financial SUBDOMAINS: 325.4 COMMUNICATING EFFECTIVELY IN ORGANIZATIONS 326.1 MANAGING INTERNAL COST & CONTROLLING FINANCES 326.2 MANAGING CAPITAL & FINANCIAL ASSETS 326.4 MANAGING ENTERPRISE RISK &

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SUBDOMAINS: 325.4 COMMUNICATING EFFECTIVELY IN ORGANIZATIONS 326.1 MANAGING INTERNAL COST & CONTROLLING FINANCES 326.2 MANAGING CAPITAL & FINANCIAL ASSETS 326.4 MANAGING ENTERPRISE RISK & CONTINUITY Competencies: 325.4.1: Enhancing Organizational Communication The graduate communicates effectively within an organizational setting. 326.1.5: Budgets The graduate utilizes budgets and a variety of proforma statements for planning and control purposes including analyzing cash flows to assure adequacy of funds for capitalizing on business opportunities. 326.2.1: Capital Budgeting The graduate uses capital budgeting to analyze business opportunities and applies risk mitigation concepts to capital budgeting situations. 326.2.2: Financial Goals The graduate considers risk and the potential value added for all stakeholders when balancing risk and return and the tradeoffs between competing financial goals. 326.2.3: Capital Structure The graduate considers the costs and the advantages and disadvantages of equity financing versus debt alternatives while designing the capital structure that balances risk and reward. 326.2.4: Working Capital The graduate demonstrates the use of working capital management and working capital acquisition concepts to balance the related tradeoff between profitability and risk. 326.4.4: Risk Evaluation and Mitigation The graduate evaluates internal and external risks and recommends risk mitigation strategies and techniques to an organization. Introduction: In this task you will prepare a report for the chief financial officer (CFO) to present to a bank vice president who may consider extending a longterm loan to Custom Snowboards, Inc. The CFO has requested that you analyze the financial statements to arrive at a selection of key financial statement line items, a risk assessment and ratios that the banker may use to assess and, if the loan is granted, track the progress of the company's ability to repay the loan. You will prepare another report to present directly to the chief executive officer (CEO) of Custom Snowboards Inc. and the board of directors. The report will include a recent history of the company and a recommendation on how to proceed with the expansion plans. Be sure to enter your first initial and last name on the first worksheet in Custom Snowboards, Inc. Financial Data excel document. Task: Note: Be sure to submit a copy of your Excel workbook when submitting your JET2 Task 5 work. When you enter your first initial and last name at the top of the Income Statement you are given a dataset that is based on your name. The evaluator will need a copy of your data to ensure correct evaluation. A. Create a report for the chief financial officer in which you do the following: 1. Summarize the key points of the company's financial picture that could impact the bank officer's decision. Note: A variety of analyses that will provide a solid understanding of the highlights of the financial statements should be included. 2. Explain how any financial risks pointed out by the bank loan officer could be mitigated by the company. 3. Analyze the ratios that will indicate the ability to repay the principal and interest on the 5year loan. B. Create a report with your recommendations on the European expansion of Custom Snowboards Inc. for the chief executive officer (CEO) by doing the following: 1. Present a historical analysis of past performance. a. Analyze what the historical analysis indicates about future performance. 2. Discuss how the current operations can be improved through better cost controls. Note: Multiple cost controls should be discussed to address how operations can be improved. 3. Discuss both the internal risks and external risks that Custom Snowboards, Inc. will face with any expansion alternative into the European market. a. Recommend strategies and techniques that can be used to mitigate those risks. 4. Discuss the potential returns of procuring a new plant in Europe that must be presented to and considered by the CEO and company board in your report. Note: The discussion should include a logical interpretation of the NPV and IRR results. 5. Custom Snowboards, Inc. has the opportunity to enter the European market by procuring a new production plant, merging with European SnowFun, Inc. via a stock swap, or acquiring European SnowFun, Inc. outright via a stock purchase. After analyzing the data provided select the best option for expanding operations into Europe. 6. Based on the option selected in #5 above present a final financing recommendation to the CEO. C. When you use sources, include all intext citations and references in APA format. Note: When bulleted points are present in the task prompt, the level of detail or support called for in the rubric refers to those bulleted points. Note: For definitions of terms commonly used in the rubric, see the Rubric Terms web link included in the Evaluation Procedures section. Note: When using sources to support ideas and elements in a paper or project, the submission MUST include APA formatted intext citations with a corresponding reference list for any direct quotes or paraphrasing. It is not necessary to list sources that were consulted if they have not been quoted or paraphrased in the text of the paper or project. Note: No more than a combined total of 30% of a submission can be directly quoted or closely paraphrased from sources, even if cited correctly. For tips on using APA style, please refer to the APA Handout web link included in the General Instructions section. File Attachments: 1. Task 5 Custom Snowboards Excel workbook link opens in new window 2. Task 5 Custom Snowboards Inc Storyline Custom Snowboards, Inc. Expansion into Europe The management of Custom Snowboards, Inc. is considering an expansion into Europe. The percentage of the total sales from Europe has grown and the growth is expected to continue. The company could pursue this expansion from a variety of different options. Business Risk Assessment: The CEO is concerned about the risks of expansion into Europe. In particular, he wonders about what affects an European expansion will have on the internal operations of the entity and how the company will react to external issues that any company expanding into Europe will encounter. Expansion Options: Custom Snowboards has two options for European expansion. In the first option, they can expand by building a new manufacturing facility. In the second option, then can merge with or acquire the operations of European SnowFun. The relevant information for the two options is given below: 1. Custom Snowboards has investigated expanding into Europe by building a new manufacturing facility. The manufacturing facility to include building and equipment will cost $800,000. An additional $200,000 of working capital will be needed for starting up operations. There are some additional considerations for the company to consider for the procurement of building and equipment. The company has researched alternatives of paying for the building and equipment on a time basis at a 6% financing rate. The following two alternatives are under consideration: a. Entering into a sale-leaseback. b. A straight purchase over time. An analysis of both options are presented in the Excel workbook. 2. European SnowFun is currently operating in Europe and has heard about your expansion plans. European SnowFun has proposed to combine businesses with Custom Snowboards. European SnowFun's product is less durable, but the company's sales are relatively strong based on offering a personalized paintjob on snowboards that are special ordered. The following two alternatives are under consideration: a. A merger where the shareholders of European SnowFun would receive one share of Custom Snowboards' stock for each three shares they hold at the time of the merger (stock swap). European SnowFun currently has 300,000 shares outstanding. b. An Acquisition. European SnowFun has offered to be acquired. Custom Snowboards is considering this option at $2.40/share (stock purchase). The Excel workbook includes data calculations for all of the options in the expansion decision. The company uses a 10% cost of capital (hurdle rate) for capital budgeting and expansion decision. The CEO is expecting your recommendation regarding which expansion option the company should pursue when you make the presentation. Financing the European Expansion: If Custom Snowboards chooses the first expansion option highlighted above, then it has decided to fund it through increasing its capital structure. It has concluded that it can raise the capital through the issuance of long-term debt, sale of common stock, or a combination of both debt and common stock. The CEO would like a recommendation for the option that would maximize the value for shareholders of the company. Product Cost Comparison: Traditional vs. ABC Custom Snowboards traditionally uses two separate single overhead rates to apply overhead to its two product lines: regular snowboards and personalized snowboards. It is investigating using ABC analysis to better allocate overhead to its two product lines. The unit product cost for the two product lines using traditional and ABC method of applying overhead is given in the excel workbook. Revision Date: 03/01/2013 Student Name: A Enter your first initial and last name in the fields above and then click out of the cell to populate the information you will need. Custom Snowboards Inc. Income Statement December 31, Years 12, 13, and 14 39800 41200 41000 Units Sold Year 14 REVENUE: Net Sales Cost of Goods Sold Gross Profit OPERATING EXPENSES Selling Expenses Transportation ($5 per board) Sales Commissions Advertising Total Selling Expense General and Admin Expenses Administrative Payroll Executive Compensation Research and Development Website Creation and Maintenance Depreciation Expense Utilities & Services Other General and Admin Expenses Total General and Admin Expenses Total Operating Expenses OPERATING INCOME Interest Income (Expense): Interest Income Interest Expense Interest, net EARNINGS BEFORE INCOME TAXES Provision for Income Taxes NET EARNINGS Year 13 Year 12 6,407,800 4,457,600 1,950,200 6,633,200 4,614,400 2,018,800 6,601,000 4,592,000 2,009,000 218,900 298,500 238,800 756,200 226,600 309,000 247,200 782,800 225,500 307,500 246,000 779,000 250,000 215,000 90,000 12,000 100,000 260,000 170,000 1,097,000 220,000 195,000 90,000 12,000 100,000 255,000 158,000 1,030,000 210,000 190,000 90,000 12,000 100,000 238,000 120,500 960,500 1,853,200 97,000 1,812,800 206,000 1,739,500 269,500 300 -75,000 -74,700 22,300 5,575 16,725 3,200 -80,000 -76,800 129,200 32,300 96,900 2,500 -85,000 -82,500 187,000 46,750 140,250 Custom Snowboards, Inc. Balance Sheets December 31, Years 12, 13, and 14 Year 14 ASSETS Current Assets: Cash and Cash Equivalents Short-Term Investments Accounts Receivable, net Raw Materials Inventory Finished Goods Inventory Other Current Assets Total Current Assets Property and Equipment, at cost: Land Manufacturing Plants and Offices Furniture, Fixtures and Equipment Less Accumulated Depreciation Net Property and Equipment TOTAL ASSETS LIABILITIES Current Liabilities: Accounts and Notes Payable Current Portion of Long Term Debt Total Current Liabilities Long-Term Liabilities: Mortgage Payable Other Long-Term Liabilities Total Long-Term Liabilities Total Liabilities STOCKHOLDERS' EQUITY: Common Stock ($1.00 Par) Paid In Capital Retained Earnings Total Stockholders' Equity TOTAL LIABILITIES and EQUITY Year 13 Year 12 238,373 30,000 192,234 35,820 133,728 110,000 740,155 222,442 180,000 198,996 37,080 138,432 104,000 880,950 121,000 150,000 198,030 36,900 137,760 95,000 738,690 100,000 800,000 500,000 1,400,000 (400,000) 1,000,000 1,740,155 100,000 800,000 300,000 1,200,000 (300,000) 900,000 1,780,950 100,000 800,000 300,000 1,200,000 (200,000) 1,000,000 1,738,690 71,640 55,000 126,640 74,160 55,000 129,160 73,800 55,000 128,800 700,000 50,000 750,000 876,640 750,000 55,000 805,000 934,160 800,000 60,000 860,000 988,800 200,000 400,000 263,515 863,515 1,740,155 200,000 400,000 246,790 846,790 1,780,950 200,000 400,000 149,890 749,890 1,738,690 Custom Snowboards Inc. Winter Comparative Income Statements Ratio Analysis: December 31, Years 12, 13, and 14 Horizontal Analysis Year 14 Year 12 6,407,800 4,457,600 1,950,200 6,633,200 4,614,400 2,018,800 6,601,000 4,592,000 2,009,000 218,900 298,500 238,800 756,200 REVENUE: Net Sales Cost of Goods Sold Gross Profit Year 13 226,600 309,000 247,200 782,800 225,500 307,500 246,000 779,000 OPERATING EXPENSES Selling Expenses Transportation Out Sales Commissions Advertising Total Selling Expense Years 14 and 13 Change % Inc (Dec) (225,400) -3.40% (156,800) -3.40% (68,600) -3.40% Horizontal Analysis Years 13 and 12 Change % Inc (Dec) 32,200 0.49% 22,400 0.49% 9,800 0.49% Current Ratio 5.84 6.82 4.20 Acid-Test Ratio 3.64 4.66 3.40 Inventory Turnover 33.3 33.4 30.4 Average Collection Period (7,700) (10,500) (8,400) (26,600) -3.40% -3.40% -3.40% -3.40% Custom Snowboards, Inc. Sports Year 14 Year 13 Year 14 1,100 1,500 1,200 3,800 0.49% 0.49% 0.49% 0.49% 11.0 11.0 32.5 Debt Ratio 50.4% 52.5% 38.0% Gross Profit Margin General and Admin Expenses Administrative Salaries Executive Compensation Utilities Research and Development Website Creation and Maintenance Depreciation Expense Other General and Admin Expenses Total General and Admin Expenses 250,000 215,000 260,000 90,000 12,000 100,000 170,000 1,097,000 220,000 195,000 255,000 90,000 12,000 100,000 158,000 1,030,000 210,000 190,000 238,000 90,000 12,000 100,000 120,500 960,500 30,000 20,000 5,000 0 0 0 12,000 67,000 13.64% 10.26% 1.96% 0.00% 0.00% 0.00% 7.59% 6.50% 10,000 5,000 17,000 0 0 0 37,500 69,500 4.76% 2.63% 7.14% 0.00% 0.00% 0.00% 31.12% 7.24% 1,853,200 97,000 1,812,800 206,000 1,739,500 269,500 40,400 (109,000) 2.23% -52.91% 73,300 (63,500) 4.21% -23.56% 30.4% 30.4% 32.1% Operating Profit Margin 1.5% 3.1% 5.2% Net Profit Margin 0.3% 1.5% 5.1% 0.02 0.11 0.08 Earnings per Share Interest Income (Expense): Interest Income Interest Expense Interest, net EARNINGS BEFORE INCOME TAXES 300 -75,000 -74,700 22,300 3,200 -80,000 -76,800 129,200 2,500 -85,000 -82,500 187,000 (2,900) 5,000 2,100 (106,900) -90.63% -6.25% -2.73% -82.74% 700 5,000 5,700 (57,800) 28.00% -5.88% -6.91% -30.91% Provision for Income Taxes NET EARNINGS 5,575 16,725 32,300 96,900 46,750 140,250 (26,725) (80,175) -82.74% -82.74% (14,450) (43,350) -30.91% -30.91% Custom Snowboards Inc. Comparative Balance Sheets December 31, Years 14 and 13 Year 14 ASSETS Current Assets: Cash and Cash Equivalents Short-Term Investments Accounts Receivable, net Raw Materials Inventory Finished Goods Inventory Other Current Assets Total Current Assets Property and Equipment, at cost: Land Manufacturing Plants and Offices Furniture, Fixtures, and Equipment Less Accumulated Depreciation Net Property and Equipment TOTAL ASSETS LIABILITIES Current Liabilities: Accounts and Notes Payable Current Portion of Long-Term Debt Total Current Liabilities Long-Term Liabilities: Mortgage Payable Other Long-Term Liabilities Total Long-Term Liabilities Total Liabilities STOCKHOLDERS' EQUITY: Common Stock ($1.00 Par) Paid In Capital Retained Earnings Total Stockholders' Equity TOTAL LIABILITIES and EQUITY Year 13 Year 12 Horizontal Analysis Horizontal Analysis Years 14 and 13 Change % Inc (Dec) 15,931 7.2% (150,000) -83.3% (6,762) -3.4% (1,260) -3.4% (4,704) -6,000 5.8% (140,795) -16.0% Years 13 and 12 Change % Inc (Dec) 101,442 83.8% 30,000 20.0% 966 0.5% 180 0.5% 672 -9,000 9.5% 142,260 19.3% 238,373 30,000 192,234 35,820 133,728 110,000 740,155 222,442 180,000 198,996 37,080 138,432 104,000 880,950 121,000 150,000 198,030 36,900 137,760 95,000 738,690 100,000 800,000 500,000 1,400,000 -400,000 1,000,000 1,740,155 100,000 800,000 300,000 1,200,000 -300,000 900,000 1,780,950 100,000 800,000 300,000 1,200,000 -200,000 1,000,000 1,738,690 0 0 200,000 200,000 (100,000) 100,000 (40,795) 0.0% 0.0% 66.7% 16.7% 33.3% 11.1% -2.3% 0 0 0 0 (100,000) (100,000) 42,260 0.0% 0.0% 0.0% 0.0% 50.0% -10.0% 2.4% 71,640 55,000 126,640 74,160 55,000 129,160 73,800 55,000 128,800 (2,520) 0 (2,520) -3.4% 0.0% -2.0% 360 0 360 0.5% 0.0% 0.3% 700,000 50,000 750,000 876,640 750,000 55,000 805,000 934,160 800,000 60,000 860,000 988,800 (50,000) (5,000) (55,000) (57,520) -6.7% -9.1% -6.8% -6.2% (50,000) (5,000) (55,000) (54,640) -6.3% -8.3% -6.4% -5.5% 200,000 400,000 263,515 863,515 1,740,155 200,000 400,000 246,790 846,790 1,780,950 200,000 400,000 149,890 749,890 1,738,690 0 0 16,725 16,725 (40,795) 0.0% 0.0% 6.8% 2.0% -2.3% 0 0 96,900 96,900 42,260 0.0% 0.0% 64.6% 12.9% 2.4% 1.0% 5.4% 4.8% Return on Common Equity 1.9% 11.4% 8.10% Price / Earnings Ratio Total Operating Expenses OPERATING INCOME Return on Total Assets 170.52 90.82 29.00 Times Interest Earned 1.29 2.58 5.10 Custom Snowboards Inc. Comparative Income Statements - Vertical Analysis December 31, Years 12, 13, and 14 Year 14 REVENUE: Net Sales Cost of Goods Sold Gross Profit Year 12 Interest Income (Expense): Interest Income Interest Expense Interest, net EARNINGS BEFORE INCOME TAXES 100.0% 69.6% 30.4% 6,601,000 4,592,000 2,009,000 100.0% 69.6% 30.4% 3.4% 4.7% 3.7% 11.8% 226,600 309,000 247,200 782,800 3.4% 4.7% 3.7% 11.8% 225,500 307,500 246,000 779,000 3.4% 4.7% 3.7% 11.8% 250,000 215,000 90,000 12,000 100,000 260,000 170,000 1,097,000 3.9% 3.4% 1.4% 0.2% 1.6% 4.1% 2.7% 17.1% 220,000 195,000 90,000 12,000 100,000 255,000 158,000 1,030,000 3.3% 2.9% 1.4% 0.2% 1.5% 3.8% 2.4% 15.5% 210,000 190,000 90,000 12,000 100,000 238,000 120,500 960,500 3.2% 2.9% 1.4% 0.2% 1.5% 3.6% 1.8% 14.6% 28.9% 1.5% 1,812,800 206,000 27.3% 3.1% 1,739,500 269,500 26.4% 4.1% 300 -75,000 -74,700 22,300 0.0% -1.2% -1.2% 0.3% 3,200 -80,000 -76,800 129,200 0.0% -1.2% -1.2% 1.9% 2,500 -85,000 -82,500 187,000 0.0% -1.3% -1.2% 2.8% 5,575 16,725 Total Operating Expenses OPERATING INCOME 6,633,200 4,614,400 2,018,800 1,853,200 97,000 General and Admin Expenses Administrative Salaries Executive Compensation Research and Development Website Creation and Maintenance Depreciation Expense Utilities & Services Other General and Admin Expenses Total General and Admin Expenses 100.0% 69.6% 30.4% 218,900 298,500 238,800 756,200 OPERATING EXPENSES Selling Expenses Transportation Out Sales Commissions Advertising Total Selling Expense Provision for Income Taxes NET EARNINGS Year 13 6,407,800 4,457,600 1,950,200 0.1% 0.3% 32,300 96,900 0.5% 1.5% 46,750 140,250 0.7% 2.1% Custom Snowboards Inc Balance Sheets - Vertical Analysis December 31, Years 12, 13, and 14 Year 14 ASSETS Current Assets: Cash and Cash Equivalents Short-Term Investments Accounts Receivable, net Raw Materials Inventory Finished Goods Inventory Other Current Assets Total Current Assets Property and Equipment, at cost: Land Manufacturing Plants and Offices Furniture, Fixtures and Equipment Less Accumulated Depreciation Net Property and Equipment TOTAL ASSETS LIABILITIES Current Liabilities: Accounts and Notes Payable Current Portion of Long-Term Debt Total Current Liabilities Long-Term Liabilities: Mortgage Payable Other Long-Term Liabilities Total Long-Term Liabilities Total Liabilities STOCKHOLDERS' EQUITY: Common Stock ($1.00 Par) Paid In Capital Retained Earnings Total Stockholders' Equity TOTAL LIABILITIES and EQUITY Year 13 Year 12 238,373 30,000 192,234 35,820 133,728 110,000 740,155 13.7% 1.7% 11.0% 2.1% 7.7% 6.3% 42.5% 222,442 180,000 198,996 37,080 138,432 104,000 880,950 12.5% 10.1% 11.2% 2.1% 7.8% 5.8% 49.5% 121,000 150,000 198,030 36,900 137,760 95,000 738,690 7.0% 8.6% 11.4% 2.1% 7.9% 5.5% 42.5% 100,000 800,000 500,000 1,400,000 (400,000) 1,000,000 1,740,155 5.7% 46.0% 28.7% 80.5% -23.0% 57.5% 100.0% 100,000 800,000 300,000 1,200,000 (300,000) 900,000 1,780,950 5.6% 44.9% 16.8% 67.4% -16.8% 50.5% 100.0% 100,000 800,000 300,000 1,200,000 (200,000) 1,000,000 1,738,690 5.8% 46.0% 17.3% 69.0% -11.5% 57.5% 100.0% 71,640 55,000 126,640 4.1% 3.2% 7.3% 74,160 55,000 129,160 4.2% 3.1% 7.3% 73,800 55,000 128,800 4.2% 3.2% 7.4% 700,000 50,000 750,000 876,640 40.2% 2.9% 43.1% 50.4% 750,000 55,000 805,000 934,160 42.1% 3.1% 45.2% 52.5% 800,000 60,000 860,000 988,800 46.0% 3.5% 49.5% 56.9% 200,000 400,000 263,515 863,515 1,740,155 11.5% 23.0% 15.1% 49.6% 100.0% 200,000 400,000 246,790 846,790 1,780,950 11.2% 22.5% 13.9% 47.5% 100.0% 200,000 400,000 149,890 749,890 1,738,690 11.5% 23.0% 8.6% 43.1% 100.0% Custom Snowboards Inc. Historical Trend Analysis December 31, Years 12-14 Year 14 6,407,800 Net Sales Trend Percentages (Year 12 as base) Year to Year Increase Year 13 Year 12 6,633,200 6,601,000 97.1% 96.6% 100.5% 100.5% 100.0% Custom Snowboards Inc. Forecasted Trend Analysis December 31, Years 14-17 Year 17 Net Sales Trend Percentages (Year 14 as base) Year to Year Increase Year 16 Year 15 Year 14 6,647,452 6,535,956 6,600,034 6,407,800 103.7% 101.7% 102.0% 99.0% 103.0% 103.0% 100.0% The management of Custom Snowboards has prepared the following projected income statements for an anticipated expansion to Europe. Different potential financing options are presented in the spreadsheets that follow. Custom Snowboards Inc. European Sales Forecast Comparative Pro Forma Income Statements December 31, Years 15-19 Year 19 REVENUE: Net Sales Cost of Goods Sold Gross Profit OPERATING EXPENSES Selling and Admin Expenses Advertising Sales Commissions Transportation Out ($5/unit) Factory Manager/Staff Total Selling and Admin Depreciation Expense* EARNINGS Year 18 Year 17 Year 16 Year 15 2,232,990 1,692,079 540,911 2,029,991 1,538,254 491,737 1,845,446 1,398,413 447,034 1,537,872 1,165,344 372,528 1,281,560 971,120 310,440 80,000 27,046 69,348 66,853 243,246 80,000 24,587 63,043 63,669 231,299 100,000 22,352 57,312 60,638 240,301 100,000 18,626 47,760 57,750 224,136 100,000 15,522 39,800 55,000 210,322 40,000 257,665 40,000 220,438 40,000 166,732 40,000 108,392 40,000 60,118 Insert the EBIT from the European Sales Forecast into the box. Each year can be analyzed individually. 60,118 CHOOSING AN OPTIMAL CAPITAL STRUCTURE Alternative Capital Sources Long Term Debt Preferred Common * Total Earnings before Interest and Tax (EBIT) Interest on Long Term Debt Income before tax (EBT) Income Tax (25% marginal rate) Net Income Total Income Available for Common Stock Common Stock Shares Outstanding Earnings per Common Stock share Long Term Debt 1,000,000 30% Long-Term 80% Long-Term Debt and Debt and Common Common 300,000 800,000 No LongTerm Debt 1,000,000 700,000 1,000,000 200,000 1,000,000 1,000,000 1,000,000 60,118 67,500 -7,382 0 -7,382 60,118 20,250 39,868 9,967 29,901 60,118 54,000 6,118 1,530 4,589 60,118 0 60,118 15,030 45,089 -7,382 200,000 -0.037 29,901 550,000 0.054 4,589 300,000 0.015 45,089 700,000 0.064 * Capital received from the additonal shares: $2.00 per share consisting of $1 par value plus $1 of additional paid in capital. EBIT from European Forecast Year 15 60,118 Year 16 108,392 Year 17 166,732 Year 18 220,438 Year 19 257,665 Projected Five-Year Income Statements for European operations Year 15 Year 16 Year 17 Expected Annual Sales Increase from Europe 1,281,560 1,537,872 1,845,446 Expected Costs of New Product: Cost of Goods Sold Depreciation on European Fixed Assets Selling and administrative expenses Income before taxes Income tax at 25% marginal rate Net income Net cash flow (Net Income with Depreciation) 971,120 40,000 210,322 60,118 15,030 45,089 85,089 Year 18 2,029,991 Year 19 2,232,990 1,692,079 40,000 243,246 257,665 64,416 193,249 233,249 1,165,344 40,000 224,136 108,392 27,098 81,294 121,294 1,398,413 40,000 240,301 166,732 41,683 125,049 165,049 1,538,254 40,000 231,299 220,438 55,109 165,328 205,328 Cash Flows 85,089 121,294 165,049 205,328 233,249 200,000 600,000 10% PV Factors 0.909 0.826 0.751 0.683 0.621 0.621 0.621 Present Value 77,345 100,189 123,952 140,239 144,847 124,200 372,600 Net Present Value at a minimum expected 10% Cost of Capital Year 15 Year 16 Year 17 Year 18 Year 19 Working Capital Return Salvage Return Total Present Value Investment Net Present Value 1,083,373 1,000,000 83,373 Internal Rate of Return: Investment Year 15 Year 16 Year 17 Year 18 Year 19 Cash Flows -1,000,000 85,089 121,294 165,049 205,328 1,033,249 Internal Rate of Return 12.2% Custom Snowboards Inc. Lease vs. Buy Decision Analysis of Extended Payment Options for Procurement of Plant & Equipment Leasing Interest and Principal Calculations Loan Payment: Payments 189,917.12 End of Year 15 16 17 18 19 Loan Payments 189917 189917 189917 189917 189917 Beg., Year Principal 800,000 658,083 507,651 348,193 179,167 Principal 141,917 150,432 159,458 169,026 179,167 End Year Principal 658,083 507,651 348,193 179,167 0 End of Year 15 16 17 18 19 Loan Payments 189917 189917 189917 189917 189917 After-tax Cash Flow if Purchased Operational Costs Depreciation Interest 25,000 35,000 48,000 25,000 35,000 39,485 25,000 35,000 30,459 25,000 35,000 20,892 25,000 35,000 10,750 Total Deductions 108,000 99,485 90,459 80,892 70,750 Interest 48,000 39,485 30,459 20,892 10,750 Tax Shields 27,000 24,871 22,615 20,223 17,688 Lease vs. Purchase Comparison of Cash Flows Annual Lease Payment: $195,000 End of Year 15 16 17 18 19 Cash buyout After Tax Cash Flows 146,250 146,250 146,250 146,250 146,250 50,000 Leasing Present Value Factors (6%) 0.943 0.890 0.840 0.792 0.747 0.747 Present Value After Tax of Outflows Cash Flows 137,914 130,163 122,850 115,830 109,249 37,350 653,355 187,917 190,046 192,302 194,694 197,230 Purchasing Present Value Factors (6%) 0.943 0.890 0.840 0.792 0.747 Present Value of Outflows 177,206 169,141 161,534 154,198 147,331 809,409 After Tax Cash Flows 187,917 190,046 192,302 194,694 197,230 CONSIDER A MERGER Financial Data for Custom Snowboards Inc. and European Snowfun Custom Snowboards European SnowFun 196,876 80,000 Earnings Available for Common Stock Projections based on Year 15 # of shares of common stock outstanding 200,000 300,000 Earnings available for common Earnings per share 0.98 0.27 stock forecast for the two entities. Market price per share $15.00 $2.40 Price/Earnings ratio 20.0 9.0 Earnings per Share Expected EPS Before Merger After Merger Custom Snowboards European SnowFun 0.98 0.27 0.92 Expected EPS based on combined projected EPS for the two entities CONSIDER AN ACQUISITION Net Present Value of European SnowFun Projected Cash Flows Year 15 Year 16 Year 17 Year 18 Year 19 Total Net Cash Flows 113,453 155,331 205,894 250,257 282,670 1,007,605 10% Present Value factor 0.909 0.826 0.751 0.683 0.621 Present Value 103,129 128,303 154,626 170,926 175,538 732,522 Offer/share: 2.40 Offer Price: 720,000 Custom Snowboards, Inc. Overhead Analysis - Traditional vs. ABC Five overhead items with identified costs Item Activity Cost Pool Cost Driver Factory Setups 186,200 Setups Quality Control 315,800 QC Inspections Engineering Service 142,000 Product Movements Cost Driver Quantity 332,588 Product Line Production Volume Activity Cost per Unit of Product 20 Regular Personalized 125 9,375 2,442 183,758 186,200 37,377 9,344 0.07 19.67 1,986 159 Regular Personalized 93 1,892 14,862 300,938 315,800 37,377 9,344 0.40 32.21 140 1,013 Regular Personalized 37 103 37,867 104,133 142,000 37,377 9,344 1.01 11.14 841 372 Regular Personalized 374 467 139,010 173,757 312,767 37,377 9,344 3.72 18.60 46,721 7 Regular Personalized 37,377 9,344 266,072 66,516 332,588 37,377 9,344 7.12 7.12 Engineering Packaging Activity Cost for Product Line 9,500 312,767 Forklift Service Pkg & Shipping Cost Driver Quantity Pool Rate Product Line for Product Line Miscellaneous Data $1,289,355 Overhead allocated to Activity Cost Pools 37,377 Regular Snowboard Production 9,344 Personalized Snowboard Production. $1,403,030 Total Applied Overhead Summary: Regular Personalized Traditional ABC Traditional ABC 1,177,376 1,177,376 490,560 490,560 2,197,768 2,197,768 686,784 686,784 3,375,143 3,375,143 1,177,344 1,177,344 Direct Material Direct Labor Total direct cost of materials and labor Manufacturing Overhead (ABC) Traditional Factory Setups Quality Control Engineering Services Product Movements Packaging and Shipping Overhead cost unallocated to activity cost pools Total ABC Overhead Cost ABC Total Product cost Unit Cost Comparisons: Regular Unit Cost - Traditional Unit Cost - Activity Based 119 105 Personalized Unit Cost - Traditional Unit Cost - Activity Based 162 218 1,068,982 4,444,125 334,048 2,442 14,862 37,867 139,010 266,072 86,610 546,863 3,922,006 1,511,392 1,403,030 183,758 300,938 104,133 173,757 66,516 27,065 856,167 2,033,511 113675 1,403,030 -GITM.ch14.625-667.CTP.v5.dd 12/8/04 5:55 PM Page 625 PA R T F I V E Short-Term Financial Decisions CHAPTERS IN THIS PART 14 15 Working Capital and Current Assets Management Current Liabilities Management Integrative Case 5: Casa de Diseo 625 -GITM.ch14.625-667.CTP.v5.dd 12/8/04 6:01 PM Page 626 Chapter 14 Working Capital and Current Assets Management L E A R N I N G LG1 LG2 LG3 G O A L S Understand short-term financial management, net working capital, and the related tradeoff between profitability and risk. Describe the cash conversion cycle, its funding requirements, and the key strategies for managing it. Discuss inventory management: differing views, common techniques, and international concerns. ACROSS TH E DISCI P LI N ES LG5 LG6 Explain the credit selection process and the quantitative procedure for evaluating changes in credit standards. Review the procedures for quantitatively considering cash discount changes, other aspects of credit terms, and credit monitoring. Understand the management of receipts and disbursements, including float, speeding up collections, slowing down payments, cash concentration, zero-balance accounts, and investing in marketable securities. WHY THIS CHAPTER MATTERS TO YOU Accounting: You need to understand the cash conversion cycle and the management of inventory, accounts receivable, and receipts and disbursements of cash. Information systems: You need to understand the cash conversion cycle, inventory, accounts receivable, and receipts and disbursements of cash to design financial information systems that facilitate effective short-term financial management. Management: You need to understand the management of working capital so that you can efficiently manage cur- 626 LG4 rent assets and decide whether to finance the firm's funds requirements aggressively or conservatively. Marketing: You need to understand credit selection and monitoring because sales will be affected by the availability of credit to purchasers; sales will also be affected by inventory management. Operations: You need to understand the cash conversion cycle because you will be responsible for reducing the cycle through the efficient management of production, inventory, and costs. -GITM.ch14.625-667.CTP.v5.dd 12/7/04 6:15 PM Page 627 AT&T OUTSOURCING IS IN THE CARDS T&T (www.att.com) is among the world's A premiere voice, video, and data communi- cations companies, serving consumers, businesses, and government. Backed by the research and development capabilities of AT&T Labs, the company runs the world's largest, most sophisticated communications network and is a leading supplier of data and Internet services for businesses. One of AT&T's services consists of prepaid phone cards. The company, which is highly skilled at delivering telecommunications services, had minimal experience in the supply chain management processes needed to bring tangible, packaged goods to channels such as convenience stores and mass merchants. AT&T made a strategic business decision to outsource its PrePaid Card end-to-end supply chain management functions. AT&T chose Accenture, a global management-consulting, technology services, and outsourcing company, to solve its problem. Accenture teamed with AT&T to develop a customer-focused supply chain operating model for the prepaid phone cards. This model integrated all of the supply chain business processes, including sourcing, production, scheduling, account service, warehousing, fulfillment, inventory, billing, and systems management. Accenture organized purchasing and inventory decision-making processes and substantially reduced inventory levels and cost. Together, AT&T and Accenture transformed and accelerated the delivery of bottom-line business results, including reducing PrePaid Card production costs by 15 percent, improving warehouse productivity by 25 percent, and reducing raw materials inventory by 25 percent. Reducing raw materials inventory through outsourcing or by converting to just-in-time manufacturing can lower net working capital requirements, the difference between a firm's current assets (including inventory) and a firm's current liabilities. Because long-term assets provide a better return than short-term assets, reducing short-term assets can free up capital, which can then be better employed by the company. In this chapter we look at techniques and strategies for managing working capital and current assets. We first discuss the fundamentals of net working capital and then demonstrate the cash conversion cycle. The balance of the chapter considers the management of inventory, accounts receivable, and receipts and disbursements in the context of the cash conversion cycle. Source: www.accenture.com. What are the possible benefits of outsourcing finance and accounting activities? 627 -GITM.ch14.625-667.CTP.v5.dd 628 PART FIVE LG1 12/7/04 6:15 PM Page 628 Short-Term Financial Decisions 14.1 short-term financial management Management of current assets and current liabilities. Net Working Capital Fundamentals The firm's balance sheet provides information about the structure of the firm's investments on the one hand and the structure of its financing sources on the other hand. The structures chosen should consistently lead to the maximization of the value of the owners' investment in the firm. Important components of the firm's financial structure include the level of investment in current assets and the extent of current liability financing. In U.S. manufacturing firms, current assets account for about 40 percent of total assets; current liabilities represent about 26 percent of total financing. Therefore, it should not be surprising to learn that short-term financial managementmanaging current assets and current liabilitiesis one of the financial manager's most important and time-consuming activities. A study of Fortune 1000 firms found that more than one-third of financial management time is spent managing current assets and about one-fourth of financial management time is spent managing current liabilities.1 The goal of short-term financial management is to manage each of the firm's current assets (inventory, accounts receivable, cash, and marketable securities) and current liabilities (accounts payable, accruals, and notes payable) to achieve a balance between profitability and risk that contributes positively to the firm's value. This chapter does not discuss the optimal level of current assets and current liabilities that a firm should have. That issue is unresolved in the financial literature. Here we first use net working capital to consider the basic relationship between current assets and current liabilities and then use the cash conversion cycle to consider the key aspects of current asset management. In the following chapter, we consider current liability management. Net Working Capital working capital Current assets, which represent the portion of investment that circulates from one form to another in the ordinary conduct of business. net working capital The difference between the firm's current assets and its current liabilities; can be positive or negative. Current assets, commonly called working capital, represent the portion of investment that circulates from one form to another in the ordinary conduct of business. This idea embraces the recurring transition from cash to inventories to receivables and back to cash. As cash substitutes, marketable securities are considered part of working capital. Current liabilities represent the firm's short-term financing, because they include all debts of the firm that come due (must be paid) in 1 year or less. These debts usually include amounts owed to suppliers (accounts payable), employees and governments (accruals), and banks (notes payable), among others. As noted in Chapter 8, net working capital is commonly defined as the difference between the firm's current assets and its current liabilities. When the current assets exceed the current liabilities, the firm has positive net working capital. When current assets are less than current liabilities, the firm has negative net working capital. 1. Lawrence J. Gitman and Charles E. Maxwell, \"Financial Activities of Major U.S. Firms: Survey and Analysis of Fortune's 1000,\" Financial Management (Winter 1985), pp. 57-65. -GITM.ch14.625-667.CTP.v5.dd 12/7/04 6:15 PM Page 629 CHAPTER 14 Hint Stated differently, some portion of current assets is usually held to provide liquidity in case it is unexpectedly needed. Working Capital and Current Assets Management 629 The conversion of current assets from inventory to receivables to cash provides the cash used to pay the current liabilities. The cash outlays for current liabilities are relatively predictable. When an obligation is incurred, the firm generally knows when the corresponding payment will be due. What is difficult to predict are the cash inflowsthe conversion of the current assets to more liquid forms. The more predictable its cash inflows, the less net working capital a firm needs. Because most firms are unable to match cash inflows to outflows with certainty, current assets that more than cover outflows for current liabilities are usually necessary. In general, the greater the margin by which a firm's current assets cover its current liabilities, the better able it will be to pay its bills as they come due. The Tradeoff Between Profitability and Risk profitability The relationship between revenues and costs generated by using the firm's assets both current and fixedin productive activities. risk (of technical insolvency) The probability that a firm will be unable to pay its bills as they come due. technically insolvent Describes a firm that is unable to pay its bills as they come due. Hint It is generally easier to turn receivables into the more liquid asset cash than it is to turn inventory into cash. As we will learn in Chapter 15, the firm can sell its receivables for cash. Often inventory is sold on credit and is therefore converted to a receivable before it becomes cash. A tradeoff exists between a firm's profitability and its risk. Profitability, in this context, is the relationship between revenues and costs generated by using the firm's assetsboth current and fixedin productive activities. A firm's profits can be increased by (1) increasing revenues or (2) decreasing costs. Risk, in the context of short-term financial management, is the probability that a firm will be unable to pay its bills as they come due. A firm that cannot pay its bills as they come due is said to be technically insolvent. It is generally assumed that the greater the firm's net working capital, the lower its risk. In other words, the more net working capital, the more liquid the firm and therefore the lower its risk of becoming technically insolvent. Using these definitions of profitability and risk, we can demonstrate the tradeoff between them by considering changes in current assets and current liabilities separately. Changes in Current Assets How changing the level of the firm's current assets affects its profitability-risk tradeoff can be demonstrated using the ratio of current assets to total assets. This ratio indicates the percentage of total assets that is current. For purposes of illustration, we will assume that the level of total assets remains unchanged.2 The effects on both profitability and risk of an increase or decrease in this ratio are summarized in the upper portion of Table 14.1 (on page 630). When the ratio increasesthat is, when current assets increaseprofitability decreases. Why? Because current assets are less profitable than fixed assets. Fixed assets are more profitable because they add more value to the product than that provided by current assets. Without fixed assets, the firm could not produce the product. The risk effect, however, decreases as the ratio of current assets to total assets increases. The increase in current assets increases net working capital, thereby reducing the risk of technical insolvency. In addition, as you go down the asset side of the balance sheet, the risk associated with the assets increases: Investment in cash and marketable securities is less risky than investment in accounts receivable, inventories, and fixed assets. Accounts receivable investment is less risky 2. To isolate the effect of changing asset and financing mixes on the firm's profitability and risk, we assume the level of total assets to be constant in this and the following discussion. -GITM.ch14.625-667.CTP.v5.dd 630 PART FIVE 12/7/04 6:15 PM Page 630 Short-Term Financial Decisions TA B L E 14 . 1 Effects of Changing Ratios on Profits and Risk Change in ratio Effect on profit Effect on risk Current assets Total assets Increase Decrease Decrease Decrease Increase Increase Current liabilities Total assets Increase Increase Increase Decrease Decrease Decrease Ratio than investment in inventories and fixed assets. Investment in inventories is less risky than investment in fixed assets. The nearer an asset is to cash, the less risky it is. The opposite effects on profit and risk result from a decrease in the ratio of current assets to total assets. Changes in Current Liabilities How changing the level of the firm's current liabilities affects its profitability-risk tradeoff can be demonstrated by using the ratio of current liabilities to total assets. This ratio indicates the percentage of total assets that has been financed with current liabilities. Again, assuming that total assets remain unchanged, the effects on both profitability and risk of an increase or decrease in the ratio are summarized in the lower portion of Table 14.1. When the ratio increases, profitability increases. Why? Because the firm uses more of the less expensive current liabilities financing and less long-term financing. Current liabilities are less expensive because only notes payable, which represent about 20 percent of the typical manufacturer's current liabilities, have a cost. The other current liabilities are basically debts on which the firm pays no charge or interest. However, when the ratio of current liabilities to total assets increases, the risk of technical insolvency also increases, because the increase in current liabilities in turn decreases net working capital. The opposite effects on profit and risk result from a decrease in the ratio of current liabilities to total assets. R EVI EW QU ESTIONS 14-1 14-2 14-3 Why is short-term financial management one of the most important and time-consuming activities of the financial manager? What is net working capital? What is the relationship between the predictability of a firm's cash inflows and its required level of net working capital? How are net working capital, liquidity, and risk of technical insolvency related? Why does an increase in the ratio of current to total assets decrease both profits and risk as measured by net working capital? How do changes in the ratio of current liabilities to total assets affect profitability and risk? -GITM.ch14.625-667.CTP.v5.dd 12/7/04 6:15 PM Page 631 CHAPTER 14 LG2 14.2 Working Capital and Current Assets Management 631 The Cash Conversion Cycle Central to short-term financial management is an understanding of the firm's cash conversion cycle.3 This cycle frames discussion of the management of the firm's current assets in this chapter and that of the management of current liabilities in Chapter 15. Here, we begin by demonstrating the calculation and application of the cash conversion cycle. Calculating the Cash Conversion Cycle operating cycle (OC) The time from the beginning of the production process to the collection of cash from the sale of the finished product. A firm's operating cycle (OC) is the time from the beginning of the production process to collection of cash from the sale of the finished product. The operating cycle encompasses two major short-term asset categories: inventory and accounts receivable. It is measured in elapsed time by summing the average age of inventory (AAI) and the average collection period (ACP). Hint A firm can lower its working capital if it can speed up its operating cycle. For example, if a firm accepts bank credit (like a Visa card), it will receive cash sooner after the sale is transacted than if it has to wait until the customer pays its accounts receivable. OC AAI ACP cash conversion cycle (CCC) The amount of time a firm's resources are tied up; calculated by subtracting the average payment period from the operating cycle. (14.1) However, the process of producing and selling a product also includes the purchase of production inputs (raw materials) on account, which results in accounts payable. Accounts payable reduce the number of days a firm's resources are tied up in the operating cycle. The time it takes to pay the accounts payable, measured in days, is the average payment period (APP). The operating cycle less the average payment period is referred to as the cash conversion cycle (CCC). It represents the amount of time the firm's resources are tied up. The formula for the cash conversion cycle is CCC OC APP (14.2) Substituting the relationship in Equation 14.1 into Equation 14.2, we can see that the cash conversion cycle has three main components, as shown in Equation 14.3: (1) average age of the inventory, (2) average collection period, and (3) average payment period. CCC AAI ACP APP (14.3) Clearly, if a firm changes any of these time periods, it changes the amount of resources tied up in the day-to-day operation of the firm. EXAMPLE MAX Company, a producer of paper dinnerware, has annual sales of $10 million, a cost of goods sold of 75% of sales, and purchases that are 65% of cost of goods sold. MAX has an average age of inventory (AAI) of 60 days, an average collection period (ACP) of 40 days, and an average payment period (APP) of 35 days. Thus the cash conversion cycle for MAX is 65 days (60 40 35). Figure 14.1 (on page 632) presents MAX Company's cash conversion cycle as a time line. 3. The conceptual model that is used in this section to demonstrate basic short-term financial management strategies was developed by Lawrence J. Gitman in \"Estimating Corporate Liquidity Requirements: A Simplified Approach,\" The Financial Review (1974), pp. 79-88, and refined and operationalized by Lawrence J. Gitman and Kanwal S. Sachdeva in \"A Framework for Estimating and Analyzing the Required Working Capital Investment,\" Review of Business and Economic Research (Spring 1982), pp. 35-44. -GITM.ch14.625-667.CTP.v5.dd 632 PART FIVE 12/7/04 6:15 PM Page 632 Short-Term Financial Decisions F I G U R E 14 . 1 Time Line for MAX Company's Cash Conversion Cycle MAX Company's operating cycle is 100 days, and its cash conversion cycle is 65 days Time = 0 100 days Operating Cycle (OC) Purchase Raw Materials on Account Collect Accounts Receivable Sell Finished Goods on Account Average Age of Inventory (AAI) Average Collection Period (ACP) 60 days 40 days Average Payment Period (APP) Pay Accounts Payable Cash Inflow Cash Conversion Cycle (CCC) 65 days 35 days Cash Outflow Time The resources MAX has invested in this cash conversion cycle (assuming a 365-day year) are Inventory ($10,000,000 0.75) (60/365) Accounts receivable ( 10,000,000 40/365) Accounts payable ( 10,000,000 0.75 0.65) (35/365) Resources invested $1,232,877 1,095,890 467,466 $1,861,301 Changes in any of the time periods will change the resources tied up in operations. For example, if MAX could reduce the average collection period on its accounts receivable by 5 days, it would shorten the cash conversion time line and thus reduce the amount of resources MAX has invested in operations. For MAX, a 5-day reduction in the average collection period would reduce the resources invested in the cash conversion cycle by $136,986 [$10,000,000 (5/365)]. Funding Requirements of the Cash Conversion Cycle We can use the cash conversion cycle as a basis for discussing how the firm funds its required investment in operating assets. We first differentiate between permanent and seasonal funding needs and then describe aggressive and conservative seasonal funding strategies. permanent funding requirement A constant investment in operating assets resulting from constant sales over time. Permanent Versus Seasonal Funding Needs If the firm's sales are constant, then its investment in operating assets should also be constant, and the firm will have only a permanent funding requirement. If the firm's sales are cyclic, then its investment in operating assets will vary over time -GITM.ch14.625-667.CTP.v5.dd 12/7/04 6:15 PM Page 633 CHAPTER 14 seasonal funding requirement An investment in operating assets that varies over time as a result of cyclic sales. EXAMPLE Working Capital and Current Assets Management with its sales cycles, and the firm will have seasonal funding requirements in addition to the permanent funding required for its minimum investment in operating assets. Nicholson Company holds, on average, $50,000 in cash and marketable securities, $1,250,000 in inventory, and $750,000 in accounts receivable. Nicholson's business is very stable over time, so its operating assets can be viewed as permanent. In addition, Nicholson's accounts payable of $425,000 are stable over time. Thus Nicholson has a permanent investment in operating assets of $1,625,000 ($50,000 $1,250,0000 $750,000 $425,000). That amount would also equal its permanent funding requirement. In contrast, Semper Pump Company, which produces bicycle pumps, has seasonal funding needs. Semper has seasonal sales, with its peak sales being driven by the summertime purchases of bicycle pumps. Semper holds, at minimum, $25,000 in cash and marketable securities, $100,000 in inventory, and $60,000 in accounts receivable. At peak times, Semper's inventory increases to $750,000, and its accounts receivable increase to $400,000. To capture production efficiencies, Semper produces pumps at a constant rate throughout the year. Thus accounts payable remain at $50,000 throughout the year. Accordingly, Semper has a permanent funding requirement for its minimum level of operating assets of $135,000 ($25,000 $100,000 $60,000 $50,000) and peak seasonal funding requirements (in excess of its permanent need) of $990,000 [($25,000 $750,000 $400,000 $50,000) $135,000]. Semper's total funding requirements for operating assets vary from a minimum of $135,000 (permanent) to a seasonal peak of $1,125,000 ($135,000 $990,000). Figure 14.2 depicts these needs over time. F I G U R E 14 . 2 Semper Pump Company's Total Funding Requirements Semper Pump Company's peak funds need is $1,125,000, and its minimum need is $135,000 Funding Requirements for Operating Assets ($) 633 1,125,000 Peak Need 1,000,000 Seasonal Need ($0 to $990,000, average = $101,250 [calculated from data not shown]) 500,000 Total Need 135,000 0 Permanent Need ($135,000) Minimum Need 1 year Time Total Need (between $135,000 and $1,125,000) -GITM.ch14.625-667.CTP.v5.dd 634 PART FIVE 12/7/04 6:15 PM Page 634 Short-Term Financial Decisions aggressive funding strategy A funding strategy under which the firm funds its seasonal requirements with short-term debt and its permanent requirements with long-term debt. conservative funding strategy A funding strategy under which the firm funds both its seasonal and its permanent requirements with long-term debt. EXAMPLE Aggressive Versus Conservative Seasonal Funding Strategies Short-term funds are typically less expensive than long-term funds. (The yield curve is typically upward-sloping.) However, long-term funds allow the firm to lock in its cost of funds over a period of time and thus avoid the risk of increases in short-term interest rates. Also, long-term funding ensures that the required funds are available to the firm when needed. Short-term funding exposes the firm to the risk that it may not be able to obtain the funds needed to cover its seasonal peaks. Under an aggressive funding strategy, the firm funds its seasonal requirements with short-term debt and its permanent requirements with long-term debt. Under a conservative funding strategy, the firm funds both its seasonal and its permanent requirements with long-term debt. Semper Pump Company has a permanent funding requirement of $135,000 in operating assets and seasonal funding requirements that vary between $0 and $990,000 and average $101,250 (calculated from data not shown). If Semper can borrow short-term funds at 6.25% and long-term funds at 8%, and if it can earn 5% on the investment of any surplus balances, then the annual cost of an aggressive strategy for seasonal funding will be Cost of short-term financing 0.0625 $101,250 $ 6,328.13 Cost of long-term financing 0.0800 135,000 10,800.00 0 Earnings on surplus balances4 0.0500 0 $17,128.13 Total cost of aggressive strategy Alternatively, Semper can choose a conservative strategy, under which surplus cash balances are fully invested. (In Figure 14.2, this surplus will be the difference between the peak need of $1,125,000 and the total need, which varies between $135,000 and $1,125,000 during the year.) The cost of the conservative strategy will be Cost of short-term financing 0.0625 $ 0 $ 0 Cost of long-term financing 0.0800 1,125,000 90,000.00 Earnings on surplus balances5 0.0500 888,750 44,437.50 Total cost of conservative strategy $45,562.50 It is clear from these calculations that for Semper, the aggressive strategy is far less expensive than the conservative strategy. However, it is equally clear that Semper has substantial peak-season operating-asset needs and that it must have adequate funding available to meet the peak needs and ensure ongoing operations. Clearly, the aggressive strategy's heavy reliance on short-term financing makes it riskier than the conservative strategy because of interest rate swings and possible difficulties in obtaining needed short-term financing quickly when sea4. Because under this strategy the amount of financing exactly equals the estimated funding need, no surplus balances exist. 5. The average surplus balance would be calculated by subtracting the sum of the permanent need ($135,000) and the average seasonal need ($101,250) from the seasonal peak need ($1,125,000) to get $888,750 ($1,125,000 $135,000 $101,250). This represents the surplus amount of financing that on average could be invested in shortterm vehicles that earn a 5% annual return. -GITM.ch14.625-667.CTP.v5.dd 12/7/04 6:15 PM Page 635 CHAPTER 14 Working Capital and Current Assets Management 635 sonal peaks occur. The conservative strategy avoids these risks through the locked-in interest rate and long-term financing, but it is more costly because of the negative spread between the earnings rate on surplus funds (5% in the example) and the cost of the long-term funds that create the surplus (8% in the example). Where the firm operates, between the extremes of the aggressive and conservative seasonal funding strategies, depends on management's disposition toward risk and the strength of its banking relationships. Strategies for Managing the Cash Conversion Cycle A positive cash conversion cycle, as we saw for MAX Company in the earlier example, means the firm must use negotiated liabilities (such as bank loans) to support its operating assets. Negotiated liabilities carry an explicit cost, so the firm benefits by minimizing their use in supporting operating assets. Simply stated, the goal is to minimize the length of the cash conversion cycle, which minimizes negotiated liabilities. This goal can be realized through application of the following strategies: 1. Turn over inventory as quickly as possible without stockouts that result in lost sales. 2. Collect accounts receivable as quickly as possible without losing sales from high-pressure collection techniques. 3. Manage mail, processing, and clearing time to reduce them when collecting from customers and to increase them when paying suppliers. 4. Pay accounts payable as slowly as possible without damaging the firm's credit rating. Techniques for implementing these four strategies are the focus of the remainder of this chapter and the following chapter. R EVI EW QU ESTIONS 14-4 14-5 14-6 14-7 LG3 14.3 What is the difference between the firm's operating cycle and its cash conversion cycle? Why is it helpful to divide the funding needs of a seasonal business into its permanent and seasonal funding requirements when developing a funding strategy? What are the benefits, costs, and risks of an aggressive funding strategy and of a conservative funding strategy? Under which strategy is the borrowing often in excess of the actual need? Why is it important for a firm to minimize the length of its cash conversion cycle? Inventory Management The first component of the cash conversion cycle is the average age of inventory. The objective for managing inventory, as noted earlier, is to turn over inventory as quickly as possible without losing sales from stockouts. The financial manager -GITM.ch14.625-667.CTP.v5.dd 636 PART FIVE 12/7/04 6:15 PM Page 636 Short-Term Financial Decisions tends to act as an advisor or \"watchdog\" in matters concerning inventory; he or she does not have direct control over inventory but does provide input to the inventory management process. Differing Viewpoints About Inventory Level Differing viewpoints about appropriate inventory levels commonly exist among a firm's finance, marketing, manufacturing, and purchasing managers. Each views inventory levels in light of his or her own objectives. The financial manager's general disposition toward inventory levels is to keep them low, to ensure that the firm's money is not being unwisely invested in excess resources. The marketing manager, on the other hand, would like to have large inventories of the firm's finished products. This would ensure that all orders could be filled quickly, eliminating the need for backorders due to stockouts. The manufacturing manager's major responsibility is to implement the production plan so that it results in the desired amount of finished goods of acceptable quality at a low cost. In fulfilling this role, the manufacturing manager would keep raw materials inventories high to avoid production delays. He or she also would favor large production runs for the sake of lower unit production costs, which would result in high finished goods inventories. The purchasing manager is concerned solely with the raw materials inventories. He or she must have on hand, in the correct quantities at the desired times and at a favorable price, whatever raw materials are required by production. Without proper control, in an effort to get quantity discounts or in anticipation of rising prices or a shortage of certain materials, the purchasing manager may purchase larger quantities of resources than are actually needed at the time. Common Techniques for Managing Inventory Numerous techniques are available for effectively managing the firm's inventory. Here we briefly consider four commonly used techniques. The ABC System ABC inventory system Inventory management technique that divides inventory into three groupsA, B, and C, in descending order of importance and level of monitoring, on the basis of the dollar investment in each. two-bin method Unsophisticated inventorymonitoring technique that is typically applied to C group items and involves reordering inventory when one of two bins is empty. A firm using the ABC inventory system divides its inventory into three groups: A, B, and C. The A group includes those items with the largest dollar investment. Typically, this group consists of 20 percent of the firm's inventory items but 80 percent of its investment in inventory. The B group consists of items that account for the next largest investment in inventory. The C group consists of a large number of items that require a relatively small investment. The inventory group of each item determines the item's level of monitoring. The A group items receive the most intense monitoring because of the high dollar investment. Typically, A group items are tracked on a perpetual inventory system that allows daily verification of each item's inventory level. B group items are frequently controlled through periodic, perhaps weekly, checking of their levels. C group items are monitored with unsophisticated techniques, such as the two-bin method. With the two-bin method, the item is stored in two bins. As an item is needed, inventory is removed from the first bin. When that bin is empty, an order is placed to refill the first bin while inventory is drawn from the second bin. The second bin is used until empty, and so on. -GITM.ch14.625-667.CTP.v5.dd 12/7/04 6:15 PM Page 637 CHAPTER 14 Working Capital and Current Assets Management 637 The large dollar investment in A and B group items suggests the need for a better method of inventory management than the ABC system. The EOQ model, discussed next, is an appropriate model for the management of A and B group items. The Economic Order Quantity (EOQ) Model economic order quantity (EOQ) model Inventory management technique for determining an item's optimal order size, which is the size that minimizes the total of its order costs and carrying costs. order costs The fixed clerical costs of placing and receiving an inventory order. carrying costs The variable costs per unit of holding an item in inventory for a specific period of time. One of the most common techniques for determining the optimal order size for inventory items is the economic order quantity (EOQ) model. The EOQ model considers various costs of inventory and then determines what order size minimizes total inventory cost. EOQ assumes that the relevant costs of inventory can be divided into order costs and carrying costs. (The model excludes the actual cost of the inventory item.) Each of them has certain key components and characteristics. Order costs include the fixed clerical costs of placing and receiving orders: the cost of writing a purchase order, of processing the resulting paperwork, and of receiving an order and checking it against the invoice. Order costs are stated in dollars per order. Carrying costs are the variable costs per unit of holding an item of inventory for a specific period of time. Carrying costs include storage costs, insurance costs, the costs of deterioration and obsolescence, and the opportunity or financial cost of having funds invested in inventory. These costs are stated in dollars per unit per period. Order costs decrease as the size of the order increases. Carrying costs, however, increase with increases in the order size. The EOQ model analyzes the tradeoff between order costs and carrying costs to determine the order quantity that minimizes the total inventory cost. Mathematical Development of EOQ A formula can be developed for determining the firm's EOQ for a given inventory item, where S usage in units per period O order cost per order C carrying cost per unit per period Q order quantity in units The first step is to derive the cost functions for order cost and carrying cost. The order cost can be expressed as the product of the cost per order and the number of orders. Because the number of orders equals the usage during the period divided by the order quantity (S/Q), the order cost can be expressed as follows: Order cost O S/Q (14.4) The carrying cost is defined as the cost of carrying a unit of inventory per period multiplied by the firm's average inventory. The average inventory is the order quantity divided by 2 (Q/2), because inventory is assumed to be depleted at a constant rate. Thus carrying cost can be expressed as follows: Carrying cost C Q/2 total cost of inventory The sum of order costs and carrying costs of inventory. (14.5) The firm's total cost of inventory is found by summing the order cost and the carrying cost. Thus the total cost function is Total cost (O S/Q) (C Q/2) (14.6) -GITM.ch14.625-667.CTP.v5.dd 638 PART FIVE 12/7/04 6:15 PM Page 638 Short-Term Financial Decisions Hint The EOQ calculation helps management minimize the total cost of inventory. Lowering order costs will cause an increase in carrying costs and may increase total cost. Likewise, a decrease in total cost may result from reduced carrying costs. The goal, facilitated by using the EOQ calculation, is to lower total cost. reorder point The point at which to reorder inventory, expressed as days of lead time daily usage. Because the EOQ is defined as the order quantity that minimizes the total cost function, we mus