Topic 5

APPLY FINANCIAL
MANAGEMENT
PRINCIPLES TO PERFORM
COMPLEX INVESTMENT
APPRAISAL
 Learning Outcome
a) Explain factors to be considered in investment
appraisal analysis other than quantitative
factors
b) Explain the impact non-financial factors on
making an appropriate investment decisions
c) Calculate risk and inflation into investment
appraisal using various techniques
d) Perform investment appraisal (Calculate optimal
investment and capital rationing)
Other factors that may need to be considered beyond basic
investment appraisal analysis

i. Assessment of Risk
ii. Subjective factors
iii. Intangible factors
iv. Limitations in data and
information
 Assessment of risk
 The terms risk and uncertainty have different meanings though in
practical life they are sometimes used interchangeably.
Risk refers to quantifiable sets of circumstances, to which probabilities
can be assigned. implications:
i. Expected returns may vary in the future
ii. Different outcomes are possible
iii. risk increases proportionately with the project life
iv. risk also increases proportionately with the greater variability
v. companies show more concern for the ‘downside risk’ (i.e.
possibility of receiving lower returns than expected in comparison
to a higher return than expected)
vi. probabilities can be assigned, and the risks can be quantified
 Cont.……
 Uncertainty refers to a situation where it
is impossible to assign probabilities to sets of
circumstances.
 implications.
Different outcomes are possible.
Assignment of probabilities or quantification of
costs and benefits is difficult mainly due to little
past experience.
 2. Subjective factors
a)Capital Structure
 Aims of investment appraisals is to maximize shareholder
wealth.
 The company value is influenced by the way it is financed;
therefore, the capital structure should be used to its full
potential.
 Beyond the basic investment appraisal analysis, management
needs to also consider the way it decides to finance a project.
 It needs to identify the optimum capital structure which
involves external debt and internal capital through shares, for
example, and then choose the option that leads to the highest
shareholder wealth.
Cont….
 b) Inflation
 Inflation is also a subjective factor as the
impact of inflation on an investment
appraisal is forward looking and therefore,
only an estimate can be made as to what
the rate is anticipated to be.
 3. Intangible factors
b) Management vs. Shareholders
 There is often a difference between the interests and opinions of
management compared to shareholders.
 Therefore, within the investment appraisal analysis this intangible
factor should also be taken into consideration.
 This intangible factor takes into consideration incentives and
information problems that occur due to the information being
interpreted by different people, with their own opinions and
perspectives.
 The interests or incentives of both parties make the information
on the project sensitive to the available resources of the
company.
 Cont…
b) Characteristics of those in charge of
governance
 Certain research has shown that the characteristics of the Chief
Executive Officer (CEO) of an organization can influence the
investment policy implemented by the firm. Any misrepresentation in
the policy can lead to over confident management together with
over estimation in the cash flow calculations of the project’s return,
mainly in cases with excess cash flow.
 On the other hand, if the CEO is uncertain of its rewards as a result
of investment decisions, the level of investments undertaken by the
company is expected to be low.
 Similar to the point above, shareholders require an effective
incentive scheme to encourage management to make investment
decisions that are in the best interests of the firm and be value
enhancing.
 4. Limitations in data and
information
a) Source of data and information
 The information used in the calculations or
assessment of non-financial factors has an impact
on the advice given.
 There are a number of sources of information,
such as via television, newspapers, magazines,
word of mouth etc.
 There are limitations in this type of information,
as it is dependent on where the data has come
from.
b)Quality of information
Similar to the above point, the presentation and quality of the
information impacts the decision made.
c) IT limitations
 there can be limitations in information due to the limitations of IT
functionality.
 The company may not have the appropriate IT resource to perform
a full estimation of a project and then perform sensitivity analysis as
an example.
 Cont……..
d) Availability of experts
 For certain projects, management may require the use of experts
in the performance of evaluating a potential project.
 The company may not have sufficient resources to perform the
calculations themselves or the technical knowledge, in which case
external experts may be required.
 It is possible that management are unable to spend the capital on
experts or that the required level of experts for the particular
project are not available, which has an impact on the reliability of
the information.
The impact non-financial factors on making an
appropriate investment decisions –Qualitative factors
 After the quantitative analysis is completed, management then need
to make a decision on which project (s) to implement or whether
the project being reviewed should be accepted or not.
 However, management will not automatically base this decision purely
on whether the project has a positive NPV or whether one
alternative has a higher overall return than other projects.
 In this decision, they will need to take into account non-financial
factors that may affect the project (s).
 A company has used the NPV method of appraisal on Project X,
which has a positive NPV and therefore, financially will increase the
value of the company. However, the project involves some damage to
the environment, and this factor alone can change the decision to
accept the project, due to the adverse impact it will have on the
company’s image.
 Cont…..
i. Legal issues: any legal issues the company may face as a result of undertaking
the project, e.g. whether the project will meet the requirements of current and
future legislation etc.
ii. Ethical issues: a project may be legal, but if the actions involved in the project
are deemed unethical, this can have severe adverse impact on the company’s
image and reputation.
iii. Industry issues: e.g. does the project conform to industry standards and good
practice.
iv. Government regulation: this can include various regulations such as
employment laws, environmental law, competition law and also planning
permissions given by local governments etc.
v. Environmental issues: e.g. will the project have an adverse impact on the
surrounding environment.
vi. Strategy of company: consideration needs to be given as to whether the
project is in-line with the aims and objectives of the business.
vii. Impact on various relationships: will the project lead to improved staff
morale, better relations with suppliers, customers and local community.
viii. Developing the skills of the company: will the project lead to an increase in
skills and experience in a particular field, which overall leads to stronger
capabilities.
 Incorporate risk and inflation into the investment
appraisal using various techniques/models.
 Techniques of adjusting for risk and
uncertainty
a)Sensitivity analysis
 Sensitivity analysis is a method used to
estimate the risk of an investment project by
evaluating how much the NPV of the project
changes when the variables from which it has
been calculated change.
Relevant variables
 The following items can be considered as
relevant variables while calculating the net
present value (NPV) of a project.
Methods used for sensitivity
analysis
a) Quantifying the change in each key
variable that will make the NPV zero.
b) Changing each key variable by a set
percentage and checking the impact on
the NPV.
c) Certainty equivalent approach
 i) Quantifying the change in each variable that will
make the NPV zero
 In this method, it is verified as to how much change in each key variable will
cause the NPV to become zero.
 These changes are converted into percentage terms.
 Then a conclusion is reached about which variables are most important.
 It can be said that the project is more sensitive to those variables of which
even a small percentage change can cause the NPV to become zero.
 Management needs to keep a close watch on these variables if it wants the
project to succeed.
Example
 A 3% reduction in sales volume is sufficient to make the NPV of a project zero.
As against this, it requires a 15% increase in the initial investment to make the
NPV of a project zero. This project is more sensitive to reduction in sales
volume. Management needs to take care that the sales volume does not dip.
 ii)Changing each variable by a set
percentage and checking the impact on the
NPV
 Since we are more concerned with the downside risk, a
percentage change that will reduce the NPV is considered.
 The project is more sensitive to the variables that cause
higher reduction.
Example
 A 5% reduction in the selling price reduces the NPV by
Tshs 50,000,000; a 5% reduction in sales volume reduces
the NPV by Tshs 10,000,000. The project is more sensitive
to changes in sales price than to changes in sales volume.
 Limitations of sensitivity
analysis
a) Only one variable can be changed at a time. This
requires that the changes in each key variable
must be isolated.This may be unrealistic.
b) This analysis only identifies key variables. It does
not assess the risk in the real sense, since it does
not consider the probabilities or likelihood of
variables actually changing.
c) Management may not have control over the key
factors, even if they are identified.
d) Unless parameters are set, this analysis in itself
does not provide a decision rule.
 b) Probability analysis
 Instead of using single point estimates that have been used so far, a
probability distribution of expected cash flows can be prepared. It can be
used to arrive at an expected NPV. This probability analysis can be used to
find out the possibility of achieving a negative NPV and the probability of the
best- and worst-case scenario.
 Simple probability distributions may just have a few probabilities.

Probability Cash flow

Tshs 000’s
0.3 200,000
0.6 300,000
0.1 100,000
Expected net present value = (0.3 x Tshs 200,000,000) + (0.6 x Tshs 300,000,000) + (0.1 x
Tshs 100,000,000) =
Tshs 250,000,000.
 Probability distribution of
expected cash flows
a) Using different probabilities or joint probabilities, a probability
distribution is prepared. This approach recognises that there are
several possible outcomes.
b) Expected NPV is calculated.
c) Risk is analysed from different angles.
Example
 The cost of capital for Supernova Inc is 14%. The initial investment
for the project is Tshs 470,000,000. Estimate the cash flows of the
project under different economic circumstances. Their respective
probabilities are as follows
 Net cash flows for Year 1
Economic
Conditions Weak Moderate Good
Probability 0.3 0.5 0.2
Cash Flow ( Tshs
000’s) 150,000 300,000 450,000
Net cash flows for Year 2

Economic
Conditions Moderate Good
Probability 0.7 0.3
Cash Flow ( Tshs
000’s) 375,000 525,000
Find the expected value (EV) of the project’s NPV assuming that the economic conditions in
Year 2 are not dependant on Year 1. Also find out how much is the risk that NPV will become
negative.
Standard deviation of NPV

 Example
 Two mutually exclusive projects P or Q
are to be considered by Grill Plc. There is
some uncertainty about the running costs
with each project. The probability
distribution of the NPV for each project
has been estimated as follows:
NPV Tshs million Project probability NPV TZS Million Project Q probability
-10 0.15 5 0.2
10 0.2 10 0.3
15 0.35 20 0.4
35 0.3 30 0.1
Which project should the company opt for?
 Step 1: Calculation of the EV of
the NPV for project P and Q
P
NPV Tshs million Project probability EV TZS million
-10 0.15 -1.5
10 0.2 2
15 0.35 5.25
35 0.3 10.5
16.25
Q
NPV TZS Million Project Q probability EV TZS million
5 0.2 1
10 0.3 3
20 0.4 8
30 0.1 3
15

Project P has higher EV of NPV, but we need to find out the risk
of variation in the NPV above or below the EV;
this is to be measured by Standard Deviation of the NPV. It can
be calculated as:
S=√𝑃(𝑥 − ̅)2
Where, x is the EV of the NPV
 Step 2: Calculation of Standard
Deviation of a project’s NPV
X TZS Million P X- ̅X Tshs million P(X- X ̅) 2TZS
-1.5 0.15 -17.75 47.26
𝑥 𝑥 𝑥 𝑥
2 0.2 -14.25 40.61
5.25 0.35 -11 42.35
10.5 0.3 -5.75 9.92
140.14

X TZS Million P X- ̅X Tshs million P(X- X ̅) 2TZS

1 0.2 -14 39.2
𝑥 𝑥 𝑥
3 0.3 -12 43.2
8 0.4 -7 19.6
3 0.1 -12 14.4
116.4

Project P Project Q
SD=√140.14 SD=√140.14
= 11.838 = 10.789
= TZS 11.838m TZS 10.789m
Cont…
 Project P has higher EV of NPV, it also has higher
standard deviation of NPV and therefore has a higher
risk attached to it. Selection of a project depends on the
management’s appetite to risk.
 If the management is risk averse, it will select the less
risky project, Project Q.
 If the management is prepared to take a risk with a low
NPV in the hope of a higher NPV, it will select Project P.
 3. Evaluation of probability
analysis
 This method is growing in popularity. The fact
that it is based on the subjective estimates of
the managers does not reduce their utility.
These estimates are made by the managers on
the basis of the information available.
 They represent the assessments of the
likelihood of future events. Such assessments
are made by the managers regularly in the
normal course of business.
 c) Simulation
 One major limitation of sensitivity analysis is that it analyses the sensitivity of the
project’s NPV to changes in one variable at a time. In reality, a change in one
variable may have knock-on effects on another.
 Simulation models are useful to handle changes in more than one variable at a time.
They determine by repeated analysis, how simultaneous changes in these variables
affect NPV. This method is also called Monte Carlo method.
 The following steps are included while using a simulation model for appraising a
project:
a) For each project variable, a range of random numbers is assigned to the values at
different probabilities.
b) A computer generates a set of random numbers and uses these numbers to
randomly select a value for each variable.
c) NPV of this set of variables is calculated.
d) This process is repeated and a frequency distribution of the NPVs is generated.
e) From the frequency distribution, the expected NPV and its standard deviation are
calculated.
 However, the variables are likely to be interdependent, e.g. an increase in prices may
reduce sales volume. Simple simulation models assume that these factors are
unrelated to each other. Such interrelationships are frequently complex to model.
 Example
 The Finance executive of J.W. Pillers Plc has drawn the
following projections with probability distributions
Wages and Proba
Raw material Probability Sales revenue Probability
salaries bility

Tshs
Tshs million Tshs million
million
10-Aug 0.3 8-Jun 0.2 28-32 0.1
12-Oct 0.5 10-Aug 0.3 32-36 0.2
14-Dec 0.2 12-Oct 0.3 36-40 0.5
14-Dec 0.2 40-44 0.2
Fixed costs are Tshs 12,000,000 and available cash balance is Tshs 52,000,000.
Students are required to simulate the cash flow projection and expected cash balance at
the end of the sixth month. Use the following random numbers:

Wages and salaries 3 8 9 3 9 7

Raw materials 4 5 1 0 3 4
Sales Revenue 0 5 6 8 0 2
1. Simulation of cash flow
projection
(a) Random number allocation
Random numbers are allocated on the basis of cumulative
probabilities of the lowest to the highest values e.g. if the
available random numbers for wages and salaries are taken
as 10 (0 to 9) the random numbers range based on the
cumulative probability of 0.3 is (0-2). It covers three digits
of 0, 1 and 2. Next cumulative figure is 0.8 (3-7) It covers
next five digits 3,4,5,6 and 7.The next cumulative
probability is 1.0. (8-9).It covers the next two digits 8 and
9.
 Wages and Salaries Raw Materials Sales Revenue
Midpoint Cum. Random Midpoint Cum. Random Midpoint Cum. Random
Tshs Tshs Tshs
Prob. Nos. Prob. Nos. Prob. Nos.
million million million

9 0.3 0-2 7 0.2 0-1 30 0.1 0

11 0.8 7-Mar 9 0.5 4-Feb 34 0.3 2-Jan
13 1 9-Aug 11 0.8 7-May 38 0.8 7-Mar
13 1 9-Aug 42 1 9-Aug
(b) Simulation of cash flow
 Actual random numbers for the
respective months are given above.
Depending upon the range under which
the number falls, the amount for that
month is determined. For example,
random numbers for wages and salaries
for 6 months are 3, 8, 9, 3, 9 and 7. They
fall under the classes having midpoints 11,
13, 13, 11, 13 and 11 respectively. These
values are filled up in the table below.
 Wages
Sales Raw Fixed Net Cash
Cash balance
and
revenues materials costs Flow
Month Opening
salaries
balance
Tshs Tshs Tshs Tshs
Tshs 52 million
million million million million
million

1 30 11 9 12 -2 50
2 38 13 11 12 2 52
3 38 13 7 12 6 58
4 42 11 7 12 12 70
5 30 13 9 12 -4 66
6 34 11 9 12 2 68

From the above simulation it will be observed that there are 4 months which have net cash inflows, the probability of net cash inflows can therefore be estimated as
4/6 = 0.66. From the above table, the estimated cash balance at the end of sixth month is Tshs 68,000,000.
 2. Expected Value (EV) Method
of Cash Flow Projection
Tshs
million
EV of salaries and wages (9 x 0.3) + (11 x 0.5) + (13 x 0.2) 10.8
EV of raw materials (7 x 0.2) + (9 x 0.3) + (11 x 0.3) + (13 x 0.2) 10
EV of sales revenue (30 x 0.1) + (34 x 0.2) + (38 x 0.5) + (42 x 0.2) 37.2
Expected net cash inflow per month Tshs 37.2 – 10.8 – 10.0 – 12.0 4.4
Expected cash balance after six months Tshs 52.0 + (4.4 x 6) 78.4

The dif erence between Tshs 68,000,000 and Tshs 78,400,000 is due to sample errors. If a number of simulation iterations were carried out, then the mean of the balances
predicted should approach the expected value more closely as the number is increased.
 Inflation incorporated into
investment appraisal
 The above case study shows that the factors of inflation
and taxation affect the investment decisions.You may be
wondering how these are reviewed in investment
decisions.
 In this Study Guide, we understand the techniques used
to do this. In our discussions on DCF methods so far,
the effect of inflation was considered, but the impact on
investment decisions were not detailed.
 This Study Guide discusses how when inflation
increases, the rate of return expected by the investors
also goes up.
Real vs. nominal cash flows (the effect of
inflation on investment appraisal)
 Real cash flows are cash flows that have
not been subjected to inflation.
 Nominal cash flows or money cash flows
have been influenced by inflation.
 Example
 Steve will receive Tshs 100,000,000 in cash next
year. During the year, inflation of 3% is expected.
Next year, the nominal value will be Tshs
100,000,000 but the real value (after stripping
away the effects of inflation) will be Tshs
97,087,379 ( Tshs 100,000,000 / 1.03).
 The discount rate used in assessing projects so far, has been
the real rate of return required by investors. This is the rate
which compensates investors for the risk of undertaking the
activity and for not being able to use the money. Since inflation
erodes the purchasing power of money, investors will require
compensation for this additional factor. Therefore, the rate of
return required for investments will increase.
 The rate of interest which incorporates the real rate and the
inflation rate is known as the nominal or money rate of return.
It can be calculated using the following formula:
(1 + Nominal rate or money rate) = (1+ Real rate) x (1+ Inflation
rate)
If Steve’s real rate of return required is 10% and inflation is 3%, the effective nominal rate wil be:
Nominal rate = (1+ 0.10) x (1+ 0.03) – 1
1.10 x 1.03 - 1
1.133 - 1
0.133
13.3%
Which rate is to be used for
discounting?
 The answer depends upon which cash
flows are being discounted. If real cash
flows are being discounted, the real cost
of capital should be used.
 If nominal cash flows are being
discounted, the nominal cost of capital
should be used.
 Continuing Steve’s example
from above
Nominal cash flow Tshs 100,000,000
Nominal cost of capital 13.3% Discounted value of the
cash flow = Tshs 100,000,000/1.133 Tshs 88,261,253

Real cash flow Tshs 97,087,379

Real cost of capital 10% Discounted value of the cash
flow = Tshs 97,087,379/1.10 Tshs 88,261,253
 HW
 Fisher’s plans to make an investment in a production line which
will facilitate the sale of a new product called XBX. An initial
investment of Tshs 396,000,000 in working capital would also be
needed. Non-current assets costing Tshs 840,000,000 would be
needed, with Tshs 600,000,000 payable at once and the balance
payable after one year. Fisher’s expects that, after four years, the
XBX will be obsolete and the disposal value of the non-current
assets will be zero.
 The project would incur incremental total fixed costs of Tshs
660,000,000 per year at current prices, including annual
depreciation of Tshs 216,000,000. Expected sales are 130,000 units
per year at a selling price of Tshs 25,000 per unit and a variable
cost of Tshs 18,000 per unit, both in current price terms.
 Fisher’s expects the following annual increases because of inflation:
 Cont…
%
General prices 7.4
Variable costs 7
Selling price 5
Fixed costs 5
Working capital 6

Assuming Fisher’s real cost of capital is 8 per cent, is the project viable? Ignore taxation for this question
 Perform investment appraisal (Calculate
optimal investment and capital rationing)
 Capital rationing arises when the amount of funds
available for investments are restricted or limited.
 This restriction on funds may apply to only one
time period (single period capital rationing) or
may extend indefinitely into the future (multi-
period capital rationing).
 In both cases, the finance manager must ensure
that projects yielding the greatest returns are
prioritised. In this Study Guide the issues relating
to single period capital rationing are discussed.
 Calculation of profitability indexes for
divisible investment projects

1. Divisible investment projects

 A divisible investment project is the one where
any portion of the project may be undertaken. In
other words, if funds are insufficient, the
company may partly invest in the project.
 Along with being divisible, it is also assumed that
the project is non deferrable (if not
undertaken now, it cannot be undertaken in the
future) and non repeatable (it can be
undertaken only once).

3. Decision rule
• Projects will be ranked according to their PI and
invested in accordingly, starting with the project
producing the highest PI.
• This will be done until the available funds are
exhausted. If this approach is adopted for divisible
projects, it will ensure that the company achieves
the highest possible NPV.
• The PI approach to capital rationing is more
suitable for single-period capital rationing
situations.
 Determine the optimal combination of
products assuming that the projects are
divisible. Total funds available are Tshs
4,200,000.
Project A B C D

1 Initial investment ( Tshs 000’s) 1,250 1,625 2,000 2,125

2 Net present value ( Tshs 000’s) 1,625 1,790 2,000 1,910

3 Initial investment + NPV ( Tshs 000’s) 2,875 3,415 4,000 4,035

 Cont,..
Project A B C D

Profitability index (3/1) 2.3 2.1 2 1.9

Ranking by profitability index 1 2 3 4
Profitability Index = PV of future cash flows / Initial Investment

Cumulative
Optimum investment schedule: NPV (
investment
Tshs 000’s) ( Tshs 000’s)
Tshs 1,250,000 invested in Project A 1,625 1,250
Tshs 1,625,000 invested in Project B 1,790 2,875
Tshs 1,325 invested in Project C ( Tshs
1,325 4,200
4,200,000 - 1,250,000 - 1,625,000)* Total
NPV for $4200 invested: 4,740
(4,200 − 2,875)
* × 2,000 ( Tshs 000’s)
2,000

Therefore, the optimal combination of projects is project

A, B and 2/3rd of project C.
 Calculation of the NPV of combinations of
non-divisible investment projects
 If projects are non-divisible it is a case of ‘all or nothing’ i.e. the
option to partly invest, as in the example above, will not be
available. In such a case, the PI approach will not apply. The finance
manager will use a ‘trial and error’ approach to maximise the
company’s NPV.
Continuing the example of the previous page,
 Assuming that the projects are now indivisible, the combined
investment schedule is as follows:
Projects A and B Total NPV = 3,415
Projects A and C Total NPV = 3,625
Projects A and D Total NPV = 3,535
Projects B and C Total NPV = 3,790
Projects B and D Total NPV = 3,700
Projects C and D Total NPV = 3,910

As project C and D have the highest NPV, so the optimum investment schedule is a
combination of project C and D.
 Nature of project Meaning Approach to decision making
(a) Determine the combination of
Indivisible (no fractional investment) Investment should be made in full.
projects to
utilise the available amount
Partial / proportional investment is not (b) Calculate the NPV of each
possible. combination
(c) Select the combination with the
highest NPV
Partial investment is possible and (a) Compute the profitability indices (PI)
Divisible (fractional investment) proportional NPV can be generated of various projects and rank them
b) Select the projects based on
maximum PI
 Reasons for capital rationing
 Ideally, a company would prefer to implement all possible
projects that will maximise the shareholder value if it had
unlimited capital.
 In theory, any project can be put to market so as to raise funds.
 However, in reality there is a limit to the amount of capital that a
company has or can raise from the capital market.
 This gives rise to the need for capital rationing.
 The reasons for capital rationing may arise due to external
restrictions by the capital market, in which case it is called ‘hard
capital rationing’.
 Alternatively, they may arise due to internal limits imposed by the
managers, in which case it is called ‘soft capital rationing.
 Hard capital rationing may be caused
due to any of the following reasons:
 (a) If capital markets are depressed, raising money may
not be possible.
(b) Based on the credit appraisals, the financial institutions may
consider lending to a company too risky.
(c) Cost of capital issue may be disproportionate, especially if the
amount of capital requirement is small.
(d) Due to the credit policy of the government, there may be
restrictions on lending.
 In reality, hard capital rationing is less frequent. Most of
the capital rationing is self imposed (soft).
 Soft capital rationing may be caused by any of the
following reasons:

a) Management may refuse to raise additional funds through

the issue of new shares to avoid dilution of control for
existing shareholders.
b) To avoid commitment to large payments of interest or
installments of principal. This applies to debt finance.
c) Small and Medium Enterprises (SMEs) may decide to rely
only on internally generated funds for the purpose of
expansion.
d) Managers may wish to create an internal market for funds,
thereby ensuring that only the most financially viable
projects are selected.
e) There may be a lack of managerial time or expertise to
manage projects, therefore a limitation on the amount of
investments may be imposed.
 HW
Required initial investment NPV at appropriate cost of capital
Project Tshs Tshs
P 50,000 10,000
Q 150,000 17,500
R 25,000 8,000
S 100,000 12,500
T 50,000 15,000
The amount available with the company is Tshs 150,000,000:

Determine the optimal combination of projects assuming

that the projects are:

Divisible
Indivisible
Topic 6

APPLY FINANCIAL
MANAGEMENT
PRINCIPLES TO MANAGE
WORKING CAPITAL
 Learning Outcomes
 Explain working capital management
 Explain principles underlying effective management of working
capital
 Explain working capital policies and its impact of each on
profitability and liquidity position of the business
 Estimate the working capital requirements of a firm
 Decide on the level of inventory
 Determine credit policy variables and their impact on the wealth
of the shareholders as well as managing collections
 Determine the optimal cash balance (Baumol’s and Miller-Orr
models)
 Concept of working capital
 Gross working capital refers to the firm’s investment in
current assets. Current assets are basically those assets which
can be liquidated within a period of twelve months in the normal
course of business. . Example - inventory, debtors, cash and bank
etc. Gross working capital gives us an idea of the total
investment required in the various forms of current assets. The
planning for short term financing starts with estimation of gross
working capital needs.
 Net working capital is the difference between current assets
and current liabilities. It helps us to understand the short-term
liquidity position of the company.
 Current liabilities are those claims which must be repaid within a
period of twelve months
 Current
Current assets
liabilities
Cash and bank balances Trade payables
Inventories of raw materials, work in
Current tax liability
progress and finished goods
Trade receivables Dividends payable
Marketable financial assets Short-term loans
Long-term loans i.e. the part
Advances to suppliers
maturing within twelve months
Other liabilities payable within 12
Other assets realisable within 12 months
months
 Excess working capital has its
disadvantages in terms of:
a) Funds not being put to productive use and
impact on company earnings
b) Excess inventory
c) Diluted focus on debtor control
d) Leakages in the system which might go
unnoticed due to excess liquidity
e) Inefficiency in the organization ultimately
affecting market value of the firm.
 On the other hand, inadequate working capital
would be disadvantageous in terms of

i. Impact of liquidity and non-availability of

liquid funds for fulfilling various obligations
ii. Impact on company reputation due to
danger of non-fulfilment of commitments.
iii. No benefits of economies of scale
iv. Impact on sales, i.e. needing to sell below
target prices on account of liquidity
pressure
v. Delay in implementation of certain growth
strategies affecting profit goals
Principles of working capital
management
 Working capital management refers to the
management of current assets and current
liabilities and the interrelationship between
them. Cash management, receivables
management and inventory management are all
important facets of working capital
management.
 The following are the principles underlying
effective working capital
 1. Principle of equity position
 According to this principle, every shilling of investment
made in working capital should enhance the net worth of
the firm i.e. to determine the ideal working capital level.
The finance manager should enhance investment in
working capital so long as it has a positive impact on
equity.
 The level of current assets can be measured with two
ratios:
a) Current assets as a percentage of total assets
b) Current assets as a percentage of total sales
 ZYT Ltd has reported sales of Tsh150 million. The fixed assets
were Tshs 50 million. If the current assets stand at Tsh50 million,
the ratios would be computed as follows:
Current assets
(a) = 50/(50+50) = 50/100 = 50%
Total assets

Current assets
(b) = 50/150 = 33.33%
Total sales
 2. Principle of risk variation
 This is very critical in order to manage working capital effectively.
 Generally, the higher the risk the management is willing to take,
the higher is the return that it can expect.
 Risk in this case refers to the risk of non fulfillment of liabilities.
 If the current assets are reduced beyond a certain level,
there will not be enough liquidity to meet all obligations.
 We shall study in the subsequent Learning Outcomes how
different working capital policies are followed depending on the
management appetite for risk and reward.
 3. Principle of cost of capital
 In evaluating different sources of finance, one has
to be guided by the fact that different sources
have different costs of capital.
 Working capital financing can happen through
debt or equity or a combination of both. While
debt capital is relatively cheaper than equity
capital (due to the tax arbitrage), overall risk also
increases with deployment of debt capital.
4. Principle of maturity of
payment
 This principle requires one to match the
maturities of payment in respect of
liabilities with the flow of funds - i.e. cash
inflows and outflows should be matched
across maturities, else it would jeopardise
the liquidity and solvency position of the
firm.
 Working capital management should be
guided by this principle at all times.
 working capital policies and the impact of each on the profitability
and liquidity position of the business.
 Permanent and temporary working capital
 Current assets, by their very nature, are assets which are held by the
business for periods of twelve months or less.
 These assets, in total, fluctuate depending on the level of business
activity. However, in most businesses a particular base level of
inventory is always held and cash balances are never allowed to fall
below a certain level.
 These represent the proportion of current assets permanently held
i.e. the proportion of current assets which are fixed (hence the term
‘permanent current assets’). It is also called core working capital.
 From this point of view, the assets of a company are classified into
non-current assets, permanent current assets and fluctuating current
assets.
Permanent working capital = Minimum inventory level + Minimum cash balance +
Level of trade receivables - Level of trade payables
 The changes in working capital
occur on account of
1. Changes in policy
 In case management changes its current asset policy (after
review), i.e. decides to shift to a more conservative / aggressive
policy, it would impact the working capital position.
2. Changes in sales
 Current assets change in direct relation to a changes in sales. The
quantum of current assets would increase / decrease with change
in sales. For example, with an increase in sales there would be an
increase in stock, receivables, collections etc.
3.Technological improvements
 Technological advancements would have a positive impact on
improving efficiency and thereby reducing the working capital
cycle. This would change the working capital position of the firm.
Distinction between Fluctuating Current Assets,
Permanent Current Assets and Non-Current
Assets
Working capital policies
 Working capital policy is concerned
with policy decisions such as:
i. Maintaining an adequate amount of
working capital (current assets and
current liabilities)
ii. Deciding on the sources of finance of
working capital
1. Maintaining an adequate amount of
working capital (current assets and current
liabilities)

 Cont….
 The current ratio mainly gives an idea of the company's ability to
pay back its current liabilities i.e. short-term debt and payables
with its current assets i.e. cash, inventory and receivables.
 The higher the current ratio, the more capable the company is of
paying its obligations. This is because a high current ratio depicts
that the company has more current assets as compared to its
current liabilities. Furthermore, a ratio less than 1 suggests that
the company would be unable to pay off its obligations if they fall
due at that point.
 The current ratio can give an idea of the efficiency of a
company's operating cycle or its ability to turn its products into
cash.
 Cont…

 Example
 The following information is extracted from the
financial statements of Padidas Co
20X9 20X0
Tshs
Tshs million
million
Current Assets
650 700
Inventory
Trade receivables 900 1,030
Cash and bank 50 75
Total current assets 1,600 1,805
Current liabilities
490 410
Trade payables
Bank overdraft 480 530
Total current Liabilities 970 940
Credit sales 5,100 5,300
Total sales 6,200 7,300
Credit purchases 2,500 2,600
Cost of sales 6,100 6,800
 Average production period is 30 days.
 Let’s calculate current ratio and quick ratio.
Curre nt ra tio
Current assets 1600 1805
Current liabilities 970 940
1.65 1.92
Quick ra tio
Quick assets 950 1105
Quick liabilities 490 410
1.938 2.695

 From 20X9 to 20X0 both the current and the quick

ratios have improved indicating better liquidity for the
company. Padidas’s ability to cover its current liabilities
has improved.
 2. Deciding on the sources of finance of working capital
 The working capital can be financed either through short term or
long-term sources of finance.
 Short term sources of finance include:
a) Short term credit lines offered by banks in terms of bank overdraft, cash credit
b) Trade creditors
c) Short term debt instruments
d) Customer advances (if the business practice permits)
 Short term sources of finance are:
 Cheaper: since lenders are deprived of cash for a relatively short
period, interest rates on short-term finance are likely to be lower than those
on long term. This is in line with the liquidity preference theory. In addition, no
interest is usually charged on trade credit from suppliers (unless payment
deadlines are missed).
 More flexible: these sources are flexible; in the sense that the company can use
them to the extent needed.
 But: More risky: as the sources are short term, it may be withdrawn at any
time.
 Cont…
Long term sources of finance include
a) Equity – issue of additional share capital
b) Retained earnings ploughed back into business
c) Secured debt in terms of debentures
d) Long term loans from banks / financial institutions
e) Public deposits (subject to the laws of the land)
 Long term sources of finance tend to be more expensive (as the
lender’s money is tied up for a longer period) but more secure.
Terms for payment of interest and re- payment of the principal
amount borrowed are agreed up front which allows businesses to
plan their cash flows. Since everything is agreed beforehand, the
likelihood of long term finance being withdrawn is minimized. When
deciding on the mix of long term and short-term finance, the
company must consider its view on risk
 2.3 Types of working capital
policies
 There are three types of policies that can be followed
1. Conservative policy
 Under this policy, the current assets are held at a fairly high level.
In firms where the conservative policy is followed, the current
ratio (i.e. current assets divided by current liabilities) would be
higher than the generally accepted 2:1.
 Furthermore, the working capital requirement under this policy is
met largely though funds obtained from long term sources. The
use of short- term funds is restricted to emergency situations.
This policy is a low profit – low risk measure. Since long
term funds are used for working capital finance it ensures
sufficient liquidity. However, profitability may be impacted since
long term funds, as discussed above, would have higher cost as
compared to short term funds (in general).
 Cont…
2. Matching policy (also called hedging policy)
 According to this policy, the current assets are divided
into
(i) those current assets which are essential at any point in time
i.e. hard-core working capital and
(ii) balance which varies from time to time i.e. temporary
working capital.
 This policy endeavors to match the maturity profiles of
assets and liabilities i.e. permanent working capital is
treated like fixed assets and financed through long term
funds, while the fluctuating current assets are financed
through short term funds.
 Example
 The management of New Horizon Ltd has estimated the
working capital requirements for the next six months:
Split as
Total working
Permanent Temporary
Month
capital required
( Tshs m) ( Tshs m)
( Tshs m)

Apr 10,000 8,500 1,500

May 8,500 8,500 -
Jun 11,000 8,500 2,500
Jul 9,000 8,500 500
Aug 10,900 8,500 2,400
Sep 9,500 8,500 1,000

 Under the matching policy, Tshs 8,500 m would be financed

through long term sources since this is permanent working
capital and the balance through short term sources.
 Let’s compare the above two policy styles in terms of their
impact on liquidity and profitability
 (a) Liquidity
i) When we compare the two policies in terms of risk involved, it is
evident that hedging policy is riskier than conservative policy. This is
because in hedging policy only short term funds are used to finance
short term working capital needs. The use of short term loans always
carries a risk of early repayment since they are repayable on demand.
 The ability to liquidate the current assets to match the repayment
of short term funds is questionable. Furthermore, short term funds
also carry repricing risk since rates can be revised by the lenders at
any time based on the liquidity and interest rate scenario in the
economy. Therefore, profitability forecasts may get affected.
ii) In contrast, the conservative approach does not deploy short term
funds and is financed completely through long term funds with
comfortable level of working capital. So there is no strain on liquidity.
 (b) Profitability
i) Under the conservative approach, in contrast to other policies,
there would be an impact on profitability on account of increase in
cost due to:
Higher amount of investment in working capital
Financing through long term funds
 Since long term funds in general carry a higher rate than short term
funds, the overall cost of funds would be higher under the
conservative approach.
ii) There is another type of impact on profitability on account of
inefficient use of working capital. In case funds are not put to
optimum use, profitability would be negatively impacted due to the
cost of idle funds.
Trade-off between the two
approaches
 There is no one policy which can be considered suitable
for a business at all points in time. It would depend on
the management perception of the level of acceptable
risk.
 One possible financing mix which can be considered to
be a trade-off between the two approaches is to arrive
at an average of maximum and minimum monthly
requirements for a given period. Upto this level,
financing can be done through long term funds and the
balance through short term funds.
 Example
 Continuing the example of New Horizon Ltd, the above
trade-off is worked out as follows
Split as

Total w orking
Permanent Temporary
Month
capital required
( Tshs m) ( Tshs m)
( Tshs m)

Apr 10,000 9,750 250

May 8,500 9,750 -
Jun 11,000 9,750 1,250
Jul 9,000 9,750 -
Aug 10,900 9,750 1,150
Sep 9,500 9,750 -

 Thus the average is worked out at Tshs 9,750 million (average of

maximum and minimum of working capital required, i.e.11,000 plus
8,500 divided by 2) which is financed through long term funds. At
this level, short term funding is required only in three months.
 3. Aggressive policy
 Under this policy, the management adopts an aggressive approach
to working capital management. Working capital is squeezed and
kept at a minimal level. Furthermore, the financing is also done
largely through short term sources. This is advantageous from the
viewpoint of returns i.e. it would have a positive impact on
profitability since fund requirement is minimized and funding is
through cheaper sources.
 This policy measures high in terms of risk. This is because
components of current assets like inventory cannot be liquidated
and converted to cash as quickly as may be required to meet the
short term obligations. Therefore, aggressive policy adversely
affects liquidity and in extreme cases, can jeopardized the solvency
position of the firm.
 Determinants of the working
capital policy of businesses.
1.The industry in which the organisation operates
i. Manufacturers: manufacturing organizations will hold high levels of inventory in the
form of raw materials, work in progress and finished goods. They may also benefit from
high levels of credit from suppliers.
ii. Supermarkets and retailers: supermarkets and other retailers receive most of
their sales in cash, by credit card or by debit card. Thus the level of trade receivables
tends to be relatively low. Trade payables, on the other hand, tend to be quite high as
they purchase from suppliers mainly on credit. As a result they may have the advantage
of significant cash holdings which they may choose to invest.
iii. Wholesalers: a company which supplies to other companies, such as a wholesaler, is
likely to be buying and selling primarily on credit; and coordinating the flow of cash may
be quite a problem. Such a company may make use of short-term borrowings such as
an overdraft to manage its cash.
iv. Small companies with relatively low turnover: smaller companies with a limited
trading record may face severe problems especially in obtaining credit from suppliers.
At the same time, customers will expect to receive the length of credit period that is
normal for the particular business concerned. As a result, trade receivables could be
moderate or high. Such firms may encounter problems in their management of cash
 Cont…
2. Business dynamics
 The working capital needs vary widely with the fluctuations in
business. During a boom there is an increase in sales accompanied by
an increase in each of the components of current assets, requiring
additional investments. On the other hand, in the case of a slowdown
/ recession, the level of activity decreases causing a decline in
debtors, level of inventory etc.
 Therefore, working capital requirements are significantly influenced
by the business cycle.
3 Operating cycle
 The size of working capital is influenced by the operating cycle i.e.
time taken from procurement of raw materials to manufacturing of
finished goods. In other words it is the production cycle time and as
such will be determined by the skill and efficiency of labour as well
as technical factors, such as the processing time taken by a machine.
 Cont…
4 Demand linked production policies
 In the case of certain lines of business, demand is seasonal wherein peak demand lasts for
only certain months of a year. In such cases, management has two options. Either production
can be undertaken only for certain months of the year adjusted to the demand period or
production can be undertaken for the entire year based on the forecasted demand.
 In case production is done for certain months only, there is a problem of maintenance of
idle machinery and labour, unless the management is able to involve them in some alternate
activity. Hence, each organisation should formulate a working capital policy which considers
the impact of its production policy.
5 Raw material availability
 In case certain inputs / raw materials are not available on a continuous basis, it becomes
necessary to stock them. They can then be utilised in the periods of short supply. This would
require an increase in the quantum of working capital. Furthermore, the firm should have
ready funds when the raw materials are available in the market.
6 Terms of credit
 Working capital policies are influenced by the terms of credit which are offered to
customers and received from suppliers. Sometimes, due to the prevailing market practices,
the firm is required to offer credit terms to all customers. Also, due to fierce competition,
the firm would need to stock a variety of products, requiring an increase in the level of
working capital.
 Cont…
7 Growth strategy
 All companies which are on a growth trajectory require increased working
capital. However, another important aspect is that companies which foresee
growth opportunities should make additional investments in all facets of
business, including working capital. It is important to adjust working capital to
changing growth estimates and plan the cash flow accordingly.
8 Profits earned
 The cash profit generated by a firm is absorbed in order to finance working
capital. The earnings need to be adjusted for depreciation and other non-cash
outflows to arrive at the amount of cash profit. It is essential to estimate the
level of earnings for each period to ascertain the quantum that would be
available for working capital financing.
9 Taxation
 Taxes form an integral part of any business venture and adequate provision has
to be made for payment of taxes.
 According to the laws applicable, taxes also need to be paid in advance based on
profit forecasts.
10 Depreciation policy
 Depreciation is a non-cash expenditure; however, depreciation provisions impact
cash flows through their impact on tax provisions. If the depreciation provision
reduces due to a change in the depreciation policy, the tax liability would
increase, requiring additional funds to fulfil it.
 If the actual capital expenditure to replace a fixed asset is lower than the
accumulated depreciation provisions, the company would stand to gain. In the
case of a reverse situation, the shortfall would have to be funded through long
term funds, in the absence of which, the working capital position would be
adversely impacted.
11 Dividend policy
 Dividend is generally paid in the form of cash dividend. The payment of dividend
would reduce the working capital on hand. On the other hand, in case dividend is
not paid and profits are ploughed back, it would strengthen the cash position of
the company.
12 Efficiency in operations
 If a firm monitors its resources in such a way so as to ensure optimum utilisation, it
would contribute to a strong working capital position. All inefficiencies in the
system in terms of leakages need to be ironed out. This would automatically
contribute to increase in cash profits.
13 Changes in prices
 Any variations in the prices of raw materials, cost of operations etc. need to be
factored in. If the effect of these variations can be passed on to consumers through
increased prices, there is no material effect on cash flows. However, if the effect of
the variations is to be absorbed by the firm for some time, considering the current
market situation, then additional funds would be required. This would have a direct
impact on the working capital position.
 Estimate the working capital requirements of a firm
Operating or working capital cycle
-Working capital cycle is the time taken from the procurement of raw materials and
conversion to finished goods to realisation of proceeds from sales.

Any lender of working capital finance has to first estimate the operating cycle of the
company to determine the credit limit required. The faster the movement of stock, debtors
etc., the lower is the length of the operating cycle. It is in the interest of the company to
reduce the working capital cycle to the extent possible in order to minimise the requirement
for external funds.
 Cont..
Average time the raw material remains in inventory 1.5
Less: Credit period allowed by suppliers (2)
Time taken to convert raw material into finished goods 1
Average time the finished goods remain in inventory Negligible
Credit period allowed to customers 1
Cash cycle period 1.5
 Estimation of working capital on the basis of current
1. Current
assets and current liabilities
assets
Sr Current
Formula
no. asset

{Budgeted prod. X estimated raw mat cost /unit} X Average holding period
Raw material
1

stock 360 days or 12 months

Work-in- {Budgeted prod. X estimated WIP cost /unit} X Average holding period of WIP
2

progress 360 days or 12 months

Finished {Bud. prod. X cost of prod.(per unit exclg depreciation)} X Average holding period
3

goods 360 days or 12 months

{Est. credit sales X Cost of sales (Exclg depreciation per unit} X Avg. collection period
4 Receivables

360 days or 12 months

5 Cash Estimated based on minimum required cash and bank balances to be maintained
 2. Current liabilities
Sr. Current
Formula
no. liability

Trade {Budgeted prod. x estimated raw mat cost /unit} x Average credit period by suppliers
1

Creditors 360 days or 12 months

{Budgeted prod. x Overhead cost /unit} x average time lag in payment of overheads
2 Overheads

360 days or 12 months

{Budgeted prod. x direct labour cost /unit} x Average time lag in payment of wages
3 Direct wages

360 days or 12 months

 Example
 The finance manager of Trustwell Ltd is estimating the working
capital requirements for the year. Production is budgeted at
1,000,000 units per annum. The costs as a percentage of sale price
are raw materials 25%, direct labour 30%, and overheads 10%.
 Raw materials are held in stock for 15 days and finished goods for
25 days. Production takes 30 days, credit given to customers is 60
days (60% is credit sales) and credit availed from suppliers is 1
month. While each unit is expected to be in process for 1 month,
the raw materials are fed into the pipeline immediately and labour
and overheads accrue evenly during the month. The selling price is
Tshs 1000/ unit.
Cost of production
soln
Raw materials 1,000,000 X 1000 X0.25 Tshs

Labour 1,000,000X1000 X 0.30 250,000,000

Overheads 1,000,000 X 1000 X0.10 Tshs
Total Tshs
Credit sales 1,000,000 X 1000 X0.6 650,000,000

Particulars Tshs Ts

Stock of raw materials 250,000,000 X 15/360 104,166,6

Work in progress
250,000,000 X30/360
Raw materials 20,833,333
Labour 300,000,000X30/360 X 1/2 12,500,000
Overheads 100,000,000 X 30/360 X 1/2 4,166,667 37,500,0
Finished goods 650,000,000 X25/360 45,138,8
Debtors 600,000,000*60/360 100,000,0

Current assets
286,805,5
Creditors 250000000X30/360 20,833,3

Current liabilities
20,833,3

Estimated working capital Current assets - current liabilities

265,972,2
 Estimation of working capital on cash cost basis
 Under this approach, the components of working capital are estimated on
cash cost basis i.e. actual cost of production. Depreciation and other non-
cash costs are excluded from the cost of production. Cost of production
rather than sales is considered in estimation of debtors.

The following figures relate to Leap Ahead Ltd.

Tshs
Materials consumed (credit by suppliers: 2 months) 10,00,000
Wages paid (30 days in arrears) 7,00,000
Manufacturing expenses (outstanding at year end) (1 month in
80,000
arrears)
Sales promotion and administration expenses (quarterly in
4,00,000
advance)
Sales (credit of 60 days) 40,00,000

The company sells its products at a profit of 25%, counting depreciation as part of cost of
production. Cash balance is estimated at Tshs 1,00,000 and the company keeps one-month
stock of raw material and finished inventory. Safety margin is 10%.

Estimate the working capital requirements of the firm:

 working
Particulars Tshs
Stock of raw materials 10,00,000 X 1/12 83,333
Stock of Finished goods (W1) 2,660,000 X 1/12 221,667
Cash 100,000
Sales promotion and admin
expenses paid
100,000

quarterly in advance i.e. 1/4th )

Current assets
1,015,000

Trade creditors 1,000,000 X 2/12 166,667

Wages 700,000 x 1/12 58,333

Direct expenses 80,000

Current liabilities 305,000

Current assets -
Net w orking capital 710,000

current liabilities
Add: Safety margin @10% 71,000

Estimated net w orking capital 781,000

Workings
W1 Cost of production

Particulars Tshs Tshs

Raw materials 1,000,000
Wages 700,000
Direct Expenses (80000 X 12) 960,000 2,660,000
 Cont….
Workings
W1 Cost of production

Particulars Tshs Tshs

Raw materials 1,000,000
Wages 700,000

Direct Expenses (80000 X 12) 960,000 2,660,000

W2 Cost of goods sold

Particulars Tshs Tshs
Cost of production 2,660,000
Other overheads 400,000 3,060,000
level of inventory
 Inventories are a major constituent of
working capital. Manufacturers hold the
widest variety of inventory i.e. raw
materials; work in progress and finished
goods or consumables. Other types of
businesses e.g. service organisations or
retailers may hold fewer categories.
 1. Holding cost
i. Warehousing costs: inventory occupies space for which the
company incurs costs such as rent (for rented premises) or
depreciation, interest on capital, insurance (for owned premises),
and repairs and maintenance.
ii. Handling costs: salary to warehouse keeper, costs of movement
of material.
iii. Cost of capital or opportunity cost: cash tied up in idle
inventory could be invested elsewhere to earn a return.
iv. Insurance: inventories are invariably insured against risks such as
fire, flood, theft etc.
v. Deterioration and obsolescence: the quality of inventory lying
in hand may deteriorate due to external factors such as heat or
dust. It may become technologically obsolete.
vi. Pilferage: a small percentage of inventories are often lost due to
theft.
 2. Ordering cost
a) Ordering costs: salaries to the purchasing staff, stationery,
and telephone bill.
b) Delivery costs: salaries to the staff checking the quality of
material.
 If a company wants to hold fewer inventories in order to
reduce holding costs, it will have to place orders more
frequently and incur higher ordering costs. On the other
hand, if a company reduces the number or orders, it will have
to purchase and store larger quantities. The costs of holding
and ordering, therefore, have an inverse relationship.
Economic Order Quantity
(EOQ)

 Economic Order Quantity

The above diagram illustrates the inverse relationship between holding costs and ordering costs.
It can also be
seen that total cost is the lowest where total holding costs and total ordering costs are equal.
 The following formulae will be useful in calculating ordering and
holding costs
=Average inventory x Cost of
Total cost of holding
holding one unit
Q/2 ×Cℎ
=No. of orders x Cost per order
Total cost of ordering (D/Q)xC0

 ABC Ltd is a distributor of mobile handsets. Handsets are

ordered in lot sizes of 1,000 and each order costs Tsh40 to place.
Demand for handsets is 40,000 per month and carrying cost is
Tsh0.05 a handset per month.
 calculate the optimum order quantity.


Soln

 Question
Nellone Co provides the following information:
Tshs
Annual requirement of component Z 50,000
Price per unit 0.12
Holding costs per year per unit 0.02
Ordering costs per order 6

Required:

Calculate the EOQ for Z.

Calculate the total cost of holding and the total cost of ordering.
Prove that EOQ is the cheaper option.
 Bulk Discounts and EOQ
 Bulk discounts encourage the purchase of larger
quantities at a cheaper price. The quantity required to
obtain the discount may not be the same as the EOQ.
 In addition, once bulk discounts are filtered in, ordering
according to the EOQ may no longer be the most
economical ordering policy.
 In such a case the total annual costs associated with
adhering to the EOQ as well as the costs associated with
the quantities where the bulk discounts are obtained need
to be calculated.The cheapest option will be selected.
 Total annual costs (TAC) = Annual cost of (Purchasing
+ Holding + Ordering
 Just-in-time (JIT) techniques
 This technique originated in Japan. Its use was pioneered in a Toyota plant in
1970. This philosophy regards inventories as a “poor excuse for bad planni ng!”
Inventory levels are minimised (sometimes to zero) by manufacturing the exact
quantities required by customers for the exact time needed. It concentrates on
the elimination of waste i.e. any activity performed which does not add value to
the product.
The JIT system requires:
i. Reliable suppliers in terms of delivery times, quality and quantity of materials.
ii. Accurate production planning taking into account defects and wastage.
Businesses will aim for total quality management (TQM) i.e. the elimination of
waste and defects.
iii. Factory layout where there is a minimum movement and handling of
material. Work centres should be adjacent to each other to allow for quick
and easy flow of work between centres. This should help in reducing queues
of work in progress.
iv. Minimal finished goods stock held. Production by order only. This serves to
eliminate holding costs for finished goods.
 Benefits of using the JIT
technique
a) Minimises or eliminates inventory levels and
related costs.
b) Minimises or eliminates time between delivery
and use of inventory.
c) On receipt, material is sent directly to the
production line. This saves on material holding
and handling costs.
d) It forces managers to plan more accurately and
encourages efficiency through the elimination of
wastage and work in progress.
 External extended just-in-time
 With the advent of the internet, JIT systems are
extended outside the company borders.
 Suppliers are connected to the network and
have up-to-date information on the plans of the
company.
 They can therefore plan their production and
deliveries in such a manner that the deliveries
reach the company just in time for assembly.
 Thus, the benefits of JIT spill over to suppliers.
 Other techniques for managing inventory
1. Reorder Level
 As the name indicates, this is the inventory level at which an order should be
placed with the supplier for replenishment of the used inventory. This is calculated
as:
 Reorder level = Maximum consumption x Maximum lead time
 (Lead time means the delay between ordering and physical delivery of the material)
 This level aims to eliminate the risk of an inventory out. Actual consumption and
actual lead time are likely to be lower than the maximum numbers used in this
formula. Therefore, the fresh material will be delivered well before the
existing inventory is finished.
2. Minimum level
 Minimum level is a level that serves as a warning that the inventory levels are
dangerously low and that stock outs are possible. If stock out does occur,
it will bring production to a halt. For this reason, management wants to avoid a
stock out situation. This level is also known as safety level.
 This level aims to maximise customer service levels while minimising stock
investment, and is calculated as follows:
 Minimum level = Reorder level - (Average usage x Average lead time)
3. Maximum level
 Maximum level is a level beyond which there is a risk of compromising
appropriate storage and handling conditions. It is a potentially wasteful
level, and is calculated as:
 Maximum level = Reorder level + Reorder quantity - (Minimum usage x
Minimum lead time)
4. Average inventory level
 Average inventory level = (Minumum level + Maximum level) /2
5. Buffer stock
 Buffer stock is the minimum level of inventory that an organisation carries
as reserve against emergency or short-term shortages. It allows an
organisation to avoid fluctuations in the price of raw materials.
 If the organisation carries buffer stock then average inventory level is
calculated as:
 Average inventory level = Buffer stock + Economic order quantity/ 2
 Example
 Magna Co uses a component called 'Neel'. The company
provides the following details:
Monthly demand for finished goods (units) 100
Cost of placing an order Tshs 10
Annual carrying cost per unit Tsh1.50

Normal usage of input Neel per week (units) 40

Maximum usage per week (units) 65

Minimum usage per week (units) 25

Reorder period (weeks) 4 to 6

Calculate the following for Neel:
(a) Reorder quantity
(b) Reorder level
(c) Minimum level
(d) Maximum level
(e) Average inventory

 Cont….
(c) Minimum level = Reorder level - (Average usage x Average lead time)
 Reorder level = 390 units
 Average usage = (Maximum usage + Minimum usage)/2
 (65 + 25)/2 =45
 Average lead time = (Maximum lead time + Minimum lead time)/2
 (4 + 6)/2 =5
 Minimum level = 390 - (45 x 5)
 = 390 - 225
 =165 units
(d) Maximum level = Reorder level + Reorder quantity - (Minimum usage x
Minimum lead time)
 = 390 + 167- (25 x 4)457 units
 (e)Average inventory level = (Minimum level + Maximum level)/2
 = (165 + 457)/2=311 units
 Credit policy variables and their impact on the wealth of the
shareholders as well as managing collections.

 Receivables management is an integral part of overall working capital management.

When an organisation sells goods on credit, receivables are created. In addition to
cash sales, selling goods on credit helps to boost the sales of the firm. However,
there are certain costs involved in receivables management.
 Cost of additional capital required for investment in debtors
 Collection costs in terms of setting up of a credit department which would
handle the entire receivables management in terms of setting up credit policies,
analysis and credit approval, monitoring and collections.
 In event of delay in payment by debtors, delinquency costs to collect the
outstanding, legal charges etc.
 In case of default, bad debts which would have to be written off.
 Credit policy is a decision on whether or not to extend credit, and what should be
the quantum. It is important to evaluate the decision to extend credit or not based
on the impact it has on the wealth of shareholders through increase in profitability
and on managing collections i.e. the incremental benefit from extending credit
should exceed the costs / managerial issues involved.
 Credit benchmarks
 Each organisation / line of business would have certain criteria for extending
credit. These benchmarks can either be extremely stringent / tight or relaxed.
These credit standards can be established based on quantitative inputs such as:
a) Credit references: obtained from others in the same line of business having
dealing experiences
b) Credit ratings: if available as provided by various rating agencies
c) Financial ratios which can be developed as standards over a period of time.
Ratio analysis to determine long term financial position, short term liquidity etc
can be used.
d) Average collection period (based on past experience)
To analyse the trade-off between benefit to the firm in terms of profitability and cost
to the firm in terms of management of receivables, let’s evaluate the impact of
relaxation / tightening of credit benchmarks on each ofthese factors:
 1. Sales volume: relaxing the credit policy would increase the sales volume and
vice- versa. However, if the increased volume can be sold at the same rate or a
discount is warranted needs to be determined.
 Cont…
 2. Increase in working capital finance requirements: an increase in sales as
discussed above would require a consequent increase in requirement of funds. This
is because the quantum of receivables would increase as also the collection period
would go up.
 3. Bad debts: another factor which needs to be considered is bad debts which
would emerge in the event of default. An increase in bad debts beyond expected
level can erode shareholder wealth significantly depending on the size of receivable
outstanding.
 3. Investment in credit and collection mechanisms: a loosening of credit
standards would mean increased credit flow requiring larger staff to service the
receivables. Beyond a point, a full fledged credit and collections department would
be required to handle the following:
i. Maintenance of complete records
ii. Customer service
iii. Follow ups and soft collections
iv. Hard collections (including legal procedures)
 Therefore with a relaxation in credit standards there is an increase in sales
accompanied by increase in collection costs, investment etc. The reverse is true
when the credit standards are tightened.
 Example
 Danon Plc is selling a product at Tshs 100 per unit. The variable cost is 60%
of sales and fixed cost is Tshs 500,000. The firm currently sells 25,000 units.
The average collection period is 25 days.
 The finance manager has received a request from the sales department to
increase the credit to 40 days which would increase sales by 15%. The firm
would require additional working capital of Tshs 100,000. The cost of
additional finance is 12%.
 In the above scenario, let us evaluate the impact of credit relaxation on
sales and cost on a marginal basis.
 Incremental revenue
Tshs Tshs
Incremental sales 25,000 X 15/100 3,750
Contribution Tshs 100 - Tshs 60 150,000
Fixed costs (absorbed by existing units)
Incremental revenue 150,000
 Cont…
 Incremental cost
 Let us compute the incremental investment in receivables
Tshs Tshs
Working capital
Cost of sales
-Present 25000 X 80 2,000,000
25000 X 80 plus
Proposed 2,225,000
3750 X 60

Average investment in receivables

-Present 2,000,000 X 25/360 138,889

-Proposed 2,225,000 X 40/360 247,222
Incremental investment
108,333

Incremental cost @15% funds 16,250

100,000X15
Cost of additional working capital = Tshs 15,000

100

 Therefore, incremental revenue less incremental cost = 150,000 –

(16,250 +,15 000) =118,750, so we can conclude that the finance
manager should allow the increase in credit lines.
 Credit Analysis and Scrutiny
 Once the credit benchmarks are established, the second aspect of credit policy is
credit analysis and scrutiny. This involves:
1. Data mining to obtain credit information
 To evaluate the credit worthiness of the client, the company has to obtain all the
necessary information to arrive at an informed decision. This can be obtained from
 (a) External sources
 There are various sources of information which can be tapped in terms of:
I. Company financial statements, director’s report, quarterly results etc. which
would help in analysing the financial standing and solvency position of the client.
II. Trade references – references from firms who are in the same line of business
based on past dealings with the client.
III. Bank references – firms can write to the bankers of the client to obtain their
references maintaining strict confidentiality.
IV. Organised credit rating agencies – depending on the maturity of the industry, if
rating by external agencies is available, it can be utilised.
Cont….
Internal sources
i. Payment and performance report based
on past experience with the client.
ii. Information obtained from client itself in
terms of forms / documents. This could
be supported through personal
discussions with the client to
understand the promoter background,
business acumen etc.
 Determine the optimal cash balance
(Baumol’s and Miller-Orr models)
 Cash management is an integral part of working
capital management. The aim of working capital
management is to ensure optimal investment so
that all other forms of current assets can be
easily converted to cash. However, excess cash
can also be counter -productive. In this section,
let’s discuss the motives of holding cash and how
to determine optimal cash balance.
 Reasons for holding cash
 It is generally maintained that surplus cash should be invested to earn returns as
surplus cash on hand is considered to be an idle asset. It follows, therefore, that
if a business expects to have surplus cash even for one day, that surplus should
be invested for that one day. However, there are exceptions as businesses need
to hold some cash. Reasons for holding cash include:
1.Transactions motive
 This refers to cash held for conducting day-to-day business e.g. paying suppliers,
employees and general expenses.
2. Precautionary motive
 In the normal course of business, there may be some unexpected cash outflows.
Any cash balances held for this purpose are referred to as precautionary
balances and satisfy the same function as buffer inventory levels. In some cases,
however, instead of holding these balances in cash, a company may hold them in
the form of highly liquid investments so that it can earn a return on the
balances while they are not required.
 Cont…
3. Speculative motive
 Sometimes attractive investment opportunities may arise. To
benefit from these opportunities, companies build cash reserves.
 As a result of announcements by the government about monetary
and interest policy, bond prices are expected
 to increase sharply. The company wants to capitalise on this. It
invests in bonds which it later sells off at a profit.
4. Finance motive
 E.g. cash required to redeem a debenture or to pay off a loan.
 Baumol’s model of determining optimal
cash balance
 The aim of this model is to calculate the amount of cash which a
finance manager should maintain by counter balancing the following
two objectives
Converting the securities to cash at a minimum cost
Minimising the cost of keeping idle funds which could have been invested
elsewhere to earn a rate of return.
 Earlier the EOQ model of inventory management was discussed.
Baumol developed a model similar to this for cash management.
This model treats
i. Cash as inventory
ii. The costs of arranging funds (buying and selling securities, issue of equity
finance or negotiating overdraft) as ordering costs
iii. Interest lost (opportunity cost) as the cost of holding cash.
 

The total cost split as conversion cost plus opportunity cost can be
Frepresented as: [𝐶/2] + [𝑁F/C]


Drawbacks of the Baumol
model
 One major problem with the Baumol model is that it
assumes that cash requirements are known and cash is
used on a steady, predictable basis. In reality, this is not
the case. Cash flows can fluctuate tremendously and
balances can therefore be uncertain.
 The Miller-Orr model, as discussed below, is seen to be
superior to the Baumol model as it takes the
uncertainty of cash flows into account. It is more
realistic from this perspective.
 Miller-Orr Model
 This approach to cash management establishes upper and lower
cash limits and a return point (or optimal cash balance) to which
the cash balance will be restored on reaching any of the limits.
 The firm buys securities when cash exceeds the upper limit and
sells securities when cash is less than the lower limit.
 There are no securities transactions when cash is between the
limits. The model takes the following variables into consideration
The fixed cost of securities transactions which are assumed to be the
same for both buying and selling transactions,
The daily interest rate on marketable securities and
The variance of the daily net cash flows.
The Miller-Orr model can be
depicted by the following graph
 The Miller-Orr formula
 𝑆𝑆 = 3 ×((3/4×𝑇C×𝑉C)/3)1/3
Where,
 S= Spread between lower and upper limits
 LL= Lower point
 TC= Transaction cost
 VC= Variance of cash flows
 i = Interest rate per day on marketable securities
 Return point or Zero point = Lower limit + 1/3 x
Spread
 Upper limit = Lower limit + Spread
Steps
 1. Set the lower limit. (The question will
normally give this).
 2. Identify the variance of cash flows.
 3. Note interest rate and transaction cost.
 4. Calculate spread.
 5. Calculate return point by adding 1/3 of
the spread to the lower limit.
 6. Calculate the upper limit by adding the
spread to the lower limit.
 A company disburses a total of Tshs 50,000,000 per
year in cash. It costs Tshs 75 on an average every time
securities are sold for cash. The treasury manager
estimates that the variance of change in the daily cash
flowbalance is Tshs 20,000,000. He also establishes that
the lower cash limit is Tshs 50,000.
Required:
 Calculate the return point and the upper cash limit if
the current short-term investment rate is 5%.
Daily interest rate = Rate per annum/365
= 0.05/365
= 0.000137
Spread =3 x (3/4 x 75 x 20,000,000/0.000137)1/3
=3 x (1,125,000,000/0.000137)1/3
= 3 x 20,175
= Tshs 60,525
Return point = Lower limit + 1/3 x Spread
= 50,000 + 60,525 /3
= Tshs 70,175
Upper limit = Lower limit + Spread
= 50,000 + 60,525
= Tshs 110,525