CH-15-16 Dividends – Practical Financial Management : Book Guide

This Document Contains Chapters 15 to 16 CHAPTER 15 DIVIDENDS FOCUS Dividends are central to valuation, yet their effect on stock price is uncertain. Our focus is on understanding that issue, as well as investors' attitudes about dividends. Practical matters including the mechanics of cash dividends, stock dividends and splits, and repurchases are also discussed. PEDAGOGY Dividend and repurchase issues are straightforward and relatively easy to understand. The subject is effectively covered with plainly written prose. TEACHING OBJECTIVES Students should complete this chapter with an understanding of the role of dividends in financial management. They should particularly appreciate the uncertainty involved in the trade-off between paying dividends and using the cash to enhance a firm's prospects for growth. In addition they should gain a thorough grounding in the following procedural issues: Cash dividend payments Payment Restrictions Dividend policies Stock repurchases Stock splits and dividends Signaling OUTLINE I. BACKGROUND A. Dividends as a Basis for Value The value of stock is based on cash flows which come from dividends. B. Understanding the Dividend Decision How much to pay. Stockholders receive either current cash or potential growth through reinvested earnings. II. THE DIVIDEND CONTROVERSY Does paying dividends or paying larger dividends affect stock price? Three theories: A. Dividend Irrelevance Dividends viewed as a trade-off between future and present benefits for a wash in present value. Tailoring a cash flow stream to meet current income needs. Practical problems with the concept. B. Dividend Preference A bird in the hand, stockholders know they've got a current dividend, value appreciation is uncertain. C. Dividend Aversion Taxes on ordinary income versus capital gains. Idea is less important today since dividends are currently taxed at capital gains rates. D. Other Theories and Ideas The clientele effect, dividends as a residual, the signaling effect. E. Conclusion There's no general rule. All the ideas have some validity. III. PRACTICAL CONSIDERATIONS A. Legal and Contractual Restrictions Capital impairment and solvency rules. Restrictive covenants, cumulative preferred stock. B. Dividend Policy Payout ratio and dividend stability. Typical policies: target payout ratio, stable dividend per share, small dividend with extras. C. The Mechanics of Dividend Payments Four key dates: declaration, record, payment, and ex-dividend. Reinvestment plans. D. Stock Splits and Dividends Definitions, effects, rationale, accounting. IV. STOCK REPURCHASES A. Repurchase as an Alternative to a Dividend The mechanics and effects of repurchasing shares to accomplish a distribution to stockholders The benefit to shareholders who don’t sell. B. Other Repurchase Issues: taxes, avoiding the signaling effect, executive compensation . QUESTIONS 1. Dividends are said to be the basis for the value of stocks. If that's true, how do we explain the fact that companies that pay no dividends often have substantial market value? (Such companies are usually relatively young and in high growth fields.) First explain the phenomenon in terms of the individual valuation model (a stream of dividends followed by a selling price, equation (15-1)). Then reconcile the idea with the whole market model (an infinite stream of dividends). Can you explain cases in which managements claim their companies will never pay dividends? (Hint: Does such a claim make sense?) Answer: When a company with positive earnings doesn't pay dividends, the income is reinvested enabling the firm to grow faster in the future. Faster growth implies market price and later dividends may be larger than they would have been had the earnings not been retained. In the context of the individual valuation model, the no-dividend choice implies a trade-off between current dividends and a combination of larger future dividends and stock price appreciation. In the whole market model, the trade-off is between current and future dividends only. Many investors are happy with the prospect of future income substituted for current income and therefore value stocks that don't pay dividends. This is especially true when firms have promising growth opportunities. In such cases, investors expect their future incomes to be much larger that what the firm could pay out currently. Taken as a whole, the investment community simply doesn't believe statements that firms will never pay dividends. If such statements were true, it would be irrational to put any value on the stocks involved, since dividends are the only way firms can pass value back to investors. 2. Given the importance of dividends to the well-being of equity investors, why do they put up with the fact that dividends are discretionary? Answer: The discretionary nature of dividends is part of the risk that comes along with the expectation of higher returns. A discretionary dividend may be lowered or held constant, but also may be raised, and that's what appeals to investors. 3. Fully explain the choices implied by the dividend decision. Are the results of the choices known or uncertain? Answer: The dividend decision involves the choice between paying earnings out as dividends or retaining them for reinvestment. To the extent earnings are reinvested, the firm is expected to grow faster making its stock more valuable. Hence, the dividend decision involves management's choice about what to do with the stockholders' income. It can be paid out currently as an immediate benefit, or retained to provide a deferred benefit. There is uncertainty in the decision because the future benefit of increased value can never be guaranteed. 4. There is said to be a controversy over dividends. What is it and why is it important? Answer: The dividend controversy is over whether or not paying dividends out of positive earnings makes a difference in stock price. That is, whether investors are sensitive to the difference between current income received from dividends and the deferred income implied by the price appreciation associated with retaining earnings. The issue is important because it bears on management's most important goal of maximizing shareholder wealth through stock price. 5. You're an investment advisor, and have several well-off older people among your clients. One of these individuals, Charlie Haverty, steadfastly refuses to invest in companies that pay significant dividends. A successful investment counselor advised him to avoid such stocks in 1965, and he's stuck to that view ever since. However, he never really did understand the reasoning behind the advice. How would you advise Charlie today? Include an explanation of why the advisor said what he did in 1965, and whether it was better advice then than it is now. Answer: There are two possible reasons for the 1965 advice. The first has to do with taxes. At that time marginal tax rates for the wealthy were much higher than they are today, and capital gains received very favorable tax treatment (rates as much as 60% below ordinary rates). Therefore, it made sense for wealthy people to seek investments in which the returns came from price appreciation (taxed as capital gains) rather than dividends (taxed as ordinary income). Today that incentive isn't nearly as strong, because top rates are lower and the preferential treatment of capital gains is much less significant. The second reason for the 1960's advice has to do with age-related investment strategies. No (or low) dividend stocks are often high risk-high reward issues. Investment advisors frequently put younger clients into such stocks, because they have a lifetime to recover from losses. Older clients tend to be put into stable, conservative issues that usually pay at least half of their earnings in dividends. The 1965 advisor may have been basing his recommendation on the tax issue or the fact that Charlie was relatively young then. The tax code has changed and Charlie is no longer young. Hence he should be advised to abandon the strategy of avoiding dividends. 6. You're a financial analyst for a large mutual fund. You're doing an analysis of the True bright Apparel Company, which makes stylish cotton clothes for teenagers. The company has recently been under attack by foreign competition, and seems to have lost its edge in the fashion market. EPS fell from $2.00 to $1.80 and then down to $1.20 over the past three years. However, dividends were steady at $1.00 per share in spite of the declining earnings, and last year the dividend was raised to $1.50. Why do you think the dividend was maintained and then raised? How would this affect your recommendation? Answer: Maintaining the dividend in the face of declining earnings was probably an attempt by management to signal to investors that the firm's problems were temporary, and that a recovery was expected. Raising the dividend in the face of a continuing decline seems to be an attempt to send a stronger message to the same effect. In this case the last signal appears to contain an element of desperation and might therefore affect an analyst's opinion negatively. 7. Explain how the two methods of cash distribution work, and describe their impact on shareholders. Does everyone always receive cash? If not are some stockholders left out? Answer: When a dividend is paid, every shareholder receives cash proportionate to his or her ownership of the company. When stock is repurchased, only shareholders who sell shares receive cash. Stockholders who don’t sell receive no cash, but they generally get a benefit. That’s because the repurchase reduces the number of shares outstanding, so the value of the company is spread over fewer shares of stock. As a result, the stock’s value usually increases. The same conclusion can be reached by considering the firm’s EPS before and after the repurchase. Earnings are spread over fewer shares after the repurchase, so EPS on the remaining shares goes up. Then, if the market maintains the firm’s price earnings ratio (P/E) before and after the repurchase, the price of the remaining shares will increase. Notice, however, that to get any cash, those don’t sell to the company in the repurchase have to sell to another investor later on. 8. How do repurchases help firms manage the signaling effect of dividends. Answer: The signaling effect refers to the idea that investors react very negatively to any decrease in dividends. But business conditions move up and down all the time. Firms would like to pay higher dividends when profits are up, and a lower dividends when conditions are just average. The problem is that the negative response to a decrease is generally worse than the positive effect of the increase, so most firms avoid such up and down dividend policies. But repurchases don’t seem to have the signaling effect of dividends. That means a modest steady dividend supplemented by a repurchase that’s variable in size allows a company to distribute more or less cash, depending on business conditions, without causing its stock price to decline when the total payment goes down for a while. BUSINESS ANALYSIS 1. You're the treasurer of Super Tech Inc., a high technology firm in the fast growing computer business. The management team has recently been trying to decide on a long-term dividend policy. Earnings are good, but the firm has far more investment opportunities than income. There's no doubt that the company will need to sell more equity in the near future to fund its growth. Therefore management wants to do everything possible to maximize stock price including making the right dividend decision. This morning the chief engineer, Susan Mathematica, came into the meeting and professed to have the answer to the firm's problems. She said she's been taking a high-powered finance course at night, and that her instructor assured her that dividends don't matter to stock price. According to Susan, that's because investors are perfectly capable of tailoring their own income stream from any investment. Therefore, she suggests not paying any dividends and using the money for projects. How would you respond to Susan's suggestion? Do you think she's missed part of her instructor's message? Is it possible that her suggestion is right, but for the wrong reason? What would you recommend that Super Tech do? Answer: Susan has taken some theory out of context. Theoretically investors can tailor an income stream by selling off shares of stock to make up for the current income lost if dividends aren't paid. In practice, however, transactions costs, especially brokerage commissions, limit this ability. Further, real investor's don't like going to the trouble of selling off shares little by little. The instructor will probably get to these points in the next lecture. However, Susan's suggestion is likely to be right for a different reason. In high growth situations many firms don't pay dividends, because the money can be used to fund high return projects. Stockholders don't mind because they get a big growth in stock price in return for foregoing dividends. In fact, high risk - high return companies like Super Tech generally attract the kind of investor that doesn't require dividends but is more interested in price appreciation. An appropriate policy for Super Tech would probably be to pay no dividends or very small ones while high growth opportunities exist reviewing the situation periodically. 2. The Tangle fern Corporation has traditionally paid out 60% of its earnings in dividends. Recently some marvelous growth opportunities have arisen that involve only a little risk but require a lot of cash. Most of the executive team thinks the firm should do two things to raise the cash needed to take advantage of the opportunities. They want to (1) sell more stock and (2) suspend dividend payments for two to three years. The dividend suspension would be accompanied by an explanation to stockholders of what was going on. You're the company's CFO. Prepare a response to the others' suggestion. Do the two proposed actions taken together create a particular problem? Answer: Executive Staff: The two-part proposal to sell stock and suspend dividends creates a financial problem. Since we've been paying a substantial dividend for a long time, we've attracted a stockholder group that likes the current income derived from the payments. Indeed, many probably need their quarterly Tangle fern dividend to live comfortably. The fact that companies attract investors who like their particular dividend paying policies is well known and is called the "clientele effect." The result of the clientele effect is that if a firm like Tangle fern suspends dividends, it upsets most of its stockholders who are then likely to dump their stock. That depresses its market price. This means if we try to sell new shares at the same time we suspend dividends, we're likely to get a lot less for them than we would if we didn't suspend dividends at the same time. Hence I recommend that we either sell new stock or suspend dividends, but not do both at the same time. 3. You're a bank officer considering making a loan to small family-owned company. The firm's principal owner is a hard-working, conservative woman who has built up the company over a number of years. However, two of her grown children are now active in the company's management. They're both bright and hard-working, but have a reputation for taking business risks as well as for extravagant living. You'd like to make the loan, but are concerned about a potential change in the character of the company. How might you make the loan and still protect your bank's investment? Answer: Include restrictive covenants in the loan agreement that limit payments of any kind (mainly salary or dividends) to the principal owners while the loan remains outstanding. Also include limits on the risks the firm can undertake by requiring bank approval of substantial new projects. Require minimum levels of performance on key ratios and measures. Secure the loan with marketable assets and stipulate the conditions constituting default carefully. Stipulate that if default occurs the bank takes control of the company until the loan is satisfied. If default occurs act promptly to take control. 4. Your pal, Fred Flinder binder, came into class this morning grinning from ear to ear. It seems a stock in which he advised his parents to invest is doing fabulously well. Fred said the firm usually pays a dividend of $2.00 a share, which is about 4% of its recent $50 market price. Yesterday, however, his folks got a letter that said the cash dividend was being passed, but instead the firm was issuing a stock dividend of one share for every 10 owned. Fred calculates that's worth the equivalent of $5 a share, two and a half times the normal cash dividend! Fred has told you all this knowing you're taking finance. He's asked you what you think obviously expecting praise and approval. What would you say to Fred? Answer: Fred, old buddy, you've got the wrong idea. A stock dividend gives extra shares to existing shareholders but increases the overall number of shares outstanding by the same proportion. Since the company isn't worth any more by virtue of the dividend, nobody has actually gotten anything. In other words, the value of the existing shares decreases by an amount exactly equal to the value of the new shares issued. The bad news is that if the stock dividend accompanied a passing of a cash dividend, it could be an attempt to disguise the fact that the company is in trouble. The firm may not have the cash to make the regular dividend payment, but wants to give a prosperous impression, so it gives something that doesn't cost anything. 5. Blazingame Mill Works recently sold a tract of land it owned for 30 years. All expenses and taxes have been paid, and the company has $10 million sitting in the bank as a result of the sale. As there aren't any pressing investment opportunities available, and the board would like to distribute the money to shareholders. Most of the board members are high-income individuals and major stockholders themselves. Discuss the company's options for disposing of the money. Answer: Blazingame can pay the money to its shareholders as a special, one-time dividend. That, however, would create a current tax liability for each stockholder based on ordinary income tax rates. Alternatively the firm could repurchase and retire some of its own stock. Stockholders who sell would be subject to a capital gains tax on any appreciation of their shares since the time they were purchased. After the repurchase, remaining shares would represent proportionately more of the company, and can be expected to rise in value. There would be no tax on this increase in value until those shares are sold. Then the tax would be at capital gains rates. (Unless the repurchase is challenged by the IRS as a dividend in disguise, which is unlikely if it's only done once.) When a dividend is paid, every shareholder receives cash proportionate to his or her ownership of the company. When stock is repurchased, only shareholders who sell shares receive cash some of which will be a gain if the repurchase price is higher than the price at which the sellers bought the shares sold. Stockholders who don’t sell receive no cash, but they generally get a benefit. That’s because the repurchase reduces the number of shares outstanding, so the value of the company is spread over fewer shares of stock. As a result, the stock’s value usually increases. The same conclusion can be reached by considering the firm’s EPS before and after the repurchase. Earnings are spread over fewer shares after the repurchase, so EPS on the remaining shares goes up. Then, if the market maintains the firm’s price earnings ratio (P/E) before and after the repurchase, the price of the remaining shares will increase. Notice, however, that to get any cash in hand, the person who didn’t sell in the repurchase has to sell to another investor later on. PROBLEMS Dividends and Ratios: Concept Connection Example 15-1 (page 638) 1. The Argo Pamphlet Company’s dividend payout ratio is 35%. It is currently paying an annual dividend of $1.30. a. What is Argo’s EPS? b. What is the market price of Argo’s stock if its P/E ratio is 14? c. How much current income per share will stockholders lose if Argo cuts its payout ratio to 20% and nothing else changes? d. If the change in payout ratio does not affect the stock’s price, approximately how many shares would a stockholder who owns 1,000 shares have to sell to make up her loss in current income? Ignore tax effects and transaction costs. Solution: Tailoring the Income Stream: Concept Connection Example 15-2 (page 640) 2. Randal Flapjack is a retired short-order cook living on a fixed income in the state of Utopia where all financial markets are perfectly efficient. Randal has 20,000 shares of the Sugarcooky Corp., which pays an annualized dividend of $1.00 per share. Sugarcooky sells at a P/E of 10, has maintained a payout ratio of 50% for many years, and has not grown in some time. Management has recently announced that it will reduce Sugarcooky's payout ratio to 25% but expects earnings to grow at 5% from now on. a. What is Sugarcooky's current price? b. How much current income is Randal losing as a result of management's action? c. If Randal keeps his money in Sugarcooky but needs to maintain his current income, how many shares will he have to sell in the first year? d. What will be the value of his remaining shares at the end of a year if the P/E remains the same? Is his investment growing? Why? Solution: The stock's value is increasing at 5%, but Randal sold off only 2.5% of his shares, his net investment is therefore growing. 3. Biltmore Industries has grown at an average of 6% per year over its long history. Its stock price is currently $40 and its most recent dividend was $2.50. Biltmore just announced that it plans to discontinue dividends for several years to take advantage of some growth opportunities. Analysts expect the stock price to increase by 10% per year for at least the next two years because of this growth. Elmer Bartlett owns 4,000 shares of Biltmore and has counted on their dividend payments to supplement his retirement income. Now it appears that he will have to start selling off his Biltmore stock to replace this lost income. How many shares of stock will Elmer have to sell in each of the next two years to replace his lost dividend income? Ignore taxes and transaction costs. Solution: The Residual Dividend Theory: Concept Connection Example 15-3 (page 644) 4. The Holder all Rope and Yarn Co. has 2 million common shares outstanding. Its capital structure is two-thirds equity. The firm expects earnings of $10 million next year, and anticipates capital spending of $12 million on projects. How much will the per-share dividend be next year if the firm adheres to a residual dividend policy? Solution: Capital spending is $12M, two-thirds of which will be equity financed, hence $8M of the earnings will be spent on the capital program. The remaining ($10M  $8M = ) $2M is the residual available for dividends. The per share dividend is then D = $2M/2M shrs = $1.00 per share. Dividend Reinvestment Plans: Concept Connection Example 15-4 (page 649) 5. The Montauk Company has a dividend reinvestment plan in which shareholders owning 25% of its common stock participate. Last year the firm’s EPS was $4.20 and its payout ratio was 50%. There are 2 million shares of common stock outstanding. How much new capital did Montauk raise through the reinvestment program? Solution: Earnings = EPS x number of shares = $4.20  2M = $8.4M Dividends = earnings x payout ratio = $8.4M  .50 = $4.2M Reinvested = dividends x participation = $4.2  .25 = $1.05M 6. Segwick Petroleum Ltd. has a dividend reinvestment plan in which new stock is issued to participating investors. Segwick's payout ratio is 40%, and 30% of stockholders participate in the plan. The firm's ROE is 10%. What percentage increase in flotation-cost-free equity capital does the plan provide? Solution: Earnings are 10% of equity 40% of 10% = 4% is paid out 30% of 4% = 1.2% is reinvested 7. Harrison Hardware anticipates $2 million in net income next year and a 20% participation in the firm’s dividend reinvestment plan. Management expects to spend $2.375 million on new capital projects, and maintain the current capital structure which is 64% equity without issuing new stock. What dividend payout ratio has Harrison included in its plan for next year? Solution: Of the $2.375 million capital program for next year, $2.375 x .64 or $1.52 million will have to come from equity, which will be sourced from retained earnings and dividend reinvestment. d = Dividend Payout Ratio [$2.0 million x (1 – d)] + [20% x $2.0 million x d] = $1.52 million 2 – 2d + .4d = 1.52 1.6d = .48 d = .3 = 30% Dividend Payout Ratio Stock Splits: Basics (page 650) 8. You own 1,000 shares of Jennings Corp. stock, which is currently selling for $88.00. Calculate the number of shares you would own and the stock’s market price after each of the following stock splits. a. A two-for-one stock split b. A three-for-one stock split c. A three-for-two stock split d. A three-for-four reverse stock split e. A five-for-three stock split Solution: a. 1,000 x 2 = 2,000 shares $88/2 = $44 b. 1,000 x 3 = 3,000 shares $88/3 = $29.33 c. (3/2) x 1,000 = 1,500 shares (2/3) x = $58.67 d. (3/4) x 1,000 = 750 shares (4/3) x $88 = $117.33 e. (5/3) x 1,000 = 1,666 shares (3/5) x $88 = $52.80 Accounting for Stock Splits and Dividends: Tables 15-1 – 15-3, (pages 651-652) 9. The Addington Book Company has the following equity position. The stock is currently selling for $3 per share. a. What was the average price at which the company originally sold its stock? b. Reconstruct the equity statement above to reflect a four-for-one stock split. c. Reconstruct the statement to reflect a 12.5% stock dividend. Solution: 10. Seinway Corp. just declared a 10% stock dividend. Before the dividend the stock sold for $34 per share and the equity section of the firm’s balance sheet was as follows: Restate the equity accounts and estimate the stock’s price after the dividend. Solution: A 10% stock dividend requires issuing 1,000,000 new shares at a par value of $.50. The common stock account will increase by the par value of the new shares or $500,000 to $5,500,000. The paid in excess account will increase by the remainder of the market value of the new shares as if they were sold. That’s $33.50 per share or ($33.50 x 1,000,000 = ) $33,500,000 raising the paid in account to ($56,000,000 + $33,500,000 = ) $89,500,000. Both of these increases come out of the retained earnings account which becomes ($87,500,000 – $34,000,000 = ) $53,500,000. Hence the new equity section will be: If the firm’s market value remains unchanged through the stock dividend at ($34 x 10,000,000 = ) $340,000,000, the new price will be $340,000,000 / 11,000,000 shares = $30.91. As a practical matter, many would simply say that the stock’s price should decrease by approximately 10% to (.9x$34 = ) $30.60. 11. Wysoski Enterprises is considering a stock dividend. The firm’s capital includes 3 million shares of $1 par value stock issued at an average price of $8. Retained earnings total $20 million. State the equity accounts now and after each of the following possible stock dividends. a. Wysoski declared a 5% stock dividend and the current price of the stock is $15 b. Wysoski declared a 10% stock dividend and the current price of the stock is $20 c. Wysoski declared a 15% stock dividend and the current price of the stock is $23 Solution: 12. The Alligator Lock Company is planning a two-for-one stock split. You own 5,000 shares of Alligator's common stock that is currently selling for $120 a share. a. What is the value of your Alligator stock now, and what will it be after the split? b. Alligator's CFO says that the value of the shares will decline less than proportionately with the split because the stock is now out of its trading range. If the decline is 45% how much will the split make you? Solution: Stock Repurchases: Concept Connection Example 15-5 (page 654) 13. The Featherstone Corp. has $8M in cash for its next dividend but is considering a repurchase instead. Featherstone has 10M shares outstanding, currently selling at $40 per share. The P/E is 20 on EPS of $2. a. If the dividend is paid how large will it be per share? b. If stock is repurchased how many shares will remain outstanding and what will the new EPS be? c. If the P/E holds at 20, what will be the new stock price and how much per share will continuing stockholders have gained? How does that compare with the dividend that could have been paid? d. Are there other considerations (words only)? Solution: d. Yes. The gain is in share price rather than cash, so it isn’t available as current income to stockholders without selling some shares. If that’s done the gain will probably be taxed as a capital gain rather than as ordinary income. This is a favorable result as long as Featherstone hasn’t done repurchased stock often. Finally there is some risk that the P/E won’t remain constant through the repurchase. 14. Parnell Bolts Inc. has 20 million common shares outstanding, and net income of $30 million. The stock sells at a P/E of 15. The company has $5 million available to pay the next quarterly dividend, but is considering a repurchase instead. a. If Parnell pays the cash dividend, what will be its dividend yield on an annualized basis? b. How many shares will be redeemed if the repurchase option is chosen and the stock is acquired at market value? c. What will be the EPS after the repurchase if earnings remain unchanged? d. What will be the new stock price if the P/E remains unchanged? Solution: The Opportunistic Repurchase: Example 15-6 (page 656) 15. Tydek Inc. just lost a major lawsuit and its stock price dropped by 40% to $6. There are 3.5 million shares outstanding with a book value per share of $10. The company has $5 million in cash readily available. The CFO feels the decline in price is temporary and the firm's stock is an excellent investment at this time. If Tydek spends the entire $5 million on its own stock, and the market to book value ratio returns to its former level, how much more will each remaining share be worth than it was before the temporary price decline? Solution: Previous price = $6/.6 = $10 = Book value, so book to market value ratio is 1.0, and total Book Value = $10  3.5M shares = $35M. Shares purchased = $5M/$6 = 833,333 Remaining shares = 3,500,000  833,333 = 2,666,667 New book value = $35M  $5M = $30M New book value per share = $30M/2,666,667 = $11.25 If the book to market value ratio returns to 1.0, new P = $11.25 and per share price increase is $1.25. 16. The stock market is generally depressed, and the price of Westin Metals Inc.’s common shares has been below its historic average value for some time. The shares are trading at $35 which represents a P/E of 19 on earnings of $7,000,000. Before the current slump, Westin generally maintained a P/E of at least 24. Despite the general downturn, the firm is doing well, and the CFO is considering an equity repurchase to enhance the position of stockholders who retain their shares when the market recovers. She has identified a piece of real estate the company owns but isn’t using, which was purchased 20 years ago for $2,000,000 and can be sold for $9,000,000 today. Using the proceeds of such a sale would make it possible to do the repurchase without impacting dividends or the capital budget. The CFO has asked you to quantify the effect of her plan on stock price, and make a recommendation as to whether she should present it to the Board of Directors. Assume it takes two years for the market to recover and that Westin’s P/E returns to 24 at that time. Also assume earnings grow at 5% per year until then and the company’s marginal tax rate is 37%. Round any number of shares calculations to the nearest 1,000 shares. Solution: The impact on stock price is significant but not huge. Therefore the CFO should be cautious about making her proposal to the Board as it may generate expectations that won’t be met. It might be especially ill advised if selling the land is difficult or if there is a potential use for it in the future. CHAPTER 16 THE MANAGEMENT OF WORKING CAPITAL FOCUS Day to day business runs on working capital. We can't do without it, but we'd like to use as little as possible. Our focus is on understanding what's involved in running the routine aspects of a business effectively without wasting resources. That means understanding the implications of decisions about each of the working capital accounts and about how working capital is financed. PEDAGOGY Our approach is especially practical in this area. We stay away from optimization models and concentrate on trade-offs that are generally analyzed with a little math and a lot of intuition. We provide a special insight into internal relations and company politics in the area of receivables. TEACHING OBJECTIVES In this chapter students should gain an insight into the short term operating nature of working capital and its importance in running any company. In particular they should understand that working capital requires financing and appreciate the short term sources of funds available to support operating needs. Further they should have a detailed understanding of the issues and problems associated with managing each of the three major working capital assets: cash, receivables and inventories. OUTLINE I. WORKING CAPITAL BASICS The short term nature of the assets and liabilities that arise from routine operations. A. Working Capital, Funding Requirements, and the Current Accounts The conceptual relationship between working capital and the current accounts. The need to fund net working capital. Spontaneous financing. B. The Objective of Working Capital Management Running the firm effectively with as little as possible tied up in W/C. C. Operations - The Cash Conversion Cycle Graphic portrayal of cash flows in and out through the working capital accounts. D. Permanent and Temporary Working Capital The variation in W/C with business activity. E. Financing Net Working Capital W/C lends itself to short term financing. F. Working Capital Policy The elements of W/C policy defined. II. SOURCES OF SHORT TERM FINANCING A. Spontaneous Financing The nature of accruals and payables. Credit terms, prompt payment discounts B. Unsecured Bank Loans Notes, lines, compensating balances. C. Revolving Credit Agreement D. Commercial Paper The nature of commercial paper and its issuers. E. Short-Term Credit Secured by Current Assets Pledging and factoring receivables. Inventory financing, liens and warehousing. III. CASH MANAGEMENT A. Definitions and Objectives The motives for holding cash and the objective of achieving adequate liquidity while tying up minimum resources. B. Marketable Securities Near cash liquidity with a modest return. C. Check Disbursement and Collection Procedures The check collection/clearing system and how it works. D. Accelerating Cash Receipts Lock boxes, concentration banking, wire transfers. E. Managing Cash Outflow Central vs. local cash management, remote disbursing. F. Evaluating the Cost of Cash Management Services Cost benefit analyses to determine if cash management systems are worthwhile. G. Cash Budgeting (Forecasting) Receipts and Disbursements IV. MANAGING ACCOUNTS RECEIVABLE A. Objectives and Policy The balance between more revenue with easy customer relations and bad debt losses. A shared responsibility with sales. B. Determinants of the Receivables Balance Credit policy, terms of sale, collection policy, and the conflict with sales. C. Summary and Conclusion- A Practical Management Warning The politics of uncollected receivables can be a career pitfall for the CFO. V. INVENTORY MANAGEMENT A. Who Is Responsible for Inventory Primary responsibility generally in manufacturing or operations. Finance has an oversight function. B. The Benefits and Costs of Carrying Inventory Business runs smoother with more inventory but the costs include interest, storage, insurance, and taxes, exposure to shrinkage and obsolescence. C. Inventory Control and Management Balancing the costs and benefits of inventory. D. The Economic Order Quantity (EOQ) Model The popular model to balance ordering and carrying costs. E. Safety Stocks, Reorder Points, and Lead Times The concepts incorporated with the EOQ model. F. Tracking Inventories - the ABC System The effort to control proportional to cost/ importance of the inventory. G. Just In Time (JIT) Inventory Systems The objective of JIT and the practical limitations. QUESTIONS 1. Explain the different circumstances under which firms should use short-term or long-term financing. Answer: Whether financing should be long or short term depends on the longevity of the things it's used to support. Long-term money is used to acquire things that remain with the firm for substantial periods such as fixed assets or extended projects. These things are generally funded with money that doesn't have to be paid back for similarly long periods like equity and long term loans. Short-term items like inventory and receivables come and go quickly. They "turn over" constantly (there's always inventory, but the items within it change). These assets are generally funded by trade credit or by short term borrowing that has to be repaid in a relatively brief period. The idea of short or long term financing is related to the maturity matching principle. Money should be repayable when whatever it finances generates cash. 2. Because companies always have inventory and accounts receivable, most banks are happy to make long term loans to support those assets. Either refute or support that statement. Answer: The statement isn't true. Although firms always have inventory and receivables, the underlying assets in which the value resides turn over constantly. Therefore banks are willing to make short-term loans based on those items. 3. Describe the maturity matching principle. What are the risks of not matching maturities? How would you characterize a firm that ignores the principle? Can you think of situations in which it would be advisable for an otherwise prudent firm to deviate from the principle? Answer: The maturity matching principle says that financing to support assets (and projects) should be repayable at the time those items generate enough cash to make the repayments. Financing long-term items with short-term money tends to reduce interest costs (short rates are generally lower), but exposes one to the risk that refinancing will be either expensive or unavailable sometime during the item's life. A firm that does that exposes itself to additional financial risk. This can occur if management is imprudent or ignorant, or is forced into the situation because long-term money isn't available. Financing short-term needs with long-term money ignores the maturity matching principle, but is conservative rather than risky. Such a policy implies funds will always be available for short-term needs, but they may be more expensive than if acquired short term. Some very risk-averse managers feel this is the right thing to do. 4. Working capital spontaneously finances itself because it's being turned over all the time. Is this statement true, false, or a little of both? Exactly what is meant by spontaneous financing? Does working capital require funding? Why? Answer: The statement is partially true. Spontaneous financing refers to the fact that some resources, mainly inventory and labor, don't have to be paid for immediately. These unpaid liabilities are reflected in the payables and accruals accounts. They remain on the balance sheet because new inventory and labor are being acquired and used all the time. Typically, however, spontaneous financing supports only a fraction of working capital requirements. Hence net working capital, the difference between gross working capital (current assets) and spontaneous financing (current liabilities), requires funding. 5. Working capital is generally defined as the difference between current assets and current liabilities. Is this definition precisely correct? Why? Answer: No. The working capital concept involves the assets and liabilities that arise from the normal day to day activities of a business. These are only roughly equivalent to the current accounts in most companies. Things like prepaid expenses and the current portion of long term debt are included in the current accounts but conceptually aren't working capital items. 6. Support or challenge each of the following statements individually: a. Because accounts receivables aren't purchased like inventory or fixed assets, they don't require financing. b. Cash represents a pool of available money, so it actually reduces financing needs. Answer: a. A receivable is generated when product is shipped reflecting the fact that a sale has been made. Building the product, however, requires cash that isn't recovered until the receivable is collected. Therefore, receivables require funding. b. Cash is money in the bank available to pay bills and transact business. That money has to be deposited and therefore represents an asset just like a machine or an inventory item. In effect, the firm "buys" an account balance at the bank. Therefore cash requires financing. It certainly doesn't reduce the need for financing. 7. How does a firm's operating cycle differ from its cash conversion cycle? Explain fully. Answer: A business's operating cycle begins with the purchase of inventory that in time is turned into product and sold. The sale results in a receivable that becomes cash when collected. The cash is used to purchase more inventory starting the cycle again. The term operating cycle refers to both the sequence of events and the time required to go through it once. The cash conversion cycle is the operating cycle in days less the payables deferral period, which is the time between receiving and paying for inventory. 8. You work in the finance department of a manufacturing company. Over lunch, a friend in the engineering department said she'd heard that the firm used a lot of temporary working capital. Because temporary equipment is usually of lower quality than permanent material, she wonders why the company, which is quite prosperous, doesn't buy the best and store it when it isn't needed. What misconceptions does your friend have? Write a brief explanation for someone who knows nothing about finance to straighten out her understanding. Answer: Your friend probably thinks working capital is an asset that's purchased like a machine or building. In this misconception she's confusing working capital with capital equipment. Working capital refers to the assets and liabilities that arise from the everyday running of the business including cash, receivables, and inventory, less payables and accruals. These things depend on the level of business being done at a point in time, and can vary over the year if volume is seasonal. Permanent working capital refers to the minimum level required during an annual cycle. Temporary working capital is the increase over the minimum level required when seasonal increases occur. There isn't a quality issue in the distinction. 9. Why does it make sense to finance net working capital separately from fixed assets? Answer: The assets making up working capital turn over regularly in short periods. They also tend to generate cash shortly after they're held. This situation lends itself to short term financing. Fixed assets, on the other hand, require commitments of funds for long periods. It makes sense to finance these items separately, because of their different terms. 10. You work in the finance department of HiTech Inc. The firm's owner and CEO, Charlie Dollars, is very profit oriented. He understands that short-term interest rates are quite low at the moment, and has suggested that the firm finance all of its working capital needs with short term loans. The CFO has asked you to prepare a memo for his signature outlining why this may not be the best strategy. In your memo, outline the working capital financing options available to most firms and discuss the trade-offs involved in using long term versus short term financing Answer: Working capital can be financed by either short- or long-term funds. Short-term money is always borrowed while long-term funds can be either debt or equity. Short-term financing is usually cheaper (lower interest) but has to be renewed periodically as loans become due for repayment. This means a strategy of supporting working capital with short-term borrowing requires a continuous series of new loans. This creates a risk, because short rates do sometimes exceed long rates. Worse, situations occasionally occur in which refinancing isn't available at any rate. That can put a company out of business, because it suddenly has no way to sustain its working capital requirements. Therefore, in order not to risk ruin, most companies limit their short term financing, and use some long-term debt and/or equity to support working capital. 11. What are the advantages and disadvantages of stretching payables? If you owned your own business, would you do it? Why or why not? Answer: Slowing cash payments to vendors is known as stretching payables or leaning on the trade. It generally means paying in a longer period than specified by the terms of sale. The practice conserves the payer's cash reducing the need for working capital financing which saves interest expense. The disadvantage is that it offends suppliers who want to be paid on time making them reluctant to do business with the slow payer. In extreme cases suppliers refuse to make further credit sales to slow paying customers demanding cash in advance. This can cause disruptions in the slow payers production and administrative processes. Stretching payables also affects a firm's credit rating. Vendors report slow payers to credit bureaus, which include the information in their reports. Being labeled a slow payer makes it more difficult to get credit of any kind. In other words, paying vendors slowly today can keep you from getting a bank loan or credit from a new vendor tomorrow. The firm that stretches payables walks a fine line. Most vendors will tolerate a little tardiness, the trick is not to overdo it. Whether you would do it or not is a matter of personal preference. 12. What's the difference between a promissory note, a line of credit, and a revolving credit agreement? Are they mutually exclusive? That is, might one be part of the other? Answer: A promissory note is a contractual document associated with a specific loan. A line of credit and a revolving credit agreement are agreements between a company and a bank as to the maximum amount the firm can borrow during a specified period. The line is informal meaning the unused portion can be revoked by the bank at any time. The revolver is a commitment to have funds available and requires a commitment fee on unused balances. Individual loans made under either a line or a revolver may have separate promissory notes. 13. Explain the difference between pledging and factoring receivables. Which is likely to be more a more expensive source of financing? Is factoring the same kind of financing as pledging? Answer: Pledging involves borrowing money based on the collateral value of receivables. The accounts continue to belong to the borrowing company, which is responsible for their administration and collection. Factoring means actually selling the receivable to the factor, who then takes care of collection. Factoring is more expensive because the financial institution does more work. 14. Factoring may involve interest even though it isn't a loan. How can this come about? Answer: If the factor pays its customer (the firm selling the receivable) before money is collected from the customer, it is out funds until collection is actually made. In such cases the factor's charges have to include interest for that interim period. 15. What is the biggest problem associated with financing secured by inventory? How is it addressed in practice? Answer: The biggest administrative difficulty associated with inventory financing is keeping track of the secured material and making sure it's available to the lender in the event of default. The difficulty arises because the borrower needs to continue to use the inventory during the financing period. This makes continuous monitoring necessary for complete security. Third party warehousing companies are able to do that, but their services are expensive. 16. Outline the reasons for holding cash and the big cost associated with it. How do these lead to the objective of cash management? How do marketable securities help or hinder achievement of the objective? Answer: Cash is held to conduct normal business activities (transactions demand), to provide the capability of handling emergencies (precautionary demand), and to take advantage of unexpected opportunities (speculative demand). It may also be necessary to hold cash to satisfy compensating balance requirements. Having enough cash is known as having adequate liquidity. The problem associated with holding cash is that it earn a very small return if any at all. Therefore it isn't wise to tie up any more money than necessary in cash balances. The objective of cash management is to balance the need for liquidity with cost of holding extra cash. Marketable securities help in achieving the objective because they provide nearly the liquidity of cash, but also offer a modest return. 17. The Medco Supply Co. operates out of Waco, Texas, and has a number of customers around Portland, Maine. It seems to take a particularly long time for the Portland customers' payment checks to reach Medco. What can the company do to speed things up? Explain how your solution would work. Answer: Medco's mail float from Maine can be reduced by installing a lockbox in Portland that is operated by a local bank. Customers in that area would mail payment checks to the Portland lockbox which would be deposited in the check clearing system by the bank immediately. This avoids the delay of mailing all the way to Texas. 18. Sally Johnson lives in Baltimore, and does business with a large, national brokerage firm. When she sends the broker a check, she mails it to a local address in Baltimore. However, when she receives a check, from the broker, it comes from San Francisco. Her sister Joan lives in Los Angeles and uses the same firm. She mails payments to an office a few blocks from her home, but receives checks from an office in Miami. What's going on? Should the Johnson sisters be upset? Answer: The brokerage firm is playing the mail float to its advantage at the expense of clients. Receipts travel a short distance so the firm gets its money quickly. Disbursements, on the other hand, travel cross-country keeping customers' funds in the firm's account a few days longer where it earns interest. The Johnson sisters have a right to be upset. This kind of dealing is a violation of the trust inherent in the broker-client relationship (called a fiduciary relationship). 19. You're the cash manager for Huge Inc., which has factories and stores all over the country. Each operation has several bank accounts to receive deposits and pay vendors, so the company's cash is spread all over the country under the control of divisional CFO's. It's essential that those divisional executives have control of their cash to run their operations effectively. However, the rather substantial cash total isn't earning anything because it's too dispersed to be invested in marketable securities. Suggest a way to fix this problem and explain how it will work. Answer: Huge should consider concentration banking in which a single bank monitors the amounts in remote locations daily, and sweeps excess amounts into a central account. The central balance is likely to be large enough to be invested effectively. 20. Every company should take full advantage of the sophisticated cash management services offered by today's banking industry. Right or wrong? Explain. Answer: Wrong. Cash management systems should only be used if they save money. The benefit of sophisticated systems is that they reduce cash balances, which reduces the amount of working capital financing needed, which in turn saves on interest expense. The cost generally involves a fixed annual fee for setup and maintenance and a variable charge related to volume. For the system to be cost effective, the interest savings it generates have to exceed its total cost. In small firms the cash volume affected by a system may not be large enough to generate interest savings sufficient to cover its cost. In such cases sophisticated techniques shouldn't be used. 21. Outline the costs and benefits involved in the trade-off between a tighter versus a looser receivables policy. Answer: A tighter receivables policy means credit is granted only to higher quality customers and overdue receivables are pursued more aggressively. This reduces bad debt losses but also tends to offend customers and lower sales. 22. Inventory management is a shared responsibility between finance and manufacturing just as receivables management involves both sales and finance. Right or wrong? Explain. Answer: Wrong. Finance rarely has a direct responsibility for inventory. Manufacturing or operations executives usually determine what and how much to carry. Finance has an overview responsibility to ensure inventory is usable and current and that the firm isn't carrying more than it needs. 23. Because of the advances in computer technology, inventory management is a precise science, and there's no excuse for not having the optimal quantity on hand at all times. Is that statement true or false? Explain. Answer: False. Inventory management is far from an exact science. Cost effective inventories are achieved through frequent reviews of what is needed and what is on hand, attention to detail, and a combination of manual and automated tracking systems. 24. Does the EOQ model properly applied prevent stockouts? Does it address stockouts at all? Do you think the EOQ model solves very many of management's inventory problems? Answer: The EOQ model itself doesn't address stockouts. The safety stock concept does. Hence when EOQ is combined with a safety stock the overall model does help to manage stockouts. EOQ itself just balances the cost of ordering against the cost of holding inventory. These issues are a small part of overall inventory management. EOQ is presented in most text because it is concise and easy to understand. However, it may give the impression that there's less to inventory management than there really is, and that the subject is more precise than it actually is. 25. The Philipps Lighting Company manufactures decorative light fixtures. Its revenues are about $100 million a year. It purchases inputs from approximately 20 suppliers most of which are much larger companies located in various parts of the country. Sam Spade, the vice president of manufacturing is a sophisticated executive who has always been very impressed by the latest innovative techniques in management. Last week Sam came into a meeting of the executive team with a proposal to cut inventory costs to almost nothing. Just in time (JIT) is the wave of the future, he said, and proposed that Philipps enter into negotiations with of all its suppliers to implement the concept immediately. You're the CFO and tend to be more skeptical about new methods. Prepare a memo to the team, tactfully outlining the problems and risks involved in Sam's proposal. Answer: Staff: JIT is a great idea in theory, but it has two important practical problems. The firm using JIT is essentially pushing the task of carrying its inventory back onto its suppliers. That means the suppliers have to be willing to work very hard to maintain the inventory and to ensure precisely timed shipments arrive "just in time" for production. Suppliers are generally willing to do that only if the customer using JIT is very important to them. For example, suppose a company makes piston rings, and sells 90% of its output to General Motors. That firm will go to any lengths to keep GM's business, including orchestrating timely JIT deliveries. If the piston ring manufacturer sold its output to 20 or 30 different customers, it wouldn't be particularly motivated to do JIT for any of them. Since Philipps doesn't buy a large portion of the output of any of our suppliers, it's hard to imagine that they would be willing to go to the trouble of managing JIT shipments for us. Distance is another complicating factor. If suppliers are located far away, a trucking company is between them and the JIT company. That means the trucker also has to commit to precisely timed deliveries to make the JIT idea work. That can be almost impossible if large distances are involved. This would be a big problem in our case, since our suppliers are from several hundred to thousands of miles away. Further, the risks of JIT are substantial. If we're not carrying inventory and a promised shipment fails to arrive, everything stops. That can obviously be very costly. In summary, although JIT has some benefits for very large and powerful companies, I doubt that it will be feasible for us. BUSINESS ANALYSIS 1. You're a supervisor in the treasury department of Big Corp. Recently there's been increasing concern about the firm's rising interest costs. Fred Eyeshade is an analyst in your group who transferred from the accounting department a short time ago. He has suggested that senior management mandate a 50% across the board cut in cash, inventory, and receivables along with a doubling of payables to reduce the firm's financing needs for net working capital. Explain why this might not be a good idea with respect to each of the elements of net working capital (four accounts). Answer: Reducing current assets and increasing current liabilities reduces the money tied up in working capital. That reduces related borrowing and saves interest expense. However these actions can be overdone. Collecting receivables too aggressively offends customers and can reduce sales. Too little inventory in production can cause expensive idle time and missed schedules. A lack of inventory can also cause stockouts at the point of sale, which delay customer orders and can result in lost business. Similarly, too little cash can make it impossible to pay bills on time and conduct business efficiently. Stretching payables offends vendors and can lead to higher prices for input and delays in resupply. Unless working capital is being managed very poorly, Fred's suggestion is probably too drastic and might hurt more than it helps. 2. Things tend to run more smoothly and efficiently with more working capital. With respect to receivables and inventory, explain why this statement isn't absolutely true. In other words, why might a very large inventory or receivables balance not do much good at all? Answer: Large balances in receivables may indicate the presence of uncollectible items that should be written off. A big inventory account can imply material that's useless because it's damaged or obsolete. In both cases the items are "inactive," and lie under the things that are turning over. They don't help in running the company because they aren't used for anything. 3. You and your friend Harry have started a business. Harry is a technical whiz, but doesn't know much about business or finance. After several months you've been approved for a $100,000 bank loan at what seems to be a rather high interest rate, 12%. Harry is especially bothered by the rate. He thinks banks shouldn't get any more than 4% or 5%, but doesn't really know why he feels that way. When you both were about to sign the loan papers the banker mentioned that a minimum balance of $20,000 would have to remain in the bank. Hearing this, Harry pulled out his calculator and made a calculation at which he became outraged. He then stormed out of the meeting. Why is Harry so upset? What calculation did he make? Write a short memo explaining banking practices to calm Harry down. Is there a kind of minimum balance requirement that might make Harry's calculation invalid? Answer: Harry's calculation probably figured the effective interest rate on the loan with a 20% minimum compensating balance. This would have been 12% / .8 = 15%, a rate that does seem excessively high. It seems that the bank is being devious by quoting 12% when it's actually charging 15%. However, minimum balances are a standard practice designed to "compensate" banks for their services. Further, Harry probably doesn't understand two things about the loan business, the bank's cost and its risk. The bank lends businesses money it "borrows" from depositors, and operates on the "spread" between the interest it pays out and the rate it charges on loans. When interest rates are up, both of these rates are high, but the bank doesn't get to keep any more money that it does when rates are lower. Spreads are generally between five and ten percent. Out of that the bank has to pay all of its operating costs, cover loans that default, and make a profit. Harry's anger should be directed at generally high rates, which usually reflect inflation, rather than at the bank. The other thing Harry should keep in mind is risk from the bank's viewpoint. To the loan committee your business is a high-risk venture with a good chance of failure which implies a default on their loan. The bank has to be compensated with interest for bearing that risk. Admittedly, it's hard for entrepreneurs to identify with that view of themselves. Things may not be as bad as they seem if the requirement is for an average minimum balance. In that case all of the loaned money can be used at times as long as an average balance of at least 20% is maintained. You might have done that anyway. 4. You're the CFO of the Wachusett Window Company, which sells windows to residential builders. The firm's customers tend to be small, thinly capitalized construction companies that are frequently short of cash. Over the past year, there's been a slump in the housing industry and Wachusett's sales have slowed. Several months ago the marketing department initiated a program to attract new customers to counteract the downward sales trend. The VP of Marketing and the president agreed that the firm would have to deal with even smaller, newer builders if it was going to keep sales up. At the time the president overruled your concerns about the credit quality of such customers. He personally approved a number of accounts brought in by the sales department that ordinarily wouldn't have qualified for credit. More recently receivables have gone up substantially, and collection efforts have been less successful than usual. Collectors have asked for help from sales representatives in chasing down delinquent customers, but the VP of marketing says they don't have time because "reps have to be out on the street selling." The president has suddenly become concerned about the receivables increase, and has demanded to know why Finance has let it happen. Prepare a memo explaining the processes behind the creation and management of receivables and explain what's behind the increase. Tactfully explain why the blame should not be placed solely on the finance department. Can you argue that finance is completely without fault in this matter? Answer: Receivables are ordinarily considered the responsibility of the finance department. However, the appropriate management of problem accounts calls for consideration of how they arise in the first place. In the normal course of events receivables come from credit sales proposed by the sales/marketing department and approved by the credit and collections department. The approval by the credit department is key to the idea that finance is responsible for collection. It signifies a judgment by specialists that the debt is likely to be collectible. Rejection signifies a high probability that the account will not be collected and will result in a loss. The sales department, on the other hand, is responsible for delivering customers. Salespeople don't generally worry too much about credit worthiness, because under normal conditions the credit department takes care of that. In our current situation, we made the decision to extend credit despite concern about several customers' ability to pay. This has created a delinquency situation that we have to work together to resolve. When a receivable isn't paid, the credit department starts calling and writing the customer. Those contacts, however, tend to be with lower level administrative personnel. In collecting from cash poor companies, the trick is to get the debtor to prioritize our bill over those of other vendors. People in the customer's payables department don't have the authority or motivation to do that. Getting paid by troubled companies generally takes an executive decision, and it's relatively hard for collectors to get to the customer's executives. The sales force, on the other hand, tends to have an ongoing relationship with people higher up in the customer organization who can prioritize bill payments. In problem situations, that relationship can be crucial to successful collection of the account. The sales rep is in the best position to present the customer with the reality that unless the old bill is paid, we can't supply any more product. In small cash poor companies, that pitch generally has to be made to the president, and the salesperson has much better access to that office than the bill collector. It's therefore imperative that the collections department get some help from sales to work the overdue receivables. Without that we're unlikely to collect much. This needs to happen quickly, because the older receivables get, the less likely they are to be collected. In this case, because of the nature of the customers involved, we should probably get ready for some loss whatever we do. (Notice the wording of the first four paragraphs. The problem is the fault of the president and the VP of marketing, because they made the decision to lower credit standards over the CFO's objection. However, it would rarely be wise to come right out and say that. Saying, "I told you so," to your boss isn't likely to get you anything but grief. The idea is to gently remind the president of how the situation came about without accusing anyone of fault, and then to quickly focus on the team effort required to fix the problem. Particularly notice the wording in the fourth paragraph "we" made the decision..., not "you" made the decision... Also notice the last paragraph. It would be unwise to give the impression that everything will be ok if you get some help from sales. There's very likely to be a write-off required, and it’s better not to surprise the president with that later. Unfortunately, it's possible that the CFO is going to be the scapegoat in this situation regardless of what he or she does. Many top executives don't like to admit that they were wrong, and routinely lay the blame for mistakes elsewhere.) 5. In the situation at Wachusett Window outlined in the last question, do you think a higher prompt payment discount alongside the new sales program would have kept receivables down? Why? Answer: No. The problem customers aren't likely to have the cash to pay their bills promptly regardless of the incentive offered. An additional discount would probably hurt because it would be taken by customers who are already paying on time. 6. Speculate on the nature of the relationship between the credit and collections department and the sales department at Wachusett Window in the last two questions. Answer: It probably isn't too good. Credit and collections is likely to be resentful of the override of their rejections and to be really upset that the accounts are now proving to be problems. The fact that sales is unwilling to help in the collection effort is probably rubbing salt in the wound. 7. Wilde brant Inc runs out of inventory all the time both in the factory and at the point of sale. However, the company is profitable, and no one worries about it much. Is this ok? What's probably going on that management doesn't see? Why don't they see it? What would you suggest to fix the problem? How would it work? Answer: The problem is that the cost of running out of inventory isn't identified on financial statements. Shortages result in lower sales when they prevent filling orders and higher costs when they disrupt production, but those effects are buried in the financial results and aren't explicitly identified as being the result of inventory problems. When a company is profitable, such inefficiencies tend to be overlooked. They frequently aren't identified until times get tough and people start to look for ways to increase sales and lower cost. This, of course, is a mistake, because the firm could be doing even better in good times if it controlled inventory more effectively. The problem can be addressed by a tracking system that creates a report whenever a stockout occurs. An estimate can then be made of the financial consequences of each stockout. Compiling a list of all stockouts every month for management review will go a long way to motivate some attention to watching inventory levels more closely. PROBLEMS Definitions: (pages 667 – 669) 1. Scherbert Industries has the following balance sheet accounts as of 12/31/x3 (not a complete balance sheet): Solution: Cash Conversion Cycle: Figure 16-2 (page 671) 2. Southport Inc. has an inventory turnover of 10X, an ACP of 45 days, and turns over its payables once a month. How long are Southport's operating and cash conversion cycles? (Use a 360-day year.) Solution: Working Capital Financing Policies: Concept Connection Example 16-1 (page 675) 3. The Langley Corporation is in a seasonal business. It requires a permanent base of net working capital of $10 million all year long, but that requirement temporarily increases to $20 million during a four-month period each year. Langley has three financing options for net working capital. a. Finance the peak level year-round with equity which costs 20%, and invest temporarily unused funds in marketable securities which earn 6%. b. Finance permanent net working capital with equity and temporary net working capital with a short-term loan at 12%. c. Finance all net working capital needs with short-term debt at 12.5%. Calculate the cost of each option. Which would you choose? Why? Solution: The decision is subjective depending on the firm's profitability and the likely prospects for future increases in short term rates. Prompt Payment Discount (page 677) 4. Calculate the effective interest rate implied by the following terms of sale, using a 365-day year. 2/10, net 30 1/5, net 15 .5/10, net 30 2.5/10, net 25 1/5, net 20 Solution: (365/20)  2 = 36.5% (365/10)  1 = 36.5% (365/20)  1/2 = 9.125% (365/15)  2.5 = 60.833% (365 /15)  1 = 24.333% 5. Rocky Inc. can buy its inventory from any of four suppliers all of which offer essentially the same pricing and quality. Their credit terms, however, vary considerably as follows: a. Calculate the implied interest rate associated with each policy. b. If Rocky buys some material from each vendor, which discounts should it take and which should it forego if it pays 18% for working capital financing? Why? Solution: b. Rocky is effectively borrowing at the rates calculated in part a if does not take the discounts offered. Hence Rocky should pay promptly and take the discounts from suppliers A and B, because those rates are much higher than the 18% it pays for working capital financing. I.e., it should avoid borrowing from suppliers A and B. On the other hand, Rocky should forego the discounts, pay on the net date, and effectively borrow from suppliers C and D, because those rates are lower than the 18% it pays for working capital financing. Revolving Credit Agreements: Concept Connection Example 16-2 (page 680) 6. Thompson Inc. has a $10M revolving credit agreement with its bank. It pays interest on borrowing at 2% over prime and a ¼% commitment fee on available but unused funds. Last month Thompson had borrowings of $5M for the first half of the month and $10M for the second half. Calculate its interest charges for the month. The bank’s prime rate is 6%. Solution: 7. The Conejo Corp. borrows from its bank under an $8 million revolving credit arrangement. It pays a base rate of 9% on its outstanding loan plus a ¼% commitment fee on the unused balance. The firm had borrowed $2 million going into April and borrowed an additional $4 million on April 11. No further borrowing or repayment was made during the month. Calculate Canejo’s interest charges for April. Solution: 8. The Grass Ridge Company has the following current asset accounts Its current ratio is 2.5:1. The bank is willing to lend the company enough to finance its working capital needs under a $10 million revolving credit arrangement at a base rate of 12% with a 3/8% commitment fee on the unused balance. If the current accounts stay relatively constant throughout the year, what will Grass Ridge pay the bank for working capital financing? Solution: 9. Bridgeport Inc has a $30 million revolving credit agreement with its bank at prime plus 3.2% based on a calendar year. Prior to the month of April, it had taken down $15 million that was outstanding for the entire month. On April 10, it took down another $5M. Prime is 8.2%, and the bank's commitment fee is .25% annually. Calculate the charges associated with Bridgeport's revolving credit agreement for the month of April. Solution: Compensating Balances: Concept Connection Example 16-3 (page 681) 10. What is the effective interest rate on a $750,000 loan at 8% for 120 days if a 20% minimum compensating balance is required? Solution: 8%/(1  .20) = 10% 11. Calculate the effective interest rate on loans with the following minimum compensating balance requirements: Solution: a. 6.5/.8 = 8.125% b. 12.0/.9 = 13.333% c. 10.5/.85 = 12.353% d. 14/.75 = 18.667% e. 8.5/.7 = 12.143% Pledging Accounts Receivable: Concept Connection Example 16-4 (page 683) 12. Jenkins Appliances has cash flow problems and needs to borrow between $50,000 and $60,000 for approximately sixty (60) days. Because the business is small and relatively new, unsecured loans are very hard to get and are expensive when they are available. The bank has offered such a loan at 25%. Climax Inc., A finance company, has offered an alternative loan if receivables are pledged as collateral. Climax will lend 70% of the average receivables balance for 14% plus an administrative fee of $1,200. Jenkins’ average receivables balance is $80,000. Which alternative should Jenkins choose? Calculate using a 360-day year. Assume the bank is willing to lend the same amount as Climax. Solution: Assume that the loan will be $80,000 x 70% = $56,000 Cost of 25% loan for 60 days: $56,000 x .25 x 60/360 = $2,333.33 Cost of pledging: $56,000 x .14 x 60/360 + $1,200 = $2,506.67 Hence the bank loan is cheaper. 13. DeSquam Inc. pledges receivables of $250M per year to the Sharkskin Finance Company which advances cash equal to 80% of the face value of the accounts pledged. DeSquam’s receivables are usually collected in about 36 days, so 10% of the annual amount advanced is generally outstanding at any time. (36 days is one tenth of a year, so receivables “turn over” ten times a year.) Sharkskin charges 14% interest plus an administrative fee of 1.6% of the amount pledged. What is DeSquam’s cost of receivables financing? State the result in dollar terms and as a rate. Solution: Amount advanced per year = $250M  .8 = $200M Average amount outstanding @ 10% = $200M  .10 = $20M Interest on loan = $20M  .14 = $2.8M Administrative fee = $250M  .016 = $4M Total financing charges = $4.0M + $2.8M = $6.8M Charges as a % of avg loan balance = $6.8 / $20M = 34% 14. The York Company has an average receivables balance of $55,000, which turns over once every 30 days. It offers all of its receivables to its bank as collateral for short-term borrowing (pledging). The bank generally accepts 60% of the accounts offered and advances cash equal to 85% of those. Interest is 3% over prime and the bank charges a 1% administrative fee on the gross value of all accounts offered. The prime rate is currently 9.5%. What effective rate is York paying for its receivables financing? Solution: Factoring Receivables: Concept Connection Example 16-5 (page 685) 15. Southern Fabrics Inc factors all of its receivables. The firm does $150 million in business each year, and would have an ACP of 36.5 days if it collected its own receivables. The firm's gross margin is 35%. The factor operates without recourse and pays immediately upon taking over the accounts. It discounts by 10% the gross amount factored and pays Southern immediately. Because the factor doesn't collect from customers until they pay, it charges interest at 10% in the interim. a. Calculate the gross cost of factoring to Southern Fabrics if all receivables are collectible. b. What interest rate is implied by the arrangement? c. Suppose Southern is considering giving up the factoring arrangement and handling its own collections. Should the firm do it if bad debt losses are expected to average 3% of gross sales and running a collections department will cost about $1.5 million per year? Assume the interest cost of carrying the receivable balance is also 10%. d. What is the implied interest rate in the factoring arrangement if the costs in part c are taken into account? Solution: a. Factor's Discount = $150M  .10 = $15M Interest = (36.5 / 365)  .10  $150M = 1%  $150M = $1.5M Total charges = $16.5M b. Ordinary A/R balance = $150M  (36.5/365) = $15M Implied interest = Total financial charges/loan balance = $16.5M/$15M = 110% c. The cost of doing the collections job includes the cost of product lost on the bad debts (not the entire amount of the lost revenue since the gross margin on those sales isn't an actual loss) and the cost of running a collections department. Southern is better off to do the job itself, since the cost is considerably less than the $16.5M the firm is paying to the factor. d. ($16.5M  $5.9M)/$15M = 70.67% Inventory Financing: Concept Connection Example 16-6 (page 686) 16. Central City Bank will lend Williams Inc. 60% of the value of its inventory at 12% if Williams will pledge the inventory as collateral for the loan. The bank also insists that Williams employ a warehousing company to monitor and control the inventoried material. Blyth Warehousing will do the job for an annual fee of $150,000 plus 2% of the value of all the inventory it handles. Williams moves inventory valued at about $15M through its plant each year at a turnover rate of 5 times. What will the cost of financing be under this proposal? State the result in both dollar and percentage (of amount borrowed) terms. Solution: Average inventory balance = $15,000,000 / 5 = $3,000,000 Average loan @ 60% of inventory = $3,000,000  .6 = $1,800,000 Interest on average loan balance = $1,800,000  .12 = $216,000 Handling fee = $150,000 + ($15,000,000  .02) = $150,000 + $300,000 = $450,000 Total charges = interest + handling = $216,000 + $450,000 = $666,000 Financing cost as a % of average loan = $666,000 / $1,800,000 = 37% 17. The Shamrock Company has a raw materials inventory of $20M, which is completely replaced approximately 10 times a year. The Bridgewater Bank is willing to advance financing of 75% of the value of Shamrock's inventory at an interest rate of 12%. However, it requires a warehousing system to secure its interests. A warehousing company will install and operate the system for $800,000 a year plus .5% of the value of materials entering the system. What is the effective cost of this financing to Shamrock? Solution: Evaluating Lock Box Systems – Concept Connection Example 16-7 (page 694) 18. Tambourines Inc. collects $12M per year from customers in a remote location. The average remittance check is $1,200. A lock box system would shorten the overall float on these receipts from 8 days to 7 days, but would cost $2,500 per year plus $.20 per check. The relevant interest rate is 9%. Should Tambourines install the system? Use a 360-day year. Solution: Hence the cost exceeds the savings by $1,500 per year so the system should not be installed. 19. The Hadley Motor Company is located in Florida but has a number of customers in the Pacific Northwest. Sales to those customers are $30 million a year paid in checks that average about $1,500. The checks take an average of nine days to clear into Hadley's Florida bank. A bank in Oregon will operate a lock box system for Hadley for $8,000 a year plus $.50 per check. The system can be expected to reduce the clearing time to six days. a. Is the lock box system worthwhile if Hadley borrows at 13.5%? b. What is the minimum number of days of float time the system has to save (to the nearest tenth of a day) to make it worthwhile? Solution: 20. Colburn Inc. is considering a lock box system. The firm has analyzed its credit receipts and determined the following: Average time checks are in mail – 3 days Average internal check processing time – 3 days Average to clear the banking system – 2 days Total credit sales - $180 million Average check - $10,000 Colburn funds its accounts receivable with short-term debt at 8%. First Bank has indicated their lock box system will reduce mail float by an average of one day and eliminate internal processing time. The cost of the system is $0.50 for each check processed, plus 0.05% of the gross revenues processed. Should Colburn implement the lock box system? If the charge based on gross revenue remains constant, at what per check charge would Colburn be indifferent to lock box arrangement? Solution: Number of checks: $180 million/$10,000 = 18,000 checks Reduction in A/R: $180 million x 4/360 = $2 million Savings in interest expense: $2 million x .08 = $160,000 Cost of new system: $180 million x .0005 + $.50 x 18,000 = $99,000 Implementing would save $160,000 - $99,000 = $61,000 If C = per check charge Colburn would be indifferent if the cost of the system was equal to the interest saved or $160,000 = $90,000 + 18,000C $70,000 = 18,000C C = $3.89 21. Bozarth Business Machines (BBM) has analyzed the value of implementing a lock box system. The firm anticipates revenues of $630 million with an average invoice of $1,500. BBM borrows at 12% and has made an arrangement with Old Second Bank to manage a lock box for $.24 per check and .06% of total receipts. BBM has estimated that the lock box will save $200,000 annually. How many days does BBM expect the system save in the collection process? Solution: Number of invoices: $630 million/$1,500 = 420,000 invoices cost of the system + net annual benefit = interest savings $630 million x .0006 + (.24 x 420,000) + $200,000 = (Days/360) x $630 million x .12 $378,000 + $100,800 + $200,000 = $210,000 (Days) Days = $678,800/$210,000 = 3.23 Days Credit and Collections Policy: Concept Connection Example 16-8 (page 698) 22. The Bailey Machine Tool Company thinks it can increase sales by $10M by loosening its credit standards somewhat. The firm normally experiences bad debts of about 2% of sales, but marketing estimates that the incremental business would be from financially weaker customers who would not pay about 17% of the time. The firm’s gross margin is 18% (production related costs are 82% of revenue). a. Should Bailey lower its credit standards to get the new business? b. Would your answer change if taking on the new business also involved incremental collection expenses of $150,000 per year. Solution: a. The contribution to profit from new customers that pay is $10,000,000  .83  .18 = $1, 494,000 The loss on bad debts associated with new customers that don’t pay is $10,000,000  .17  .82 = $1,394,000 (Note that the loss on an uncollected debt is just the cost of the product sold, not the entire revenue amount that includes the profit that would have been made on the sale.) Hence the loosening of credit standards looks marginally profitable by $100,000 per year. That’s probably not enough to make implementing the plan advisable because of the inaccuracies inherent in making estimates like these. b. Another $150,000 in cost makes the project marginally unacceptable (by $50,000), which would make the argument against doing it even stronger. 23. Over the past few years, the marketing department at Goldston & Co has convinced the finance department to permit credit sales to increasingly marginal customers. Revenue has risen as a result, but bad debts are now at 6% of sales. Finance has suggested that credit policy be tightened to reduce bad debt losses. Their proposal calls for a more restrictive policy under which sales would fall by 8% but bad debt losses would drop to 2.6% of revenue. Under the current policy Golston’s revenue forecast is $400 million with a contribution margin of 38%. Implementing the new credit policy wouldn’t have an effect on contribution margin but would require an additional $500,000 in annual fixed costs. a. Should Goldston implement finance’s new credit policy? b. What non-financial considerations should be evaluated. c. Should the new policy be implemented if bad debts only are only expected to drop to 4% of revenues? Solution: ($000) 24. The Kranberry Kids Klothing Kompany is in the volatile garment business. The firm has annual revenues of $250 million and operates with a 30% gross margin on sales. Bad debt losses average 3% of revenues. Kranberry is contemplating an easing of its credit policy in an attempt to increase sales. The loosening would involve accepting a lower quality customer for credit sales. It is estimated that sales could be increased by $20 million a year in this manner. However, the collections department estimates that bad debt losses on the new business would run four times the normal level, and that internal collection efforts would cost an additional $1 million a year. a. Is the policy change a good idea? b. Is it likely that coupling an increased prompt payment discount with the looser guidelines would reduce the bad debt losses? c. Is it possible that the idea in part b could have a net negative impact? How? Solution: The policy change looks like a good idea, since the added margin on new sales exceeds the expected losses and costs. b. No, because the new customers are likely to be so cash poor that they won't take the discount. c. An increased discount might hurt because it would be taken by customers who are already paying on time, but not by those who create collection problems. Economic Order Quantity Model (EOQ): Concept Connection Example 16-9 (page 706) 25. Sharon’s Sweater Shop orders 5,000 sweaters per year from a supplier at a wholesale cost of $65 each. Carrying costs are 22% of cost, and it costs $52 to place and receive an order. How many orders should Sharon place with the supplier each year and how large should each be. Solution: 26. Smithson Hydraulics Inc. carries an inventory of valves that cost $25 each. The firm's inventory carrying cost is approximately 18% of the value of the inventory. It costs $38 to place, process, and receive an order. The firm uses 20,000 valves a year. a. What ordering quantity minimizes the inventory costs associated with the valves? (Round to the nearest unit.) b. How many orders will be placed each year if the EOQ is used? c. What are the valves' carrying and ordering costs if the EOQ is used? Solution: 27. Emmons Motors is a distributor of electric motors. The firm projects product demand next year of 25,000 units. It costs $320 to place an order with suppliers. Management has determined that the EOQ is 1,000 units. How much per year does it cost Emmons to carry a unit of inventory? Solution: EOQ = [2FD/C]1/2 1,000 = [(2 x 320 x 25,000)/C]1/2 C1/2 = [(16,000,000)1/2]/1000 = 4 C = $16 Just In Time (JIT) Inventory Systems: Concept Connection Example 16-10 (page 709) 28. EverFit Inc. manufactures commercial grade fitness equipment used in spas and health clubs. The firm produces complex resistance exercise machines designed to strengthen specific muscles. Ever Fit’s engineering department designs the equipment and then contracts with metal working shops to produce parts to their specifications. The parts are inventoried at Ever Fit’s factory and assembled for shipment to customers. The $250,000 parts inventory is financed with short-term debt at 6% interest. Shrinkage and obsolescence cost about 1%, while taxes and insurance run about $10,000 per year. EverFit has discussed a just in time (JIT) system with its suppliers all of which are located within fifty miles. The suppliers are small firms that depend on Ever Fit’s business, and are willing to try to deliver parts in accordance with its production schedule. However, Ever Fit’s CFO is concerned that although their intentions are good, the suppliers won’t be able to manage their operations precisely enough to consistently meet customer JIT requirements. Further, he thinks that when a JIT delivery is missed, it will generally be a day and a half before it is finally received. During that time the assembly staff of 25 people will be idle. Each assembly worker earns about $30 per hour and must be paid for eight hours a day whether working or not. a. If the measure of the system is saving money, how many JIT failures can the system tolerate and still break even? b. Comment on the advisability of the JIT idea based on your answer to part a. c. What qualitative factors might also be concerns? d. Suggest a way to test the system before making a final decision. Solution: a. Operating perfectly annual JIT savings will be The cost of a delivery failure is: 25 people x $30 per hour x 8 hrs per day x 1.5 days = $9,000 Break even number of failures = $27,500 / $9,000 = 3.1 b. It seems unlikely that small, presumably unsophisticated suppliers located as far as 50 miles away will be able to make JIT deliveries missing only three times each year. Hence the idea seems unlikely to be cost effective. c. An extended delivery failure lasting several days or weeks could be a financial disaster. It could also have negative consequences on Ever Fit’s relations with its own customers who may be anxious to receive product on time. d. Run the JIT system for a few months without getting rid of the existing inventory. When a delivery is missed, use parts out of inventory If there are a lot of missed deliveries, scrap the system. If not, slowly work down the existing inventory. Solution Manual for Practical Financial Management William R. Lasher 9781305637542