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Module 3
Uses of Funds
Framework•Capital budgeting process•Basic principles of capital budgeting•Investment decision criteria (PP,DPP, NPV, PI, ARR, IRR)
Capital Budgeting
•CA and CL Mgmt•WC financing•Short-term credit
Working Capital Management
•Liquid assets•Collection and disbursement•MS Portfolio
Cash and Marketable Securities
Management
•A/R Management•Inventory Management•TQM and JIT
AR and Inventory Management
Framework•Capital budgeting process•Basic principles of capital budgeting•Investment decision criteria (PP,DPP, NPV, PI, ARR, IRR)
Capital Budgeting
•CA and CL Mgmt•WC financing•Short-term credit
Working Capital Management
•Liquid assets•Collection and disbursement•MS Portfolio
Cash and Marketable Securities
Management
•A/R Management•Inventory Management•TQM and JIT
AR and Inventory Management
Capital Budgeting
The process in which the firm renews and reinvents itself Includes decision such as: opening a new
plant, introducing a new product line, closing operations, selling a business, etc.
Answers the question: should the proposed project be accepted or rejected
Capital budgeting decision criteria
Payback period Discounted payback period Net present value Profitability Index Internal rate of return (IRR)
Payback period Number of years needed to recover the initial cash
outlay of the project
Example: if the firm’s maximum desired payback period is 3 years and an investment proposal requires an initial cash outlay of $10,000 and yields the following set of annual free cash flows, what is the payback period? Should the project be accepted?Year After-tax free CF
1 2,000.00$ 2 4,000.00$ 3 3,000.00$ 4 3,000.00$ 5 10,000.00$
Decision:ACCEPT if payback period ≤ maximum acceptable payback periodREJECT if payback period ≥ maximum acceptable payback period
Payback Period: Pros and Cons
Advantages Uses free cash flows Easy to calculate and understand May be used as a rough screening devise
Disadvantages Ignores the time value of money Ignores free cash flows occurring after the
payback period Selection of the maximum acceptable
payment period is arbitrary
Discounted Payback Period
Number of years needed to recover the initial cash outlay from the discounted free cash flow.
Given the following after tax free cash flows, compute for the discounted payback period. The required rate of return is 17% p.a.
Decision:ACCEPT if discounted payback period ≤ maximum acceptable payback periodREJECT if discounted payback period ≥ maximum acceptable payback period
Year After-tax free CF Discounted Cash Flow Cumulative0 ($10,000.00) ($10,000.00) ($10,000.00)1 $6,000.00 $5,128.21 ($4,871.79)2 $4,000.00 $2,922.05 ($1,949.74)3 $3,000.00 $1,873.11 ($76.63)4 $2,000.00 $1,067.30 $990.675 $1,000.00 $456.11 $1,446.78
DPP: Pros and Cons
Advantages Uses free cash flows Easy to calculate and understand Considers time value of money
Disadvantages Ignores free cash flows occurring after the
payback period Selection of the maximum acceptable
payment period is arbitrary
Net Present Value (NPV)
Present value of the free cash flows less the investment’s initial outlay.
Gives a measurement of the net value of an investment proposal in terms of today’s dollars.
If NPV is zero, it returns the required rate of return and should be accepted.
Decision:ACCEPT if NPV ≥ 0REJECT if NPV ≤ 0
IOi
FCFNPV
n
nnn
1 )1(
Where:IO = initial cash outlayFCF = free cash flown = project’s expected life
NPV: An Example
J&J is considering new machinery that would reduce manufacturing costs associated with making Johnson’s baby cologne. If the firm has a 12% required rate of return, should the project be accepted?Year Free cash flow Present Value
Initial Outlay ($40,000.00) ($40,000.00)1 $15,000.00 $13,392.862 $14,000.00 $11,160.713 $13,000.00 $9,253.144 $12,000.00 $7,626.225 $11,000.00 $6,241.70
NPV: Pros and Cons
Advantages Uses free cash flows Considers time value of money Consistent with the firm’s goals of
shareholder and wealth maximization
Disadvantages Requires detailed long term
forecasts of a project’s free cash flows
Sensitivity to the choice of the discount rate
Profitability Index Benefit/cost ratio The ratio of the future free cash flows to the
initial cash outlay If NPV provides a measure of the absolute
dollar desirability of a project, the PI produces a relative measure of an investment proposals desirability
Decision:ACCEPT if PI ≥ 1REJECT if PI ≤ 1
IOi
FCF
PI
n
nnn
1 )1(
Where:IO = initial cash outlayFCF = free cash flown = project’s expected life
PI: Pros and Cons
AdvantagesUses free cash flowsConsiders time value of moneyConsistent with the firm’s goals of shareholder and wealth maximization
DisadvantagesRequires detailed long term forecasts of a project’s free cash flows
Internal Rate of Return (IRR)
Answers the question: what rate of return does this project earn?
IRR: discount rate that equates the present value of the project’s future net cash flows with the project’s initial cash outlay. You have to solve for IRR.
Decision:ACCEPT if IRR ≥ required rate of returnREJECT if IRR ≤ required rate of return
n
nn
n
IRR
FCFIO
1 )1(
Where:IO = initial cash outlayFCF = free cash flown = project’s expected life
IRR: Pros and Cons Advantages
Uses free cash flows Considers time value of money Is in general consistent with the firm’s
goals of shareholder and wealth maximization
Disadvantages Requires detailed long term forecasts of a
project’s free cash flows Possibility of multiple IRR’s Assumes cash flows over the life of the
project are reinvested at the IRR
Seatwork
You are considering a project that will require an initial outlay of $54,200. This project has an expected life of 5 years and will generate after-tax cash flows to the company as a whole of $20,608 at the end of each year over its five-year life. In addition to the $20,608 free cash flow from operations during the 5th and final year, there will be an additional cash inflow of $13,200 at the end of the 5th year associated with the salvage value of a machine, making the cash flow in year 5 equal to $33,308. Given a required rate of return of 15%, calculate the following. Should the project be accepted? Minimum acceptable no of years for PP and DPP is 3 years.
a.Payback periodb.Discounted payback periodc.Net Present Valued.Profitability Indexe.IRR
Assignment1. You are considering 2 independent projects, project
A and project B. the initial cash outlay associated with project A is $45,000, whereas the initial cash outlay associated with project B is $70,000. The required rate of return on both projects is 12%. The expected annual free cash inflows from each project are as follows:
Calculate the payback period, discounted payback period, NPV, and PI for each project and indicate if the project should be accepted. Min acceptable years for PP and DPP is 3 years
Year Project A Project B0 (45,000) (70,000)1 12,000 14,0002 12,000 14,0003 12,000 14,0004 12,000 14,0005 12,000 14,000
Assignment2. Artie’s Soccer Stuff is considering building
a new plant. This plant would require an initial cash outlay of $8 million and will generate annual free cash inflows of $2 million per year for eight years. Calculate the project’s payback period, discounted payback period (min acceptable payback period is 4.5 years), NPV and Profitability Index given a required rate of return of 12%. Will you accept or reject the project?
Framework•Capital budgeting process•Basic principles of capital budgeting•Investment decision criteria (PP,DPP, NPV, PI, ARR, IRR)
Capital Budgeting
•CA and CL Mgmt•WC financing•Short-term credit
Working Capital Management
•Liquid assets•Collection and disbursement•MS Portfolio
Cash and Marketable Securities
Management
•A/R Management•Inventory Management•TQM and JIT
AR and Inventory Management
Working Capital Management
Working capital is the difference in the firm’s current assets and is current liabilities
WC = Current Assets – Current Liabilities
Can give rise to short-term financing problems
Appropriate level of working capital
Hedging principle, or principle of self-liquidating debt Matching the cash-flow generating
characteristics of an asset with the maturity of the source of financing used to finance its acquisition
E.g. a seasonal expansion in inventories should be financed with short-term credit or current liability
Sources of financing
Temporary sources of financing Unsecured bank loans, commercial
paper, loans secured by accounts receivable and inventories
Permanent sources of financing Intermediate term loans, long-term
debt, preferred stock, common equity
Spontaneous sources of financing Trade credit, wages payable,
accrued interest, accrued taxes
Measuring WC efficiency
Minimize working capital by: Speeding up collection of cash Increasing inventory turns Slowing down disbursement of cash
CASH CONVERSION CYCLE
Cash Conversion Cycle (CCC)
=days of sales outstanding
(DSO)+
days of sales in inventory (DSI)
+days of payable
outstanding (DPO)
Cash Conversion Cycle
Cash Conversion Cycle (CCC)
=days of sales outstanding
(DSO)+
days of sales in inventory (DSI)
+days of payable
outstanding (DPO)
accounts receivablesales/365
=days of sales
outstanding (DSO)
inventoriesCGS/365
days of sales in inventory (DSI)
=
accounts payableCGS/365
days of payable outstanding (DPO)
=
Estimating the cost of short-term credit (APR)
APR = interest/ (principal x time)
Example: SKK Corporation plans to borrow $1,000 for a 90-day period. At maturity, the firm will repay the $1,000 principal amount plus $30 interest. What is the effective annual rate of interest for the loan?
Interest = Principal x Rate x Time
Estimating the cost of short-term credit (APY)
To account for the influence of compounding
Example: SKK Corporation plans to borrow $1,000 for a 90-day period. At maturity, the firm will repay the $1,000 principal amount plus $30 interest. What is the APY of the loan?
11
m
m
iAPY
Where:m = number of compounding periodsi = nominal rate of interest per year
Sources of short-term credit
Trade Credit Credit terms and cash discount Stretching of trade credit
Bank credit Line of credit Credit terms
Transaction loans Commercial paper
Accounts receivable loans Factoring accounts receivables Inventory loans
Framework•Capital budgeting process•Basic principles of capital budgeting•Investment decision criteria (PP,DPP, NPV, PI, ARR, IRR)
Capital Budgeting
•CA and CL Mgmt•WC financing•Short-term credit
Working Capital Management
•Liquid assets•Collection and disbursement•MS Portfolio
Cash and Marketable Securities
Management
•A/R Management•Inventory Management•TQM and JIT
AR and Inventory Management
Motives for holding cash
Transactions motive
Precautionary motive
Speculative motive
• Allow the firm to meet cash needs that arise in the ordinary course of doing business
• Buffer stock of liquid assets. • To be used to satisfy possible,
but indefinite needs
• To take advantage of potential profit-making situations
Cash Management Decisions
What can be done to speed up cash collections? Manage the cash inflow
and cash outflows What should be the
composition of a marketable securities portfolio?
Cash Gathering System
Step 1: Customer writes check and places it in the mail
Step 2: Mail is delivered to firm’s headquarters
Step 3: checks are processes and deposited in bank
Step 4: checks are forwarded to the clearing system
Step 5: checks are passed on to customer’s bank
Step 6: Customer’s funds are declared good
Step 7: Firm receives notice that checks have cleared
Day 1
Day 2-3
Day 4-5
Day 6
Day 7
Mail float
Processing float
Transit float
Managing cash inflows
Lock-box arrangements Firms mail their checks not to the
company but into a numbered post office box, which will be opened by the bank
Pre-authorized checks Resembles an ordinary check, but it
does not contain nor require the signature of the person whose account is being drawn
Concentration banking and wire transfers
Managing cash outflows
Zero-balance accounts Permit centralized control over cash
outflows Payable –through drafts
With the appearance of ordinary checks but are not drawn on a bank. It is drawn against the issuing firm and is presented to the issuing firm’s bank
Electronic funds transfer
Marketable Securities
General selection criteria Financial risk: possible changes in
financial capacity of the security issuer to make future payments
Interest rate risk: changes in interest rate
Liquidity: ability to transform the security into cash
Taxability: tax treatment of the income a firm receives
Yields: return; influenced by financial risk, interest rate risk, liquidity and taxability
Marketable Securities Alternatives
Treasury bills Banker’s acceptances Negotiable certificates of
deposit Commercial paper Repurchase agreements Money market mutual funds