Chapter Twelve Current Investment Decisions Copyright  2004 McGraw-Hill Australia Pty Ltd 12-1 Chapter Organisation 12.1 The Investments Involved 12.2 The Operating Cycle and the Cash Cycle 12.3 Some Aspects of Short-term Financial Policy 12.4 The Cash Budget 12.5 A Short-term Financial Plan 12.6 Summary and Conclusions Copyright  2004 McGraw-Hill Australia Pty Ltd 12-2 Chapter Objectives • Understand the components of the operating cycle and the cash cycle • Explain the key issues in a firm’s short-term financial policy • Understand and apply the inventory model • Prepare a cash budget Copyright  2004 McGraw-Hill Australia Pty Ltd 12-3 Current Investment Decisions • Involve the administration of the company’s current assets (cash and marketable securities, receivables and inventory), and the financing needed to support these assets • Problems in using discounted cash flow techniques to evaluate these decisions: – – – identification of all relevant cash inflows and outflows determining the size and timing of these cash flows determining the correct discount rate Copyright  2004 McGraw-Hill Australia Pty Ltd 12-4 Operating Cycle versus Cash Cycle • Operating cycle—the time period between the acquisition of inventory and the collection of cash from receivables Operating cycle = Inventory period + A/cs receivable period • Cash cycle—the time period between the outlay of cash for purchases and the collection of cash from receivables Cash cycle = Operating cycle – A/cs payable period Copyright  2004 McGraw-Hill Australia Pty Ltd 12-5 Cash Flow Time Line Cash received Inventory sold Inventory purchased Inventory period Accounts receivable period Time Accounts payable period Cash paid for inventory Operating cycle Cash cycle Copyright  2004 McGraw-Hill Australia Pty Ltd 12-6 Example—Operating Cycle The following information has been provided for Overcredit Co.: Sales for the year were $510 000 (assume all credit) and the cost of goods sold was $350 000 Calculate the operating cycle and cash cycle Copyright  2004 McGraw-Hill Australia Pty Ltd 12-7 Example—Operating Cycle (continued) a) Find the inventory period: COGS Avg inventory 350 000 = ( 90 000 + 102 000) Inventory turnover = = 3.65 times 365 Inventory period = Inventory turnover 365 3.65 times = 100 days = Copyright  2004 McGraw-Hill Australia Pty Ltd 12-8 Example—Operating Cycle (continued) b) Find the accounts receivable period: Credit sales Receivables t/o = Avg receivable s 510 000 = ( 72 000 + 78 000) = 6.8 times 365 Receivables period = Receivables t/o 365 = 6.8 times = 53.7 days Copyright  2004 McGraw-Hill Australia Pty Ltd 12-9 Example—Operating Cycle (continued) Operating cycle = Inventory period + Receivables period = 100 + 53.7 = 153.7 days Copyright  2004 McGraw-Hill Australia Pty Ltd 12-10 Carrying Costs and Shortage Costs Copyright  2004 McGraw-Hill Australia Pty Ltd 12-18 The Inventory Model The economic quantity (EOQ) is the optimal quantity of inventory ordered that minimises the costs of purchasing and holding the inventory TC = YP + ( Y/X ) A + ( X/2 ) C EOQ = Where TC ( 2YA/C ) = total cost X = order size EOQ = economic order qty A = acquisition costs Y = total demand C = carrying costs P = price per unit Copyright  2004 McGraw-Hill Australia Pty Ltd 12-19 Example—EOQ Smile Camera Shop sells 10 000 rolls of film per year, each with a wholesale price of $3.20 The cost of processing each order placed is $10.00 and carrying costs are 20 cents per roll per year Calculate the EOQ EOQ = ( 2YA/C ) × 10 000 × $10.00 = $0.20 = 1000 rolls Copyright  2004 McGraw-Hill Australia Pty Ltd 12-20 EOQ Example With Quantity Discounts Smile Camera Shop is offered a 2-cent-per-roll discount if 2000–3500 rolls of film are ordered, and a 3-cent-per-roll discount if more than 3500 rolls are ordered at a time Determine the optimal order quantity Copyright  2004 McGraw-Hill Australia Pty Ltd 12-21 EOQ Example With Quantity Discounts (continued) Calculate the total cost for each quantity: 000 units = (10 000 × $3.20 ) + (10 000/1 000 ) $10 + (1 000/2 ) $0.20 = $32 200 000 units = (10 000 × $3.18) + (10 000/2 000) $10 + ( 000/2 ) $0.20 = $32 050 500 units = (10 000 × $3.17 ) + (10 000/3 500) $10 + ( 500/2 ) $0.20 = $32 080 Smile Camera Shop would be better off purchasing in lots of 2000 to reduce the total cost Copyright  2004 McGraw-Hill Australia Pty Ltd 12-22 Inventory Management Under Uncertainty • Inventory management requires two decisions: – quantity to be ordered – reorder point • Safety stock is the additional inventory held when demand is uncertain so as to reduce the probability of a stock out • Reorder point takes into account the lead time from placement of an order to receipt of the goods Copyright  2004 McGraw-Hill Australia Pty Ltd 12-23 EOQ Example Under Uncertainty Smile Camera Shop’s EOQ (with quantity discounts) is 2000 rolls of film and five orders are placed each year Determine the reorder point if it takes 30 days to fill an order, a safety stock of 100 is desired and daily usage is 30 rolls Copyright  2004 McGraw-Hill Australia Pty Ltd 12-24 EOQ Example Under Uncertainty Reorder point Qty 100 Reorder points 000 100 Safety stock Time Copyright  2004 McGraw-Hill Australia Pty Ltd 12-25 Cash Budget • Forecast of cash receipts and disbursements over the next short-term planning period • Primary tool in short-term financial planning • Helps determine when the firm should experience cash surpluses and when it will need to borrow to cover working-capital costs • Allows a company to plan ahead and begin the search for financing before the money is actually needed Copyright  2004 McGraw-Hill Australia Pty Ltd 12-26 Example—Cash Budget • • • Projected sales for the first six months of 2004: Jan $130 000 Apr $140 000 Feb $125 000 May $155 000 Mar $145 000 Jun $145 000 Analysis of collection of accounts receivable: – collected in month of sale 20% – collected in month following sale 60% – collected in second month following sale 20% Actual sales for November and December were $125 000 and $120 000 respectively Copyright  2004 McGraw-Hill Australia Pty Ltd 12-27 Example—Cash Budget (continued) • • • • • • Wages and other expenses are 30 per cent of total monthly sales Purchases are 50 per cent of the month’s estimated sales, all paid for in the month of purchase Monthly interest payments are $15 000 (interest rate is 1.5 per cent per month) An annual dividend of $60 000 is payable in March The beginning cash balance is $30 000 The minimum cash balance is $20 000 Copyright  2004 McGraw-Hill Australia Pty Ltd 12-28 Cash Collections Copyright  2004 McGraw-Hill Australia Pty Ltd 12-29 Cash Disbursements Copyright  2004 McGraw-Hill Australia Pty Ltd 12-30 Cash Budget Copyright  2004 McGraw-Hill Australia Pty Ltd 12-31 Short-term Financial Planning Copyright  2004 McGraw-Hill Australia Pty Ltd 12-32 .. .Chapter Organisation 12. 1 The Investments Involved 12. 2 The Operating Cycle and the Cash Cycle 12. 3 Some Aspects of Short-term Financial Policy 12. 4 The Cash Budget 12. 5 A Short-term... Ltd 12- 26 Example—Cash Budget • • • Projected sales for the first six months of 2004: Jan $130 000 Apr $140 000 Feb $125 000 May $155 000 Mar $145 000 Jun $145 000 Analysis of collection of accounts... • Size of investments in current assets -Flexible policy—maintain a high ratio of current assets to sales -Restrictive policy—maintain a low ratio of current assets to sales • Financing of current