency b will not have depreciated (appreciated) against
C by k%. This is simply the way percentages work.
The text uses the following example. Suppose the initial (i.e., time-0) exchange rate of
US dollars for British pounds is X$/£ 0 = 2.00 and the final (i.e., time-1) exchange rate is
X$/£ 1 = 1.80.
Then the percentage change is % .X$/£
.X$/£ = (X$/£
(X$/£ 1 - X$/£0)
X$/£0)
X$/£ 0 = X$/£
X$/£ 1
X$/£0 -1 = 1.80 -2.00
2.00= 1.80
2.00 - 1 = -.10 = -10%
Now consider the same basic calculation for X£/$
X£/$.. By definition,

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X£/$0 = 1
X$/£0 and X£/$
X£/$
1=1
X$/£1,
So that
X£/$0 = 1
2.00= .50 and X£/$
X£/$
1=1
1.80= .55.
.55. Therefore,
% .X£/$
.X£/$ = (X£/$1
(X£/$1 - X£/$0)
X£/$0)
X£/$0=
£/$0= .55 - .50
.50= .11> 11%
Thus, where the British pound has depreciated 10% against the US$, the US$ has
appreciated by more than 11% against the British pound. There is no paradox here.
“Common sense” suggests that we will have %. X$/£
X$/£ = -%. X£/$
X£/$.. Suppose this is true.
Then we have % .X$/£
.X$/£ = X$/£1
X$/£1
X$/£0-
$/£0- 1 = -(X£/$1
-(X£/$1X
X£/$0-
£/$0- 1)= % .X£/$.
.X£/$.
By definition,
X$/£1 = 1X£/$1
1X£/$1 and X$/£0
X$/£0 = 1X£/$0
1X£/$0
So that the equality % .X$/£
.X$/£ = X$/£1
X$/£1X
X$/£0-
$/£0- 1 = -(X£/$1
-(X£/$1X
X£/$0-
£/$0- 1)= % .X£/$
.X£/$
Becomes % .X$/£
.X$/£ = X$/£1
X$/£1X
X$/£0 - 1
= -1X£/$1
-1X£/$1 1X£/$0
1X£/$0-1...
-1... . . ........ÿÿ ÿ ÿ ÿ
= - X£/$0
X£/$0X
X£/$1 +1.
+1.
Rearranging the components of the end-most terms yield
X$/£1X
$/£1X$/£0+
$/£0+ X£/$0
X£/$0X
X£/$1=
£/$1= 2.
Rearranging again yields
(X$/£1)
(X$/£1) 2 + (X$/£0)
(X$/£0) 2X$/£0 X£/$1 = 2, so that (X$/£1
(X$/£1 )2 + (X$/£0
(X$/£0 )2 = 2X$/£0
2X$/£0 X£/$1 ,
(X$/£1)
(X$/£1) 2 - 2X$/£0
2X$/£0 X£/$1 +(X$/£0)
+(X$/£0) 2 = 0,
(X$/£1
(X$/£1 - X$/£0)
X$/£0) 2 = 0, which implies X$/£1 = X$/£0
X$/£0 .
Therefore, the only time that the “common sense” view that %.X $/£ = -%.X£/$
-%.X£/$ holds is
when %.X$/£
%.X$/£ = -%.X£/$
-%.X£/$ = 0.

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As noted, there is no paradox. What is at issue is the weakness of common sense as it
pertains to the behavior of percentages.

8.9 Key Topics in Global Financial Management

Global financial managers must deal with three basic issues, as follows:
8.9.1 Corporate Financing
• In which countries and currencies should a firm find financing?
• Is there an international financial package that minimizes financing costs?
8.9.2. Measurement and Management of Exposure and Risk
• What is the company’s currency exposure?
• What are the problems associated with measurement and management of
exposure and risk?
8.9.3 Capital Budgeting Decisions in a Global Environment
• What are the relevant cash flows?
• What are the proper accept/reject criteria?

These questions are addressed in the remaining parts of the text. The rest of Part I provide
a brief history of, and some background to, the evolution and structure of the
contemporary international financial system.

8.10 Currency Markets

The Eurocurrency markets and foreign exchange markets provide clearance and
settlement mechanisms for inter-bank transfers. Graphically, part of the system is as
follows:
The Eurocurrency market transfers purchasing power over time (by bringing together
borrowers and savers).
The foreign exchange markets transfers purchasing power over currencies, i.e., from one
currency to another.
Spot market -- trades made for immediate (i.e., 24 hour) delivery.

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Forward market -- trades made for future delivery according to an agreed upon delivery
date, exchange rate, and amount.

8.11 Forward Exchange and Hedging

A money market hedge is an arrangement to exchange currencies, the purpose of which is
to reduce or remove exposure risk. The currency market determines exchange rates for
various times to delivery. The rates determined for delivery are called spot rates; the rates
for longer times to delivery are called forward rates.

Notation: FC/$
FC/$ = forward rate of currency C in $ = spot rate, at time t, of currency C in $
Terminology contract amount = the money value of the contract (in the denominator
currency) contract size = the money value of the contract (in the numerator currency)
E.g., a contract for the amount $1,000,000 at the forward rate FDM/$
FDM/$ = 1.5 is a contract
of size DM 1,500,000 More Notation C# = forward contract size $GL
$GL = gain (measured
in $) on long forward position on currency C Accounting Identity $G L = C#( X$/C 1 -
F$/C ) where time 1 is the time of the forward contract.

8.12 Forward Premiums and Discounts Again

We need to be careful with both the terminology and the timing on the spot rate. In
particular, we must keep careful track of which currency is in the numerator currency and
which is in the denominator currency. And note that premiums and discounts, unlike
gains and losses (as discussed above), are determined by the difference between a
forward rate and the present spot rate.

Remember that the spread is the difference between the forward and spot rates. If the
spread is positive (negative), i.e., if the forward rate is higher (lower) than the spot rate,
then the denominator currency is said to be at a premium (discount) with respect to the
numerator currency.

For example, suppose the difference between the 90-day forward rate and (the present)
spot rate for the Canadian dollar and the US dollar is F$/C - X$/C
X$/C 0 = .7599(US$/Can$) -
.7609(US$/Can$) = -.0010 < 0.

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Thus, the Canadian dollar (i.e., the denominator currency) is at a discount against the
US$ (i.e., the numerator currency).
 Rules of thumb:
Always use direct quotes; then ‘buy low and sell high’ makes sense. Always think of the
currency in the denominator as the currency of reference (i.e., the currency being bought
and sold).
The calculation above is a direct quote calculation for a Canadian. The direct quote
calculation for an American is FC/$ - XC/$
XC/$ 0 = 1.7599 (Can$ / US$)- 1.7609 (Can$ /
US$) = 1.3160(Can$/US$) - 1.3142(Can$/US$) = 0.0018 > 0
Consistent with the earlier calculation, this calculation shows the US$ at a premium
against the Can$.

8.13 Forward Contracts and Transaction Exposure

Consider a simple transaction whereby your firm, which functions in US$, will receive
DM 3,000,000 in 3 months (90 days). You, the manager, are uncertain about the spot
exchange rate that will hold 90 days hence. However, you are certain about the 90 days
forward exchange rate. Thus, you can hedge the uncertainty by purchasing today a dollar-
denominated forward contract at the standing forward rate. Following the example in the
text, suppose the 90-day forward rate is 1.50 (DM/$). At that rate, the DM 3,000,000 you
will receive in 90 days will be, without risk, equal to $ 2,000,000.

Alternatively, you can do the accounting in cash settlement terms. Of course, given the
forward contract, the cash settlement terms show the DM 3,000,000 as $2,000,000 with
certainty. It is the ‘with certainty’ that is of immediate relevance here. Finally, this can be
reversed. If you are an American manager who must deliver DM 3,000,000 ninety days
hence, you can purchase a forward contract at today’s forward rate, say 1.5 DM/$, which
will commit you to deliver $2,000,000 ninety days hence.

Again, all this is done to remove risk. There is an interesting side point here—who’s risk
are we removing? Even if the firm is not exposed, and therefore requires no hedging, the
manager of a division may find hedging in his/her own best interest. Suppose you are the
manager of the export division of a (two division) firm. Suppose the export division buys
jewelry in US and sells it in France, and suppose that the import division buys high

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fashion clothing in France and sells it in the US. Suppose also that contracts are settled in
six months. Suppose your export division sells FF 1,000,000 worth of jewelry and the
import division purchases FF 1,000,000 worth of clothing. The net of this contract, with
respect to transaction exposure, is zero. Therefore, the firm has no need for a hedge. You,
however, may find a hedge a great idea and for either of two reasons. First, by hedging
the transaction exposure of your division you are reducing the variability of divisional
performance. If you are the division manager, then this is the source your reward and you
may be very interested in hedging. Second, your management performance is usually
judged on the basis of accounting performance (as opposed to cash flow performance), so
you may be interested in hedging your accounting (i.e., translation) exposure to risk. By
reducing the translation exposure you can reduce the variability in your performance.

Now, view all this from the perspective of shareholders. If the managers are running
around hedging divisional risk when there was no firm risk, then shareholder’s costs are
rising for no good reason. The solution to all this is to align the incentives of managers
and shareholders. The interesting open issue is this--does such an alignment exist for a
given firm? The hedged value of the contract is F$/DM
F$/DMT
T and the speculative value is
X$/DM 1 T. Then the two line intersect at X$/DM 1 = F$/DM.
F$/DM. Clearly, if X$/DM 1 >
F$/DM, speculation would have been superior to hedging; and if X$/DM 1 < F$/DM,
F$/DM,
then hedging would have been superior to speculation. The amount of the gain/loss from
speculation is straightforward. All we require is a probability distribution on the spot
exchange rate, and we can compute the expected gain/loss on speculation. Indeed,
assuming informational efficiency in the currency markets, we know the mean of the
distribution, i.e., we know E[X$/DM
E[X$/DM 1 ]= F$/DM
F$/DM . If we have a normal distribution with
E [X$/DM1]
[X$/DM1]=
= F$/DM,
F$/DM, then we have the following:
Spot exchange rate Dollar value of the contract F$/DM
F$/DM
F$/DMTX
$/DMTX$/DM
$/DM1TX1
1TX1$/DM
$/DM
Now consider the linearity comment. The text notes that if the obligation is denominated
in DM, then we need to use exchange rates where the direct quote is in DM, i.e., where
DMs are in the denominator. If we do not, then the graph is non-linear. This is easy to
see. Suppose we have a contract for DMT and we represent the situation in terms of

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forward and spot exchange rates in terms of DM per $. Then the hedged Value of the
contract is 1 F$/DM
F$/DM T and the speculative value is 1X$/DM1
1X$/DM1T.
T.

8.14 Hedging Philosophy

The text makes two important points here:
(1) “Philosophically, the use of forward exchange contracts for hedging should be to
eliminate uncertainty.”
(2) (2) Thus, the opportunity cost of hedging with the forward exchange contract
“really should not matter to the hedger.”

The text then makes an odd point:

“Thus, you may choose not to eliminate your exposure with a forward contract position if
you have a strong belief that the future spot rate will be favorable to your natural
position.”

What is odd here is the term “strong belief.” Taken literally, this means that if you have a
very high probability that the future spot rate will be greater than the forward rate, and
then you should not hedge. This can be taken literally only if we mean that the
probability that the future spot rate will be greater than the forward rate (by a sufficiently
large amount) is itself greater than the critical value of the relevant probability, then you
should not hedge. Correctly stated, we have the following translation of the text: if your
probabilities over future spot rates and your utilities (i.e., risk attitudes) over payoffs are
such that the expected utility of not hedging is greater than the expected utility of
hedging, then you should not hedge.

The key point is this--hedging removes risk; i.e., it is a form of insurance. [Note-Strictly
speaking, uncertainty is reduced by gathering information; risk is reduced by buying
insurance.] Note that a forward rate hedge is an insurance contract.

8.15 Foreign Exchange Futures Contracts

The key points are as follows:
Spot exchange rate Dollar value of the contract
FDM/$TX
DM/$TXDM/$
DM/$1F
1FDM/$
DM/$X
XDM/$1T/
DM/$1T/

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(1) Foreign exchange futures contracts are very similar to forward exchange contracts;
and
(2) They are not the same thing.
Differences: where traded timing settlement futures contracts open market settled daily
cash-settled; on standardized dates forward contracts inter-bank currency market settled
on specified dates not necessarily cash-settled; on standardized dates.

Summary
When money crosses international boundaries, individuals, businesses, and governments
must deal with special kinds of problems so, this unit should focus into the issues that are
required to finance manager in the international arena. The basic problems, which are
encountered in the international finance, are the export risk and transactional exposure
risk. International finance deals with issues like, international banking, international
capital markets, and export risk, and exposure risk. International banks acts as financial
intermediaries across national boundaries, and provide a range of banking services to
international trading activities. International banking consists of:
I. Traditional foreign banking – involving transactions in the domestic
currency with non-resident business organizations.
II. Currency banking – involving transactions in currencies other than
domestic currency.

The volume of international banking transactions has increased enormously in recent

decades mainly centered at New York, London and Tokyo. The following are reasons,
which can be attributed to the growth of international banking.
I. Growth of international trade and overseas investment increasing the
demand for international funds.
II. Abolition of exchange controls encouraging the globalization of
international financial markets where by national financial markets became
integrated into a single international market.
III. Deregulation of capital markets permitting securities like debt instruments
which company’s issue internationally traded debt instruments such as euro-
bonds and euro commercial papers.

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 IV. Development of multi-national companies, including the major banks
themselves, operates in a range of countries.

International Money and Capital Markets

The primary function of banks is to act as financial intermediaries tat is to provide a link
between net savers and net borrowers. In international banking the same function is
fulfilled but across national boundaries. In addition international banks provide a range
of banking services for their customers engaged in international business activities like:
Financing foreign trade, Financing capital investments, Providing local banking services
in a range of countries, Trading in foreign exchange markets, Providing advice and
information.
Foreign trade risk can be classified into two categories and they are:
I. Export risk; and the other
II. Foreign exchange transaction exposure.

Export credit risk

The following are possible risk factors applicable to the foreign trade: Illiquidity,
Bankruptcy or failure of the bank in the remittance chain, poorly specified remittance
channel, Inconvertibility of customer’s currency, and lack of access to the currency in
which payment is due. This can be caused by deliberate exchange controls or unplanned
foreign exchange requirements in the customer’s central banks Political risks – like
change of regime, civil war or blockade to the country concerned.

Exporters can protect themselves against the above risks as follows:

 Use banks in both countries to act as the collecting channel for the remittance
and to control the shipping documents so that they are only released against
payment or acceptance of negotiable instruments.
 Commit the customer’s bank through an irrevocable letter of credit.
 Obtain support form the third parties like get a guarantee of payment from a
local bank, get a letter from the local finance ministry or central bank
confirming availability of foreign currency.
 Take out export credit cover.

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  Use an intermediary like confirming, export finance, factoring or forfeiting
house to handle the problem on their behalf.

Foreign exchange transactions exposure

This leads to uncertainty as to future domestic currency cash flows arising from sales,
purchases, and so on. The impact of this uncertainty can be minimizes by the following
means: Hedging the currency forward or future contract, Hedging money market,
Leading and lagging, Settlement in domestic currency, Matching.
I. Answer
Answer to the Exercises of chapter 3:

1. Solution:

A=

Given Ad = $ 1,000,000
Ct = $ 200
Ir = 12 percent or 0.12
A =?

A=

A = $ 57,735
2. Solution:

A=

Given Ad = $ 408,000
Ct = $ 120
Ir = 9 percent or 0.09
A =?

A=

A = $ 32,984
3. Solution.

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 A=

Given Ad = $ 560,000
Ct = $ 180
Ir = 12 percent or 0.12
A=?

A=

A = $ 40,987

4. Solution:

A=

Given Ad = $ 1,000
Ct = $ 80
Ir = 0.0002 percent per day
A=?

A=

A = $ 28,284

7. Solution:

Sol: ¾ transaction cost variance of cash flow 1/3

Spread =3 -----------------------------------------------------------
Interest rate

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Transaction cost per sale/purchase = $ 15
Standard deviation = $ 1,200 per day
Interest rate = 7.3 percent p.a. or 0.02 per day

$ 15 {$ 1,200  $ 1,200}

¾
1/3

Spread =3 ---------------------------------------------------
0.02

= $ 2,060

8. Solution:
Sol: ¾ transaction cost variance of cash flow 1/3

Spread =3 -----------------------------------------------------------
Interest rate

Transaction cost per sale/purchase = $ 25

Standard deviation = $ 200 per day
Interest rate = 12 percent p.a. or 0.04 per day

$ 25 {$ 200  $ 200}

¾
1/3

Spread =3 ---------------------------------------------------
0.04

= $ 877
9. Solution:

Sol: ¾ transaction cost variance of cash flow 1/3

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Spread =3 -----------------------------------------------------------
Interest rate

Transaction cost per sale/purchase = $ 20

Standard deviation = $ 800 per day
Interest rate = 10 percent p.a. or 0.027 per day

$ 20 {$ 800  $ 800}

¾
1/3

Spread =3 ---------------------------------------------------
0.027

= $ 2,125

10.
Solution:
Solution:

transaction cost variance of cash flow

¾
1/3

Spread =3 -----------------------------------------------------------
Interest rate

Transaction cost per sale/purchase = $ 32

Standard deviation = $ 750 per day
Interest rate = 8 percent p.a. or 0.022 per day

$ 32 {$ 750  $ 750}

¾
1/3

Spread =3 ---------------------------------------------------
0.022

= $ 2,550

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II. Answer
Answer to the chapter 6:

Solutions
1.
Sol: required rate of return = 10 %
Current credit terms = net 10
Volume of credit sales = 12 millions
Collection period = 60 days
Existing return is equal to $ 2 millions X 10 % = $ 1.2 millions
New credit terms=
a) 2/10 and net 30 with 60 % of the customers taking the advantage
b) Increase in investment cost = $ 12 million X 60 % X 2 % = $ 144,000
c) Decrease in interest (borrowing rate)= $ 12 million X 60% X 98% X 2 %=
$ 14,400
d) Decision existing policy is best.
2. Solution:
Assessment of existing policy:
Volume of credit sales $3,000,000
Return on investment $3,000,000 X 10 % $300,000
Less : Incremental expenses
1) Bad debts *1 $0
2) Interest on additional investment *2 $25,000
Net return on investment $275,000
Average collection period is given as 30 days
Accounts receivables = Credit sales / Average collection period $250,000
*1 Bad debts expenses = (incremental sales X bad debts ratio)

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*2 interest on additional investment = Increased investment on receivables X interest rate

Assessment of Credit policy A:

Volume of credit sales $5,500,000
Return on investment $ 5,100,000 X 10 % $250,000
Less : Incremental expenses
1) Bad debts *1
2) Interest on additional investment *2 $43,750
Net return on investment $206,250
Average collection period is given as 45 days
Accounts receivables = Credit sales / Average collection period $687,500
*1 Bad debts expenses = (incremental sales X bad debts ratio)
*2 interest on additional investment = Increased investment on receivables X interest rate

Assessment of Credit policy B:

Volume of credit sales $6,000,000
Incremental sales $200,000
Incremental return $ 200,000 X 10 % $20,000
Less : Incremental expenses
1) Bad debts *1 $3,000
2) Interest on additional investment *2 $75,000
Net return on investment ($58,000)
Average collection period is given as 30 days
Accounts receivables = Credit sales / Average collection period $1,000,000
*1 Bad debts expenses = (incremental sales X bad debts ratio)
*2 interest on additional investment = Increased investment on receivables X interest rate

Assessment of Credit policy C:

Volume of credit sales $7,000,000

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Incremental sales $2,000,000
Return on investment $ 7,000,000 X 10 % $700,000
Less : Incremental expenses
1) Bad debts *1
2) Interest on additional investment *2 $120,833
Net return on investment $579,167
Average collection period is given as 30 days
Accounts receivables = Credit sales / Average collection period $1,458,333
*1 Bad debts expenses = (incremental sales X bad debts ratio)
*2 interest on additional investment = Increased investment on receivables X interest rate

3. Sol:
Current collection peiod = 60days
Average investment in receivables = 600,000
Credit sales = ?
Credit sales = (average investment X 360)/ 60 days
= $ 600,000 X 6 = 3,600,000
Receivables turn over = 360 days / 60 days
= 6 times

4. Sol:
Proposal A
Bad debts expenses @ 1.5 % on credit sales
1.5 % of ($12,000,000) $ 180,000
Collection charges per annum (given) 100,000
Interest on receivables investment

Total expenses $ 280,000

Factoring Services as an alternative of own collection policy:

Factor commission

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 [$12,000,000 X 2.5%] $ 300,000
Interest expenses (same as above) 200,000
Total expenses $ 500,000

It can be concluded that the total expenses with factoring services of proposal A is lower
than proposal B. therefore it advisable to the firm to go for factor service of proposal A
for collection of receivables.

5. Sol:
Annual consumption 50,000
Ordering cost per order placed 20
Inventory carrying cost per unit 50%
Cost per unit 1

Estimation of economic order quantity (trial and error method)

Particulars
Total quantity per annum 50,000 50,000 50,000 50,000 50,000 50,000 50,000
Cost per unit purchased $1 $1 $1 $1 $1 $1 $1
total purchasing cost (a) $50,000 $50,000 $50,000 $50,000 $50,000 $50,000 $50,000
Number of orders 1 2 4 5 8 10 12
Ordering cost per order $20 $20 $20 $20 $20 $20 $20
Total ordering cost (b) $20 $40 $80 $100 $160 $200 $240
Quantity purchased per order 50000 25000 12500 10000 6250 5000 4167
Average inventory 25000 12500 6250 5000 3125 2500 2083
Inventory carrying cost per unit $0.5 $0.5 $0.5 $0.5 $0.5 $0.5 $0.5
Total inventory carrying cost [c] $12,500 $6,250 $3,125 $2,500 $1,563 $1,250 $1,042

total cost (a) + (b) + [c] $62,520 $56,290 $53,205 $52,600 $51,723 $51,450 $51,282
Economic ordering quantity $51,450

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6. Sol:
Given AC = 50,000 units

O = $ 100 per order placed

I = $ 4 per unit

EOQ =

EOQ =

EOQ = 1,581 units per order.

7. Sol:
Given AC = 2,500 units
O = $ 400 per order placed
I = $ 50 per unit

EOQ =

EOQ =

EOQ = 200 units per order.

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1. Sol:
Quantity purchased Discount rate

001 – 500 units none

500 – 1,000 units 0.5 %

1,000 – 2,000 units 1.0 %

2,000 – 3,000 units 2.0 %

3,000 and above 2.5 %

Given AC = 3,000 units

O = $ 30 per order placed
I = $ 0.5 per unit

EOQ =

EOQ =
EOQ = 600 units per order.

2. Sol:
Classification Quantity % of total Total cost %
"A" class items
3 16,800 5 $35,280 23
1 6,000 2 $24,000 15
4 3,000 23 $18,000 12
Total 25,800 30 77,280 50
"B" class

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 7 26,640 7 $17,316 11

Total 26,640 7 17,316 11

"C" class
2 61,200 16 $3,060 2
5 55,800 15 $11,160 7
6 22,680 6 $11,340 7
8 14,760 4 $5,904 4
9 20,520 6 $8,208 5
10 90,000 24 $9,000 6
11 29,940 8 $898 1
12 24,640 7 $12,320 8
Total 319,540 86 31,464 40
% of Total
Units % of total Cumulative Unit price total cost cost Cumulation
6,000 0.02 0.02 $4.00 $24,000 0.15 0.15
61,200 0.16 0.18 $0.05 $3,060 0.02 0.17
16,800 0.05 0.23 $2.10 $35,280 0.23 0.40
3,000 0.01 0.23 $6.00 $18,000 0.12 0.51
55,800 0.15 0.38 $0.20 $11,160 0.07 0.58
22,680 0.06 0.44 $0.50 $11,340 0.07 0.66
26,640 0.07 0.52 $0.65 $17,316 0.11 0.77
14,760 0.04 0.56 $0.40 $5,904 0.04 0.81
20,520 0.06 0.61 $0.40 $8,208 0.05 0.86
90,000 0.24 0.85 $0.10 $9,000 0.06 0.92
29,940 0.08 0.93 $0.03 $898 0.01 0.92
24,640 0.07 1.00 $0.50 $12,320 0.08 1.00
1.00

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 3. Sol:
Construction of ABC Analysis of control measure
% Of Total
Item Number Units % Of total Cumulative Unit price Total cost cost Cumulating
1 7,000 0.14 0.14 $10.00 $70,000 0.1400 0.1400
2 8,000 0.16 0.30 $9.00 $72,000 0.1440 0.2840
3 10,000 0.20 0.50 $2.00 $20,000 0.0400 0.3240
4 6,000 0.12 0.62 $8.00 $48,000 0.0960 0.4200
5 8,000 0.16 0.78 $1.00 $8,000 0.0160 0.4360
6 2,000 0.04 0.82 $60 $120,000 0.2400 0.6760
7 5,000 0.10 0.92 $0.40 $2,000 0.0040 0.6800
8 4,000 0.08 1.00 $40.00 $160,000 0.32 1.0000
Total 50,000 1.00 1.00 None $500,000 1.0000 1.0000

Classification Quantity % Of total Total cost %

"A" class items
8 4,000 8 $160,000 32
6 2,000 4 $120,000 24

Total 6,000 12 280,000 56

"B" class
1 7,000 14 $70,000 14
2 8,000 16 $72,000 14
Total 15,000 30 142,000 28
"C" class
3 10,000 20 $20,000 4
4 6,000 12 $48,000 10
5 8,000 16 $8,000 1.6
7 5,000 10 $2,000 0.4
Total 29,000 58 78,000 16

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 Reference

K. C. Butler, Multinational Finance,

Finance, Cincinnati, OH: South-Western College
Publishing, p. 57.)

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