TRADE-OFF BETWEEN PROFITABILITY AND RISK
MODULE 5: WORKING ⚫ Profitability is the relationship between
CAPITAL MANAGEMENT
(CURRENT ASSETS)
WORKING CAPITAL
⚫ It is the difference between the firm’s
current assets and current liabilities.
WC = CA - CL
⚫ It is used as measure to check the liquidity
of the firm.
⚫ If the firm’s current assets are greater than
the current liabilities, it is capable of
paying its current obligations.
CA > CL = Capable
⚫ If the firm’s current assets are less than
the current liabilities, it is not capable of
paying its current obligations, and has to
resort to borrowings.
CA < CL = Not Capable
⚫ Current assets are assets that are
realizable within 1 year
(cash, accounts receivable, marketable
securities , inventory, and prepaid assets).
⚫ Current liabilities are short-term
obligations that are expected to mature
within one year
(accounts payable, notes payable, accruals,
current portion of LT debts).
⚫ Managing the movement of working
capital ensures the continuity of company
operations.
WORKING CAPITAL MANAGEMENT
Working capital management is concerned with
the effective and efficient utilization of working
capital to attain the predetermined objectives
of the company relative to:
◼ profitability of operations
◼ liquidity of financial resources
◼ minimization of risks and company
costs
Working capital (or short-term financial)
management is the management of current
assets and current liabilities.
◼ Firms are able to reduce financing
costs or increase the funds available
for expansion by minimizing the
amount of funds that is tied up with
the working capital.
revenues and costs generated by using the
firm’s assets - both current and fixed - in
productive activities.
◼ A firm can increase its profits by (1)
increasing revenues or (2) decreasing
costs
⚫ Risk (or insolvency) is the probability that
a firm will not be able to pay its bills when
they come due.
⚫ Insolvent describes a firm that is unable to
pay its bills when they come due.
EFFECTS OF CHANGING RATIOS ON PROFITS
AND RISKS
CASH CONVERSION CYCLE
Cash Conversion Cycle (CCC) is the length of
time required for a company to convert cash
invested in its operations to cash received as a
result of its operations.
Formula for the Cash Conversion Cycle (CCC):
CCC = Operating Cycle - Ave. Payment Period
OPERATING CYCLE
A firm’s operating cycle (OC) is the time from
the beginning of the production process to
collection of cash from the sale of the finished
product.
It is measured in elapsed time by summing the
average age of inventory (AAI) and the average
collection period (ACP).
Formula of Operating Cycle:
OC = AAI + ACP
AVERAGE PAYMENT PERIOD
The process of producing and selling a product
also includes the purchase of production inputs
(raw materials) on account, which results in
accounts payable.
The time it takes to pay the accounts payable,
measured in days, is the average payment
period (APP).
Formula of Average Payment Period: CONSERVATIVE
Accounts Payable Turnover
= Net Credit Purchases / Ave. Accounts Payable
Average Payment Period
= 360 / Accounts Payable Turnover

TIMELINE CASH CONVERSION CYCLE

STRATEGIES FOR MANAGING THE CASH

CONVERSION CYCLE
The goal is to minimize the length of the cash
conversion cycle, which minimizes negotiated
liabilities. This goal can be realized through use
of the following strategies:
1. Turn over inventory as quickly as possible
without stockouts that result in lost sales.
2. Collect accounts receivable as quickly as
A COMPANY’S TOTAL FUNDING possible without losing sales from high-
REQUIREMENTS pressure collection techniques.
3. Manage mail, processing, and clearing
time to reduce then when collecting from
customers and to increase them when
paying suppliers.
4. Pay accounts payable as slowly as possible
without damaging the firm’s credit rating.

INVENTORY MANAGEMENT
Differing viewpoints about appropriate
inventory levels commonly exist among a firm’s
AGGRESSIVE VS CONSERVATIVE SEASONAL
finance, marketing, manufacturing, and
FUNDING STRATEGIES
purchasing managers.
⚫ An aggressive funding strategy is a funding
⚫ The financial manager’s general
strategy under which the firm funds its
disposition toward inventory levels is to
seasonal requirements with short-term
keep them low, to ensure that the firm’s
debt and its permanent requirements
money is not being unwisely invested in
with long-term debt.
excess resources.
⚫ A conservative funding strategy is a
⚫ The marketing manager. on the other
funding strategy under which the firm
hand, would like to have large inventories
funds both its seasonal and its permanent
of the firm’s finished products.
requirements with long-term debt.
⚫ The manufacturing manager’s major
Example:
responsibility is to implement the
AGGRESSIVE
production plan so that it results in the
desired amount of finished goods of
acceptable quality available on time at a
low cost.
⚫ The purchasing manager is concerned
solely with the raw materials inventories.
 COMMON TECHNIQUES FOR MANAGING
INVENTORY
ABC inventory system. The ABC inventory
system is an inventory management technique
that divides inventory into three groups - A, B,
and C, in descending order of importance and
level of monitoring, on the basis of the dollar
investment in each.
⚫ The A group includes those items with the
largest dollar investment. Typically, this
group consists of 20 percent of the firm’s
inventory items but 80 percent of its
investment in inventory.
⚫ The B group consists of items that account
for the next largest investment in
inventory.
⚫ The C group consists of a large number of
items that require a relatively small
investment
The inventory group of each item determines
the item’s level of monitoring.
⚫ The A group items receive the most
intense monitoring because of the high
dollar investment. Typically, A group items
are tracked on a perpetual inventory
system that allows daily verification of
each item’s inventory level.
⚫ B group items are frequently controlled
through periodic inventory system,
perhaps weekly, checking of their levels.
⚫ C group items are monitored with
unsophisticated techniques, such as the
two-bin method: an unsophisticated
inventory-monitoring technique that
involves reordering when one of two bins
is empty.
⚫ The large dollar investment in A and B
group items suggests the need for a better
method of inventory management than
the ABC system.
⚫ The Economic Order Quantity (EOQ)
Model is an inventory management
technique for determining an item’s
optimal order size, which is the size that
minimizes the total of its order costs and
carrying costs.
⚫ The EOQ model is an appropriate model
for the management of A and B group
items.
EOQ assumes that the relevant costs of
inventory can be divided into order costs and
carrying costs.
1. Order costs are the fixed clerical costs of
placing and receiving an inventory order.
2. Carrying costs are the variable costs per
unit of holding an item in inventory for a
specific period of time.
The EOQ model analyzes the tradeoff between
order costs and carrying costs to determine the
order quantity that minimizes the total
inventoriable cost.
⚫ A formula can be developed for
determining the firm’s EOQ for a given
inventory item, where
S = usage in units per period -- 100,000 units
O = order cost per order -- P50
C = carrying cost per unit per period -- P10
Q = order quantity in units -- 10,000 units
ORDER COST
⚫ The order cost can be expresses as the
product of the cost per order and the
number of orders. Because the number of
orders equals the usage during the period
divided by the order quantity (S/Q), the
order cost can be expressed as follows:
Order Cost = O x S/Q
= P50 x (100,000 / 10,000)
= 100,000 / 10,000
= 10 x P50
= P500
CARRYING COST
The carrying cost is defined as the cost of
carrying a unit of inventory per period
multiplied by the firm’s average inventory. The
average inventory is the order quantity divided
by 2 (Q/2), because inventory is assumed to be
depleted at a constant rate.
Thus carrying cost can be expresses as follows:
Carrying cost = C x Q/2
= 10 x (10,000 /2)
= P50,000
TOTAL COST
The firm’s total cost of inventory is found by
summing the order cost and the carrying cost.
Thus the total cost function is:
Total cost = Order Cost + Carrying Cost
= P500 + P5,000
= P50,500
 ECONOMIC ORDER QUANTITY (EOQ)
⚫ Because the EOQ is defined as the order
quantity that minimizes the total cost
function, we must solve the total cost
function for the EOQ. The resulting
equation is
= (2 x 100,000 x P50) / P10
= 1,000
⚫ The reorder point is the point at which to
reorder inventory, expresses as days of
lead time x daily use.
3 days x 10 units = 30 units
⚫ Because lead time and usage rates are not
precise, most firms hold safety stock -
extra inventory that is held to prevent
stockouts of important items.
Example:
The reorder point for MAX depends on the
number of days MAX operates per year.
⚫ Assuming that MAX operates 250 days per
year and uses 1,100 units of this item, its
daily usage is 4.4 units
◼ 1,100 / 250 = 4.4
⚫ If its lead time is 2 days and MAX wants to
maintain a safety stock of 4 units, the
reorder point for this item is 12.8 units
◼ (2 x 4.4) + 4 = 12.8
⚫ However, orders are made only in whole
units, so the order is placed when the
inventory falls to 13 units.
JUST-IN-TIME (JIT) SYSTEM
Just-in-time (JIT) system is an inventory
management technique that minimizes
inventory investment by having materials arrive
at exactly the time they are needed for
production.
⚫ Its objective is to minimize inventory
investment, a JIT system uses no (or very
little) safety stock.
⚫ Extensive coordination among the firm’s
employees, its suppliers, and shipping
companies must exist to ensure that
material inputs arrive on time.
⚫ Failure of materials to arrive on time
results in a shutdown of the production
line until the materials arrive.
⚫ Likewise, a JIT system requires high-quality
parts from suppliers.
INVENTORY MANAGEMENT: COMPUTERIZED
SYSTEMS FOR RESOURCE CONTROL
Materials Required Planning (MRP) system is
an inventory management technique that
applies EOQ concepts and a computer to
compute production needs to available
inventory balances and determine when orders
should be placed for various items on a
product’s bill of materials.
Manufacturing Resource Planning II (MRP II) is
a sophisticated computerized system that
integrates data from numerous areas such as
finance, accounting, marketing, engineering,
and manufacturing and generates production
plans as well as numerous financial and
management reports.
Enterprise resource planning (ERP) is a
computerized system that electronically
integrates external information about the
firm’s suppliers and customers with the firm’s
departmental data so that information on all
available resources—human and material—can
be instantly obtained in a fashion that
eliminates production delays and controls costs.
1

4
 MODULE 6: WORKING
CAPITAL MANAGEMENT
ACCOUNTS RECEIVABLE MANAGEMENT
The second component of the cash conversion
cycle is the average collection period. The
average collection period has two parts:
1. The time from the sale until the customer
mails the payment.
2. The time from when the payment is
mailed until the firm has the collected
funds in its bank account.
The objective for managing accounts receivable
is to collect accounts receivable as quickly as
possible without losing sales from high-pressure
collection techniques. Accomplishing this goal
encompasses three topics:
1. Credit selection and standards
2. Credit terms
3. Credit monitoring.
CREDIT SELECTION AND STANDARDS
Credit standards are a firm’s minimum
requirements for extending credit to a
customer.
THE FIVE C’S OF CREDIT ARE AS FOLLOWS:
1. Character: The applicant’s record of
meeting past obligations.
2. Capacity: The applicant’s ability to repay
the requested credit.
3. Capital: The applicant’s debt relative to
equity.
4. Collateral: The amount of assets the
applicant has available for use in securing
the credit.
5. Conditions: Current general and industry-
specific economic conditions, and any
unique conditions surrounding a specific
transaction.
CREDIT SCORING is a credit selection method
commonly used with high-volume/small-dollar
credit requests; relies on a credit score
determined by applying statistically derived
weights to a credit applicant’s scores on key
financial and credit characteristics.
The firm sometimes will contemplate changing
its credit standards in an effort to improve its
returns and create greater value for its owners.
To demonstrate, consider the following changes
and effects on profits expected to result from
the relaxation of credit standards.
EFFECTS OF RELAXATION OF CREDIT
STANDARDS
EXAMPLE:
Dodd Tool is currently selling a product for $10
per unit. Sales (all on credit) for last year were
60,000 units. The variable cost per unit is $6.
The firm’s total fixed costs are $120,000.The
firm is currently contemplating a relaxation of
credit standards that is expected to result in the
following:
1. A 5% increase in unit sales to 63,000 units;
60,000 x 5% = 3,000 +60,000 = 63,000
2. An increase in the ave. collection period
from 30 days (the current level) to 45 days;
3. An increase in bad-debt expenses from 1%
of sales (the current level) to 2%.
The firm’s required return on equal-risk
investments, which is the opportunity cost of
tying up funds in accounts receivable, is 15%.
Because fixed costs are “sunk” and therefore
are unaffected by a change in the sales level,
the only cost relevant to a change in sales is
variable costs. Sales are expected to increase
by 5%, or 3,000 units. The profit contribution
per unit will equal the difference between the
sale price per unit ($10) and the variable cost
per unit ($6). The profit contribution per unit
therefore will be $4. The total additional profit
contribution from sales will be $12,000 (3,000
units × $4 per unit).
SP 10 - VC 6 = $4 profit contribution
To determine the cost of the marginal
investment in accounts receivable, Dodd must
find the difference between the cost of carrying
receivables under the two credit standards.
Because its concern is only with the out-of-
pocket costs, the relevant cost is the variable
cost. The average investment in accounts
receivable can be calculated by using the
following formula:
Average investment in accounts receivable
Accounts Receivable Turnover
Total variable cost of annual sales:
Under present plan: ($6 × 60,000 units)
= $360,000
Under proposed plan: ($6 × 63,000 units)
= $378,000
The turnover of accounts receivable is the
number of times each year that the firm’s
accounts receivable are actually turned into
cash. It is found by dividing the average
collection period into 360 (the number of days
assumed in a year).
Turnover of accounts receivable:
Under present plan: (360/30) = 12
Under proposed plan: (360/45) = 8
By substituting the cost and turnover data just
calculated into the average investment in
accounts receivable equation for each case, we
get the following average investments in
accounts receivable:
Under present plan:($360,000/12) = $30,000
Under proposed plan:($378,000/8) = $47,250
Cost of marginal investment in accounts
receivable:
The resulting value of $2,587.50 is considered a
cost because it represents the maximum
amount that could have been earned on the
$17,250 had it been placed in the best equal-
risk investment alternative available at the
firm’s required return on investment of 15%.
Cost of marginal bad debts:
Effects on Dood Tool of a Relaxation of Credit
Standards:
Credit management is difficult enough for
managers of purely domestic companies, and
these tasks become much more complex for
companies that operate internationally.
1. This is partly because international
operations typically expose a firm to
exchange rate risk.
2. It is also due to the dangers and delays
involved in shipping goods long distances
and in having to cross at least two
international borders.
Credit terms are the terms of sale for
customers who have been extended credit by
the firm.
A cash discount is a percentage deduction from
the purchase price; available to the credit
customer who pays its account within a
specified time.
For example, terms of 2/10 net 30 mean the
customer can take a 2 percent discount from
the invoice amount if the payment is made
within 10 days of the beginning of the credit
period or can pay the full amount of the invoice
within 30 days.
EXAMPLE:
MAX Company has annual sales of $3.3 million
and an average collection period of 40 days
(turnover = 360/40 = 9). In accordance with the
firm’s credit terms of net 30, this period is
divided into 32 days until the customers place
their payments in the mail (not everyone pays
within 30 days) and 8 days to receive, process,
and collect payments once they are mailed.
MAX is considering initiating a cash discount by
changing its credit terms from net 30 to 2/10
net 30. The firm expects this change to reduce
the amount of time until the payments are
placed in the mail, resulting in an average
collection period of 25 days (turnover = 360/25
= 14.4).
MAX is currently selling 1,100 units at a selling
price of $3,000. Variable cost per unit is $2,300.
Implementation of the proposed plan will
increase its sales by 50 units, and it is expected
that 80% of the customers will take advantage
of the cash discount. Opportunity cost is 14%.
Aditional profit contribution from sales:
50 units x ($3,000 - $2,300) = 35,000
Cost of marginal investment in accounts
receivable:
Average investment presently (without
discount)
= ($2,300 x 1,100 units) / 9
= $2,530,000 / 9
= $281,111.11
Average investment with proposed cash
discount:
= ($2,300 x 1,150 unit) / 14.4
= $2,645,000 / 14.4
= $183,680.56
Reduction in accounts receivable investment:
$281,111.11 - $183,680.56 = $97,430.55
Cost savings in reduced investment in accounts
receivable:
$97,430.55 x 14% = $13,640.28
Cost of cash discount:
1,150 units x $3,000 x 80% x 2% = $55,200
A CASH DISCOUNT PERIOD is the number of
days after the beginning of the credit period
during which the cash discount is available. 2/10,
n/30
The net effect of changes in this period is
difficult to analyze because of the nature of the
forces involved.
For example, if a firm were to increase its cash
discount period by 10 days (for example,
changing its credit terms from 2/10 n/30 to
2/20 n/30), the following changes would be
expected to occur:
1. Sales would increase, positively affecting
profit.
2. Bad-debt expenses would decrease,
positively affecting profit.
3. The profit per unit would decrease as a
result of more people taking the discount,
negatively affecting profit.
The CREDIT PERIOD is the number of days after
the beginning of the credit period until full
payment of the account is due. 2/10, n/30
Changes in the credit period, the number of
days after the beginning of the credit period
until full payment of the account is due, also
affect a firm’s profitability.
For example, increasing a firm’s credit period
from net 30 days to net 45 days should increase
sales, positively affecting profit. But both the
investment in accounts receivable and bad-
debt expenses would also increase, negatively
affecting profit.
CREDIT MONITORING is the ongoing review of
a firm’s accounts receivable to determine
whether customers are paying according to the
stated credit terms.
If they are not paying in a timely manner,
credit monitoring will alert the firm to the
problem.
Slow payments are costly to a firm because
they lengthen the average collection period and
thus increase the firm’s investment in accounts
receivable.
Two frequently used techniques for credit
monitoring are average collection period and
aging of accounts receivable. 0-30 days , 31-60
days, 61-90 days
n/30, 45 days = 15 days / under 0-30 days
An AGING SCHEDULE is a credit-monitoring
technique that breaks down accounts
receivable into groups on the basis of their time
of origin; it indicates the percentages of the
total accounts receivable balance that have
been outstanding for specified periods of time
Proper Collection Techniques:
1. Letters
2. Telephone calls
3. Personal visits
4. Collection agencies
5. Legal action
MANAGEMENT OF RECEIPTS AND
DISBURSEMENTS: FLOAT
FLOAT refers to funds that have been sent by
the payer but are not yet usable funds to the
payee.
Float has three component parts:
1. Mail float is the time delay between when
payment is placed in the mail and when it
is received.
2. Processing float is the time between
receipt of a payment and its deposit into
the firm’s account.
3. Clearing float is the time between deposit
of a payment and when spendable funds
become available to the firm.
Speeding up collections reduces customer
collection float time and thus reduces the firm’s
average collection period, which reduces the
investment the firm must make in its cash
conversion cycle.
A popular technique for speeding up collections
is a LOCKBOX SYSTEM, which is a collection
procedure in which customers mail payments
to a post office box that is emptied regularly by
the firm’s bank, which processes the payments
and deposits them in the firm’s account. This
system speeds up collection time by reducing
processing time as well as mail and clearing
time.
FLOAT is also a component of the firm’s average
payment period.
CONTROLLED DISBURSING is the strategic use
of mailing points and bank accounts to
lengthen mail float and clearing float,
respectively.
CASH CONCENTRATION is the process used by
the firm to bring lockbox and other deposits
together into one bank, often called the
concentration bank. Cash concentration has
three main advantages.
First, it creates a large pool of funds for use in
making short-term cash investments. Because
there is a fixed-cost component in the
transaction cost associated with such
investments, investing a single pool of funds
reduces the firm’s transaction costs. The larger
investment pool also allows the firm to choose
from a greater variety of short-term investment
vehicles.
Second, concentrating the firm’s cash in one
account improves the tracking and internal
control of the firm’s cash.
Third, having one concentration bank enables
the firm to implement payment strategies that
reduce idle cash balances.
DEPOSITORY TRANSFER CHECK (DTC) is an
unsigned check drawn on one of a firm’s bank
accounts and deposited in another.
AUTOMATED CLEARINGHOUSE (ACH) transfer
is a preauthorized electronic withdrawal from
the payer’s account and deposit into the
payee’s account via a settlement among banks
by the automated clearinghouse, or ACH.
WIRE TRANSFER is an electronic
communication that, via bookkeeping entries,
removes funds from the payer’s bank and
deposits them in the payee’s bank.
ZERO-BALANCE ACCOUNT (ZBA) is a
disbursement account that always has an end-
of-day balance of zero because the firm
deposits money to cover checks drawn on the
account only as they are presented for payment
each day.
 MODULE 6: CURRENT
LIABILITIES MANAGEMENT
SPONTANEOUS LIABILITIES
Spontaneous liabilities are financing that arises
from the normal course of business; the two
major short-term sources of such liabilities are
accounts payable and accruals.
Unsecured short-term financing is short-term
financing obtained without pledging specific
assets as collateral.
The firm should take advantage of these
“interest-free” sources of unsecured short-term
financing whenever possible.
ACCOUNTS PAYABLE
⚫ Accounts payable are the major source of
unsecured short-term financing for business
firms.
⚫ They result from transactions in which
merchandise is purchased but no formal note
is signed to show the purchaser’s liability to
the seller.
⚫ The average payment period has two parts:
◼ The time from the purchase of raw
materials until the firm mails the
payment and;
◼ Payment float time (the time it takes
after the firm mails its payment until
the supplier has withdrawn spendable
funds from the firm’s account).
ACCOUNTS PAYABLE MANAGEMENT
⚫ Accounts payable management is
management by the firm of the time that
elapses between its purchase of raw
materials and its mailing payment to the
supplier.
⚫ When the seller of goods charges no interest
and offers no discount to the buyer for early
payment, the buyer’s goal is to pay as slowly
as possible without damaging its credit rating.
⚫ This allows for the maximum use of an
interest-free loan from the supplier and will
not damage the firm’s credit rating (because
the account is paid within the stated credit
terms).
COST OF GIVING UP DISCOUNT
⚫ The cost of giving up a cash discount is the
implied rate of interest paid to delay
payment of an account payable for an
additional number of days.
EXAMPLE:
⚫ Lawrence Industries, operator of a small
chain of video stores, purchased $1,000
worth of merchandise on March 01 from a
supplier extending terms of 2/10 net 30. If
the firm takes the cash discount, it must pay
$980 [$1,000 – (2% × $1,000)] by March 10,
thereby saving $20. or (1,000 x 98%)
◼ To calculate the cost of giving up the
cash discount, the true purchase price
must be viewed as the discounted cost
of the merchandise, which is $980 for
Lawrence Industries.
◼ Another way to say this is that Lawrence
Industries’ supplier charges $980 for the
goods as long as the bill is paid in 10
days.
◼ If Lawrence takes 20 additional days to
pay (by paying on day 30 rather than on
day 10), they have to pay the supplier an
additional $20 in “interest.”
◼ Therefore, the interest rate on this
transaction is 2.04% ($20 ÷ $980). Keep
in mind that the 2.04% interest rate
applies to a 20-day loan. 30 days - 10
days = 20 days
FORMULA: COST OF GIVING UP DISCOUNT
A simple way to approximate the cost of giving
up a cash discount is to use the stated cash
discount percentage, CD, in place of the first
term of the previous equation:
Approximate cost of giving up cash discount
= CD x ( 365 / N )
Substituting the values for CD (2%) and N (20
days) into these equations results in an
annualized approximate cost of giving up the
cash discount of 36.5%
[2% × (365 ÷ 20)]. 30 - 10 = 20 days
WHICH CASH DISCOUNT TO GIVE UP?
If the firm needs short-term funds, which it can
borrow from its bank at an interest rate of 13%,
and if each of the suppliers is viewed separately,
which (if any) of the suppliers’ cash discounts
will the firm give up?
⚫ A - don’t give up
⚫ B - give up
⚫ C - don’t give up
⚫ D - don’t give up
STRETCHING ACCOUNTS PAYABLE
Stretching accounts payable refers to paying
bills as late as possible without damaging the
firm’s credit rating.
EXAMPLE:
⚫ Lawrence Industries was extended credit
terms of 2/10 net 30 EOM. The cost of giving
up the cash discount, assuming payment on
the last day of the credit period, was
approximately 36.5%
◼ [2% × (365 ÷ 20)].
⚫ If the firm were able to stretch its account
payable to 70 days without damaging its
credit rating, the cost of giving up the cash
discount would be only 12.17%
◼ [2% × (365 ÷ 60)]. 70 - 10 = 60 days
⚫ Stretching accounts payable reduces the
implicit cost of giving up a cash discount.
ACCRUALS
Accruals are liabilities for services received for
which payment has yet to be made.
⚫ The most common items accrued by a firm
are wages and taxes.
⚫ Because taxes are payments to the
government, their accrual cannot be
manipulated by the firm.
⚫ However, the accrual of wages can be
manipulated to some extent.
⚫ This is accomplished by delaying payment of
wages, thereby receiving an interest-free
loan from employees who are paid sometime
after they have performed the work.
EXAMPLE:
Tenney Company, a large janitorial service
company, currently pays its employees at the end
of each work week. The weekly payroll totals
$400,000. If the firm were to extend the pay
period so as to pay its employees 1 week later
throughout an entire year, the employees would
in effect be lending the firm $400,000 for a year. If
the firm could earn 10% annually on invested
funds, such a strategy would be worth $40,000
per year
(0.10 × $400,000).
UNSECURED SOURCES: SHORT-TERM BANK
LOANS
⚫ A short-term, self-liquidating loan is an
unsecured short-term loan in which the use
to which the borrowed money is put provides
the mechanism through which the loan is
repaid.
⚫ These loans are intended merely to carry the
firm through seasonal peaks in financing
needs that are due primarily to buildups of
inventory and accounts receivable.
⚫ As the firm converts inventories and
receivables into cash, the funds needed to
retire these loans are generated.
⚫ The prime rate of interest (prime rate) is the
lowest rate of interest charged by leading
banks on business loans to their most
important business borrowers.
⚫ The prime rate fluctuates with changing
supply-and-demand relationships for short-
term funds.
⚫ Banks generally determine the rate to be
charged to various borrowers by adding a
premium to the prime rate to adjust it for
the borrower’s “riskiness.”
6% + 3% = 9%
6% + 1% = 7%
⚫ A fixed-rate loan is a loan with a rate of
interest that is determined at a set
increment above the prime rate and remains
unvarying until maturity.
⚫ A floating-rate loan is a loan with a rate of
interest initially set at an increment above
the prime rate and allowed to “float,” or vary,
above prime as the prime rate varies until
maturity.
6% 6.25% 5.8% ------
⚫ Once the nominal (or stated) annual rate is PROBLEM SOLVING
established, the method of computing
interest is determined. Interest can be paid
either when a loan matures or in advance. If
interest is PAID AT MATURITY, the effective
(or true) annual rate—the actual rate of
interest paid—for an assumed 1-year period
is equal to: ANSWER:
Interest
Borrowed Money

⚫ When interest is PAID IN ADVANCE, it is

deducted from the loan so that the borrower
actually receives less money than is
requested (and less than they must repay).
Loans on which interest is paid in advance by
being deducted from the amount borrowed
are called discount loans. The effective
annual rate for a discount loan, assuming a
1-year period, is calculated as:
Interest
Borrowed Money - Interest

EXAMPLE:
PAID AT MATURITY
Wooster Company, a manufacturer of athletic
apparel, wants to borrow $10,000 at a stated
annual rate of 10% interest for 1 year. If the
interest on the loan is paid at maturity, the firm
will pay $1,000 (10% × $10,000) for the use of
the $10,000 for the year. At the end of the year,
Wooster will write a check to the lender for
$11,000, consisting of the $1,000 interest as
well as the return of the $10,000 principal.
The effective annual rate is therefore:
⚫ 10,000 x 10% = 1,000
⚫ 1,000 / 10,000 = 10%

PAID IN ADVANCE
If the money is borrowed at the same stated
annual rate for 1 year but interest is paid in
advance, the firm still pays $1,000 in interest,
but it receives only $9,000 ($10,000 – $1,000).
The effective annual rate in this case is
The effective annual rate is therefore:
⚫ 10,000 x 10% = 1,000
⚫ 1,000 / (10,000 - 1,000) = 11.11%
0R
OR

MODULE 7: TIME VALUE
OF MONEY
TIME VALUE OF MONEY
⚫ The time value of money (TVM) is the
concept that a sum of money is worth
more now than the same sum will be at a
future date due to its earnings potential in
the interim.
⚫ This is a core principle of finance. A sum of
money in the hand has greater value than
the same sum to be paid in the future.
THE ROLE OF TIME VALUE IN FINANCE
Most financial decisions involve costs &
benefits that are spread out over time.
⚫ Time value of money allows comparison
of cash flows from different periods.
⚫ Question: Your father has offered to give
you some money and asks that you choose
one of the following two alternatives:
◼ $1,000 today, or
◼ $1,100 one year from now.
⚫ What do you do?
◼ The answer depends on what rate of
interest you could earn on any money
you receive today.
◼ For example, if you could deposit the
$1,000 today at 12% per year, you
would prefer to be paid today.
◼ Alternatively, if you could only earn 5%
on deposited funds, you would be
better off if you chose the $1,100 in
one year.
FUTURE VALUE VERSUS PRESENT VALUE
⚫ Suppose a firm has an opportunity to
spend $15,000 today on some investment
that will produce $17,000 spread out over
the next five years as follows:
⚫ Is this a wise investment?
To make the right investment decision,
managers need to compare the cash flows at a
single point in time.
TIME LINE
COMPOUNDING AND DISCOUNTING
⚫ Compounding and Discounting are simply
opposite to each other.
◼ COMPOUNDING converts the
present value into future value
◼ DISCOUNTING converts the future
value into present value.
FUTURE VALUE OF A SINGLE AMOUNT
⚫ Future value is the value at a given future
date of an amount placed on deposit today
and earning interest at a specified rate.
Found by applying compound interest over
a specified period of time.
⚫ Compound interest is interest that is
earned on a given deposit and has become
part of the principal at the end of a
specified period.
◼ (simple interest vs compound
interest)
⚫ Principal is the amount of money on
which interest is paid.
PERSONAL FINANCE EXAMPLE
If Fred Moreno places $100 in a savings account
paying 8% interest compounded annually, how
much will he have at the end of 1 year?
Future value at end of year 1
$100 x (1 + 0.08) = $108
If Fred were to leave this money in the account
for another year, how much would he have at
the end of the second year?
Future value at end of year 2
= $100 x (1 + 0.08) x (1 + 0.08)
= $116.64
OR
$100 x 1.08 = $108
$108 x 1.08 = $116.64
 FUTURE VALUE OF A SINGLE AMOUNT: THE
EQUATION FOR FV
⚫ We use the following notation for the
various inputs:
◼ FVn = future value at the end of
period n
◼ PV = initial principal, or present value
◼ r = annual rate of interest paid. (Note:
On financial calculators, I is typically
used to represent this rate.)
◼ n = number of periods (typically years)
that the money is left on deposit
⚫ The general equation for the future value
at the end of period n is FVn = PV x (1 +
r)^n
EXAMPLE:
Jane Farber places $800 in a savings account
paying 6% interest compounded annually. She
wants to know how much money will be in the
account at the end of five years.
OR
800 x (1.06 x 1.06 x 1.06 x 1.06 x 1.06) =
1,070.58
This analysis can be depicted on a time line as
follows:
PRESENT VALUE OF A SINGLE AMOUNT
⚫ Present value is the current dollar value of
a future amount—the amount of money
that would have to be invested today at a
given interest rate over a specified period
to equal the future amount.
⚫ It is based on the idea that a dollar today
is worth more than a dollar tomorrow.
⚫ Discounting cash flows is the process of
finding present values; the inverse of
compounding interest.
⚫ The discount rate is often also referred to
as the opportunity cost, the discount rate,
the required return, or the cost of capital.
PERSONAL FINANCE EXAMPLE
Paul Shorter has an opportunity to receive $300
one year from now. If he can earn 6% on his
investments, what is the most he should pay
now for this opportunity?
PV = PV x (1 + 0.06) = $300
PV = $300/ (1 + 0.06) = $283.02
PRESENT VALUE OF A SINGLE AMOUNT: THE
EQUATION FOR PV
The present value, PV, of some future amount,
FVn, to be received n periods from now,
assuming an interest rate (or opportunity cost)
of r, is calculated as follows:
EXAMPLE:
Pam Valenti wishes to find the present value of
$1,700 that will be received 8 years from now.
Pam’s opportunity cost is 8%.
This analysis can be depicted on a time line as
follows:
ANNUITIES
An annuity is a stream of equal periodic cash
flows, over a specified time period. These cash
flows can be inflows of returns earned on
investments or outflows of funds invested to
earn future returns.
⚫ An ORDINARY (DEFERRED) ANNUITY is an
annuity for which the cash flow occurs at
the end of each period.
⚫ An ANNUITY DUE is an annuity for which
the cash flow occurs at the beginning of
each period.
⚫ An annuity due will always be greater than
an otherwise equivalent ordinary annuity
because interest will compound for an
additional period.
PERSONAL FINANCE EXAMPLE
Fran Abrams is choosing which of two annuities
to receive. Both are 5-year $1,000 annuities;
annuity A is an ordinary annuity, and annuity B
is an annuity due. Fran has listed the cash flows
for both annuities as shown on the following
slide.
Comparison of Ordinary Annuity and Annuity $1,000 x ((1+.07)n - 1)/.07) x (1+.07)= $6,153.29
Due Cash Flows ($1,000, 5 yrs)
FINDING THE PRESENT VALUE OF AN
ORDINARY ANNUITY
Braden Company, a small producer of plastic
toys, wants to determine the most it should
pay to purchase a particular annuity. The
annuity consists of cash flows of $700 at the
end of each year for 5 years. The required
return is 8%.

FINDING THE FUTURE VALUE OF AN ORDINARY This analysis can be depicted on a time line as
ANNUITY follows:
You can calculate the future value of an
ordinary annuity that pays an annual cash flow
equal to CF by using the following equation:

As before, in this equation r represents the

interest rate and n represents the number of LONG METHOD FOR FINDING THE PRESENT
payments in the annuity (or equivalently, the VALUE OF AN ORDINARY ANNUITY
number of years over which the annuity is
spread).

PERSONAL FINANCE EXAMPLE

Fran Abrams wishes to determine how much
money he will have at the end of 5 years if he
chooses annuity A, the ordinary annuity and it
earns 7% annually. Annuity A is depicted
graphically below:

FINDING THE PRESENT VALUE OF AN ANNUITY

This analysis can be depicted on a time line as
DUE
follows:
You can calculate the present value of an
ordinary annuity that pays an annual cash flow
equal to CF by using the following equation:

= ($700/.08) x (1-(1/(1+.08)n)) x (1+.08)

= 8,750 x (1- (1 / 1.4693280768) x 1.08
FINDING THE FUTURE VALUE OF AN ANNUITY = $3,018.49
DUE
You can calculate the present value of an
annuity due that pays an annual cash flow
equal to CF by using the following equation:
 SUMMARY OF FORMULAS 3. 12,900 x (1 + 0.08)^2 = 15,046.56
1. FV of a Single Amount 4. 16,000 x (1 + 0.08)^1 = 17,280
PRESENT VALUE OF A MIXED STREAM
Frey Company, a shoe manufacturer, has been
2. PV of a Single Amount offered an opportunity to receive the following
mixed stream of cash flows over the next 5
years.

3. FV of Ordinary Annuity

4. FV of Annuity Due

If the firm must earn at least 9% on its

5. PV of Ordinary Annuity investments, what is the most it should pay for
this opportunity?
This situation is depicted on the following time
line.
6. PV of Annuity Due

FUTURE VALUE OF A MIXED STREAM

Shrell Industries, a cabinet manufacturer,
expects to receive the following mixed stream
of cash flows over the next 5 years from one of
its small customers.
1. 400 / (1 + 0.09)^1 = 366.97
2. 800 / (1 + 0.09)^2 = 673.34
3. 500 / (1 + 0.09)^3 = 386.09
4. 400 / (1 + 0.09)^4 = 283.37
5. 300 / (1 + 0.09)^5 = 194.98

If the firm expects to earn at least 8% on its

investments, how much will it accumulate by
the end of year 5 if it immediately invests these
cash flows when they are received?
This situation is depicted on the following time
line.

1. 11,500 x (1 + 0.08)^4 = 15,645.62

2. 14,000 x (1 + 0.08)^3 = 17,635.97
PV OF A SINGLE AMOUNT (PAY) FV OF MIXED STREAM (ORDINARY ANNUITY)
(NO PAY, END, PABABA, 0)

FV OF A SINGLE AMOUNT (NO PAY)

FV OF MIXED STREAM (ANNUITY DUE)

FV OF ORDINARY ANNUITY (NO PAY, END) (NO PAY, BEG, PABABA, NO 0)

FV OF ANNUITY DUE (NO PAY, BEG.)

PV OF MIXED STREAM (ORDINARY ANNUITY)

PV OF ORDINARY ANNUITY (PAY, END) (PAY, END, PATAAS, NO 0)

PV OF ANNUITY DUE (PAY, BEG.)

PV OF MIXED STREAM (ANNUITY DUE)

(PAY, BEG, PATAAS, 0)

MODULE 8: PAYOUT
POLICY
PAYOUT POLICY
The term payout policy refers to the decisions
that a firm makes regarding whether to
distribute cash to shareholders, how much cash
to distribute, and the means by which cash
should be distributed.
THE MECHANICS OF PAYOUT POLICY: CASH
DIVIDEND PAYMENT PROCEDURES
⚫ At quarterly or semiannual meetings, a
firm’s board of directors decides whether
and in what amount to pay cash dividends.
⚫ If the firm has already established a
precedent of paying dividends, the
decision facing the board is usually
whether to maintain or increase the
dividend, and that decision is based
primarily on the firm’s recent performance
and its ability to generate cash flow in the
future.
⚫ Boards rarely cut dividends unless they
believe that the firm’s ability to generate
cash is in serious jeopardy.
⚫ The date of record (dividends) is set by
the firm’s directors, the date on which all
persons whose names are recorded as
stockholders receive a declared dividend
at a specified future time.
⚫ A stock is ex dividend for a period,
beginning 2 business days prior to the date
of record, during which a stock is sold
without the right to receive the current
dividend.
⚫ The payment date is set by the firm’s
directors, the actual date on which the
firm mails the dividend payment to the
holders of record.
DIVIDEND PAYMENT TIME LINE
THE MECHANICS OF PAYOUT POLICY: CASH
DIVIDEND PAYMENT PROCEDURES
On June 24, 2010, the board of directors of Best
Buy announced that the firm’s next quarterly
cash dividend would be $0.15 per share,
payable October 26 to shareholders of record
on October 5. At the time, Best Buy had
420,000,000 shares of common stock
outstanding. Before the dividend was declared,
the key accounts of the firm were as follows
(dollar values quoted in thousands):
⚫ Cash: $1,826,000,000
⚫ Dividends payable: $0
⚫ Retained earnings: $5,797,000,000
When the dividend was announced by the
directors, $63 million of the retained earnings
($0.15 per share 420 million shares) was
transferred to the dividends payable account.
The key accounts thus became:
⚫ Cash: $1,826,000,000
⚫ Dividends payable: $63,000,000
⚫ Retained earnings: $5,734,000,000
◼ ($5,797,000,000 - $63,000,000)
When Best Buy actually paid the dividend on
October 26, this produced the following
balances in the key accounts of the firm:
⚫ Cash: $1,763,000,000
◼ ($1,826,000,000 - $63,000,000)
⚫ Dividends payable: $0
◼ ($63,000,000 - $63,000,000)
⚫ Retained earnings: $5,734,000,000
The net effect of declaring and paying the
dividend was to reduce the firm’s total assets
(and stockholders’ equity) by $63 million.
THE MECHANICS OF PAYOUT POLICY: SHARE
REPURCHASE PROCEDURES
Common methods for repurchasing shares
include:
⚫ OPEN-MARKET SHARE REPURCHASE - is a
share repurchase program in which firms
simply buy back some of their outstanding
shares on the open market.
⚫ TENDER OFFER REPURCHASE - is a
repurchase program in which a firm offers
to repurchase a fixed number of shares,
usually at a premium relative to the
market value, and shareholders decide
whether or not they want to sell back their
shares at that price.
⚫ DUTCH AUCTION REPURCHASE - is a
repurchase method in which the firm
specifies how many shares it wants to buy
back and a range of prices at which it is
willing to repurchase shares. Investors
specify how many shares they will sell at
each price in the range, and the firm
determines the minimum price required to
repurchase its target number of shares. All
investors who tender receive the same
price.
THE MECHANICS OF PAYOUT POLICY:
DIVIDEND REINVESTMENT PLANS
Dividend reinvestment plans (DRIPs) are plans
that enable stockholders to use dividends
received on the firm’s stock to acquire
additional shares—even fractional shares—at
little or no transaction cost.
⚫ Some companies even allow investors to
make their initial purchases of the firm’s
stock directly from the company without
going through a broker.
⚫ With DRIPs, plan participants typically can
acquire shares at about 5 percent below
the prevailing market price.
THE MECHANICS OF PAYOUT POLICY: STOCK
PRICE REACTIONS TO CORPORATE PAYOUTS
What happens to the stock price when a firm
pays a dividend or repurchases shares?
⚫ In theory, when a stock begins trading ex
dividend, the stock price should fall by
exactly the amount of the dividend.
⚫ In theory, when a firm buys back shares at
the going market price, the market price
of the stock should remain the same.
⚫ In practice, taxes and a variety of other
market imperfections may cause the
actual change in share price in response to
a dividend payment or share repurchase to
deviate from what we expect in theory.
RELEVANCE OF PAYOUT POLICY
⚫ The financial literature has reported
numerous theories and empirical findings
concerning payout policy.
⚫ Although this research provides some
interesting insights about payout policy,
capital budgeting and capital structure
decisions are generally considered far
more important than payout decisions.
⚫ In other words, firms should not sacrifice
good investment and financing decisions
for a payout policy of questionable
importance.
⚫ The most important question about
payout policy is this: Does payout policy
have a significant effect on the value of a
firm?
RELEVANCE OF PAYOUT POLICY: RESIDUAL
THEORY OF DIVIDENDS
RESIDUAL THEORY OF DIVIDENDS is a school of
thought that suggests that the dividend paid by
a firm should be viewed as a residual—the
amount left over after all acceptable
investment opportunities have been
undertaken.
Using the residual theory of dividends, the firm
would treat the dividend decision in three steps,
as follows:
1. Determine its optimal level of capital
expenditures, which would be the level
that exploits all of a firm’s positive NPV
projects.
2. Using the optimal capital structure
proportions, estimate the total amount of
equity financing needed to support the
expenditures generated in Step 1.
3. Because the cost of retained earnings, rr,
is less than the cost of new common stock,
rn, use retained earnings to meet the
equity requirement determined in Step 2.
If retained earnings are inadequate to
meet this need, sell new common stock. If
the available retained earnings are in
excess of this need, distribute the surplus
amount—the residual—as dividends.
Relevance of Payout Policy: The Dividend
Irrelevance Theory
The dividend irrelevance theory is Miller and
Modigliani’s theory that in a perfect world, the
firm’s value is determined solely by the earning
power and risk of its assets (investments) and
that the manner in which it splits its earnings
stream between dividends and internally
retained (and reinvested) funds does not affect
this value.
⚫ In a perfect world (certainty, no taxes, no
transactions costs, and no other market
imperfections), the value of the firm is
unaffected by the distribution of dividends.
⚫ Of course, real markets do not satisfy the
“perfect markets” assumptions of
Modigliani and Miller’s original theory.

The CLIENTELE EFFECT is the argument that

different payout policies attract different types
of investors but still do not change the value of
the firm.
⚫ Tax-exempt investors may invest more
heavily in firms that pay dividends because
they are not affected by the typically
higher tax rates on dividends.
⚫ Investors who would have to pay higher
taxes on dividends may prefer to invest in
firms that retain more earnings rather
than paying dividends.
⚫ If a firm changes its payout policy, the
value of the firm will not change—what
will change is the type of investor who
holds the firm’s shares.