Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
1
Financial Management II
Course
Material
(AcFn
2102
, 3 cr.hrs)
Prepared By
Abeba Kelelew Woldesenbet
(
MS
c
)
Department of Accounting and Finance
C
ollege of
B
usiness and
E
conomics
Mekelle University
Mekelle, Ethiopia
April, 2020
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
2
Introduction
This document is compiled to be used as a course material for undergraduate stude
nts taking
financial management
II. The primary goal of this material is
to enable students
continue
studying the
underlying theories,
fundamental
principles, and practices of financial management
as a logical continuation of financial management pa
r
t one
.
The material contains five cha
pters. Chapter one is about dividend or profit allocation decision.
Chapter two introduces principles of working capital management. In chapter
s
three through five
detail
analyses
is presented
on how financial managers make decisions in the management of
a
firm’s current assets
;
i.e.,
cash, marketable securit
ies, receivables, and inventory.
Chapter
-
end
exercises
are provi
ded at the end
of the material
to help students evaluate their understanding of
contents covered in each chapter.
Students are advised to
attempt all multiple choice and d
iscussion questions so that the learners
will work more on the course consulting other
reference materials
as well. Answer
key
to
chapter
-
end exercises
will be provided once we resume classes.
The material is mainly compiled
from Rose 10
th
ed, Bringham 13
th
ed, and IM Pandey, 10
th
ed, and hence
students could use them
as reference materials to further their understanding and attempt the chapter
-
end exerc
ises.
Course plan is also attached in the annex part for a general overview of the course contents.
This material is the property of
Abeba Kelel
ew (MSC),
Department of Accounting and
Finance of Mekelle
University. Permission must be obtained from the Department prior to
reproduction.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
3
Table of Contents
Introduction………………………………………………………………………
…..
2
Chapter One: Dividend Theory and Policy
………………………………………
…..
4
Chapter Two: Working Capital
Management……………………………………
….
22
Chapter Three: Cash and Liquidity Management………………………………
...
....
37
Chapter Four: Receivables Management…………………………………………
…
54
Chapter Five: Inventory Management……………………………………………
…
65
Chapter
-
End
Exercises……………………………………………………………
…
74
Annex
-
1: Course Outline…………………………………………………………
….
8
1
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
4
Chapter One
Dividend Policy and Theory
1.
Introduction
Successful companies earn income. That income can then be reinvested
in operating assets, used
to acquire securities, used to retire debt, or
distributed to stockholders as dividends
. If the
decision is made to distribute income to stockholders, three key issues arise:
(1)
How much should be distributed
?
(2)
Should the di
stribution be as cash dividends
, or should the cash be passed on to
shareholders by buying back some of the stock they hold?
(3)
How stable should the distribution be?
➢
should the funds paid out from year to year be stable and dependable, which
stockhold
ers would probably prefer, or
➢
be allowed to vary with the firms’ cash flows and investment requirements, which
would probably be better from the firm’s stand point.
When deciding how much cash to distribute to stockholders, financial managers must keep in
mind that the firm’s objective is to
maximize shareholder value.
Consequently, the
target
payout ratio
—
defined as the
percentage of net income to be paid out as cash dividends
,
should be based in large part on investors’ preferences for dividends versus c
apital gains. That is,
do investors prefer:
(1) to have the firm distribute income as cash dividends, or
(2) to have it either repurchase stock or else invest the earnings back into the business, both of
which should result in capital gains?
If the compan
y increases the payout ratio, this raises dividend paid at the end of the year. This
increase in dividend, taken alone, would cause the stock price to rise. However, if dividend is
raised, then less money will be available for reinvestment which will cause
the firm’s expected
growth rate to decline, and that will tend to lower the stock’s price. Thus, any change in payout
policy will have
two opposing effects
: rising stock’s price due to increase in dividends and later
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
5
lowering the price due to decline in e
xpected growth rate. Therefore, the firm’s
optimal
dividend policy
must strike a balance between current dividends and future growth so as to
maximize the stock price.
Meaning of Dividend
Dividend
refers to the business concerns net profits
distributed among the shareholders.
It may also be termed as that part of the profit of a business concern which is distributed
among its shareholders.
Dividend decision
of a business is one of the crucial parts of the financial manager
because it determin
es the amount of profit to be distributed among shareholders and
amount of profit to be treated as retained earnings for financing its long term growth.
Hence, dividend decision plays vital part in corporate financial management.
1.1 Dividend Classificati
ons
Dividend may be distributed among the shareholders in various forms. The major categories
I
nclude
:
a. Cash dividend
b. Stock dividend
c. Bond dividend
d. Property dividend
a)
Cash Dividend
If the dividend is paid in the form of cash to the
shareholders, it is called cash dividend. It is paid
periodically out of the business concerns EAIT (Earnings after interest and tax). Cash dividends
are common and popular types followed by majority of the business concerns.
Cash dividends come in several
different forms. The basic types are:
i.
Regular cash dividend
-
A cash payment made by a firm to its owners in the normal
course of the business, usually made
four times
a year. i.e, management sees nothing
unusual about the dividend and no reason why it won
’t be continued.
ii.
Extra dividend
-
sometimes firms will pay a regular cash dividend and an extra cash
dividend. Extra indicates that the extra part
may or may not be repeated
in the future.
Companies with fluctuating earnings payout additional dividends when their earnings
warrant it, rather than fighting to keep a higher quantity of regular dividends.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
6
iii.
Special dividend
-
is unusual or onetime event, and won’t be repeated. Gener
ally
company declares special dividend in case of abnormal profits.
iv.
Liquidating dividend
-
it happens when
the board of directors wishes to return the
capital originally contributed by shareholders as a dividend, known as liquidating
dividend.
These dividen
ds are those which reduce paid
-
in capital, a
nd it may be a
precursor to shutting down the business.
b)
Stock Dividend
Stock dividend is paid out in shares of stock due to increase in financing needs. Under this type,
cash is retained by the business
concern and stockholders are given additional shares of stock. It
is not a true dividend because no cash leaves the firm rather a stock dividend increases the
number of shares outstanding, thereby reducing the value of each share. A Stock dividend may
be b
onus issue. This issue is given only to the existing shareholders of the business concern. If
the company issues less than 25 percent of the total number of previously outstanding shares,
you treat the transaction as a
stock dividend
. If the transaction is for a greater proportion of the
previously outstanding shares, then treat the transaction as a
stock split
(Fina
ncial Accounting)
.
The following are some of the advantages of stock dividends:
1.
They can
preserve
a company's
cash position
if a substantial number of shareholders
take up the share option.
2.
Investors may be able to obtain
tax advantages
if
dividends are in the form of shares.
3.
Investors looking to
expand their holding
can do so
without incurring
the
transaction
costs
of buying more shares.
c)
Bond Dividend
Bond dividend is also known as scrip dividend. If the company does not have
sufficient funds to
pay cash dividend in the near future, the company promises to pay the shareholders at a future
specific date with the help of issue of bonds or notes.
d)
Property Dividend
Property dividends are paid in the form of some assets other than c
ash. A company will
distribute such divided under exceptional circumstances. This form of dividend is sometimes
used by a business to deliberately issue property dividends in order to
alter
their taxable and/or
reported income.
1.2 Types of Dividend Policy
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
7
Dividend policy depends upon the nature of the firm, type of shareholder and profitable position
of the firm. On the basis of dividend
declaration
by the firm, the dividend policy may be
classified under the following types:
Regular dividend policy
Stabl
e dividend policy
Irregular dividend policy
No dividend policy
.
Regular Dividend Policy
Dividend payable at the
usual rate
is regarded as regular dividend policy. Though the rate is
usual, the dividends vary per income earned. This type of policy is suitable to the
small
investors, retired persons
and companies which get regular earning. Regular dividend policy
has several a
dvantages, including:
1.
Creating confidence among shareholders
2.
Stabilizing market value of shares
3.
Giving regular income to shareholders, etc
Stable Dividend Policy
Stable dividend policy means payment of certain
minimum amount
of dividend regularly. This
dividend policy consists of the following three important forms:
Constant dividend per share
-
irrespective of the level of earning year after year, fixed
dividend is
paid to owners. In case the earnings are not enough, companies create reserve
fund to pay the fixed amount. This is suitable for companies having stable earning for a
number of years.
Constant payout ratio
-
this is a
fixed percentage of net income
to be pa
id as cash dividend
every year. In this case, the amount of dividend fluctuates in a direct proportion to the
earnings of the company. Since it relates to the ability of a company to pay dividends, it is
preferable way.
Stable Birr dividend plus extra d
ividend.
Irregular Dividend Policy
When companies are facing constraints of earnings and unsuccessful business operation, they
may follow irregular dividend policy. It is one of the temporary arrangements to meet the
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
8
financial problems. Companies follow th
is type of policy due to uncertain earnings of the
company, lack of liquid resources, and afraid of regular dividend.
No Dividend Policy:
Sometimes the company may follow no dividend policy because of
the requirement of funds for
the growth of the company
or working capital requirements.
1.3 Factors Influencing Dividend Policy
Did you ever wonder why some companies pay dividends while others don't? There are several
factors that influence whether or not a company pays a dividend and how much it chooses to
pay.
While there are too many possible factors to list here, these are some of the most influential.
1.
Profitability Position of the Firm:
d
ividend decision depends on the profitability
position of the business concern. When the firm earns more
profit, they can distribute
more dividends to the shareholders. Unprofitable companies cannot for ever go on paying
dividends out of retained profits made in the past.
2.
Uncertainty of Future Income:
f
uture income is a very important factor, which affects
th
e dividend policy. When the shareholder needs regular income, the firm should
maintain regular dividend policy. But, if future income is uncertain, the amount and
timing of dividend paid may vary.
3.
Legal Constrains:
companies put several restrictions regard
ing payments and
declaration of dividends.
4.
Liquidity Position:
the firm’s ability to pay cash dividend is constrained by the amount
of liquid assets (such as cash and marketable securities) available
.
Liquidity position of a
firm leads to easy payments of
dividend. If firms have high liquidity, the firms can
provide cash dividend otherwise, they have to pay stock dividend.
5.
Sources of Finance:
t
he ease with which a company could raise
extra finance
from
sources other than retained
earnings affects its divi
dend policy. Small companies which
find it hard to raise finance might have to rely more heavily on
retained earnings than
large companies.
6.
Growth Rate of the Firm;
high growth rate implies that the firm can distribute more
dividends to its
shareholders. On the other hand, fast growing companies may choose to
reinvest their earnings for further growth and expansion.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
9
7.
Tax Policy:
tax policy of the government also affects the dividend policy of the firm.
When the government gives tax incentives,
the company pays more dividends.
8.
Capital Market Conditions:
due to the capital market conditions, dividend policy may
be affected. If the capital market
is prefect, it leads to improve the higher dividend.
1.4 Payment Procedures
Dividends are normally
paid quarterly, and, if conditions permit the dividend is increased once
each year. Take the following example to illustrate dividend payment procedures;
Example1
: Assume that on January 15, 20xx the board of directors of XYZ Company met and
decided to pay
a dividend of $1 per share on February16, 20xx to all holders of record as of
January 30, 20xx.
The actual payment procedures
(
chronologically
)
are
as follows:
1.
Declaration date:
This is the day on which the board of directors declares payment of
dividend. Based on the above example, the
declaration date
is
January 15, 20xx. On this
date the directors met and declared the regular dividend, and hence current liability will
be record
ed.
2.
Ex
-
dividend date
–
is
the date when the right to the dividend
leaves
the stock for
new
owner.
This date is two business days before date of record. This date is specified to
make sure that dividend checks go to the right people. In our example above, si
nce the
record date is on January 30, then the ex
-
dividend date is January 28, 20xx.
❖
If you buy a stock (of XYZ) before January 28, then you are entitled to receive
divided.
❖
If you buy the stocks on or after Jan. 28, then the previous owner will get the
d
ividend.
3.
Holder
-
of
-
record date:
the company prepares a list of stockholders from the stock
transfer book at the close of business on the date of record. All the stockholders of the
record date are entitled to receive dividend declared by the board of direc
tors. At the
close of business on the
holder
-
of
-
record date,
January 30, the company closes its stock
transfer books and makes up a list of shareholders as of that date.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
10
4.
Payment date:
is the date when board of directors actually pays the dividend to the
holders of shares on the record date.
In the above example, payment date when checks
are mailed to each recipient is February 16, 20xx.
1.5 The Effect of divided policy on firm value
“
Does a dividend policy really have any effect on the firm's value?"
Several theories have been documented on the relevance and irrelevance of dividend
policy on firm value maximization.
Here, we begin by describing the dividend
irrelevance theory, develop
ed by Merton Miller and Franco Modigliani (MM), which is
used as a backdrop for discussion of the key arguments in support of dividend irrelevance
and then those in support of dividend relevance will be presented.
1.5.1 Dividend Irrelevance Theories
Accor
ding to professors
Modigliani and Miller (MM)
, a firm’s dividend policy has
no
effect
on firm value or its stock price. That is, there is no relation between the dividend
rate and value of the firm. Modigliani and Miller contributed a major approach to pro
ve
the irrelevance dividend concept.
a.
Modigliani and Miller’s (MM) Approach
According to MM, under a perfect market condition, the dividend policy of a company is
irrelevant to affect the value of the firm. “Under conditions of perfect market, rational
inve
stors, absence of tax discrimination between dividend income and capital
appreciation, given the firm’s investment policy, its dividend policy may have no
influence on the market price of shares”. MM proposed that in a tax
-
free world,
shareholders are indi
fferent between dividends and capital gains, and value of a company
is determined solely by the “earning power “of its assets and investments.
In other words, MM argued that the value of the firm depends only on the income
produced by its assets, not on how this income is split between dividends and retained
earnings. To understand MM’s argument, recognize that any shareholder can in theory
const
ruct his own dividend policy. For example, if a firm does not pay dividends, a
shareholder who wants a 5% dividend can “create” it by selling 5% of his stock.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
11
Conversely, if a company pays a higher dividend than an investor desires, the investor
can use th
e unwanted dividends to buy additional shares of the company’s stock. If
investors could buy and sell shares and thus create their own dividend policy without
incurring costs, then the firm’s dividend policy would truly be irrelevant.
Assumptions
MM appro
ach is based on the following important assumptions:
1. Perfect capital market.
2. Investors are rational.
3. There are no taxes.
4. The firm has fixed investment policy.
5. No risk or uncertainty.
Proof for MM approach
MM approach can be proved with the h
elp of the following formula:
Where,
P
o
= Prevailing market price of a share.
K
e
= Cost of equity capital.
D
1
= Dividend to be received at the end of period one.
P
1
= Market price of the share at the end of period one
P
1
can be calculated with the help of the following formula.
P
1
= P
o
(1+K
e
)
–
D
1
Hence, by replacing P
1
=P
o
(1+K
e
)
–
D
1
in the P
o
formula, we get
P
o
=
D
1
+ P
1
(1+k
e
)
P
o
=
D
1
+ P
o
(1+K
e
)
–
D
1
(1+k
e
)
P
o
= P
o
,
which indicates that price of stock, remains constant regardless of the amount of
dividends declared and paid by the company.
Criticism of MM approach
MM approach consists of certain criticisms. The following are the major ones.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
12
MM
approach assumes that tax does not exist (or constant). It is not applicable in the
practical life of the firm.
MM approach assumes that, there is no risk and uncertainty of the investment. It is also not
applicable in present day business life.
MM appro
ach does not consider floatation and transaction costs both of which affect value of
the firm.
MM approach assumes that, investor behaves rationally. But we cannot give assurance that
all investors will behave rationally.
b.
Residual Theory
Residual
Theory is one school of thought that suggests the dividend paid by a firm be viewed as
a residual, i.e. the amount leftover after all acceptable investment opportunities have been
undertaken. According to this theory;
New equity capital is more expensive t
han capital raised through retained earnings. Hence,
financing investments internally (through dividends) may be favored.
Using this approach, the dividend decision is done in three steps:
1. Determine the optimal level of capital expenditures;
2. Estimat
e the total amount of equity financing needed to support the expenditures;
3. Use reinvested profits to meet the equity requirement. If the available reinvested profits are in
excess of the equity need, then the surplus, the residual, is distributed to sha
reholders as
dividends. Therefore, according to residual theory, since dividend is paid only when all
profitable investments are undertaken, the dividend paid will have no effect on the firm’s value.
c. Dividend Clientele effect
If investors have ow
n preferences, they will invest in firms having dividend policies consistent
with their preferences.
The clientele effect says that dividend policy is irrelevant because investors that prefer high
payouts will invest in firms that have high payouts, and i
nvestors that prefer low payouts will
invest in firms with low payouts.
If a firm changes its payout policy, it will not affect the stock value; it will just end up with a
different set of investors.
This is true as long as the “market” for dividend poli
cy is in equilibrium.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
13
d.
Expectation theory
As the time approaches for management to announce the amount of next dividend, investors
form expectations as to
how much
the dividend will be.
If the actual dividend is as expected, the market prices will remain
unchanged; otherwise higher
or lower than expected amounts will force investors to reassess their perception about the firm,
and the value of its shares. It is the investors expectation as compared to actual dividend declared
that affects the stock price,
not the dividend policy itself.
1.5.2 Dividend Relevance Theories
According to this concept, dividend policy is considered to affect the value of the firm. Dividend
relevance implies that shareholders prefer current dividend and hence there is direct rel
ationship
between dividend policy and value of the firm. Relevance of dividend concept is supported by
two eminent persons: Walter and Gordon.
i.
Walter’s Model
Prof. James E. Walter
argues that the dividend policy almost always affects the value of the
firm.
Walter’s model is based on the relationship between the following important factors:
• Internal rate of return r
• Cost of capital (k)
Walter’s model argues that:
❖
if r > k, the firm is able to earn more than what the shareholders could by
reinvesting, if
the earnings are paid to them,
❖
if r < k, the shareholders can earn a higher return by investing elsewhere,
❖
If the firm has r = k, it is a matter of indifference whether earnings are retained or
distributed. The following table summarizes
such relationships.
Relationship between
r and k
Increase in Dividend Payout
Decrease in Dividend Payout
r>k
Value of the firm decreases
Value of the firm increases
r<k
Value of the firm increases
Value of the firm decreases
r=k
No change in the
value of the firm
No change in the value of the firm
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
14
Assumptions
Walter’s model is based on the following important assumptions:
1. The firm uses only internal finance.
2. The firm does not use debt or new equity finance.
3. The firm has constant
return and cost of capital.
4. The firm has 100 percent payout/retention policy.
5. The firm has constant EPS and dividend.
6. The firm has an infinite life.
Walter has developed a mathematical formula for determining the value of market share.
Where, P
= Market price of an equity share
D = Dividend per share
E = Earnings per share
K
e
= Cost of equity capital
r = Internal rate of return
Which indicates that market price of a company’s stock is the sum of the present value of
dividends and capital gains on an investment.
Example2
From the following information given to you, ascertain whether the firm is following an optimal
dividend poli
cy as per Walter’s Model?
The firm is expected to maintain its rate of return on fresh investments as well. Will your
decision change if the P/E ratio is 7.25 and return on investment is 10%?
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
15
Solution
The price of a share as per Walter’s Model is:
푃
=
퐷
+
푟
/
퐾
푒
(
퐸
−
퐷
)
퐾
푒
푃
=
5
+
0
.
15
/
0
.
10
(
10
−
5
)
0
.
10
푃
=
5
+
7
.
50
0
.
10
푃
=
푅푠
.
125
.
00
Dividend
Payout
=
퐷푃푆
퐸푃푆
푋
100
Dividend
Payout
=
5
10
푋
100
Dividend
Payout
=
50%
Since r >k
e,
the firm is not following an optimal dividend policy by
distributing 50% of the
earnings. In this case, the optimal dividend policy for the firm would be to pay zero dividends.
And the Market Price would be:
푃
=
0
+
0
.
15
/
0
.
10
(
10
−
0
)
0
.
10
푃
=
5
+
15
0
.
10
푃
=
150
푅푠
.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
16
Criticism of Walter’s Model
The following are some of the important criticisms against Walter’s model:
❖
Walter’s model assumes that there is no extracted finance used by the firm. It is not
practically applicable.
❖
There is no possibility of constant return. Return may increase or de
crease depending
upon the business situation.
❖
Walter’s model is based on constant cost of capital; however, cost of capital varies
mainly due to differences in risk exposures of firms.
ii.
Gordon’s Model
Myron Gordon
suggests one of the popular models, which
assumes that dividend policy of a
firm affects its value. It is based on the following basic assumptions:
1. The firm is an all equity firm (no debt).
2. The firm has no external finance.
3. Cost of capital and return are constant.
4. The firm has
perpetual life.
5. There are no taxes.
6. There is constant relation ratio (g=br).
7. Cost of capital is greater than growth rate (K
e
>br).
Gordon’s model can be proved with the help of the following formula
Where,
P = Price of a share
E =
Earnings per share
1
–
b = D/P ratio (i.e., percentage of earnings distributed as dividends)
K
e
= Capitalization rate
br = Growth rate = rate of return on investment of an all equity firm.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
17
Note
: the above model indicates that the market value of the compan
y’s share is the sum total of
the present values of infinite future dividends to be declared.
Example3
Raja Company earns a rate of 12% on its total investment of Birr 600,000 in assets. It has
600,000 outstanding common shares at Birr 10 per share. Disco
unt rate of the firm is 10% and it
has a policy of
retaining 40%
of the earnings. Determine the price of its share
s
using Gordon’s
Model. What shall happen to the price of the share if the company has
retention
policy of 25%
(or) 80%?
Solution:
According t
o Gordon’s Model, the price of a share is computed as
Remark
: under Gordon’s model;
❖
The market value of the share,
P
0
, increases with the retention ratio,
b
, for firms with
growth opportunities, i.e. when
r
>
k
.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
18
❖
The market value of the share,
P
0
, increases with the payout ratio, (1
–
b
), for declining
firms with
r
<
k
.
❖
The market value of the share is not affected by dividend policy when
r
=
k
.
Criticism of G
ordon’s Model
Gordon’s model consists of the following important criticisms:
❖
Gordon model assumes that there is no debt and
new
equity finance used by the firm. But
in practice companies make use of a mix of debt and equity financing
❖
K
e
and r cannot be constant in the real practice.
❖
According to Gordon’s model, there are no taxes paid by the firm. It is not practically
applicable
as well
.
▪
Two Supplementary Models of dividend relevance theory
Traditional Model
As to this model, stock market is overwhelmingly in favor of liberal dividends and against
meager dividends. Accordingly, in the valuation of shares, the weight attached to dividends is
higher than the weight attached to retained earnings.
Bird
-
in
-
the
-
Han
d Theory (high dividend payout)
Investors think dividends are less risky than potential future capital gains, hence they like
dividends. If so, investors would value high payout firms more highly
than firms with low
dividends.
i.e., a high payout would res
ult in a high
stock
price (P
0
).
1.6
Establishing a Dividend Policy
How do firms actually determine the
amount
of dividends they will pay at a particular time? As
we have seen, there are good reasons for firms to pay high dividends, and there are good reasons
to pay low dividends. For the rest of this chapter, we will try to illustrate some of these dividend
policy strategies.
1.6. 1 Residual Dividend Approach
As noted above, firms with higher dividend payouts will have to sell stocks more often. Though
such
sales are not very common, and they can be very expensive. Consistent with this, we will
assume that a particular firm wishes to minimize the need to sell new equity.
We will also
assume that the firm wishes to maintain its current capital structure. If a
firm wishes to avoid
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
19
new equity sales, then it will have to rely on internally generated equity to finance new positive
NPV projects. Dividends can only be paid out of what is left over. This leftover is called the
residual,
and such a dividend policy is
called a
residual dividend approach
.
With a residual dividend policy, the firm’s objective is to meet its investment needs and
maintain its desired debt
–
equity ratio before paying dividends
. For a given firm, the optimal
payout ratio is a function of four factors: (1) investor’s preferences for dividends versus capital
gains, (2) the firm’s investment opportunities, (3) its target capital structure, and (4) the
availability and cost of exter
nal capital. The last three elements are combined in what we call the
residual dividend model.
Under this model a firm follows these four steps when establishing its target payout ratio:
(1) It determines the optimal capital budget;
(2) It determines the amount of equity needed to finance that budget, given its target capital
structure;
(3) It us
es retained earnings to meet equity requirements to the extent possible; and
(4) It pays dividends only if more earnings are available than are needed to support the optimal
capital budget. The word
residual
implies “leftover,” and the residual policy imp
lies that
dividends are paid out of “
leftover
” earnings.
Example 4
Consider the table below to illustrate the residual dividend model. In Row 1, for example, new
investment is $3,000, and the firm’s debt
-
equity ratio is 0.5 (the firm has to borrow 50 cents
for a
1 dollar equity raised). That means additional debt of $1,000 and equity of $2,000 must be raised
to keep the debt
–
equity ratio constant. Additional stock to be issued is also $1,000
because we
have only $1,000 in retained earnings. In this example
(row1), because new stock is issued,
dividends are not simultaneously paid out.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
20
In rows 2 and 3, investment drops. Additional debt needed goes down as well, because it is equal
to 1⁄3 of new investment. Because the amount of new equity needed is still
greater than or equal
to $1,000, all earnings are retained and no dividend is paid.
We finally find a situation in row 4 in which a dividend is paid where; total investment needed is
$1,000. To keep the debt
–
equity ratio constant, 1⁄3 of this investment,
or $333, is financed by
debt. The remaining 2⁄3, or $667, comes from internal funds, implying that the residual is $1,000
-
667 =$333. The company is able to pay dividend equal to $333
-
the residual.
In this case, note that no additional stock is issued. Sin
ce the needed investment is lower in rows
5 and 6, new debt is reduced further, retained earnings drop, and dividends increase. Again, no
additional stock is issued.
Given our discussion, we expect those firms with many investment opportunities to pay a sm
all
percentage of their earnings as dividends and other firms with fewer opportunities to pay a high
percentage of their earnings as dividends. This result appears to occur in the real world as well.
Young, fast
-
growing firms commonly employ a l
ow payout r
atio, whereas older and slowly
growing firms in more mature industries use a higher ratio.
1.6
.2 Dividend Stability
The key point of the residual dividend approach is that dividends are paid only after all profitable
investment opportunities are exhausted.
Of course, a strict residual approach might lead to a very
unstable dividend policy. If investment opportunities in one period are quite high, dividends will
be low or zero. Conversely, dividends might be high in the next period if investment
opportunitie
s are considered less promising.
The firm can choose between at least two types of dividend policies. First, each quarter’s
dividend can be a fixed fraction of that quarter’s earnings.
This is a cyclical dividend policy in
which dividends will vary through
out the year.
Second, each quarter’s dividend can be a fixed
fraction of yearly
earnings,
implying that all dividend payments would be equal. This is a
stable dividend policy.
Corporate officials generally agree that a stable policy is in the interest
of t
he firm and its stockholders, so the stable policy would be more common.
1.
6
.3 A Compromise Dividend Policy
In practice, many firms appear to follow what is called a compromise dividend policy. Such a
policy is based on five main goals:
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
21
1. Avoid
cutting back on positive NPV projects to pay a dividend.
2. Avoid dividend cuts.
3. Avoid the need to sell equity.
4. Maintain a target debt
–
equity ratio.
5. Maintain a target dividend payout ratio.
These goals are ranked more or less in order of
their importance. In our strict residual approach,
we assume that the firm maintains a fixed debt
–
equity ratio. Under the compromise approach,
the debt
–
equity ratio is viewed as a long
-
range goal. It is allowed to vary in the short run if
necessary, to a
void a dividend cut or the need to sell new equity.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
22
Chapter
-
Two
Working Capital Management
2.1 Introduction
To this point, we have described many of the decisions of long
-
term finance, such as those of
capital budgeting,
dividend policy, and Capital structure. In this chapter, we begin to discuss
short
-
term finance. Hence, working capital management is primarily concerned with the analysis
of decisions that affect current assets, and current liabilities.
That is, working
capital management is concerned with the problems that arise in attempting to
manage current assets, current liabilities and the interrelationships that exist between them. The
term
Current Assets
refer to those assets which in the ordinary course of business can be, or will
be, converted into cash within one year without undergoing a reduction in value and without
disrupting the operations of the firm.
Current Liabilities
are those liabilities whi
ch are intended,
at their inception, to be paid in the ordinary course of business, within a year, out of the current
assets or earnings of the business concern.
In the
management of working capital two characteristics of current assets must be borne in
mind: (i) Short life span, and (ii) swift transformation into other asset form.
Current assets have a short life span. Cash balances may be held idle for a week or two,
accounts receivables may have a life span of 30 to 60 days, and inventories may be held for 30 to
100 days. The life span of current assets depends upon the time required in the activities of
Current Assets
Current Liabilities
Cash and Bank Balances
Short term B
orrowings
Marketable Securities
Accounts Payables
Accounts Receivables
Notes Payables
Notes Receivables
Trade Advances
Inventories
Provisions
Raw Materials and Components
Work
-
in
-
Progress
Finished goods
Others
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
23
procurement, production, sales and collection and degree of co
incidence (synchronization)
among them.
Each current asset is swiftly transformed into another asset forms: cash is used for acquiring raw
material; raw material are transformed into finished goods (this transformation may involve
several stages of work
-
in
-
progress); finished goods, generally sold on credit, are converted into
accounts receivables; and finally accounts receivables, up on realization generate cash. The
following diagram (figure 2.1) shows the cycle of transformation.
Figure 2.1
–
Curre
nt Assets Cycle
The goal of working capital management is to manage the firm’s current assets and current
liabilities in such a way that a
satisfactory level
of working capital
is maintained. This is so
because if the firm cannot maintain a satisfactory level of working capital it is likely to become
insolvent and may even be forced into bankruptcy.
The current assets should be large enough
to cover its current liabilities in o
rder to ensure a reasonable margin of safety. Each of the
current assets must be managed efficiently in order to maintain the liquidity of the firm while not
keeping too high a level of any one of them. Each of the short
-
term sources of financing must be
continuously managed to ensure that they are obtained and used in the best possible way.
The
Work in Progress
Finished Goods
Accounts
Receivables
Wages, Salaries &
Overheads
Raw Materials
Cash
Suppliers
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
24
interaction between current assets and current liabilities is, therefore, the main theme of the
theory of working management.
2.2 Concepts and
Definitions of Working Capital
There are two concepts of working capital:
“Gross”
and
“Net”
The term Gross Working Capital also referred to as working capital, means the total
investment in Current Assets.
Gross
Working
Capital
=
Total
Of
Current
Assets
The term Net Working Capital can be defined in two ways (i) the most common definition of
net working capital (NWC) is the difference between current assets and current liabilities; and
(ii) alternate definition of NWC is
that portion of current assets fi
nanced with long
-
term
funds.
Net
Working
Capital
=
Current
Assets
–
Current
Liabilities
NWC is commonly defined as the difference between current assets and current liabilities
.
Efficient working capital management requires that firms should operate wi
th some amount of
NWC, the exact amount varying from firm to firm and depending, among other things, on the
nature of industry. The theoretical justification for the use of NWC to measure liquidity is based
on the basis that the greater the margin by whic
h the current assets cover the short
-
term
obligations, the more is the ability to pay obligations when they become due for payment. The
NWC is necessary because the cash outflows and inflows do not coincide. In other words, it is
the non
-
synchronous natu
re of cash flows that makes NWC necessary. In addition, the cash
outflows resulting from payment of current liabilities are relatively predictable. The cash
inflows are, however, difficult to predict, therefore, some level of NWC is necessary. The more
predictable the cash inflows are, the less NWC will be required and
vice
-
versa.
As stated above, NWC can alternatively be defined as that part of the current assets financed
with long
-
term funds. This indicates that since current liabilities represent sources of short
-
term
funds, as long as current assets exceed the current liabiliti
es, the excess must have been financed
with long
-
term funds.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
25
2.3 Need for Working Capital and Operating Cycle
The need for working capital (gross) or current assets cannot be overemphasized. Given the
objective of financial decision making to maximize t
he shareholders’ wealth, it is necessary to
generate sufficient profits. The extent to which profits can be earned will naturally depend,
among other things, upon the magnitude (Size) of the sales. A successful sales programme is, in
other words, necessa
ry for earning profits by any business enterprise. However, sales do not
convert into cash instantly; there is invariably a time
-
lag between the sale of goods and the
receipt of cash. There is, therefore a need for working capital in the form of current
assets to
deal with the problem arising out of the lack of immediate realization of cash against goods sold.
Therefore, sufficient working capital is necessary to sustain sales activity.
The Operating Cycle can be said to be at the heart of the need
for working capital
. “The
continuing flow from cash to suppliers, to inventory, to accounts receivable and back into cash is
what is called the Operating Cycle, or Operating cycle is defined as the
time period lapsed from
inventory purchase until the rece
ipt of cash.
In other words, the term
operating
cycle refers to
the length of time necessary to complete the following cycle of events:
1.
Conversion of cash into inventory;
2.
Conversion of Inventory into receivables;
3.
Conversion of receivables into ca
sh.
The Operating Cycle, which is continuous process, is shown in figure 2.2
Figure
–
2.2
–
Operating Cycle
Phase
–
3
Phase
-
1
Phase
-
2
Phase
-
1
RECEIVABLES
CASH
INVENTORY
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
26
The operating cycle consist of three phases.
In phase
–
1
, cash gets converted into inventory. This includes purchase of raw materials,
conversion of raw material into work
-
in
-
progress, finished goods and finally the transfer of
goods to
stock at the end of the manufacturing process. In the case of trading organizations, this
phase is shorter as there would be no manufacturing activity and cash is directly converted into
inventory. The phase is of course, totally absent in the case of s
ervice organization.
In phase
–
2
of the cycle, the inventory is converted into receivables as credit sales are made to
customers. Firms which do not sell on credit obviously don’t have phase
–
2 of the operating
cycle.
The last phase, phase
–
3
, represen
ts the stage when receivables are collected. This phase
completes the operating cycle. Thus, the firm has moved from cash to inventory, to receivables
and to cash again.
Cash cycle
is defined as
the time period from when cash is paid out to when cash is
received.
i, e. Cash cycle = Operating cycle
-
Accounts payable period
.
Figure 2.3 explains the cash
cycle and operating cycle of a firm
Inventory Inventory
Purchased
sold
Inventory period
Accounts Receivable period
Time
A. payable period
Cash cycle
Cash paid for cash
Inventory
received
Operating cycle
Figure 2.3: Operating and Cash
C
onversion
C
ycle
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
27
Example:
Optec Plc purchases $1,000 worth of inventory on credit. It pays the bill 30 days later, and, after
30 more days,
Optec Plc sells the $1,000 in inventory for $1,400. Its buyer does not actually pay
for another 45 days. We can summarize these events chronologically as follows:
Day Activity Cash E
ffect
0 Acquire inventory None
30 pay for inventory
-
$1,000
60 Sell inventory on
credit None
105 Collection on sale +1,400
Required:
i.
Calculate the operating cycle of Optec Plc
ii.
Calculate the cash cycle of Optec Plc.
Solution:
i.
Given
: Inventory period (to
acquire and sell) 60 days
Accounts receivable period (to collect on the sale) 45 days
Operating cycle = Inventory period + Accounts receivable period
= 60 days + 45 days
=
105 days
Note:
What the operating cycle describes is how a
product moves through the current asset accounts.
The product begins life as inventory, it is converted to a receivable when it is sold, and it is
finally converted to cash when we collect from the sale. Notice that, at each step, the asset is
moving clos
er to cash
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
28
ii.
Cash cycle = Operating cycle
-
Accounts payable period
= 105 days
-
30 days
=
75 days
2.4 Permanent and Temporary Working Capital
Adequate working capital is important for any business operations. Working capital financing,
however, can be a challenge for a business, especially for a small firm. In order to understand the
best way to finance working capital, it is important to unders
tand the difference between the two
types of working capital:
❖
permanent working capital
❖
temporary working capital
Permanent Working Capital
Permanent working capital is the minimum level of working capital required for a firm to
operate. It is also called
fixed working capital
. Permanent working capital does not depend on
the level of production or sales. It is similar
–
in some sense
–
to fix
ed assets because of its
permanent (fixed) nature. Important to note, however, is that permanent working capital is not
literally fixed: its level can change over time. The level of permanent working capital depends on
the business cycle as well as the gro
wth of a firm. Permanent working capital can be further
divided into the following categories:
❖
Regular working capital:
minimum level of working capital required to circulate from
one form to another: from cash to inventory, inventory to receivables, receivables to cash,
and so on.
❖
Reserve working capital:
permanent working capital in excess of regular working capital.
Res
erve working capital arises from such contingencies as strikes, recession, etc.
Temporary working capital
As can be seen in figure 2.4 and 2.5 below, temporary working capital
is the excess of working
capital over the permanent working capital. Temporary
working capital is also called
variable
,
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
29
fluctuating
, or
cyclical working capital
. Temporary working capital can be further dived into
the following categories:
❖
Seasonal working capital:
temporary working capital required to meet seasonal demands
❖
Special
working capital:
temporary working capital required to meet special demands
Temporary working capital differs from permanent working capital because of its cyclicality. As
a result, temporary working capital usually requires a different source of financing
than
permanent working capital. While permanent working capital is usually financed through a long
-
term financing source such as equity capital and debt, temporary working capital is often
financed by short
-
term funds.
Long
-
term sources of finance may inc
lude, but not limited to (Equity capital, Debentures, Long
-
term loans, and Retained earnings)
Short
-
term sources of finance may include but not limited to (Bank credit, Trade credit,
Commercial paper, Factoring, Sale or lease of fixed assets)
The bas
ic distinction between permanent and temporary working capital is illustrated in the
figure below.
Figure 2.4
–
Permanent and Temporary Working Capital
Figure 2.4
(above)
shows that the permanent level is fairly constant, while temporary working
capital is fluctuating
–
increasing and decreasing in accordance with seasonal demands. In the
case of an expanding firm, the permanent working capital line may not be horizontal.
This is
Amount of Temporary
Working Capital Working capital
Permanent Working Capital
0 Time
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
30
because the demand for permanent current assets might be increasing to support a rising level of
activity. In that case the line would be a rising one as shown in the figure 2.5 below.
Determinants of Working Capital (Factors effecting Working Capital)
Figure 2.5
–
Permanent and Temporary Working
Capital
A firm should plan its operations in such a way that it should have neither too much nor too little
working capital. The total working capital requirement is determine by a wide variety of factors.
These factors, however, affect different enterpr
ises differently. They also vary
2.4. Factors affecting Working Capital
A firm should plan its operations in such a way that it should have neither too much nor too little
working capital. The total working capital requirement is determined by a wide va
riety of
factors. These factors, however, affect different enterprises differently. They also vary from
time to time. In general, the following factors are involved in a proper assessment of the
quantum of working capital required.
i.
Nature of
Business
The working capital requirement of a firm is closely related to the nature of its business. A
service firm, like electricity undertaking or a transport corporation, which has a short operating
cycle and which sells predominantly on cash basis, has modest
working capital requirement. On
the other hand, a manufacturing concern like a machine tools unit, which has long operating
cycle and which sells largely on credit, has a very substantial working capital requirement.
Temporary
Working Capital
Amount of
Working Capital
Permanent Working Capital
0 Time
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
31
Moreover, working capital requirement
of financial institutions like, banks is substantially high.
This is because banks need to constantly manage their funds to ensure that they have enough
cash on hand to meet their obligations to customers and to make new loans.
ii.
Seasonality of Operations
Fi
rms which have marked seasonality in their operations usually have highly fluctuating working
capital requirements. To illustrate, consider a firm manufacturing rain coats. The sale of rain
coats reaches a peak during the rainy season and drops sharply d
uring the winter period. The
working capital need of such a firm is likely to increase considerably in rainy months and
decrease significantly during the other periods. On the other hand, a firm manufacturing a
product like lamps, which have fairly even s
ales round the year, tends to have stable working
capital needs.
iii.
Production Policy
A business marked by pronounced seasonal fluctuations in its sales may pursue a production
policy which may reduce the sharp variations in working capital requirements. F
or example, a
manufacturer of rain coasts may maintain a steady production throughout the year rather than
intensify the production activity during the peak business season. Such a production policy may
dampen the fluctuations in working capital requireme
nts.
iv.
Market Conditions
The degree of competition prevailing in the market place has an important bearing on working
capital needs. When competition is keen, a larger inventory of finished goods is required to
promptly serve customers who may not be incli
ned to wait because other manufacturer are ready
to meet their needs. Further, generous credit terms may have to be offered to attract customers in
a highly competitive market. Thus, working capital needs tend to be high because of greater
investment in
finished goods inventory and accounts receivable.
If the market is strong with weak competition, a firm can manage with a smaller inventory of
finished goods because customers can be served with some delay. Further, in such a situation the
firm can insis
t on the cash payment and avail lock
-
up of funds in accounts receivable it can even
ask for advance payment, partial or total.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
32
v.
Conditions of Supply
The inventory of raw material, spares, and finished goods depends on the conditions of supply.
If the sup
ply is prompt and adequate, the firm can manage its operations with small inventory.
However, if supply is unpredictable and scant then the firm, to ensure continuity of production,
would have to acquire stocks as and when they are available and carry lar
ger inventory on an
average. A similar policy may have to be followed when the raw material is available only
seasonally and production operations are carried out round the year.
vi.
Credit Policy
The credit policy relating to sales and purchases also affect
s working capital. The credit policy
influences the requirement of working capital in two ways: (1) through credit terms granted by
the firm to its customers/ buyers of goods; (2) Credit terms available to the firm from its
suppliers.
The credit terms gr
anted to customers have a bearing on the magnitude of working capital by
determining the level of receivables. Credit sales result in higher receivables; higher
receivables mean more working capital. On the other hand, if liberal credit terms are avail
able
from the supplier of goods, the need for working capital (cash) is less. Working capital
requirements of a business are thus, affected by the terms of purchase and sale, and the role
given to credit by a company in its dealing with suppliers and cust
omers.
vii.
Operating Efficiency
The operating efficiency of management is also an important determinant of the level of
working capital. Firms with high degree of efficiency have low wastage and can manage
operations with low level of inventory. Although man
agement cannot control the rise in prices, it
can ensure the efficient utilization of resources by eliminating waste, improving coordination,
and fuller utilization of existing resources, and so on. Efficiency of operations accelerates the
pace of cash cy
cle and improves the working capital turnover. It releases the pressure on the
working capital by improving profitability and improving the internal generation of funds.
Hence, high operating efficiency leads to less working capital requirement.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
33
Besides,
there are some other factors that influence the working capital requirement of a firm.
These include Growth and Expansion of Business, Depreciation Policy, Profit Level of the
business, Level of Tax payments, Dividend policy and Changes in the price level
s of resources.
❖
Level of Current Assets
An important working capital policy decision is concerned with the level of investment in current
assets. Under a
flexible policy
(also referred to as a ‘
Conservative policy’
), the investment in
current assets is h
igh. This means that the firm maintains huge balance of cash and marketable
securities, carries large amounts of inventories, and grants generous terms of credit to customers
which leads to high level of debtors.
Under the
restrictive policy
(also referr
ed to as an
‘Aggressive Policy’
), the investment in current
assets is low. This means that firm keeps a small balance of cash and marketable securities,
manages with small amounts of inventories, and offers still terms of credit which leads to a low
level
of debtors.
Determining the optimal level of current assets involves a tradeoff between costs that rise with
current assets and costs that fall with current assets. The former are referred to as “
carrying
costs’
and the later as ‘
shortage costs’
.
Carr
ying costs are mainly in the form of the cost of financing a higher level of current assets.
Shortage costs are mainly in the form of disruption in production schedule, lost sales, and loss
of customer goodwill.
Figure 2.6,
shows graphically how these co
sts behave in relation to the level of current assets.
The optimal
level of current assets is denoted by CA*, as the total costs (sum of carrying costs
and shortage costs) are minimized at that level.
Often the total costs curve is fairly flat around
the
optimal level. Hence, it may be difficult to precisely identify the optimal level of current
assets. The financial manager must be satisfied (by minimizing total cost) if the level of current
assets is in a range close to the optimal point.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
34
Figure 2.6
–
Level of Current Assts
2. 5 Working Capital Financing Strategies
After establishing the level of current assets, the firm must determine
how
these assets should be
financed. That is,
what mix of long
-
term funds and short term debt should the
firm employ to
support its current assets?
Figure 2.7
(on page 13) depicts how total assets
–
and hence the
capital requirements
–
change over time for a growing firm. For the sake of simplicity, assets are
divided into two classes, namely,
fixed assets a
nd current assets.
Fixed assets are assumed to
grow at a constant rate which reflects the secular rate of growth in sales. Current assets, too, are
expected to display the same long
-
term rate of growth; however, they exhibit substantial
variation around
the trend line, due to seasonal (or even cyclical) patterns in sales and or
purchases.
The investment in current assets may be broken into two parts:
permanent current assets and
temporary current assets.
Permanent current assets represent what the firm
requires even at the
bottom of its sales cycle; temporary current assets on the other hand reflect a variable component
that moves up and down with seasonal fluctuations. Thus, permanent and temporary working
capital needs different financing approaches.
There are three strategies or methods of working capital financing:
Hedging, Conservative and
Aggressive strategies
. Hedging approach is an
ideal
method of financing with moderate risk and
profitability. The other two are extreme strategies. Conservative a
pproach is highly conservative
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
35
with very low risk and therefore low profitability. Aggressive approach is highly aggressive
having high risk and high profitability.
Conservative Strategy:
As the name suggests, it is a conservative strategy of financing the
working capital with low risk and low profitability. In this strategy, apart from the fixed assets
and permanent current assets, part of temporary working capital is also financed by long term
financing sources. It has the lowest liquidity risk at the cos
t of higher interest outlay. Here, funds
are applied as below.
Long Term Funds = FA + PWC + Part of TWC
Short Term Fund = Remaining Part of TWC
Aggressive Strategy:
This strategy is the most aggressive strategy out of all the three. The
complete focus of the strategy is in profitability. It is a high risk high profitability strategy. In
this strategy, the long term funds are utilized only to finance fixed assets and
part of permanent
working capital
. Complete temporary
working capital and part of permanent working capital are
financed by the short term funds. It saves the interest cost at the cost of high risk.
Long Term Funds = FA + Part of P
WC
Short Term Funds = Remaining Part of PWC + TWC
Hedging (Maturity Matching) Strategy:
This is a careful strategy of financing the working
capital with moderate risk and profitability. In this strategy, each of the assets would be financed
by a
debt instrument of almost the same maturity. It means if the asset is maturing after 30 days,
the payment of the debt which has financed it will also have its due date of payment after almost
30 days. Hedging strategy works on the cardinal principle of fi
nancing i.e. utilizing long term
sources for financing long term assets i.e. fixed assets and permanent working capital; and
temporary working capital is financed by short term sources of finance.
Long Term Funds = FA + PWC
Short Term Funds
= TWC
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
36
Conclusion:
If these three strategies are plotted on a number line
with one side as ‘risk’ and the
other side as ‘profitability’, conservative strategy is on the side of lower profitability and lower
risk. On the contrary, aggressive stra
tegy is on the side of higher profitability and higher risk.
Hedging strategy is somewhere between the two. Executing the hedging strategy in its true sense
is not practically possible. Management’s attitude towards risk and other factors would decide
thei
r place on this number line.
Figure 2.7: Working Capital Financing Strategies
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
37
Chapter three
Cash and Liquidity Management
Introduction:
This chapter discusses about
how firms manage cash. The basic objective in cash management is
to keep the investment in cash as low as possible while still keeping the firm operating efficiently
and effectively. This goal usually reduces to the dictum
“Collect early and
P
ay late
.”
Accordingly, we discuss ways of accelerating collections and managing disbursements.
3.1 Reasons for Holding Cash
John Maynard Keynes, in his classic work “
The General Theory of Employment,
Interest, and Money”,
identi
fied three motives for
holding cas
h:
a)
The transaction motive
b)
The speculative motive, and
c)
The precautionary
motive
a) The Transaction Motive
Cash is needed to
meet regular
commitments
of paying accounts payable, employees’ wages,
taxes, annual dividends to shareholders, bills and so on.
Cash is collected from product sales, the
selling of assets, and n
ew financing. However, t
he cash inflows /collections and outflows
/disbursements are
not perfectly synchronized, and
thus
some level of cash holdings is necessary
to serve as a buffer
.
b) The Speculative Motive
The
speculative motive
is the need to hold cash in order to be able to take advantage of profit
-
making opportunities as and when
they arise; such as
bargain purchases that might arise,
attractive interest rates
, and (in the case of international firms) favorable exchange rate
fluctuations
.
The opportunity to make
-
profit may arise when
sec
urity prices change. For
instance, a
firm holds cash, when it expects interest rate arise and security price fall. It purchases
security, when interest rate is expected to fall. The firm may also speculate on materials’ prices.
If it is expecte
d that material price will fall, the
firm postpon
e
s
material purchases and make
purchases in the future.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
38
c)
The
Precautionary Motive
The
Precautionary Motive
is
the need to hold cash to meet contingencies in the future. It
provides a cushion or buffer to wit
hstand some unexpected/unanticipated
emergen
cies; such as
sudden increase in raw material costs, strikes etc.
It depends on the predictability of cash flows
and ability of the firm to borrow at short notice.
*
Compensating Balances
Compensating balances are another reason to hold cash. Cash balance
s are kept at commercial
banks to compensate for banking services the firm receives. A minimum compensating balance
requirement may impose a lower limit on the level of cash a firm holds.
*Cash Management versus Liquidity Management
The distinction between liquidity management and cash management is straightforward.
Liquidity management
concerns the optimal quantity of liquid assets a firm should have on
hand, and it is one particular aspect of the current asset management policies.
Cash management
is much more closely related to optimizing mechanisms for collecting and
disbursing cash, and it is this subject that we primarily focus on in this chapter.
3.2 Understanding Float
As you no doubt know, the amount of money you have accord
ing to your book balance can be
very different from the amount of money that your bank thinks you have. The reason is that some
of the checks you have written haven’t yet been presented to the bank for payment. The same
thing is true for a business. The ca
sh balance that a firm shows on its books is called the
firm’s
book,
or
ledger, balanc
e
.
The difference between the available
(bank) balance and ledger
balance, called the
float
, represents the net effect of checks in the process of
clearing
(moving
through the banking system).
3.2.1 Disbursement Float
Checks written by a firm generate
disbursement float,
causing a
decrease
in the firm’s book
balance but no change in its availab
le balance.
For example
,
suppose General Mechanics, Inc. (GMI), currently has $100,000 on deposit with
its bank. On June 8, it buys some raw materials and pays with a check for $100,000. The
company’s book balance is immediately reduced by $100,000 as a result. GMI’s bank, howeve
r,
will not find out about this check until it is presented to GMI’s bank for payment on, say, June
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
39
14. Until the check is presented, the firm’s available balance is greater than its book balance by
$100,000.
In other words, before June 8, GMI has a zero
float:
Float = Firm’s available balance
-
Firm’s book balance
= $100,000
-
100,000
= $0
GMI’s position from June 8 to June 14 is:
Disbursement floa
t = Firm’s available balance
-
Firm’s book balance
=$100,000
–
0
= $100,000
While the check is clearing, GMI has a balance with the bank of $100,000
. It can obtain the
benefit of such
cash during this period. For example, the availabl
e balance could be temporarily
invested in marketable securities and thus earn some interest.
3.2.2 Collection Float and Net Float
Checks received by the firm create
collection float
.
Collection float increases book balances but
does not
immediately change available balances. For example, suppose GMI receives a check
from a customer for $100,000 on October 8. Assume, as before, that the company has $100,000
deposited at its bank and a zero float. It deposits the check and increases its boo
k balance by
$100,000 to $200,000. However, the additional cash is not available to GMI until its bank has
presented the check to the customer’s bank and received $100,000. This will occur on, say,
October 14. In the meantime, the cash position at GMI will
reflect a collection float of $100,000.
We can summ
arize these events:
Before October 8, GMI’s position is: Float = Firm’s available
balance
-
Firm’s book balance
=$100,000
-
100,000
= $0
GMI’s position from October 8 to October 14 is:
Collection float = Firm’s available balance
-
Firm’s book balance
= $100,000
-
200,000
=
-
$100,000
In general, a firm’s payment (disbursement) act
ivities generate disbursement float, and its
collection activities generate collection float
. The net effect
—
that is, the sum of the total
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
40
collection and disbursement floats
—
is the net float
. The net float at a point in time is simply the
overall differenc
e between the
firm’s available balance and its book balance
. If the net float is
positive, then the firm’s disbursement float
exceeds
its collection float, and its available balance
exceeds its book balance. If the available balance is less than the book balance, then the firm has
a
net collection float.
A firm should be concerned with its
net float
and
available balance
more than with
its book
balance. If a financial manager knows that a check written by the company will not clear for
several days, that manager will be able to keep lower cash balance at the bank than might be
possible otherwise. This can generate a great deal of money.
3.2.3 Float
Management
Float management involves controlling the
collection and disbursement of cash
. The objective in
cash collection is to speed up collections and reduce the lag between the time customers pay their
bills and the time the cash becomes av
ailable. The objective in cash disbursement is to control
payments and minimize the firm’s costs associated with making payments. Total collection or
disbursement times can be broken down into three parts:
mailing time, processing delay, and
availability d
elay
.
1.
Mailing time
is the part of the collection and disbursement process during which
checks are
trapped in the postal
system.
2.
Processing delay
is the time it takes the
receiver
of a check to process the payment
and deposits it in a bank for collection.
3
.
Availability delay
refers to the time required to
clear a check through the banking
system. Speeding up collections involves reducing one or more of these components.
Slowing u
p disbursements involves increasing one of them.
3.2.4
Measuring Float
The size of the float depends on both the
dollars and the time delay
involved. For example,
suppose you mail a
check for $500 to another
region
each month. It takes five days in the mail
for the check to reach its destination (the mailing time) and one day for the recipient to get over
to the bank (the processing delay). The recipient’s bank holds out
-
of
-
region
checks for three days
(availability
delay).
The total delay
is: 5 + 1 + 3 =
9 days.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
41
In this case, what is your average daily disbursement float? There are two equivalent ways of
calculating the answer.
First, you have a $500 float for nine days, so we say that the total float is:
9 x $500 = $4,500.
Assuming 30 days in the month, the aver
age daily float is:
$4,500/30 =$150.
Alternatively, your disbursement float is $500 for 9 days out of the month and zero the other 21
days (again assuming 30 days in a month). Your average daily float is thus:
Average daily float
= (9 x $500 +
21 x 0)/30
= 9/30 x $500 + 21/30 x0
= $4,500/30
= $150
Some Details:
In measuring float, there is an important dif
ference to note between collection and disbursement
float. We defined
float
as the difference between the firm’s available cash balance and its book
balance. With a disbursement, the firm’s book balance goes down when the check is
mailed,
so
the mailing time is an important component in disbursement float. However, with a collection,
the firm’s book balance isn’t increased until the check is
received,
so
mailing time is not a
component of collection float
.
This doesn’t mean that mailing tim
e is not important. The point is that when collection
float
is
calculated, mailing time should not be considered. When total collection
time
is considered, the
mailing time is a crucial component. Also, when we talk about availability delay, how long it
ac
tually takes a check to clear isn’t really crucial. What matters is
how long we must wait
before the bank grants availability
—
that is, use of the funds. Banks actually use availability
schedules to determine how long a check is held based on time of deposi
t and other factors.
Beyond this, availability delay can be a matter of negotiation between the bank and a customer.
In a similar vein, for outgoing checks, what matters is the date our account is debited, not when
the recipient is granted availability.
Co
st of the Float
The basic cost of collection float to the firm is simply the opportunity cost of not being able to
use the cash.
Ethical and Legal Questions:
The cash manager must work with collected bank cash balances
and not the firm’s book balance (wh
ich reflects checks that have been deposited but not
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
42
collected). If this is not done, a cash manager could be drawing on uncollected cash as a source
of funds for short
-
term investing. Most banks charge a penalty rate for the use of uncollected
funds. Howe
ver, banks may not have good enough accounting and control procedures to be fully
aware of the use of uncollected funds. This raises some ethical and legal questions for the firm.
3.3
Cash Collection and Concentration
From our previous discussion, we know
that collection delays work against the firm. All other
things being the same, then, a firm will adopt procedures to speed up collections and thereby
decrease collection times.
Cash collection policies depend on the nature of the business. Firms can choos
e to have checks
mailed to one location, or many locations (reduces mailing time). Many firms also accept online
payments either with a credit card or with authorization to request the funds directly from your
bank. In addition, even after cash is collecte
d, firms need procedures to funnel, or concentrate,
that cash where it can be best used. Some common collection and concentration procedures are
presented below.
Components of collection time
Based on discussions above, we can depict the basic parts of the
cash collection process as
follows. The total time in this process is made up of mailing time, check
-
processing delay, and
the bank’s availability delay.
Figure3.1: components of collection time
The amount of time that cash spends in each part of
the cash collection process depends on
where the firm’s customers and banks are located and how efficient the firm is in collecting cash.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
43
3.3.1 Cash Collection
How a firm collects cash from its customers depends in large part on the nature of the busines
s.
The simplest case would be a business such as a restaurant chain. Most of its customers will pay
with cash, check, or credit card at the point of sale (this is called
over
-
the
-
counter collection
), so
there is no problem with mailing delay. Normally, the
funds will be deposited in a local bank,
and the firm will have some means (discussed later) of gaining access to the funds.
When some or all of the payments a company receives are checks that arrive through the mail, all
three components of collection ti
me become relevant. The firm may choose to have all the
checks mailed to one location; more commonly, the firm might have a number of different mail
collection points to reduce mailing times. Also, the firm may run its collection operation itself or
might
hire an outside firm that specializes in cash collection.
Other approaches to cash collection exist. One that is becoming more common is the
preauthorized payment arrangement. With this arrangement, the payment amounts and payment
dates are fixed in advanc
e. When the agreed
-
upon date arrives, the amount is automatically
transferred from the customer’s bank account to the firm’s bank account, which sharply reduces
or even eliminates collection delays. The same approach is used by firms that have online
termi
nals, meaning that when a sale is rung up, the money is immediately transferred to the
firm’s accounts.
LOCKBOXES
When a firm receives its payments by mail, it must decide where the checks will be mailed and
how the checks will be picked up and deposited.
Careful selection of the number and locations of
collection points can greatly reduce collection times. Many firms use special post office boxes
called
lockboxes
to intercept payments and speed
up
cash collection.
As figure 2 below illustrates, in a lockbo
x system, the collection process is started by customers’
mailing their checks to a post office box instead of sending them to the firm. The lockbox is
maintained by a local bank. A large corporation may actually maintain more than 20 lockboxes
with in a
c
ountry.
In the typical lockbox system, the local bank collects the lockbox checks several times a day.
The bank deposits the checks directly to the firm’s account. Details of the operation are recorded
(in some computer
-
usable form) and sent to the firm.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
44
A
lockbox system reduces mailing time because checks are received at a nearby post office
instead of at corporate headquarters. Lockboxes also reduce the processing time because the
corporation doesn’t have to open the envelopes and deposit checks for colle
ction. In all, a bank
lockbox system should enable a firm to get its receipts processed, deposited, and cleared faster
than if it were to receive checks at its headquarters and deliver them itself to the bank for deposit
and clearing.
Some firms have turne
d to what are called “electronic lockboxes” as an alternative to traditional
lockboxes. In one version of an electronic lockbox, customers use the telephone or the Internet to
access their account
—
say, their credit card account at a bank
—
review their bill,
and authorize
payment without paper ever having changed hands on either end of the transaction. Clearly, an
electronic lockbox system is far superior to traditional bill payment methods, at least from the
biller’s perspective.
Look for systems like this t
o continue to grow in popularity.
Figure
3.
2: lockbox system
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
45
3.3.2 Cash Concentration
As we discussed earlier, a firm will typically have a number of cash collection points; as a result,
cash collections may end up in many different banks and bank accounts. From here, the firm
needs procedures to move the cash into its main accounts. This i
s called
cash
concentration
. By
routinely pooling its cash, the firm greatly simplifies its cash management by reducing the
number of accounts that must be tracked. Also, by having a larger pool of funds available, a firm
may be able to negotiate or otherw
ise obtain a better rate on any short
-
term investments.
In setting up a concentration system, firms will typically use one or more
concentration banks.
A
concentration bank pools the funds obtained from local banks contained within
some geographic
region.
Concentration systems are often used in conjunction with lockbox
systems.
A key part of the cash collection and concentration process is the transfer of funds to the
concentration bank. There are several options available for accomplishing this transfer.
The
cheapest is a
depository transfer
check (DTC),
which is a preprinted check that usually needs no
signature and is valid only for transferring funds between specific accounts within the
same
firm.
The money becomes available one to two days later.
Auto
mated clearinghouse
(
ACH
) transfers
are basically electronic versions of paper checks. These may be more expensive, depending on
the circumstances, but the funds are available the next day. The most expensive means of
transfer are
wire transfers,
which pro
vide same
-
day availability. Which approach a firm will
choose depends on the number and size of payments? For example, a typical ACH transfer might
be $200, whereas a typical wire transfer would be
for
several million dollars.
Firms with a large number of
collection points and relatively small payments will choose the
cheaper route, whereas firms that receive smaller numbers of relatively large payments may
choose more expensive procedures.
Figure
3.
3:
Lockboxes and Concentration Banks in a Cash
Management System
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
46
ACCELERATING COLLECTIONS: AN EXAMPLE
The decision of whether or not to use a bank cash management service incorporating lockboxes
and concentration banks depends on where a firm’s customers are located and the speed of
a
country’s
postal system.
Suppose ABC
Corporation, located in
Addis Ababa
, is considering a
lockbox system. Its collection delay is currently eight days.
ABC
does business in the southwestern
part of the country (N
ekemte
,
Awassa, and Arsi
). The
proposed lo
ckbox system
would be located in Awassa and operated by Commercial
Bank
of
Ethiopia (CBE). Commercial
Bank
has analyzed ABC
’s cash
-
gathering system and has
concluded that it can decrease collection time by two days. Specifically, the bank has come up
with
the following information on the proposed lockbox system
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
47
The cash flows for the current collection operation are shown in the following cash flow time
chart:
Figure
3.
4
: Cash flow time
The Commercial
Bank has agreed to operate this lockbox system for a
fee of 25 cents per
check
processed. Should ABC
give the go
-
ahead?
Solution:
We first need to determine the benefit of the system. The average daily collections from the
customers
are $1.2 million (2,000 x $600). The collection time will be decreased by t
wo days, so
the lockbox system will increase the collected bank balance by $1.2 million x 2 = $2.4 million.
In other words, the lockbox system releases $2.4 million to the firm by reducing processing,
mailing, and clearing time by two days. From our earlie
r discussion, we know that this $2.4
million is the PV of the proposal.
To calculate the NPV, we need to determine the PV of the costs. There are several different ways
to proceed. First, at 2,000 checks per day and $.25 per check, the daily cost is $500.
This cost
will be incurred every day forever. At an interest rate of .025 percent per day, the PV is therefore
$500/.00025 = $2 million. The NPV is thus $2.4 million = 2 million + $400,000, and the system
appears to be
desirable
.
Alternatively, ABC
could invest the $2.4 million at .025 percent per
day. The interest earned would be $2.4 million x .00025= $600 per day. The cost of the system is
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
48
$500 per day; so, running it obviously generates a profit in the amount of $100 per day. T
he PV
of $100 per day forever is $100/.00025 = $400,000, just as we had before.
Finally, and most simply, each check is for $600 and is available two days sooner if the system is
used. The interest on $600 for two days is 2 x$600 x .00025 = $.30. The cost
is 25 cents per
check, so A
BC
makes a nickel ($.30
-
.25) on every check. With 2,000 checks per day, the profit
is $.05 x2, 000 checks = $100 per day, as we calculated
. So, yes, ABC should give the go
-
ahead.
3.4 Managing Cash Disbursements
From the firm’s point of view, disbursement float is desirable, so the goal in managing
disbursement float is to slow down disbursements. To do this, the firm may develop strategies to
increase
mail
ing
float, processing float, and availability float on the
checks it writes. Beyond
this, firms have developed procedures for minimizing cash held for payment purposes.
I
ncreasing
D
isbursement
F
loat
As we have seen, slowing down payments comes from the time involved in mail delivery, check
processing, and collection of funds. Disbursement float can be increased by writing a check on a
geographically distant bank.
For example, a supplier in Addis might
be paid with checks drawn
on a Mekelle bank. This will increase the time required for the checks to clear through the
banking system. Mailing checks from remote post offices is another way firms slow down
disbursement.
Tactics for maximizing disbursement
float are debatable on both ethical and economic grounds.
First, as we
will
discuss in some detail in the next chapter, payment terms frequently offer a
substantial discount for early payment. The discount is usually much larger than any possible
savings f
rom “playing the float game.” In such cases, increasing mailing time will be of no
benefit if the recipient dates payments based on the date received (as is common) as opposed to
the postmark date.
Beyond this, suppliers are not likely to be fooled by atte
mpts to slow down disbursements.
The negative consequences of poor relations with suppliers can be costly. In broader terms,
intentionally delaying payments by taking advantage of mailing times or unsophisticated
suppliers may amount to avoiding paying bil
ls when they are due
—
an unethical business
procedure.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
49
C
ontrolling
D
isbursements
We have seen that maximizing disbursement float is probably poor business practice. However, a
firm will still wish to tie up as little cash as possible in disbursements. Firm
s have therefore
developed systems for efficiently managing the disbursement process. The general idea in such
systems is to have no more than the minimum amount nece
ssary to pay bills on deposit with
the
bank. We discuss some approaches to accomplishing t
his goal next.
1.
Zero
-
Balance Accounts
:
-
w
ith a
zero
-
balance account
system, the firm, in cooperation
with its bank, maintains a master account and a set of subaccounts. When a check written
on one of the subaccounts must be paid, the necessary funds are transferred in from the
master account. Figure3.5
(refer
next page) il
lustrates how such a system might work. In
this case, the firm maintains two disbursement accounts, one for suppliers and one for
payroll. As shown in the figure, if the firm does not use zero
-
balance accounts, then each
of these accounts must have a safet
y stock of cash to meet unanticipated demands. If the
firm does use zero
-
balance accounts, then it can keep one safety stock in a master account
and transfer the funds to the two subsidiary accounts as needed. The key
point
is that the
total amount of cash
held as a buffer is smaller under the zero
-
balance arrangement,
which frees up cash to be used elsewhere.
Figure3.
5
: No zero
-
balance and two zero
-
balance accounts
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
50
2.
Controlled Disbursement Accounts
:
-
w
ith a
controlled disbursement account
system,
almost all payments that must be made in a given day are known in the morning. The bank
informs the firm of the total, and the firm transfers (usually by wire) the amount needed.
3.5 Investing Idle Cash
I
f
a firm has a temporary cash surplus, it c
an invest in short
-
term securities. As we have
mentioned at various times, the market for short
-
term financial assets is called the
money
market.
The maturity of short
-
term financial assets that trade in the money market is one year or less.
Most large fir
ms manage their own short
-
term financial assets, carrying out transactions through
banks and dealers. Some large firms and many small firms use money market mutual funds.
These are funds that invest in short
-
term financial assets for a management fee. The
management
fee is compensation for the professional expertise and diversification provided by the fund
manager.
Among the many money market mutual funds, some specialize in corporate customers.
In
addition, banks offer arrangements in which the bank takes
all excess available funds at the close
of each business day and invests them for the firm.
T
emporary
C
ash
S
urpluses
Firms have temporary cash surpluses for various reasons. Two of the most important are the
financing of seasonal or cyclical activities of
the firm and the financing of planned or possible
expenditures.
Seasonal or Cyclical Activities
-
Some firms have a predictable cash flow pattern. They have
surplus cash flows during part of the year and deficit cash flows the rest of the year.
For example,
Toys “ R” Us, a retail toy firm, has a seasonal cash flow pattern influenced by the
holiday season. A firm such as Toys “ R” Us may buy marketable securities when surplus cash
flows occur and sell marketable securities when deficits occur. Of course, bank
loans are another
short
-
term financing device. The use of bank loans and marketable securities to meet temporary
financing needs is illustrated in
Rose page 602 (
Figure 20.6
)
. In this case, the firm is following a
compromise working capital policy in
the sense we discussed in the previous chapter.
Planned or Possible Expenditures
:
Firms frequently accumulate temporary investments in
marketable securities to provide the cash for a plant construction program, dividend payment, or
other large
expenditure
s
. Thus, firms may issue bonds and stocks before the cash is needed,
investing the proceeds in short
-
term marketable securities and then selling the securities to
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
51
finance the expenditures. Also, firms may face the possibility of having to make a
large cash
outlay. An obvious example would involve the possibility of losing a large lawsuit. Firms may
build up cash surpluses against such a contingency.
3.6 Determining the Target Cash Balance
Based on our general discussion of current assets in the p
revious chapter, the target cash balance
involves a trade
-
off between the opportunity costs of holding too much cash (the carrying costs)
and the costs of holding too little (the shortage costs, also called adjustment costs). The nature of
these costs de
pends on the firm’s working capital policy.
If the firm has a flexible working capital pol
icy, it will probably maintain
marketable securities
portfolio. In this case, the adjustment, or shortage, costs will be the trading costs associated with
buying and
selling
securities. On the other hand, if
the firm has a restrictive working capital
policy, it will probably borrow in the short term to meet cash shortages. The costs in this case
will be the interest and other expenses associated with arranging a loan.
In our discussion that follows, we will assume the firm has a flexible policy. Its cash
management, then, consists of moving money in and out of marketable securities. This is a
traditional approach to the subject, and it is a nice way of illustrating th
e costs and benefits of
holding cash. Keep in mind, however, that the distinction between cash and money market
investments is becoming increasingly blurred.
The Basic Idea
The
Figure below
presents the cash management problem for our flexible firm. If a f
irm tries to
keep its cash holdings too low, it will find itself running out of cash more often than is desirable
and thus selling marketable securities (and perhaps later buying marketable securities to replace
those sold) more frequently than would be th
e case if the cash balance were higher. Thus,
trading costs
will be high when the cash balance is small. That is, trading costs are increased
when the firm must sell securities to establish a cash balance. These costs will fall as the cash
balance becomes
larger
.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
52
On the other hand, when a firm holds cash in excess of some necessary minimum to reduce
trading costs, it incurs an
opportunity cost
. The opportunity cost of holding excess cash (held in
currency or bank deposits) is the interest income
that could have been earned in the next best use,
such as investment in marketable securities. Given the opportunity cost of holding cash, why
would a firm hold cash in excess of its compensating balance requirements? The answer is that a
cash balance must
be maintained to provide the liquidity necessary for transaction needs
—
paying bills. If the firm maintains too small cash balance, it may run out of cash. If this happens,
the firm may have to raise cash on a short
-
term basis. This could involve, for exam
ple, selling
marketable securities or borrowing. Activities such as selling marketable securities and
borrowing involve various costs. Holding cash than is needed has an opportunity cost. To
determine the appropriate cash balance, the firm must weigh the b
enefits of holding cash against
these costs
.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
53
In the above figure, the sum of the costs is given by the total cost curve. As shown, the minimum
total cost occurs where the two individual cost curves cross at point
C*
. At this point, the
opportunity costs a
nd the trading costs are equal. This point represents the target cash balance,
and it is the point the firm should try to find.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
54
Chapter Four
Receivables Management
4
.
1 Credit and Receivables
When a firm sells goods and
services, it can demand cash on or before the delivery date or it can
extend credit to customers and allow some delay in payment. Granting credit is making an
investment in a customer
—
an investment tied to the sale of a product or service.
Why do firms gra
nt credit?
The obvious reason is that offering credit
is a way of stimulating
sales. However, t
he costs associated with granting credit are not trivial.
First
, there is a
chance
that the customer will not pay.
Second,
the firm has to bear the costs of carr
ying the receivables.
The credit policy decision thus involves a trade
-
off between the benefits of increased sales and
the costs of granting credit. From an accounting perspective, when credit is granted, an account
receivable is created. Such receivables
include credit to other firms, called
trade credit,
and credit
granted to consumers, called
consumer credit.
4.1.1 C
omponents of
C
redit
P
olicy
If a firm decides to grant credit to its customers, then it must establish procedures for extending
credit
and collecting. In particular, the firm will have to deal with the following components of
credit policy:
1.
Terms of sale
: The terms of sale establish how the firm proposes to sell its goods and
services. A basic decision is whether the firm will require
cash or will extend credit. If the firm
does grant credit to a customer, the terms of sale will specify (perhaps implicitly) the credit
period, the cash discount and discount period, and the type of credit instrument.
2.
Credit analysis
: In granting credit
, a firm determines how much effort to expend trying to
distinguish between customers who will pay and customers who will not pay. Firms
use a
number of devices and procedures to determine the probability that customers will not pay; put
together, these a
re called credit analysis.
3.
Collection policy
: After credit has been granted, the firm has the potential problem of
collecting the cash, for which it must establish a collection policy. In the next several sections,
we will discuss these components of cr
edit policy that collectively make up the decision to grant
credit.
4.1.2 T
he
C
ash
F
lows
from
G
ranting
C
redit
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
55
The accounts receivable period is described as the time it takes to collect on a
credit
sale. There
are several events that occur during this peri
od. These events are the cash flows associated with
granting credit, and they can be illustrated with a cash flow diagram as follows:
Figure
4.1: cash f
low
s from granting c
redit
As the time line indicates, the typical sequence of events when a firm grants credit is as follows:
(1) The credit sale is made, (2) the customer sends a check to the firm
(3) the firm deposits the
check, and (4) The firm’s account is credited for the amount of the check.
It is apparent that one
of the factors influencing the receivables period is float. Thus, one way to reduce the receivables
period is to speed up the check
mailing, processing, and clearing delays.
4.1.3 T
he
I
nvestment
in
Receivables
The investment in accounts receivable for any firm depends on the amount of credit sales and the
average collection period. A
firm’s receivables generally will be equal to its
average daily sales
multiplied by its average collection period.
Thus, a firm’s investment in accounts receivable
depends on factors that influence credit
sales and collections.
Recall that we use the terms
days’ sales in receivables, receivables period,
and
average collection
period
interchangeably to refer to the length of time it takes for the firm to collect on a
credit
sale.
4.2 Terms of the Sale
The terms of a sale are made up of three distinct elements:
1. The period for which credit is granted (the
credit period
).
2. The
cash discount
and the
discount period
.
3. The type of
credit instrument
.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
56
Within a given industry, the terms of sale are usually fairly standard, but these terms vary quite a
bit across industries.
THE BASIC FORM
The easiest way to u
nderstand the
terms of sale
is to consider an example. Terms such as 2/10,
net/ 60 is common. This means that customers have 60 days from the invoice date to pay the full
amount
(say $1000)
; however, if payment is made within 10 days, a 2 percent cash
discount can
be taken. In such term
s
, the
buyer has an option of paying $980 within the discount period, or
paying the full $1,000 in 60 days
. In general, credit terms are
interpreted in the following way as:
take this discount off the invoice price if you
pay in this many days, else pay the full
invoice
amount in this many days.
The
credit period:
is the basic length of time for which credit is granted.
The credit period
varies widely from industry to industry, but it is almost always between 30 and 120 da
ys. If a
cash discount is offered, then the credit period has two components: the net credit period and the
cash discount period. The net credit period is the length of time the customer has to pay. The
cash discount period is the time during which the dis
count is available.
The Invoice Date
is the beginning of the credit period. Possible arrangements
include
:
❖
ROG (
for
receipt of goods
),
i
n
this case, the credit period starts when the customer
receives the order.
❖
EOM dating, all sales made during a particular month are assumed to be made at the end
of that month. Confusingly, the end of the month is sometimes taken to be the 25th day of
the
month.
❖
MOM, for middle of month, is another variation.
❖
Seasonal dating is sometimes used to encourage sales of seasonal products during the
off
-
season
period
.
Length of the Credit Period
:
Several factors influence the length of the credit period. Two
impor
tant ones are;
❖
T
he
buyer’s
inventory period
,
and
❖
Operating cycle
(buyer’s inventory + receivables period)
.
All else equal, the shorter these are, the shorter the credit period will be.
The buyer’s inventory
period is the time it takes the buyer to acquire inventory (from us), process and sell it.
The
buyer’s receivables period is the time it then takes the buyer to collect on the sale.
On
top of
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
57
customers’ inventory period and
operating cycle, there are a number of other factors that
influence the credit period. Many of these also influence our customer’s operating cycles; so,
once again, these are related subjects. Among the most important are:
1.
Perishability and collateral valu
e
: Perishable items have relatively rapid turnover and
relatively low collateral value. Credit periods are thus shorter for such goods.
2.
Consumer demand
: Products that are well established generally have more rapid turnover.
Newer or slow
-
moving products wi
ll often have longer credit periods associated with them to
entice buyers. Also, as we have seen, sellers may choose to extend much longer credit
periods for off
-
season sales (when customer demand is low).
3.
Cost, profitability, and standardization
: Relat
ively inexpensive goods tend to have shorter
credit periods. The same is true for relatively standardized goods and raw materials. These all
tend to have lower markups and higher turnover rates, both of which lead to shorter credit
periods. However, there
are exceptions.
4.
Credit risk
: The greater the credit risk of the buyer, the shorter the credit period is likely to be
(if credit is granted at all).
5.
Size of the account
: If an account is small, the credit period may be shorter because small
accounts
cost more to manage, and the customers are less important.
6.
Competition
: When the seller is in a highly competitive market, longer credit periods may be
offered as a way of attracting customers.
7.
Customer type
: A single seller might offer different cre
dit terms to different buyers.
A food wholesaler, for example, might supply groceries, bakeries, and restaurants. Each group
would probably have different credit terms. More generally, sellers often have both wholesale
and retail customers, and they freque
ntly quote different terms to the two types.
Cash discounts
-
are often part of the terms of sale. One reason discounts are offered is to speed
up the collection of receivables. This will have the effect of reducing the amount of credit being
offered, and the firm must trade this off against the cost of the discount.
Notice that when a cash discount is offered, the credit is essentially free during the discount
period. The buyer pays for the credit only after the discount expires.
Cost of the
Credit
:
In our examples, it might seem that the discounts are rather small. With
2/10, net 30, for example, early payment gets the buyer only a 2 percent discount.
Does this
provide a significant incentive for early payment? Yes and
let u
s see how?
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
58
To see
why the discount is important, we will calculate the cost to the buyer of not paying early.
To do this, let’s find the interest rate that the buyer is effectively paying for the trade credit.
Suppose the order is for $1,000. The buyer can pay $980 in 10 da
ys or wait another 20 days and
pay $1,000. It’s obvious that the buyer is effectively
borrowing $980 for 20 days and that the
buyer pa
ys $20 in interest on the “loan.
” What’s the interest rate?
This interest is ordinary discount interest, with th
e $20 inte
rest on $980 borrowed: the rate is
$20/980=
2.0408%. This
rate
is relatively low, but remember that this is the rate per 20
-
day
period. There are 365/20
= 18.25 such periods in a year, so
by not taking the discount, the buyer
is p
aying an effective annual r
ate (
EAR
)
of:
EAR
=
1
.
020408
18
.
25
−
1
=
44
.
6%
From the buyer’s point of view, this is an expensive source of financing!
Meaning, the customer
is hardly going to decide not to take the discount.
Given that the interest rate is so high here, it is
unlikely that the seller benefits from early payment. Ignoring the possibility of default by the
buyer, the decision of a customer to forgo the discount almost surely works to the seller’s
advantage.
C
redit
I
nstruments
-
t
he
credit instrument
is the basic e
vidence of
buyer’s
indebtedness. Most
trade credit is offered on
an
open account.
This means that the only formal instrument of credit is
the invoice, which is sent with the shipment of goods and which the customer signs as evidence
that the goods have bee
n received. Afterward, the firm and its customers record the exchange on
their books of account.
At times, the firm may require that the customer sign a
promissory note.
This is a basic IOU and
might be used when the order is large, when there is no cash d
iscount involved, or when the firm
anticipates a problem in collections. Promissory notes are not common, but they can eliminate
possible controver
s
ies later about the existence of debt.
One problem with promissory notes is that they are signed after deliv
ery of the goods. One way
to obtain a credit commitment from a customer before the goods are delivered is to arrange a
commercial draft.
Typically, the firm draws up a commercial draft calling for the customer to
pay a specific amount by a specified date.
The draft is then sent to the customer’s bank with the
shipping invoices.
If immediate payment is required on the draft, it is called a
sight draft.
If immediate payment is
not required, then the draft is a
time draft.
When the draft is presented and the b
uyer “accepts” it,
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
59
meaning that the buyer promises to pay it in the future, then it is called a
trade
acceptance
and is
sent back to the selling firm. The seller can then keep the acceptance or sell it to someone else. If
a bank accepts the draft, meaning
that the bank is guaranteeing payment, then the draft becomes
a
banker’s acceptance.
This arrangement is common in international trade, and banker’s
acceptances are actively traded in the money market.
A firm can also use a conditional sales
contract as a credit instrument. With such an arrangement,
the firm retains legal ownership of the goods until the customer has completed payment.
Conditional sales contracts usually are paid in installments and have an interest cost built into
them.
4.3 H
ow to Create Credit & Collections Policy?
Knowing the firm’s level of risk tolerance, cash
-
on
-
hand and access to capital will go a long way
in helping a firm to determine its credit and collection policy. Firm’s credit and collection policy
can be
liberal, moderate, conservative or some combination such as:
❖
Liberal on credit/conservative(tight) on collections
❖
Moderate on credit/moderate on collections
❖
Conservative(tight) on credit/liberal on collections
The mentioned above alternative policies do ha
ve their own cost:
1.
O
pportunity cost of lost contribution/profit , and
2.
Credit administration costs and bad debt losses.
As you can see from the figure
1 below, these two costs behave contrary to each other. As a firm
moves from tight to lose credit policy
, the opportunity cost declines
;
that is the firm recaptures
lost sales and thus lost contribution/profit. However, the credit administration costs and bad debt
losses increases.
Firm’s credit policy can be determined by the tradeoff between the opportun
ity cost, credit
administration costs and bad debt loses. In the figure below
,
such trade
-
off occurs at point A
where
total of opportunity costs of lost contribution
,
and credit administrat
ion costs and bad
-
debt
-
loses is
minimum.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
60
Figure
4.2
: costs of
credit policy
Does point A represent optimum credit policy?
❖
Optimum credit policy:
-
marginal cost
-
benefit analysis
The firm’s operating profit is maximized when total cost is minimized for a given level of
revenue. Credit policy at point A in the figure ab
ove represents the maximum operating profit
(total cost minimum). But it is not necessarily the optimum credit policy.
Optimum credit
policy
is one which maximizes the firm’s value. The value of the firm is maximized when the
incremental marginal rate of r
eturn of an investment in receivable is equal to the
incremental or marginal cost of funds used to finance the investment.
The incremental rate of return can be calculated as incremental operating profit divided by the
incremental investment in
receivable. The incremental cost of funds is the rate of return required
by the suppliers of funds, given the risk of investment in accounts receivables.
Thus,
investment in accounts receivable should be evaluated following the four steps below:
1)
Estimation of incremental operating profit,
2)
Estimation of incremental investment in accounts receivable
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
61
3)
Estimation of incremental
required
rate of return of
the
investment
in receivable
4)
Comparison of the incremental rate of return with required rate of ret
urn.
4.4 Analyzing Credit Policy
4.
4
.
1 Credit Policy Effects
In evaluating credit policy, there are five basic factors to consider:
1.
Revenue effects
: If the firm grants credit, then there will be a delay in revenue collections as
some customers take
advantage of the credit offered and pay later. However, the firm may be
able to charge a higher price if it grants credit and it may be able to increase the quantity sold.
Total revenues may thus increase.
2.
Cost effects
: Although the firm may experience
delayed revenues if it grants credit, it will
still incur the costs of sales immediately. Whether the firm sells for cash or credit, it will still
have to acquire or produce the merchandise (and pay for it).
3.
The cost of debt
: When the firm grants credi
t, it must arrange to finance the resulting
receivables. As a result, the firm’s cost of short
-
term borrowing is a factor in the decision to
grant credit.
4.
The probability of nonpayment
: If the firm grants credit, some percentage of the credit
buyers wil
l not pay. This can’t happen, of course, if the firm sells for cash.
5.
The cash discount
: When the firm offers a cash discount as part of its credit terms, some
customers will choose to pay early to take advantage of the discount.
4.4.2 Credit Analysis
Th
us far, we have focused on establishing credit terms. Once a firm decides to grant credit to its
customers, it must then establish guidelines for determining who will and who will not be
allowed to buy on credit.
Credit analysis
refers to the process of de
ciding whether or not to
extend credit to a particular customer. Imagine that a firm is trying to decide whether or not to
grant credit to a customer. This decision can get complicated. The answer depends on what will
happen if credit is refused. Will the
customer simply pay cash? Or will the customer not make
the purchase at all? Credit analysis is important simply because potential losses on receivables
can be substantial. Companies report the amount of receivables they expect not to collect on their
bala
nce sheets.
Credit analysis usually involves two steps:
Gathering relevant information
and
determining
creditworthiness.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
62
i.
Credit information
If a firm wants credit information about customers, there are a number of sources. Information
sources
commonly used to assess creditworthiness include the following:
1.
Financial statements
: A firm can ask a customer to supply financial statements such as
balance sheets and income statements.
2.
Credit reports
-
about the customer’s payment history with oth
er firms
:
3.
Banks
: Banks will generally provide some assistance to their business customers in acquiring
information about the creditworthiness of other firms.
4.
The customer’s payment history
with the firm
: The most obvious way to obtain
information about the likelihood of customers not paying is to examine whether they have settled
past obligations (and how quickly).
ii. Credit Evaluation and Scoring
There are no magical formulas for assessing the probability that a customer will not pay.
In very general terms, the classic
five
Cs
of credit
are the basic factors to be evaluated:
1.
Character
: The customer’s willingness to meet credit obligations.
2.
Capacity
: The customer’s ability to meet credit obligations out of operating cash flows.
3.
Capit
al:
The customer’s financial reserves.
4.
Collateral
: An asset pledged in the case of default.
5.
Conditions
: General economic conditions in the customer’s line of business.
Credit scoring
is the process of calculating a numerical rating for a customer
based on
information collected; credit is then granted or refused based on the result. For example, a firm
might rate a customer on a scale of 1 (very poor) to 10 (very good) on each of the five Cs of
credit using all the information available about the cu
stomer. A credit score could then be
calculated by totaling these ratings. Based on experience, a firm might choose to grant credit
only to customers with a score above, say, 30.
Firms such as credit card issuers have developed statistical models for credi
t scoring. Usually, all
of the legally relevant and observable characteristics of a large pool of customers are studied to
find their historic relation to defaults. Based on the results, it is possible to determine the
variables that best predict whether a
customer will pay and then calculate a credit score based on
those variables.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
63
4.5 Collection Policy
Collection policy is the final element in credit policy. Collection policy involves monitoring
receivables to spot trouble and obtaining payment on past
-
d
ue accounts (collection Efforts).
4.
5
.1 Monitoring Receivables
To keep track of payments by customers, most firms will monitor outstanding accounts. First of
all, a firm will normally keep
track of its average collection period (ACP)
through time. If a
fi
rm is in a seasonal business, the ACP will fluctuate during the year; but unexpected increases in
the ACP are a cause for concern. Either customers in general are taking longer to pay, or some
percentage of accounts receivable are seriously overdue.
The
ag
ing schedule
is a second basic tool for monitoring receivables. To prepare one, the credit
department classifies accounts by age. Suppose a firm has $100,000 in receivables. Some of
these accounts are only a few days old, but others have been outstanding f
or quite some time.
The following is an example of an aging schedule:
Aging Schedule
Age of Account Amou
nt %
of Total Receivable
Value
0
–
10 days $ 50,000 50%
11
–
60 days 25,000 25
61
–
80 days 20,000 20
Over 80 days 5,000 5
Total $100,000 100%
If this firm has a credit period of 60 days, then 25 percent of its accounts are late. Whether or not
this is serious depends on the nature of the firm’s collections and c
ustomers. It is often the case
that accounts beyond a certain age are almost never collected. Monitoring the age of accounts is
very important in such cases.
(
For details refer Bringham pg541
)
4.
5
.2 Collection Efforts
A firm usually goes through the follow
ing sequence of procedures for customers whose
payments are overdue:
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
64
1. It sends out a
delinquency letter
informing the customer of the past
-
due status of the account.
2. It makes a
telephone call
to the customer.
3. It employs a
collection agency
.
4. It takes
legal action
against the customer.
At times, a firm may refuse to grant additional credit to customers until arrearages are cleared up.
This may antagonize a normally good customer, which points to a potential conflict between the
collections d
epartment and the sales department. In probably the worst case, the customer files
for bankruptcy. When this happens, the firm can simply wait, or it can sell its receivable
.
Besides,
Cash Discount
encourages customers to pay early,
and hence could be used as
collection tool proactively. I
t will shorten the receivables period and, all other things being equal,
reduce the firm’s investment in receivables.
For example, suppose a firm currently has terms of net 30 and an average collect
ion period
(ACP) of 30 days. If it offers terms of 2/10, net /30, then perhaps 50 percent of its customers (in
terms of volume of purchases) will pay in 10 days. The remaining customers will still take an
average of 30 days to pay. What will the new ACP be
? If the firm’s annual sales are $15 million
(before discounts), what will happen to the investment in receivables?
If half of the customers take 10 days to pay and half take 30, then the new average collection
period will be:
푁푒푤
퐴퐶푃
=
0
.
50
810
푑푎
푦푠
+
0
.
50
∗
30
푑푎푦푠
=
20
푑푎푦푠
The ACP thus falls from 30 days to 20 days. Average daily sales are 15 million/365 day =
41,096 per day. Receivables will thus fall by 41,096 * 10 = 410,960.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
65
Chapter Five
Inventory Management
Introduction
Like receivables, inventories represent a significant investment for many firms. For a typical
manufacturing operation, inventories will often exceed 15 percent of assets. For a retailer,
inventories could represent more than 25 percent of ass
ets. Despite the size of a typical firm’s
investment in inventories, the financial manager of a firm will not normally have primary control
over inventory management. Instead, other functional areas such as purchasing, production, and
marketing will usuall
y share decision
-
making authority regarding inventory. Inventory
management has become an increasingly important specialty in its own right, and financial
management will often only have
input
into the decision. For this reason, we will just survey
some ba
sics of inventory and inventory policy.
5.1 Inventory Types
For a manufacturer, inventory is normally classified into one of three categories. The first
category is raw materials.
This is whatever the firm uses as a starting point in its production
proce
ss. Raw materials might be something as basic as iron ore for a steel manufacturer or
something as sophisticated as disk drives for a computer manufacturer. The second type of
inventory is work
-
in
-
progress,
which is just what the name suggests
—
unfinished p
roduct. How
big this portion of inventory is depends in large part on the length of the production process. For
an airframe manufacturer, for example, work
-
in
-
progress can be substantial. The third and final
type of inventory is finished goods
—
that is, pro
ducts ready to ship or sell.
Keep in
mind three things
concerning inventory types. First, the
names
for the different types
can be a little
misleading
because one company’s raw materials can be another’s finished goods.
For example, going back to our stee
l manufacturer, iron ore would be a raw material, and steel
would be the final product. An auto body panel stamping operation will have steel as its raw
material and auto body panels as its finished
goods
and an automobile assembler will have body
panels a
s raw materials and automobiles as finished products. The second thing to keep in mind
is that the various types of inventory can be quite different in terms of
their liquidity
. Raw
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
66
materials that are commodity
-
like or relatively standardized can be easy t
o convert to cash.
Work
-
in
-
progress, on the other hand, can be quite illiquid and have little more than scrap value.
As always, the liquidity of finished goods depends on the nature of the product. Finally, a very
important distinction between finished goo
ds and other types of inventories is that the demand
for an inventory item that becomes a part of another item is usually termed
derived or
dependent demand
because the firm’s need for these inventory types depends on its need for
finished items. In contra
st, the firm’s demand for finished goods is not derived from demand for
other inventory items, so it is sometimes said to be independent.
5.2 Inventory Costs
As we discussed in Chapter
2
, two basic types of costs are associated with current assets in
general and with inventory in particular. The first of these is
carrying costs
.
Here, carrying costs
represent all of the direct and opportunity costs of keeping inventory on hand. These incl
ude:
i.
Storage and tracking costs.
ii.
Insurance and taxes.
iii.
Losses due to obsolescence, deterioration, or theft.
iv.
The opportunity cost of capital on the invested amount.
The sum of these costs can be substantial, ranging roughly from 20 to 40 percent of inv
entory
value per year. The other type of costs associated with inventory is
shortage costs
.
Shortage
costs
are
costs associated with having inadequate inventory on hand. The two components
of
shortage costs are restocking costs and costs related to safety
reserves. Depending on the firm’s
business, restocking or order costs are either the costs of placing an order with suppliers or the
costs of setting up a production run. The costs related to safety reserves are opportunity losses
such as lost sales and lo
ss of customer goodwill that result from having inadequate inventory. A
basic trade
-
off
exists in inventory management because carrying costs increase with inventory
levels, whereas shortage or restocking costs decline with inventory levels. The basic goal
of
inventory management is thus to
minimize the sum of these two costs
. We consider ways to
reach this goal in the next section.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
67
5.3 Inventory Management Techniques
As we described earlier, the goal of inventory management is usually framed as cost
min
imization.
Three techniques
are discussed in this section, ranging from the relatively simple
to the very complex.
5.3.1
The ABC Approach
The ABC approach is a simple approach to inventory management in which the basic idea is to
divide inventory into three (or more) groups. The underlying rationale is that a small portion of
inventory in terms of quantity might represent a large portion in
terms of inventory value. For
example, this situation would exist for a manufacturer that uses some relatively expensive, high
-
tech components and some relatively inexpensive basic materials in producing its products.
Figure
5.1
illustrates an ABC compari
son of items in terms of the percentage of inventory value
represented by each group versus the percentage of items
Figure 5.1 ABC Approach
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
68
As Figure
5.1
shows, the A Group constitutes only 10 percent of inventory by item count, but it
represents over h
alf of the value of inventory. The A Group items are thus
monitored closely
,
and inventory levels are kept relatively low. At the other end, basic inventory items, such as nuts
and bolts, also exist; but, because these are crucial and inexpensive, large qu
antities are ordered
and kept on hand. These would be C Group items. The B Group is made up of in
between items.
5.3.2
The
Economic Order Quantity Model
The economic order quantity (EOQ) model is the best
-
known approach for explicitly establishing
an opt
imal inventory level. The basic idea is illustrated in Figure
5.2
, which plots the various
costs associated with holding inventory (on the vertical axis) against inventory levels (on the
horizonta
l axis).
l
Figure 5.2: Costs of holding inventory
As
shown, inventory carrying costs rise and restocking costs decrease as inventory levels
increase.
W
ith the EOQ model, we will attempt to specifically locate the minimum total cost
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
69
point, Q*. In our discussion that follows, an important point to keep in mind
is that the actual
cost of the inventory itself is not included. The reason is that the total amount of inventory the
firm needs in a given year is dictated by sales. What we are analyzing here is
how much
the firm
should have
on hand
at any particular ti
me. More precisely, we are trying to determine what
order size the firm should use when it restocks its inventory.
Inventory Depletion
:
To develop the EOQ, we will assume that the firm’s inventory is sold off
at a steady rate until it hits zero. At that point, the firm restocks its inventory back to some
optimal level. For example, suppose the Eyssell Corporation starts out today with 3,60
0 units of
a particular item in inventory. Annual sales of this item are 46,80
0 units, which is 900 per week.
If Eyssell sells 900 units of inventory each week,
the entire
available inventory will be sold after
four weeks, and Eyssell will restock by orde
ring (or manufacturing) another 3,600 and start over.
This selling and restocking process produces a saw
tooth pattern for inventory holdings; this
pattern is illustrated in Figure
5.3 below.
As the figure shows, Eyssell always starts with 3,600
units in i
nventory and ends up at zero. On average, then, inventory is half of 3,600, or 1,800
units.
Figure 5.3:
average (Q/2) inventory holdings
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
70
The Carrying Costs
:
-
As
Figure
5.2
illustrates, carrying costs are normally assumed to be
directly proportional to inventory levels. Suppose we let Q
be the quantity of inventory that
Eyssell orders each time (3,600 units); we will call this the restocking quantity. Average
inventory would
then jus
t be Q/
2, or 1,800 units. If we let CC be the carrying cost per unit per
year, Eyssell’s total carrying costs will be:
Total carrying costs =Average inventory X
Carrying costs per unit
= Q/2
*
CC
In Eyssell’s case, if carrying costs were
$.75 per unit per year, total carrying costs would be the
average inventory of 1,800 multiplied by $.75, or
$1,350 per year
.
The Shortage Costs
:
-
For now, we will focus only on the restocking costs. In essence, we will
assume that the firm never actuall
y runs short on inventory, so that costs relating to safety
reserves are not important. We
will return to this issue later.
Restocking costs are normally assumed to be fixed. In other words, every time we place an order,
fixed costs are associated with th
at order (remember that the cost of the inventory itself is not
considered here). Suppose
we let T
be
the firm’s total unit sales per year. If the firm orders Q
units each time, then it will need to place a total of
T/
Q
orders. For Eyssell, annual sales ar
e
46,800, and the order size is 3,600. Eyssell
thus places a total of 46,800/
3,600
=
13 orders per
year. If the fixed cost per order is F, the total restocking cost for the year would be:
Total restocking cost
= Fixed cost per order X
Number of orders
= F
*
(T/
Q)
For Eyssell, order costs might be $50 per order, so the total restocking cost for 13
orders would
be $50
*
13
=
$650 per year
.
The
Total Costs
:
-
The total costs associated with holding inventory are the sum of the carrying
costs and the restocking costs:
Total costs=
Car
rying costs +
Restocking costs
= (Q/2) *CC + F( T/Q)
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
71
➢
Our goal is to find the value of Q, the restocking
quantity that
minimizes this cost. To see
how we might go about this, we can calculate total costs for some different values of Q.
For the Eyssell Corporation, we had carrying costs (CC) of $.75 per unit p
er year, fixed
costs
(F
) of $50 per order, and total sales
(T
) of 46,800 units.
To find the cost
-
minimizing quantity, we can look back at Figure
5.2
. What we
notice is that the
minimum point occurs right where the two lines cross. At this point, carrying
costs and
restocking costs are the same. For the particular types of costs we have assumed here, this will
always be true; so we can find the minimum point just by setting these costs equal to each other
and solving for Q*:
Carrying costs =
Restocking cos
ts
(Q*/2) x CC =
F
x ( T/
Q*)
With a little algebra, we get:
Q*
2
=
2T × F
CC
To solve for Q*, we take the square root of both sides to find:
Q* = √
2T × F
CC
This reorder quantity, which minimizes the total inventory cost, is called the economic order
quantity (EOQ).
For the Eyssell Corporation, the EOQ is:
Q* = √
2T × F
CC
=
√
(2 ×46,800) ×$50
.75
= √6,240,000
=
2,498 units
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
72
Thus, for
Eyssell, the economic order quantity is 2,498 units. At this level, verify that the
restocking costs and carrying costs are both $936.75.
Extensions t
o t
he EOQ Model
Thus far, we have assumed that a company will let its inventory run down to zero and th
en
reorder.
In reality
, a company will wish to reorder before its inventory goes to zero for two
reasons. First, by always having at least some inventory on hand, the
firm minimizes the
risk of
a
stock
out and the resulting losses of sales and customers. S
econd, when a firm does reorder,
there will be some
time lag
before the inventory arrives. Thus, to finish our discussion of the
EOQ, we consider two extensions:
s
afety stocks
and
reordering points
.
Safety Stocks
:
-
A safety stock
is the
minimum level
of inventory that a firm keeps on hand.
Inventories are reordered whenever the level of inventory falls to the safety stock level.
Reorder points
:
-
To allow for delivery time, a firm will place orders before inventories reach a
critical level. The reord
er points
are the
times
at which the firm will actually place its inventory
order
s. For illustrative figures please refer Rose 10
th
ed (page878).
`
5.3.3 Managing Derived
-
Demand Inventories
The third type of inventory management technique is used to manag
e derived
-
demand
inventories. As we described earlier, demand for some inventory types is derived from, or
dependent on, other inventory needs. A good example is given by the auto manufacturing
industry, in which the demand for finished products depends on
consumer demand, marketing
programs, and other factors related to projected unit sales. The demand for inventory items such
as tires, batteries, headlights, and other components is then completely determined by the number
of autos planned. Materials requi
rements planning and just
-
in
-
time inventory management are
two methods for managing demand
-
dependent inventories.
Materials Requirements
P
lanning
(MRP):
-
Production and inventory specialists have
developed computer
-
based systems for ordering and/or schedu
ling production of demand
-
dependent types of inventories. These systems fall under the general heading of materials
requirements planning (MRP).The basic idea behind MRP is that, once finished goods inventory
levels are set, it is possible to determine wha
t levels of work
-
in
-
progress inventories must exist to
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
73
meet the need for finished goods. From there, it is possible to calculate the quantity of raw
materials that must be on hand. This ability to schedule backward from finished goods
inventories stems fro
m the dependent nature of work
-
in
progress and raw materials inventories.
MRP is particularly important for complicated products for which a variety of components are
needed to create the finished product.
Just
-
in
-
Time Inventory
(JIT)
:
-
inventory
is a modern approach to managing dependent
inventories. The goal of JIT is to minimize such inventories, thereby maximizing turnover.
As
the name suggests, the basic goal of JIT is to have only enough inventory on hand to meet
immediate producti
on needs. The result of the JIT system is that inventories are reordered and
restocked frequently. Making such a system work and avoiding shortages requires a high degree
of cooperation among suppliers. A JIT inventory system is an important part of a larg
er
production planning process. A full discussion of it would necessarily shift our focus away from
finance to production and operations management, so we will leave it here.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
74
Chapter
-
End E
xercises by Chapter
Chapter one: Dividend
Policy & Theory
Multiple choice questions
1.
Modigliani and Miller argue that the dividend decision __________.
a.
is irrelevant as the value of the firm is based on the earning power of its assets
b.
is relevant as the value of the firm is not based just on
the earning power of its assets
c.
is irrelevant as dividends represent cash leaving the firm to shareholders, who own the
firm anyway
d.
is relevant as cash outflow always influences other firm decisions
2.
_________ is a nonrecurring dividend paid to
shareholders in addition to the regular
dividend.
a.
A stock split
b.
A stock dividend
c.
An extra dividend
d.
A regular dividend
3.
The Board of Directors announces the amount and date of the next dividend on the
__________ date; while the __________ date is the
first date on which the purchaser of a
stock is no longer entitled to the recently declared dividend.
a.
declaration; record
b.
ex
-
dividend; record
c.
declaration; ex
-
dividend
d.
payment; record
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
75
4.
The major difference between traditional and bird
-
in
–
the hand views on the one hand, and
walter’s and Gordon’s model on the other hand is_______
a.
While walter and Gordon argue that dividend is irrelevant to affect firm value, the first
group argue a firm’s
dividend policy affects its value.
b.
The 2
nd
group of scholars gives a room for dividend to vary while the 1
st
group do not.
c.
In the 1
st
group risk analysis is considered in dividend decision while Walter and Gordon
do not.
d.
All of the above
Di
scussion Que
stions
1.
How is it possible that dividends are so important, but at the same time dividend policy is
irrelevant?
2.
It is sometimes suggested that firms should follow a “residual” dividend policy. With
such a policy, the main idea is that a firm should
focus on meeting its investment needs
and maintaining its desired debt−equity ratio. Having done so, a firm pays out any
leftover, or residual, income as dividends. What do you think would be the chief
drawback to a residual dividend policy?
3.
On Tuesday, De
cember 8, Home Land Inc.’s board of directors declares a dividend of 75
cents per share payable on Wednesday, January 17, to shareholders of record as of
Wednesday, January 3. When is the ex
-
dividend date? If a shareholder buys stock before
that date, who
gets the dividends on those shares
—
the buyer or the seller?
4.
Assume that a firm has identified profitable investment opportunity which requires 20,
000 birr. The firm’s debt equity ratio is 0.6, in the same period the firm has retained
earnings equal to 15,
000 including current income. Calculate the amount of dividend to
be declared if the firm was to follow residual policy approach. What happens to the
dividend amount if the retained earnings are 12,000 birr?
Chapter Two: Working Capital Management
Multipl
e choice questions
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
76
1.
Working capital management is mainly concerned with:
a.
the placement of the firm's debt and equity issues,
b.
management of the firm's capital assets,
\
c.
the financing and management of the firm's current assets,
d.
inventory management.
2.
The
cash conversion cycle equals:
a.
payables period
-
inventory period
-
collection period
b.
inventory period + collection period
-
payables period
c.
inventory period
-
collection period + payables period
d.
payables period + inventory period
-
collection period
3.
A major advantage of using short term funds is:
a.
there is no advantage,
b.
they are always more easily obtained
c.
there are no governmental procedures with which to comply
d.
interest rates are normally lower
4.
A firm with heavy risk exposure due to short term bo
rrowing should:
a. carry a large amount of fixed assets
b. carry more highly liquid assets
c. increase production to avoid inventory
d. prosper in the event of a credit crunch
5.
Which of the following would be consistent with a more aggressive approach t
o financing
working capital?
a.
Financing short
-
term needs with short
-
term funds.
b.
Financing permanent inventory buildup with long
-
term debt
c.
Financing seasonal needs with short
-
term funds
d.
Financing some long
-
term needs with short
-
term funds.
6.
In deciding t
he appropriate level of current assets for the firm, management is confronted
with:
a.
trade
-
off between profitability and risk.
b.
a trade
-
off between liquidity and marketability.
c.
a trade
-
off between equity and debt.
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
77
d.
a
trade
-
off between short
-
term versus long
-
term borrowing.
Discussion questions:
1.
Is it possible for a firm’s cash cycle to be longer than its operating cycle? Explain why or
why not.
2.
In an ideal economy, net working capital is always zero. Why might net w
orking capital
be positive in a real economy?
Use the following information to answer Questions 3
-
4. Last month, Messebo Cement
Factory PLC announced that it would stretch out its bill payments to 45 days from 30 days.
The reason given was that the compan
y wanted to “control costs and optimize cash flow.”
The increased payables period will be in effect for all of the company’s suppliers.
3.
What impact did this change in payables policy have on Messebo’s operating cycle? Its
cash cycle?
4.
What impact did the an
nouncement have on Messebo’s suppliers?
5.
Mention some possible sources of short term fund and long term fund
Chapter Three: Cash and Liquidity Management
Multiple choice questions
1.
What is the difference between cash management and liquidity management?
a.
Cash management only considers cash, while liquidity management considers
assets that are considered liquid.
b.
Cash management deals with only one account, while liquidity management
involves everything on the balance sheet.
c.
Cash management only considers
the current financial reporting period, while
liquidity management looks out 2
-
3 years.
d.
Cash management is essential to financial reporting while liquidity management
is just a good practice.
2.
Which one of the following
increases
collection float?
a.
Over
-
the
-
counter collection
b.
Preauthorized payment arrangements
c.
Checks received through mail
d.
Wire transfers
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
78
3.
Lockbox system primarily reduces/eliminates;
a.
Mailing time
b.
Processing delay
c.
Clearing delay
d.
All of the above
4.
Which term refers to how
quickly and easily an asset can be converted to cash?
a.
Speculation
b.
Sales forecasting
c.
Liquidity
d.
Precaution
5.
A desired cash level as determined by the tradeoff between carrying costs and shortage
costs is called a firm's:
a.
target cash balance
b.
concentration balance
c.
compensating balance
d.
all of the above
Discussion questions
1.
Suppose a firm has a book balance of $2 million. At the automatic teller machine (ATM),
the cash manager finds out that the bank balance is $2.5
million. What is the situation
here? If this is an ongoing situation, what ethical dilemma arises?
2.
Each business day, on average, a company writes checks totaling $17,000 to pay its
suppliers. The usual clearing time for the checks is four days. Meanwhi
le, the company is
receiving payments from its customers each day, in the form of checks, totaling $28,500.
The cash from the payments is available to the firm after two days.
Required:
a.
Calculate the company’s disbursement float, collection float, and
net float.
b.
How would your answer to part (a) change if the collected funds were available in
one day instead of two?
3.
Rainbow Corporation, an international dealer, receives an average of $16,000 in checks
per day. The delay in clearing is typically three d
ays. The current interest rate is .018
percent per day.
Required:
a.
What is the company’s float?
b.
What is the most that Rainbow should be willing to pay today to eliminate its float
entirely?
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
79
c.
What is the highest daily fee the company should be willing to p
ay to eliminate its
float entirely?
Chapter Four: Receivables Management
Multiple choice questions
1.
Scrimpy Co buys materials from Frugal Enterprises. Frugal offers discount terms of 2%
discount for payment within 10 days or full payment within 30 days. Ass
uming a 360
-
day
year, what is the annual percentage cost associated with Scrimpy’s failure to take
advantage of the discount offered by Frugal?
a.
2.0%
b.
33.3%
c.
36.0%
d.
36.7%
2.
Amicable Wireless Co offers customers credit terms of 2% discount for payment within
10 days or full payment within 25 days. 60% of Amicable’s customers take the 2%
discount and pay on day 10. The remainder of Amicable’s customers pays on day 30.
What are
Amicable’s receivables days?
a.
16
b.
12
c.
18
d.
20
3.
Identify the alternative that does not explain costs of credit sale.
a.
Chances of default
b.
Increased sales
c.
Cash discounts
d.
Capital tied up in receivables
e.
All of the above
4.
Which one of the following factors indicates the customer’s integrity and willingness to
maintain long
-
term relationship?
a.
Capital
b.
Character
c.
Capacity
d.
condition
Discussion questions
1.
What are the key elements of a firm’s credit terms? Wha
t is the key determinant of the credit
terms offered by a firm?
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
80
2.
Briefly define a firm’s collection policy. Indicate the typical sequence of actions taken by a
firm when attempting to collect an overdue account?
3.
A firm
sales bi.2,000 product on
terms of 1/
10, net 40.
Calculate the
annual effective interest
rate
(AER).
Do you think customers will take the discount? Justify why or why not.
Chapter
Five
:
Inventory
Management
Multiple choice questions
1.
Suppose that there are several inventory items
required in the manufacturing process that
make up a small percentage of the overall physical inventory, but represent a large
percentage of total inventory value. Which one of the following inventory management
techniques do you suggest?
a.
EOQ mode
l
b.
ABC model
c.
Derived demand model
d.
Inventory depletion model
2.
One of the following is assumptions of the EOQ model except;
a.
Inventory quantities should reach zero before we place another order
b.
The carrying cost per unit and ordering cost per order
are allowed to vary
c.
Firm is able to forecast inventory demand for a year
d.
Companies should hold safety stock to avoid losing a customer
e.
A and C
f.
B and D
Discussion questions
1.
Contrary to EOQ model, companies do not want to let their inventory levels
to zero, list
out and discuss two models used to maintain certain level of inventory.
2.
Redan
Manufacturing needs 90,000 switch assemblies per year. The cost per unit of
switch assemblies is Br.3. If the relevant annual carrying cost per switch assembly is Br.6
and the fixed cost per order is Br. 300;
a.
What is the optimal level (EOQ) of switches to
be hold by Redan?
b.
How many orders does Redan Manufacturing place in a year?
c.
What is the total annual cost if the EOQ is ordered?
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
81
Annex
-
1
Name of University:
Mekelle University
Name of College/Faculty:
CBE
Name of Department: Accounting and Finance
Course Information
Course code
AcFn 2102
Course Title
Financial Management II
Degree Program
BA Degree in Accounting and Finance
Module
Module Coordinator
Abeba Kelelew
Lecturer
s
Abeba Kelelew,….
ETCTS Credits
5
Contact Hours (per
week)
3
Course Objectives
The basic objective of this course is to familiarize students with the bas
ics
of investment, financing,
dividend
and liquidity
decisions that are the
central thematic areas of finance
profession.
Course Description
This course is a continuation of Financial Management I. It emphasizes on
building and applying financial models, following the principle of financial
management, for planning
and decision making purposes.
It explains with
the help of the language of financial accounting, how top management
conducts systematic analysis, builds innovative plans, understands and
manages risk, and creates more profit, cash and value for the organization.
Topics included are: Introduction to
di
vidend policy and theory
,
principles
of working capital management
, cash flow models f
or planning
,
receivables
and
inventory management decisions
.
WEEKS
Course Contents
Reading
1,2, 3
1.
Dividend Policy and theory
1.1.
Dividend C
lassification
s
1.2.
Types of
Dividend Policy
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
82
1.3.
Factors Influencing D
ividend
Policy
1.4.
The Effect of Dividend Policy on Firm Value
1.5.
Establishing
D
ividend
P
olicy
1.5.1.
Residual Dividend
A
pproach
1.5.2.
Dividend
S
tability
1.5.3.
A Compromise
3,4,5,6
2.
Principles of Working capital management
2.1.
The
C
oncept of
W
orking
C
apital
2.2.
Operating and
C
ash
C
onversion
C
ycle
2.3.
Permanent and Variable Working C
apital
2.4.
Determinants of
W
orking
C
apital
M
anagement
2.5.
Financing Current Assets
7,8,9
3.
Cash and Liquidity Management
3.1.
Reasons for Holding Cash
3.2.
Understanding Float
3.3.
Cash Collection and Concentration
3.4.
Managing Cash Disbursement
3.5.
Investing Ideal Cash
3.6.
Determining the
T
arget
C
ash
B
alance
10,11,12
4.
Receivable
s
Management
4.1.
Credit and
R
eceivables
4.2.
Terms of
S
ale
4.3.
Analyzing
C
redit
P
olicy
4.4.
Credit Analysis
4.5.
Collection policy
13,14,15
5.
Inventory Management
5.1.
Introduction
5.2.
Meaning & Nature of I
nventory
5.3.
Benefits &
C
osts of Holding Inventory
5.4.
Inventory
M
anagement
T
echniques
Teaching &
Learning
Methods/strategy
The teaching and learning methodology include
s
lecturing, discussions,
problem solving, and analysis. Take
-
home assignment will be given at the
end of each chapter for submission within a week. Solution
s
to the
assignments will be given once assignments are collected. Cases with local
relevance will a
lso be given for each chapter for gr
oup of students to
present in class.
The full and active participation of students is highly
encouraged.
Assessment/Evalu
ation
The evaluation scheme will be as follows:
Test
1
Test
2
Assignment
and other
class
activities
Presentation
Final
Total
Compiled
by
Abeba Kelelew, Dep’t of Accounting &
Finance,
CBE,
Mekelle University
Page
83
10
%
15
%
2
0%
5
%
50%
100%
Work load in hours
Hours Required
Tot
al
Hrs
ECT
S
Lectur
es
La
b
Assessme
nts
Tutoria
ls
Self
-
Studi
es
Assignme
nt
Advisi
ng
48
-
10
12
55
-
-
135
5
Roles of the
Instructor
He/she will come to the class regularly on time and deliver the lecture in
a well
-
organized manner. Besides, at the end of each class he/she gives
reading assignment for the next class. He/she will make sure that proper
assessments
are given. He/she is also responsible to give feedback for
each assessment.
Roles of the students
The success of this course depends on the students’ individual and
collective contribution to the class discussions. Students are expected to
participate vol
untarily, or will be called upon, to contribute to set exercises
and problems. Students are also expected to read the assigned readings and
prepare the cases before each class so that they could contribute effectively
to class discussions. Stude
nts must at
tempt assignments by
their own.
Proficiency in this course comes from individual knowledge and
understanding.
Copying the works of others is considered as serious offence
and leads to disciplinary actions.
Text and reference
books
Text Book:
•
Ross, Westerf
ield
&
Jordan
.
Fundamentals of corporate finance.
10
th
ed
.
Reference Books
•
Brigham Ehrhadt.
Financial management theory and practice. 13
th
e
d
•
Khanna & Jain.
Financial management.
•
I M.
Pandey
.
Financial management.
9
th
&10
th
ed