Chapter

20PrinciplesofCorporateFinanceNinth

EditionWorking

CapitalManagement30-2Topics

CoveredInventoriesCredit

ManagementCash30-3Working

CapitalCurrent

assets

and

liabilities

for

U.S.manufacturingfirms

(2nd

qtr.2006)…$billions30-4Balance

Sheet

Modelof theFirmHow

muchshort-term

cash

flowdoes

a

companyneed

to

pay

itsbills?NetWorkingCapitalCurrent

AssetsFixed

AssetsTangibleIntangibleShareholders’EquityCurrentLiabilitiesLong-TermDebt30-5Net

Working

Capital

-

Current

assets

minuscurrentliabilities. Often

called

working

capital.Cash

Cycle

-

Period

between

firm’s

payment

formaterials

and

collection

on

its

sales.Net

WorkingCapitalOtherCurrentAssetsCurrentLiabilities–=

Cash

+30-6The

Operating

Cycle

and

the

Cash

CycleTimeCash

cycleOperating

cycleCashreceivedAccounts

receivable

periodInventoryperiodFinished

goods

soldAccounts

payable

periodFirm

receives

invoice Cash

paid

for

materialsOrderPlacedStockArrivesRaw

materialpurchased30-7CashCash

does

not

pay

interestMove

money

from

cash

accounts

intoshortterm

securitiesLiquidity!30-820-8Reasons

for

Holding

CashSpeculative

motive

–

hold

cash

to

takeadvantage

of

unexpected

opportunitiesPrecautionary

motive

–

hold

cash

in

case

ofemergenciesTransaction

motive

–

hold

cash

to

pay

theday-to-day

billsCompensation

motive-keepcash

tocompensate

bank

service30-9Target

Cash

BalancesTarget

cash

balance

–

desired

cash

leveldetermined

by

trade-off

between

carryingcosts

and

shortage

costs30-1020A-10Figure30-1120A-11BAT

ModelAssumptionsCash

is

spent

at

the

same

rate

every

dayCash

expenditures

are

known

withcertaintyOptimal

cash

balance

is

where

opportunity

cost

ofholdingcash

=

trading

costOpportunity

cost

=

(C/2)*RTrading

cost

=(T/C)*FTotal

cost

=

(C/2)*R

+(T/C)*F30-12InventoriesThe

optimal

amount

of

short

term

securities

soldto

raise

cash

will

be

higher

when

annual

cashoutflows

are

higher

and

when

the

cost

per

sale

ofsecurities

is

higher.30-1320A-13Example:

BAT

ModelYour

firm

will

have

$5

million

in

cashexpenditures

over

the

next

year.

The

interestrate

is

4%

and

the

fixed

trading

cost

is

$25per

transaction.What

is

the

optimal

cash

balance?What

is

the

average

cash

balance?What

is

the

opportunity

cost?What

is

the

shortage

cost?What

is

the

total

cost?30-14Optimal

cash

balance

=sqrt(2*25*5,000,000/.04)

=

79,057Average

cash

balance

=

79,057/2

=39,528.50Opportunity

cost

=

39,528.5(.04)

=1581.14Number

of

transactions

=

5,000,000/79,057=

64Trading

cost

=

64(25)

=

1600Total

cost

=

1600

+

1581.14

=

3,181.1430-15cashMiller-OrrCashBalanceTimeUpper

limitReturn

pointLower

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