EVA NOPAT Capital costs EBIT(1 T) WACC (Total capital employed) If EVA is positive, then the firms management is creating value On the other hand, if EVA is negative, then the firm is not covering its cost of capital and stockholders value is being eroded If RR could generate its current level of sales with fewer assets, it would need less capital This would, other things held constant, lower capital costs and increase its EVA Historically, RR has done little to examine working capital, mainly because of poor communication among business functions In the past, the production manager resisted Johnsons efforts to question his holdings of raw materials, the marketing manager resisted questions about finished goods, the sales staff resisted questions about credit policy (which affects accounts receivable), and the treasurer did not want to talk about the cash and securities balances However, with the recent credit scare, this resistance became unacceptable and Johnson has undertaken a company wide examination of cash, marketable securities, inventory, and accounts receivable levels Johnson also knows that decisions about working capital cannot be made in a vacuum For example, if inventories could be lowered without adversely affecting operations, then less capital would be required, the dollar cost of capital would decline, and EVA would increase However, lower raw materials inventories might lead to production slowdowns and higher costs, and lower finished goods inventories might lead to stock outs and loss of sales So, before inventories are changed, it will be necessary to study operating as well as financial effects The situation is the same with regard to cash and receivables Johnson has begun her investigation by collecting the ratios shown below RR Industry Current 1 75 2 25 Quick 0 92 1 16 Total liabilities assets 58 76 50 00 Turnover of cash and securities 16 67 22 22 Days Sales Outstanding (365 day basis) 45 63 32 00 Inventory Turnover 10 80 20 00 Fixed Assets Turnover 7 75 13 22 Total Assets Turnover 2 60 3 00 Profit Margin on Sales 2 07 3 50 Return on Equity 10 45 21 00 Payable Deferrals Period 30 00 33 00 Group 1 Group 2 Group 3 Group 4 Group 5 Annual Sales $865,000 $905,000 $915,000 $750,000 $800,000 Johnson plans to use the preceding ratios as the starting point for discussions with RRs operating team She wants everyone to think about the pros and cons of changing each type of current asset and how changes would interact to affect profits and EVA Based on the data, does RR seem to be following a relaxed, moderate, or restricted working capital policy How can one distinguish between a relaxed but rational working capital policy and a situation in which a firm simply has excessive current assets because it is inefficient Does RRs working capital policy seem appropriate Calculate the firms cash conversion cycle given that annual sales are $860,000 and cost of goods sold represents 82 of sales Assume a 365 day year What might RR do to reduce its cash without harming operations Cash Budget (Thousands of Dollars) Nov Dec Jan Feb Mar Apr Sales Forecast Sales (gross) 71,218 00 68,212 00 65,213 00 52,475 00 42,909 00 30,524 00 Collections During month of sale (0 2) (0 98) (months sales) 12,781 75 10,285 10 During first month after sale (0 7) (previous months sales) 47,748 40 45649 10 During second month after sale (0 1) (sales 2 months ago) 7,121 80 6,821 20 Total Collections 67,651 95 62,755 40 Purchases (0 85) (forecasted sales 2 months from now) 44,603 75 36,472 65 25,945 40 Payments Payments (1 month lag) 44,603 75 36,472 65 Wages and Salaries 6,690 56 5,470 90 Rent 2,500 00 2,500 00 Taxes Total Payments 53,794 31 44,443 55 NCFs Cash on hand at start of forecast 3,000 00 NCF Collections Payments 13857 64 18,311 85 Cumulative NCF Prior this mos NCF 16857 64 35169 49 Cash Surplus (or Loan Requirement) Target Cash Balance 1,500 00 1,500 00 Surplus Cash or Loan needed 15,357 64 33,669 49 In an attempt to better understand RRs cash position, Johnson developed a cash budget for the first 2 months of the year The budget template appears above Recreate the cash budget by assuming that the Sales forecast in November is 12 5 of the annual sales in part c, thereafter sales declines by 5 monthly Use the formulas to calculate total collections, payments and purchases All expenses that do not vary with Sales such as Wages are expected to remain the same as in the template In her preliminary cash budget, Johnson has assumed that all sales are collected and thus that RR has no bad debts Is this realistic If not, how would bad debts be dealt with in a cash budgeting sense (Hint Bad debts will affect collections but not purchases ) Is there any reason to think that RR may be holding too much inventory If so, how would that affect EVA and ROE If the company reduces its inventory without adversely affecting sales, what effect should this have on the companys cash position (1) in the short run and (2) in the long run Explain in terms of the cash budget and the balance sheet Johnson knows that RR sells on the same credit terms as other firms in its industry Use the ratios presented earlier to explain whether RRs customers pay more or less promptly than those of its competitors If there are differences, does that suggest RR should tighten or loosen its credit policy What four variables make up a firms credit policy, and in what direction should each be changed by RR If the company reduces its DSO without seriously affecting sales, what effect would this have on its cash position (1) in the short run and (2) in the long run Answer in terms of the cash budget and the balance sheet What effect should this have on EVA in the long run In addition to improving the management of its current assets, RR is also reviewing the ways in which it finances its current assets Is it likely that RR could make significantly greater use of accruals Assume that RR purchases $280,000 (net of discounts) of materials on terms of 1 10, net 30, but that it can get away with paying on the 40th day if it chooses not to take discounts How much free trade credit can the company get from its equipment supplier, how much costly trade credit can it get, and what is the nominal annual interest rate of the costly credit Should RR take discounts RR tries to match the maturity of its assets and liabilities Describe how RR could adopt either a more aggressive or a more conservative financing policy What are the advantages and disadvantages of using short term debt as a source of financing

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EVA = NOPAT - Capital costs = EBIT(1 - T) - WACC (Total capital employed) If EVA is positive, then the firms management is creating

EVA = NOPAT - Capital costs

= EBIT(1 - T) - WACC (Total capital employed)

If EVA is positive, then the firms management is creating value. On the other hand, if EVA is negative, then the firm is not covering its cost of capital and stockholders value is being eroded. If RR could generate its current level of sales with fewer assets, it would need less capital. This would, other things held constant, lower capital costs and increase its EVA. Historically, RR has done little to examine working capital, mainly because of poor communication among business functions. In the past, the production manager resisted Johnsons efforts to question his holdings of raw materials, the marketing manager resisted questions about finished goods, the sales staff resisted questions about credit policy (which affects accounts receivable), and the treasurer did not want to talk about the cash and securities balances. However, with the recent credit scare, this resistance became unacceptable and Johnson has undertaken a company-wide examination of cash, marketable securities, inventory, and accounts receivable levels. Johnson also knows that decisions about working capital cannot be made in a vacuum. For example, if inventories could be lowered without adversely affecting operations, then less capital would be required, the dollar cost of capital would decline, and EVA would increase. However, lower raw materials inventories might lead to production slowdowns and higher costs, and lower finished goods inventories might lead to stock-outs and loss of sales. So, before inventories are changed, it will be necessary to study operating as well as financial effects. The situation is the same with regard to cash and receivables. Johnson has begun her investigation by collecting the ratios shown below.

	RR	Industry
Current	1.75	2.25
Quick	0.92	1.16
Total liabilities/assets	58.76%	50.00%
Turnover of cash and securities	16.67	22.22
Days Sales Outstanding (365 day basis)	45.63	32.00
Inventory Turnover	10.80	20.00
Fixed Assets Turnover	7.75	13.22
Total Assets Turnover	2.60	3.00
Profit Margin on Sales	2.07%	3.50%
Return on Equity	10.45%	21.00%
Payable Deferrals Period	30.00	33.00

	Group 1	Group 2	Group 3	Group 4	Group 5
Annual Sales	$865,000	$905,000	$915,000	$750,000	$800,000

Johnson plans to use the preceding ratios as the starting point for discussions with RRs operating team. She wants everyone to think about the pros and cons of changing each type of current asset and how changes would interact to affect profits and EVA. Based on the data, does RR seem to be following a relaxed, moderate, or restricted working capital policy?

How can one distinguish between a relaxed but rational working capital policy and a situation in which a firm simply has excessive current assets because it is inefficient? Does RRs working capital policy seem appropriate?

Calculate the firms cash conversion cycle given that annual sales are $860,000 and cost of goods sold represents 82% of sales. Assume a 365-day year.

What might RR do to reduce its cash without harming operations?

Cash Budget (Thousands of Dollars)	Nov	Dec	Jan	Feb	Mar	Apr
Sales Forecast
Sales (gross)	71,218.00	68,212.00	65,213.00	52,475.00	42,909.00	30,524.00
Collections
During month of sale: (0.2) * (0.98) * (months sales)			12,781.75	10,285.10
During first month after sale: (0.7)*(previous months sales)			47,748.40	45649.10
During second month after sale: (0.1)* (sales 2 months ago)			7,121.80	6,821.20
Total Collections			67,651.95	62,755.40
Purchases
(0.85) *(forecasted sales 2 months from now)		44,603.75	36,472.65	25,945.40
Payments
Payments (1-month lag)			44,603.75	36,472.65
Wages and Salaries			6,690.56	5,470.90
Rent			2,500.00	2,500.00
Taxes
Total Payments			53,794.31	44,443.55
NCFs
Cash on hand at start of forecast			3,000.00
NCF: Collections -Payments			13857.64	18,311.85
Cumulative NCF: Prior + this mos. NCF			16857.64	35169.49
Cash Surplus (or Loan Requirement)
Target Cash Balance			1,500.00	1,500.00
Surplus Cash or Loan needed			15,357.64	33,669.49

In an attempt to better understand RRs cash position, Johnson developed a cash budget for the first 2 months of the year. The budget template appears above. Recreate the cash budget by assuming that the Sales forecast in November is 12.5% of the annual sales in part c, thereafter sales declines by 5% monthly. Use the formulas to calculate total collections, payments and purchases. All expenses that do not vary with Sales such as Wages are expected to remain the same as in the template.

In her preliminary cash budget, Johnson has assumed that all sales are collected and thus that RR has no bad debts. Is this realistic? If not, how would bad debts be dealt with in a cash budgeting sense? (Hint: Bad debts will affect collections but not purchases.)

Is there any reason to think that RR may be holding too much inventory? If so, how would that affect EVA and ROE?

If the company reduces its inventory without adversely affecting sales, what effect should this have on the companys cash position: (1) in the short run and (2) in the long run? Explain in terms of the cash budget and the balance sheet.

Johnson knows that RR sells on the same credit terms as other firms in its industry. Use the ratios presented earlier to explain whether RRs customers pay more or less promptly than those of its competitors. If there are differences, does that suggest RR should tighten or loosen its credit policy? What four variables make up a firms credit policy, and in what direction should each be changed by RR?

If the company reduces its DSO without seriously affecting sales, what effect would this have on its cash position: (1) in the short run and (2) in the long run? Answer in terms of the cash budget and the balance sheet. What effect should this have on EVA in the long run?

In addition to improving the management of its current assets, RR is also reviewing the ways in which it finances its current assets. Is it likely that RR could make significantly greater use of accruals?

Assume that RR purchases $280,000 (net of discounts) of materials on terms of 1/10, net 30, but that it can get away with paying on the 40th day if it chooses not to take discounts. How much free trade credit can the company get from its equipment supplier, how much costly trade credit can it get, and what is the nominal annual interest rate of the costly credit? Should RR take discounts?

RR tries to match the maturity of its assets and liabilities. Describe how RR could adopt either a more aggressive or a more conservative financing policy.

What are the advantages and disadvantages of using short-term debt as a source of financing?