Chapter 19

Working Capital Management

 Chapter Outline

19.1 Overview of Working Capital

19.2 Trade Credit
19.3 Receivables Management
19.4 Payables Management
19.5 Inventory Management
19.6 Cash Management
 Learning Objectives

 Understand the cash cycle of the firm and why managing

working capital is important
 Use trade credit to the firm’s advantage
 Make decisions on extending credit and adjusting credit
terms
 Learning Objectives (cont’d)

 Manage accounts payable

 Know the costs and benefits of holding additional
inventory
 Contrast the different instruments available to a financial
manager for investing cash balances
 19.1 Overview of Working Capital

 Main Components of Net Working Capital

 Cash
 Inventory
 Receivables
 Payables
 19.1 Overview of Working Capital

 Cash Cycle
 Operating Cycle
 The average length of time between when a firm originally purchases
its inventory and when it receives the cash back from selling its
product
 Cash Cycle
 The length of time between when the firm pays cash to purchase its
initial inventory and when it receives cash from the sale of the output
produced from that inventory
 19.1 Overview of Working Capital

 Cash Cycle
 Cash Conversion Cycle (CCC)
 CCC = Inventory Days + A/R Days – A/P Days (19.1)
where:

Inventory
Inventory Days =
Average Daily Cost of Goods Sold
Accounts Receivable
Accounts Receivable Days =
Average Daily Sales
Accounts Payable
Accounts Payable Days =
Average Daily Cost of Goods Sold
Figure 19.1 The Cash and Operating
Cycle for a Firm
 Example 19.1 Calculating the CCC

Problem:
 The following information is from Dell’s 2009 Income Statement and
Balance Sheet (numbers are $ millions). Use it to compute Dell’s cash
conversion cycle.

Sales 52,902
Cost of Goods Sold 43,641

Accounts Receivable 5,837

Inventory 1,051
Accounts Payable 11,373
 Example 19.1 Calculating the CCC

Solution:
Plan:
 The CCC is defined in Eq. 19.1 as Inventory Days + Accounts Receivable
Days – Accounts Payable Days. Thus, we need to compute each of the three
ratios in the CCC. In order to do that, we need to convert Sales and COGS
into their average daily amounts simply by dividing the total given for the
year by 365 days in a year.
 Example 19.1 Calculating the CCC

Execute:
 Average Daily Sales = Sales/365 Days = 52,902/365 = 144.94
 Average Daily COGS = COGS/365 Days = 43,641/365 = 119.56

Inventory 1051
Inventory Days    8.79
Average Daily Cost of Goods Sold 119.56
Accounts Receivable 5837
Accounts Receivable Days    40.27
Average Daily Sales 144.94
Accounts Payable 11,373
Accounts Payable Days    95.12
Average Daily Cost of Goods Sold 119.56

 Dell’s CCC = 8.79 + 40.27 −95.12= − 46.06

 Example 19.1 Calculating the CCC

Evaluate:
 Dell actually has a negative cash conversion cycle, meaning that it generally
receives cash for its computers before it pays its suppliers for the parts in
the computer. Dell is able to do this because it primarily sells directly to the
consumer, so it charges your credit card as soon as you place the order.
Dell’s direct sales generate basically no receivables, so Dell’s accounts
receivables are due to sales to businesses, educational institutions and retail
outlets. Once you place your order, Dell places orders for the parts for
your computer with its suppliers. Because of Dell’s size and bargaining
power, its suppliers allow it to wait more than 95 days before paying them!
 Example 19.1a Calculating the CCC

Problem:
 Given the following information from Elite PC’s 2010 income
statement and balance sheet (numbers are in $ millions),
calculate the company’s cash conversion cycle (CCC) and use
it to evaluate the company’s efficiency:

Sales 66,467
Cost of Goods Sold 54,226
Accounts Receivable 5,160
Inventory 643
Accounts payable 10,234
 Example 19.1a Calculating the CCC

Solution:
Plan:
 The CCC is defined in Eq. 19.1 as Inventory Days + Accounts Receivable
Days – Accounts Payable Days. Thus, we need to compute each of the three
ratios in the CCC. In order to do that, we need to convert Sales and
COGS into their average daily amounts simply by dividing the total given for
the year by 365 days in a year.
 Example 19.1a Calculating the CCC

Execute:
 Average Daily Sales = Sales/365 Days = 66,467/365 = 182.10
 Average Daily COGS = COGS/365 Days = 54,226/365 = 148.56
 Example 19.1a Calculating the CCC

Execute (cont'd):
Inventory Days = Inventory/Average Daily Cost of Goods Sold =
643/148.56= 4.33
Accounts Receivable Days = A/R/Average Daily Sales =
5,160/182.10= 28.34
Accounts Payable Days = A/P/Average Daily Cost of Goods Sold =
10,234/148.56= 68.89

So, Elite’s CCC = 4.33+28.34 – 68.89 = -36.22!

 Example 19.1a Calculating the CCC

Evaluate:
 Elite PC actually has a negative cash conversion cycle, meaning that it
generally receives cash for its computers before it pays its suppliers for the
parts in the computer. Elite PC is able to do this because it sells directly to
the consumer, so that it charges your credit card as soon as you place the
order. Once you place your order, Elite PC places orders for the parts for
your computer with its suppliers. Elite PC is paid by the credit card
company about 28 days after you place your order. Because of Elite’s size
and bargaining power, its suppliers allow it to wait about 69 days before
paying them.
Table 19.1 Working Capital in Various
Industries (Fiscal Year End 2009)
 19.1 Overview of Working Capital

 Firm Value and Working Capital

 Any reduction in working capital requirements generates a
positive free cash flow that the firm can distribute immediately
to shareholders
 Example 19.2 The Value of Working Capital
Management

Problem:
 The projected net income and free cash flows next year for Emerald City
Paints are given in the following table in $ thousands:

Net Income 20,000

+Depreciation +5,000
-Capital Expenditures -5,000
- Increase in Working Capital -1,000
=Free Cash Flow 19,000
 Example 19.2 The Value of Working Capital
Management

Problem (cont'd):
 Emerald City expects capital expenditures and depreciation to
continue to offset each other and for both net income and
increase in working capital to grow at 4% per year. Emerald
City’s cost of capital is 12%. If Emerald City were able reduce
its annual increase in working capital by 20% by managing its
working capital more efficiently without adversely affecting any
other part of the business, what would be the effect on
Emerald City’s value?
 Example 19.2 The Value of Working
Capital Management
Solution:
Plan:
 A 20% decrease in required working capital increases would reduce the
starting point from $1,000,000 per year to $800,000 per year. The working
capital increases would still grow at 4% per year, but each increase would
then be 20% smaller because of the 20% smaller starting point.
 Example 19.2 The Value of Working
Capital Management

Plan (cont'd):
 We can value Emerald City using the formula for a growing
perpetuity from Chapter 4 (Eq. 4.7):
CF1
PV 
rg
As shown in the table, we can get to Emerald City’s free cash
flow as:
Net Income + Depreciation – Capital Expenditures – Increases in
Working Capital.
 Example 19.2 The Value of Working
Capital Management
Execute:
 Currently, Emerald City’s value is:

20, 000, 000  5, 000, 000  5, 000, 000  1, 000, 000

 237,500, 000
.12  .04
 If they can manage their working capital more efficiently, the value will be:

20, 000, 000  5, 000, 000  5, 000, 000  800, 000

 240, 000, 000
.12  .04
 Example 19.2 The Value of Working
Capital Management
Evaluate:
 Although the change will not affect Emerald City’s earnings (net income), it
will increase the free cash flow available to shareholders, increasing the
value of the firm by $2.5 million.
 Example 19.2a The Value of Working
Capital Management
Problem:
 The projected net income and free cash flows next year for River City
Games are given in the following table in $ thousands:

Net Income 120,000

+Depreciation +80,000
-Capital Expenditures -95,000
- Increase in Working Capital -40,000
=Free Cash Flow 65,000
 Example 19.2a The Value of Working
Capital Management

Problem (cont'd):
 River City expects capital expenditures and depreciation to
continue to offset each other and for both net income and
increase in working capital to grow at 6% per year. River City’s
cost of capital is 8%. If River City were able reduce its annual
increase in working capital by 10% by managing its working
capital more efficiently without adversely affecting any other
part of the business, what would be the effect on River City’s
value?
 Example 19.2a The Value of Working
Capital Management
Solution:
Plan:
 A 10% decrease in required working capital increases would reduce the
starting point from $40,000,000 per year to $36,000,000 per year. The
working capital increases would still grow at 6% per year, but each increase
would then be 10% smaller because of the 10% smaller starting point.
 Example 19.2a The Value of Working
Capital Management

Plan (cont'd):
 We can value River City using the formula for a growing
perpetuity from Chapter 4 (Eq. 4.7):
CF1
PV 
rg
As shown in the table, we can get to River City’s free cash flow
as:
Net Income + Depreciation – Capital Expenditures – Increases in
Working Capital.
 Example 19.2a The Value of Working
Capital Management
Execute:
 Currently, River City’s value is:

120,000,000  80,000,000  95,000,000  40,000,000

 3,250,000,000
.08  .06

 If they can manage their working capital more efficiently, the value will be:

120,000,000  80,000,000  95,000,000  36,000,000

 3,450,000,000
.08  .06
 Example 19.2a The Value of Working
Capital Management
Evaluate:
 Although the change will not affect River City’s earnings (net income), it will
increase the free cash flow available to shareholders, increasing the value of
the firm by $200 million.
 19.2 Trade Credit

 Trade Credit
 The difference between receivables and payables that is the net
amount of a firm’s capital consumed as a result of those credit
transactions
 The credit that a firm extends to its customers
 19.2 Trade Credit

 Trade Credit Terms

 Example: 2/10, Net 30
 Cash Discount
 In this example, a 2% cash discount is taken if paid by during the discount
period
 Discount Period
 In this example, 10 days
 Credit Period
 The total length of time credit is extended to the buyer.
 In this example, 30 days
19.2 Trade Credit
 19.2 Trade Credit

 Trade Credit and Market Frictions

 Cost of Trade Credit

EAR = (1 + r)n – 1
 Example 19.3 Estimating the Effective
Cost of Trade Credit
Problem:
 Your firm purchases goods from its supplier on terms of 1/15, net 40. What
is the effective annual cost to your firm if it chooses not to take advantage
of the trade discount offered?
 Example 19.3 Estimating the Effective
Cost of Trade Credit

Solution:
Plan:
 Using a $100 purchase as an example: 1/15, net 40 means that
you get a 1% discount if you pay within 15 days, or you can pay
the full amount within 40 days. 1% of $100 is a $1 discount, so
you can either pay $99 in 15 days, or $100 in 40 days. The
difference is 25 days, so you need to compute the interest rate
over the 25 days and then compute the EAR associated with
that 25-day interest rate.
 Example 19.3 Estimating the Effective
Cost of Trade Credit
Execute:
 $1/$99 = 0.0101, or 1.01% interest for 25 days. There are 365/25 = 14.6 25-
day periods in a year. Thus, your effective annual rate is (1.0101)14.6-1 =
0.158, or 15.8%
 Example 19.3 Estimating the Effective
Cost of Trade Credit
Evaluate:
 If you really need to take the full 40 days to produce the cash to pay, you
would be better off borrowing the $99 from the bank at a lower rate and
taking advantage of the discount.
 Example 19.3a Trade Credit

Problem:
 Your corporation,Vitamin Soda, purchases goods from a supplier at 2/10 net
40. If your business requires the entire 40 days to pay back your supplier,
would it be better to take a loan from the bank after the discount or just
pay the EAR given by the trade credit?
 Example 19.3a Trade Credit

Solution:
Plan:
 Using a $200 purchase as an example: 2/10, net 40 means that
you get a 2% discount if you pay within 10 days, or you can pay
the full amount within 40 days. 2% of $200 is a $4 discount, so
you can either pay $196 in 10 days, or $200 in 40 days. The
difference is 30 days, so you need to compute the interest rate
over the 30 days and then compute the EAR associated with
that 30-day interest rate.
 Example 19.3a Trade Credit

Execute:
 $4/$196 = 0.0204, or 2.04% interest for 30 days. There are 365/30 = 12.17
thirty-day periods in a year. Thus, your effective annual rate is (1.0204)12.17-1
=.2786, or 27.86%
 Example 19.3a Trade Credit

Evaluate:
 If you really need to take the full 40 days to produce the cash to pay, you
would be better off borrowing the $196 from the bank at a lower rate and
taking advantage of the discount.
 Example 19.3b Estimating the Effective
Cost of Trade Credit
Problem:
 Your firm purchases goods from its supplier on terms of 2/10, net 45. What
is the effective annual cost to your firm if it chooses not to take advantage
of the trade discount offered?
 Example 19.3b Estimating the Effective
Cost of Trade Credit

Solution:
Plan:
 Using a $100 purchase as an example: 2/10, net 45 means that
you get a 2% discount if you pay within 10 days, or you can pay
the full amount within 45 days. 2% of $100 is a $2 discount, so
you can either pay $98 in 10 days, or $100 in 45 days. The
difference is 35 days, so you need to compute the interest rate
over the 35 days and then compute the EAR associated with
that 35-day interest rate.
 Example 19.3b Estimating the Effective
Cost of Trade Credit
Execute:
 $2/$98 = 0.0204, or 2.04% interest for 35 days. There are 365/35 = 10.4 35-
day periods in a year. Thus, your effective annual rate is (1.0204)10.4-1 =
0.234, or 23.4%
 Example 19.3b Estimating the Effective
Cost of Trade Credit
Evaluate:
 If you really need to take the full 45 days to produce the cash to pay, you
would be better off borrowing the $98 from the bank at a lower rate and
taking advantage of the discount.
 19.2 Trade Credit

 Trade Credit and Market Frictions

 Benefits of Trade Credit
 It is simple and convenient to use, and it has lower transaction costs
than alternative sources of funds
 It is a flexible source of funds, and can be used as needed
 It is sometimes the only source of funding available to a firm
 19.2 Trade Credit

 Trade Credit and Market Frictions

 Trade Credit Versus Standard Loans
 Firms offer trade credit because:
 Providing financing at below-market rates is an indirect way to lower prices
for only certain customers
 A supplier may have an ongoing business relationship with its customer, it
may have more information about the credit quality of the customer than a
traditional outside lender such as a bank would have
 If the buyer defaults, the supplier may be able to seize the inventory as
collateral
 19.2 Trade Credit

 Managing Float
 Collection Float
 Mail Float
 Processing Float
 Availability Float
 Disbursement Float
 Electronic Check Processing
 Check Clearing for the 21st Century Act (Check 21)
Figure 19.2 Collection Float
 19.3 Receivables Management

 Determining Credit Policy

 Establishing a credit policy involves three steps:
1. Establishing credit standards
2. Establishing credit terms
3. Establishing a collection policy
 19.3 Receivables Management

 Determining Credit Policy

 5 C’s of Credit
 Character
 Capacity
 Capital
 Collateral
 Conditions
 Example 19.4 Evaluating a Change in
Credit Policy
Problem:
 Your company currently sells its product with a 1% discount to customers
who pay cash immediately. Otherwise the full price is due within 30 days.
Half of your customers take advantage of the discount.You are considering
dropping the discount so that your new terms would just be net 30. If you
do that, you expect to lose some customers who were only willing to pay
the discounted price, but the rest will simply switch to taking the full 30
days to pay. Altogether, you estimate that you will sell 20 fewer units per
month (compared to 500 units currently).Your variable cost per unit is $60
and your price per unit is $100. If your required return is 1% per month,
should you switch your policy?
 Example 19.4 Evaluating a Change in
Credit Policy

Solution:
Plan:
 To decide whether to change your policy, compute the NPV of
the change. It costs you $30,000 to make the 500 units.You
receive payment for half of the units immediately at a price of
$99 per unit (1% discount). The other half comes in 30 days at
a price of $100 per unit. At that point, you are starting over
again with the next set of product. Thus, you can think of your
cash flows in any 30-day period as:
 Example 19.4 Evaluating a Change in
Credit Policy
Plan (cont'd):
 Example 19.4 Evaluating a Change in
Credit Policy
Plan (cont'd):
 Example 19.4 Evaluating a Change in
Credit Policy
Execute:
25, 000  5, 250
NPVcurrent  5, 250   1,969, 750
.01
48, 000  28,800
NPVnew  28,800   1,891, 200
.01

 So the NPV of the switch will be:

$1,891,200- $1,969,750=-$78,550.
 Example 19.4 Evaluating a Change in
Credit Policy
Evaluate:
 You shouldn’t make the switch because you will lose too many customers,
even though your remaining customers will be paying the full price. The
Valuation Principle helps us weigh this tradeoff—the present value of the
costs outweighs the present value of the benefits, so the decision is not a
good one.
 Example 19.4a Evaluating a Change in
Credit Policy
Problem:
 Your company currently sells its product with a 2% discount to customers
who pay cash immediately. Otherwise the full price is due within 30 days.
Sixty percent of your customers take advantage of the discount.You are
considering dropping the discount so that your new terms would just be
net 30. If you do that, you expect to lose some customers who were only
willing to pay the discounted price, but the rest will simply switch to taking
the full 30 days to pay. Altogether, you estimate that you will sell 20 fewer
units per month (compared to 1,000 units currently).Your variable cost per
unit is $90 and your price per unit is $150. If your required return is 0.5%
per month, should you switch your policy?
 Example 19.4a Evaluating a Change in
Credit Policy

Solution:
Plan:
 To decide whether to change your policy, compute the NPV of
the change. It costs you $90,000 to make the 1,000 units.You
receive payment for sixty percent of the units immediately at a
price of $147 per unit (2% discount). The other forty percent
comes in 30 days at a price of $150 per unit. At that point, you
are starting over again with the next set of product. Thus, you
can think of your cash flows in any 30-day period as:
 Example 19.4a Evaluating a Change in
Credit Policy
Plan (cont'd):

Cash flows under the current policy Now 30 days

Produce first set of 1000 units at $90 apiece -90,000
Customers pay for 750 units at $147 apiece 88,200
Customers pay for 250 units at $150 apiece 60,000
Produce next set of 1000 units at $90 apiece -90,000
Customers pay for 750 units at $147 apiece 88,200
-1,800 60,000 - 1800
 Example 19.4a Evaluating a Change in
Credit Policy
Plan (cont'd):

Cash flows under the alternative policy Now 30 days

Produce first set of 980 units at $90 apiece -88,200
Customers pay for 980 units at $150 apiece 147,000
Produce next set of 1000 units at $90 apiece -88,200
-88,200 147,000 – 88,200
 Example 19.4a Evaluating a Change in
Credit Policy
Execute:
60,000  1,800
NPVcurrent  1,800   11,638,200
0.005
147,000  88,200
NPVnew  88,200   11,671,800
0.005

 So the NPV of the switch will be :

$11,671,800-11,638,200=$33,600
 Example 19.4a Evaluating a Change in
Credit Policy
Evaluate:
 You should make the switch because you will collect enough more from all
customers to make up for the loss of customers. The Valuation Principle
helps us weigh this tradeoff—the present value of the benefits outweighs
the present value of the costs, so the decision is a good one.
 19.3 Receivables Management

 Monitoring Accounts Receivable

 Accounts Receivable Days
 The average number of days that it takes a firm to collect on its sales
 Aging Schedule
 Categorizes accounts by the number of days they have been on the
firm’s books
 Can be prepared using either the number of accounts or the dollar
amount of the accounts receivable outstanding
 19.3 Receivables Management

 Monitoring Accounts Receivable

 Payments Patterns
 Provides information on the percentage of monthly sales that the firm
collects in each month after the sale
Table 19.2 Aging Schedules
 Example 19.5 Aging Schedules

Problem:
 Financial Training Systems (FTS) bills its accounts on terms of 3/10, net 30.
The firm’s accounts receivable include $100,000 that has been outstanding
for 10 or fewer days, $300,000 outstanding for 11 to 30 days, $100,000
outstanding for 31 to 40 days, $20,000 outstanding for 41 to 50 days,
$10,000 outstanding for 51 to 60 days, and $2,000 outstanding for more
than 60 days. Prepare an aging schedule for FTS.
 Example 19.5 Aging Schedules

Solution:
Plan:
 An aging schedule shows the amount and percent of total accounts
receivable outstanding for different lengths outstanding. With the available
information, we can calculate the aging schedule based on dollar amounts
outstanding.
 Example 19.5 Aging Schedules

Execute:
 Example 19.5 Aging Schedules

Evaluate:
 FTS does not have an excessive percent outstanding at the long-end of the
table (only 6% of their accounts receivable are more than 40 days
outstanding).
 Example 19.5a Aging Schedules

Problem:
 Bubba’s Bikes bills its accounts on terms of 2/10, net 30. The firm’s accounts
receivable include $5,000 that has been outstanding for 10 or fewer days,
$3,000 outstanding for 11 to 30 days, $2,000 outstanding for 31 to 40 days,
$1,500 outstanding for 41 to 50 days, $1,000 outstanding for 51 to 60 days,
and $500 outstanding for more than 60 days. Prepare an aging schedule for
Bubba’s.
 Example 19.5a Aging Schedules

Solution:
Plan:
 An aging schedule shows the amount and percent of total accounts
receivable outstanding for different lengths outstanding. With the available
information, we can calculate the aging schedule based on dollar amounts
outstanding.
 Example 19.5a Aging Schedules

Execute:

Days Amount Percentage

Outstanding Outstanding ($) Outstanding (%)
1-10 5000 38.46%
11-30 3000 23.08%
31-40 2000 15.38%
41-50 1500 11.54%
51-60 1000 7.69%
60+ 500 3.85%
13000 100.00%
 Example 19.5a Aging Schedules

Evaluate:
 Bubba’s has an excessive percent outstanding at the long-end of the table
(23.08% of their accounts receivable are more than 40 days outstanding).
 19.4 Payables Management

 Determining Accounts Payable Days Outstanding

 Firms should monitor their accounts payable to ensure that
they are making their payments at an optimal time
 Example 19.6 Accounts Payable
Management
Problem:
 The Rowd Company has an average accounts payable balance of $250,000.
Its average daily cost of goods sold is $14,000, and it receives terms of 2/15,
net 40, from its suppliers. Rowd chooses to forgo the discount. Is the firm
managing its accounts payable well?
 Example 19.6 Accounts Payable
Management

Solution:
Plan:
 Given Rowd’s AP balance and its daily COGS, we can compute
the average number of days it takes to pay its vendors by
dividing the average balance by the daily costs. Given the terms
from its suppliers, Rowd should either be paying on the 15th
day (the last possible day to get the discount), or on the 40th
day (the last possible day to pay). There is no benefit to paying
at any other time.
 Example 19.6 Accounts Payable
Management
Execute:
 Rowd’s accounts payable days outstanding is $250,000/$14,000 = 17.9 days.
If Rowd made payment three days earlier, it could take advantage of the 2%
discount. If for some reason it chooses to forgo the discount, it should not
be paying the full amount until the fortieth day.
 Example 19.6 Accounts Payable
Management
Evaluate:
 The firm is not managing its accounts payable well. The earlier it pays, the
sooner the cash leaves Rowd. Thus, the only reason to pay before the 40th
day is to receive the discount by paying before the fifteenth day. Paying on
the eighteenth day not only misses the discount, but costs the firm 22 days
(40 - 18) use of its cash.
 Example 19.6a Accounts Payable
Management
Problem:
 Bugs Bunny Baked Chicken (BBBC) has an average accounts payable balance
of $300,000. Its average daily cost of goods sold is $15,000, and it receives
terms of 2/15, net 35, from its suppliers. BBBC chooses to forgo the
discount. Is the firm managing its accounts payable well?
 Example 19.6a Accounts Payable
Management

Solution:
Plan:
 Given BBBC’s AP balance and its daily COGS, we can compute
the average number of days it takes to pay its vendors by
dividing the average balance by the daily costs. Given the terms
from its suppliers, BBBC should either be paying on the 15th
day (the last possible day to get the discount), or on the 35th
day (the last possible day to pay). There is no benefit to paying
at any other time.
 Example 19.6a Accounts Payable
Management
Execute
 BBBC’s accounts payable days outstanding is $300,000/$15,000 = 20 days. If
BBBC made payment five days earlier, it could take advantage of the 2%
discount. If for some reason it chooses to forgo the discount, it should not
be paying the full amount until the thirty fifth day.
 Example 19.6a Accounts Payable
Management
Evaluate
 The firm is not managing its accounts payable well. The earlier it pays, the
sooner the cash leaves BBBC. Thus, the only reason to pay before the 35th
day is to receive the discount by paying before the 15th day. Paying on the
20th day not only misses the discount, but costs the firm 15 days (35-20)
use of its cash.
 Example 19.6b Accounts Payable
Management
Problem:
 The HOH Company has an average accounts payable balance of $750,000.
Its average daily cost of goods sold is $50,000, and it receives terms of 2/10,
net 45, from its suppliers. HOH chooses to forgo the discount. Is the firm
managing its accounts payable well?
 Example 19.6b Accounts Payable
Management

Solution:
Plan:
 Given HOH’s AP balance and its daily COGS, we can compute
the average number of days it takes to pay its vendors by
dividing the average balance by the daily costs. Given the terms
from its suppliers, HOH should either be paying on the 10th
day (the last possible day to get the discount), or on the 45th
day (the last possible day to pay). There is no benefit to paying
at any other time.
 Example 19.6b Accounts Payable
Management
Execute:
 HOH’s accounts payable days outstanding is $750,000/$50,000 = 15.0 days.
If HOH made payment five days earlier, it could take advantage of the 2%
discount. If for some reason it chooses to forgo the discount, it should not
be paying the full amount until the 45th day.
 Example 19.6b Accounts Payable
Management
Evaluate:
 The firm is not managing its accounts payable well. The earlier it pays, the
sooner the cash leaves HOH. Thus, the only reason to pay before the 45th
day is to receive the discount by paying before the 10th day. Paying on the
15th day not only misses the discount, but costs the firm 30 days (45 - 15)
use of its cash.
 19.4 Payables Management

 Stretching Accounts Payable

 When a firm ignores a payment due period and pays later
 COD
 Cash On Delivery
 CBD
 Cash Before Delivery
 Example 19.7 Cost of Trade Credit with
Stretched Accounts Payable
Problem:
 What is the effective annual cost of credit terms of 1/15,
net 40, if the firm stretches the accounts payable to 60
days?
 Example 19.7 Cost of Trade Credit with
Stretched Accounts Payable
Solution:
Plan:
 First, we need to compute the interest rate per period. The 1%
discount means that on a $100 purchase, you can either pay
$99 in the discount period, or keep the $99 and pay $100 later.
Thus, you pay $1 interest on the $99. If you pay on time, then
this $1 in interest is over the 25 day period between the 15th
day and the 40th day. If you stretch, then this $1 in interest is
over the 45 day period between the 15th day and the 60th day.
 Example 19.7 Cost of Trade Credit with
Stretched Accounts Payable
Execute:
 The interest rate per period is $1/$99 = 1.01%. If the firm delays payment
until the sixtieth day, it has use of the funds for 45 days beyond the discount
period. There are 365/45 = 8.11 45-day periods in one year. Thus the
effective annual cost is (1.0101)8.11 – 1 = 0.0849, or 8.49%.
 Example 19.7 Cost of Trade Credit with
Stretched Accounts Payable
Evaluate:
 Paying on time corresponds to a 25-day credit period and there are 365/25
= 14.6 25-day periods in a year. Thus, if it pays on the 40th day, the effective
annual cost is (1.0101)14.6-1=.1580, or 15.8%. By stretching its payables, the
firm substantially reduces its effective cost of credit.
 Example 19.7a Cost of Trade Credit with
Stretched Accounts Payable
Problem:
 What is the effective annual cost of credit terms of 2/10, net 30, if the firm
stretches the accounts payable to 60 days?
 Example 19.7a Cost of Trade Credit with
Stretched Accounts Payable
Solution:
Plan:
 First, we need to compute the interest rate per period. The 2%
discount means that on a $100 purchase, you can either pay
$98 in the discount period, or keep the $98 and pay $100 later.
Thus, you pay $2 interest on the $98. If you pay on time, then
this $2 in interest is over the 20 day period between the 10th
day and the 30th day. If you stretch, then this $2 in interest is
over the 50 day period between the 10th day and the 60th day.
 Example 19.7a Cost of Trade Credit with
Stretched Accounts Payable
Execute:
 The interest rate per period is $2/$98 = 2.04%. If the firm delays payment
until the sixtieth day, it has use of the funds for 50 days beyond the discount
period. There are 365/50 = 7.3 50-day periods in one year. Thus the
effective annual cost is (1.0204)7.3 – 1 =0.1588, or 15.88%.
 Example 19.7a Cost of Trade Credit with
Stretched Accounts Payable
Evaluate:
 Paying on time corresponds to a 20-day credit period and there are 365/20
= 18.25 20-day periods in a year. Thus, if it pays on the 30th day, the effective
annual cost is (1.0204)18.25-1=0.4456, or 44.56%. By stretching its payables,
the firm substantially reduces its effective cost of credit.
 19.5 Inventory Management

 Benefits of Holding Inventory

 Inventory helps minimize the risk that the firm will not be able
to obtain an input it needs for production and helps avoid
stock-outs
 Factors such as seasonality in demand mean that customer
purchases do not perfectly match the most efficient production
cycle
 19.5 Inventory Management

 Costs of Holding Inventory

 Acquisition Costs
 Order Costs
 Carrying Costs
 19.5 Inventory Management

 Costs of Holding Inventory

 “Just-In-Time” (JIT) Inventory Management
 When a firm acquires inventory precisely when needed so that its
inventory balance is always zero, or very close to it
 19.6 Cash Management

 Motivation for Holding Cash

 Transactions Balance
 To meet its day-to-day needs
 Precautionary Balance
 To compensate for the uncertainty associated with its cash flows
 Compensating Balance
 To satisfy bank requirements
 19.6 Cash Management

 Alternative Investments
 There are several short-term securities that firms with excess
cash can invest in
Table 19.3
Money Market
Investment
Options
 Chapter Quiz

1. How does working capital impact a firm’s value?

2. What are the three factors that determine the collection
float?
3. What is the difference between accounts receivable days and
an aging schedule?
4. What is the optimal time for a firm to pay its accounts
payable?
5. What are the direct costs of holding inventory?
6. List three reasons why a firm holds cash.