Module 3 Uses of Funds. Framework Capital budgeting process Basic principles of capital budgeting Investment decision criteria (PP,DPP, NPV, PI, ARR,

Module 3

Uses of Funds

Framework•Capital budgeting process•Basic principles of capital budgeting•Investment decision criteria (PP,DPP, NPV, PI, ARR, IRR)

Capital Budgeting

•CA and CL Mgmt•WC financing•Short-term credit

Working Capital Management

•Liquid assets•Collection and disbursement•MS Portfolio

Cash and Marketable Securities

Management

•A/R Management•Inventory Management•TQM and JIT

AR and Inventory Management


Capital Budgeting





Management



Capital Budgeting

The process in which the firm renews and reinvents itself Includes decision such as: opening a new

plant, introducing a new product line, closing operations, selling a business, etc.

Answers the question: should the proposed project be accepted or rejected

Capital budgeting decision criteria

Payback period Discounted payback period Net present value Profitability Index Internal rate of return (IRR)

Payback period Number of years needed to recover the initial cash

outlay of the project

Example: if the firm’s maximum desired payback period is 3 years and an investment proposal requires an initial cash outlay of $10,000 and yields the following set of annual free cash flows, what is the payback period? Should the project be accepted?Year After-tax free CF

1 2,000.00$ 2 4,000.00$ 3 3,000.00$ 4 3,000.00$ 5 10,000.00$

Decision:ACCEPT if payback period ≤ maximum acceptable payback periodREJECT if payback period ≥ maximum acceptable payback period

Payback Period: Pros and Cons

Advantages Uses free cash flows Easy to calculate and understand May be used as a rough screening devise

Disadvantages Ignores the time value of money Ignores free cash flows occurring after the

payback period Selection of the maximum acceptable

payment period is arbitrary

Discounted Payback Period

Number of years needed to recover the initial cash outlay from the discounted free cash flow.

Given the following after tax free cash flows, compute for the discounted payback period. The required rate of return is 17% p.a.

Decision:ACCEPT if discounted payback period ≤ maximum acceptable payback periodREJECT if discounted payback period ≥ maximum acceptable payback period

Year After-tax free CF Discounted Cash Flow Cumulative0 ($10,000.00) ($10,000.00) ($10,000.00)1 $6,000.00 $5,128.21 ($4,871.79)2 $4,000.00 $2,922.05 ($1,949.74)3 $3,000.00 $1,873.11 ($76.63)4 $2,000.00 $1,067.30 $990.675 $1,000.00 $456.11 $1,446.78

DPP: Pros and Cons

Advantages Uses free cash flows Easy to calculate and understand Considers time value of money

Disadvantages Ignores free cash flows occurring after the

payback period Selection of the maximum acceptable

payment period is arbitrary

Net Present Value (NPV)

Present value of the free cash flows less the investment’s initial outlay.

Gives a measurement of the net value of an investment proposal in terms of today’s dollars.

If NPV is zero, it returns the required rate of return and should be accepted.

Decision:ACCEPT if NPV ≥ 0REJECT if NPV ≤ 0

IOi

FCFNPV

n

nnn

1 )1(

Where:IO = initial cash outlayFCF = free cash flown = project’s expected life

NPV: An Example

J&J is considering new machinery that would reduce manufacturing costs associated with making Johnson’s baby cologne. If the firm has a 12% required rate of return, should the project be accepted?Year Free cash flow Present Value

Initial Outlay ($40,000.00) ($40,000.00)1 $15,000.00 $13,392.862 $14,000.00 $11,160.713 $13,000.00 $9,253.144 $12,000.00 $7,626.225 $11,000.00 $6,241.70

NPV: Pros and Cons

Advantages Uses free cash flows Considers time value of money Consistent with the firm’s goals of

shareholder and wealth maximization

Disadvantages Requires detailed long term

forecasts of a project’s free cash flows

Sensitivity to the choice of the discount rate

Profitability Index Benefit/cost ratio The ratio of the future free cash flows to the

initial cash outlay If NPV provides a measure of the absolute

dollar desirability of a project, the PI produces a relative measure of an investment proposals desirability

Decision:ACCEPT if PI ≥ 1REJECT if PI ≤ 1

IOi

FCF

PI

n

nnn

1 )1(


PI: Pros and Cons

AdvantagesUses free cash flowsConsiders time value of moneyConsistent with the firm’s goals of shareholder and wealth maximization

DisadvantagesRequires detailed long term forecasts of a project’s free cash flows

Internal Rate of Return (IRR)

Answers the question: what rate of return does this project earn?

IRR: discount rate that equates the present value of the project’s future net cash flows with the project’s initial cash outlay. You have to solve for IRR.

Decision:ACCEPT if IRR ≥ required rate of returnREJECT if IRR ≤ required rate of return

n

nn

n

IRR

FCFIO

1 )1(


IRR: Pros and Cons Advantages

Uses free cash flows Considers time value of money Is in general consistent with the firm’s

goals of shareholder and wealth maximization

Disadvantages Requires detailed long term forecasts of a

project’s free cash flows Possibility of multiple IRR’s Assumes cash flows over the life of the

project are reinvested at the IRR

Seatwork

You are considering a project that will require an initial outlay of $54,200. This project has an expected life of 5 years and will generate after-tax cash flows to the company as a whole of $20,608 at the end of each year over its five-year life. In addition to the $20,608 free cash flow from operations during the 5th and final year, there will be an additional cash inflow of $13,200 at the end of the 5th year associated with the salvage value of a machine, making the cash flow in year 5 equal to $33,308. Given a required rate of return of 15%, calculate the following. Should the project be accepted? Minimum acceptable no of years for PP and DPP is 3 years.

a.Payback periodb.Discounted payback periodc.Net Present Valued.Profitability Indexe.IRR

Assignment1. You are considering 2 independent projects, project

A and project B. the initial cash outlay associated with project A is $45,000, whereas the initial cash outlay associated with project B is $70,000. The required rate of return on both projects is 12%. The expected annual free cash inflows from each project are as follows:

Calculate the payback period, discounted payback period, NPV, and PI for each project and indicate if the project should be accepted. Min acceptable years for PP and DPP is 3 years

Year Project A Project B0 (45,000) (70,000)1 12,000 14,0002 12,000 14,0003 12,000 14,0004 12,000 14,0005 12,000 14,000

Assignment2. Artie’s Soccer Stuff is considering building

a new plant. This plant would require an initial cash outlay of $8 million and will generate annual free cash inflows of $2 million per year for eight years. Calculate the project’s payback period, discounted payback period (min acceptable payback period is 4.5 years), NPV and Profitability Index given a required rate of return of 12%. Will you accept or reject the project?


Capital Budgeting





Management




Working capital is the difference in the firm’s current assets and is current liabilities

WC = Current Assets – Current Liabilities

Can give rise to short-term financing problems

Appropriate level of working capital

Hedging principle, or principle of self-liquidating debt Matching the cash-flow generating

characteristics of an asset with the maturity of the source of financing used to finance its acquisition

E.g. a seasonal expansion in inventories should be financed with short-term credit or current liability

Sources of financing

Temporary sources of financing Unsecured bank loans, commercial

paper, loans secured by accounts receivable and inventories

Permanent sources of financing Intermediate term loans, long-term

debt, preferred stock, common equity

Spontaneous sources of financing Trade credit, wages payable,

accrued interest, accrued taxes

Measuring WC efficiency

Minimize working capital by: Speeding up collection of cash Increasing inventory turns Slowing down disbursement of cash

CASH CONVERSION CYCLE

Cash Conversion Cycle (CCC)

=days of sales outstanding

(DSO)+

days of sales in inventory (DSI)

+days of payable

outstanding (DPO)

Cash Conversion Cycle

Cash Conversion Cycle (CCC)

=days of sales outstanding

(DSO)+


+days of payable

outstanding (DPO)

accounts receivablesales/365

=days of sales

outstanding (DSO)

inventoriesCGS/365


=

accounts payableCGS/365

days of payable outstanding (DPO)

=

Estimating the cost of short-term credit (APR)

APR = interest/ (principal x time)

Example: SKK Corporation plans to borrow $1,000 for a 90-day period. At maturity, the firm will repay the $1,000 principal amount plus $30 interest. What is the effective annual rate of interest for the loan?

Interest = Principal x Rate x Time

Estimating the cost of short-term credit (APY)

To account for the influence of compounding

Example: SKK Corporation plans to borrow $1,000 for a 90-day period. At maturity, the firm will repay the $1,000 principal amount plus $30 interest. What is the APY of the loan?

11

m

m

iAPY

Where:m = number of compounding periodsi = nominal rate of interest per year

Sources of short-term credit

Trade Credit Credit terms and cash discount Stretching of trade credit

Bank credit Line of credit Credit terms

Transaction loans Commercial paper

Accounts receivable loans Factoring accounts receivables Inventory loans


Capital Budgeting





Management



Motives for holding cash

Transactions motive

Precautionary motive

Speculative motive

• Allow the firm to meet cash needs that arise in the ordinary course of doing business

• Buffer stock of liquid assets. • To be used to satisfy possible,

but indefinite needs

• To take advantage of potential profit-making situations

Cash Management Decisions

What can be done to speed up cash collections? Manage the cash inflow

and cash outflows What should be the

composition of a marketable securities portfolio?

Cash Gathering System

Step 1: Customer writes check and places it in the mail

Step 2: Mail is delivered to firm’s headquarters

Step 3: checks are processes and deposited in bank

Step 4: checks are forwarded to the clearing system

Step 5: checks are passed on to customer’s bank

Step 6: Customer’s funds are declared good

Step 7: Firm receives notice that checks have cleared

Day 1

Day 2-3

Day 4-5

Day 6

Day 7

Mail float

Processing float

Transit float

Managing cash inflows

Lock-box arrangements Firms mail their checks not to the

company but into a numbered post office box, which will be opened by the bank

Pre-authorized checks Resembles an ordinary check, but it

does not contain nor require the signature of the person whose account is being drawn

Concentration banking and wire transfers

Managing cash outflows

Zero-balance accounts Permit centralized control over cash

outflows Payable –through drafts

With the appearance of ordinary checks but are not drawn on a bank. It is drawn against the issuing firm and is presented to the issuing firm’s bank

Electronic funds transfer

Marketable Securities

General selection criteria Financial risk: possible changes in

financial capacity of the security issuer to make future payments

Interest rate risk: changes in interest rate

Liquidity: ability to transform the security into cash

Taxability: tax treatment of the income a firm receives

Yields: return; influenced by financial risk, interest rate risk, liquidity and taxability

Marketable Securities Alternatives

Treasury bills Banker’s acceptances Negotiable certificates of

deposit Commercial paper Repurchase agreements Money market mutual funds

Documents

Module 3 Uses of Funds. Framework Capital budgeting process Basic principles of capital budgeting Investment decision criteria (PP,DPP, NPV, PI, ARR,