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Since about half of the typical firms capital is invested
in current assets, decisions need to be made on
managing the working capital at its optimum level as
well as deciding on ways of financing them.






Learning objectives

After learning this chapter, you should be able to:

1. Describe the concept of working capital
2. Determine the optimal cash balance
3. Make decision on choosing marketable securities
4. Make decision on credit policy
5. Calculate economic order quantity for inventory.




Working Capital
Management
GOAL
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6.0 INTRODUCTION

Working capital management involves day-to-day decisions regarding investment in current
assets and how these assets are to be financed. It concerns with all aspects of the
administration of the firm's current assets and current liabilities and involves making
decisions regarding:

1. the appropriate levels and mix of current assets,
2. the appropriate levels and mix of current liabilities

These decisions must be based on the firm's need for adequate liquidity that is sufficient
cash on hand to meet all short-term obligations. It will affect the firm's riskiness and the
expected rate of return, and hence its value. The effects of these decisions on larger firms
are less drastic compared to smaller firms due to their flexible financing sources. However, it
can significantly affect its risk, return, and share price.

Failure to manage the current assets' components effectively and efficiently will lead to
financial problems that may force the company into technical insolvency, and eventually
bankruptcy. Low investment in current assets could lead to financial distress and
complications, but relatively high investments will result in lower productivity of assets and
lower profits. This interplay of risk-return trade-off must be considered explicitly when making
decisions without fail. For example a cash shortage will results in the following sequence of
events:

1. Delays of payment to creditors and suppliers,
2. Inability to secure materials,
3. Low production levels due to lack of materials,
4. Less amount of finished goods available for sales,
5. Low cash flows due to lack of sales resulting in further cash shortages, and
6. Eventually the company will face technical insolvency and bankruptcy.

The challenge is therefore to decide a proper mix of current assets holding that strike a
balance between the to maintain certain level of profitability with appropriate level of risk.
This chapter specifically deals with the management techniques and identification of risk-
return tradeoff in managing the major components of current assets that is cash and
marketable securities, receivable and inventories in details.
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6.1 MANAGEMENT OF CAPITAL WORKING CAPITAL

The objective of managing working capital is to achieve risk-return tradeoff that maximizes
the value of the firm. As such, current assets must be available at all time to support the
firm's operations while maintaining its holdings to a minimum amount to reduce investment
and, hence the cost of financing. There are three basic policies that the company can adopt
that are relaxed policy, restricted policy, and moderate policy.

Relaxed policy

This is a low risk policy; whereby the firm will maintains large amount of current
assets coupled with liberal credit policy. It has high liquidity, and potentially low return
from investments due to low productivity of current assets relative to fixed asset.

Restricted policy

On the other hand, restricted policy is a high-risk policy whereby current assets'
holding is reduced to a minimum coupled with stringent credit policy. Lower
investments in current assets enable the firm to increase investment in other
productive investments, and thus will results in higher returns.

Moderate policy

This is a middle of the road policy in between relaxed and restricted policies. It will
result in moderate risk and returns. High current assets' investments such under
relaxed policy will reduce risk of technical insolvency, but at the same time it will
results in lower returns due to lower productivity of current assets. Therefore,
investment in current assets should be at a minimum level without sacrificing the
liquidity requirements. As such more funds are available for investment in fixed
assets that are more productive.

The use of current liabilities or short term financing to finance current assets are
generally less expensive than long-term financing such as long-term debt, preferred
stock, and common equity. Short-term financing represents a relatively lower cost of
capital and could improve the firm's profitability. Consequently, aggressive use of
short-term financing led to a decrease in net working capital, and hence increases
the risk of insolvency.


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6.1.1 Working Capital Strategies

Working capital strategies range from the aggressive to the conservative
approach, in which each will produce different levels of profitability and risk
exposure. To the extreme, aggressive policy sacrifices safety or liquidity for
return, and conservative policy sacrifices return for safety. Under whatever
conditions, the basic risk-return tradeoffs will definitely apply; higher return is
a result of corresponding higher risk.

A typical firm normally has production and sales cycles that vary during the
course of operations. These cycles will result in accumulation and depletion of
the firm's current assets, and therefore its value will fluctuate over time. This
suggests that certain current assets are temporary in nature and others are
permanent.
Permanent Assets

It refers to all assets, fixed of current, that are necessary for the firm to
hold at all time regardless of the firm's sales level. Fixed assets are
permanent in nature since it is inflexible in the short-term.
Simultaneously, certain amount of current assets should be on hand
to support operations even if the sales activity is at the lowest such as
a minimum amount of cash. This part of current assets is, therefore
regarded as permanent.

Temporary Assets

It refers to part of current assets that fluctuate directly with changes in
sales level. It is the additional current assets required to support the
increase in sales. This principle work hand in hand with the principles
presented in chapter 6, percent of sales method.

Similarly, the above classifications will also apply to liabilities and
equity. All equity, long-term debts are permanent source of funds.
Certain components of short-term borrowing or current liabilities are
permanent in nature to finance permanent current assets. Others are
temporary to support the need for temporary current assets'
investments.

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The working capital strategies or approaches presented in the
following sections will show the methods of financing these assets. In
each of the approaches presented, the total requirements to finance
temporary current assets are net of spontaneous financing generated
from spontaneous liabilities; such as from accounts payable and
accruals.

Hedging Approach

The hedging approach is where the firm uses temporary financing to
finance temporary current assets (TCA), and permanent financing to
finance permanent assets (FA plus PCA). Therefore, this strategy is in
line with traditional notion where financing maturities should match
with the assets' requirement. Refer to Figure 6-1 for graphic
illustrations.

Figure 6-1 The Hedging Approach

Ringgits



TCA

PCA

FA

Time

Since the approach matches the financing duration and the assets'
requirements, there is no need for emergency funds and idle funds are
non-existence. This approach results in moderate risk with moderate
returns. A firm wishing to adopt a financially aggressive or
conservative approach may modify the above approach by focusing
on using more of temporary financing or permanent financing
respectively.




Short-term or Temporary
financing
Permanent plus
spontaneous financing

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Aggressive Approach

This strategy involves more risk, as it uses short-term or temporary
financing to support a relatively large portion of current assets. In this
approach, a firm would finance all fixed assets and part of permanent
current assets with long-term financing. The firm will resort to short-
term financing to finance the remaining permanent current assets and
temporary current assets. Current ratio under this approach is low and
may equal to less than one. Refer to Figure 6-2 for graphic illustration.

Figure 6-2 The Aggressive Approach


Ringgits



TCA

PCA

FA

Time

Conservative Approach

This approach has the lowest risk among the working capital
approaches. It uses permanent financing to finance the majority of its
assets that includes all permanent assets and part of temporary
assets. It will resort to the use of temporary financing only for peak
requirements or when total assets exceed permanent financing.
Therefore, the firm assured of the availability of funds even during
period of tight money supply. During low requirements, a firm will
invest its excess funds in marketable securities as shown in Figure
6-3.





Short-term or Temporary
financing
Permanent plus
spontaneous financing

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Figure 6-3 The Conservative Approach


Ringgits



TCA

PCA

FA

Time


Most of the time the firm will have excess liquidity and this reduces the
need for temporary financing, hence it results in lower risk of technical
insolvency. Conversely, the returns are low. This is due to higher
costs of permanent financing and low returns from marketable
securities investment. Both of these factors combined will result in a
relatively low average return.
Given the three alternative strategies, which approach to maintain
appropriate level of liquidity or margin of safety is the best? There is
no right answer, and it will depend on:
1. The profitability of the firm;
2. The stability of cash flows;
3. The liquidity of the firm's assets;
4. The management attitude towards risk and
5. The expected future interest rates.

The higher the levels of profitability, stability of cash flows and liquidity
of assets tend to reduce the need for current assets to achieve the
desired level of protection against technical insolvency. Other thing
being equal, these conditions may suggest a more aggressive
approach is appropriate. On the other hand, if the above conditions
are reversed, a more conservative approach is more appropriate.

In the case of interest rates, the expectation of higher future rates will
lead to more use of long-term financing. This will ensure that the firm
Short-term or Temporary
financing
Permanent plus
spontaneous financing

.
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is able to enjoy a lower interest rate although the rate goes up later. In
this case, hedging and conservative approaches are most likely to be
adopted. Due to the differences in industry liquidity, it is necessary to
analyze the liquidity requirements or current ratio of the firm
accordingly, relative to the firm's stage of operations and management
attitudes.

Risk and Return Tradeoff

To illustrate the effects of the working capital strategies on risk-return
tradeoffs, consider the following examples in Table 6-1. Assume that
Miasma Company is trying to decide the alternative approach to
manage working capital ranging from conservative to aggressive
strategies, while its total assets' components remain constant.

Table 6.1 shows that the return on equity is lowest for the
conservative approach and highest for aggressive approach. This
relates directly to the liquidity and risk position for each of the
approaches; with current assets to current liabilities' ratio of 6:1 (=120
/ 20), 3:1 (=120 / 40), and 1.7:1 (=120 / 70) for conservative, hedging,
and aggressive respectively. Thus, expected return from aggressive
approach should be higher relative to its risk. Financial data in Table
6.1 will substantiate this.

Table 6-1 Effects of Working Capital Strategies on Return on Equity

In thousands of RM

Assets Conservative Hedging Aggressive
Current assets 120.00 120.00 120.00
Fixed assets 120.00 120.00 120.00
Total assets 240.00 240.00 240.00



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Liabilities and Equity
Accounts payable 20.00 20.00 40.00
Notes payable
a
(10%) 0.00 20.00 30.00
Long term debt
b
(15%) 60.00 40.00 10.00
Equity 160.00 160.00 160.00
Total claims 240.00 240.00 240.00

EBIT/Operating Income 50.00 50.00 50.00
Interest (a +b) 9.00 8.00 4.50
Earnings before taxes 41.00 42.00 45.50
Taxes (40%) 16.40 16.80 18.20
Earnings after taxes 24.60 25.20 27.30
Return on equity 15.38% 15.75% 17.06%


6.2 MANAGEMENT OF CASH
Cash is defined as coins and currency plus demand deposit accounts that are available to
meet immediate payments. It is the most liquid among the firm's asset and often called a
"non earning asset" as its holdings give no return, but are needed to meet all types of
payments required by the firm, without which the firm cannot operate. Therefore, it is crucial
for the firm to hold minimum amount of cash sufficiently to support its normal business
activities. This is crucial for the firm to balance between: (1) the needs for liquidity to meet
maturing obligations, and (2) for profitability by reducing cash holdings. Firms hold cash for
several reasons or motives such as for:

1. Transaction demand. Cash for transaction balances is necessary to meet
obligations or payments arising from normal business activities such as payments for
purchases, wages, taxes, dividends, and etceteras. It relates to day-to-day payments
and collections associated with the business activity.

2. Precautionary demand. The precautionary balances are the "safety stock" of cash
necessary for the firm to meet the unexpected contingencies. The amount the firm
must hold will depend on the predictability of its cash flows; if less predictable, the
larger such balances should be.

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3. Speculative demand. The holding of speculative balances will enable the firm to
take advantage of any investment opportunities or bargain purchases that might arise
in the future.
4. Compensating balances. The compensating balances are necessary to
compensate financial institutions for providing loans and services. It requires that the
firm maintain minimum level of money in its bank's account, normally based on
certain percentage of the loans taken.

With the advancement and development of financial securities, the need to hold cash for
precautionary and speculative purposes seems unnecessary. This is because the cash
requirements can readily be met by borrowed funds and any excess cash is invested in
short-term or marketable securities.
6.2.1 Cash Management Activity

The goal of cash management is to minimize the cash balance while
maintaining certain level of liquidity. Too much liquidity reduces return,
whereas too little, increases risk exposure. As outlined in Figure 6-1, cash
management activity consists of several areas.

Cash Flow management

The cash flow management involves the process of controlling the
cash movement, inflows, and outflows, of the firm to minimize the
cash required to support working capital. Slowing disbursements and
speeding up collections can do this. In addition, it is to the firm's
advantage to maintain good banking relationships so as banking
transactions can be done with ease.

Estimation cash requirements

The estimation of cash requirements involves the preparation of cash
budget, which allow the firm to plan, coordinate, and control the actual
cash flow through the firm. Once the cash flow has been estimated,
the appropriate level of cash holdings can be established.




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Developing borrowing or investment strategies

With the establishment of the appropriate cash balance, the strategies
to finance any cash shortfalls can be developed ahead of time. In case
of cash excess, effective investment strategies can be developed to
use the idle temporary liquidity and earn return.
The cash management activity as outlined in Figure 6-4 and the cash
flow cycle in chapter 9, involves many aspects of the firm's operations.
It relates directly to the management of inventories, marketable
securities portfolio, notes payable, account payable, and account
receivable. Therefore, the management of cash is of utmost important
to the firm as famous quotation puts it "the cash will take care of the
profits if the firm takes care of the cash."
Figure 6-4 The Cash Management Activity

Speeding up
receipts




Slowing down
disbursement
Management of
firm cash flows
Cash
budgeting

Maintaining
good banking
relationship
Determining
the optimal
cash balances



Short-term financing
strategies for cash
shortfalls
Marketable securities
investment strategies for
cash excess



1. Strategies of an efficient cash management
There are several strategies of an efficient cash management
a) Make all payments such as accounts payable as late
as possible without damaging the firms credit rating.
However at the same time we must take advantage of
any favourable cash discounts offered by the suppliers.

b) Make all collections such as accounts receivable as
soon as possible without losing future sales and use
cash discounts to encourage early payments of
accounts receivable
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c) Turn over the inventory as quickly as possible and
avoiding stockouts that might result in shutting down
the production line or any loss in sales.

2. Determining Minimum Operating Cash (MOC)

Since the objective of a firm is to run the business effectively
without running out of cash, a firm must keep the minimum cash
balance. By keeping this amount (MOC) it will allow the firm to
invest in various alternatives and to repay debts when they are
due.

Cash balances and safety stock of cash are influenced by the
firms production and sales techniques and procedure for
collecting sales receipt and payment for purchases or
operating cycle and cash cycle.

Therefore by efficiently managing these cycles, the financial
manager can maintain a low level of cash investment and
thereby contribute towards maximizing the share value

6.2.2 Operating Cycle, Cash Cycle and Cash Turnover

The operating cycle (OC) is the lag time in days between the purchase of
raw materials and the time cash is collected from sales of finished goods or
receivables. Consequently, cash cycle (CC) is the lag time between cash
outlay to purchase raw materials or inventories and cash is collected from
receivables. Therefore, CC is the amount of time the firm's capital is tied up in
inventories sold. To illustrate this concept, refer to Figure 6.5 that shows the
movement of goods and cash in a normal business operation.





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Figure 6-5 The Operating Cycle, Cash Cycle, and Cash Turnover in Days


OC =110
AAI =70 ACP =40

Purchase raw materials on credit Sell finished goods on credit
Accounts payable Accounts receivable


0 10 20 30 40 50 60 70 80 90 100 110


Pay accounts payable Collect accounts receivable
Cash outflows Cash inflows
APP =30 CC =80

The cash cycle equals to:

OC
0
=Average age of inventory (AAI) +Average collection period (ACP)
=70 days +40 days
=110 days

CC
0

=Average age of inventory (AAI) +Average collection period (ACP)
Average payment period (APP)
=70 days +40 days 30 days
=80 days

Since cash cycle is a measure of the amount of time cash tied up, lower
operating cycle and cash cycle is better as the firm could recover the cash
outlay in a shorter period.

Another measure of how effective cash is managed in the firm is the cash
turnover (CTO). It refers to the number of times the firm's cash is actually
turned over each year and can be calculated as follows:

CTO
0

=360 /Cash cycle
=360 / 80
=4.5 times

The firm's cash cycles directly affect the amount of cash that need to be held
at any given time to support the operations. This amount represents the
minimum operating cash (MOC) to avoid any cash shortages in meeting all
its payments. To illustrate, let assume that firm's annual cash expenditures or
outlays are expected at RM300,000.
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MOC
0

=Annual Cash Outlays / Cash turnover
=300,000 / 4.5
=RM66,666.67

Therefore, the firm needs RM66,666.67 as a minimum cash requirement to
support the firm's day-to-day operations without risk of technical insolvency.
This represents a large investment for the company, and it is crucial to
minimize cash cycle and maximize cash turnover, without scarifying the firm's
liquidity and profitability. This can be done by managing the basic elements of
cash cycle that includes accounts payable (APP), accounts receivable (ACP),
and inventories (AAI). There are several strategies to reduce the cash cycles,
hence increase its turnover:

1. Increasing Average Payment Period. It involves delaying payments
on accounts payable as late as possible (ALAP) without damaging the
firm's credit rating. In addition, favorable cash discount should not be
ignored, as the opportunity cost is high if not taken.

2. Reducing Average Inventory of Age. This is to increase inventory
turnover as quickly as possible by: (1) efficient management of
inventories, (2) better production planning, scheduling, and control, (3)
effective sales forecasting, and (4) synchronize the production and
demand.

3. Reducing Average Collection Period. It involves speeding up
collection of account receivable as soon as possible (ASAP) without
losing potential sales. The use of proper techniques such as changes
in credit policies and collection policies that will improve collection
period will benefits the company.

The implementations of the above strategies will reduce cash cycles, and
thus will result in freeing some of the capital tied up in inventories and
account receivable. The freed capital, are available for other investment
opportunities that could provide additional return to the firm and/or reduces
the cost of financing.
To illustrate, let assume that the company in the above example able to:

1. Negotiate a better credit term with its suppliers from net 30 to net 35;
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2. Improve production process and selling effectiveness that reduces
average age of inventory by 10 days to 60 days; and
3. Decrease average collection period by 7 days to 33 days by changing
its credit terms.

Other things being equal, the above changes are expected to improve the
firm's performance, as it will result in lower of cash cycle, higher cash turnover
and lower minimum operating cash.
OC
1

=60 days +33 days
=93 days.

CC
1

=60 days +33 days 35 days
=58 days.

CTO
1

=360 / 58
=6.21 times

MOC
1

=300,000 / 6.21
=RM48,309.17

The above changes will have several impacts:

1. Shorter operating cycle, cash cycle, and thus higher cash turnover.

Change in OC =OC
1

OC
0

=110 93
=(17 days)

Change in CC =CC
1

CC
0

=58 80
=(22 days)

Change in CTO =CTO
1

CTO
0

=6.21 4.5
=1.71 times
2. Lower minimum operating cash requirements, and hence lower
investment in cash to support the firm's operations.

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Change in investment MOC =MOC
1

MOC
0

=48,309.17 66,666.67
=(RM18,357.50)

3. Lower cost of financing and higher profits. If the cost of funds is at 10
percent, the firm can realize a yearly saving of RM1,835.75.

Change in cost of financing =Change in MOC (Cost of funds)
=(18,357.50)(0.10)
=(RM1,835.75)

The effects of lower cash cycle are quite significant for large firms with cash
reserves and cash outlays that run in millions of Ringgits. Proper cash
management will have a direct impact on the firm's liquidity and profits. These
represent a tradeoff that needs to be balanced to ensure that all obligations
can be met without sacrificing the needs for higher profits.

Determine an optimal Cash Balance

To determine a firms desired cash level or an optimal amount of cash,
it involves a tradeoff between the opportunity costs of holding too
much cash (carrying costs) and the costs of holding too little cash
(trading costs.)

If a firm tries to keep its cash holding too low, it will be running out of
cash more often than is desirable and thus leads to selling marketable
securities more frequently. Therefore, trading costs will be high when
the size of cash balance is low and vice versa.

In contrast, the opportunity costs of holding cash are very low if the
firm holds very little cash. These costs will increase as the cash
holdings rise because the firm is giving up more and more in interests
(return) that would be earned. An example of trading cost is brokerage
fees or underwriting fees whereas an example of carrying cost is
interest expense. The sum of these costs is shown by the total cost
curve in the diagram below:


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Figure 6-6 Total Cost Curve








From the diagram we can see that the more a firm holds cash, the
lower will be the trading cost. A firm does not have to convert so
many times from marketable securities to cash or vice versa because
it already holds too much cash

At point C* as shown, the minimum total costs occur where these two
individual cost curves crossed. At this point the carrying cost and
trading cost are equal. Therefore this is the optimal cash balance that
the firm should have.

Baumol Model

Baumol Model try to analyze the companys cash management
problem i.e. to establish the target cash balance

It is an economic model that determines the optimal cash balance by
using Economic Order Quantity (EOQ) concepts. This model
balances the opportunity cost of holding cash (Cc) against the trading
cost (Fc) associated with replenishing the cash account by selling off
marketable securities by borrowing.

Thus, the optimal cash transfer will be :

C* = 2(F
c
) T
C
c


Where C* = optimal cash balance
Fc = trading cost
T = total amount of cash needed in a year
C
c
= opportunity cost of carrying cash
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Total costs of cash balances consist of total opportunity cost of
carrying cash and total trading cost of holding cash, so

TC = TC
c
+TF
c


= C*(Cc) +T (F
c
)
2C*

The minimum total costs are achieved when C* is at the optimal cash
transfer.

Example:

ABC Company start at week O with cash balance of RM1.2 million.
Each week cash outflow MORE than cash inflow by RM600,000. By
the second week RM1.2 will be gone, Cash Balance =0

Cash Balance

Start RM1.2 million
RM2.4 million

Average RM600,000
RM1.2 million

0 1 2 3 4 5
weeks


By the end of the 2
nd
week, RM1.2 million has to replenished

If Company start with lower cash balance last for 1 week will
decrease.

Company has to replenish more often, average balance to
RM300,000. Company will sell securities more often that will result in
higher Trading cost. (brokerage charges will increase)




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In order to determine the optimal strategy, the company need to
know 3 things

1. F - Fixed Cost of making securities trade to
replenish cash

2. T - Total amount of cash needed over planning
period

3. R - is the opportunity cost of holding cash i.e. the
interest rate on marketable securities

With this information, ABC can determine the total costs of any
particular cash balance policy i.e. optimal cash balance policy.

SOLD Co. has cash outflow of RM100/day
Interest rate is 5%
Fixed Cost of replenishing cash balance is RM10 per transaction

T Total cash needed for the year
RM100 x 365 = RM36,500
R 5%
F RM10% per transaction

1. C = 2T x F Opportunity Cost = Trading cost
R
C x R = T x F
2
(Optimal Initial
Cash Balance) C
2
= 2T x F
R

= 2 x RM36500
.05

= 14.6 million

Therefore C = RM3,821


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2. Average Cash Balance =C = 3.821 = RM1, 911
2 2

3. Opportunity Cost =C x R
2

=RM3,821 x 0.5 = RM 96
2

Trading Cost =T x F
C

= RM36, 500 x RM10
RM3, 821

= RM96
If Company decides to convert their cash 10 times in a year
Therefore C = RM36, 500 =RM3, 650
10 times

Therefore The New Total Cost =[RM3,650 x 0.5]+[RM36,500 x RM10]
3,650

= RM912.50 +RM100

= RM1012.50

To Determine the Opportunity Cost Of Holding Cash
We therefore have to find how much interest if forgone (on average
balance).

Therefore Opportunity = Average Cash Balance x interest Rate
Cost
i.e. = C x R
2

Example:

If the initial cash balance per year is RM1.2 million,
the average cash = RM1.2
2

= RM600,000


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If 10% interest could be earned,
Therefore Opportunity Cost = RM600,000 x 10%
= RM60,000 (to give up i.e. the
Lost)

To determine Trading Cost

We need to know how many times ABC Company will have to sell
marketable securities during the year?

Amount of cash needed = RM600,000/Week x 52 weeks = RM31,200,000
Cash needed per week Initial cash per week RM1, 200,000

= 26 times per year
From the above illustration, it is shown that increased in opportunity
cost will increase the cash average balance

If Fixed Cost per transaction is RM1,000
Trading = 26 times x RM1, 000 per transaction
Cost in a year

= T x F
c

C

= RM31.2 million x RM1,000
RM1.2 million

= RM26, 000 per year

Therefore, Opportunity Cost +Trading Cost = Total Cost
+RM26 million = RM86 million
This is not optimal
initial Cash balance
because Opportunity
Cost/Trading Cost

In order to get optimal initial cash balance, you have to use Baumol
Model as explained earlier

i.e. C = 2T x FC
R

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Assumptions on the model:

1. Cash inflow and cash outflow are certain

2. It does not take into account any seasonal or cyclical trends


Implications of the model:

1. The higher the interest rate (opportunity cost), the lower will be
the optimal cash balances

2. The higher the trading cost, the higher will be the optimal cash
balance.

6.2.3 Management of Marketable Securities

The management of cash and marketable securities, in reality cannot be
separated as marketable securities are near-cash items and considered as
part of cash. This is particularly important in the management of the firm's
cash reserve that acts as a "cushion" against technical insolvency. The cash
reserve decisions involve the determination of: (1) appropriate level of liquidity
requirement; and (2) appropriate mix of cash and marketable securities.

Marketable securities are as liquids as cash as it takes a relatively short time
for its conversion to cash without losing the face value. In essence, it
represents a storehouse of liquidity in which to absorb any cash excess and
to convert to cash when the need for cash arises. Due to its nature, it serves
as an investment vehicle for full utilization of idle cash that could provide
some return from the investment. There are two reasons or motives for
holding marketable securities:
1. As a substitute for cash. In many cases, the firm holds marketable
securities for precautionary purposes as a cushion against
unexpected shortage of bank credit and other emergency cash
outflows. Most firms tend to rely on short-term bank credit such as
overdraft for transactions and speculative purposes.

2. As a temporary investment This reason is very important as firm's
cash receipts rarely match its disbursement. The firm invests cash
temporarily in marketable securities to: (1) finance seasonal or cyclical
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need for cash; and (2) meet known future financial requirements. For
example, idle funds available for future dividend payments are
temporarily available for investment in marketable securities that
provides some return before its actual use.

For whatever motives the investments in marketable securities are for, it will
provide return from the investments of idle funds. The marketable securities
portfolio consists of different types of securities that differ in: (1) maturity; (2)
liquidity; and (3) returns.

6.2.4 The Portfolio Selection Process and Criteria

The investment decisions concerning the marketable securities portfolio
should explicitly consider the availability of cash in terms of its amount and its
need in relation to the firm's cash flows. This is in line with its purpose of
investment as a substitute for cash. At times, the need for cash arises in a
relatively short notice that forces the firm to liquidate its marketable securities
holdings on demand.

To meet these stringent requirements, the choice of securities in the portfolio
is in accordance to the nature of cash available for investment: (1) ready cash
segment for immediate cash needs; (2) controllable cash segment for
expenditures that are predictable; and (3) cash segment for speculative
purposes.
Ready cash segment (RCS)

It represents cash on call and requires investment in high liquidity
securities. This factor is very important as it guards against the
unexpected cash flows that may occur in the firm, such as the cash
receipts are lower than expected.

Controllable cash segment (CCS)

Unlike ready cash segment, controllable cash segment gives less
emphasis on liquidity. The expected timing and amount of cash
disbursement is known with relative certainty, such as cash for tax and
dividend payment. The cash investment is for the duration of idle time
before it is liquidated to meet the expected cash outflow.
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Free cash segment (FCS)

The cash from this segment is normally for speculative purposes, in
which there is no immediate need for the cash involved. Therefore,
yield rather than liquidity is the main criteria in investment to ensure
high return with some degree of safety.

In addition to the above constraints that focus on cash needs, the
individual characteristics of the securities involved represent a major
criterion in marketable securities selection. The risk-return tradeoffs'
factors will play a major role in determining the proper types of
securities a firm will hold. Factors influencing the choice of marketable
securities are:

1. Security. It concerns with the safety of the principal
investment due to the risk of default in principal or interest
payment and capital loss. The risk involved should be at a
minimum level.

2. Liquidity. Another measure of risk is the marketability of the
securities involved. It refers to the ease of converting the
securities to cash without losing the face value. Securities that
have market demand are highly liquid and will satisfy the cash
demand.

3. Yields. The yields or returns are not as important as the first
two factors. It represents a tradeoff between risk and returns in
choosing marketable securities. Given the purpose of the
portfolio as temporary investment and substitute for cash,
yields should be the deciding factor only after both security and
liquidity is accounted for.

Other factors such as event risk, interest rate risk, and inflation risk also
influence the choice of marketable securities. Any event or variables that may
affect the safety, liquidity, and yields of the securities should not be ignored
deciding which marketable securities should be invested in. Thus, proper
analysis of risk-return tradeoffs is necessary in determining the appropriate
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mix of the marketable securities portfolio, so as the investment serves both as
support for liquidity and profitability.

6.2.5 Alternative Investments

In the money market, there are wide ranges of marketable securities
available, which carry various characteristics. The issuers of short-term
securities are either government issues such as treasury bills, or private
issues such as commercial paper.

Treasury bills (T-bills)

It is a Government Issue, and represents the obligation of the
Treasury Department. Most of the T-bills mature in 91-182 days, with
longer maturity such as 9 months or one year are available from time
to time and in smaller amount. The treasury holds a weekly auction at
a discount with the smallest denomination of RM1,000 and considered
as risk-free. Evaluations: High liquidity with strong secondary market,
lowest risk, low return, and caters for segments RCS and CCS.

Treasury notes (T-notes)

Similar to T-bills in that it is the obligations of the Treasury
department. However, its initial maturity is between 1-7 years. T-notes
are part of the marketable securities portfolio because of its high
security and liquidity. Evaluations: High liquidity with strong secondary
market, lowest risk, return is slightly higher than T-bill, and caters for
segments RCS and CCS.

Negotiable certificate of deposits (CDs)

Is a negotiable instrument as an evidence of deposit in a commercial
bank. The amount (smallest RM100,000) and the maturity (commonly
30 days) are dependent on the investor's (depositor's) needs.
Evaluations: High liquidity with strong secondary market, moderate
risk that depends on the bank involved high return and for caters
segments RCS and CCS.


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Commercial paper (CP)

Commercial paper is a short-term unsecured promissory note issued
by a large firm with high credit standing. Maturity ranging from 3-270
days, as longer maturity requires a formal registration. Evaluations:
Low liquidity with weak secondary market, moderate risk that depends
on the issuer, return is slightly lower than CDs, and caters for segment
CCS.

Banker's acceptance (BAs)

It is similar to cashier's check payable in future, with typical maturity of
30 days or 180 days. Banker's acceptance arises from a short-term
credit arrangement between purchaser and its bank for financing
certain transactions. The purchaser with its bank approval issues a
draft, on which payment is contingent on some events, to the seller for
the amount purchased. The seller who holds BAs, then may sell it at a
discount in the secondary market to obtain immediate funds.
Evaluations: High liquidity with strong secondary market, moderate
risks since it involves three parties, high return similar to CP, and
caters for segments RCS and CCS.

Other types of securities are available for investment that can be
included in the marketable securities portfolio. The five securities
presented above are the most commonly available and demanded in
the money market. As for Malaysian money market, major securities
are: (1) Bankers acceptance; (2) negotiable money market
instruments; (3) Malaysian government securities; (4) Malaysian
government treasury bills; and (5) Cagamas bonds.

The cash management and marketable securities management are
highly dependent on each other, and therefore it must be managed
concurrently. These two liquid assets represent the firm's liquidity that
will determine its long-term viability and ability to increase
stockholders' wealth.


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6.3 MANAGEMENT OF ACCOUNT RECIEVABLE

Accounts receivable is the outstanding amount owed to a firm by its customers from credit
sales. Most of the time it represents a significant part of the firm's current asset investment
and need to be managed effectively. The size of investment in accounts receivable, at any
given time, is a function of:

1. The volume of credit sales; and
2. The average collection period.

Both of these factors have a direct relationship with the firm's credit and collection policies.
Since accounts receivable is an important link in the working capital management, the
establishment and implementation of these policies will have a direct impact on the firm's
operations and profitability as a whole.

6.3.1 Credit Policy

Credit policy is a system or procedures in managing accounts receivable that
includes credit standards, credit terms, and collection activities. Some
policies are sales oriented and accept higher risk, while others are
conservative and sacrifices' sales for safety.

The use of credit or accounts receivable to attract sales is not without costs.
It involves explicit opportunity cost of investment in receivables and thus,
demands careful analysis in deciding the appropriate credit policy for
adoption. It involves a cost-benefit or risk-return tradeoff analysis to ensure
that the investment will contribute enough or more revenues to compensate
the costs involved, hence will ultimately increase the firm's value.

Credit Standards

The credit standard provides the basis for specifying acceptable levels
of credit risk that a firm is willing to bear and in deciding who will
receive credit. In essence, it looks at the minimum financial strengths
and moral standings the applicants should have in order to receive the
credit facilities.

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The purpose of credit standards is to screen potential credit customers
for their ability and willingness to pay the credit facilities given. The
determination of credit risks focuses on several specific factors that
are known as 6C's of credit.
a) Character. A customer's character will determine his
willingness to pay. It is a measure of his moral obligations to
fulfill his promise, and can be determined by looking at his
business and social reputation, his past payment records,
other factors or events that affects his character.

b) Capacity. The capacity is a function of cash flow and will
determine a customer's ability to pay. This involves his ability
to manage the business in generating revenues and meet all
current obligations without affecting his business operations.

c) Capital. The capital will determine a customer's ability to pay.
It concerns with the availability of resources in possession, or
the ability to generate resources to pay debt when due. The
particular factor focuses on the customer's net working capital
as it represents the margin of safety offered to short term
creditors. Other capital such as fixed assets is not available to
pay creditors, unless it is liquidated or mortgaged.

d) Conditions. The conditions concerned with uncontrollable
factors with may affect a customer's operations, hence his
ability to pay. The firm must anticipate existence of external
factors such as: (1) changes in business environment; (2)
political instability; (3) changes in social values; and (4) other
factors that may affect firm's cash flow.

e) Collateral. In most commercial bank loans, collateral is a
perquisite before granting a loan. Collateral, whether tangible
or intangible assets, offers to the bank as commitment, is a
guarantee that the debt will be paid on time. In order to be
acceptable as collateral, the assets must have value, liquid,
and transferable.
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f) Coverage. It refers to the extent the firm is covered with
insurance policy. This is to ensure the firm's ability to start over
or meet payment in case of major disaster.

Because of the subjective nature of the credit risk evaluations, most
firms attempt to classify their customers in several risk classifications,
in accordance to the expected risk of bad debt or default of payment.

a) Most desirable. These are top-rated customers, and are in a
firm's preferred list. This group of customers requires a
minimum supervision or reviews as the risk involved is very
low; minimal risk with low potential for problems.

b) Desirable. These are customers with good ratings, but below
the first group. This group of customers requires more
supervision compared to the top rated customers.

c) Average. These are customers with fair to good ratings, and
may represent a large proportion of the firm's customers. The
firm will have no problems of default under normal economic
circumstances. However, slow payments can occur under
adverse conditions, and therefore need more supervision.

d) Marginal. This group of customers is the least desirable
accounts. Careful screening and close supervisions are
necessary to reduce risk. The accounts involved have the
potential of becoming bad debts under adverse economic
conditions.

It is to the firm's interest to get the best customer mix by ensuring that
the majority of customers are in the first two groups. However, they
actually represent a minority group. Most customers are either
average or marginal. As a rule of thumb, marginal customers should
be part of the customer mix, and 10 percent is a comfortable limit.
Beyond 10 percent mix, a firm is absorbing higher risk than it should
have
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Credit Terms

The credit terms dictate the conditions under which credit given to
customers. It concerns with: (1) cash discount for early payment; (2)
discount period; (3) the length of time credit outstanding; and (4)
financial charges for late payment, if any. The most common credit
and/or payment terms are:

a) Open terms. A line of credit is granted.

b) Cash before delivery (CBD). A firm must receive cash before
deliveries can be made. No risk involved, as no credit is
granted.

c) Cash in advance (CIA). Similar to CBD.

d) Cash with order (CWO). Similar to CBD.

e) Cash on delivery (COD). Customer will pay for shipment or
goods when it is received. Some risk involves as customer
may refuse to accept the shipments or give bad checks.

f) Net 30. Payment in full is due full within 30 days after date of
shipment.

g) Net 10 EOM. EOM stands for end of month. A payment in full
is due before the tenth day of the month following shipment.
For example if the shipment is in J anuary, the due date is
before February the 10th. Another similar version is Net 10
MOM (middle of month).

h) 2/10 net 30. If invoice is paid within 10 days from shipment
date, a 2 percent discount is permitted; or else, payment in full
is due within 30 days.

9. 2/10 prox, net 30. If invoice is paid on approximately the tenth
day of the month following shipment date, a 2 percent discount
is permitted; or else, payment in full is due within 30 days.

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10. 2/10 EOM, net 40. If invoice is paid by the tenth day of the
following month, a 2 percent discount is permitted; or else,
payment in full is due in 40 days.

11. 2/10 ROI, net 40. If invoice is paid within 10 days of receipt of
invoice, a 2 percent discount is permitted; or else, the payment
in full is due in 40 days.

The offer of cash discount tends to induce early payments from the
credit customers. The change in credit terms has a direct impact on
average collection period and the level of receivable management,
and thus sales.

Collection Activities

The collection policy provides guidelines for appropriate actions to be
taken when accounts are overdue. It involves the use of certain
procedures to collect past due accounts:

a) Reminder. It is to give reminders to customers that the
account is overdue without payment. The techniques involve
usually by sending postcard, duplicate invoice or statement
with reminder phrases or stickers, brief and courteous letter,
printed cards, and aging schedule for the account with
reminder notes. The objective is to remind customer that the
account is overdue and it is to his advantage to pay the invoice
immediately.

b) Follow Up. If the reminder notes fail getting the customers to
pay, the firm will resort to sending successive follow up letters
with increasing firmness such as telegram, telephone, and
personal visits. The most effective method is personal visit and
is particularly important after the account is overdue for
sometime. The follow up stage may last several months, until
the firm is convinced that the customer is unwilling or unable to
pay.

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c) Drastic Action. The drastic action is the last stage that
includes drawing a draft on a customer, collection by attorney,
or employing collection agency. These actions are as last
resort effort by the firm after follow up fails to collect the past
due accounts as it is drastic and unfriendly. In addition, a firm
may lose these customers and thus future sales.

The collection policies will depend largely on the firm's management
view towards risk. A risk adverse management normally adopts a
more aggressive approach. They are not willing to take much risk as
the accounts aged with time as it may lead to definite bad debts.

6.3.2 Analysis of Key Credit Policy Changes

Any proposed change in credit policy should provide benefits more than the
additional cost incurred. This is in line with the firm's goal to maximize owners'
wealth via the increase in profits while controlling risk at an acceptable level.
The cost-benefit analysis uses incremental approach to look at the
incremental difference or change in sales, costs, and ultimately profits. The
cost-benefit analysis follows certain framework that isolates essential
revenues and cost variables items such as:

Item 1. Contribution from changes in sales. Focus on the incremental
change in sales and its contribution to gross profit.

Item 2. Changes in cost of accounts receivable investment. Focus on
incremental change in the level of receivable investment and the
cost of tied up funds in accounts receivable.

Item 3. Changes in bad debt costs. Focus on incremental change in bad
debt losses due to change in essential credit policy.

Item 4. Changes in other costs. It focuses on the incremental change in
other costs associated with managing the credit accounts such as
cost of discount, cost of running the credit department and
collection expenses.

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Item 5. Incremental profits. It is the net impact of the proposed policy
change on the firm's operating income that provides the basis for
decision-making. Item 5 =1 2 3 4

Changing Credit Standards.

The change in credit standards will not affect all customers. For
example, if the firm plans to adepts a more stringent standard that
provides credit to those with good ratings, the current marginal
customers will be dropped from the customer mix. Other group of
customers will remain as it is. On the other hand, if less stringent
policy results in an increase in marginal customers while present
customers remain constant. Therefore, the analysis in receivable
investment is the sales change ( S) as shown in step 2 of the
analysis.

To illustrate, consider the financial data for Suria Products Inc.
presented in Table 6-2. In the following examples, refer to changes
and t
n
refers to time frame where t=0 is current and t=1 is the
expected.

Table 6-2 Suria Products Inc. Present Characteristics

S
0

: Current sales revenues. RM500,000
AR
0

: Current levels of account receivable. RM62,500
ACP
0

: Current average collection period. 45 days
P
0

: Profit before taxes RM 50,000
D
0

: Current discount rate 0%
k : Opportunity cost of funds 10%
V : Variable cost as percentage of sales 80%
B
m0

: Bad debt percentage for marginal customers 8%
B
a0

: Average bad debt 4%
Stated credit terms Net 30 days
Capacity Excess

By using the data in Table 6.2, assume that Suria's management is
planning to change its present credit standards as follows:
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1. More stringent standards (W). The company only extents
credit to customers with default risk of 5% or lower. This would
reduce sales by RM50,000 and increase average collection
period to 60 days for eliminated customers.

2. More Liberal Standards (X). Under this option, the company
is willing to extent credit facilities to customers with default risk
of 15% or less. This should increase sales by RM60,000 and
average collection period for new customers to 70 days.

The above alternatives will have an impact on Suria's profit in three
areas; gross profit margin, cost of investment in receivables, and bad
debt costs. Other costs such as collection expenses may change, but
it is assume to be constant in the case. For more stringent standards:

1. Change in contribution margin (CM)
CM
W

=S (CM)
=(S
1
S
0
)(1 V)
=(450,000 500,000)(1 0.80) Where S
1

=RM500,000 RM50,000
=RM10,000

2. Change in carrying costs (CC)
Change in receivable investment (RI)
RI
W

=(ACP
1
/ 360)(V)(S)
=(60 / 360)(0.80)( 50,000)
=RM6,666.67



Therefore, Change in carrying costs (CC)
CC
W

=k (RI
W
)
=0.10 (6,666.67)
=RM666.67


Note: Present customers S
0
are not
accounted for
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3. Change in bad debt costs (BD)
BD
W

=B
m0
(S)
=0.08 (50,000)
=RM4,000

4. Changes in other costs: None

5. Incremental profit (IP)
IP
W

= CM
W
CC
W
BD
W

=10,000 (666.67) (4,000)
=RM5,333.33

The above calculations show that Proposal W reduces Suria's profits
by RM5,333.33, and therefore it should not be accepted. When
dealing with cost-benefit analysis, the decision criterion is to accept
only if the incremental profit is positive. The more relax credit standard
can be evaluated using similar format:

1. Changes in contribution margin (CM)
CM
X

=S (CM)
=(S
1
S
0
)(1 V)
=(560,000 500,000)(1 0.80)
=RM12,000

2. Changes in carrying costs (CC)
CC
X

=k ((ACP
1
/ 360)(V)(S))
=0.10((70 / 360)(0.80)(60,000))
=RM933.33



3. Changes in bad debt costs (BD)
BD
X

=B
mX
(S)
=0.15 (60,000)
=RM9,000

4. Changes in other costs: None

Note: Present customers S
0
are not
accounted for
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5. Incremental profit (IP)
IP
X

= CM
X
CC
X
BD
X

=12,000 933.33 9,000
=RM2,066.67

On the other hand, proposal X's incremental profit is positive
RM2,066.67. Thus, this policy is acceptable and could improve Suria's
profits.

Changing Credit Terms

The incremental profit analysis to evaluate changes in credit terms will
differ slightly from the analysis of changes in credit standards. Unlike
changes in credit standards, any changes in credit terms will affect all
customers regardless of whether they are new or old, or their risk
classifications. For example, if more relaxed terms such as net 40
instead of net 30 are offered, all customers will obviously take
advantage of the lenient terms. Therefore, the analysis of changes in
credit terms will use average values as shown in the following
examples.

Instead of changing credit standards, Suria Products Inc. decides to
investigate the possibility of changing credit terms; either to tighten or
to liberalize the present term of net 30. The followings are the
proposed changes in credit terms:

1. Severe Credit Terms (Y). This involves shortening the current
credit terms of net 30 to net 20. This would reduce sales by
RM40,000 and average collection period by 10 days to 35
days. The lost sales are assumed to be from the marginal
customers, and the bad debt loss is expected at 8%.

2. Relaxed credit terms (Z). It involves lengthening the current
credit terms of net 30 to net 40. This will cause sales to
increase by RM70,000 and average collection period from 45
days to 60 days. With the new terms, the expected bad debt
for new sales is 10%.

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Changes in credit terms will have an impact in three similar areas as
the changes in credit standards; gross profit margin, cost of
investment in receivable, and costs of bad debt. Only the methods of
calculating the changes in receivable investment are different from
that of the changes in credit standards. The revised new formula
consists of two parts; that is changes in receivable investment
associate with original sales and with new sales, instead of one
previously. For proposal Y, the following changes will occur in the
three essential areas:

1. Changes in contribution margin (CM)
CM
Y

=S (CM)
=(S
1
S
0
) CM
=(460,000 500,000)(1 0.8)
=RM8,000
2. Changes in carrying costs (CC)

Changes in receivable investment (RI)
RI
Y

=[((ACP
1
ACP
0
) / 360)(S
0
)) +((ACP
1
/ 360)(V)(S)]
=[((35 45) / 360)(500,000)) +((35 / 360)(0.80)( 40,000)]
=RM17,000



Therefore, changes in carrying costs (CC)
CC
Y

=k (RI
Y
)
=0.10 (17,000)
=RM1,700

3. Changes in bad debt costs (BD)
BD
Y

=B
m0
(S)
=0.08 (40,000)
=RM3,200

4. Changes in other costs: None



Note: Present customers S
0
and S
are not accounted for
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5. Incremental profit (IP)
IP
Y

=CM
Y
CC
Y
BD
Y
=8,000 (1,700) (3,200)
=RM3,100

The result shows a negative incremental profit of RM3,100 and
therefore, proposal Y is not acceptable to the firm. For proposal Z:

1. Changes in contribution margin (CM)
CM
Z

=S (CM)
=(S
1
S
0
) CM
=(570,000 500,000)(1 0.80)
=RM14,000


2. Changes in carrying costs (CC)
CC
Z

=k [((ACP
1
ACP
0
) / 360)(S
0
) +(ACP
1
/ 360)(V)(S)]
=0.10 [((60-45)/360)(500,000)+(60/360)(0.80)(70,000)]
=RM3,016.67



3. Changes in bad debt costs (BD)
BD
Z

=B
mZ
(S)
=0.10(70,000)
=RM7,000

4. Changes in other costs: None

5. Incremental profit (IP)
IP
Z

=CM
Z
CC
Z
BD
Z
=14,000 3,016.67 7,000
=RM3,983.33

Under proposal Z, Suria's profit will increase by RM3,983.33 and
therefore the proposal is acceptable. The illustrations for Suria do not
use average bad debt percentage as a basis for calculations. Other
problems may not provide details bad debt percentage; that is only
Note: Present customers S
0
and S
are not accounted for
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average debt's data provided. To accommodate this data, calculations
for bad debts are as follows:

3. Changes in bad debt costs (BD):
BD =BD
1
BD
0
=(S
1
)(B
a1
) (S
0
)(B
a0
)

Where B
at

: Average bad debt rate for period t

The preceding examples do not consider changes in cash discount for
early payment as a way to liberalize credit and increasing sales. To
illustrate the effects of changes in discount terms, let's assume that
Anis Inc. is currently offering credit terms of 2/10 net 30, and other
characteristics are shown in Table 6.3.
Table 6.3 Anis Inc. Present Financial Characteristics

S
0
: Current sales revenues. RM500,000
AR
0
: Current levels of account receivable. RM62,500
P
0
: Profit before taxes RM 50,000
k : Opportunity cost of funds 10%
V : Variable cost as percentage of sales 80%
D
0
: Current discounts 2%
DT
0
: Current discounts takers 30%
Stated credit terms 2/10 net 30
Capacity Excess

The company is considering changing the current terms of 2/10 net 30
to 3/7 net 30; and it is estimated that 50% of the customers will take
the discount. In order to simplify the calculations, assume that sales
will remain constant and there is no bad debt involved. The approach
in analyzing these changes is similar to the preceding examples, with
one additional area to focus; that is changes in discount costs. Thus,
the incremental profit formula from the proceeding analysis of changes
in credit terms can be modified to accommodate this, as following
example illustrates.
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The estimations of average collection period for present terms and
proposed terms are necessary if there is no average collection data
available. The estimates can be computed as follows:
ACP
t

=(DT
t
)(DP
t
) +(1 DT
t
) CP
t


Where ACP
t

: Approximate average collection period
DT
t

: Discount takers
DP
t

: Discount period
CP
t

: Credit period

ACP
0

=(DT
0
)(DP
0
) +(1 DT
0
) CP
0

=(0.30)(10) +(1 0.30) 30
=24 days

ACP
1
=(DT
1
)( DP
1
) +(1 DT
1
)CP
1

=(0.50)(7) +(1 0.50) 30
=18.5 days

1. Changes in contribution margin (CM)
CM =Zero; since sales remain constant

2. Changes in carrying costs (CC):
CC =k [((ACP
1
ACP
0
) / 360)(S
0
) +(ACP
1
/ 360)(V)(S)]
=0.10[((18.524)/360)(500,000) +(18.5 / 360)(0.80)(0)]
=RM763.89

3. Changes in bad debt costs (BD): None

4. Changes in other costs; discount costs(DC)
DC =(DT
1
)(S
1
)(D
1
) (DT
0
)(S
0
)(D
0
)
=(0.50)(500,000)(0.03) (0.30)(500,000)(0.02)
=RM4,500

5. Incremental profit (IP):
IP =CM CC BD DC
=RM0 (763.89) (0) (4,500)
=RM3,736.11
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Offering new discount terms will speed up collection of accounts
receivable by RM7,638.89, which represent RM763.89 savings for the
firm. However, the discount expenses change drastically which give
an incremental profit of negative RM3,736.11. Thus, Anis should not
change its present discount policy.

In the preceding examples presented, it involves only changes in one
of the policy variable at a time. However, the same framework could
be used to evaluate the effects of changes in several policy variables
simultaneously. The equations may become complex, but the
underlying principles are still the same and valid.

6.4 MANAGEMENT OF INVENTORY

The financial manager does not have a direct control over inventory investment decision, but
tends to have indirect input as it relates directly to the firm's working capital. Thus, proper
management of these inventories is important as it affects the firm's day-to-day operations
and provides the basis for production and sales. In addition, it represents a significant
investment for most firms. Inventories consist of the firm's stock of raw materials, work in
progress, and finished goods. The characteristics of the inventories are as follows.

a. Raw Materials

It consists of basic raw materials purchased from suppliers to initiate the production
process. The purpose of holding raw materials is to make production function
independent from the purchasing function. That is, any problems with purchasing
function such as shipment delays will not cause production shut down.

b. Work In Process

The work in process is consists of partially finished goods requiring additional work
before they become finished goods and be sold to customers. Its purpose is to make
these production processes independent from each other; that is a break down in
one process will not affect the other operations.


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c. Finished Goods

The finished goods represent products that are completed in the production process
but not sold. Its purpose is to make production function independent from the sales
functions. Any productions slow down will not hamper sales due to the inability to
meet demands.

As in any financial decisions, investment in inventory involves risk-return tradeoffs.
As such, firms with low inventory levels may face potential stock out and production
delays, which results in low inventory cost and potential loss of sales. Firms that
maintain large inventories, on the other hand, can be assured of no production
delays, thus will be able to meet demand and to provide prompt shipment of orders if
necessary; but will experience high inventory costs.
Due to its role in making the firm's function independent from each other and the
financial burden involved, the objectives of the firm's inventory management are:

1. To maximize inventory turnover. That is the same action as to minimize the
investment levels in the inventories. This will release the tied up funds in
inventories, which is less productive, to be used in other more profitable
investment; thus improving the firm's profitability.

2. To carry sufficient inventories. Sufficient inventories are important to satisfy
the production and sales demands. This will smooth out production process
and provides better product selections and prompt deliveries.

Therefore, the firm must determine the "optimal" level of inventories holding to
reconcile both of these conflicting objectives. Proper inventory management will
balance both of these needs, and hence would result in increase stockholders'
wealth. Other reasons for the firm to keep inventory are: (1) it will take some time to
order the raw materials; (2) it will be cheaper to buy in large quantities; and (3)
economic-of-scales.

6.4.1 Economic Order Quantity

There are several techniques in controlling inventory, but the most prevailing
method is the basic economic order quantity (EOQ) model; together with
reorder point and safety stock. EOQ model is a tool to determine the optimal
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order quantity that results in the lowest total inventory cost. The EOQ model
focuses on basic costs associated with inventory management without taking
into considerations the actual cost of the inventory itself. The basic cost
consists of order costs, carrying costs and total inventory costs.

1. Oder Costs (OC). The order costs associate with fixed clerical costs
of placing and receiving and ordering; such as cost of processing,
telephoning, typing, mailing, and receiving orders. It is stated as
Ringgits per order and its annual costs vary inversely with order
quantity. That is high order quantity will reduce the number of orders
per period, and thus the total order cost per period will also decline.

2. Carrying Costs (CC) The carrying costs associate with the cost of
carrying each unit of inventory in the firm's stock per period, normally
on a yearly basis. These costs are commonly stated as Ringgits per
unit per period or as a percentage (approximately 20-25%) of
inventory cost per period. It includes the costs of invested capital and
other costs such as storing, handling, taxes, insuring, physical
damage, obsolescence, and auditing the inventories. The total
carrying cost per period relates directly to the order quantity, that is
higher order quantity will results in higher total carrying cost for the
given period.

3. Total inventory costs (TIC) The total inventory costs are defined as
the sum of total order costs (TOC) and the total carrying costs
(TCC). The total inventory costs are important in the EOQ model, as
its objective is to determine the optimal inventory order quantity that
minimizes it. Any order quantity below or above the optimal order
quantity, the firm's total inventory costs not being at a minimum.
However, within the range of plus or minus 20 percent from the stated
EOQ, the total cost function is quite flat.

To determine the optimal order quantity, under EOQ model, two approaches
can be used; graphically or mathematically. The focus in the following
sections is on the latter methods, but to promote better understand of the
concept behind EOQ model, a graphic approach will briefly be presented.
Thus, let:
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D : Usage, demand, or sales in unit per period
O : Order cost in Ringgits per order
C : Carrying cost per unit in Ringgits per period
Q : Order quantity in units; can be EOQ or other quantity
SS : Safety Stock

a. Total ordering costs (TOC)

TOC =Order cost per order (Numbers of orders per period)
=O (D / Q)

b. Total carrying costs (TCC)

TCC =Carrying cost per unit (Average inventory)
=C ((Q / 2) +SS)

c. Total inventory costs (TIC)

TIC =Total ordering costs +Total carrying costs
=TOC +TCC.

The above formula provide the basis for the development of EOQ model
using graphical and mathematical approaches by using financial data from
Table 6-4.
Table 6-4 TOC, TCC, And TIC for Biener Products Inc.

C =RM2 O =RM25 D =3,600
Q TOC TCC TIC
50 units
150
RM1,800
600
RM 50
150
RM1,850
750
300 300 300 600
450
600
200
150
450
600
650
750



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0
100
200
300
400
500
600
700
800
900
1000
1100
1200
1300
1400
1500
1600
1700
1800
1900
2000
50 100 150 200 250 300 350 400 450 500 550 600 650
Quantity
C
o
s
t
s

i
n

R
M
TIC
TCC
TOC
A Graphical Approach

To illustrate, assume that Biener Products Inc. expects to sell 1,800
units of inventory for the coming year. The firm estimates that the cost
of carrying each unit of inventory per year is RM2, and Wiener will
incur RM50 each time an order is placed. The calculated costs
associated with ordering and carrying the inventories for the upcoming
period without safety stocks' requirements are presented in Table 6-4,
based on order quantity of multiples of 50 units per order. By using the
data in Table 6-4, a graph to determine EOQ presented in Figure 6-6
can be developed. It shows the nature of each of the costs functions
relative to order quantity and total costs.
Figure 6-7 A Graphic Presentation of EOQ Model















A Mathematical Approach

The economic order quantity (EOQ) is defined as the order quantity
that minimizes the total inventory costs. Thus, EOQ can be solved
mathematically by setting total ordering cost function equals to total
carrying cost function. By manipulation of these two equations, it wills
results in the following formula:

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EOQ = 2DO / C

Thus, substituting Biener's financial data in Table 6-3, EOQ equals to:
EOQ = 2(3,600)(25) / 2
= 90,000
=300 units
TIC =TOC +TCC
=25 (3,600 / 300) +2 ((300 / 2) +0)
=300 +300
=RM600

The above calculations indicate that both graphical and mathematical
approaches give the same EOQ level. However, the latter approach is
quicker as no elaborate calculations and graphing are necessary.
Shaded area in Table 6-4 represents the cost structure at EOQ of 300
units. Sample calculations for TCC at 300 units:
TIC =O (D / Q) +C ((Q / 2) +SS)
=25 (3,600 / 300) +2 ((300 / 2) +0)
=RM600

Reorder Points and Safety Stock

Up to this point, we work with EOQ assumptions that inventory usage
follows the " saw tooth" pattern as shown in Figure 6-7.

Figure 6-8 Inventory Usage over time for EOQ Model














500
400
300
200
150
100
Q =
Q/2 =
Order Quantity
Time between orders 30 days
Average Inventory
10
20 30
40 50 60 70 80 00
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It implies that the demand for the products is constant and the delivery
for supplies is certain. The firm orders 300 units and uses them for 30
days at a constant rate of 10 units per day (=3,600 Units / 360 Days).
On the day 30, when the stock is depleted to zero, the new order of
300 units will be received instantaneously. Thus, there is a perfect
certainty of usage and delivery.

Figure 6-9 Inventory usage, Reorder Point, and Safety Stock
under EOQ Model

















The basic assumptions are not practical as demand may vary from
time to time, and shipment delays are possible. Thus, modifications of
the basic inventory usage are necessary to include reorder point
(ROP) and safety stock (SS). This will provide the allowance for
uncertainty in demand and delivery of inventory. Figure 6-8 illustrates
these modifications, with the assumptions of safety stock level at 100
units and delivery or lead-time (L) of 10 days.
From Figure 6-8, with delivery time of 10 days, a reorder point of 150
units should be observed. Reorder point act as an indicator of when
the firm should place an order for the new shipments. To illustrate the
reorder point and safety stock concept, let:
SS : Safety stocks in units
L : Lead-time in days
L
f

: Lead-time in days to delivery as a fraction of a year.
D
d

: Daily usage, demand, or sales
500
400
300
200
250
100
Q =
(Q/2)+SS =
Order Quantity
Lead-time 10 days
Average Inventory
ROP =
SS =
10 20
30
40
50
60
70
80
00
Expected lead
time demand
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Reorder point is a function of lead-time in days multiplied by daily
usage. This is to ensure that inventories arrived in time before safety
stock is affected. Thus, by using Biener's financial data, reorder point
equals to:

ROP =(Lead time in days)(Daily usage rate) +Safety stock
=(L)(D
d
) +SS
=(10)(5) +100
=150 units

For Biener's inventory control, when the inventory level reaches 150
units the new order must be processed and sent to the supplier. Given
that the delivery is on time, the shipment will arrive on day 30,
whereby the inventory level reaches 100 units; that is the safety stock.
The above mentioned safety stock is set arbitrarily based on usage
allowance of 10 days.

In actual sense, safety stock level should be determined based on the
certainty of usage rates and delivery times, together with the cost in
carrying inventories in stock versus the cost of lost sales from
potential stock out. As a rule of thumb, the equation that gives
approximate appropriate level of safety stock to be held by a firm is:

SS =1.85 (L
f
)(D)
=1.85 (10 / 360)3,600
=1.85 50
=19 units

The above calculations indicate that Biener should hold 19 units of
safety stock to optimize the cost function and safety needs against
uncertainty of demand and delivery. In all of the preceding examples,
lead-time and usage rate is stated in days and there are 360 days per
year. In actual case, other periods such as weekly and monthly can be
used. As such, periods should be adjusted to 50 weeks and 12
months per year respectively. This change is important to synchronize
the period involved.
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To illustrate the whole concept of EOQ model, consider the following
examples. The Abish Corporation has a monthly usage of 4,000 units.
The cost of placing an order is RM100 and it takes one week for the
shipment to arrive. On average, the inventory carrying cost per unit is
RM0.55 per three months. All orders must be placed in lot of 100 units
and safety stock is required. Assume that 50-week in a year. Thus:

D =4,000 (12)
=48,000 units

C =RM0.55 (12 / 3)
=RM2.20

O =RM100

SS =1.85 (L
f
)(D)
=1.85 (1 / 50)(48,000)
=1.85 960
=57.32 Equals to 58 units

ROP =(L)(D
d
) +SS
=(1 (48,000 / 50)) +58
=1,018 units

EOQ = 2DO / C
= (2(48,000)(100)) / RM2.20
=2,088.93 units

With the presence of constraints in order quantity, that is lot or
multiples of 100 units, some adjustment is necessary if EOQ is not
compatible such as the above example of 2,088.93 units. The order
quantity must be changed accordingly to multiples of 100 since the
firm cannot place an order in quantity of 88.93 units, but a minimum lot
of 100 units. Therefore, the order quantity (Q) is not equal EOQ and
should be changed to 2,100 units. Therefore, TOC, TCC and TIC:


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TOC
0
=O (D / Q)
=100 (48,000 / 2100)
=RM2,285.71

TCC
0
=C ((Q / 2) +SS)
=2.20 ((2,100 / 2) +58)
=RM2,437.60

TIC
0
=TOC +TIC
=2,285.71 +2,437.60
=RM4,723.31

Substituting the data for Abish Corporation, the requirements for
safety stock and reorder point is 58 units and 1,018 units respectively.
The total inventory costs involve in the inventory management equals
to RM4,723.31 including the cost of carrying the required safety stock.
If Abish Corporation decides to place an order more or less than EOQ
units at a time, the total inventory costs will increase accordingly.

Now let assume that the supplier is willing to give a quantity discount
of RM0.10 each unit if orders are placed 3,000 units and above. With
this new information, should Abish Corporation take the offers? To
answer this, let order quantity equal 3,000 units and calculate new
level of TIC:

TOC
1

=O (D / Q)
=100 (48,000 / 3,000)
=RM1,600

TCC
1

=C ((Q / 2) +SS)
=2.20 ((3,000 / 2) +58)
=RM3,427.60

TIC
1

=TOC
1
+TCC
1

=1,600 +3,427.60
=RM5,027.60
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If the proposal to order at least 3,000 units per order is accepted, the
total inventory costs will increase and the company is able to save
RM0.10 per unit.

Increase in cost =TIC
1
TIC
0


=5,027.60 4,723.31
=RM304.29

Savings =D(Discount per unit)
=48,000 (0.10)
=RM4,800.00


Incremental Profit =Savings Increase in cost
=4,800.00 304.29
=RM4,495.71

Therefore, the firm should take the discount offer since the
incremental profit is positive RM4,495.71. The cost-benefit analysis is
important in inventory management as to balance the need for
meeting the production and demands requirement, and the need to
minimize the cost of inventory investment and other related costs.




















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QUESTION 1

Syarikat Emas faces liquidity problem. The firm needs RM500,000 for the next 90
days. Syarikat Emas has decided to use its short-term financing alternatives. The
alternatives available are as follows:

a) To sell its accounts receivable to a factoring company which will charge 5%
factoring fee, 5% factors reserve and 10% interest on advance

b) Syarikat Emas can borrow a discounted loan from Bank Merdeka at a rate of
12% per annum

c) To sell commercial papers at 8% interest per annum. The company also has
to bear RM5,000 for cost of issuing the papers

d) Which is the best alternative? Why?

e) Explain a straight loan.
(20 marks)
QUESTION 2

Hitam Manis Distributor has determined the following inventory information:

1. Orders can be placed only in multiples of 100 units
2. Annual usage is 500,000 units. (Assume a fifty-week in your calculations.)
3. The carrying cost if RM10 per unit
4. The ordering cost is RM100 per order
5. The desired safety stock is 2,500 units
6. Delivery time is 5 days.

Given these information:

i) What is the EOQ level?
ii) How much it the total inventory cost?
iii) At what inventory level should a reorder be made?
iv) Define the terms average inventory and re-order point or level.

(20 marks)