Chapter 18-20Chapter 18-20Working capital Working capital managementmanagement2022/5/8Main topicsSome Aspects of Short-Term Financial PolicyCash Budget and liquidity managementCredit policy and accounts receivable management Inventory managementShort-Term Borrowing18-22022/5/8Short-Term Financial PolicySize of investments in current assetsFlexible (conservative) policy maintain a high ratio of current assets to salesRestrictive (aggressive) policy maintain a low ratio of current assets to salesCompromise policy-maintain a tradeoff ratio of current assets to sales18-32022/5/8Carrying vs. Shortage CostsManaging short-term assets involves a trade-off between carrying costs and shortage costsCarrying costs increase with increased levels of current assets, the costs to store and finance the assetsShortage costs decrease with increased levels of current assetsTrading or order costsCosts related to safety reserves, i.e., lost sales and customers, and production stoppages18-42022/5/8Temporary vs. Permanent AssetsTemporary current assetsSales or required inventory build-up may be seasonalAdditional current assets are needed during the “peak” timeThe level of current assets will decrease as sales occurPermanent current assetsFirms generally need to carry a minimum level of current assets at all timesThese assets are considered “permanent” because the level is constant, not because the assets arent sold18-52022/5/818-62022/5/8Financing of current assetsFlexible (conservative) policy less short-term debt and more long-term debtRestrictive (aggressive) policy more short-term debt and less long-term debtCompromise policy-long-term debt for permanent current assets and short-term-debt for temporary current assets2022/5/818-82022/5/8Choosing the Best PolicyCash reservesHigh cash reserves mean that firms will be less likely to experience financial distress and are better able to handle emergencies or take advantage of unexpected opportunitiesCash and marketable securities earn a lower return and are zero NPV investmentsMaturity hedgingTry to match financing maturities with asset maturitiesFinance temporary current assets with short-term debtFinance permanent current assets and fixed assets with long-term debt and equityInterest RatesShort-term rates are normally lower than long-term rates, so it may be cheaper to finance with short-term debtFirms can get into trouble if rates increase quickly or if it begins to have difficulty making payments may not be able to refinance the short-term loansHave to consider all these factors and determine a compromise policy that fits the needs of the firm18-92022/5/8Cash managementWhy should firm hold cash?How much cash should a firm hold?How to forecast and management cash?2022/5/8Reasons for Holding CashSpeculative motive hold cash to take advantage of unexpected opportunitiesPrecautionary motive hold cash in case of emergenciesTransaction motive hold cash to pay the day-to-day billsTrade-off between opportunity cost of holding cash relative to the transaction cost of converting marketable securities to cash for transactions19-112022/5/8Costs of Holding CashOpportunity CostsTrading costsTotal cost of holding cashC*Costs in dollars of holding cashSize of cash balanceThe investment income foregone when holding cash.Trading costs increase when the firm must sell securities to meet cash needs.19A-12The BAT ModelF = The fixed cost of selling securities to raise cashT = The total amount of new cash neededR = The opportunity cost of holding cash, i.e., the interest rateTimeC1 2 3C2If we start with $C, spend at a constant rate each period and replace our cash with $C when we run out of cash, our average cash balance will be C2The opportunity cost of holding is C2C2R19A-13The BAT ModelTimeCAs we transfer $C each period we incur a trading cost of F. 1 2 3C2The trading cost is F TCTCIf we need $T in total over the planning period we will pay $F times.19A-14The BAT ModelC*Size of cash balanceOpportunity CostsTrading costs19A-15The BAT ModelOpportunity Costs = Trading CostsThe optimal cash balance is found where the opportunity costs equals the trading costs.Multiply both sides by C19A-16The Miller-Orr ModelThe firm allows its cash balance to wander randomly between upper and lower control limits.$TimeUCLWhen the cash balance reaches the upper control limit U, cash is invested elsewhere to get us to the target cash balance C.When the cash balance reaches the lower control limit, L, investments are sold to raise cash to get us up to the target cash balance.19A-17The Miller-Orr Model MathGiven L, which is set by the firm, the Miller-Orr model solves for C* and Uwhere s2 is the variance of net daily cash flows.The average cash balance in the Miller-Orr model is: 19A-18Implications of the Miller-Orr ModelTo use the Miller-Orr model, the manager must do four things:1.Set the lower control limit for the cash balance.2.Estimate the standard deviation of daily cash flows.3.Determine the interest rate. 4.Esti