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Corporate Finance

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Corporate Finance ­FIN 622
Lesson 29
The following topics will be discussed in this lecture.
Miller-Orr Model of cash management
Inventory management
Inventory costs
Economic order quantity
Reorder level
Discounts and EOQ
Miller-Orr Model for Cash Management:
Most firms maintain a minimum amount of cash on hand to meet daily obligations or as a requirement from
the firm's bank. A maximum amount may also be specified to reflect the tradeoff between the transaction
cost of investing in liquid assets (e.g. Money Market Funds) and the cost of lost interest if the cash is not
invested. The Miller-Orr model computes the spread between the minimum and maximum cash balance
limits as
Spread = 3(0.75 x transaction cost x variance of daily cash flows / daily interest rate) ^(1/3)
(where a^b is used to denote "a to the power b").
The maximum cash balance is the spread plus the minimum cash balance, which is assumed to be known.
The "return point" is defined as the minimum cash balance plus spread/3.
Whenever the cash balance hits (or exceeds) the maximum, the firm should invest the difference between
the amount available and the return point; if the minimum is reached, sufficient securities should be sold to
bring it up to the return point.
Graph Explanation:
When cash balance reaches point `A', the upper limit, company will invest the surplus to bring down the
cash balance to return point.
When cash balance touches down point `B', the lower limit, the company would liquidate some of its
securities to increase the balance back to return point.
Upper and lower limits are determined as explained above.
These limits depend upon variance of cash flow, transaction cost and interest rate.
If variability of cash flow is high and transaction cost is high too, then the limits will be wide apart,
otherwise narrow would suffice.
If interest rates are high then the narrow limits would be set.
Corporate Finance ­FIN 622
To keep interest cost as low as possible, the return point is set 1/3 of the spread between the lower and
upper limit.
Inventory Management:
Inventory management is the active control program which allows the management of sales, purchases
and payments.
Inventory management software helps create invoices, purchase orders, receiving lists, payment receipts
and can print bar coded labels. An inventory management software system configured to your warehouse,
retail or product line will help to create revenue for your company. The Inventory Management will
control operating costs and provide better understanding. We are your source for inventory management
information, inventory management software and tools.
A complete Inventory Management Control system contains the following components:
· Inventory Management Definition
· Inventory Management Terms
· Inventory Management Purposes
· Definition and Objectives for Inventory Management
· Organizational Hierarchy of Inventory Management
· Inventory Management Planning
· Inventory Management Controls for Inventory
· Determining Inventory Management Stock Levels
1. Inventory costs
Inventory costs depend on the amount of space required, and how much that space costs. If the assumption
is made that every part spends an equal amount of time located in inventory, then the cost of inventory can
be shared equally amongst all parts. This simplification leads to equation 3.4.1 as an expression for the
inventory costs:
Carrying cost:
Cost of holding an item in inventory.
Ordering cost:
Cost of replenishing inventory
Shortage Cost:
Temporary or permanent loss of sales when demand customers don't find the product in the market and
switch over to substitute products.
2. Economic order quantity
EOQ The amount of orders that minimizes total variable costs required to order and hold inventory.
Re-order quantity is the quantity for which order is placed when the stock reached re-orders level. By fixing
this quantity the purchaser has not to be to re-calculate the quantity to be purchased each time he orders for
Re-order quantity is known as economic order quantity because it is the quantity which is most economical
to order. In other words, economic order quantity is that size of quantity of the order which gives
maximum economy in purchasing any material and ultimately contributes towards maintaining the material
at the optimum level and minimum cost.
While setting economic order quantity, two types of cost should be taken into account:
1. Ordering Cost: This is the cost of placing an order with the supplier. Because of so many factors
involved, it is quite difficult to quantify this cost. It mainly includes the cost of stationary, salaries of
those engaged in receiving and inspection, salaries of those engaged in placing an order, etc.
2. Cost of Carrying Stock: This is the cost of holding the stock in storage.
It includes the following:
(a) cost of operating the stores,(salaries, rent, stationary)
(b) the incidence of insurance cost;
(c) interest on the capital locked up in store;
(d) Deterioration and wastage of material.
Corporate Finance ­FIN 622
A graph illustrating the relationship amongst the Ordering Costs curve, the Holding Costs curve, the Total
Costs curve and the Economic ordering quantity
The single item EOQ formula can be seen as the minimum point of the following cost function:
Total cost = purchase cost + order cost + holding cost, which corresponds to:
Taking the derivative of both sides of the equation and setting equal to zero, one obtains
The result of this differentiation is:
Solving for Q:
3. Reorder level
This is that level of material at which purchase requisition is initiated for fresh supplies. This is fixed some
where between minimum level and maximum level. This is fixed in such a way that by re-ordering when
material falls to this level, then in the normal course of events, new supplies will be received just before the
minimum level is reached. Its formula is:
Re-order Level = Maximum consumption * Maximum re-order period
The following factors are considered in fixing this level:
Corporate Finance ­FIN 622
1. Rate of consumption of the material
2. Minimum level
3. Delivery time; i.e., the time normally taken from the time of initiating a purchase requisition, to the
receipts of material
4. Variation in delivery time.
4. Discounts and EOQ
Discounts are reductions to a basic price. They could modify either the manufacturer's list price
(determined by the manufacturer and often printed on the package), the retail price (set by the retailer and
often attached to the product with a sticker), or the list price (which is quoted to a potential buyer, usually in
written form). The market price (also called effective price) is the amount actually paid. The purpose of
discounts is to increase short-term sales, move out-of-date stock, reward valuable customers, or encourage
distribution channel members to perform a function. Some discounts and allowances are forms of sales
EOQ The amount of orders that minimizes total variable costs required to order and hold inventory.
Re-order quantity is the quantity for which order is placed when the stock reached re-orders level. By fixing
this quantity the purchaser has not to be to re-calculate the quantity to be purchased each time he orders for
Table of Contents:
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk