A B C D E F 1 2 3 Chapter 16: Tool Kit for Working Capital Management 4 5 Tab 1. Cash Conversion Cycle (Section 16.

3) 6 7 Figure 16-4. GBM's Cash Conversion Cycle (Dollars in Millions) 8 9 Panel a. Target CCC: Based on Planned Conditions Planned Cash Credit Terms Inventory Conversion = + Offered to Our Conversion Cycle (CCC) Customers 10 Period (ICP) 11 = 50.0 + 60.0 12 13 Target CCC = 70.0 14 15 Panel b. Actual CCC: Based on Financial Statements 16 17 Sales $1,216.7 18 COGS $1,013.9 19 Inventories $140.0 20 Receivables $445.0 21 Payables $115.0 22 Days/year 365 Inventory Receivables Actual CCC = + 23 COGS/365 Sales/365 $140 $445 = + 24 ($1,013.9/365) ($1,216.7/365) 25 = 50.4 + 133.5 26 27 Actual CCC = 142.5 28

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E ACP 133.5 - 60.0

29 Panel c. Actual versus Target components 30 ICP 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70 71 72 73 Actual - Target % Difference = = = 50.4 - 50.0 0.4 0.8% OK +

73.5 122.5% VERY BAD

GBM's inventories are in line with its plans, and it's paying its suppliers about on time, so the ICP and PDP are OK. However, some of its customers are paying quite late, so its average collection period (or DSO) is 133.5 days even though all customers should pay on Day 60.

Figure 16-5. Benefits from Reducing the CCC (Dollars in Millions) Old (Actual) 50.4 133.5 -41.4 142.5 117.5

Inventory conversion period (ICP, days) Average collection period (ACP, days) Payable deferral period (PDP, days) Cash Collection Cycle (CCC, days) Reduction in CCC Effects of the CCC Reduction Annual sales Costs of goods sold (COGS) Inventory = Actual Old, New = new ICP(COGS/365) Receivables = Actual Old, New = new ACP(Sales/365) Payables = Actual Old, New = new PDP(COGS/365) Net operating WC = Inv + Receivables Payables Reduction in NOWC Reduction in interest expense @ 10%

$1,216.7 $1,013.9 $140.0 445.0 -115.0 $470.0 $378.3 $37.8

In the chapter's opening vignette, we discussed "Days of working capital." DWC is essentially the same as the CCC except that the CCC uses the COGS when calculating both the ICP and the PDP whereas DWC uses sales for all calculations. Here's the DWC calculation for GBM: Days of Working Capital (DWC): NOWC/(Sales/365) CCC: NOWC component Sales or COGS 365 Actual data 141.0 142.5

The CCC is slightly larger than the DWC because Sales > COGS, and Sales is always used in the denominator for DWC, lowering the result if inventories exceed payables. We regard the CCC as being somewhat better because it better reflects actual values.

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pital

G 1 4/11/2010 2 Management 3 4 5 6 7 8 9 Credit Terms Our Supplier Offers Us 40.0

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28

Payables COGS/365 $115 ($1,013.9/365) 41.4

3 of 18

G 29 30 PDP

41.4 - 40.0 31 32 1.4 33 3.5% 34 OK 35 36 about on time, so the ICP and 37 ts average collection period (or 38 39 40 41 42 43 44 New (Target) 45 35.0 46 40.0 47 -50.0 48 25.0 49 50 117.5 51 52 53 $1,216.7 54 $1,013.9 55 $97.2 56 133.3 57 -138.9 58 $91.7 59 60 $378.3 61 $37.8 62 63 64 al." DWC is essentially the 65 both the ICP and the PDP 66 on for GBM: 67 68 69 70 71 ales is always72 used in the denominator for the CCC as being 73somewhat better because it is

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A 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37

H I 4/11/2010

Tab 2. The Cash Budget (Section 16.4)

Educational Procucts Corporation (EPC), Cash Budget (Millions)
The cash budget shows expected cash flows over a given period. EPC uses a monthly cash budget for the coming year plus a daily cash budget for the coming month. The monthly cash budget is used for planning purposes, the daily budget for actual cash control. The following monthly cash budget examines the firm's projected cash flows for the last 6 months of 2011. One of EPC's primary concerns is negotiating a loan from its bank to cover any cash shortfall that might occur during the year. The treasurer, who is responsible for developing the cash budget, sets up several scenarios that vary mainly in terms of the credit policy and the state of the economy. Information about each scenario is given below, and the scenario data are shown below the verbal descriptions. Also, on a screen to the right, the cost of additional credit (beyond the discount period) is provided for each scenario.

Description of the scenarios.

Base case (Current).The company sells on terms of 2/10, net 60. 20% of customers pay in the 1st month and take discounts, 70% pay on time in the 2nd month, and 10% either pay in the 3rd month or never pay and end up as bad debts. Purchases are 60% of next month's sales, and payments for purchases are made the month after the purchase. Lease payments and payments due on a new plant are shown on the cash budget. Monthly gross sales are shown on the cash budget, and sales are adjusted for the 2% cash discount. The Big discount. Change the credit terms to 4/10, net 30. The payment pattern shifts as follows: 70% pay 1st month, 20% pay 2nd month, 10% pay 3rd month or never. Sales rise by 10% over the base case. Bad debts remain at zero. 4% discount is a price cut, stimulates sales. The nominal cost of add'l credit is 76%, which

Short net period. Change the credit terms to 2/10, net 30. The payment pattern shifts as follows: 50% pay in 1st month, 40% pay in 2nd month, 10% pay in 3rd month or never. Sales fall by 10% versus the base case. Bad debts remain at zero. Reducing the net period turns off some potential customers, reduces sales. The nominal cost of add'l credit is 37%, which is high enough to stimulate early payment. Long net period. Change the credit terms to 1/10, net 90. The payment pattern shifts as follows: 5% pay 1st Current month, 5% pay 2nd month, 90% pay 3rd month or never. Sales rise by 20% versus the base case because of the long credit period, but many new customers are weak credits. Bad debts rise to 15%. The nominal cost of Big Disc't add'l credit is only 4.61%, which leads to few customers taking discounts. Short net

A B C D E F G H I J K L 38 Terrible economy. Leave credit terms unchanged. Due to the economy, the firm has more late payers, more 39 bad debts, lower sales, and fewer discount customers. 40 41 42 Data set up to create scenarios (Milions of Dollars) Active 43 Scenar 44 Use Scenario Manager to Pick a Scenario io 45 Active Scenario Shown in Shown

M
Long net Bad econ.

Tan
Terribl e econo my 15% 40% 45% 100% 60% $35 $200 $10 2% 10 60 10% -20%

46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65 66 67 68 69 70

Part 1. Inputs for the Cash Budget % customers who take discounts and pay in 1st month % who don't take discount and pay in 2nd month % who don't pay in 1st or 2nd month. Lates + bad debts Total: Must equal 100% Purchases as a % of next month's sales Other payments Construction cost for new plant (Sept) Target cash balance Disc % for early pmt; reduces 1st month collections Discount period Net period Bad debt % (BD%); reduces 3rd month payments Sales % change from base-case forecast

Base Case 20% 70% 10% 100% 60% $30 $150 $10 2% 10 60 0% 0%

Big Short Long Base Discou net net Case nt period period 20% 70% 50% 5% 70% 20% 40% 5% 10% 10% 10% 90% 100% 100% 100% 100% 60% 60% 60% 60% $30 $30 $30 $30 $150 $150 $150 $150 $10 $10 $10 $10 2% 4% 2% 1% 10 10 10 10 60 30 30 90 0% 0% 0% 15% 0% 10% -10% 20%

1. EPC sells on terms of 2/10, net 60, meaning that it gives a discount to customers who pay within 10 days, and non-discount customers have 60 days to pay. 2. All discount customers pay on the 10th day, and other customers pay on the 60th or 90th day, or are bad debts and never pay. No one pays after the 3rd month.

A 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 100 101 102 103 104 105 106

Figure 16-6. EPC's Cash Budget, July - December, 2011 (Dollars in Millions) Base Case
Forecasted gross sales (manual inputs): Adjustment: % deviation from forecast Adjusted gross sales forecast May June July August $200.0 $250.0 $300.0 $400.0 0% 0% 0% 0% $200.0 $250.0 $300.0 $400.0 Sept Oct Nov Dec $500.0 $350.0 $250.0 $200.0 0% 0% 0% 0% $500.0 $350.0 $250.0 $200.0

Collections on sales: During sales' month: 0.2 (Sales)(1 discount %) During 2nd month: 0.7 (prior month's sales) Due in 3rd month: 0.1 (sales 2 months ago) Less bad debts (BD% Sales 2 months ago) Total collections Purchases: 60% of next month's sales Payments Pmt for last month's purchases (30 days of credit) Wages and salaries Lease payments Other payments (interest on LT bonds, dividends, etc.) Taxes Payment for plant construction Total payments Net cash flows: Assumed excess cash on hand at start of forecast period Net cash flow (NCF): Total collections Total pmts Cumulative NCF: Prior month cum plus this month's NCF Cash surplus (or loan requirement) Target cash balance Surplus cash or loan needed: Cum NCF Target cash Max required loan (most negative on Row 102) Max investable funds (most positive on Row 102)

$58.8 175.0 20.0 0.0 $253.8 $180.0 $240.0 $180.0 30.0 30.0 30.0

$78.4 210.0 25.0 0.0 $313.4 $300.0 $240.0 40.0 30.0 30.0

$98.0 $68.6 $49.0 $39.2 280.0 350.0 245.0 175.0 30.0 40.0 50.0 35.0 0.0 0.0 0.0 0.0 $408.0 $458.6 $344.0 $249.2 $210.0 $150.0 $120.0 $120.0 $300.0 $210.0 $150.0 $120.0 50.0 40.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 30.0 150.0 $590.0 $310.0 $240.0 $240.0

$270.0

$340.0

$0.0 -16.2 -$16.2

-26.6 -182.0 -$42.8 -$224.8

148.6 -$76.2

104.0 $27.8

9.2 $37.0

$10.0 -$26.2 $234.8 $27.0

$10.0 $10.0 -$52.8 -$234.8

$10.0 -$86.2

$10.0 $17.8

$10.0 $27.0

A 107 108 109 110 111 112 113 114 115 116 117 118 119 120 121 122 123 124 125 126 127 128 129 130 131 132 133 134 135 136 137 138 139 140

Base case Big discount Short net period Long net period Bad economy

D E F Max Loan Requirement $234.8 103.5 199.3 550.7 470.9

Question: In the Base Case, suppose the credit manager did a bad job and the % of customers who paid late (3rd month rather than 2nd month) increased, and bad debts also rose. How would this affect the max loan required? Also, from base-case values, how would changes in sales affect the max loan requirement?
% pay late Max loan $234.8 % bad debts Max loan $234.8 % Sales Max Loan

variation $234.8 0% $215 0% $235 -30% $311 15% $245 3% $257 -15% $273 30% $275 6% $280 0% $235 45% $305 9% $302 15% $197 60% $335 12% $325 30% $158 Graph scales are set for the Base Case. Lines won't show for some scenarios because max loan is out of displayed range.
Late Pay Effect Max Loan $320 $330 Max Loan Bad Debt Effect Max Loan $300 Sales Effect

$280 $280 $240

$250

$200

$200 0% 20% % Late 40% 60%

$230 0% 4% % Bad Debts 8% 12%

$150 -50% % Change in Sales

A 141

142 Maximum Required Loan 143 BD% % Late Payers 144 $234.8 0% 15% 30% 45% 60% 145 0% $214.8 $244.8 $274.8 $304.8 $334.8 146 3% 237.3 267.3 297.3 327.3 357.3 147 6% 259.8 289.8 319.8 349.8 379.8 148 9% 282.3 312.3 342.3 372.3 402.3 149 12% 304.8 334.8 364.8 394.8 424.8 150 151 Combined Effect: Bad Debts and Late 152 $450 153 0% late 154 15% late 155 30% late 156 $400 45% late 157 60% late 158 159 $350 160 161 162 $300 163 164 165 166 $250 167 168 169 $200 170 0% 2% 4% 6% 8% 10% 12% 171 172 % Bad Debts 173 174 175 176 The higher the bad debt %, the larger the loan requirement. Similarly, the higher the % of late payers, the 177 larger the loan requirement. If EPC has high bad debts combined with a high % of late payers, it will have a

Max Loan Required

4/11/2010

Tabl 3. Costs of Different Types of Short-Term Credit

Accruals and Accounts Payable (Trade Credit) (Section 16.9)

Cost of Trade Credit

If a company allows its customers to pay after say 30 days, then it is extending 30 days of free credit. If it has terms like 2/10, net 30, then it is extending 10 days of free credit and an additional 20 days of "non-free credit" that has a cost equal to the 2% discount that is foregone. Firms should calculate the cost of the non-free credit, compare it to the cost of funds from other sources such as banks, and then borrow from the source with the lowest cost, other things equal. Example: 2/10, net 30 Discount % Nominal cost of trade = 100 Discount % 0.020 = 1 0.02 = = = Effective cost of trade = = Periodic cost 0.02041 0.37245 x x 37.24% x 20 Periods per year 18.25 x Days credit out Discount period 365 365

(1 + Periodic rate)^No. of periods 1 0.44585 = 44.59%

Figure 16-7 Different Credit Terms and Their Associated Costs Days in year: 365 Credit terms Discount 1/10, net 20 1/10, net 30 1/10, net 90 2/10, net 20 2/10, net 30 3/15, net 45 1% 1% 1% 2% 2% 3% Discount period 10 10 10 10 10 15 Net period 20 30 90 20 30 45 Cost of additional credit Nominal 36.87% 18.43% 4.61% 74.49% 37.24% 37.63% Effective 44.32% 20.13% 4.69% 109.05% 44.59% 44.86%

Traditional Bank Loan to Businesses

Simple Interest
Most short-term working capital bank loans to businesess are documented with a promissory note that

Example: Borrow $10,000 for one year @ 5.25% simple interest, paid monthly.
Amount borrowed Stated annual rate Days per year Stated rate per day: Nominal rate/Days per year Interest cost per day (Daily rate x Amount borrowed) Interest cost per 30-day month (Daily cost x 30) $10,000.00 5.250% 360 0.000145833 $1.46 $43.75

Months per year Effective interest rate per month (N=12,-PV,PMT,FV. Press I/Yr. Or use Rate function) Nominal interest rate per year. Nominal monthly rate x 12 Effective interest rate per year. (1 + monthly rate)^12 1

12 0.438% 5.25% 5.38%

Add-On Loan Rate

With a monthly payment add-on loan, the amount borrowed is multiplied by the stated interest rate to get the If the loan is for more than a year, say 2 years, use the same procedures except use 24 rather than 12 for the 1-month 1-Year 2-Year Amount borrowed $10,000.00 $10,000.00 $10,000.00 Stated annual rate 7.250% 7.250% 7.250% Payments per year 12 12 12 Stated rate per month: Annual rate/12 0.604% 0.604% 0.604% Months loan will be outstanding 1 12 24 Total interest: (Stated rate/month)(Borrowed)(no. of months) $60.42 $725.00 $1,450.00 Total loan: Amount borrowed + Total Interest $10,060.42 $10,725 $11,450.00 Monthly payment: Total loan / Months of loan $10,060.42 $893.75 $477.08 Rate/month: N=1,12, or 24, PV=-10000, PMT= varies. 0.604167% 1.093585% 1.112845% Nominal APR = monthly rate 12 7.25% 13.12% 13.35% EFF% = (1+monthly rate)^12 1 7.50% 13.94% 14.20% Note that the nominal and effective interest rate increases as the term of the loan increases. More interest is

SECTION 16.3
SOLUTIONS TO SELF TEST

A company has $20 million in inventory, $5 million in receivables, and $4 million in payables. Its annual sales revenue is $80 million and its cost of goods sold is $60 million. What is its CCC?

Inventory Receivables Payables Sales COGS Inventory conversion period = Average collection period = Payables deferral period = Cash conversion cycle =

$20 $5 $4 $80 $60 121.67 22.81 24.33 120.15

SECTION 16.7
SOLUTIONS TO SELF TEST A company has $20 million in sales and an inventory turnover ratio of 2.0. If it can reduce its inventory and improve its inventory turnover ratio to 2.5 with no loss in sales, by how much will FCF increase? Sales Old inventory turnover ratio New inventory turnover ratio Old inventory = Sales/Inv. turnover New inventory = Sales/Inv. turnover Increase in available free cash flow $20 2.0 2.5 $10.00 $8.00 $2.00

SECTION 16.8
SOLUTIONS TO SELF TEST A company has annual sales of $730 million. If its DSO is 35, what is its average accounts receivables balance? Annual sales DSO Daily sales Accounts receivables = DSO Daily Sales $730 35.0 $2.00 $70.00

SECTION 16.9
SOLUTIONS TO SELF TEST A company has credit terms of 2/12 net 28. What is the nominal annual cost of trade credit? The effective annual cost? Discount Dicount period Days credit is outstanding 2% 12 28

Nominal annual cost of credit =

Cost per period 0.0204 46.6%

Number of periods per year 22.8125

Effective annual cost of credit =

(1 + Cost per period) ^ 1.0204 ^ 1.5855 58.5%

Number of periods per year 22.8125 1

1 1

SECTION 16.12
SOLUTIONS TO SELF TEST Simple interest loan If a firm borrowed $500,000 at a rate of 10% simple interest with monthly interest payments and a 365-day year, what would be the required interest payment for a 30-day month? Nominal rate Amount borrowed Days/year Rate/day = nominal rate / 365 = (fraction, not %) Amount borrowed rate/day 30 = Interest / month = 10% $500,000.00 365 0.000273973 $4,109.59

If interest must be paid monthly, what would be the effective annual rate? If interest had to be paid daily, the effective rate would be found as follows: Effective rate = (1 + nom rate/365)^365 1.0 = 0.105155782 However, interest must be paid monthly, so the effective rate is lower, found as follows: Effective rate = (1 + nom rate/12)^12 1.0 = 0.104713067

or

10.52%

or

10.47%

It would be easy to go wrong on this problem for two reasons. First, you must recognize that the monthly interest payment will vary depending on how many days are in the month, and second, you must differentiate from daily interest compounding and monthly compounding. Add-on Loan If this loan had been made on a 10% add-on basis, payable in 12 end-of-month installments, what would be the monthly payments? Find the total interest: Find the total amount of the loan: Find the monthly payments: What is the annual percentage rate? APR: Find the rate that causes the PV of the monthly payment stream to equal the amount borrowed. This is the nominal rate. What is the effective annual rate? EFF%: =(1 + 0.1797/12)^12 1 = paste function: =EFFECT(G37,12) 0.1953 0.1953 or or 19.53% 19.53% 0.1 $500,000 = $500,000 + $50,000 = $550,000/12 = $50,000.00 $550,000 $45,833.33

17.97%