Professor: Preeti Agrawal Coverage of Midterm: Financial Planning Working Capital Options

1. Chapter
29:
Financial
Panning
A.
Financial
Planning:
A
decision
making
process
and
tool
that
enable
management
and
investors
to
assess
Financial
results
and
set
targets
for
Financial
growth
of
the
Company.
B.
Needs
of
Financial
Planning:
A. Contingency
Planning
- formulate
responses
to
inevitable
surprises
B. Considering
options
C. Forcing
Consistency
- firm’s
growth
and
financing
requirements
should
be
connected
C.
Financial
Planning
Involves
Setting:
- Short-­‐Term
goals
and
objective
- Long-­‐Term
goals
and
objective
Ø Then
design
a
strategy
to
achieve
goals.
D.
Short
Term
Financial
Planning
Ø Spans
a
period
of
(1)
year
or
less
Ø Forecasting
future
sources
and
uses
of
cash
Ø
Managing
accounts
receivable
and
accounts
payable
Ø
A
standard
against
which
subsequent
performance
can
be
judged
Ø
Makes
sensible
short
term
borrowing
and
lending
decisions
E.
Option
of
Short
Term
Financing
Bang
Loans
Stretching
Payables
F.
Cash
Cycle
A
metric
that
expresses
the
length
of
time
(in
days)
that
it
takes
for
a
company
to
convert
resource
inputs
into
cash
flows
This
metric
looks
at
the
amount
of
time
needed
to
sell
inventory,
the
amount
of
time
needed
to
collect
receivables
and
the
length
of
time
the
company
is
afforded
to
pay
its
bills
without
incurring
penalties.
Ø Cash
Cycle
(days)=
average
days
in
inventory
+
average
collection
period
–
average
payment
period
G.
Strategies
for
reducing
cash
flow
problems:
1. Maturity
Hedging
2. Decrease
cash
cycle
time
3. Cash
Budgeting
4. Cash
Reserves
Maturity
Hedging
- is
paying
for
short-­‐term
costs,
like
inventory,
with
short-­‐term
loans.
Decrease
Cash
Cycle
Time
- can
be
done
by
decrease
their
inventory
and
receivables
time
periods
- delay
payment
to
supplier
Cash
Budgeting
- gives
managers
a
“heads-­‐up”
about
when
short-­‐term
financing
may
be
needed.
- cash
budget
simply
records
estimates
of
cash
receipts
and
payments.
- starts
with
a
sales
forecast,
usually
by
the
quarter,
for
the
upcoming
year
- used
to
estimate
of
the
timing
of
cash
collections
by
quarter.
Cash
Reserves
- Keeping
cash
reserves
and
few
short-­‐term
liabilities
can
go
a
long
way
to
help
avoid
financial
distress.
- Higher
reserve
=
greater
liquidity
- Having
idle
cash
that
is
not
put
to
work
or
invested
means
future
revenue
is
foregone.
H.
Long
Term
Financial
Planning
Ø concerned
with
funding
the
growth
and
development
of
the
company
for
three
(3)
to
five
(5)
years
or
even
longer.
Ø obtaining
debt
capital
from
commercial
banks
or
other
financial
institutions.
Ø Helps
to
avoid
surprises
and
be
prepared
for
the
unavoidable.

2. I.
Similarities
and
Difference
of
Short
Term
and
Long
Term
Similarities:
- focused
on
the
financial
health
of
a
company
- objective
is
to
maximize
the
efficient
use
of
capital
-
All
business
require
capital,
that
is
money
invested
in
assets,
can
be
financed
by
long
term
or
short
term
sources
of
capital
Difference:
- Short-­‐term
involves
short
lived
assets
and
liabilites
- Short-­‐term
are
easily
reverable
J.
Reasons
why
Cash
Budgeting
is
important
to
Long
Term
Financial
Planning.
• Cash
budgeting
ensures
that
a
company's
cash
position
advances
its
overall
long-­‐term
financial
plan
• Provides
the
foundation
necessary
to
achieve
the
objectives.
K.
Growth
and
External
Financing
Internal
growth
rate
maximum
growth
that
company
can
achieve
without
external
funds
“maximum
growth
without
external
funds”
𝐼𝑛𝑡𝑒𝑟𝑛𝑎𝑙 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 =
𝑟𝑒𝑡𝑎𝑖𝑛𝑒𝑑 𝑒𝑎𝑟𝑛𝑖𝑛𝑔
𝑛𝑒𝑡 𝑎𝑠𝑠𝑒𝑡𝑠
Sustainable
growth
rate
highest
growth
rate
the
firm
can
maintain
without
increasing
its
financial
leverage
“highest
growth
rate
maintained
without
financial
leverage”
𝑆𝑢𝑏𝑠𝑡𝑎𝑛𝑡𝑖𝑎𝑙 𝑔𝑟𝑜𝑤𝑡ℎ 𝑟𝑎𝑡𝑒 = 𝑝𝑙𝑜𝑤𝑏𝑎𝑐𝑘 𝑟𝑎𝑡𝑜 × 𝑟𝑒𝑡𝑢𝑟𝑛 𝑜𝑛 𝑒𝑞𝑢𝑖𝑡𝑦
Chapter
30:
Working
Capital
Management
A.
Working
Capital
Short-­‐term,
or
current,
assets
and
liabilities
are
collectively
known
as
working
capital.
Current
Assets:
• Inventories
• Accounts
Receivables
• Cash
Current
Liabilities
• Accounts
Payable
• Accrued
Expense
• Debt
due
within
year
B.
Inventory
Management
Is
the
sensible
balance
between
the
benefits
of
holding
inventory
and
the
costs.
C.
Components
of
Inventory
•
Raw
materials
•
Work
in
process
•
Finished
goods
D.
Inventory
Trade-­‐Off
Involves
two
(2)
costs:
Ø Carrying
cost
–
storage
cost
Ø Order
cost
–
cost
of
purchase
from
supplier
E.
Relationship
of
the
Order
Size,
Order
Cost,
and
Carrying
Cost
F.
Economic
Order
Quantity
Order
size
that
minimizes
Total
Inventory
Costs.
◆ Example
–
A
retailer
sells
255,000
tons
of
coal
per
year.
Each
order
that
the
company
places
involves
a
fixed
order
cost
of
$450,
while
the
annual
carrying
cost
of
the
inventory
is
estimated
at
$55
a
ton.
(a)
What
is
the
economic
order
quantity
for
this
company?
(b)
How
many
orders
will
be
made?
a.
Economic
Order
Quanitity
𝐸𝑂𝑄 =
2×255,000×450
55
= 2,042.73 𝑡𝑜𝑛𝑠
Economic Order Quantity =
2 x annual sales x cost per order
carrying cost
Order
Size
Order
Cost
Order
Size
Average
Amount
of
Inventory
Carrying
Cost

3. b.
Number
of
Order
255,000
2,042.73
= 124.83 𝑡𝑖𝑚𝑒𝑠
G.
Tools
To
Minimize
Inventory
1. Just-­‐in-­‐time
2. Producing
goods
to
order
H.
Credit
Management:
Account
Receivables
-
Trade
Credit
-
Consumer
Credit
I.
Term
of
Sales
Credit,
discount,
and
payment
terms
offered
on
a
sale.
- Cash
on
Delivery
- Cash
before
Delivery
- Credit
terms
◆
Example
-­‐
5/10
net
30
– 5
-­‐
percent
discount
for
early
payment
– 10
-­‐
number
of
days
that
the
discount
is
available
– net
30
-­‐
number
of
days
before
payment
is
due
A
firm
that
buys
on
credit
is
in
effect
borrowing
from
its
supplier.
It
saves
cash
today
but
will
have
to
pay
later.
This,
of
course,
is
an
implicit
loan
from
the
supplier.
𝐸𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒 𝐴𝑛𝑛𝑢𝑎𝑙 𝑅𝑎𝑡𝑒
= 1 +
𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑝𝑟𝑖𝑐𝑒
!"# !"#$% !"#$ !"#$%&
− 1
◆ Example
-­‐
On
a
$100
sale,
with
terms
5/10
net
60,
what
is
the
implied
interest
rate
on
the
credit
given?
𝐸𝐴𝑅 = 1 +
0.05
95
!"# !"
− 1 = .454 𝑜𝑟 45.4%
J.
Credit
Agreements
a. Open
account
b. Sight
draft
–
is
a
message
to
the
buyer
to
pay
immediately
since
shipment
is
already
delivered
c. Time
draft—is
an
agreement
to
pay
later
on
according
to
the
period
given
in
the
draft
d. Trade
acceptance—buyer
accepts
the
period
stated
in
the
time
draft
e. Banker’s
acceptance—buyer
received
time
or
sight
draft
but
does
not
have
the
money
to
pay,
so
buyer
goes
to
the
bank
and
bank
accept
to
pay
for
the
buyer
first.
f. Irrevocable
letter
of
credit—trade
happens
overseas.
Buyer’s
bank
writes
a
letter
to
the
seller’s
bank.
Buyer
and
Seller’s
bank
manages
the
transactions.
g. Conditional
sale—bank
owns
title
of
ownership
until
buyer
pays
his
loan.
K.
Credit
Analysis
- Determines
the
likelihood
a
customer
will
pay
its
bills.
o Bond
Ratings
for
large
firms
o Credit
rating
agencies,
such
as
Dun
&
Bradstreet
provide
reports
on
the
credit
worthiness
of
businesses
worldwide
o Credit
bureaus
on
customer’s
credit
standing
L.
Credit
Decisions
Credit
Policy
-­‐
Standards
set
to
determine
the
amount
and
nature
of
credit
to
extend
to
customers.
- Extending
credit
gives
you
the
probability
of
making
a
profit,
not
the
guarantee.
There
is
still
a
chance
of
default.
- Denying
credit
guarantees
neither
profit
or
loss.
Based
on
the
probability
of
payoff,
expected
profit
can
be
expressed
as:
𝑝 × 𝑃𝑉 𝑅𝑒𝑣 − 𝐶𝑜𝑠𝑡 − 1 − 𝑝 × 𝑃𝑉 𝐶𝑜𝑠𝑡
The
Break
Even
probability
of
collection
is:
𝑝 =
𝑃𝑉 𝐶𝑜𝑠𝑡
𝑃𝑉 𝑅𝑒𝑣
M.
Collection
Policy
◆ Collection
Policy
-­‐
Procedures
to
collect
and
monitor
receivables.
◆ Aging
Schedule
-­‐
Classification
of
accounts
receivable
by
time
outstanding.
◆ Factoring
-­‐
Arrangement
whereby
a
financial
institution
buys
a
company's
accounts
receivable
and
collects
the
debt.
N.
Cash
Management
- Responsibility
to
provide
adequate
cash
to
the
firm
- Responsibility
to
ensure
funds
are
not
blocks
and
remain
idle
O.
Objectives
of
Cash
Management
a. Liquidity
b. Marginal
Benefits
(interests)
c. Trade
off
between
cost
of
idle
cash
and
benefits.
Ways
to
invest
idle
cash
- Sweep
programs

4. P.
Way
of
Receiving
Cash
Electronically
o Automated
Clearing
House
o Wire
Transfer
are
large-­‐
value
payments
between
companies
– Fedwire
– Chips
Q.
Speeding
Check
Collection
Ø Allows
the
firm
to
gain
quicker
use
of
funds
Ø Transfer
times
are
reduced
Ø Check
clearance
is
fast
◆ Concentration
Banking:
Decentralized
system
of
account
receivables
◆ Lock
Box
System:
Payments
send
to
regional
post
office
box
◆ International
cash
Management:
Multinational
bank
with
branches
in
each
country
◆ Compensating
balances:
– Monthly
fee
– Minimum
average
balance
R.
Short
Term
Investments
Ø Readily
marketable
securities
(stocks
and
bonds)
Ø
Convert
the
investment
into
cash
within
one
(1)
year
S.
Sources
of
Short
Term
Borrowings
◆ Bank
loan
(features)
– Commitment
– Maturity
– Rate
of
interest
◆ Syndicated
loans
◆ Loan
sales
and
CDOs
◆ Secured
loans
◆ Commercial
paper
◆ Medium
term
notes
Chapter
20:
Understanding
Options
A.
Terminologies
a. Derivatives
-­‐
Any
financial
instrument
that
is
derived
from
another.
(e.g..
options,
warrants,
futures,
swaps,
etc.)
b.
Option
-­‐
Gives
the
holder
the
right
to
buy
or
sell
a
security
at
a
specified
price
during
a
specified
period
of
time.
c.
Call
Option
-­‐
The
right
to
buy
a
security
at
a
specified
price
within
a
specified
time.
d.
Put
Option
-­‐
The
right
to
sell
a
security
at
a
specified
price
within
a
specified
time.
e.
Option
Premium
-­‐
The
price
paid
for
the
option,
above
the
price
of
the
underlying
security.
f. Intrinsic
Value
-­‐
Difference
between
the
market
value
of
the
underlying
and
the
strike
price
of
the
given
option.
g. Time
Premium
-­‐
Value
of
option
above
the
intrinsic
value
h. Exercise
Price
-­‐
(Striking
Price)
The
price
at
which
you
buy
or
sell
the
security.
i. Expiration
Date
-­‐
The
last
date
on
which
the
option
can
be
exercised.
j. American
Option
-­‐
Can
be
exercised
at
any
time
prior
to
and
including
the
expiration
date.
k. European
Option
-­‐
Can
be
exercised
only
on
the
expiration
date.
B.
Call
Option
Buyer
has
the
right
to
buy
Seller
has
the
obligation
to
buy
if
buyer
exercises
option
to
buy
◆ Suppose
the
stock
of
XYZ
company
is
trading
at
$40.
A
call
option
contract
with
a
strike
price
of
$40
expiring
in
a
month's
time
is
being
priced
at
$2.
You
believe
that
XYZ
stock
will
rise
sharply
in
the
coming
weeks
and
so
you
paid
$200
to
purchase
a
single
$40
XYZ
call
option
covering
100
shares.
◆ Say
you
were
proven
right
and
the
price
of
XYZ
stock
rallies
to
$50
on
option
expiration
date.
With
underlying
stock
price
at
$50,
if
you
were
to
exercise
your
call
option,
you
invoke
your
right
to
buy
100
shares
of
XYZ
stock
at
$40
each
and
can
sell
them
immediately
in
the
open
market
for
$50
a
share.
This
gives
you
a
profit
of
$10
per
share.
As
each
call
option
contract
covers
100
shares,
the
total
amount
you
will
receive
from
the
exercise
is
$1000.
Since
you
had
paid
$200
to
purchase
the
call
option,
your
net
profit
for
the
entire
trade
is
therefore
$800.
◆ However,
if
you
were
wrong
in
your
assessment
and
the
stock
price
had
instead
dived
to
$30,
your
call
option
will
expire
worthless
and
your
total
loss
will
be
the
$200
that
you
paid
to
purchase
the
option.

5. C.
Put
Option
Seller
has
the
right
to
sell
Buyer
is
obligated
to
buy
if
seller
exercises
option
to
sell
◆ Suppose
the
stock
of
XYZ
company
is
trading
at
$40.
A
put
option
contract
with
a
strike
price
of
$40
expiring
in
a
month's
time
is
being
priced
at
$2.
You
strongly
believe
that
XYZ
stock
will
drop
sharply
in
the
coming
weeks
after
their
earnings
report.
So
you
paid
$200
to
purchase
a
single
$40
XYZ
put
option
covering
100
shares.
◆ Price
of
XYZ
stock
plunges
to
$30
after
the
company
reported
weak
earnings
and
lowered
its
earnings
guidance
for
the
next
quarter.
With
this
crash
in
the
underlying
stock
price,
your
put
buying
strategy
will
result
in
a
profit
of
$800.
◆ you
invoke
your
right
to
sell
100
shares
of
XYZ
stock
at
$40
each.
Although
you
don't
own
any
share
of
XYZ
company
at
this
time,
you
can
easily
go
to
the
open
market
to
buy
100
shares
at
only
$30
a
share
and
sell
them
immediately
for
$40
per
share.
This
gives
you
a
profit
of
$10
per
share.
Since
each
put
option
contract
covers
100
shares,
the
total
amount
you
will
receive
from
the
exercise
is
$1000.
As
you
had
paid
$200
to
purchase
this
put
option,
your
net
profit
for
the
entire
trade
is
$800.
Call
Option
Buyer
Seller
Expectation
MP↑
MP↓
Loss
Limited
to
OP
Unlimited
Profit
Unlimited
Limited
to
OP
Put
Option
Buyer
Seller
Expectation
MP↓
MP↑
Loss
Limited
to
OP
Limited
to
Stock
Price
Profit
Limited
to
Stock
Price
Limited
to
OP
D.
Moneyness
A
term
describing
the
relationship
between
the
strike
price
of
an
option
and
the
current
trading
price
of
its
underlying
security
At
the
money
In
the
Money
Out
the
Money
(breakeven)
(to
exercise)
(not
to
exercise)
EP
=
MP
EP
<
MP:
call
option
EP
>
MP:
put
option
EP
<
MP:
put
option
EP
>
MP:
call
option
IN
THE
MONEY
◆ In-­‐the-­‐money
options
are
generally
more
expensive
as
their
premiums
consist
of
significant
intrinsic
value.
◆ Has
an
intrinsic
value
The
Intrinsic
value
is
a
difference
between
the
strike
price
and
the
underlying
price.
It
can
be
only
positive
Ø Intrinsic
value
for
the
CALL
Option
=
Underlying
Price
–
Strike
Price
Ø
Intrinsic
value
for
the
PUT
Option
=
Strike
Price
–
Underlying
Price
OUT
THE
MONEY
◆ Out-­‐of-­‐the-­‐money
options
have
zero
intrinsic
value
◆ Out-­‐of-­‐the-­‐money
options
are
cheaper
as
they
possess
greater
likelihood
of
expiring
worthless.
AT
THE
MONEY
◆ Has
no
intrinsic
value
Long Short
Call option Right to buy asset Obligation to sell asset
Put option Right to sell asset Obligation to buy asset
EP
MP
MP
Put
Option
Call
Option

6. E.
Financial
Alchemy
with
Options
Ø looks
at
how
options
can
be
used
to
modify
the
risk
characteristics
of
a
portfolio.
1. Protective
Put
- A
risk-­‐management
strategy
that
investors
can
use
to
guard
against
the
loss
of
unrealized
gains.
The
put
option
acts
like
an
insurance
policy.
Advantages
of
Protective
Puts...
o Allows
you
to
hold
on
to
your
stocks
and
participate
in
the
upside
potential
while
at
the
same
time
insuring
against
any
losses
o The
cost
to
buy
the
insurance
is
relatively
cheap
considering
how
much
money
you
are
protecting
Disadvantages
of
Protective
Puts...
o Cost
of
the
Put
option
eats
into
your
profit
o The
option
has
a
limited
lifespan
(it
expires)
and
has
to
keep
being
renewed
(buying
another
option)
2. Straddle
- Involves
purchasing
both
put
and
call
option
- Both
options
has
the
same
EP
and
expiration
date
- Straddle
is
useful
in
a
high
volatile
market
since
it
allows
you
to
choose
which
ever
option
would
benefit
you
the
most
F.
Six
(6)
Factors
Affecting
Option
Premium
1. Underlying
Price
(MP)
2. Strike
Price
(EP)
3. Time
until
expiration
4. Volatility
5. Interest
Rate
6. Dividends
Underlying
Price
- most
influential
factor
on
an
option
premium
- MP↑:
call
prices
increase
and
put
prices
decrease
- MP↓:
call
prices
decrease
and
put
prices
increase.
Strike
Price
- determines
if
the
option
has
any
intrinsic
value
- More
in
the
money
=
OP↑
- More
out
the
money
=
OP↓
Expected
Volatility
- Volatility
is
the
degree
to
which
price
moves,
regardless
of
direction.
- DEGREE
OF
PRICE
MOVEMENT
- Historical
volatility
refers
to
the
actual
price
changes
that
have
been
observed
over
a
specified
time
period.
o historical
volatility
is
used
to
determine
possible
volatility
in
the
future.
- Implied
volatility
is
a
forecast
of
future
volatility
and
acts
as
an
indicator
of
the
current
market
sentiment.
- ↑Volatility
=
↑OP
Time
until
expiration
- The
longer
an
option
has
time
until
expiration,
the
greater
the
chance
that
it
will
end
up
in-­‐the-­‐money,
or
profitable.
(because
of
time
money
value)
- ‘Time
Decay’
is
the
ratio
of
the
change
in
an
option's
price
to
the
decrease
in
time
to
expiration.
(Also
known
as
"theta"
and
"time-­‐value
decay")
o As
an
option
approaches
its
expiry
date
without
being
in
the
money,
its
time
value
declines
because
the
probability
of
that
option
being
profitable
(in
the
money)
is
reduced.
Call
Option
100
shared
@50
EP:5
2
MP:60
MP:40
Put
Option
can
buy
share
for….
can
sell
share
for….

7. Interest
Rates
- also
have
small,
but
measurable,
effects
on
option
prices.
- ↑
interest
rates:
call
premiums
will
increase
and
put
premiums
will
decrease.
o because
of
the
costs
associated
with
owning
the
underlying;
the
purchase
will
incur
either
interest
expense
(if
the
money
is
borrowed)
or
lost
interest
income
(if
existing
funds
are
used
to
purchase
the
shares).
In
either
case,
the
buyer
will
have
interest
costs.
Dividends
- underlying
stock's
price
typically
drops
by
the
amount
of
any
cash
dividend.
- ↑underlying's
dividend:
call
prices
will
decrease
and
put
prices
will
increase
- ↓underlying's
dividend:
call
prices
will
increase
and
put
prices
will
decrease.