Part VII Short Term Financial Planning and Management

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Part VII Short Term Financial Planning and Management Prepared by: Thomas J. Cottrell Modified

Part VII Short Term Financial Planning and Management Prepared by: Thomas J. Cottrell Modified by: Carlos Vecino HEC-Montreal Chapter 18 Short-Term Finance and Planning Chapter 19 Cash and Liquidity Management Chapter 20 Credit and Inventory Management FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 1

Managers Who Deal with Short-Term Financial Problems (Table 18. 1) Duties related to short-term

Managers Who Deal with Short-Term Financial Problems (Table 18. 1) Duties related to short-term Title of manager financial management Assets/liabilities influenced Cash manager Collection, concentration, disbursement; Cash, marketable investments; short-term borrowing; securities, short-term loans banking relations Credit manager Monitoring and control of accounts receivable; credit policy decisions Marketing manager Credit policy decisions short-term Accounts receivable Purchasing manager Decisions on purchases, suppliers; may negotiate payment terms Inventory, accounts payable Production manager Setting of production schedules and materials requirements Inventory, accounts payable Payables manager Decisions on payment policies and on whether to take discounts Accounts payable Controller Accounting information on cash flows; accounts payable; application accounts payable of payments to accounts receivable Accounts receivable, reconciliation of Source: Ned C. Hill and William L. Sartoris, Short-Term Financial Management, 2 nd ed. (New York: Macmillan, 1992), p. 15. FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 2

Survey: The Importance of Short-Term Finance and Planning Long-term investment decisions (capital budgeting) and

Survey: The Importance of Short-Term Finance and Planning Long-term investment decisions (capital budgeting) and long-term financing decisions are characterized by the facts that they (a) generally involve large amounts of money, and (b) are relatively infrequent occurrences. Decisions that come under the heading “short-term finance” are equally important, because, while typical decisions often don’t involve as much money, decisions are much more frequent. This is suggested in the results of a recent survey of CFOs. Activity Financial Planning Working Capital Mgmt. Capital Budgeting Long-Term Financing Total Ranked Greatest Importance 59% 27% Average Time Allocated 35% 32% 9% 5% 19% 14% 100% FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 3

Cash Flow Time Line (Figure 18. 1) Operating and Cash cycles FINANCIAL ANALYSIS AND

Cash Flow Time Line (Figure 18. 1) Operating and Cash cycles FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 4

Hermetic, Inc. , Operating Cycle n The operating cycle a) Inventory turnover = times

Hermetic, Inc. , Operating Cycle n The operating cycle a) Inventory turnover = times Finding the inventory period COGS = $480 = 1. 362 Avg. inventory $352. 5 Inventory period = 365 = 268 days 1. 362 times FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 5

Hermetic, Inc. , Operating Cycle (concluded) b) Finding the accounts receivable period Credit sales

Hermetic, Inc. , Operating Cycle (concluded) b) Finding the accounts receivable period Credit sales Receivables turnover = Avg. receivables 365 Receivables period = 2. 491 times $710 = $285 = 2. 491 times = 147 days Operating cycle = Inventory period + Receivables period = 268 + 147 = 415 days FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 6

Hermetic, Inc. , Cash Cycle n The cash cycle a) Finding the payables turnover

Hermetic, Inc. , Cash Cycle n The cash cycle a) Finding the payables turnover COGS Payables turnover = = $480 $235 Avg. payables = 2. 043 times Payables period = 365 2. 043 times = 179 days Cash cycle = Operating cycle - Payables period = 415 - 179 = 236 days FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 7

The Size of the Firm’s Investment in Current Assets n The size of the

The Size of the Firm’s Investment in Current Assets n The size of the firm’s investment in current assets is determined by its short-term financial policies. n Flexible policy actions include: u Keeping large cash and securities balances u Keeping large amounts of inventory u Granting liberal credit terms n Restrictive policy actions include: u Keeping low cash and securities balances u Keeping small amounts of inventory u Allowing few or no credit sales Is it better Flexible or Restrictive ? FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 8

Cost of holding current assets n Carrying cost (costs that rise with the amount

Cost of holding current assets n Carrying cost (costs that rise with the amount held in assets) Financial cost, storage cost and other costs of holding current assets. n Shortage cost (cost that decrease with the amount held in assets) Cost of not having current assets available on-hand, or having to get them rapidly. The optimal choice of holding current assets is a trade-off of: u Carrying costs versus Shortage costs: FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 9

Total Cost of holding current assets (Cash, receivables and inventory) Cost ($) Total holding

Total Cost of holding current assets (Cash, receivables and inventory) Cost ($) Total holding cost Carrying cost Shortage cost Amount of assets FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 10

Carrying Costs and Shortage Costs (Figure 18. 2) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals

Carrying Costs and Shortage Costs (Figure 18. 2) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 11

Carrying Costs and Shortage Costs (Figure 18. 2) When is a “Flexible policy” appropriate?

Carrying Costs and Shortage Costs (Figure 18. 2) When is a “Flexible policy” appropriate? FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 12

Carrying Costs and Shortage Costs (Figure 18. 2) When is a “Restrictive policy” appropriate?

Carrying Costs and Shortage Costs (Figure 18. 2) When is a “Restrictive policy” appropriate? FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 13

Financing Policy for an “Ideal” Economy (Figure 18. 3) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL)

Financing Policy for an “Ideal” Economy (Figure 18. 3) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 14

Alternative Asset Financing Policies (Figure 18. 5) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of

Alternative Asset Financing Policies (Figure 18. 5) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 15

A Compromise Financing Policy (Figure 18. 6) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of

A Compromise Financing Policy (Figure 18. 6) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 16

A Closer look to Cash, Credit and Inventory n Cash policy u What is

A Closer look to Cash, Credit and Inventory n Cash policy u What is the tradeoff between carrying a large versus a small cash balance? u What is the proper management of the cash balance? n Credit policy u What is the tradeoff between a flexible versus a restrictive credit policy? u Analysis of a credit policy change u Credit information and evaluation of customer credit capacity n Inventory policy u What are the components of an inventory management system? u Use of EOQ inventory model u Inventory management systems FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 17

A Closer look to Cash, Credit and Inventory ØCash Policy n Credit Policy n

A Closer look to Cash, Credit and Inventory ØCash Policy n Credit Policy n Inventory Policy FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 18

Reasons for Holding Cash n Speculative Motive - the need to hold cash to

Reasons for Holding Cash n Speculative Motive - the need to hold cash to take advantage of additional investment opportunities, such as bargain purchases. n Precautionary Motive - the need to hold cash as a safety margin to act as a financial reserve. n Transaction Motive - the need to hold cash to satisfy normal disbursement and collection activities associated with a firm’s ongoing operations. n Compensating Balance Requirements - cash balances kept at commercial banks to compensate for banking services the firm receives. FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 19

Determining the Target Cash Balance n Optimal choice of cash balance is a trade-off

Determining the Target Cash Balance n Optimal choice of cash balance is a trade-off of u Carrying costs: Opportunity costs of holding cash instead of some other income-producing asset. versus u Shortage costs: Cost of not having cash available on-hand, or having to rapidly get the cash. n Other factors influencing the target cash balance u Ability to borrow rather than marketable securities u Scale economies in cash management - large firm advantage. FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 20

Determining the Target Cash Balance (Figure 19. 1) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals

Determining the Target Cash Balance (Figure 19. 1) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 21

Cash Balances - The Baumol-Allais-Tobin BAT Model Starting (C) Average (C/2) Ending=0 Minimum cash

Cash Balances - The Baumol-Allais-Tobin BAT Model Starting (C) Average (C/2) Ending=0 Minimum cash allowed Time in days, weeks, etc. 2 4 FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 22

Cost minimization model We seek to find the minimum cost of meeting the short-term

Cost minimization model We seek to find the minimum cost of meeting the short-term cash needs n F = Fixed cost of selling securities to replenish cash n T = Total amount of new cash needed for transactions purposes over the relevant planning period (e. g. over a year) n R = Opportunity cost of holding cash (e. g. the interest rate on marketable securities) Total Cost = Total Opportunity cost + Total Trading cost Total Opportunity cost = (Average balance) (R) = (C/2)(R) Total Trading cost = (T/C) (F) Total Cost = (C/2)(R) + (T/C) (F) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 23

Optimal Solution n Differentiate the Total Cost with respect to the cash balance to

Optimal Solution n Differentiate the Total Cost with respect to the cash balance to find the. . . Optimal Cash Balance, when d. TC/d. C = R/2 + (-1)TF/C 2 = 0 FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 24

Example 19 A. 1 (pp 663 -664) Vulcan corp. has outflows of $100 per

Example 19 A. 1 (pp 663 -664) Vulcan corp. has outflows of $100 per day, seven days a week R= 5%, F=$10 per transaction C* = ? Total Cost = ? n T = Total Cash needed per year = 365 * $100 = $36, 500 n Optimal Balance (C*) u C = SQRT(2 TF/R) = SQRT(2 * $36, 500 * $10 / 0. 05) = $3, 821 Optimal Balance (C*) =$3, 821 u Average Cash Balance = $ 1, 911 u n Total cost u u u Opportunity Costs = C/2*R= $1, 911 (0. 05) = $96 The re-supply time is $3, 821/$100 per day = 38. 21 days Number of re-supplies per year = 365 / 38. 21 = 9. 6 times Total Trading Costs = 9. 6 ($10) = $96 Total Cost = Opportunity cost + Trading cost = $96 + $96 Total Cost = $192 FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 25

The Cash Budget Objective: Identification of short term financial needs, cash surpluses or deficits.

The Cash Budget Objective: Identification of short term financial needs, cash surpluses or deficits. n Main source of cash : Sales and Cash Collections n Other sources of cash: Asset sales, investment income, loans, increase in equity, etc. n Main Cash Outflows : u Payments of accounts payable u Wages, Utilities and other expenses u Taxes u Capital expenditures – Fixed assets acquisitions u Debt services and principal payments FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 26

Example: Cash Budget for Ajax Company n All sales on credit n Dec. sales

Example: Cash Budget for Ajax Company n All sales on credit n Dec. sales were $95, 000 ; Expected Jan 55, 000 Feb & March 65, 000 n December 31 receivables were $135, 000 n Accounts receivable period is 45 days (50% - 30 days, 50% - 60 days) n Wages, taxes, and other expenses are 30% of sales n Raw materials are ordered two months in advance of sales n Raw materials are 50% of sales n All purchases on trade credit n An annual dividend of $100, 000 is expected to be paid in March n No capital expenditures are planned for the first quarter n The beginning cash balance is $41, 000 n The minimum cash balance is $25, 000 FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 27

Example: Cash Budget for Ajax Company (continued) n Cash collections for Ajax (all figures

Example: Cash Budget for Ajax Company (continued) n Cash collections for Ajax (all figures rounded to the nearest dollar) JAN FEB MAR Beginning receivables $135, 000 Sales $102, 500 $ 92, 500 55, 000 65, 000 Cash collections 87, 500 75, 000 60, 000 Ending receivables $102, 500 $ 97, 500 FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 28

Example: Cash Budget for Ajax Company (continued) n Cash disbursements for Ajax JAN FEB

Example: Cash Budget for Ajax Company (continued) n Cash disbursements for Ajax JAN FEB MAR Payment of accounts (50% of next month’s sales) $30, 000 $ 32, 500 Wages, taxes, and other 16, 500 19, 500 Capital expenditures 0 0 Long-term financing expenses 0 0 Total 0 $ 49, 000 $52, 000 $32, 500 100, 000 $149, 500 FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 29

Example: Cash Budget for Ajax Company (continued) n Net cash inflow for Ajax JAN

Example: Cash Budget for Ajax Company (continued) n Net cash inflow for Ajax JAN FEB Total cash collections MAR $ 87, 500 $ 75, 000 $ 60, 000 Total cash disbursements 49, 000 52, 000 149, 500 Net cash inflow $ 38, 500 $23, 000 -$ 89, 500 FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 30

Example: Cash Budget for Ajax Company (concluded) n Cash balance for Ajax JAN FEB

Example: Cash Budget for Ajax Company (concluded) n Cash balance for Ajax JAN FEB MAR Beginning cash balance $102, 500 $ 41, 000 $79, 500 Net cash inflow 38, 500 23, 000 -89, 500 Ending cash balance $ 79, 500 Minimum cash balance - 25, 000 Cumulative surplus (deficit) 12, 000 $102, 500 $ 13, 000 - 25, 000 $ 54, 500 $ 77, 500 -$ FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 31

A Closer look to Cash, Credit and Inventory ü Credit Policy ØCredit Policy n

A Closer look to Cash, Credit and Inventory ü Credit Policy ØCredit Policy n Inventory Policy FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 32

Components of Credit Policy n Terms of sale The conditions under which a firm

Components of Credit Policy n Terms of sale The conditions under which a firm sells its goods and services for cash or credit. n Credit analysis The process of determining the probability that customers will not pay. n Collection policy Procedures followed by a firm in collecting accounts receivable. FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 33

The Cash Flows from Granting Credit sale is made Customer mails check Firm deposits

The Cash Flows from Granting Credit sale is made Customer mails check Firm deposits check in bank Bank credits firm’s account Time Cash collection Accounts receivable FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 34

Determinants of the Length of the Credit Period n Several factors influence the length

Determinants of the Length of the Credit Period n Several factors influence the length of the credit cycle. Among these factors are: u u u u Perishability and collateral value Consumer demand for the product Cost, profitability and standardization Credit risk of the buyer The size of the account Competition in the product market Customer type FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 35

Credit Policy Effects n Revenue effects Payment is received later, but price and quantity

Credit Policy Effects n Revenue effects Payment is received later, but price and quantity sold may increase n Cost effects Running a credit department and collecting receivables has costs n The cost of debt The firm must finance receivables and, therefore, incur financing costs n The probability of nonpayment The firm always gets paid if it sells for cash, but risks losses due to customer default if it sells on credit n The cash discount Discounts induce buyers to pay early; the size of the discount affects payment patterns and amounts FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 36

Evaluating a Proposed Credit Policy P v Q Q’ R = = = price

Evaluating a Proposed Credit Policy P v Q Q’ R = = = price per unit variable cost per unit current quantity sold period new quantity expected to be sold periodic required return The benefit of switching is the change in cash flow: New cash flow - old cash flow [(P - v) Q’] - [(P - v) Q] rearranging, (P - v) (Q’ - Q) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 37

Evaluating a Proposed Credit Policy (concluded) The present value of switching is: PV =

Evaluating a Proposed Credit Policy (concluded) The present value of switching is: PV = [(P - v) (Q’ - Q)]/R The cost of switching is the amount uncollected for the period + the additional variable costs of production: Cost = PQ + v(Q’ - Q) And the NPV of the switch is: NPV = -[PQ + v(Q’ - Q)] + [(P - v)(Q’ - Q)]/R FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 38

The Costs of Granting Credit (Figure 20. 1) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals

The Costs of Granting Credit (Figure 20. 1) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 39

The Five C’s of Credit n Character The borrower’s willingness to pay n Capacity

The Five C’s of Credit n Character The borrower’s willingness to pay n Capacity The borrower’s ability to pay n Capital Financial reserves/borrowing capacity n Collateral Pledged assets n Conditions Relevant economic conditions FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 40

A Closer look to Cash, Credit and Inventory ü Credit Policy ØInventory Policy FINANCIAL

A Closer look to Cash, Credit and Inventory ü Credit Policy ØInventory Policy FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 41

Inventory Management n Inventory Types u Raw Materials u Work-in-Progress u Finished Goods n

Inventory Management n Inventory Types u Raw Materials u Work-in-Progress u Finished Goods n Inventory Costs u Storage and tracking costs u Insurance and taxes u Losses due to obsolescence, deterioration, or theft u Opportunity cost of capital on the invested amount FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 42

Costs of Holding Inventory (Figure 20. 5) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of

Costs of Holding Inventory (Figure 20. 5) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 43

Inventory Management Techniques n ABC Approach u Compare number of items with the value

Inventory Management Techniques n ABC Approach u Compare number of items with the value of the items u An illustration of the “ 80 -20” rule n EOQ Model Economic Order Quantity is most widely known approach. u Inventory depletion rate u Carrying costs u Shortage costs and Restocking costs u Total costs n Extensions to EOQ u Safety stocks u Reorder points n MRP - Material Requirements Planning n Just-in-Time Inventory FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 44

ABC Inventory Analysis (Figure 20. 4) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate

ABC Inventory Analysis (Figure 20. 4) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 45

Inventory Holdings for the Transcan Corporation (Figure 20. 6 ) The Transcan Corporation starts

Inventory Holdings for the Transcan Corporation (Figure 20. 6 ) The Transcan Corporation starts with inventory of 3, 600 units. The quantity drops to zero by the end of the fourth week. The average inventory is Q/2 = 3, 600/2 = 1, 800 over the period. FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 46

Cost minimization –The Economic Order Quantity EOQ model We seek to find the minimum

Cost minimization –The Economic Order Quantity EOQ model We seek to find the minimum cost of holding inventory by defining what size order the firm should place when restocking. n Q = Quantity of restocking (size order) n F = Fixed cost per order n T = Total unit sales per year n CC = Carrying Cost of holding inventory (e. g. financial, storage, insurance, obsolescence, deterioration and theft costs) Total Cost = Total Carrying cost + Total Restocking cost Total Carrying cost = (Average stock) (CC) = (Q/2)(CC) Total Restocking cost = (T/Q) (F) Total Cost = (Q/2)(CC) + (T/Q) (F) FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 47

Optimal Solution n Differentiate the Total Cost with respect to the size order “Q”

Optimal Solution n Differentiate the Total Cost with respect to the size order “Q” to find the. . . Optimal size order “Q*”, when d. TC/d. Q = CC/2 + (-1)TF/Q 2 = 0 2 TF Q = CC * FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 48

Solution to Problem 20. 11 n Bell Mfg. uses 1, 600 switch assemblies per

Solution to Problem 20. 11 n Bell Mfg. uses 1, 600 switch assemblies per week and then reorders another 1, 600. If the relevant carrying cost per assembly is $40, and the fixed order cost is $800, is Bell’s inventory policy optimal? Why or why not? Carrying costs = (_____/2)($40) = $_____ Order costs = (52)($_____) = $_____ EOQ = [2(52)(1, 600)($800)/$40]1/2 = _____ units The firm’s policy (is/is not) optimal, since the costs are not equal. Bell should _______ the order size and _______ the number of orders per year. FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 49

Solution to Problem 20. 11 n Bell Mfg. uses 1, 600 switch assemblies per

Solution to Problem 20. 11 n Bell Mfg. uses 1, 600 switch assemblies per week and then reorders another 1, 600. If the relevant carrying cost per assembly is $40, and the fixed order cost is $800, is Bell’s inventory policy optimal? Why or why not? Carrying costs = (1, 600/2)($40) = $32, 000 Order costs = (52)($800) = $41, 600 EOQ = [2(52)(1, 600)($800)/$40]1/2 = 1, 825 units The firm’s policy is not optimal, since the costs are not equal. Bell should increase the order size and decrease the number of orders per year. FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 50

Material Requirements Planning (MRP) - Safety Stocks and Reorder Points (Figure 20. 7) Inventory

Material Requirements Planning (MRP) - Safety Stocks and Reorder Points (Figure 20. 7) Inventory A. Safety Stocks Minimum inventory level Safety Stocks Time FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 51

Material Requirements Planning (MRP) - Safety Stocks and Reorder Points (Figure 20. 7) Inventory

Material Requirements Planning (MRP) - Safety Stocks and Reorder Points (Figure 20. 7) Inventory B. Reorder points Minimum inventory level Delivery time Time FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 52

Material Requirements Planning (MRP) - Safety Stocks and Reorder Points (Figure 20. 7) Inventory

Material Requirements Planning (MRP) - Safety Stocks and Reorder Points (Figure 20. 7) Inventory Delivery time B. Reorder points Minimum inventory level Safety Stocks Time FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 53

Just – in – Time Inventory n Basic Idea: Parts, Raw Material and in

Just – in – Time Inventory n Basic Idea: Parts, Raw Material and in general “Work In Process components” are delivered exactly as needed for production n Objective: Minimize Inventory n Production Objective? n Is Just-in-time consistent with EOQ? n Financial Objective ? n How does JIT fits into Du-Pont? FINANCIAL ANALYSIS AND FORECASTING (HEC-MONTREAL) Fundamentals of Corporate Finance 2002 Mc. Graw-Hill Ryerson, Ltd Slide 54