Other Topics in Working Capital Management

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• Chapter 23 - I
• Other Topics in Working Capital Management

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THE CONCEPT OF ZERO WORKING CAPITAL

• The goal of the zero-working capital concept is
  for investments in receivables and inventories to
  be financed by _____.
• For the purpose of the zero-working capital
  concept, w/c is defined as

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• The average firm uses 0.20 to carry w/c for a
  year for each dollar of _____ (i.e., w/c turnover
  of 5.0).
• Few companies can achieve zero w/c, but it is a
  desirable goal.

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• The major benefits of reducing working capital
  are a _____ (from the reduction in w/c) and _____
  from the lower carrying costs for operating
  capital.

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• Thinking in terms of a balance sheet, if more of
  the investment in receivables and inventories are
  financed by accounts payable, _____ will be
  needed in the form of bank loans, so interest
  expense is _____.

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• Moving toward zero working capital requires
  increased _____, which is achieved by
• producing items _____, rather than holding large
  inventories of raw materials and finished goods.
• starting production _____ after an order is
  received, but still meeting customer delivery
  requirements (called _____).

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• replacing paper with _____ data.
• developing _____ production lines.
• shipping _____ as soon as production is completed.

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SETTING THE TARGET CASH BALANCE

• The goal in setting the minimum cash balance is
  to _____ the cash needed to operate efficiently
  (i.e., minimize idle cash).
• Many firms protect against adverse (unpredicted)
  cash outflows by carrying large _____ of
  near-cash in the form of _____ and _____.

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• If a firm faces a more unpredictable cash flow
  pattern, it will typically carry a _____ level of
  safety stocks in near-cash form.

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The Baumol Model

• Carrying a small average level of cash requires
  making frequent loans, which results in an
  excessive amount of broker fees (i.e., _____
  costs).
• Carrying a large average level of cash requires
  making large loans, which results in excessive
  interest expense (i.e., _____ costs).

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• The Baumol model attempts to _____ the sum of
  total transactions costs and total carrying costs
  for the year.
• A weakness of the Baumol model are its
  assumptions that
• - cash outflows are _____
• - cash outflows are _____

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If cash payments are perfectly predictable
If C is the size of each loan, then the
average loan balance is C/2
Loan Size (C)
C/2
0 1 2 3 4 5 6 7 8
9 10 11 12 weeks
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• Given the following variables, what is the
  formula for the total cost of providing cash for
  a year? (i.e., carrying costs ordering costs)
• F fixed cost of obtaining a loan
• rd i-rate on loans
• T total amount of cash needed
• for disbursements for the year
• C size of each loan

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Graphical Picture of Total Cost of Cash Balances

Total Costs
Carrying Costs
Transactions Cost
0 C Loan Size
(or Cash Transfer Size)
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• We want to operate at the _____ point on the
  total cost function.
• In calculus, we learned that the first derivative
  of the total cost function gives the slope
  function

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• Setting the slope function equal to zero and
  solving for C gives the value of C that minimizes
  the total cost of providing cash

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• For the following situation, what are is total
  cost of providing cash for a year?
• - annual disbursements 5,000,000
• - fixed cost per loan (processing costs
• and credit check) 150
• - interest rate on loan 15
• - borrow in 200,000 amounts

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• Based on the Baumol model, what should be the
  optimal loan size?
• C 2(F)(T)/r0.5

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• If we change to borrowing in 100,000 amounts,
  what is the total cost associated with providing
  cash for the year?
• Note that there is a _____ annual savings by
  switching to the optimal borrowing amount.

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The Miller-Orr Model

• The Miller-Orr model allows cash inflows and
  outflows to be _____.
• The Miller-Orr model assumes that the firm can
  _____ when it runs short of cash, and _____ when
  it has excess cash.
• Therefore, which of the two models uses more
  realistic assumptions Baumol model or
  Miller-Orr model?

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• Many of the variables of the Miller-Orr model are
  similar to those of the Baumol model.
• The Miller-Orr variables are
• C optimal size of the loan
• rd interest rate on debt
• F fixed cost to borrow/invest
• ?2 variance of daily cash flow

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• Which variable is new? _____

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Miller-Orr Formulas

• C represents the optimal cash transfer
  size
• C (3Fs2)/4r0.5
• Upper and lower control limits are
• UCL 3(C) LCL
• LCL set by the firm

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• The return point is
• Return Point C LCL
• The average cash balance is
• Avg Cash (4/3)C LCL

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Cash Balance
UCL 2C Z LCL C LCL
Time
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• When the companys cash drops to the LCL, cash is
  too _____ and the company _____ (_____
  dollars).
• When the company hits the UCL, the company has
  _____ in excess cash and _____ some debt (_____
  dollars).

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Miller-Orr example problem

• - Fixed cost to borrow is 150
• - interest rate on loans is 15
• - daily std deviation of cash flows is
• 1,000
• - bank requires min. cash of 5,000
• for services
• Determine all Miller-Orr variables, as well as
  the annual interest expense.

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• Implementing the results
• If the cash balance drops to 5,000, the company
  should _____ an additional _____.
• If the cash balance rises to 87,158, the company
  should _____ an amount equal to _____ .

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In-Class Exercise

• - Fixed cost to borrow is 100
• - interest rate on loans is 7
• - daily standard deviation of cash
• flows is 2,000
• - bank requires min. cash of 2,500
• for bank services
• Determine all Miller-Orr variables and the annual
  interest expense.