ZeePedia Add to Favourites   |   Contact us


Financial Management

<<< Previous CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management: Next >>>
 
img
Financial Management ­ MGT201
VU
Lesson 40
CASH MANAGEMENT AND WORKING CAPITAL FINANCING
Learning Objectives:
After going through this lecture, you would be able to have an understanding of the following topics:
·  Cash Management &
·  Working Capital Financing
Cash Dividend Payout Decision:
·  Link between Dividend Policy & Cash Management ­ Cash Dividends are paid out of Cash!
·  Cash is an idle asset that do not generate any return for the company
·  How should firm decide to pay Cash Dividend based on Its Impact on Share Price and Firm's
Value?
·  Gordon's Formula:
Dividend policy issue of the company can be seen through Gordon's Formula.
­  Po (Share Price) = DIV1 / (rE ­ g)
= EPS x (DIV1/EPS) / (rE ­ (Pb x ROE)).
DIV1 = Forecasted dividend in the next year
rE = Required rate of return on equity
g = Growth rate in dividends
Pb = Plough back ratio
The two criteria that can help to decide about dividend are ROE and rE.
·  ROE is financial accounting measure of the firm's ability to internally generate a return. rE
is the return that the firm's shareholders REQUIRE. Firms try to keep ROE HIGHER than
rE.
·  If ROE < rE then firm is not generating enough return to meet shareholder requirements so it
is better to payout the dividend. Lower ROE means company is not finding sufficient
projects to generate enough return higher than rate of return on equity.
·  If firm makes Dividend payout, in this case, share price Po (and Firm Value) will RISE as
dividend announcement has positive impact on company's share price.
·  If ROE > rE then firm is better off to Plough the Retained Earnings back into the business
and investing in Positive NPV Projects or the Firm's core business. In this case, company
is generating higher return than the return shareholders require, so the best use of internally
generated retained earnings is to use them as a cheap source of capital or financing.
·  In this case of ROE > rE if firm makes Dividend payout, share price (and Firm Value) Po
will FALL. Here it makes sense for the company to keep cash and invest it in investments
as company is generating positive higher returns on its projects rather than paying dividend.
·  If ROE = rE then dividend payment has no impact on share price of the company.
Inventory Management:
In the last lecture we studied working capital and cash management in detail. Now we discuss inventory
management, another part of working capital.
·  3 Types of Inventories: Raw Material, Work in Process, Finished Goods
·  Issues to Consider in Inventory Management:
­  Inventory is acquired BEFORE sales so estimates must be accurate. EOQ (Economic Order
Quantity) difficult to estimate otherwise:
· Shortfall in Inventories: interruptions in production and loss or sales orders
· Surplus Inventories: high carrying costs, wastage, and depreciation
­  Case of Eid Time Sales: Using Short-term Finance or Loan to buy extra inventory can be Risky
because if you can't sell it, you will be forced to sell at a Deep Discount. So sell at a loss. Cash
trickling in BUT Retained Earnings being wiped out. Not enough cash to pay interest on the
loan. Possibly default and bankruptcy.
­  Inventory Costs:
·  Carrying Costs (cost of capital, storage / warehouse rent, insurance premium, wastage)
as high as 20 ­ 30 % of Inventory value!
166
img
Financial Management ­ MGT201
VU
·  Shipping Costs: Generally Less than 5% of Inventory value!
·  Cost of Running Short Loss of sales, customers, and goodwill difficult to estimate.
·
Inventory Management Policies:
­  Technology Based: Dynamic Systems ­ not only Static EOQ Software for inventory but
Dynamic Computer Software that considers Usage Growth Rates. MRP (Material Resource
Planning) and ERP (Economic Resource Planning) Software.
­  JIT: Just in Time. Developed by Toyota. Supplies arrive just a few hours before they are
used. Inventory and Working Capital is minimized. Improves overall Efficiency.
­  Outsourcing: Instead of making all the parts yourself, buy them from outside suppliers at a
lower cost and avoid any unionism issues. Example: IT Divisions of Large American
MNC's outsource the writing of computer software to Pakistani software houses.
Accounts Receivables Management:
This is another area of working capital. Accounts receivables are created out of credit sales.
·  Most firms would prefer to sell for Cash BUT Competition forces them to sell on Credit.
Example: Fabric trading in Pakistan where sellers offer 1 to 3 months credit (and even longer).
·  Account Receivables
= Credit Sales per day x Average Number of Days of Credit
­  Example:
Account Receivables
=Rs.10000 / day x 30 days
=Rs.300000 of fabric "Stuck in the market" or "In Rolling" at any given time.
·  A/c Receivables (other than Profit portion which appears in Retained Earnings) need to be
Financed somehow i.e. Short-term loan, trade credit, etc.
·  A/c Receivables = Daily Sales x ACP
­  ACP = Average Collection Period
= weighted average days of credit. Can be obtained from Ageing Schedule (Financial
Accounting)
­  Example: Firm makes 30% of sales on 30 day credit and 70% on 60 day credit. So
ACP
= (0.3x30) + (0.7x60)
= 9 + 42
= 51 Days
­  Try to Minimize Average Collection Period and daily credit sales.
Credit Policy:
·  Factors considered for credit:
­  Credit Quality Aspect: Proper Assessment of Credit-worthiness of each credit customer
(Credit Quality)
­  Minimize Time (Credit Duration or ACP) and Value (Credit Given)
­  Creative Credit Terms
·  Incentivize Customers to pay cash and to pay quickly
­  "Sell on 5/10.net 30 basis". 30 basis Means customer must pay full cash value within 30
days. 5/10.net means 5% discount for customers who pay within 10 days. So it is an
incentive for customer to pay cash quickly.
·  Impose Carrying Charge on Late Payments
­  Example: 2% late payment Charges if bill is not paid within 30 days. Means 24% penal
interest per year! Example: If customer does NOT pay Rs.100000 bill within 1 month,
then he will have to pay Rs.2000 extra for every month that he is late!
Working Capital Financing Policies:
It involves the discussion regarding how firms should finance this working capital.
·  Sales fluctuate with Nature of Business, Time, Season, State of Economy:
­  Economic Growth or Boom: High inventories and Current Assets
­  Economic Recession: Low inventories and Current Assets
167
img
Financial Management ­ MGT201
VU
·  Never drop to zero because always need minimal "Permanent Current Assets."
·
Total Assets = Fixed + Permanent Current + Temporary Current.
­  Total assets steadily grow with life of healthy company.
­  Temporary Current Assets fluctuate with time. Extra Spontaneous Inventory can be
financed by short-term debt financing or loan
·
3 Policies for Working Capital Financing (based on Maturity Matching Principle)
­  Aggressive
·  Maximum Short-term financing at low cost (but risk of non-renewal of loan)
·  Use short-term financing for Temporary Current Assets and even partly to buy
Permanent Current Inventory
­  Conservative
·  Maximum Long-term financing. Safe but higher interest costs.
·  Use long-term financing for Fixed Assets, entire Permanent Assets, and even
part of Temporary Current Assets
­  Moderate
·  Balance of Long and Short-term Financing.
·  Long Term Financing for Fixed and Permanent Current Assets. Use Short
Term Financing for Permanent Current Assets.  Use Spontaneous Current
Liability Financing for Temporary Current Assets
·
Advantages of Short Term Debt or Loan
­  Speed of getting finance as they are short run
­  Flexibility (not locked in)
­  Lower Interest Rates (generally Upward Sloping or Normal Yield Curve)
·
Disadvantage of Short Term Debt is that cost of debt is uncertain and variable in long run.
Non-renewable.
Graphical View of Financing Maturity Matching Principle Match the Maturity of Financing to
Usage of Asset:
Graphical View of Financing
Maturity Matching Principle
Match the Maturity of Financing to Usage of Asset
Spontaneous
Value (Rupees)
TEMPORARY CURRENT ASSETS ­
Current
Usage Less than 1 Year
Liabilities &
Short Term
Financing
Short Term
Financing
& Long
Term
"PERMANENT" CURRENT ASSETS
Financing
­ Usage More than 1 Year
Long Term
Debt &
FIXED ASSETS ­
Equity
Usage More than 1 Year
Time (Months)
Firms generally pursue moderate policy of financing. Basic logic behind this is MATURITY
MATCHING PRINCIPLE.
168
Table of Contents:
  1. INTRODUCTION TO FINANCIAL MANAGEMENT:Corporate Financing & Capital Structure,
  2. OBJECTIVES OF FINANCIAL MANAGEMENT, FINANCIAL ASSETS AND FINANCIAL MARKETS:Real Assets, Bond
  3. ANALYSIS OF FINANCIAL STATEMENTS:Basic Financial Statements, Profit & Loss account or Income Statement
  4. TIME VALUE OF MONEY:Discounting & Net Present Value (NPV), Interest Theory
  5. FINANCIAL FORECASTING AND FINANCIAL PLANNING:Planning Documents, Drawback of Percent of Sales Method
  6. PRESENT VALUE AND DISCOUNTING:Interest Rates for Discounting Calculations
  7. DISCOUNTING CASH FLOW ANALYSIS, ANNUITIES AND PERPETUITIES:Multiple Compounding
  8. CAPITAL BUDGETING AND CAPITAL BUDGETING TECHNIQUES:Techniques of capital budgeting, Pay back period
  9. NET PRESENT VALUE (NPV) AND INTERNAL RATE OF RETURN (IRR):RANKING TWO DIFFERENT INVESTMENTS
  10. PROJECT CASH FLOWS, PROJECT TIMING, COMPARING PROJECTS, AND MODIFIED INTERNAL RATE OF RETURN (MIRR)
  11. SOME SPECIAL AREAS OF CAPITAL BUDGETING:SOME SPECIAL AREAS OF CAPITAL BUDGETING, SOME SPECIAL AREAS OF CAPITAL BUDGETING
  12. CAPITAL RATIONING AND INTERPRETATION OF IRR AND NPV WITH LIMITED CAPITAL.:Types of Problems in Capital Rationing
  13. BONDS AND CLASSIFICATION OF BONDS:Textile Weaving Factory Case Study, Characteristics of bonds, Convertible Bonds
  14. BONDS’ VALUATION:Long Bond - Risk Theory, Bond Portfolio Theory, Interest Rate Tradeoff
  15. BONDS VALUATION AND YIELD ON BONDS:Present Value formula for the bond
  16. INTRODUCTION TO STOCKS AND STOCK VALUATION:Share Concept, Finite Investment
  17. COMMON STOCK PRICING AND DIVIDEND GROWTH MODELS:Preferred Stock, Perpetual Investment
  18. COMMON STOCKS – RATE OF RETURN AND EPS PRICING MODEL:Earnings per Share (EPS) Pricing Model
  19. INTRODUCTION TO RISK, RISK AND RETURN FOR A SINGLE STOCK INVESTMENT:Diversifiable Risk, Diversification
  20. RISK FOR A SINGLE STOCK INVESTMENT, PROBABILITY GRAPHS AND COEFFICIENT OF VARIATION
  21. 2- STOCK PORTFOLIO THEORY, RISK AND EXPECTED RETURN:Diversification, Definition of Terms
  22. PORTFOLIO RISK ANALYSIS AND EFFICIENT PORTFOLIO MAPS
  23. EFFICIENT PORTFOLIOS, MARKET RISK AND CAPITAL MARKET LINE (CML):Market Risk & Portfolio Theory
  24. STOCK BETA, PORTFOLIO BETA AND INTRODUCTION TO SECURITY MARKET LINE:MARKET, Calculating Portfolio Beta
  25. STOCK BETAS &RISK, SML& RETURN AND STOCK PRICES IN EFFICIENT MARKS:Interpretation of Result
  26. SML GRAPH AND CAPITAL ASSET PRICING MODEL:NPV Calculations & Capital Budgeting
  27. RISK AND PORTFOLIO THEORY, CAPM, CRITICISM OF CAPM AND APPLICATION OF RISK THEORY:Think Out of the Box
  28. INTRODUCTION TO DEBT, EFFICIENT MARKETS AND COST OF CAPITAL:Real Assets Markets, Debt vs. Equity
  29. WEIGHTED AVERAGE COST OF CAPITAL (WACC):Summary of Formulas
  30. BUSINESS RISK FACED BY FIRM, OPERATING LEVERAGE, BREAK EVEN POINT& RETURN ON EQUITY
  31. OPERATING LEVERAGE, FINANCIAL LEVERAGE, ROE, BREAK EVEN POINT AND BUSINESS RISK
  32. FINANCIAL LEVERAGE AND CAPITAL STRUCTURE:Capital Structure Theory
  33. MODIFICATIONS IN MILLAR MODIGLIANI CAPITAL STRUCTURE THEORY:Modified MM - With Bankruptcy Cost
  34. APPLICATION OF MILLER MODIGLIANI AND OTHER CAPITAL STRUCTURE THEORIES:Problem of the theory
  35. NET INCOME AND TAX SHIELD APPROACHES TO WACC:Traditionalists -Real Markets Example
  36. MANAGEMENT OF CAPITAL STRUCTURE:Practical Capital Structure Management
  37. DIVIDEND PAYOUT:Other Factors Affecting Dividend Policy, Residual Dividend Model
  38. APPLICATION OF RESIDUAL DIVIDEND MODEL:Dividend Payout Procedure, Dividend Schemes for Optimizing Share Price
  39. WORKING CAPITAL MANAGEMENT:Impact of working capital on Firm Value, Monthly Cash Budget
  40. CASH MANAGEMENT AND WORKING CAPITAL FINANCING:Inventory Management, Accounts Receivables Management:
  41. SHORT TERM FINANCING, LONG TERM FINANCING AND LEASE FINANCING:
  42. LEASE FINANCING AND TYPES OF LEASE FINANCING:Sale & Lease-Back, Lease Analyses & Calculations
  43. MERGERS AND ACQUISITIONS:Leveraged Buy-Outs (LBO’s), Mergers - Good or Bad?
  44. INTERNATIONAL FINANCE (MULTINATIONAL FINANCE):Major Issues Faced by Multinationals
  45. FINAL REVIEW OF ENTIRE COURSE ON FINANCIAL MANAGEMENT:Financial Statements and Ratios