Working Capital Management Course Code: FIN 6407 Fatima Khan Lecturer in Finance Northern University Khulna
Working Capital ManagementCourse Code: FIN 6407
Fatima Khan
Lecturer in Finance
Northern University
Khulna
Managing Cash Inflows and Outflows
Text: Modern Working Capital Frederick C. Scherr
Chapter 2
Cash inflows• payment for goods or services from your customers• receipt of a bank loan• interest on savings and investments• shareholder investmentsCash outflows• purchase of stock, raw materials or tools• wages, rents and daily operating expenses• purchase of fixed assets - PCs, machinery, office
furniture, etc• loan repayments• dividend payments• Income tax, corporation tax, VAT and other taxes
Managing Cash Flows
Cash Management
Encompasses the design of collections and disbursement systems for cash and the temporary investment of cash while it resides with the firm.
Managing Cash Flows
Objectives of Cash Management
• Cash doesn’t earn a return• Want to maintain liquidity
– Take cash discounts– Maintain firm’s credit rating– Minimize interest costs– Avoid insolvencyGood cash management implies
maintaining adequate liquidity with minimum cash in bank, also a portion of the cash balance can be placed into marketable securities
Why hold cash and marketable securities?
Cash and short-term interest-bearing investments are the least productive assets, because they are:
Not part of production Provides no direct returnBut still firms need to hold cash and
marketable securities, why?
1. Cash for Transactions: For transaction demand For payment to suppliers To make change for cash sales
Managing Cash Flows
2. Cash and Near-Cash Assets as Hedges: Unexpected emergencies Can hold little cash at hand and the
rest in form of near-cash assets Trade-off between interest revenue
and transaction costs involved
Managing Cash Flows
3. Temporary Investments: Payout excess cash to security
holders Make temporary investment
Managing Cash Flows
• Transaction demand: need money to pay bills , wages, etc.
• Precautionary demand: need money to handle emergencies [unforeseen expenses]
• Speculative demand: need money to take advantage of unexpected opportunities
Managing Cash Flows
The Money Market
Motivation of holding near-cash assets:Hedging of cash flow uncertainty Temporary investment of surplus fundsMoney market provides highly safe and liquid
near-cash assets for investmentSources of short-term borrowing for larger
corporations
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Term structure of interest rates
In finance, the yield curve is a curve showing several yields or interest rates across different contract lengths (2 month, 2 year, 20 year, etc...) for a similar debt contract. The curve shows the relation between the (level of) interest rate (or cost of borrowing) and the time to maturity.
The shape of the yield curve is influenced by supply and demand.
• Yield curves are usually upward sloping the longer the maturity, the higher the yield, with diminishing marginal increases. There are two common explanations for upward sloping yield curves.
• First, it may be that the market is anticipating a rise in the risk-free rate. If investors hold off investing now, they may receive a better rate in the future.
• Another explanation is that longer maturities entail greater risks for the investor (i.e. the lender). A risk premium is needed by the market, since at longer durations there is more uncertainty and a greater chance of catastrophic events that impact the investment.
Required return is influenced through:
• Level of inflationary expectation• Relative levels of supply and demand for
various maturities of securities• Levels of differences in investors’
perception regarding risks and return involved in investment
Managing Cash Flows
The US dollar yield curve as of February 9, 2005. The
curve has a typical upward sloping shape.
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Three most common theories of the determination of term structure of interest rates are based on the differences in inflation, relative demand and risk among securities of various maturities.
Expectation TheoryMarket Segmentation TheoryMaturity Preferences Theory
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Expectation TheoryDifferences in per period required returns
among securities of various maturity dates reflect expectations that inflation will change over time.
Expected rise in inflation will raise interest rates on the short term maturity end of the yield curve more than on long maturity end.
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Market Segmentation Theory
Investors prefer securities of different maturities
Yield curve’s level and shape reflect the availability of various maturities relative to these preferences
Larger supply of a particular maturity security, declines the price and the YTM rises
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Upslopping yield curve represents when there are relatively larger supplies of longer maturities securities
Downslopping yield curve represents when there are relatively larger supplies of shorter maturities securities
Longer maturities are said to contain more interest rate risk, so these have higher required rates o return
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Maturity Preference Theory
The shape of the yield curve is merely a reflection of the differences in interest rate risk among maturities
Longer maturities are said to contain more interest rate risk, and have higher required rates of return than shorter maturities
Interest rate risk is the relationship between the interest rate prevailing at the time and the trading price of the security
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Prices of longer-term securities fluctuate much more with changes in interest rate levels than do the prices of short-term securities, so it is riskier, and investors require a higher rate of return.
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The best of these three theories?
Expectation TheoryOr
Market Segmentation TheoryOr
Maturity Preferences Theory
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Maturity preference theory is substantially important, because
it explains empirical observation about yield curve
yield curve is positively slopped most of the times (also may be negatively slopped or even flat)
the longer the maturity the higher the per-period rate of return
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Other than yield curve effect, default risk is also engaged with money market investment
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Treasury Bills
• U.S Government securities with maturities of 91, 182 or 365 days• Free of default risk but interest rate risk occurs for longer maturities• Sold at discount and redeemed at principle at the maturity• A very active secondary market for t-bills of any maturity• Earns a lower return
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Commercial Papers
• Large-denomination unsecured debt matures about in 30 days• Issued by large firms and financial institutions• Some default risks involved, yield higher than T-bills
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Certificates of Deposit
A very large-denomination debt instrument issued by banksMaturities differ with pre specified or semi-variable interest ratesMay be placed directly with investors, or traded in the secondary market with dealers
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Banker’s Acceptance
• Issued by banks, traded through dealers, quite liquid
• Generated in course of international trade
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Repurchase Agreements
• Very short-term investments and financing• Seller agrees to sell a security to the buyer
and the seller agrees to repurchase the security at a higher price
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Eurodollars
• Dollar-denominated loans and certificates of deposit in non-U.S. banks
• In a large denominations, commonly of one week or six months maturities
• Entails a modest default risks, carry a slightly higher interest rates than domestic securities
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Hedged Dividend Capture Strategy
• Holding adjustable rate preferred stock• Holding common shares of firms and
hedging with call options (firms expected to pay dividend as well as sells the option to sell the stock at a specific price)
• Holding shares of an index fund and hedging with index fund call options
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Flotation and Check Clearing
• It is the management of cash when it is not in the firm’s hand, it is in transit to and from the firm– Mail Float– At-firm Float– Clearing Float• Only after this entire process is completed does
the receiving firm receive credit for the cash so that it is able to use the money.
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Suppose a firm receives $ 2 million per day via the transit system, assume that checks were in mail an average of 4 days, that the firm takes 0.5 days to process checks and get them to the bank, and that the firm’s bank takes 1.3 days to obtain funds for the checks. If the firm could accelerate the transit process and had these funds at hand, it could invest them at the firms cost of capital of 10%, What is the opportunity cost of the float?
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Float Type Float Time(days)
Receipts(per day)
Float in Dollars
Mail Float 4.0 $ 2 mil. $ 8.0 mil
At-Firm Float 0.5 $ 2 mil. $1.0 mil
Clearing Float 1.3 $ 2 mil. $2.6 mil
Total Transit Time
5.8 Total Float $ 11.6 mil
Required Return 0.10 per year$1.16 mil per year
Opportunity Cost of Float
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Strategies to reduce delays in receiving funds
• Selection of banks with accelerated clearing capabilities through
Clearing houses Correspondent banks
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Acceleration of Check Processing at the Firm
• Checks are received at various locations and the eventful deposit of these items
• Adopt processing procedures that speed checks into the clearing process
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Use of Electronic Collection Procedures
• An electronic message of payment for the check
• Posses substantial costs and benefits for the firms involved
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Uses of Lockbox
• Lockboxes allow organization to streamline receipts
• A “lockbox” is a post office number to which some or all of the firm’s customers are instructed to send their checks, banks are permitted to take these checks and immediately start them in clearing process
• In this way, at-firm float is eliminated
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• Two mailing addresses can lead to misrouting of some documents.
• Delay, errors and cost entailed for these misrouting documents.
Lock-boxes are not a problem-free panacea for flotation problems, their proper uses can reduce all types of flotation on incoming checks
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Decisions in formulation of lockbox strategies
• Where should the firm locate it’s lockboxes?
• To which lockboxes should each of the firms customers send their checks?
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Lockbox Location Problem• Mathematical and programming procedures for
solving lockbox location problems• Firms use both mathematical solution and
programming suggestions for determining lockbox location
• Firms seek to minimizes the sum of a) Opportunity costs of float on incoming cashb) The costs of the lockbox systemA trade-off between these two sets of costs, additional
lockboxes reduce opportunity costs of float, but adds additional fixes costs
Managing Cash Flows
Fatima; May 1, 2023
Number of Lockboxes in System
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The firm must collect four sets of data:
• The mail and clearing times for sending checks from each part of the firm’s geographic sales area to each possible lockbox.
• The total amount of daily funds and number of checks received by the firm from each part of the sales area
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• The required rate of return• The variable and fixed costs of each
proposed lockbox site
The firm must collect four sets of data:
The optimal solution is the lockbox which has the lowest total cost, defined as the sum of opportunity cost of float and the costs of the lockbox
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• The optimal solution to the one lockbox problem is the lockbox which has the lowest total cost
• But what about a larger corporation operating in big country like USA?
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A lockbox location problem algorithm
• Some lockbox and customer assignment routines will find the optimum [least cost] combination of lockbox and assignments
• Routines that lead to optimum solutions are more difficult to calculate
• Trade-off between ease of computation versus the guarantee of and optimum solution
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The variables represent here:i. Whether a lockbox is in use [open] or not
[close]?ii. Whether customers from a particular
region are assigned to a particular lockbox or not?
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Here, j = prospective lockbox bank location i = the zone which the customers
check originates n = the number of possible lockboxes m = the number of zones
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To evaluate a lockbox at location j. we need to know the charges from opening and using the lockbox.
Fixed charges of opening lockboxes+ check processing charges + opportunity cost of float on checks from customers who send their remittances to lockbox
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• Some logical constraints are:– Checks from each customer zone must be
received at a lockbox somewhere– Lockbox must be open for receipts from a
customer zone to be received there– There should be only one lockbox open at
location j and customers from zone i may send their checks to one and only lockbox
– To constraint the solution to the problem to the best solution for a maximum of k lockboxes
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Some warnings about lockbox location decisions
• Determining customer zone• Obtaining bank cost data• Obtaining a representative sample of
check volume and origination• The costing of float• Interaction with availability on borrowing
capacity