Chapter 2. Concepts in Valuation.

To make itself as valuable as possible to shareholders, a firm must choose the best combination of decisions on investment, financing, and dividends. That is, a firm must determine the company's return-risk character and the firm's value in the eyes of suppliers of capital. Risk can be defined as the possibility that the actual return will deviate from that which was expected.

THE TIME VALUE OF MONEY.
$1 now is more valuable than $1 in the future.

Compound Interest and Terminal Values.
The term itself implies that interest paid on a loan or an investment is added to the principal. As a result, interest is earned on interest.

TV_n = X₀ (1+r)ⁿ
__________________________________________________
TV = Terminal value.
X₀ = Amount invested at the beginning.
r = Interest rate.

Compounding More Than Once a Year.
More compounding in a year results in a higher terminal value.

TV_n = X₀ (1+r/m)^m•n
__________________________________________________
m = Number of times interest is paid during the year.

Quarterly Compounding. See illustration (page 14).

Infinite compounding. m approaches infinity, so this is the formula:

TV_n = X₀ • e^r•n

PRESENT VALUE OF AN ANNUITY.
Present value is a future amount discounted to present by some required rate.

A_n = PV • (1+k)ⁿ
__________________________________________________
PV = Present value
A_n = Cash flow at the end of the year.
k = Annual interest rate (discount rate).

Beyond One Period.
In solving present-value problems, it is useful to express the interest factor separately from the amount to be received in the future. In such calculations, the interest rate is known as the discount rate, and henceforth, we will refer to it as such.

PV = A_n / (1+k)ⁿ

Present Value of an Annuity.
An annuity is an even series of future cash flows.

Relationship between PV and k. Value decreases as the required return increases, but at a decreasing rate.

Amortizing a Loan.
Amortization is the reduction of a loan’s principal amount through equal payments, which embrace both interest and principal.

Present Value When Interest Is Compounded More Than Once a Year.
More compounding in a year results in a lower present value.

PV = A_n / (1+k/m)^m•n
__________________________________________________
m = Number of times a year interest is compounded.

INTERNAL RATE OF RETURN OR YIELD.
Internal rate of return is the rate of discount which equates the present value of cash inflows with the present value of cash outflows.

See formula (page 21).

BOND RETURNS.
A bond calls for a stated amount of money to be paid to the investor either at a single future date, maturity, or at a series of future dates, including final maturity.

Pure Discount (Zero Coupon) Bonds.
A pure discount bond is one where the issuer promises to make a single payment at a specified future date. This single payment is the same as the face value of the instrument, usually expressed as $100.

Important:
The normal pricing convention is to use semiannual compounding

A bond’s price is the present value of future coupon payments and face value, discounted by the bond’s yield.

Bond yield is simply a bond’s internal rate of return.

Coupon Bonds.
Most bonds are not of a pure discount variety, but rather pay a semiannual interest payment along with a final principal payment of $100 at maturity. See formula (page 24).

Relationship between Price and Yield.
1. When a bond’s market price is less than its face value of $100 so that it sells at a discount, the yield to maturity exceeds the coupon rate.
2. When a bond sells at a premium, its yield to maturity is less than the coupon rate.
3. When the market price equals the face value, the yield to maturity equals the coupon rate.

Holding-Period Return. The yield to maturity may differ from the holding-period yield if the security is sold prior to maturity.

Chapter 16. Liability Management and Short/Medium-Term Financing.

For most companies, short- and medium-term financing is the principal means by which assets are funded.

LIABILITY STRUCTURE OF A COMPANY.
If perfect and complete financial markets existed, not only would capital structure be irrelevant, but so would be the maturity and other conditions of debt. One type of instrument would be as good as the next.

Imperfections and Incompleteness.
Liability management matters when there are imperfections and incomplete markets. With imperfections and/or incompleteness in financial markets, stockholders will benefit from the firm's "packaging" its debt instruments in a way that takes advantage of these circumstances.

The imperfections that most affect debt financing are flotation costs, bankruptcy costs, costs of information, and restrictions on lenders.

Permanent and Temporary Financing.
If the firm adopts a hedging approach to financing, each asset would be offset with a financing instrument of the same approximate maturity. A firm incurs short-term debt to finance short-term or seasonal variation in current assets; it uses long-term debt or equity to finance the permanent component of current assets.

Maturity of Debt.
Although an exact synchronization of the schedule of expected future net cash flows and the payment schedule of debt is appropriate under conditions of certainty, it usually is not appropriate under uncertainty. The margin of safety that should be built into the maturity schedule to allow for adverse fluctuations in cash flows will depend on the trade-off between risk and profitability.

Maturity: The Risks Involved.
In general, the shorter the maturity schedule of a firm's debt obligations, the greater the risk that it will be unable to meet principal and interest payments. Commiting funds to a long-term asset and borrowing short carries the risk that the firm may not be able to renew its borrowings.

In addition to this sort of risk, there is also the uncertainty associated with interest costs, which is higher for short-term debt. When financing with long-term debt, the company knows precisely what its interest costs will be over the time period it needs the funds.

A mitigating factor is the possible covariance of short-term interest costs with operating income. With covariance, when operating income is low, net income will benefit from the lower interest costs at that time.

Debt maturity involves a tradeoff between interest cost and the risk of a crisis at maturity.

Maturity: The Cost Trade-off.
Differences in risk between short- and long-term financing must be balanced against differences in interest costs. The longer the maturity schedule of a firm's debt, the more costly financing is likely to be.

In addition to higher expected costs of long-term borrowings, a company may pay interest on debt over periods of time when funds are not needed. Thus, there usually is an inducement to finance funds requiremetns on a short-term basis.

Consequently, we have the familiar trade-off between risk and profitability. The margin of safety, or lag between expected net cash flows and payments on debt, will depend on the risk preferences of management.

In testing corporate debt maturity, Stohs and Mauer find that average maturity is greater the larger the size of a company, the longer term the company's assets, and the greater the quality of the earnings (less risky).

Agency and Signaling Issues.
Debt maturity may be influenced by other thoretical considerations. For example, some companies have a disincentive to invest in certain profitable investment opportunities because such projects work more to the benefit of debt holders than of stockholders.

As in capital structure and dividend decisions, the maturity of the debt a company employs may have a signaling effect. If there is asymmetric information between investors and management, the latter will want to issue short-term debt if it believes the firm is undervalued. The reason is that once expectations are realized, the company will be able to refinance at more favorable rates.


TRADE CREDIT FINANCING.
In an advanced economy, most buyers are not required to pay for goods on delivery but are allowed a short deferment period before payment is due. During this period, the seller of the goods extends credit to the buyer.

Terms of Sale.
COD and CBD - No Extension of Credit. COD terms mean cash on delivery of the goods. The only risk the seller undertakes in this type of arrangement is that the buyer may refuse the shipment (and the seller will be stuck with the shipping costs).

Ocasionally, a seller might ask for cash before delivery (CBD) to avoid all risk. CBD terms must be distinguished from progress payments, where the buyer pays the manufacturer at various stages of production prior to actual delivery of the finished product.

Net Period - No Cash Discount. Net 30 (pay within 30 days) or net/15 EOM (goods shipped before the end of the month must by paid by the fifteenth of the following month.

Net Period with Cash Discount. The terms 2/10, net 30 indicate that the seller offers a 2 percent discount if the bill is paid within 10 days.

Datings. In seasonal business, sellers frequently use datings to encourage customers to place their orderss before a heavy selling period.

Trade Credit as a Means of Financing.
Trade credit is not a discretionary source of financing. It is entirely dependendt on the purchasing plans of the firm, which, in turn, are dependent on its productions cycle.

In examining credit as a discretionary form of financing, we want to consider situations in which (1) a firm does not take a cash discount but pays on the last day of the net period and (2) a firm pays its bills beyond the net period.

Payment on the Final Due Date.
If a cash discount is offered but not taken, there is a definite opportunity cost. If terms of sale are 2/10, net 30, the firm has the use of funds for an additional 20 days if it does not take the cash discount but pays on the final day of the net period.

The longer the time between the discount date and the time of payment, the lower the cost of discount forgone.

Stretching Accounts Payable.
Stretching accounts payable beyond the due date is a source of funds, but at the expense of supplier relations.

Advantages of Trade Credit.
The firm must balance the advantages of trade credit against the cost of forgoing a cash discount, the opportunity cost associated with possible deterioration in credit reputation if it stretches its payables, and the possible increase in selling price the seller imposes on the buyer.

Probably the major advantage of trade credit is its ready availability. There is no need to arrange financing formally; it is already there. If the firm is taking cash discounts, additional credit is readily available by not paying existing accounts payable until the end of the net period.

With other sources of short-term financing, there may be a lead time between the time the need for funds is recognized and the time the firm is able to borrow them. Trade credit is a more flexible means of financing. A supplier views an occasional delinquent payment with a far less critical eye than does a banker or other lender.

Who Bears the Cost.
Trade credit involves a cost for the use of funds over time. This use is not free. The burden may fall on the supplier, on the buyer, or on both parties.


ACCRUAL ACCOUNTS AS SPONTANEOUS FINANCING.
Perhaps even more than accounts payable, accrual accounts represent a spontaneous source of financing. The most common accrual accounts are for wages and taxes. For both accounts, the expense is incurred or accrued but not paid. Like accounts payable, accruals tend to expand with the scope of the operation.

Built-in Financing.
Built-in methods of financing include payables and accruals.

In a sense, accruals represent costless financing. Services are rendered for wage, but employees are not paid and do not expect to be paid until the end or after the end of the period.

Unfortunately for the company, they do not represent discretionary financing. For taxes, the government is the creditor, and it likes to be paid on time.

Accrued Wages and Pay Period Changes.
Accrued wages are partially discretionary in that a company can change the frequency of wage payments and thereby affect the amount of financing. The longer the pay period, the greater the amount of accrued wage financing. However, an increase in the pay period is usually a "one-shot" in that it is not possible to repeat with subsequent increase.


UNSECURED SHORT-TERM LOANS.
Almost without exception, finance companies do not offer unsecured loans, simply because a borrower who deserves unsecured credit can borrow at a lower cost from a commercial bank.

Short-term, unsecured bank loans typically are self-liquidating in that the assets purchased with the proceeds generate sufficient cash flows to pay off the loan eventually.

Line of Credit.
A line of credit is an arrangement between a bank and its customer, specifying the maximum amount of unsecured credit the bank will permit the firm to owe at any one time.

Some Conditions. The cash budget gives the best insight into the borrower's short-term credit needs. If maximum or peak borrowing need over the forthcoming year are estimated at $800,000, a company might seek a line of credit of $1 million to give it a margin of safety.

If the banks regard borrowing under lines of credit as seasonal or temporary financing, they me require the borrower to clean up (pay off) bank debt for a period of time during the year, as evidence that the loan is truly seasonal in nature.

Moral, Not Legal Obligation. If the creditworthiness of the borrower should deteriorate over the year, the bank may not want to extend credit and would not be required to do so. Under most circumstances, however, a bank feels morally bound to honor a line of credit.

Revolving Credit Agreement.
Revolvers are legal obligations of banks to provide credit, in contrast to lines of credit, which are a moral obligation.

For the privilege of having this formal commitment, the borrower usually is required to pay a commitment fee on the unused portion of the revolving credit.

Transaction Loans.
A contractor may borrow from a bank in order to complete a job. For this type of loan, a bank evaluates each request by the borrower as a separate transaction.

Interest Rates.
Most business loans are determined through personal negotiation between the borrower and the lender. One index used by banks for pricing business loans is the primer rate. This rate is set by large money market banks and tends to be uniform throughout the country.

Rates other than Prime. Despite the term prime rate implying the price a bank charges its most creditworthy customers, this has not been the recent practice. With banks becoming more competitive for corporate customers, a company may be able to borrow at a lower rate. The rate charged is based on the bank's marginal cost of funds, as typically reflected by LIBOR or the rate paid on money market certificates of deposit. An interest-rate margin is added to the cost of funds, and the sum becomes the rate charged the customer.

Other borrowers will pay either the prime rate or a rate above prime, the bank's pricing of the loan being relative to the prime rate.

Loan pricing for floating-rate loans can be off of the prime rate or off of LIBOR.

Methods of Computing Interest Rates.
There are three ways in which interest on a loan may be paid:
 On a collect basis. The interest is paid at the maturity of the note.
 On a discount basis. Interest is deducted from the initial loan.
 On an add-on basis. Interest is added to the funds disbursed in order to determine the face value of the note. Then installments are to be paid at the end of each period (e.g. monthly).


SECURED LENDING ARRANGEMENTS.
Many firms cannot obtain credit on an unsecured basis. With security, lenders have two sources of loan payment: the cash-flow ability of the firm to service the debt and, if the source fails for some reason, the collateral value of the security.

Some Theoretical Notions.
We know that secured lending arrangements are more costly to administer than unsecured loans and that the incremental cost is passed on to the borrower in the form of fees and higher interest costs than would otherwise be the case. This is because the market for loans is a competitive one, so if unsecured credit is available somewhere else at less total cost, one can be sure the borrower will go there to get it. Beyond a point in risk, however, all lenders in the market will want some type of safeguard in addition to the general credit standing of the company.

With secured loans, a company’s cash flows are segregated with respect to payments to creditors. This may reduce conflict between creditors and reduce monitoring, enforcement, and foreclosure costs, which, in turn, can work to the advantage of a company and its stockholders, at the expense of existing debt holders. The idea, then, is that a company plays one set of debt holders off against another, thereby extracting gain in the option pricing model context.

Collateral Value.
The excess of the market value of the security pledged over the amount of the loan determines the lender’s margin of safety. This way, secured loans involve percent advance against collateral value, the percent varying with marketability and price volatility.

Uniform Commercial Code. A lender who requires collateral of a borrower obtains a security interest in the collateral. The collateral may be accounts receivable, inventory, equipment, or other assets of the borrower. The security interest in the collateral is created by a security agreement, also known as a security device.

Assignment of Accounts Receivable.
Accounts receivable are one of the most liquid assets of the firm; consequently, the make desirable security for a loan. From the standpoint of the lender, the major difficulties with this type of security are the cost of processing the collateral and the risk of fraud.

Quality and Size of Receivables.With an accounts receivable loan, the lender has a lien on the collateral.

In evaluating the loan request, the lender will analyze the quality of the firm’s receivables to determine how much to lend against them.

The lender is also concerned with the size of the receivables. The smaller the average size of accounts, the more it costs per dollar of loan to process them.

Procedure. A receivable loan can be either a nonnotification or a notification basis. Under a nonnotification arrangement, customers of the firm are not notified that their accounts have been pledged to the lender.

With notification arrangement, the account is notified of the assignment, and remittances are made directly to the lender.

Advantages of the Lending Agreement.
An accounts receivable loan is a more or less continuous financing agreement. New receivables replace the old, and the security base and the amount of loan fluctuate accordingly. Also, a “cleanup” of the loans is not required, because it is regarded as a more or less permanent source of financing.

Factoring receivables.
Factoring involves the sale of receivables to a factor. By factoring, a firm frequently relieves itself of the expense of maintaining a credit department and making collections. Any account that the factor is unwilling to buy is an unacceptable credit risk unless, of course, the firm want to assume this risk on its own and ship the goods.

Factoring Costs. For bearing risk and servicing the receivables, the factor receives a commission, typically 1 to 3 percent of the face value of the receivables. A firm may wish to receive payment for the sale of its receivables before they are collected, so for advancing payment the factor requires additional compensation.

Flexibility. The typical factoring agreement is continuous. Though factoring appears to be expensive, one must remember that the factor relieves the company of credit checks, of the cost of processing receivables, and of collection of expenses. Factoring also has the advantage of economies of scale, lowering costs and having more extensive credit information.

Inventory Loans.
Inventory loans can be made against inventory in general or against specific inventory.

Lenders determine the percentage that they are willing to advance by considering marketability, perishability, market price stability, and the difficulty and expense of selling the inventory to satisfy the loan.

Floating Lien. The borrower may pledge inventories “in general” without specifying the kind of inventory involved.

Chattel Mortgage. With a chattel mortgage, inventories are identified by serial number of by some other means. This inventory cannot be sold unless the lender consents. Chattel mortgages are well suited for certain capital assets, such as machine tools.

Trust Receipt Loans. Under a trust receipt financing arrangement, the borrower holds in trust for the lender the inventory and the proceeds from its sale. Trust receipt loans sometimees are known as floor planning. Inventory in trust, unlike inventory under a floating lien, is specifically identified by serial number or by other means.

Terminal Warehouse Receipt Loans. A borrower secures a terminal warehouse receipt loan by storing inventory with a public, or terminal, warehousing company. Warehouse receipts may be either nonnegotiable (the lender has the sole authority to release them) or negotiable (useful when transferring the title of the goods from one party to another).

Field Warehouse Receipt Loans. Field warehousing secures the inventory loan on property. A field warehousing company sets off a designated storage area for the inventory pledged as collateral.


INTERMEDIATE-TERM DEBT.
Typically, intermediate-term financing is self-liquidating and in that way resembles short-term financing. However, it also can satisfy more permanent funds requirements and, in addition, it can serve as an interim substitute for long-term financing.

Term Loans.
A bank or insurance company term loan is a business loan with a final maturity of more than 1 year, repayable according to a specified schedule. Sometimes the loan is amortized in equal periodic installments except for the final payment, known as a “balloon” payment, which is larger than any of the others.

Term loans can be fixed rate or floating rate.

The advantage of a term loan is flexibility. The borrower deals directly with the bank or insurance company, and then the loan can be tailored to the borrower’s needs through direct negotiation. The disadvantage? Usually, a higher interest cost than could be obtained with a public issue.

Equipment Financing.
Equipment varies in its desirability as collateral for a loan.

Sources of Equipment Financing. Commercial banks, finance companies, and the sellers of equipment are among the sources of equipment financing. Equipment loans may be secured either by a chattel mortgage or by a conditional sales contract arrangement.

Chattel Mortgage. A chattel mortgage is a lien on property other than real estate.

Conditional Sales Contract. With a conditional sales contract arrangement, the seller of the equipment retains title to it until the purchaser has satisfied all the terms of contract.

Medium-Term Notes.
Unlike loans arranged with a financial institution, medium-term notes (MTNs) are sold to investors through an investment banks. For some companies, MTNs are a major funding device.

Medium-term notes are a financing vehicle only for larger, creditworthy companies.


PROTECTIVE COVENANTS AND LOAN AGREEMENTS.
The provisions for protection contained in a loan agreement (in case the borrower’s financial condition deteriorates) are known as protective covenants.

Remedies under Default.
Protective covenants allow the lender to control the situation if any are breached.

The important protective provisions of a loan agreement may be classified as follows:
(1) general provisions used in most loan agreements, which are variable to fit the situation;
(2) routine provisions used in most agreements, which usually are not variable; and
(3) specific provisions that are used according to the situation.

Restrictions are designed to safeguard the liquidity of the borrower

General Provisions.
Working Capital. Its purpose is to preserver the company’s current position and ability to pay the loan.

Dividends/Share Repurchase. Its purpose is to limit cash going outside the business, thus preserving the liquidity of the company.

Capital Expenditures. This is another tool the lender uses to ensure the maintenance of the borrower’s current position.

Other Debt. This provision protects the lender, inasmuch as it prevents future lenders from obtaining a prior claim on the borrower’s assets.

Routine Provisions.
 Furnish the bank with financial statements.
 Maintain adequate insurance.
 The borrower must not sell a significant portion of its assets.
 Pay all taxes and other liabilities.
 A provision forbidding the pledging or mortgaging of any of the borrower’s assets (negative pledge cause).
 The company is required not to discount or sell its receivables.
 The borrower is prohibited from entering into any leasing arrangement of property.
 There is a restriction on the acquisition of other companies.

Special Provisions.
The bank uses special provisions to achieve a desired total protection of its loan.

For example, it may require that the company carries life insurance on executives that are essential to the firm’s operation. Aggregate executive salaries and bonuses are sometimes limited. Finally, an agreement may also contain a management clause under which certain key individuals must remain actively employed.

Negotiating Restrictions and the Option Pricing Theory.
Option pricing can be used to model protective-covenant determination.

The OPT Setting. The application of the option pricing theory visualizes the debt holder-equity holder relationship as being essentially an option arrangement.

Debt holders receive the lesser of the contractual amount of the debt obligation (D) or the value of the firm (V) if this obligation cannot be entirely paid.

Equity holders are the residual owners of the company and are entitled to any value of the firm that remains after the debt has been paid, V-D. In this sense, the equity holders have an option to the total value of the firm at time T. If V is less than D, the option is worth zero. The greater the variance of the distribution of possible values of the firm at time T, the greater the value of the option, all other things the same.

Equity Holder Motivation. In the context of our example, it behooves the equity holders to increase the risk of the firm to increase the variance of its total value.

Lender Restraint. Increasing the risk is done at the expense of the option writer, the debt holders. Therefore protective covenants are put in place to safeguard against these occurrences before making the loan.

There are monitoring costs associated with the writing of protective covenants and with their enforcement. There are trade-off between the increase of safeguards and costs, so the final position will be a compromise between the borrower and the lender, one that is influenced by relative conditions in the financial markets and by the costs of monitoring.

Chapter 15. Management of Accounts Receivable and Inventories.

For most companies, accounts receivable and inventories are very important investments, often dominating fixed-asset investments. With the concern for return on assets expressed by many companies in recent years, there has come ever-increasing focus on the funds committed to receivables and inventories.

CREDIT POLICIES.
Economic conditions and the firm's credit policies are the chief influences on the level of a firm's account receivable.

Credit policy embraces terms of sale and quality standards for acceptance.

Credit Standards.
Credit policy can have a significant influence on sales. In theory, the firm should lower its quality standard for accounts accepted as long as the profitability of sales generated exceeds the added costs of the receivables.

The longer the credit period, the more funds that are tied up in receivables.

Credit Period.
Credit terms involve both the length of the credit period and the discount given. The term "2/10, net 30" means that a 2 percent discount is given if the bill is paid before the tenth day after the date of invoice; payment is due by the thirtieth day.

Discount Given.
Varying the discount given involves an attempt to speed up the payment of receivables. To be sure, the discount also may have an effect on demand and bad-debt losses. Holding constant these factors, we must determine whether a speedup in collections would more than offset the cost of an increase in the discount.

Seasonal Datings.
During periods of slack sales, firms will sometimes sell to customers withouth requiring payment for some time to come.

Datings can also be used to avoid inventory carrying costs. If sales are seasonal and production is steady throughout the year, there will be buildups in finished goods inventory during certaint times of the year.

Default Risk.
In the foregoing examples, we assumed no bad-debt losses. Our concern in this section is not only the slowness of collection but also the portion of the receivables defaulting.


COLLECTION POLICY.
The firm determines its overall collection policy by the combination of collection procedures it undertakes. These procedures include telephoning the customer, sending a letter, resending the invoice, sometimes paying a person a visit, and legal action.

The Trade-off.
If sales are independent of the collection effort, the appropriate level of collection expenditure again involves a trade-off with the reduction in the cost of bad-debt losses and reduction in receivables on the other.

Collection efforts provide diminishing returns beyond some point.

Other Considerations.
In most cases, sales are likely to be affected adversely if the collection efforts of the firm become too intense and customers become increasingly irritated.

Summary of Credit and Collection Policies.
We see that the credit and collection policies of a firm involve several decisions:
(1) the quality of the account accepted,
(2) the credit period,
(3) the cash discount given,
(4) any special terms such as seasonal datings, and
(5) the level of collection expenditures.

In each case, the decision should involve a comparison of possible gains from a change in policy and the cost of change.

Effects of Changing Credit Standards. For most policy variables, profits increase at a decreasing rate up to a point and then decrease as the policy is varied from no effort to an extreme effort.


EVALUATING THE CREDIT APPLICANT.
Having established the terms of sale to be offered, the firm must evaluate individual credit applicants and consider the possibilities of a bad debt or slow payment.

Sources of Information.
A number of sources supply credit information, but for some accounts, especially small ones, the cost of collecting it may outweigh the potential profitability of the account. The firm extending credit may have to be satisfied with a limited amount of information on which to base a decision.

The credit analyst may use one or more of the following sources of information:
* Financial Statement.
* Credit Ratings and Reports.
* Bank Checking.
* Trade Checking.
* The Company's Own Experience.

Credit Analysis.
Having collected credit information, a company must make a credit analysis of the applicant and determine if the company falls above or below the minimum quality standard.

In addition to analyzing financial statements, the credit analyst will consider the character and strength of the company and its management, the business risk associated with its operation, and various other matters.

Credit Scoring. Discriminant analysis, a statistical technique, is used to determine a credit score for a credit applicant.

Sequential Investigation Process. The amount of information collected should be determined in relation to the expected profit from an order and the cost of investigation. More sophisticated analysis should be undertaken only when there is a chance that a credit decision based on the previous stage of investigation will be changed.

The value of more information must be balanced against its cost.

The Credit Decision.
Once the credit analyst has marshaled the necessary evidence and has analyzed it, a decision must be reached on the disposition of the acount.

In an initial sale, the first decision to be made is whether or not to ship the goods and extend credit. If repeat sales are likely, the company will probably want to establish procedures so that it does not have to evaluate the extension of credit each time an order is received (for example, establish a line of credit for an account).

Outsourcing Credit and Collections.
The entire credit/collection function can be outsourced. As with the outsourcing of any business function, it is a question of core competence.


INVENTORY MANAGEMENT AND CONTROL.
Inventories form a link between production and sale of a product. A manufacturing company must maintain certain amount of inventory during production, the inventory known as work in process (WIP).

Benefits versus Costs.
Although other types of inventory -namely, raw materials and finished goods- are not necessary in the strictest sense, they allow the company to be flexible. Raw materials inventory gives the firm flexibility in its purchasing. Finished goods inventory allows the firm flexibility in its production scheduling an in its marketing.

The obvious disadvantages are the total cost of holding the inventory, and the required return on capital tied up in inventory. An additional disadvantage is the danger of obsolescence.

Economic Order Quantity.
The economic order quantity (EOQ) is an important concept in the purchase of raw materials and in the storage of finished goods and in-transit inventories. In our analysis, we wish to determine the optimal order quantity for a particular item of inventory, given its forecasted usage, ordering cost (O), and carrying cost (C).

Total Costs = Carrying costs + Ordering costs
T = CQ/2 + SO/Q

EOQ: The Famous Formula.
To determine the optimal order quantity, Q*, we differentiate the equation above with respect to Q and the set the derivative equal to zero.

Q* = Sq.Rt.(2SO/C)

EOQ balances fixed ordering costs against variable carrying costs.


UNCERTAINTY AND SAFETY STOCK.
Typically, the demand for finished goods inventory is subject to the greatest uncertainty. In general, the use of raw materials inventory and in-transit inventory, both of which depend on the production scheduling, is more predictable.

Order Point and Safety Stock.
When we allow for uncertainty in demand for inventory as well as in lead time, a safety stock becomes advisable. The order point determines the amount of safety stock held. Safety stock is important in absorbing random fluctuations in usage and in lead times.

The Amount of Safety Stock.
The proper amount of safety stock to maintain depends on several things:
* The uncertainty associated with the forecasted demand for inventory.
* The uncertainty of lead time to replenish stock.
* The cost of running out of inventory.
* The cost of carrying additional inventory is crucial. If it were not for this cost, a firm could maintain whatever stock was necessary.

Just-in-Time Inventory Control and the Internet.
Just-in-time (JIT) inventory control implies the idea that inventories are acquired and inserted in production at the exact times they are needed. This requires efficient purchasing, very reliable suppliers, and an efficient inventory-handling system. The coordination of various suppliers in an efficient manner is known as supply chain management.

For standard inventory items, the use of Internet has greatly facilitated supply chain managmente. A number of exchanges have developed for business-to-business (B2B) types of transactions.


INVENTORY AND THE FINANCIAL MANAGER.
A financial manager's concern is with inventory turns and monies tied up in inventories.

Monitoring Amounts Tied Up in Inventories.
It is very important for the financial manager to watch the inventory turnover ratio. A deteriorating trend over time (decreasing inventory turns from one period to the next) should set off an alarm. More and more funds are being tied up in inventory.

Also, a deteriorating turnover ratio may indicate obsolescence problems in addition to the cost of carrying inventories.

Watching Inventory Risks.
The major risk is that the market value of specific inventories will be less than the value at which they were acquired. Certain types of inventory are subjecto to obsolescence, whether it be in technology or in consumer tastes. Other inventories, such as agricultural products, are subject to physical deterioration. In other situations, the principal risk is that of fluctuations in market price.

___________________________________________________
EJERCICIOS - Serie 3 - Capítulo 15

Chapter 14. Liquidity, Cash, and Marketable Securities.

So far, we have endeavored to understand the valuation of a company under varying assumptions as to the perfection of capital markets. In this part, we shift our focus form property, plant and equipment, and long-term financing to current assets and to short- and intermediate-term financing.

LIQUIDITY AND ITS ROLE.
The term liquid assets is used to describe money and assets that are readily convertible into money. Liquidity has two dimensions:
(1) the time necessary to convert the asset into money and
(2) the degree of certainty associate with the conversion ratio, or price, realized for the asset.

Liquidity When Perfect Capital Markets Exist.
Perfect markets imply liquidity is not a thing of value. Investors can produce homemade liquidity by either selling assets, by running the company themselves, or by effecting a costless reorganization.

Liquidity Management with Imperfections.
There are two dimensions of bankruptcy costs. The first is the "short-fall", arising from the liquidation of assets at "distress" prices. The second is the out-of-pocket fees paid to lawyers, trustees in bankruptcy, referees, receivers, liquidators, and so forth.

Another imperfection has to do with contracting costs of managers, workers, suppliers, and customers, as they may require additional incentive the riskier the firm.

Therefore, by increasing liquidity you reduce the probabilities of bankruptcy or of higher risks that reflect into costs.

Benefits Relative to Cost.
Liquid assets, like all other assets, have to be financed. Accordingly, the cost of liquidity may be thought as the differential in interest earned on the investment of funds in liquid assets and the cost of financing. The optimal level of liquidity then could be determined by marginal analysis.


CASH MANAGEMENT AND COLLECTIONS.
The cash cycle begins with the payment for purchases and services and ends with the collection of receivables.

Firms will want to reduce float (the time during which payments received by the firm remain uncollected funds) as much as possible.

Transferring funds.
Increasing cash availability also involves moving funds among banks. There are two principal methods:
(1) wire transfers and
(2) electronic depository transfer check (processed through an automatic clearing house.

Concentration Banking.
Concentration banking is a means of accelerating the flow of funds of a firm by establishing strategic collection centers, so that mailing time of payments is reduced.

Lockbox System.
The purpose of a lockbox arrangement is to eliminate the time between the receipt of remittances by the company and their deposit in the bank.

Customers are billed with instructions to mail their remittances to the lockbox. The bank picks up the mail several times a day and deposits the checks in the company's account.

Preauthorized Checks.
A preauthorized check (PAC) arrangement is sometimes used to reduce mailing and processing time. It works well for certain large customers where payments of a fixed amount are required.


CONTROL OF DISBURSEMENTS.
Accelerating collections and slowing disbursements shorten the cash cycle and result in more usable funds.

Mobilizing Funds and Slowing Disbursements.
A company with multiple banks should be able to shift funds quickly to banks from which disbursements are made, to prevent excessive balances from building up temporarily in a particular bank.

A means for delaying disbursements is through the use of payable-through drafts, which are not payable on demand (the bank must present it to the issuer for acceptance).

By maximizing disbursement float, the firm can reduce the amount of cash it holds and employ these funds in more profitable ways. One firm's gain, however, is another firm's loss and supplier relations may be hurt.

Zero balance account.
To make transfers automatically into a payroll, dividend, or other special account, some companies employ a zero balance account (ZBA). In this case, one master disbursing account services all subsidiary accounts. At the end of each day, the bank automatically transfers just enough funds to cover the checks presented for collection. As a result, a zero balance is mantained in each of the special disbursing accounts.

Payroll and Dividend Disbursements.
Many companies mantain a separate account for payroll disbursements. Based on its experience, the firm should be able to construct a distribution of when, on average, checks are presented for collection to minimize the cash balance in the account.

Electronic Funds Transfers.
Accelerating collections and slowing disbursements increasingly are being done electronically. In addition to paying bills, electronic funds transfers (EFTs) can be used to deposit payrolls automatically in employee accounts, to pay taxes, and to make dividend and other payments.

Because of lack of size or efficiency, some companies outsource their payable operation to firms that focus their core competencies in finance, including electronics funds transfers.


INVESTMENT IN MARKETABLE SECURITIES.
The financial manager will want to invest the portion of liquid assets in excess of transactions cash needs. Marketable securities serve the liquidity needs of the firm.

Yields on marketable securities vary with differences in default risk, in marketability, in length of time to maturity, in coupon rate, and in taxability.

For accounting purposes marketable securities and time deposits are shown as "cash deposits" on the balance sheets if their original maturity is 3 months or less. Other marketable securities are shown as "short-term investments", assuming their maturity is less than 1 year.

Credit Risk.
Investors are said to demand a risk premium to invest in other than default-free securities (Treasury securities). Creditworthiness is frequently judge on the basis of security ratings.

Marketability.
Marketability of a security relates to the ability of the owner to convert it into cash. There are two dimensions interrelated: the price realized and the amount of time required to sell the asset (the cheaper, the faster it will sell).

Maturity.
Credit risk and maturity are the two most important features when it comes to investment.

In general, the longer the maturity, the greater the risk of fluctuation in the market value of the security.

Coupon Rate.
For a given fixed-income security, the lower the coupon rate, the greater the price change for a given shift in interest rates (as more of the total return to the investor is reflected in the principal payment at maturity).

Taxability.
Only interest income from state and local government securities is tax exempt; as a result, they sell in the market at lower yields to maturity than other securities. Under present law, capital gains arising from the sale of a security at a profit are taxed at the full corporate tax rate.

Types of Marketable Securities.
Money markets include instruments of shorter maturity, which are liquid.

Treasury securities. The principal securities issued are bills, tax anticipation bills, notes, and bonds.

Repurchase Agreements. The repurchase agreement, or repo, is the sale of short-term securities by the dealer to the investor, whereby the dealer agrees to repurchase the securities at a specified future time.

Agency Securities. Obligations of various agencies of the federal government are guaranteed by the agency issuing the security, but not by the U.S. government as such.

Bankers' Acceptances. Bankers' acceptances are drafts that are accepted by banks, and they are used in financing foreign and domestic trade. The creditworthiness of bankers' acceptances is judged by the bank accepting the draft, not the drawer.

Commercial Paper. Commercial paper consists of short-term unsecured promisory notes issued by finance companies and certain industrial concerns. Commercial paper can be sold either directly or through dealers.

Certificates of Deposit. A short-term investment, the certificate of deposit (CD) is evidence of the deposit of funds at a commercial bank for a specified period of time and at a specified rate of interest.

Eurodollars. Although most Eurodollars are deposited in Europe, the term applies to any dollar deposit in foreign banks or in foreign branches of U.S. banks.

Short-Term Municipals. State and local governments are increasingly providing securities tailored to the short-term investor. One is commercial paper type of instrument, where the interest rate is reset every week.

Floating-Rate Preferred Stock. Straight preferred stock is a perpetual security where the dividend can be omitted by the issuer when its financial condition deteriorates. For these reasons, we usually do not think of it as being suitable for the marketable security portfolio of a corporation. However, the corporate investor gains a considerable tax advantage, in that 70 percent of the preferred stock dividend is exempt from federal taxation.

Floating-rate preferred stock, as the name implies, provides a yield that goes up or down with money market rates.

One product in this vein is money market preferred stock (MMP). With MMP, an auction is held every 49 days. This provides the investor with liquidity and relative price stability as far as interest-rate risk goes.

Portfolio Management.
The decision to invest excess cash in marketable securities involves not only the amount to invest but also the type of security in which to invest.

If future cash-flow patterns are known with reasonable certainty and the yield curve is upward sloping in the sense of longer-term securities yielding longer-term securities yielding more than shorter-term ones, a company may wish to arrange its portfolio so that securities will mature approximately when the funds will be needed.

If the yield curve is downward sloping, the company may wish to invest in securities having maturities shorter than the intended holding period, then to reinvest at maturity.

___________________________________________________
EJERCICIOS - Serie 2 - Capítulo 14