Working Capital

Short-Term Finance
 What Is (Net) Working Capital?
• Current Assets – Current Liabilities

Fall 2005 Dr. Tufte’s FIN 4250 Notes 2

 What Does It Mean to be Current?
• Convertible to cash with a year

Fall 2005 Dr. Tufte’s FIN 4250 Notes 3

 What Are Current Assets?
• Cash
– Very liquid short-term securities - like T-bills,
repurchase agreements, and commercial paper
– are usually included here
• Marketable securities
– Less liquid and longer-term investments made
out of current assets
• Inventory
• Accounts receivable
Fall 2005 Dr. Tufte’s FIN 4250 Notes 4
 What Are Current Liabilities?
• Accounts payable
• Accruals of wages and salaries
• All payments on long-term debt that are
payable within a year

Fall 2005 Dr. Tufte’s FIN 4250 Notes 5

 What Is Non-Cash Working
Capital?
• Remove cash and marketable securities from
current assets
– Cash and marketable securities are held for reasons
beyond just working capita
– They also pay interest, reducing their opportunity cost
to something much closer to zero than can
reasonably be expected from non-cash working
capital
• Remove debt as well – it gets counted in cost of
capital
• Inventory+receivables-payables-accruals
Fall 2005 Dr. Tufte’s FIN 4250 Notes 6
What Is the Pitfall in Thinking About
Non-Cash Working Capital?
• Increases in inventory and receivables
bleed cash out of the firm
• Increases in payables and accruals yield
cash for the firm

Fall 2005 Dr. Tufte’s FIN 4250 Notes 7

 What Are the Economics of Non-
Cash Working Capital?
• Non-cash working capital is a derived
demand
– You need it because of projects
– You often need it before the project is
generating cash flow
• It is subject to
– Economies of scale
– Economies of scope

Fall 2005 Dr. Tufte’s FIN 4250 Notes 8

 What Is the Non-Cash Working
Capital Tradeoff?
• Non-cash working capital is subtracted out
of the present value of the project
• Thus, present value and non-cash working
capital are traded off
– The higher present value is traded off with the
higher risk due to potential loss of customers,
and higher default risk

Fall 2005 Dr. Tufte’s FIN 4250 Notes 9

 What Are the Cons of the Tradeoff
Between Cash and Non-Cash
Working Capital?
• Holding less cash:
– Is less of an issue if the firm has access to
ready outside financing
– Is harder if the economy tanks
– Increases uncertainty about meeting debt
obligations

Fall 2005 Dr. Tufte’s FIN 4250 Notes 10

 What Are the Pros of the Tradeoff
Between Cash and Non-Cash
Working Capital?
• Holding less cash:
– Makes it easier to satisfy the customer out of
inventory
– Makes it easier to entice the customer with
easy credit

Fall 2005 Dr. Tufte’s FIN 4250 Notes 11

 Is There An Optimal Level of Non-
Cash Working Capital?
• Probably, but there are a lot of difficulties
getting the data to figure out the tradeoff

Fall 2005 Dr. Tufte’s FIN 4250 Notes 12

 What Industries Use the Most and
Least Non-Cash Working Capital?
• Most:
– Shoes, textiles, office equipment,
homebuilding, auto manufacturing
• Least:
– Advertising, cable TV, restaurants,
hotels/gaming, railroads

Fall 2005 Dr. Tufte’s FIN 4250 Notes 13

 What Are the Benefits of Holding
Inventory?
• Raw materials
• Works in progress
• Finished items
– More if it takes time to fill an order
– More if the product line is diverse
– More if competitors are ready with substitutes

Fall 2005 Dr. Tufte’s FIN 4250 Notes 14

 What Are the Costs of Holding
Inventory?
• Foregone interest
– Increases with the size of inventory
– Increased with interest rates
• Carrying costs
– Storage
– Tracking

Fall 2005 Dr. Tufte’s FIN 4250 Notes 15

 What Is EOQ (Economic Order
Quantity)?
• A solution to a simple optimization problem for
minimizing the costs of inventory
– EOQ = sqrt(2 x demand x ordering cost/carrying cost)
– This yields a graph of inventory that looks like a series
of “capital N’s” through time
– A cushion can be added above zero inventory for
safety
• Similar to the Baumol model for cash (presented
later)

Fall 2005 Dr. Tufte’s FIN 4250 Notes 16

What Are the Weaknesses of Using
EOQ?
• It assumes constant demand
• It assumes that inventories can be
replenished without a time delay
• It assumes that ordering costs do not
depend on the size of the order (i.e., there
are no volume discounts)

Fall 2005 Dr. Tufte’s FIN 4250 Notes 17

 How Can Optimal Inventories Be
Determined?
• Ideally you want to measure the change in
the value of the firm due to a marginal
change in inventory
– This is difficult in practice
• Most firms look at similar firms for
guidance

Fall 2005 Dr. Tufte’s FIN 4250 Notes 18

 What Industries Hold the Most and
Least Inventory?
• Most:
– Pharmacies, textiles, aerospace, apparel,
homebuilding
• Least
– Healthcare information systems, medical
services, telecommunications, hotels/gaming,
restaurants

Fall 2005 Dr. Tufte’s FIN 4250 Notes 19

 How Does Trade Credit Relate to
Non-Cash Working Capital?
• Leads to an accounts receivable
– Product is shipped, leading to a need to
replenish inventory
– Payment may not be made immediately
– This can create cash flow problems

Fall 2005 Dr. Tufte’s FIN 4250 Notes 20

 What Are the Costs of Offering
Trade Credit?
• Default risk
• Interest foregone on the revenue

Fall 2005 Dr. Tufte’s FIN 4250 Notes 21

 What Are the Benefits of Offering
Trade Credit?
• Locks in a sale that the buyer can afford
out of cash flows but not out of cash on
hand
• It’s also more of an additional general
enticement to the buyer
– While trade credit is being “sold” to the
prospective buyer you are keeping them on
the line for the item you actually want to sell

Fall 2005 Dr. Tufte’s FIN 4250 Notes 22

 How Do You Decide Whether or
Not to Offer Trade Credit?
• Present value analysis

Fall 2005 Dr. Tufte’s FIN 4250 Notes 23

 How Do We Evaluate Trade Credit
Policy?
• Similar to inventory policy?
– The problem is too murky to be solved
directly. So we ask:
• Does it increase the value of the firm?
• Is it consistent with what similar firms are offering?

Fall 2005 Dr. Tufte’s FIN 4250 Notes 24

 How To Construct a Scoring
System for Offering Trade Credit?
• Define characteristics associated with
default
• Obtain data legally
• Weight the data in a way consistent with
the default risk
• Test fly the system
• Put it into practice

Fall 2005 Dr. Tufte’s FIN 4250 Notes 25

 How Are Terms of Trade Credit
Expressed?
• a/b net c
– a% discount
– Lasting for b days
– The full undiscounted amount due within c
days

Fall 2005 Dr. Tufte’s FIN 4250 Notes 26

 How Do You Figure Out the Rate
You Are Offering?
• [1+discount/(1-discount)}^(365/discount
length) = 1+effective rate
• If the customer delays payment, they are
effectively increasing the discount length –
and reducing your interest rate

Fall 2005 Dr. Tufte’s FIN 4250 Notes 27

 Who Has the Most and Least
Accounts Receivable?
• Most
– Telecommunications, newspapers, energy,
semiconductors, petroleum
• Least
– Restaurants, industrial services, healthcare
information services, tobacco, trailers and
RVs

Fall 2005 Dr. Tufte’s FIN 4250 Notes 28

 What About Accepting Trade
Credit?
• This creates an accounts payable
• It also tends to increase cash flows
• The costs and benefits of this are the
opposite of extending trade credit, but …
– Don’t forget that the interest you pay is
deductible, while the interest you receive is
not – so they are not quite mirror images of
each other

Fall 2005 Dr. Tufte’s FIN 4250 Notes 29

 Who Accepts Trade Credit?
• Surprisingly, the same industries that
extend lots of trade credit also tend to
accept a lot of it
– Restaurants and tobacco firms use little of
both
– Defense and auto firms use a lot of both
– The biggest exploiters of longer payables and
shorter receivables are auto firms

Fall 2005 Dr. Tufte’s FIN 4250 Notes 30

 What About Cash?
• Cash
• Money in accounts bearing rates lower
than the risk-free rate
• Short-term securities

Fall 2005 Dr. Tufte’s FIN 4250 Notes 31

 Why Hold Operating Cash?
• Transactions motive
• Precautionary motive
• Compensating balances
– This is what you hold in the bank to get
access to lines of credit and other services

Fall 2005 Dr. Tufte’s FIN 4250 Notes 32

 What Determines Cash Holdings?
• Size
• Sophistication of the firm’s finances
• Availability of investments
• Most U.S. firms hold 1-2% of revenues as
cash

Fall 2005 Dr. Tufte’s FIN 4250 Notes 33

 What Is the Baumol Model?
• Similar to the EOQ for inventory
• Optimal cash balances = sqrt[(2 x annual
cash usage x cost per security
sale)/(interest rate)]

Fall 2005 Dr. Tufte’s FIN 4250 Notes 34

 What Is the Miller-Orr Model?
• Firm sets upper and lower limits on cash,
and it only buys or sells securities when it
reaches these thresholds. This requires us
– To assume a minimum balance
– To know the variance of cash flows
• Spread = 3[(3/4)(transactions cost x
variance/interest rate)]^(1/3)

Fall 2005 Dr. Tufte’s FIN 4250 Notes 35

 How Does Holding Cash Affect the
Firm’s Value?
• Holding operating cash is much like
holding non-cash working capital
– It reduces the flow of cash that can be paid
out to investors

Fall 2005 Dr. Tufte’s FIN 4250 Notes 36

 How Can Cash Be Reduced?
• Float managing
– Increase your disbursement float and
decrease your processing float
• Better banking
– Lockboxes
– Concentration banking
– Have the bank control disbursements so they
are made immediately after deposits

Fall 2005 Dr. Tufte’s FIN 4250 Notes 37

 What Near-Cash Investments Are
Possible?
• In order of increasing risk and return (there is
usually a less than 1% difference in this group)
– Treasury bills
– Repurchase agreements
• On T-Bills
• On non-mortgage securities
• On mortgage-backed securities
– Commercial paper
• From financial institutions
• From non-financial instititutions

Fall 2005 Dr. Tufte’s FIN 4250 Notes 38

How to Choose Between Cash and
Near-Cash?
• Benefits of near-cash
– Earn interest
• Costs of near-cash
– Transactions costs
– Default risk (admittedly, this is minimal)
• Choosing to park some cash in near-cash is an
investment decision whose hurdle rate is the risk-
free rate
– You need to be able to beat this after transactions
costs and default risk
Fall 2005 Dr. Tufte’s FIN 4250 Notes 39
 When Can Investments In Cash and
Near-Cash Reduce Firm Value?
• Not earning the market rate
– This is not much of a problem in the U.S.
– This can be a big problem with overseas investments
where local markets may be overregulated or too thin
to offer reasonable risk-free rates
• Lousy management
– The value of cash will be discounted in the market if
the firm has few viable projects
• Cash is a payment that has not been made to
equity yet
– Thus, hording cash is the same as being
underleveraged

Fall 2005 Dr. Tufte’s FIN 4250 Notes 40

 Are There Good Reasons to Hold Lots
of Cash?
• High growth industries
• High volatility industries
• Industries in which viable projects appear
unexpectedly

Fall 2005 Dr. Tufte’s FIN 4250 Notes 41

 What About Riskier Investments In the
Short-Term?
• Pros
– Higher returns
– You can take advantage of undervalued securities
issued by other firms
– Strategic investment
• Push other firms decisions in your direction
– It’s the nature of some businesses
• Cons
– Higher risk
– Higher transactions costs
Fall 2005 Dr. Tufte’s FIN 4250 Notes 42
 Who Holds Cash?
• Most
– Coal, copper, air transport, autos, steel
• Least
– Retail building supply, water utilities, pharmacies,
groceries, retail
• Cash holdings are positively associated with
revenue growth and negatively associated with
revenue

Fall 2005 Dr. Tufte’s FIN 4250 Notes 43