Fundamentals of corproate finance 3e chapter 12

Chapter Twelve
Current Investment Decisions

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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

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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.

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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.

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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

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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

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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.

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Example—Operating Cycle (continued)
a) Find the inventory period:
COGS
Avg. inventory
350 000
=
( 90 000 + 102 000)

Inventory turnover =

2

= 3.65 times
365

Inventory period =
Inventory turnover
365
3.65 times
= 100 days
=

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Example—Operating Cycle (continued)
b) Find the accounts receivable period:
Credit sales
Receivables t/o =
Avg. receivable s
510 000
=
( 72 000 + 78 000)

2

= 6.8 times
365
Receivables period =
Receivables t/o
365
=

6.8 times
= 53.7 days

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Example—Operating Cycle (continued)

Operating cycle = Inventory period + Receivables period
= 100 + 53.7
= 153.7 days

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Example—Cash Cycle
a) Find the payables period:
COGS
Avg. payables
350 000
=
( 49 000 + 55 000)

Payables t/o =

2

= 6.73 times
365
Payables period =
Payables turnover
365
=
6.73 times
= 54.2 days

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Example—Cash Cycle (continued)

Cash cycle = Operating cycle − Payables period
= 153.7 − 54.2
= 99.5 days

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Short-term Financial Policy
• 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 assets
- Flexible policy—less short-term debt and more long-term
debt

- Restrictive policy—more short-term debt and less long-term
debt

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Short-term Financial Policy
•

The size of the firm’s investment in current assets is
determined by its short-term financial policies.

•

Flexible policy actions include:
– keeping large cash and securities balances
– keeping large amounts of inventory
– granting liberal credit terms.

•

Restrictive policy actions include:
– keeping low cash and securities balances
– keeping small amounts of inventory
– allowing few or no credit sales.

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Costs of Investments
•

Need to manage the trade-off between carrying costs and
shortage costs.

•

Carrying costs increase with the level of investment in current
assets, and include the costs of maintaining economic value
and opportunity costs.

•

Shortage costs decrease with increases in the level of
investment in current assets, and include trading costs and
the costs related to being short of the current asset. For
example, sales lost as a result of a shortage of finished
goods inventory.

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Carrying Costs and Shortage Costs

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Carrying Costs and Shortage Costs

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Carrying Costs and Shortage Costs

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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

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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 )

2 × 10 000 × $10.00
=
$0.20
= 1000 rolls
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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.

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EOQ Example With Quantity
Discounts (continued)
Calculate the total cost for each quantity:

1 000 units = (10 000 × $3.20 ) + (10 000/1 000 ) $10 + (1 000/2 ) $0.20
= $32 200
2 000 units = (10 000 × $3.18) + (10 000/2 000) $10 + ( 2 000/2 ) $0.20
= $32 050
3 500 units = (10 000 × $3.17 ) + (10 000/3 500) $10 + ( 3 500/2 ) $0.20
= $32 080
Smile Camera Shop would be better off purchasing in lots of 2000
to reduce the total cost.

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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.

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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.

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EOQ Example Under Uncertainty
Reorder point
Qty
2 100

Reorder
points

1 000

100
Safety stock
Time

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