Working Capital

Management
 The Operating Cycle
and the Cash Cycle
 The operating cycle is the length of time
between purchasing the inventory and
collecting the cash from sale of the
inventory.
 The Operating Cycle
and the Cash Cycle
 The inventory period (also called
inventory conversion period or days’
sales in inventories) is the length of time
required to purchase and sell the
inventory.
 The Operating Cycle
and the Cash Cycle
 The accounts receivable period (also
called average collection period, days’
sales in receivables or days sales
outstanding) is the length of time required
to collect on credit sales.
 The Operating Cycle
and the Cash Cycle
 The formula for the operating cycle is as
follows:
 Operating cycle = Inventory period +
Accounts receivable period
The Operating Cycle
and the Cash Cycle
 The Operating Cycle
and the Cash Cycle
 The cash conversion cycle is the length
of time between the firm’s payment for its
inventory and the collection of payment
from the customer.
 The Operating Cycle
and the Cash Cycle
 The accounts payable period (also
called payables deferral period or days
payables outstanding) is the length of
time between purchase of inventory and
payment for the inventory, which is
computed by dividing 365 days by the ratio
of cost of goods sold to average accounts
payable.
 The Operating Cycle
and the Cash Cycle
 The formula for the cash conversion cycle
is as follows:
 Cash conversion cycle = Inventory period
+ Accounts receivable period – Accounts
payable period
The Operating Cycle
and the Cash Cycle
 The Operating Cycle
and the Cash Cycle
 For example, the following data were
taken from its latest financial statements of
a firm: annual sales, $1,216,666; cost of
goods sold, $1,013,889; inventory,
$250,000; accounts receivable, $300,000,
and accounts payable, $150,000.
 The Operating Cycle
and the Cash Cycle
 Inventory period = 365 /
($1,013,889/$250,000) = 90 days
 Accounts receivable period = 365 /
($1,216,666/$300,000) = 90 days
 Accounts payable period = 365 /
($1,013,889/$150,000) = 54 days
 The Operating Cycle
and the Cash Cycle
 Operating cycle = 90 days + 90 days =
180 days
 Cash conversion cycle = 90 days + 90
days – 54 days = 126 days
 Exercises
 In fiscal 2018 and 2018, The Adecco Group’s financial statements
included the following items.
(In Millions)
2018 2019
Inventory $ 9,587 $14,544
Accounts receivable 16,899 18,149
Accounts payable 5,856 8,161
Sales 42,588 60,138
Cost of goods sold 28,779 40,831
 What was The Adecco Group’s operating cycle and cash conversion
cycle in 2019?
 Exercises
 Inventory period = 365 / (40,831/((9,587 +
14,544)/2)) = 107.86 days
 Receivables period = 365 /
(60,138/((16,899 + 18,149)/2)) = 106.36
days
 Payables period = 365 / (40,831/((5,856 +
8,161)/2)) = 62.65 days
 Exercises
 Operating cycle = 107.86 + 106.36 =
214.22 days
 Cash conversion cycle = 107.86 + 106.36
– 62.65 = 151.57 days
 Receivables
Management
 Investment in accounts receivable. The
investment in accounts receivable (or
average accounts receivable) for any firm
depends on the amount of credit sales and
the average collection period.
 Receivables
Management
 The formula to compute the investment in
accounts receivable is as follows:
 Investment in accounts receivable =
Average daily sales x Accounts receivable
period
 Receivables
Management
 If a firm generated credit sales of
$365,000 during the year and the average
collection period is 21 days, its average
accounts receivable is as follows:
 Investment in accounts receivable =
$365,000 / 365 days x 21 days = $21,000
 Exercises
 McKesson sells on terms 2/10, net 30.
Total sales for the year are $912,500.
Forty percent of the customers pay on the
tenth day and take discounts; the other 60
percent pay, on average, 45 days after
their purchases. What is the average
amount of receivables?
 Exercises
 Accounts receivable period = (40% x 10
days) + (60% x 45 days) = 31 days
 Average accounts receivable = $912,500 /
365 days x 31 days = $77,500
 Exercises
 Petrobras’s budgeted sales for the coming year are
$40,500,000 of which 80% are expected to be credit
sales at terms of n/30. It estimates that a proposed
relaxation of credit standards will increase credit sales by
20% and increase the average collection period from 30
days to 40 days. Based on a 360-day year, compute the
expected increase in the average accounts receivable
balance based on the proposed relaxation of credit to
standards.
 Exercises
 Old average AR balance: $40,500,000 x
80% / 360 days x 30 days = $2,700,000
 New average AR balance: $40,500,000 x
80% x 120% / 360 days x 40 days =
$4,320,000
 Increase in average AR balance:
$4,320,000 – $2,700,000 = $1,620,000
 Receivables
Management
 Cost of carrying receivables. When
computing the cost of carrying receivables,
only variable costs enter the calculation
because this is the only cost element in
receivables that must be financed.
 Receivables
Management
 As such, the formula to compute the cost
of carrying receivables is as follows:
 Cost of carrying receivables = Average
daily sales x Accounts receivable period x
Variable cost x Cost of funds
 Receivables
Management
 For example, a firm’s annual sales is $400
million. Under its current credit policy, 50 percent
of those customers who pay do so on day 10
and take the discount, 40 percent pay on day
30, and 10 percent pay late, on day 40. Its
variable cost ratio is 70 percent, and its pre-tax
cost of capital invested in receivables is 20
percent.
 Receivables
Management
 Thus, its annual cost of carrying
receivables is:
 Cost of carrying receivables =
$400,000,000/365 x ((50% x 10 days) +
(40% x 30 days) + (10% x 40 days) x 70%
cost ratio x 20% = $3,221,917.81
 Receivables
Management
 Incremental after-tax profit. To compute
for the incremental profit, the formula is as
follows:
 Incremental profit = Incremental sales –
Variable cost – Incremental cost of
carrying receivables –Incremental bad
debts – Incremental sales discounts –
Other incremental expenses – Income tax
 Receivables
Management
 For example, a company has annual credit
sales of $1.6 million. Current expenses for
the collection department are $35,000,
bad debt losses are 1.5 percent, and the
days sales outstanding is 30 days. The
firm is considering easing its collection
efforts such that collection expenses will
be reduced to $22,000 per year.
 Receivables
Management
 The change is expected to increase bad
debt losses to 2.5 percent and to increase
the days sales outstanding to 45 days. In
addition, sales are expected to increase to
$1,625,000 per year. Should the firm relax
collection efforts if the opportunity cost of
funds is 16 percent, the variable cost ratio
is 75 percent, and taxes are 40 percent?
 Receivables
Management
 The incremental after-tax profit is as
follows:
 Cost of carrying receivables = ($1,625,000
/ 360 x 45 days x 75% x 16%) –
($1,600,000 / 360 x 30 days x 75% x 16%)
= $8,375
 Receivables
Management
 Incremental after-tax profit = (($1,625,000
– $1,600,000) x (1 – 75%) – $8,375 –
(($1,625,000 x 2.5%) – ($1,600,000 x
1.5%)) – ($35,000 $– $22,000) x (1 –
40%) = $(3,450)
 Exercises
 Uralkali sells fertilizers and pesticides to various retail hardware and
nursery stores on terms of “2/10, net 30.” The company currently does
not grant credit to retailers with a 3 (fair) or 4 (limited) Dun & Bradstreet
Composite Credit Appraisal. An estimated $5,475,000 in additional
sales per year could be generated if Uralkali extended credit to retailers
in the “fair” category. The estimated average collection period for these
customers is 75 days, and the expected bad-debt loss ratio is 5 percent.
The company also estimates that an additional inventory investment of
$800,000 is required for the anticipated sales increase. Approximately
10 percent of these customers are expected to take the cash discount.
Uralkali’s variable cost ratio is 0.75, and its required pretax rate of return
on investments in current assets is 18 percent. Determine the net
change in pretax profits.
 Exercises
 $5,475,000 x (1 – 75%) – ($5,475,000 /
365 x 75 days x 18%) – ($5,475,000 x 5%)
+ ($800,000 x 18%) – ($5,475,000 x 10%
x 2%) = $737,550
 Exercises
 Schuff Steel Company is considering changing its credit terms from 2/15,
net 30 to 3/10, net 30 in order to speed collections. At present, 40 percent of
its customers take the 2 percent discount. Under the new term, discount
customers are expected to rise to 50 percent. Regardless of the credit
terms, half of the customers who do not take the discount are expected to
pay on time, whereas the remainder will pay 10 days late. The change does
not involve a relaxation of credit standards; therefore bad debt losses are
not expected to rise above their present 2 percent level. However, the more
generous cash discount terms are expected to increase sales from $2
million to $2.6 million per year. Its variable cost ratio is 75 percent, the
interest rate on funds invested in accounts receivable is 9 percent, and the
firm’s income tax rate is 40 percent. Using 360 days a year.
a. What are the days sales outstanding before and after the change of credit
policy?
 Exercises
 Old policy: (40% x 15 days) + (50% x 60%
x 30 days) + (50% x 60% x 40 days) = 27
days
 New policy: (50% x 15 days) + (50% x
50% x 30 days) + (50% x 50% x 40 days)
= 22.5 days
 Exercises
 Schuff Steel Company is considering changing its credit terms from 2/15,
net 30 to 3/10, net 30 in order to speed collections. At present, 40 percent of
its customers take the 2 percent discount. Under the new term, discount
customers are expected to rise to 50 percent. Regardless of the credit
terms, half of the customers who do not take the discount are expected to
pay on time, whereas the remainder will pay 10 days late. The change does
not involve a relaxation of credit standards; therefore bad debt losses are
not expected to rise above their present 2 percent level. However, the more
generous cash discount terms are expected to increase sales from $2
million to $2.6 million per year. Its variable cost ratio is 75 percent, the
interest rate on funds invested in accounts receivable is 9 percent, and the
firm’s income tax rate is 40 percent. Using 360 days a year.
b. How much is the incremental carrying cost of receivable?
 Exercises
 Old policy: $2,000,000 / 360 x 27 days x
75% x 9% = $101,25
 New policy: $2,600,000 / 360 x 22.5 days
x 75% x 9% = $109,68.75
 Change in carrying cost of receivable:
$109,68.75 – $101,25 = $843.75
 Exercises
 Schuff Steel Company is considering changing its credit terms from 2/15,
net 30 to 3/10, net 30 in order to speed collections. At present, 40 percent of
its customers take the 2 percent discount. Under the new term, discount
customers are expected to rise to 50 percent. Regardless of the credit
terms, half of the customers who do not take the discount are expected to
pay on time, whereas the remainder will pay 10 days late. The change does
not involve a relaxation of credit standards; therefore bad debt losses are
not expected to rise above their present 2 percent level. However, the more
generous cash discount terms are expected to increase sales from $2
million to $2.6 million per year. Its variable cost ratio is 75 percent, the
interest rate on funds invested in accounts receivable is 9 percent, and the
firm’s income tax rate is 40 percent. Using 360 days a year.
a. How much is the incremental after-tax profit from the change in credit
terms?
 Exercises
 Incremental profit: (($2,600,000 –
$2,000,000) x (1 – 75%) – $843.75 –
($600,000 x 2%) – (($2,600,000 x 50% x
3%) – ($2,000,000 x 40% x 2%))) x (1 –
40%) = $68,493.75
 Receivables
Management
 Terms of credit. Firms that sell on credit
have a credit policy that includes their
terms of credit.
 Receivables
Management
 An example of a term of credit is “2/10, net
30.”
 A customer is entitled to a 2% discount if
he pays within 10 days.
 In any event, he must pay within 30 days.
 The discount period is 10 days while the
credit period is 30 days.
 Receivables
Management
 The following equation can be used to
calculate the annual percentage rate of not
taking discounts:
 Cost of discount forfeited = Discount
percentage / (100% – Discount
percentage) x 365 / (Credit period –
Discount period)
 Receivables
Management
 In the above example, the computation of
the nominal cost of trade credit of the term
of credit “2/10, net 30” is as follows:
 Cost of discount forfeited = 2% / (100% –
2%) x 365 / (30 – 10) = 37.24%
 Exercise
 Philip Morris International offers terms of
2/10, net 35. What effective annual rate
does the firm earn when a customer does
not take the discount?
 Exercise
 Philip Morris International offers terms of
2/10, net 35. What effective annual rate
does the firm earn when a customer does
not take the discount?
 2% / (100% – 2%)) x 365 / (35 days – 10
days) = 29.80%
 Receivables
Management
 Compensating balances. Banks
sometimes require borrowers to maintain
an average demand deposit (checking
account) balance of 10% to 20% of the
loan’s face amount.
 This is called a compensating balance,
and such balances raise the effective
interest rate on the loans.
 Receivables
Management
 The effective annual rate is as follows:
 EAR = Net cost of borrowing / (Principal
amount – Net cost of borrowing if
discounted – Compensating balance)) x
365 / Credit period = Cost of borrowing / (1
– % cost of borrowing if discounted – %
compensating balance)) x 365 / Credit
period
 Receivables
Management
 For example, compute the effective rate of
a 15% discounted loan for 90 days,
$200,000, with 10% compensating
balance. Assume 360 days per year.
 EAR = (15% x 90/360) / (1 – (15% x
90/360) – 10%) x 360/90 = 17.39%
 Receivables
Management
 Deutsche Bahn obtained a short-term bank loan
for $1,000,000 at an annual interest rate 12%.
As a condition of the loan, it is required to
maintain a compensating balance of $300,000 in
its checking account. The checking account
earns interest at an annual rate of 3%. Deutsche
Bahn would otherwise maintain only $100,000 in
its checking account for transactional purposes.
Compute the costs of the loan.
 Receivables
Management
 (($1,000,000 x 12%) – (($300,000 –
$100,000) x 3%)) / ($1,000,000 –
($300,000 – $100,000)) = 14.25%
 Inventory
Management
 A firm typically waits until inventories of
materials are about to be exhausted and
then reorders a constant quantity.
 Inventory
Management
 Inventory
Management
 Reorder point. The reorder point or
reorder level is a specific level at which
the stock needs to be replenished.
 The time required to receive the ordered
quantity once an order is placed is called
lead time.
 Inventory
Management
 In order to avoid a shortage in inventory
due to an increase in demand or a delay in
delivery, a safety stock serve as
insurance.
 Inventory
Management
 The formula for reorder point is as follows:
 Reorder point = Daily average usage x
Lead time in days + Safety stock
 Inventory
Management
 In the example above, a firm periodically
maintains a total of 3,400 bottles during a
12-day order cycle, which includes a
safety stock of 1,000 bottles. It sells 200
bottles a day. It would take 7 days from the
time the firm places an order to the time it
receives them.
 Inventory
Management
 The reorder point is computed as follows:
 Reorder Point = 200 x 7 days + 1,000 =
2,400 bottles
 Inventory
Management
 By the end of the 12-day order cycle, the
firm which has already sold 2,400 and
maintains only the safety stock of 1,000
bottles will receive its order of 2,400 to be
sold during the next 12-day order cycle.
 Inventory
Management
 Inventory-related costs. Two types of
inventory costs can be readily identified
with inventory.
 Inventory
Management
 Ordering costs are the costs of placing
and receiving an order.
 Examples include the costs of processing
an order (clerical costs and documents),
insurance for shipment, and unloading
costs.
 Inventory
Management
 Carrying costs are the costs of holding
inventory.
 Examples include insurance, inventory
taxes, obsolescence, the opportunity cost
of funds tied up in inventory, handling
costs, and storage space.
 Inventory
Management
 To compute for the total costs associated
with inventory, the formula is as follows:
 Total costs = Ordering costs + Carrying
costs = (Annual demand / Number of units
ordered x Cost per order) + (Number of
units ordered / 2 x Carrying cost per unit)
 Inventory
Management
 For example, a retail clothing shop sells
25,000 shirts each year. It costs the
company $2 per year to hold a pair of
jeans in inventory, and the fixed cost to
place an order is $40. Assume that it
orders 500 shirts each time it needs
inventory.
 Inventory
Management
 The total cost is computed as follows:
 Total costs = (25,000 / 500 x $40) + (500/2
x $2) = $2,500
 Inventory
Management
 As the firm increases its order size, the
number of orders falls and therefore the
order costs decline
 However, an increase in order size also
increases the average amount in
inventory, so that the carrying cost of
inventory rises.
 Inventory
Management
 The trick is to strike a balance between
these two costs.
 Inventory
Management
 Economic order quantity. Economic
order quantity determines the amount or
order size that should be ordered to
minimize the total ordering costs and
carrying costs.
 Inventory
Management
 EOQ is computed as follows.
 EOQ = √((2 x Annual demand x Cost per
order) / (Carrying cost per order))
 Inventory
Management
 In the previous example, the economic
order quantity is computed as follows:
 EOQ = √((2 x 25,000 x $40) / $2) = 1,000
units
 Inventory
Management
 This means that ideally, the firm should
have an order size of 1,000 units to be
able to incur inventory-related costs at a
minimum.
 Likewise it will need to place 25,000/1,000
or 25 orders during the year.
 Inventory
Management
 To check if the firm has indeed estimated
the least inventory-related costs, the total
cost for the above example is recomputed
using the economic order quantity as order
size:
 Total cost = (25,000 / 1,000 x $40) +
(1,000/2 x $2) = $2,000
 Inventory
Management
 Kuwahara makes bicycles. It produces 5,400
bicycles a year and therefore requires 10,800 tires
per year. It buys the tires for bicycles from a supplier
at a cost of $20 per tire. The company’s inventory
carrying cost is estimated to be 15% of cost of a tire
and the ordering is $50 per order. Assume 360 days
per year. Determine the following:
a. Economic order quantity.
 Inventory
Management
 Kuwahara makes bicycles. It produces 5,400
bicycles a year and therefore requires 10,800 tires
per year. It buys the tires for bicycles from a supplier
at a cost of $20 per tire. The company’s inventory
carrying cost is estimated to be 15% of cost of a tire
and the ordering is $50 per order. Assume 360 days
per year. Determine the following:
a. Economic order quantity.
 √((2 x 10,800 x $50) / ($20 x 15%)) = 600 units
 Inventory
Management
 Kuwahara makes bicycles. It produces 5,400
bicycles a year and therefore requires 10,800 tires
per year. It buys the tires for bicycles from a supplier
at a cost of $20 per tire. The company’s inventory
carrying cost is estimated to be 15% of cost of a tire
and the ordering is $50 per order. Assume 360 days
per year. Determine the following:
b. Total annual inventory costs of this policy.
 Inventory
Management
 Kuwahara makes bicycles. It produces 5,400
bicycles a year and therefore requires 10,800 tires
per year. It buys the tires for bicycles from a supplier
at a cost of $20 per tire. The company’s inventory
carrying cost is estimated to be 15% of cost of a tire
and the ordering is $50 per order. Assume 360 days
per year. Determine the following:
b. Total annual inventory costs of this policy.
 (10,800 / 600 x $50) + (600/2 x $20 x 15) = $1,800
 Inventory
Management
 Kuwahara makes bicycles. It produces 5,400
bicycles a year and therefore requires 10,800 tires
per year. It buys the tires for bicycles from a supplier
at a cost of $20 per tire. The company’s inventory
carrying cost is estimated to be 15% of cost of a tire
and the ordering is $50 per order. Assume 360 days
per year. Determine the following:
b. Optimal ordering frequency.
 Inventory
Management
 Kuwahara makes bicycles. It produces 5,400
bicycles a year and therefore requires 10,800 tires
per year. It buys the tires for bicycles from a supplier
at a cost of $20 per tire. The company’s inventory
carrying cost is estimated to be 15% of cost of a tire
and the ordering is $50 per order. Assume 360 days
per year. Determine the following:
b. Optimal ordering frequency.
 360 / (10,800 / 600) = 20 days
 Cash
Management
 Float. The cash balance that a firm shows
on its books is called the firm’s book, or
ledger, balance.
 The balance shown in its bank account as
available to spend is called its available,
or collected, balance.
 Cash
Management
 The difference between the available
balance and the ledger balance, called the
float, represents the net effect of checks
in the process of clearing (moving through
the banking system).
 Cash
Management
 Float management involves controlling the
collection and disbursement of cash.
 The objective in cash collection is to speed
up collections and reduce the lag between
the time customers pay their bills and the
time the cash becomes available.
 Cash
Management
 The objective in cash disbursement is to
control payments and minimize the firm’s
costs associated with making payments.
 Cash
Management
 Total collection or disbursement times can
be broken down into three parts:
1. Mailing time (or mail float) is the part of
the collection and disbursement process
during which checks are trapped in the
postal system.
 Cash
Management

2. Processing delay (or processing float)

is the time it takes the receiver of a check
to process the payment and deposit it in a
bank for collection.
3. Availability delay (or check-clearing
float) refers to the time required to clear
a check through the banking system.
 Cash
Management
 Cash
Management
 Lockboxes. When a firm receives its
payments by mail, it must decide where
the checks will be mailed and how the
checks will be picked up and deposited.
 Careful selection of the number and
locations of collection points can greatly
reduce collection times.
 Cash
Management
 Many firms use special post office boxes
called lockboxes to intercept payments
and speed cash collection.
 Cash
Management
 The formula for computing the net benefit
of using a lockbox is as follows:
 Net benefits = Annual (pretax) earnings on
released funds – Annual bank processing
fee = (Average daily collections x
Reduction in collection time x Interest rate)
– (Fixed cost + (Number of payments per
year x Variable cost per payment))
 Cash
Management
 Suppose that a firm is considering
establishing a bank lockbox collection
system. The lockbox would reduce
average mailing time for customer
payments from 3 days to 1 1/2 days,
check-processing time from 2 days to 1
day, and clearing time from 3 days to 1 1/2
days.
 Cash
Management
 Annual collections are $91.25 million, and
the average number of payments received
total 550 per day (assume 365 days per
year). A bank has agreed to process the
payments for an annual fee of $15,000
plus $0.10 per payment received. This
bank would not require a compensating
balance.
 Cash
Management
 Assuming an 8 percent opportunity cost
for released funds, should the firm use the
lockbox collection system?
 Net benefits = ($91,250,000 / 365 x ((3 – 1
1/2) + (2 – 1) + (3 – 1 1/2)) x 8%) –
($15,000 + (550 x 365 x $0.10)) = $44,925
 Exercise
 Builders Circle, a hardware and building supplies company, processes all its
customer credit card payments at its Atlanta headquarters. A Boston bank
has offered to process the payments from Builders Circle customers located
in the New England region for $50,000 per year plus $0.20 per payment. No
compensating balance will be required. Under this lockbox arrangement, the
average mailing time for payments would be reduced from 3 days to 1.5
days. Check processing and clearing time would be reduced from 5 days to
2. Annual collections from the New England region are $292 million. The
total number of payments received annually is 600,000 (an average of
50,000 credit card holders x 12 payments per year). Assume that any funds
released by this lockbox arrangement can be invested by Builders Circle to
earn 10 percent per year before taxes. The establishment of a lockbox
system for the New England region will reduce payment processing costs at
its Atlanta headquarters by $40,000 per year. Using this information,
determine:
 Exercise
a. The annual (pretax) earnings on the
released funds.
 Exercise
a. The annual (pretax) earnings on the
released funds.
 $292,000,000 / 365 days x ((3 – 1.5) + (5
– 2)) x 10% = $360,000
 Exercise
b. The annual fee that Builders Circle must
pay the Boston bank for processing the
payments.
 Exercise
b. The annual fee that Builders Circle must
pay the Boston bank for processing the
payments.
 $50,000 + (600,000 x $0.20) = $170,000
 Exercise
c. The annual net (pretax) benefits Builders
Circle will receive by establishing this
lockbox arrangement with the Boston
bank.
 Exercise
c. The annual net (pretax) benefits Builders
Circle will receive by establishing this
lockbox arrangement with the Boston
bank.
 $360,000 – $170,000 + $40,000 =
$230,000
 Cash
Management
 Target cash balance. A model for
establishing the firm’s target cash balance
that closely resembles the economic
ordering quantity model used for inventory.
 Cash
Management
 The firm typically incurs two types of cost.
 Holding costs (or opportunity costs) for
keeping the cash balance are the return
foregone on the marketable securities.
 Transaction costs (or trading costs) are
those cost incurred whenever it converts
its marketable securities to cash.
 Cash
Management
 To compute for the total costs associated
with the cash balance, the formula is as
follows:
 Total costs = Transaction costs + Holding
costs = (Total fund requirements x Cash
balance x Cost per transaction) + (Cash
balance / 2 x Holding cost per unit)
 Cash
Management
 The formula to compute the optimum cash
balance is as follows:
 Optimal cash balance = √((2 x Total fund
requirements x Cost per transaction) /
(Holding cost per order))
 Cash
Management
 For example, a firm projects that cash
outlays of $4.5 million will occur uniformly
throughout the year. It plans to meet its
cash requirements by periodically selling
marketable securities from its portfolio.
 Cash
Management
 The firm’s marketable securities are
invested to earn 12 percent, and the cost
per transaction of converting securities to
cash is $27.
 Cash
Management
 The computation for the optimal cash
balance is as follows:
 Optimal cash balance = √((2 x $4,500,000
x $27) / (12%)) = $45,000
 Cash
Management
 The total annual cost of maintaining cash
balances is as follows:
 Total costs = ($4,500,000 / $45,000 x $27)
+ ($45,000/2 x 12%) = $8,100
 Exercise
 Colgate-Palmolive needs a total of $21,000 in
cash during the year for transactions and
other purposes. The interest rate is 4 percent
per year, and selling securities costs $25 per
sale. Determine the following:
a. Target cash balance
 Exercise
 Colgate-Palmolive needs a total of $21,000 in
cash during the year for transactions and
other purposes. The interest rate is 4 percent
per year, and selling securities costs $25 per
sale. Determine the following:
a. Target cash balance
 √((2 x $21,000 x $25) / 15%) = $5,123.48
 Exercise
 Colgate-Palmolive needs a total of $21,000 in
cash during the year for transactions and
other purposes. The interest rate is 4 percent
per year, and selling securities costs $25 per
sale. Determine the following:
b. Total annual cost of maintaining cash
balances
 Exercise
 Colgate-Palmolive needs a total of $21,000 in
cash during the year for transactions and
other purposes. The interest rate is 4 percent
per year, and selling securities costs $25 per
sale. Determine the following:
b. Total annual cost of maintaining cash
balances
 ($21,000 / $5,123.48 x $25) + ($5,123.48 / 2
x 4%) = $204.94
End of Module 5