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Corporate Finance

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Corporate Finance ­FIN 622
VU
Lesson 28
CASH MANAGEMENT
The following topics will be discussed in this lecture.
Overtrading ­ Indications & remedies
Cash management
Motives for Cash holding
Cash flow problems and remedies
Investing surplus cash
Inventory approach to cash management
Demerits.
Overtrading ­ Indications & Remedies
In contrast with over-capitalization, overtrading occurs when a firm tries to do too much too quickly with
too little long term capital, so that it is trying to support too large trade volume with limited capital
resources.
Even a firm operating in profit may find itself in serious conditions because it is in short of money situation.
Such liquidity troubles emerge from the fact that it does not have enough cash to pay off debt as it falls due.
The major signs leading to overtrading are as follows:
-  There is significant increase in turnover.
-  Increase in current assets is rapid.
-  Stock turnover the debtors turnover might slow down, in which case the rate of increase in
stocks and debtors would be even greater than the increase in sales.
-  Payment to creditors is pushed to increase length.
-  Short term loans are exceeding the limits and firm tries to negotiate increased limits.
-  The current and quick ratio falls
-  The firm leads to liquid deficit situation where current liabilities are greater than current
assets.
Overtrading takes place when a business accepts work and tries to fulfill it, but fulfillment requires greater
resources of people, working capital or net assets than the business has available to it. It is often caused by
unforeseen events such as manufacture or delivery taking longer than anticipated, resulting in cash flow
being impaired.
Overtrading is a common problem, and it often happens to recently started businesses and to rapidly
expanding businesses. Cash often has to leave the business before more cash comes into it. For example,
wages and salaries are usually payable weekly or monthly and there may also be other expenses that need to
be met promptly, such as telephone bills and rent.
Although you may pay suppliers on credit, your customers may also pay you on credit. It doesn't take much
to upset the balance.
Remedies
Effective debt management and credit control can help you avoid overtrading, by ensuring that you get paid
more efficiently and have the cash to pay suppliers and staff.
In addition to managing debt more effectively and improving credit control, you should also think about
changing some or all of your business practices.
Set New Payment Terms
You could renegotiate payment terms, or tell customers that new terms will apply for future orders, but you
should be aware that customers may object. Much will depend on the strength or weakness of your
competitive position. You may lose business if your new terms are unattractive to your customers, or if you
are aggressive in imposing them.
Offer Discounts for Prompt Payment
This can be effective in accelerating payment, boosting cash flow and reducing bad debts. However, there
are disadvantages - it can be expensive and must be policed to ensure that customers only take discounts
when they pay promptly. See our guide on invoicing and payment terms.
Use factoring or invoice discounting
Factoring involves selling your invoices to a specialist finance company which takes on the administration
and cost of recovering the invoice payments. With invoice discounting, you raise a loan from a finance
company against the value of your invoices, but you keep the responsibility and cost of recovering invoice
payments. See our guide on debt factoring and invoice discounting: the basics.
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Corporate Finance ­FIN 622
VU
Negotiate payment terms with your suppliers
You could try to negotiate different payment terms with your suppliers or you could just take longer to pay.
However, this may be considered unethical, and you may find that some suppliers refuse to supply you if
you habitually take too long to pay. You may therefore want to consider giving something in return for
extended payment terms, such as a promise of regular orders.
Cash Management
Cash is your business's lifeblood. Managed well, your company remains healthy and strong. Managed
poorly, your company goes into cardiac arrest.
If you haven't considered cash management an important issue, then you're probably undermining your
business's short-term stability and its long-term survival. But how can you manage business cash better?
Cash Flow ­ Problems and Remedies
·  Growth: a growing business needs to have more non current assets and these fixed assets must be
financed.
·  Seasonal business: like on Eid and religious occasions, the business activity jumps manifolds and
firms need more cash to procure inventory etc.
·  Capital expense or one-off expenditure.
·  Losses increase the cash flow problems
·  How to improve cash flow:
Cash flow problems can be handled in the following ways:
·  decreasing the receipt float
·  deferring capital expenditure (capex) and developmental work
·  accelerating cash inflows which were set for recovery at a later period.
·  liquidating investments
·  deferring payments to creditors
·  rescheduling loan payments
·  planning is of immense importance especially rolling cash budgets.
Motives for Cash holding
Transactions Motive ensures that the firm has enough funds to transact its routine, day-to-day business
affairs. Safety Motive protects the firm against being unable to meet unexpected demands for cash.
Speculative Motive allows the firm to take advantage of unexpected opportunities that may arise
Estimating Cash Balances
·
The Baumol Model
ECQ = 2 x Conversion Cost x Demand For Cash
Opportunity Cost (In Decimal Form)
WHERE:
Conversion cost = cost of converting marketable securities to cash ($/conversion)
Opportunity cost = interest earnings given up due to holding funds in a non-interest-earning cash
Investing Surplus Cash
Companies may have surplus cash or some companies may be rich in cash and this leads us to think "what
to do with the surplus cash?" Obviously, the "surplus" here means temporary and it should be invested in
short term for earning return on it.
Before putting the surplus cash into any bank deposit, the firm will consider three factors:
-  Liquidity ­ company can withdraw the money out of deposit quickly and without the loss
of value.
-  Profitability ­ the deposit must offer good return for the risk being taken.
-  Safety ­ there's no chance of loss of deposit.
There are some other factors that need to be considered when investing of surplus cash is an issue. Keeping
in view the interest market it should be decided whether to put the money in a deposit bearing fixed or
floating interest rate, term to maturity and penalties for early liquidation of deposit in case, firm needs cash
for other purposes. Tax on profit and option of investing in international market should also be considered.
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Corporate Finance ­FIN 622
VU
Inventory Approach to Cash Management
The answer to question "how much cash should be held?" will vary firm to firm and business to business.
However, there are different models that can provide a relative guide as to how much cash a company
should hold.
We can identify two types of cost that are involved in obtaining cash. First is the fixed cost that may be in
terms of issuing new shares or negotiating a new loan. Second is the cost that represents the opportunity
cost of keeping the money in the form of cash. This is variable portion of the total cost of cash holding. If
you don't put the surplus money into earning, you are loosing money.
Inventory approach uses the same equation as of economic order quantity. We here reproduce the EOQ
equation with slight change.
Q = 2 FS / i
Where:
S = is the amount of cash to be used in each period
F = fixed cost of obtaining new funds
i = interest cost of holding cash
Q = quantity of cash to be held per period.
Drawbacks of inventory approach:
-  to predict cash requirement is not a simple task. Normally, it cannot be determined with
certainty.
-  There are costs associated with running out of cash which are not considered by this
approach.
-  The other normal cost of holding cash that increases with amount held is ignored.
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Table of Contents:
  1. INTRODUCTION TO SUBJECT
  2. COMPARISON OF FINANCIAL STATEMENTS
  3. TIME VALUE OF MONEY
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  6. TERM STRUCTURE OF INTEREST RATES
  7. COMMON STOCK VALUATION
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  10. METHODS OF PROJECT EVALUATIONS 2
  11. METHODS OF PROJECT EVALUATIONS 3
  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
  42. FOREIGN EXCHANGE MARKET’S OPTIONS
  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