(Revising/ completing W8)

Capital structure theory – Impact of higher leverage

(i.e., use of more debts)
M&M Proposition I M&M Proposition II
(Firm’s value) (WACC)

Case 1 RD is cheaper than RE, but RE

No impact increases with leverage. Overall
- Perfect market WACC unchanged.
Case 2 Again, RE increases with
Increase as much as PV of leverage. However, that increase
- With tax interest tax shield is not as much as Case 1.
Overall WACC decreases
Case 3 Similar to Case 2, but with the impact of smaller proportional
magnitude. This is because return on equity also enjoys benefit of
- Imputation and tax tax.
Case 4 At certain level of leverage, the firm’s value reaches to its
maximum, and WACC reaches to its minimum. With high level of
- Tax and liquidation cost leverage, liquidation cost exceeds benefit of tax.
Case 5 Similar to Case 4 but with the impact of smaller proportional
- Tax, imputation, and magnitude. This is because return on equity also enjoys benefit of
liquidation cost tax.

1
ACTL5108 - Finance and Financial Reporting for Actuaries

Term 4 2023: Week 8

Practical Issues and Applications
Reading: Ross et al. Chapter 16-17

Kyu Park
 What to learn - CB1 Syllabus
2.3 Demonstrate a knowledge and understanding of the characteristics of the
principal forms of financial instrument issued or used by companies and the ways
in which they may be issued.
5.1 Determine the working capital position of a company.
5.1.1 Analyse accounts receivables, accounts payables and inventory ratios
5.1.2 Evaluate policies for working capital management, including its individual
elements.
5.1.3 Discuss methods for financing working capital.
5.1.4 Analyse the short term cash position of a company.
5.1.5 Discuss measures to manage the short term cash position of a company.
5.1.6 Discuss dividend sustainability.

3
Before we start…

• So far, we focussed on efficient long-term

management of firm’s asset using long-term
financing sources including debt and equity.
• Today, we focus on management of firm’s short-
term assets (i.e. “working capital”).
• Consideration includes the risk of cash
shortage, inefficient management of redundant
cash, accounts receivable cycle, inventory
cycle, etc.

4
Short term cash flow issues
• A matter of matching current assets with current liabilities
–Current ratio
–Quick ratio

• Can “factor” receivables

• Most businesses affected by business cycles

• Need to recognise and manage cash receipts as sales may not

result in immediate cash and develop a credit policy

5
Net working capital (NWC) review
NWC + Fixed assets = L/T debt + Equity

NWC = (Cash + Other current assets) – Current liabilities

Cash = L/T debt + Equity + Current liabilities – Current assets other

than cash – Fixed assets

6
Sources and uses of cash

Sources of cash Uses of cash

• Obtaining financing • Paying creditors or

• Increase in long-term shareholders
debt • Decrease in long-term
• Increase in equity debt
• Increase in current • Decrease in equity
liabilities • Decrease in current
• Selling assets liabilities
• Decrease in current • Buying assets
assets • Increase in current
• Decrease in fixed assets
assets • Increase in fixed assets

7
 The operating cycle

The time it takes to receive inventory, sell it and collect on the receivables
generated from the sale

Operating cycle = inventory period + accounts receivable period

– Inventory period = the time inventory sits on the shelf.
– Accounts receivable period = the time it takes to collect on
receivables.

Inventory period = 365/Inventory turnover

– Inventory turnover = Cost of goods sold/Average inventory

Accounts receivable period = 365/Receivables turnover

– Average collection period
– Accounts receivable turnover = Credit sales/Average accounts
receivable

8
Exercise 1: Operating Cycle
A company, ABC Manufacturing, wants to evaluate its operating cycle to
improve cash flow management. In the most recent fiscal year, ABC
Manufacturing reported the following information:
• Purchases of raw materials: $250,000
• Beginning inventory: $80,000
• Ending inventory: $100,000
• Credit sales: $500,000
• Beginning accounts receivable: $60,000
• Ending accounts receivable: $70,000
Using this information, calculate the operating cycle for ABC Manufacturing.
All else being equal, what would be the impact of reduced size of inventory and
reduced size of accounts receivable on the operating cycle? Any
benefit/cost from this?

9
Exercise 1: Solution
• Cost of goods sold = Beginning inventory + Purchases – Ending inventory = 80000 +
250000 – 100000 = 230000
• Average inventory = (80000 + 100000)/2 = 90000
• Inventory turnover = 230000/90000 = 2.56 times
• Inventory period = 365/2.56 = 142.83 days
• Average accounts receivable = (60000+70000)/2 = 65000
• Accounts receivable turnover = 500000/65000 = 7.69 times
• Accounts receivable period = 365/7.69 = 47.45 days
• Operating cycle = 142.83+47.45 = 190.28 days
• Reduced size of inventory -> Higher inventory turnover/ lower inventory period ->
Lower operating cycle.
• Reduced size of receivables -> Higher accounts receivable turnover/ lower accounts
receivable period -> Lower operating cycle.

10
The cash cycle

The time between payment for inventory and receipt from the sale of
inventory

Cash cycle = Operating cycle – Accounts payable period

– Accounts payable period = time between receipt of inventory

and payment for it.

The cash cycle measures how long we need to finance inventory and
receivables.

Accounts payable period = 365/Payables turnover

Payables turnover = Cost of goods sold/Average accounts payable

11
The operating and cash cycles

12
 Example information

• Operating Cycle = Inventory period + Accounts receivables period

• Inventory period = 365/Inventory turnover
• Accounts receivables period = 365/ Receivables turnover = Average
collection period
• Cash cycle = Operating cycle – Accounts payable period
• Accounts payable period = 365/Payables turnover

Item Beginning Ending Average

Inventory $2,000,000 $3,000,000 $2,500,000
Accounts receivable $1,600,000 $2,000,000 $1,800,000
Accounts payable $750,000 $1,000,000 $875,000
Net sales $11,500,000
Cost of goods sold $8,200,000

13
Operating cycle example

Inventory period Receivables period

– Average inventory • Average receivables
= (200 000 + 300 000)/2 = (160 000 + 200 000)/2 =
= 250 000 180 000

– Inventory turnover • Receivables turnover

= 820 000 / 250 000 = 1 150 000 / 180 000 = 6.39
= 3.28 times times

– Inventory period • Receivables period

= 365 / 3.28 = 111 days = 365 / 6.39 = 57 days

• Operating cycle = 111 + 57 =

168 days

14
Cash cycle example

Accounts payable period

= 365 / payables turnover

Payables turnover
= COGS / Average AP
= 820 000 / 87 500 = 9.4 times

Accounts payables period

= 365 / 9.4 = 39 days

Cash cycle = Operating cycle - Accounts payable period

= 168 – 39 = 129 days

Inventory and receivables must be financed for 129 days.

15
Exercise 2 – Operating and cash cycles
We now know that ABC Manufacturing currently has:
• COGS = 230000
• Inventory period = 142.83 days
• Accounts receivable period = 47.45 days
• Operating cycle = 142.83+47.45 = 190.28 days
The company now wants to calculate its cash cycle, which shows how long its
cash is tied up in the operating process. It’s beginning and ending Accounts
Payables are $20,000 and $25,000, respectively.
Calculate the Cash Cycle for ABC Manufacturing. Also, suggest two ways ABC
Manufacturing could improve its cash cycle.

Average accounts payable = (20000+25000)/2 = 22500

Accounts payable turnover = 230000/22500 = 10.22 times
Accounts payable period = 365/11.11 = 35.71 days
Cash cycle = 190.28 – 35.71 = 154.57 days
Suggestions: Extend Accounts Payable Period, Reduce inventory period

16
Exercise 3

What important information is missing in the

numbers calculated for operating and cash
cycles in fully analysing a firm’s inventory/ credit
sales/ credit purchases management?

• Customer’s satisfaction on credit policy.

• Ability to collect accounts receivable
• Carrying cost of inventory
• Availability of products in timely manner

17
Exercise 4

If you are managing 4 million dollars of wealth for

yourself, how would you allocate that wealth into
the categories as follows.

Pros: Liquidity, Emergencies, Opportunities

- Cash (?%) Cons: Low return, Inflation risk

- Real Estate (?%) Pros: Appreciation (e.g., high growth history in Sydney), Tangible asset
Cons: Illiquidity, Maintenance costs, Market fluctuations
- Shares (?%) Pros: Growth potential, Liquidity
Cons: Volatility, Market risk, Requires research
- Bonds (?%) Pros: Stable income, Lower risk, Portfolio diversification
Cons: Lower returns, Interest rate risk, Inflation risk

18
Short-term financial policy
Flexible (conservative) Restrictive (aggressive)
policy policy
• Large amounts of cash • Low cash and
and marketable marketable security
securities balances
• Large amounts of • Low inventory levels
inventory • Little or no credit sales
• Liberal credit policies (low accounts
(large accounts receivable)
receivable) • Relatively high levels of
• Relatively low levels of short-term liabilities
short-term liabilities • Low liquidity
• High liquidity

19
Flexible financial policy

Advantages Disadvantages

• No difficulty • Liquid securities =

meeting short- lower return
term obligations • Financing short-
• Cash available for term assets with
emergencies long-term debt
• Lower shortage risky
costs

20
Restrictive financial policy

Advantages Disadvantages

• Higher returns on • Less liquidity for

long-term assets emergencies
• Lower carrying • Higher shortage
costs costs
• Short-term liabilities
can be decreased
more easily in event
of economic
downturn

21
 Assets costs and life

Carrying costs
– Opportunity cost of owning current assets versus long-term assets
that pay higher returns
– Cost of storing larger amounts of inventory
Shortage costs
– Order costs—the cost of ordering additional inventory or transferring
cash
– Stock-out costs—the cost of lost sales owing to lack of inventory,
including lost customers

Are current assets temporary or permanent?

– Both!

‘Permanent current assets’ refers to the level of current assets that the
company retains regardless of any seasonality in sales.

‘Temporary current assets’ refers to the additional current assets that are
added when sales are expected to increase on a seasonal basis.

22
Alternative asset financing policies: Figure
16.4

23
Choosing the best policy
Best policy will be a combination of flexible and restrictive
policies.

Things to consider:
– Cash reserves
– Maturity hedging
– Relative interest rates

Compromise policy—borrow short-term to meet peak needs;

maintain a cash reserve for emergencies.

24
A compromise financing policy

25
 Short-term borrowing: unsecured loans

Line of credit—prearranged agreement with a bank that allows the

firm to borrow up to a certain amount on a short-term basis

Committed—formal legal arrangement that may require a

commitment fee and generally has a floating interest rate

Non-committed—informal agreement with a bank that is similar to

credit-card debt for individuals

Revolving credit—non-committed agreement with a longer time

between evaluations

26
Short-term borrowing: secured loans

Loans secured by receivables or inventory or both

Accounts receivable financing

– Assigning receivables
• Lender has A/R as security but borrower still responsible for collection.
– Factoring receivables
• A/R discounted and sold to a factor
• Collection = factor’s problem

Inventory loans
– Blanket inventory lien
• Lender has lien against all inventories.
– Trust receipt
• Borrower holds specific inventory in ‘trust’ for the lender.
• Auto dealer ‘floor plans’
– Field warehouse financing
• Public warehouse acts as control agent to supervise inventory for lender.

27
Reasons for holding cash

Speculative motive—hold cash to take advantage of

unexpected opportunities.

Precautionary motive—hold cash in case of emergencies.

Transaction motive—hold cash to pay the day-to-day bills.

Trade-off between the opportunity cost of holding cash and

the transaction cost of converting marketable securities to
cash for transactions

28
Cash collection

Payment Payment Payment Cash

mailed received deposited available

Mailing time Processing delay Availability delay

Collection delay

Float management goal = reduce collection delay.

Float—difference between cash balance recorded in the cash

account and the cash balance recorded at the bank

29
Investing idle cash
Money market = financial instruments with original maturity ≤ one
year.

Temporary cash surpluses

– Seasonal or cyclical activities
 Buy marketable securities with seasonal surpluses.
 Convert back to cash when deficits occur.
– Planned or possible expenditures
 Accumulate marketable securities in anticipation of
upcoming expenses.

30
Characteristics of short-term securities

Maturity—firms often limit the maturity of short-term

investments to 90 days to avoid loss of principal owing to
changing interest rates.

Default risk—avoid investing in marketable securities with

significant default risk.

Marketability—ease of converting to cash

31
Credit management: key issues

Granting credit increases sales.

Costs of granting credit
– Chance that customers won’t pay
– Financing receivables
Credit management examines the trade-off between increased
sales and the costs of granting credit.

32
Components of credit policy
Terms of sale
– Credit period
– Cash discount and discount period
– Type of credit instrument

Credit analysis—distinguishing between ‘good’ customers who

will pay and ‘bad’ customers who will default

Collection policy—effort expended on collecting receivables

33
Credit period determinants

Factor Effect on credit

period
1. Perishable goods with low collateral credit period
value
2. Low consumer demand credit period
3. Low cost, low profitability and credit period
high standardisation
4. High credit risk credit period
5. Small account size credit period
6. Competition credit period
7. Customer type Varied

34
Terms of sale
Basic form: 2/10 net 60
– 2% discount if paid in 10 days
– Total amount due in 60 days if discount not taken

Buy $1000 worth of merchandise with the credit terms

given above.
– Pay $1000(1 − 0.02) = $980 if you pay in 10 days.
– Pay $1000 if you pay in 60 days.

35
Cash discounts example
Finding the implied interest rate when customers do not take the discount

Credit terms of 2/10 net 45 and $500 loan

– $10 interest (0.02 × 500)
– Period rate = 10 / 490 = 2.0408%
– Period = (45 – 10) = 35 days
– 365 / 35 = 10.4286 periods per year
– EAR = (1.020408)10.4286 – 1 = 23.45%

The company benefits when customers choose to forgo discounts.

36
Exercise 5 – Cash discounts
You are a customer considering a purchase with the following credit
terms: 3/15, net 60. The amount to be purchased is $1,000.
However, your business is currently experiencing a cash deficit. To
take advantage of the 3% discount offered for early payment, you
need to borrow the necessary amount at an effective annual interest
rate of 25%.
Determine if it is financially worthwhile to borrow money to take the
discount.
• Interest amount = 1000 x 0.03 = $30
• Period rate = 30/970 = 3.093% (caution: this is not annualised rate!)
• Period = 60-15 = 45 days
• 365/45 = 8.11 (i.e., there are “8.11” 45-day periods in a year)
• EAR = (1+3.093%)^8.11-1 = 28.025%
• 28.025% > 25%
• Yes, it is financially worthwhile to borrow money to take the discount.
• (If you borrow $970 at time = 15 days, then your repayment will be
$997.06, try this yourself!)
37
Credit instruments
Basic evidence of indebtedness

Open account
– Most basic form
– Invoice only

Promissory note
– Basic IOU
– Not common
– Signed after goods delivered

38
Optimal credit policy
Carrying costs
– Required return on receivables
– Losses from bad debts
– Cost of managing credit and collections

If restrictive credit policy:

– Carrying costs low
– Credit shortage = opportunity costs.

More liberal credit policy likely if:

– Excess capacity
– Low variable operating costs
– Repeat customers

39
Optimal credit policy: Figure 17.3

40
Credit analysis

Process of deciding which customers receive credit

Gathering information
– Financial statements
– Credit reports
– Banks
– Payment history with the firm

Determining creditworthiness
– 5 Cs of credit
– Credit scoring

41
Five Cs of credit
Character—willingness to meet financial obligations

Capacity—ability to meet financial obligations out of operating

cash flows

Capital—financial reserves

Collateral—assets pledged as security

Conditions—general economic conditions related to customer’s

business

42
Inventory management

Inventory can be a large percentage of a firm’s assets.

Costs are associated with carrying too much inventory.

Costs are associated with not carrying enough inventory.

Inventory management tries to find the optimal trade-off

between carrying too much inventory and not carrying
enough.

43
Types of inventory

Manufacturing firm
– Raw material—starting point in production process
– Work in progress
– Finished goods—products ready to ship or sell

Remember that one firm’s ‘raw material’ may be another

company’s ‘finished goods’.

Different types of inventory can vary dramatically in terms of

liquidity.

44
Inventory costs

Carrying costs—range from 20–40% of inventory value per

year.
– Storage and tracking
– Insurance and taxes
– Losses owing to obsolescence, deterioration or theft
– Opportunity cost of capital

Shortage costs
– Restocking costs
– Lost sales or lost customers

Consider both types of costs and minimise the total cost.

45
 Inventory management

Classify inventory by cost, demand and need.

Those items that have substantial shortage costs should be

maintained in larger quantities than those with lower shortage
costs.

Generally maintain smaller quantities of expensive items.

Maintain a substantial supply of less expensive basic materials.

46
Economic order quantity (EOQ) model

EOQ minimises total inventory cost.

Q = inventory quantity in each order

– Q/2 = average inventory

T = firm’s total unit sales per year

– T/Q = number of orders per year

CC = inventory carrying cost per unit

F = fixed cost per order

47
EOQ model continued

Total carrying cost

= (Average inventory) x (Carrying cost per unit) = (Q/2)(CC)

Total restocking cost

= (Fixed cost per order) x (Number of orders)
= F(T/Q)

Total cost
= Total carrying cost + Total restocking cost
= (Q/2)(CC) + F(T/Q)

48
Cost of holding inventory: Figure 17.5

49
EOQ model continued
Total cost
= Total carrying cost + Total restocking cost
= (Q/2)(CC) + F(T/Q)

Taking derivative: (1/2)(CC) - FT/(Q*^2)

Q* Carrying costs = Restocking costs

(Q*/2)(CC) = F(T/Q*)
2TF
Q *

CC

50
EOQ: example
Consider an inventory item that has carrying cost = $1.50 per
unit. The fixed order cost is $50 per order and the firm sells
100 000 units per year.
– What is the economic order quantity?

2(100 000)(50)
Q 
*
 2582
1.50

51
Exercise 6 - EOQ
A retail store sells 5,000 units of a product annually. The cost to place
an order is $50, and the annual carrying cost per unit is $2.
Calculate the Economic Order Quantity (EOQ) and the total annual
inventory cost.
Discuss the impact of changing the holding cost per unit to $3

EOQ = √((2 * T * F) / CC) = √((2 * 5,000 * 50) / 2) = √(500,000 / 2) =

√25,000 = 500
Number of orders = T / EOQ = 5,000 / 500 = 10 orders
Total cost = (Number of orders * F) + (EOQ / 2 * CC) = (10 * 50) + (500
/ 2 * 2) = $1,000
Impact of changing the holding cost per unit to $3: EOQ = 408.25 units
and total cost = $1,224.74

52