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Corporate Finance


Corporate Finance: personal finance, personal finances, business financing, financial planner, personal banking, corporate banking, online bank, types of banks, personal financial accounting, personal accounting, business investment, business equity, corporate finance, personal financial planning, public finance, banking and finance.

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									Corporate Finance

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   Corporate finance                           1
   Working capital                             9
   Cash conversion cycle                      11
   Return on capital                          13
   Economic Value Added                       14
   Just in time (business)                    16
   Economic order quantity                    23
   Discounts and allowances                   26
   Factoring (finance)                        31
   Capital budgeting                          39

   Article Sources and Contributors           43
   Image Sources, Licenses and Contributors   44

Article Licenses
   License                                    45
Corporate finance                                                                                                             1

    Corporate finance
    Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the
    tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder
    value.[1] Although it is in principle different from managerial finance which studies the financial decisions of all
    firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the
    financial problems of all kinds of firms.
    The discipline can be divided into long-term and short-term decisions and techniques. Capital investment decisions
    are long-term choices about which projects receive investment, whether to finance that investment with equity or
    debt, and when or whether to pay dividends to shareholders. On the other hand, short term decisions deal with the
    short-term balance of current assets and current liabilities; the focus here is on managing cash, inventories, and
    short-term borrowing and lending (such as the terms on credit extended to customers).
    The terms corporate finance and corporate financier are also associated with investment banking. The typical role
    of an investment bank is to evaluate the company's financial needs and raise the appropriate type of capital that best
    fits those needs. Thus, the terms “corporate finance” and “corporate financier” may be associated with transactions in
    which capital is raised in order to create, develop, grow or acquire businesses.

    Capital investment decisions
    Capital investment decisions[2] are long-term corporate finance decisions relating to fixed assets and capital
    structure. Decisions are based on several inter-related criteria. (1) Corporate management seeks to maximize the
    value of the firm by investing in projects which yield a positive net present value when valued using an appropriate
    discount rate in consideration of risk. (2) These projects must also be financed appropriately. (3) If no such
    opportunities exist, maximizing shareholder value dictates that management must return excess cash to shareholders
    (i.e., distribution via dividends). Capital investment decisions thus comprise an investment decision, a financing
    decision, and a dividend decision.

    The investment decision
    Management must allocate limited resources between competing opportunities (projects) in a process known as
    capital budgeting.[3] Making this investment, or capital allocation, decision requires estimating the value of each
    opportunity or project, which is a function of the size, timing and predictability of future cash flows.

    Project valuation
    In general,[4] each project's value will be estimated using a discounted cash flow (DCF) valuation, and the
    opportunity with the highest value, as measured by the resultant net present value (NPV) will be selected (applied to
    Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams#Theory). This
    requires estimating the size and timing of all of the incremental cash flows resulting from the project. Such future
    cash flows are then discounted to determine their present value (see Time value of money). These present values are
    then summed, and this sum net of the initial investment outlay is the NPV. See Financial modeling.
    The NPV is greatly affected by the discount rate. Thus, identifying the proper discount rate – often termed, the
    project "hurdle rate"[5] – is critical to making an appropriate decision. The hurdle rate is the minimum acceptable
    return on an investment—i.e. the project appropriate discount rate. The hurdle rate should reflect the riskiness of the
    investment, typically measured by volatility of cash flows, and must take into account the project-relevant financing
    mix. [6] Managers use models such as the CAPM or the APT to estimate a discount rate appropriate for a particular
    project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. (A common error
    in choosing a discount rate for a project is to apply a WACC that applies to the entire firm. Such an approach may
Corporate finance                                                                                                              2

    not be appropriate where the risk of a particular project differs markedly from that of the firm's existing portfolio of
    In conjunction with NPV, there are several other measures used as (secondary) selection criteria in corporate finance.
    These are visible from the DCF and include discounted payback period, IRR, Modified IRR, equivalent annuity,
    capital efficiency, and ROI. Alternatives (complements) to NPV include Residual Income Valuation, MVA / EVA
    (Joel Stern, Stern Stewart & Co) and APV (Stewart Myers). See list of valuation topics.

    Valuing flexibility
    In many cases, for example R&D projects, a project may open (or close) various paths of action to the company, but
    this reality will not (typically) be captured in a strict NPV approach.[7] Some analysts account for this uncertainty by
    adjusting the discount rate (e.g. by increasing the cost of capital) or the cash flows (using certainty equivalents, or
    applying (subjective) "haircuts" to the forecast numbers).[8][9] Even when employed, however, these latter methods
    do not normally properly account for changes in risk over the project's lifecycle and hence fail to appropriately adapt
    the risk adjustment.[10] Management will therefore (sometimes) employ tools which place an explicit value on these
    options. So, whereas in a DCF valuation the most likely or average or scenario specific cash flows are discounted,
    here the “flexible and staged nature” of the investment is modelled, and hence "all" potential payoffs are considered.
    See further under Real options valuation. The difference between the two valuations is the "value of flexibility"
    inherent in the project.
    The two most common tools are Decision Tree Analysis (DTA)[11][12] and Real options valuation (ROV);[13] they
    may often be used interchangeably:
    • DTA values flexibility by incorporating possible events (or states) and consequent management decisions. (For
      example, a company would build a factory given that demand for its product exceeded a certain level during the
      pilot-phase, and outsource production otherwise. In turn, given further demand, it would similarly expand the
      factory, and maintain it otherwise. In a DCF model, by contrast, there is no "branching" – each scenario must be
      modelled separately.) In the decision tree, each management decision in response to an "event" generates a
      "branch" or "path" which the company could follow; the probabilities of each event are determined or specified
      by management. Once the tree is constructed: (1) "all" possible events and their resultant paths are visible to
      management; (2) given this “knowledge” of the events that could follow, and assuming rational decision making,
      management chooses the branches (i.e. actions) corresponding to the highest value path probability weighted; (3)
      this path is then taken as representative of project value. See Decision theory#Choice under uncertainty.
    • ROV is usually used when the value of a project is contingent on the value of some other asset or underlying
      variable. (For example, the viability of a mining project is contingent on the price of gold; if the price is too low,
      management will abandon the mining rights, if sufficiently high, management will develop the ore body. Again, a
      DCF valuation would capture only one of these outcomes.) Here: (1) using financial option theory as a
      framework, the decision to be taken is identified as corresponding to either a call option or a put option; (2) an
      appropriate valuation technique is then employed – usually a variant on the Binomial options model or a bespoke
      simulation model, while Black Scholes type formulae are used less often; see Contingent claim valuation. (3) The
      "true" value of the project is then the NPV of the "most likely" scenario plus the option value. (Real options in
      corporate finance were first discussed by Stewart Myers in 1977; viewing corporate strategy as a series of options
      was originally per Timothy Luehrman, in the late 1990s.) See also Option pricing approaches under Business
Corporate finance                                                                                                               3

    Quantifying uncertainty
    Given the uncertainty inherent in project forecasting and valuation,[12][14] analysts will wish to assess the sensitivity
    of project NPV to the various inputs (i.e. assumptions) to the DCF model. In a typical sensitivity analysis the analyst
    will vary one key factor while holding all other inputs constant, ceteris paribus. The sensitivity of NPV to a change
    in that factor is then observed, and is calculated as a "slope": ΔNPV / Δfactor. For example, the analyst will
    determine NPV at various growth rates in annual revenue as specified (usually at set increments, e.g. -10%, -5%,
    0%, 5%....), and then determine the sensitivity using this formula. Often, several variables may be of interest, and
    their various combinations produce a "value-surface",[15] (or even a "value-space",) where NPV is then a function of
    several variables. See also Stress testing.
    Using a related technique, analysts also run scenario based forecasts of NPV. Here, a scenario comprises a particular
    outcome for economy-wide, "global" factors (demand for the product, exchange rates, commodity prices, etc...) as
    well as for company-specific factors (unit costs, etc...). As an example, the analyst may specify various revenue
    growth scenarios (e.g. 0% for "Worst Case", 10% for "Likely Case" and 20% for "Best Case"), where all key inputs
    are adjusted so as to be consistent with the growth assumptions, and calculate the NPV for each. Note that for
    scenario based analysis, the various combinations of inputs must be internally consistent (see discussion at Financial
    modeling), whereas for the sensitivity approach these need not be so. An application of this methodology is to
    determine an "unbiased" NPV, where management determines a (subjective) probability for each scenario – the NPV
    for the project is then the probability-weighted average of the various scenarios. See First Chicago Method.
    A further advancement which "overcomes the limitations of sensitivity and scenario analyses by examining the
    effects of all possible combinations of variables and their realizations." [16] is to construct stochastic[17] or
    probabilistic financial models – as opposed to the traditional static and deterministic models as above.[14] For this
    purpose, the most common method is to use Monte Carlo simulation to analyze the project’s NPV. This method was
    introduced to finance by David B. Hertz in 1964, although it has only recently become common: today analysts are
    even able to run simulations in spreadsheet based DCF models, typically using a risk-analysis add-in, such as @Risk
    or Crystal Ball. Here, the cash flow components that are (heavily) impacted by uncertainty are simulated,
    mathematically reflecting their "random characteristics". In contrast to the scenario approach above, the simulation
    produces several thousand random but possible outcomes, or trials, "covering all conceivable real world
    contingencies in proportion to their likelihood;" [18] see Monte Carlo Simulation versus “What If” Scenarios. The
    output is then a histogram of project NPV, and the average NPV of the potential investment – as well as its volatility
    and other sensitivities – is then observed. This histogram provides information not visible from the static DCF: for
    example, it allows for an estimate of the probability that a project has a net present value greater than zero (or any
    other value).
    Continuing the above example: instead of assigning three discrete values to revenue growth, and to the other relevant
    variables, the analyst would assign an appropriate probability distribution to each variable (commonly triangular or
    beta), and, where possible, specify the observed or supposed correlation between the variables. These distributions
    would then be "sampled" repeatedly – incorporating this correlation – so as to generate several thousand random but
    possible scenarios, with corresponding valuations, which are then used to generate the NPV histogram. The resultant
    statistics (average NPV and standard deviation of NPV) will be a more accurate mirror of the project's "randomness"
    than the variance observed under the scenario based approach. These are often used as estimates of the underlying
    "spot price" and volatility for the real option valuation as above; see Real options valuation: Valuation inputs. A
    more robust Monte Carlo model would include the possible occurrence of risk events (e.g., a credit crunch) that drive
    variations in one or more of the DCF model inputs.
Corporate finance                                                                                                              4

    The financing decision
    Achieving the goals of corporate
    finance requires that any corporate
    investment          be         financed
    appropriately.      The sources of
    financing are, generically, capital
    self-generated by the firm and capital
    from external funders, obtained by
    issuing new debt and equity (and
    hybrid- or convertible securities). As
    above, since both hurdle rate and cash                        Domestic credit to private sector in 2005.
    flows (and hence the riskiness of the
    firm) will be affected, the financing mix will impact the valuation of the firm (as well as the other long-term
    financial management decisions). There are two interrelated considerations here:

    • Management must identify the "optimal mix" of financing—the capital structure that results in maximum firm
      value.[20] (See Balance sheet, WACC, Fisher separation theorem; but, see also the Modigliani-Miller theorem.)
      Financing a project through debt results in a liability or obligation that must be serviced, thus entailing cash flow
      implications independent of the project's degree of success. Equity financing is less risky with respect to cash
      flow commitments, but results in a dilution of share ownership, control and earnings. The cost of equity (see
      CAPM and APT) is also typically higher than the cost of debt - which is, additionally, a deductible expense - and
      so equity financing may result in an increased hurdle rate which may offset any reduction in cash flow risk.[21]
    • Management must attempt to match the long-term financing mix to the assets being financed as closely as
      possible, in terms of both timing and cash flows. Managing any potential asset liability mismatch or duration gap
      entails matching the assets and liabilities respectively according to maturity pattern ("Cashflow matching") or
      duration ("immunization"); managing this relationship in the short-term is a major function of working capital
      management, as discussed below. Other techniques, such as securitization, or hedging using interest rate- or credit
      derivatives, are also common. See Asset liability management; Treasury management; Credit risk; Interest rate
    Much of the theory here, falls under the umbrella of the Trade-Off Theory in which firms are assumed to trade-off
    the tax benefits of debt with the bankruptcy costs of debt when making their decisions. However economists have
    developed a set of alternative theories about financing decisions. One of the main alternative theories of how firms
    make their financing decisions is the Pecking Order Theory (Stewart Myers), which suggests that firms avoid
    external financing while they have internal financing available and avoid new equity financing while they can
    engage in new debt financing at reasonably low interest rates. Also, Capital structure substitution theory
    hypothesizes that management manipulates the capital structure such that earnings per share (EPS) are maximized.
    An emerging area in finance theory is right-financing whereby investment banks and corporations can enhance
    investment return and company value over time by determining the right investment objectives, policy framework,
    institutional structure, source of financing (debt or equity) and expenditure framework within a given economy and
    under given market conditions. One of the more recent innovations in this are from a theoretical point of view is the
    Market timing hypothesis. This hypothesis, inspired in the behavioral finance literature, states that firms look for the
    cheaper type of financing regardless of their current levels of internal resources, debt and equity.
Corporate finance                                                                                                             5

    The dividend decision
    Whether to issue dividends,[22] and what amount, is calculated mainly on the basis of the company's unappropriated
    profit and its earning prospects for the coming year. The amount is also often calculated based on expected free cash
    flows i.e. cash remaining after all business expenses, and capital investment needs have been met.
    If there are no NPV positive opportunities, i.e. projects where returns exceed the hurdle rate, then – finance theory
    suggests – management must return excess cash to shareholders as dividends. This is the general case, however there
    are exceptions. For example, shareholders of a "growth stock", expect that the company will, almost by definition,
    retain earnings so as to fund growth internally. In other cases, even though an opportunity is currently NPV negative,
    management may consider “investment flexibility” / potential payoffs and decide to retain cash flows; see above and
    Real options.
    Management must also decide on the form of the dividend distribution, generally as cash dividends or via a share
    buyback. Various factors may be taken into consideration: where shareholders must pay tax on dividends, firms may
    elect to retain earnings or to perform a stock buyback, in both cases increasing the value of shares outstanding.
    Alternatively, some companies will pay "dividends" from stock rather than in cash; see Corporate action. Today, it is
    generally accepted that dividend policy is value neutral – i.e. the value of the firm would be the same, whether it
    issued cash dividends or repurchased its stock (see Modigliani-Miller theorem).

    Working capital management
    Decisions relating to working capital and short term financing are referred to as working capital management.[23]
    These involve managing the relationship between a firm's short-term assets and its short-term liabilities. In general
    this is as follows: As above, the goal of Corporate Finance is the maximization of firm value. In the context of long
    term, capital investment decisions, firm value is enhanced through appropriately selecting and funding NPV positive
    investments. These investments, in turn, have implications in terms of cash flow and cost of capital. The goal of
    Working Capital (i.e. short term) management is therefore to ensure that the firm is able to operate, and that it has
    sufficient cash flow to service long term debt, and to satisfy both maturing short-term debt and upcoming operational
    expenses. In so doing, firm value is enhanced when, and if, the return on capital exceeds the cost of capital; See
    Economic value added (EVA). Managing short term finance and long term finance is one task of a modern CFO.

    Decision criteria
    Working capital is the amount of capital which is readily available to an organization. That is, working capital is the
    difference between resources in cash or readily convertible into cash (Current Assets), and cash requirements
    (Current Liabilities). As a result, the decisions relating to working capital are always current, i.e. short term,
    decisions. In addition to time horizon, working capital decisions differ from capital investment decisions in terms of
    discounting and profitability considerations; they are also "reversible" to some extent. (Considerations as to Risk
    appetite and return targets remain identical, although some constraints – such as those imposed by loan covenants –
    may be more relevant here).
    Working capital management decisions are therefore not taken on the same basis as long term decisions, and
    working capital management applies different criteria in decision making: the main considerations are (1) cash flow /
    liquidity and (2) profitability / return on capital (of which cash flow is probably the most important).
    • The most widely used measure of cash flow is the net operating cycle, or cash conversion cycle. This represents
      the time difference between cash payment for raw materials and cash collection for sales. The cash conversion
      cycle indicates the firm's ability to convert its resources into cash. Because this number effectively corresponds to
      the time that the firm's cash is tied up in operations and unavailable for other activities, management generally
      aims at a low net count. (Another measure is gross operating cycle which is the same as net operating cycle
      except that it does not take into account the creditors deferral period.)
Corporate finance                                                                                                             6

    • In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a
      percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity
      (ROE) shows this result for the firm's shareholders. As above, firm value is enhanced when, and if, the return on
      capital, exceeds the cost of capital. ROC measures are therefore useful as a management tool, in that they link
      short-term policy with long-term decision making.

    Management of working capital
    Guided by the above criteria, management will use a combination of policies and techniques for the management of
    working capital.[24] These policies aim at managing the current assets (generally cash and cash equivalents,
    inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.
    • Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but
      reduces cash holding costs.
    • Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces
      the investment in raw materials – and minimizes reordering costs – and hence increases cash flow. Note that
      "inventory" is usually the realm of operations management: given the potential impact on cash flow, and on the
      balance sheet in general, finance typically "gets involved in an oversight or policing way".[25]:714 See Supply
      chain management; Just In Time (JIT); Economic order quantity (EOQ); Dynamic lot size model; Economic
      production quantity (EPQ); Economic Lot Scheduling Problem; Inventory control problem; Safety stock.
    • Debtors management. There are two inter-related roles here: Identify the appropriate credit policy, i.e. credit
      terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be
      offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.
      Implement appropriate Credit scoring policies and techniques such that the risk of default on any new business is
      acceptable given these criteria.
    • Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the
      inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan
      (or overdraft), or to "convert debtors to cash" through "factoring".

    Relationship with other areas in finance

    Investment banking
    Use of the term “corporate finance” varies considerably across the world. In the United States it is used, as above, to
    describe activities, decisions and techniques that deal with many aspects of a company’s finances and capital. In the
    United Kingdom and Commonwealth countries, the terms “corporate finance” and “corporate financier” tend to be
    associated with investment banking – i.e. with transactions in which capital is raised for the corporation.[26] These
    may include
    • Raising seed, start-up, development or expansion capital
    • Mergers, demergers, acquisitions or the sale of private companies
    • Mergers, demergers and takeovers of public companies, including public-to-private deals
    • Management buy-out, buy-in or similar of companies, divisions or subsidiaries – typically backed by private
    • Equity issues by companies, including the flotation of companies on a recognised stock exchange in order to raise
      capital for development and/or to restructure ownership
    • Raising capital via the issue of other forms of equity, debt and related securities for the refinancing and
      restructuring of businesses
    • Financing joint ventures, project finance, infrastructure finance, public-private partnerships and privatisations
Corporate finance                                                                                                              7

    • Secondary equity issues, whether by means of private placing or further issues on a stock market, especially
      where linked to one of the transactions listed above.
    • Raising debt and restructuring debt, especially when linked to the types of transactions listed above

    Financial risk management
          See also: Credit risk; Default (finance); Financial risk; Interest rate risk; Liquidity risk; Operational risk;
          Settlement risk; Value at Risk; Volatility risk.
    Risk management [27][17] is the process of measuring risk and then developing and implementing strategies to
    manage ("hedge") that risk. Financial risk management, typically, is focused on the impact on corporate value due to
    adverse changes in commodity prices, interest rates, foreign exchange rates and stock prices (market risk). It will
    also play an important role in short term cash- and treasury management; see above. It is common for large
    corporations to have risk management teams; often these overlap with the internal audit function. While it is
    impractical for small firms to have a formal risk management function, many still apply risk management informally.
    See also Enterprise risk management.
    The discipline typically focuses on risks that can be hedged using traded financial instruments, typically derivatives;
    see Cash flow hedge, Foreign exchange hedge, Financial engineering. Because company specific, "over the counter"
    (OTC) contracts tend to be costly to create and monitor, derivatives that trade on well-established financial markets
    or exchanges are often preferred. These standard derivative instruments include options, futures contracts, forward
    contracts, and swaps; the "second generation" exotic derivatives usually trade OTC. Note that hedging-related
    transactions will attract their own accounting treatment: see Hedge accounting, Mark-to-market accounting, FASB
    133, IAS 39.
    This area is related to corporate finance in two ways. Firstly, firm exposure to business and market risk is a direct
    result of previous Investment and Financing decisions. Secondly, both disciplines share the goal of enhancing, or
    preserving, firm value. There is a fundamental debate [28] relating to "Risk Management" and shareholder value. Per
    the Modigliani and Miller framework, hedging is irrelevant since diversified shareholders are assumed to not care
    about firm-specific risks, whereas, on the other hand hedging is seen to create value in that it reduces the probability
    of financial distress. A further question, is the shareholder's desire to optimize risk versus taking exposure to pure
    risk (a risk event that only has a negative side, such as loss of life or limb). The debate links the value of risk
    management in a market to the cost of bankruptcy in that market. See Fisher separation theorem.

    Personal and public finance
    Corporate finance utilizes tools from almost all areas of finance. Some of the tools developed by and for corporations
    have broad application to entities other than corporations, for example, to partnerships, sole proprietorships,
    not-for-profit organizations, governments, mutual funds, and personal wealth management. But in other cases their
    application is very limited outside of the corporate finance arena. Because corporations deal in quantities of money
    much greater than individuals, the analysis has developed into a discipline of its own. It can be differentiated from
    personal finance and public finance.

    Alternate Approaches
    A standard assumption in Corporate finance is that shareholders are the residual claimants and that the primary goal
    of executives should be to maximize shareholder value. Recently, however, legal scholars (e.g. Lynn Stout [29]) have
    questioned this assumption, implying that the assumed goal of maximizing shareholder value is inappropriate for a
    public corporation. This criticism in turn brings into question the advice of corporate finance, particularly related to
    stock buybacks made purportedly to "return value to shareholders," which is predicated on a legally erroneous
Corporate finance                                                                                                                                        8

    [1] See Corporate Finance: First Principles (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/ AppldCF/ other/ Image2. gif), Aswath
        Damodaran, New York University's Stern School of Business
    [2] The framework for this section is based on Notes (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/ AppldCF/ other/ Image2. gif)
        by Aswath Damodaran at New York University's Stern School of Business
    [3] See: Investment Decisions and Capital Budgeting (http:/ / www. duke. edu/ ~charvey/ Classes/ ba350_1997/ vcf2/ vcf2. htm), Prof. Campbell
        R. Harvey; The Investment Decision of the Corporation (http:/ / www. bus. lsu. edu/ academics/ finance/ faculty/ dchance/ Instructional/
        FinancialManagementDecisions. ppt#257,2,Slide), Prof. Don M. Chance
    [4] See: Valuation (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/ lectures/ val. html), Prof. Aswath Damodaran; Equity
        Valuation (http:/ / www. duke. edu/ ~charvey/ Classes/ ba350_1997/ vcf1/ vcf1. htm), Prof. Campbell R. Harvey
    [5] See for example Campbell R. Harvey's Hypertextual Finance Glossary (http:/ / biz. yahoo. com/ f/ g/ hh. html) or (http:/ /
        www. investopedia. com/ terms/ h/ hurdlerate. asp)
    [6] Prof. Aswath Damodaran: Estimating Hurdle Rates (http:/ / people. stern. nyu. edu/ adamodar/ pdfiles/ acf3E/ presentations/ hurdlerate. pdf)
    [7] See: Real Options Analysis and the Assumptions of the NPV Rule (http:/ / www. realoptions. org/ papers2002/ SchockleyOptionNPV. pdf. ),
        Tom Arnold & Richard Shockley
    [8] Aswath Damodaran: Risk Adjusted Value (http:/ / pages. stern. nyu. edu/ ~adamodar/ pdfiles/ valrisk/ ch5. pdf); Ch 5 in Strategic Risk
        Taking: A Framework for Risk Management. Wharton School Publishing, 2007. ISBN 0-13-199048-9
    [9] See: §32 "Certainty Equivalent Approach” & §165 "Risk Adjusted Discount Rate" in: Joel G. Siegel; Jae K. Shim; Stephen Hartman (1
        November 1997). Schaum's quick guide to business formulas: 201 decision-making tools for business, finance, and accounting students (http:/
        / books. google. com/ books?id=4JpojQPk8YsC). McGraw-Hill Professional. ISBN 978-0-07-058031-2. . Retrieved 12 November 2011.
    [10] Dan Latimore: Calculating value during uncertainty (http:/ / www-935. ibm. com/ services/ uk/ igs/ pdf/
        esr-calculating-value-during-uncertainty. pdf). IBM Institute for Business Value
    [11] See: Decision Tree Analysis (http:/ / www. mindtools. com/ pages/ article/ newTED_04. htm),; Decision Tree Primer (http:/ /
        www. public. asu. edu/ ~kirkwood/ DAStuff/ decisiontrees/ index. html), Prof. Craig W. Kirkwood Arizona State University; Using Decision
        Trees In Finance (http:/ / www. investopedia. com/ articles/ financial-theory/ 11/ decisions-trees-finance. asp),
    [12] See: "Capital Budgeting Under Risk". Ch.9 in Schaum's outline of theory and problems of financial management (http:/ / books. google.
        com/ books?id=_lnmxnhoAUEC& printsec=frontcover& dq=related:ISBN0070580316#v=onepage& q& f=false), Jae K. Shim and Joel G.
    [13] See: Identifying real options (http:/ / faculty. fuqua. duke. edu/ ~charvey/ Teaching/ BA456_2002/ Identifying_real_options. htm), Prof.
        Campbell R. Harvey; Applications of option pricing theory to equity valuation (http:/ / pages. stern. nyu. edu/ ~adamodar/ New_Home_Page/
        lectures/ opt. html), Prof. Aswath Damodaran; How Do You Assess The Value of A Company's "Real Options"? (http:/ / www.
        expectationsinvesting. com/ tutorial11. shtml), Prof. Alfred Rappaport Columbia University & Michael Mauboussin
    [14] See Probabilistic Approaches: Scenario Analysis, Decision Trees and Simulations (http:/ / www. stern. nyu. edu/ ~adamodar/ pdfiles/
        papers/ probabilistic. pdf), Prof. Aswath Damodaran
    [15] For example, mining companies sometimes employ the “Hill of Value” methodology in their planning; see, e.g., B. E. Hall (2003). "How
        Mining Companies Improve Share Price by Destroying Shareholder Value" (https:/ / www. u-cursos. cl/ ingenieria/ 2008/ 1/ MI75E/ 1/
        material_docente/ bajar?id_material=167438) and I. Ballington, E. Bondi, J. Hudson, G. Lane and J. Symanowitz (2004). "A Practical
        Application of an Economic Optimisation Model in an Underground Mining Environment" (http:/ / downloads. cyestcorp. com/ Technical
        Papers/ Practical Application of an Economic Optimisation Model in an Underground Mining Environment. pdf).
    [16] Virginia Clark, Margaret Reed, Jens Stephan (2010). Using Monte Carlo simulation for a capital budgeting project (http:/ / findarticles. com/
        p/ articles/ mi_m0OOL/ is_1_12/ ai_n57086241/ ), Management Accounting Quarterly, Fall, 2010
    [17] See: Quantifying Corporate Financial Risk (http:/ / www. qfinance. com/ financial-risk-management-best-practice/
        quantifying-corporate-financial-risk?full), David Shimko.
    [18] The Flaw of Averages (http:/ / www. analycorp. com/ uncertainty/ flawarticle. htm), Prof. Sam Savage, Stanford University.
    [19] See: The Financing Decision of the Corporation (http:/ / www. bus. lsu. edu/ academics/ finance/ faculty/ dchance/ Instructional/
        FinancialManagementDecisions. ppt#256,1,Slide), Prof. Don M. Chance; Capital Structure (http:/ / pages. stern. nyu. edu/ ~adamodar/ pdfiles/
        ovhds/ capstr. pdf), Prof. Aswath Damodaran
    [20] Capital Structure: Implications (http:/ / www. qfinance. com/ mergers-and-acquisitions-best-practice/ capital-structure-implications?full),
        Prof. John C. Groth, Texas A&M University; A Generalised Procedure for Locating the Optimal Capital Structure (http:/ / rdcohen. 50megs.
        com/ genOCS. pdf), Ruben D. Cohen, Citigroup
    [21] See: Optimal Balance of Financial Instruments: Long-Term Management, Market Volatility & Proposed Changes (http:/ / www.
        lawyersclubindia. com/ articles/
        Optimal-Balance-of-Financial-Instruments-Long-Term-Management-Market-Volatility-Proposed-Changes-3765. asp), Nishant Choudhary,
        LL.M. 2011 (Business & finance), George Washington University Law School
    [22] See Dividend Policy (http:/ / pages. stern. nyu. edu/ ~adamodar/ pdfiles/ ovhds/ divid. pdf), Prof. Aswath Damodaran
    [23] See Working Capital Management (http:/ / www. studyfinance. com/ lessons/ workcap/ index. mv),; Working Capital
        Management (http:/ / www. treasury. govt. nz/ publicsector/ workingcapital/ chap2. asp),
Corporate finance                                                                                                                                  9

    [24] See The 20 Principles of Financial Management (http:/ / www. bus. lsu. edu/ academics/ finance/ faculty/ dchance/ Instructional/
        PrinciplesofFinancialManagement. htm), Prof. Don M. Chance, Louisiana State University
    [25] William Lasher (2010). Practical Financial Management. South-Western College Pub; 6 ed. ISBN 1-4390-8050-X
    [26] Beaney, Shaun, "Defining corporate finance in the UK" (http:/ / www. icaew. com/ en/ technical/ corporate-finance/
        corporate-finance-faculty/ what-is-corporate-finance-122299), Corporate Finance Faculty, ICAEW, April 2005 (revised January 2011)
    [27] See: Global Association of Risk Professionals (GARP) (http:/ / www. garp. com/ ); Professional Risk Managers' International Association
        (PRMIA) (http:/ / www. primia. org/ )
    [28] See for example: Prof. Jonathan Lewellen, MIT: Financial Management Notes: Risk Management (http:/ / ocw. mit. edu/ courses/
        sloan-school-of-management/ 15-414-financial-management-summer-2003/ lecture-notes/ lec19_options. pdf)
    [29] Lynn A. Stout (2002). Bad and Not-So-Bad Arguments for Shareholder Primacy (http:/ / www. uclouvain. be/ cps/ ucl/ doc/ etes/
        documents/ Stout_-SSRN-id331464. pdf), University of California, Los Angeles School of Law Research Paper No. 25; Lynn A. Stout (2007).
        The Mythical Benefits of Shareholder Control (http:/ / www. lccge. bbk. ac. uk/ publications-and-resources/ docs/ Stout 2007. pdf),
        REGULATION Spring 2007.

    Working capital
    Working capital (abbreviated WC) is a financial metric which
    represents operating liquidity available to a business, organization or
    other entity, including governmental entity. Along with fixed assets
    such as plant and equipment, working capital is considered a part of
    operating capital. Net working capital is calculated as current assets
    minus current liabilities. It is a derivation of working capital, that is            Domestic credit to private sector in 2005
    commonly used in valuation techniques such as DCFs (Discounted
    cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a
    working capital deficit.

    A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be
    converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and
    that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The
    management of working capital involves managing inventories, accounts receivable and payable, and cash.

    Current assets and current liabilities include three accounts which are of special importance. These accounts
    represent the areas of the business where managers have the most direct impact:
    • accounts receivable (current asset)
    • inventory (current assets), and
    • accounts payable (current liability)
    The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current
    assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit.
    An increase in working capital indicates that the business has either increased current assets (that it has increased its
    receivables, or other current assets) or has decreased current liabilities—for example has paid off some short-term
    Implications on M&A: The common commercial definition of working capital for the purpose of a working capital
    adjustment in an M&A transaction (i.e. for a working capital adjustment mechanism in a sale and purchase
    agreement) is equal to:
    Current Assets – Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus assets and/or
    deposit balances.
    Cash balance items often attract a one-for-one, purchase-price adjustment.
Working capital                                                                                                                10

    Working capital management
    Decisions relating to working capital and short term financing are referred to as working capital management. These
    involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of
    working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash
    flow to satisfy both maturing short-term debt and upcoming operational expenses.

    Decision criteria
    By definition, working capital management entails short-term decisions—generally, relating to the next one-year
    period—which are "reversible". These decisions are therefore not taken on the same basis as capital-investment
    decisions (NPV or related, as above); rather, they will be based on cash flows, or profitability, or both.
    • One measure of cash flow is provided by the cash conversion cycle—the net number of days from the outlay of
      cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit
      the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this
      number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other
      activities, management generally aims at a low net count.
    • In this context, the most useful measure of profitability is return on capital (ROC). The result is shown as a
      percentage, determined by dividing relevant income for the 12 months by capital employed; return on equity
      (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital,
      which results from working-capital management, exceeds the cost of capital, which results from capital
      investment decisions as above. ROC measures are therefore useful as a management tool, in that they link
      short-term policy with long-term decision making. See economic value added (EVA).
    • Credit policy of the firm: Another factor affecting working capital management is credit policy of the firm. It
      includes buying of raw material and selling of finished goods either in cash or on credit. This affects the cash
      conversion cycle.

    Management of working capital
    Guided by the above criteria, management will use a combination of policies and techniques for the management of
    working capital. The policies aim at managing the current assets (generally cash and cash equivalents, inventories
    and debtors) and the short term financing, such that cash flows and returns are acceptable.
    • Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but
      reduces cash holding costs.
    • Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces
      the investment in raw materials - and minimizes reordering costs - and hence increases cash flow. Besides this,
      the lead times in production should be lowered to reduce Work in Process (WIP) and similarly, the Finished
      Goods should be kept on as low level as possible to avoid over production - see Supply chain management; Just
      In Time (JIT); Economic order quantity (EOQ); Economic quantity
    • Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such
      that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return
      on Capital (or vice versa); see Discounts and allowances.
    • Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the
      inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan
      (or overdraft), or to "convert debtors to cash" through "factoring".
Cash conversion cycle                                                                                                             11

    Cash conversion cycle
    In management accounting, the cash conversion cycle (CCC) measures how long a firm will be deprived of cash if
    it increases its investment in resources in order to expand customer sales. It is thus a measure of the liquidity risk
    entailed by growth. However, shortening the CCC creates its own risks: while a firm could even achieve a negative
    CCC by collecting from customers before paying suppliers, a policy of strict collections and lax payments is not
    always sustainable.

    CCC = # days between disbursing cash and collecting cash in connection with undertaking a discrete unit of operations.

          =   Inventory conversion      +       Receivables conversion      –      Payables conversion
                     period                            period                            period

          =      Avg. Inventory         +           Avg. Accounts           –         Avg. Accounts
                                                     receivable                         payable
                  COGS / 365
                                                      Sales / 365                      COGS / 365

    Cashflows insufficient. The term "Cash Conversion Cycle" refers to the timespan between a firm's disbursing and
    collecting cash. However, the CCC cannot be directly observed in cashflows, because these are also influenced by
    investment and financing activities; it must be derived from Statement of Financial Position data associated with the
    firm's operations.
    Equation describes retailer. Although the term "cash conversion cycle" technically applies to a firm in any
    industry, the equation is generically formulated to apply specifically to a retailer. Since a retailer's operations consist
    in buying and selling inventory, the equation models the time between
                   (1) disbursing cash to satisfy the accounts payable created by purchase of inventory, and
                   (2) collecting cash to satisfy the accounts receivable generated by that sale.
    Equation describes a firm that buys and sells on account. Also, the equation is written to accommodate a firm
    that buys and sells on account. For a cash-only firm, the equation would only need data from sales operations (e.g.
    changes in inventory), because disbursing cash would be directly measurable as purchase of inventory, and
    collecting cash would be directly measurable as sale of inventory. However, no such 1:1 correspondence exists for a
    firm that buys and sells on account: Increases and decreases in inventory do not occasion cashflows but accounting
    vehicles (receivables and payables, respectively); increases and decreases in cash will remove these accounting
    vehicles (receivables and payables, respectively) from the books. Thus, the CCC must be calculated by tracing a
    change in cash through its effect upon receivables, inventory, payables, and finally back to cash—thus, the term cash
    conversion cycle, and the observation that these four accounts "articulate" with one another.
Cash conversion cycle                                                                                                                                12

    Label                   Transaction                     Accounting (use different accounting vehicles if the transactions occur in a different

    A       Suppliers (agree to) deliver inventory      •   Operations (increasing inventory by $X)
                   →Firm owes $X cash (debt) to                 →Create accounting vehicle (increasing accounts payable by $X)

    B       Customers (agree to) acquire that inventory •   Operations (decreasing inventory by $Y)
                   →Firm is owed $Y cash (credit)               →Create accounting vehicle (booking "COGS" expense of $Y; accruing revenue and
                   from customers                               increasing accounts receivable of $Y)

    C       Firm disburses $X cash to suppliers         •   Cashflows (decreasing cash by $X)
                   →Firm removes its debts to its               →Remove accounting vehicle (decreasing accounts payable by $X)

    D       Firm collects $Y cash from customers        •   Cashflows (increasing cash by $Y)
                   →Firm removes its credit from its            →Remove accounting vehicle (decreasing accounts receivable by $Y.)

    Taking these four transactions in pairs, analysts draw attention to five important intervals, referred to as conversion
    cycles (or conversion periods):
    • the Cash conversion cycle emerges as interval C→D (i.e. disbursing cash→collecting cash).
    • the Payables conversion period (or "Days payables outstanding") emerges as interval A→C (i.e. owing
      cash→disbursing cash)
    • the Operating cycle emerges as interval A→D (i.e. owing cash→collecting cash)
        • the Inventory conversion period or "Days inventory outstanding" emerges as interval A→B (i.e. owing
          cash→being owed cash)
        • the Receivables conversion period (or "Days sales outstanding") emerges as interval B→D (i.e.being owed
          cash→collecting cash)
    Knowledge of any three of these conversion cycles permits derivation of the fourth (leaving aside the operating
    cycle, which is just the sum of the inventory conversion period and the receivables conversion period.)

               interval {C → D} =            interval {A → B}         +         interval {B → D}          –       interval {A → C}

               CCC (in days)        = Inventory conversion period + Receivables conversion period – Payables conversion period

    In calculating each of these three constituent Conversion Cycles, the equation Time =Level/Rate is used (since each
    interval roughly equals the Time needed for its Level to be achieved at its corresponding Rate).
    • Its LEVEL "during the period in question" is estimated as the average of its levels in the two balance-sheets that
      surround the period: (Lt1+Lt2)/2.
    • To estimate its Rate, note that Accounts Receivable grows only when revenue is accrued; and Inventory shrinks
      and Accounts Payable grows by an amount equal to the COGS expense (in the long run, since COGS actually
      accrues sometime after the inventory delivery, when the customers acquire it).
        • Payables conversion period: Rate = [inventory increase + COGS], since these are the items for the period that
          can increase "trade accounts payables," i.e. the ones that grew its inventory.
                            Note that an exception is made when calculating this interval: although a period average for the
                            Level of inventory is used, any increase in inventory contributes to its Rate of change. This is
                            because the purpose of the CCC is to measure the effects of inventory growth on cash outlays. If
                            inventory grew during the period, this would be important to know.
        • Inventory conversion period: Rate = COGS, since this is the item that (eventually) shrinks inventory.
Cash conversion cycle                                                                                                            13

        • Receivables conversion period: Rate = revenue, since this is the item that can grow receivables (sales).

    Aims of CCC
    The aim of studying cash conversion cycle and its calculation is to change the policies relating to credit purchase and
    credit sales. The standard of payment of credit purchase or getting cash from debtors can be changed on the basis of
    reports of cash conversion cycle. If it tells good cash liquidity position, past credit policies can be maintauned. Its
    aim is also to study cash flow of business. Cash flow statement and cash conversion cycle study will be helpful for
    cash flow analysis.

    External links
    • Measuring the Cash Conversion Cycle in an International Supply Chain [1]

    [1] http:/ / www. bus. tu. ac. th/ usr/ ruth/ file/ C2C%20LRN%202005. pdf

    Return on capital
    Return on capital (ROC) is a ratio used in finance, valuation, and accounting. The ratio is estimated by dividing the
    after-tax operating income (NOPAT) by the book value of invested capital.


    This differs from ROIC. Return on invested capital (ROIC) is a financial measure that quantifies how well a
    company generates cash flow relative to the capital it has invested in its business. It is defined as net operating profit
    less adjusted taxes divided by invested capital and is usually expressed as a percentage. In this calculation, capital
    invested includes all monetary capital invested: long-term debt, common and preferred shares.
    When the return on capital is greater than the cost of capital (usually measured as the weighted average cost of
    capital), the company is creating value; when it is less than the cost of capital, value is destroyed.

    ROIC formula

    Note that the numerator in the ROIC fraction does not subtract interest expense, because denominator excludes debt

Economic Value Added                                                                                                          14

    Economic Value Added
    In corporate finance, Economic Value Added or EVA, is an estimate of a firm's economic profit – being the value
    created in excess of the required return of the company's investors (being shareholders and debt holders). Quite
    simply, EVA is the profit earned by the firm less the cost of financing the firm's capital. The idea is that value is
    created when the return on the firm's economic capital employed is greater than the cost of that capital. This amount
    can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments that
    could be made but in practice only five or seven key ones are made, depending on the company and the industry it
    competes in.

    Calculating EVA
    EVA is net operating profit after taxes (or NOPAT) less a capital charge, the latter being the product of the cost of
    capital and the economic capital. The basic formula is:


    •                   , is the Return on Invested Capital (ROIC);
    •   is the weighted average cost of capital (WACC);
    •     is the economic capital employed;
    • NOPAT is the net operating profit after tax, with adjustments and translations, generally for the amortization of
      goodwill, the capitalization of brand advertising and others non-cash items.
    EVA Calculation:
    EVA = net operating profit after taxes – a capital charge [the residual income method]
    therefore EVA = NOPAT – (c × capital), or alternatively
    EVA = (r x capital) – (c × capital) so that
    EVA = (r-c) × capital [the spread method, or excess return method]

                       r = rate of return, and
                       c = cost of capital, or the Weighted Average Cost of Capital (WACC).

    NOPAT is profits derived from a company’s operations after cash taxes but before financing costs and non-cash
    bookkeeping entries. It is the total pool of profits available to provide a cash return to those who provide capital to
    the firm.
    Capital is the amount of cash invested in the business, net of depreciation. It can be calculated as the sum of
    interest-bearing debt and equity or as the sum of net assets less non-interest-bearing current liabilities (NIBCLs).
    The capital charge is the cash flow required to compensate investors for the riskiness of the business given the
    amount of economic capital invested.
    The cost of capital is the minimum rate of return on capital required to compensate investors (debt and equity) for
    bearing risk, their opportunity cost.
    Another perspective on EVA can be gained by looking at a firm’s return on net assets (RONA). RONA is a ratio that
    is calculated by dividing a firm’s NOPAT by the amount of capital it employs (RONA = NOPAT/Capital) after
    making the necessary adjustments of the data reported by a conventional financial accounting system.
    EVA = (RONA – required minimum return) × net investments
Economic Value Added                                                                                                                      15

    If RONA is above the threshold rate, EVA is positive.

    Comparison with other approaches
    Other approaches along similar lines include Residual Income Valuation (RI) and residual cash flow. Although EVA
    is similar to residual income, under some definitions there may be minor technical differences between EVA and RI
    (for example, adjustments that might be made to NOPAT before it is suitable for the formula below). Residual cash
    flow is another, much older term for economic profit. In all three cases, money cost of capital refers to the amount of
    money rather than the proportional cost (% cost of capital); at the same time, the adjustments to NOPAT are unique
    to EVA.
    Although in concept, these approaches are in a sense nothing more than the traditional, commonsense idea of
    "profit", the utility of having a separate and more precisely defined term such as EVA is that it makes a clear
    separation from dubious accounting adjustments that have enabled businesses such as Enron to report profits while
    actually approaching insolvency.
    Other measures of shareholder value include:
    • Added value
    • Market value added
    • Total shareholder return.

    Relationship to market value added
    The firm's market value added, or MVA, is the discounted sum (present value) of all future expected economic value

    Note that MVA = PV of EVA.
    More enlightening is that since MVA = NPV of Free cash flow (FCF) it follows therefore that the
    NPV of FCF = PV of EVA;
    since after all, EVA is simply the re-arrangement of the FCF formula.

    Integrating EVA and PBC
    Recently, Mocciaro Li Destri, Picone & Minà (2012)[1] proposed a performance and cost measurement system that
    integrates the EVA criteria with Process Based Costing (PBC). The EVA-PBC methodology allows us to implement
    the EVA management logic not only at the firm level, but also at lower levels of the organization. EVA-PBC
    methodology plays an interesting role in bringing strategy back into financial performance measures.

    [1] Mocciaro Li Destri A., Picone P. M. & Minà A. (2012), Bringing Strategy Back into Financial Systems of Performance Measurement:
        Integrating EVA and PBC, Business System Review, Vol 1., Issue 1. pp.85-102 http:/ / papers. ssrn. com/ sol3/ papers.

    • G. Bennett Stewart III (1991). The Quest for Value. HarperCollins.
    • Erik Stern. The Value Mindset. Wiley.
    • Joel Stern and John Shiely. The EVA Challenge. Wiley.
    • Al Ehrbar. EVA, the Real Key to Creating Wealth. Wiley.
Economic Value Added                                                                                                           16

    External links
    • ( Free online PRVit analysis form shares on US Stockmarket
    • What's wrong with the Economic Value Added? (
      cfm?abstract_id=1120917), Sergei Cheremushkin, 2008
    • A Reading List on EVA/Value Based Management (
      htm/vbm.htm) from Robert Korajczyk
    • Economic Value Added ( from EVA Dimensions LLC
    • Economic Value Added (EVA) (
      html), Prof. Aswath Damodaran
    • EVA valuation tutorial ( from
    • Understanding Economic Value Added (,
    • All About EVA (,
    • Economic Value Added: A simulation analysis of the trendy, owner-oriented management tool (http://lipas., Timo Salmi and Ilkka Virtanen, 2001
    • The Origins of EVA ( Chicago-Booth

    Just in time (business)
    Just in time (JIT) is a production strategy that strives to improve a business return on investment by reducing
    in-process inventory and associated carrying costs. To meet JIT objectives, the process relies on signals or Kanban
    (看 板 Kanban) between different points in the process, which tell production when to make the next part. Kanban
    are usually 'tickets' but can be simple visual signals, such as the presence or absence of a part on a shelf.
    Implemented correctly, JIT focuses on continuous improvement and can improve a manufacturing organization's
    return on investment, quality, and efficiency. To achieve continuous improvement key areas of focus could be flow,
    employee involvement and quality.
    Quick notice that requires personnel to order new stock once existing stock is depleting is critical to the inventory
    reduction at the center of the JIT policy, which saves warehouse space and costs. However, JIT relies on other
    elements in the inventory chain as well. For instance, its effective application cannot be independent of other key
    components of a lean manufacturing system or it can "end up with the opposite of the desired result."[1] In recent
    years manufacturers have continued to try to hone forecasting methods such as applying a trailing 13-week average
    as a better predictor for JIT planning;[2] however, some research demonstrates that basing JIT on the presumption of
    stability is inherently flawed.[3]

    The philosophy of JIT is simple: the storage of unused inventory is a waste of resources. JIT inventory systems
    expose hidden cost of keeping inventory, and are therefore not a simple solution for a company to adopt. The
    company must follow an array of new methods to manage the consequences of the change. The ideas in this way of
    working come from many different disciplines including statistics, industrial engineering, production management,
    and behavioral science. The JIT inventory philosophy defines how inventory is viewed and how it relates to
    Inventory is seen as incurring costs, or waste, instead of adding and storing value, contrary to traditional accounting.
    This does not mean to say JIT is implemented without an awareness that removing inventory exposes pre-existing
    manufacturing issues. This way of working encourages businesses to eliminate inventory that does not compensate
Just in time (business)                                                                                                          17

     for manufacturing process issues, and to constantly improve those processes to require less inventory. Secondly,
     allowing any stock habituates management to stock keeping. Management may be tempted to keep stock to hide
     production problems. These problems include backups at work centers, machine reliability, process variability, lack
     of flexibility of employees and equipment, and inadequate capacity.
     In short, the Just-in-Time inventory system focus is having “the right material, at the right time, at the right place,
     and in the exact amount”-Ryan Grabosky, without the safety net of inventory. The JIT system has broad implications
     for implementers.

     Transaction cost approach
     JIT reduces inventory in a firm. However, a firm may simply be outsourcing their input inventory to suppliers, even
     if those suppliers don't use Just-in-Time (Naj 1993). Newman (1994) investigated this effect and found that suppliers
     in Japan charged JIT customers, on average, a 5% price premium.

     Environmental concerns
     During the birth of JIT, multiple daily deliveries were often made by bicycle. Increased scale has required a move to
     vans and trucks (lorries). Cusumano (1994) highlighted the potential and actual problems this causes with regard to
     gridlock and burning of fossil fuels. This violates three JIT waste guidelines:
     1. Time—wasted in traffic jams
     2. Inventory—specifically pipeline (in transport) inventory
     3. Scrap—fuel burned while not physically moving

     Price volatility
     JIT implicitly assumes a level of input price stability that obviates the need to buy parts in advance of price rises.
     Where input prices are expected to rise, storing inventory may be desirable.

     Quality volatility
     JIT implicitly assumes that input parts quality remains constant over time. If not, firms may hoard high-quality
     inputs. As with price volatility, a solution is to work with selected suppliers to help them improve their processes to
     reduce variation and costs. Longer term price agreements can then be negotiated and agreed-on quality standards
     made the responsibility of the supplier. Fixing up of standards for volatility of quality according to the quality circle

     Demand stability
     Karmarker (1989) highlights the importance of relatively stable demand, which helps ensure efficient capital
     utilization rates. Karmarker argues that without significantly stable demand, JIT becomes untenable in high capital
     cost production.

     Supply stability
     In the U.S., the 1992 railway strikes caused General Motors to idle a 75,000-worker plant because they had no

     JIT implementation design
     Based on a diagram modeled after the one used by Hewlett-Packard’s Boise plant to accomplish its JIT program.
           1) F Design Flow Process
Just in time (business)                                           18

     – F Redesign/relayout for flow
            – L Reduce lot sizes
            – O Link operations
            – W Balance workstation capacity
            – M Preventive maintenance
            – S Reduce setup Times

           2) Q Total Quality Control

     – C worker compliance
            – I Automatic inspection
            – M quality measures
            – M fail-safe methods
            – W Worker participation

           3) S Stabilize Schedule

     – S Level schedule
            – W Establish freeze windows
            – UC Underutilize Capacity

           4) K Kanban Pull System

     – D Demand pull
            – B Backflush
            – L Reduce lot sizes

           5) V Work with Vendors

     – L Reduce lead time
            – D Frequent deliveries
            – U Project usage requirements
            – Q Quality expectations

           6) I Further Reduce Inventory in Other Areas

     – S Stores
            – T Transit
            – C Implement carrousel to reduce motion waste
            – C Implement conveyor belts to reduce motion waste

           7) P Improve Product Design

     – P Standard production configuration
            – P Standardize and reduce the number of parts
            – P Process design with product design
            – Q Quality expectations
Just in time (business)                                                                                                          19

     A surprising effect was that factory response time fell to about a day. This improved customer satisfaction by
     providing vehicles within a day or two of the minimum economic shipping delay.
     Also, the factory began building many vehicles to order, eliminating the risk they would not be sold. This improved
     the company's return on equity.
     Since assemblers no longer had a choice of which part to use, every part had to fit perfectly. This caused a quality
     assurance crisis, which led to a dramatic improvement in product quality. Eventually, Toyota redesigned every part
     of its vehicles to widen tolerances, while simultaneously implementing careful statistical controls for quality control.
     Toyota had to test and train parts suppliers to assure quality and delivery. In some cases, the company eliminated
     multiple suppliers.
     When a process or parts quality problem surfaced on the production line, the entire production line had to be slowed
     or even stopped. No inventory meant a line could not operate from in-process inventory while a production problem
     was fixed. Many people in Toyota predicted that the initiative would be abandoned for this reason. In the first week,
     line stops occurred almost hourly. But by the end of the first month, the rate had fallen to a few line stops per day.
     After six months, line stops had so little economic effect that Toyota installed an overhead pull-line, similar to a bus
     bell-pull, that let any worker on the line order a line stop for a process or quality problem. Even with this, line stops
     fell to a few per week.
     The result was a factory that has been studied worldwide. It has been widely emulated, but not always with the
     expected results, as many firms fail to adopt the full system.[4]
     The just-in-time philosophy was also applied to other segments of the supply chain in several types of industries. In
     the commercial sector, it meant eliminating one or all of the warehouses in the link between a factory and a retail
     establishment. Examples in sales, marketing, and customer service involve applying information systems and mobile
     hardware to deliver customer information as needed, and reducing waste by video conferencing to cut travel time.[5]

     Main benefits of JIT include:
     • Reduced setup time. Cutting setup time allows the company to reduce or eliminate inventory for "changeover"
       time. The tool used here is SMED (single-minute exchange of dies).
     • The flow of goods from warehouse to shelves improves. Small or individual piece lot sizes reduce lot delay
       inventories, which simplifies inventory flow and its management.
     • Employees with multiple skills are used more efficiently. Having employees trained to work on different parts of
       the process allows companies to move workers where they are needed.
     • Production scheduling and work hour consistency synchronized with demand. If there is no demand for a product
       at the time, it is not made. This saves the company money, either by not having to pay workers overtime or by
       having them focus on other work or participate in training.
     • Increased emphasis on supplier relationships. A company without inventory does not want a supply system
       problem that creates a part shortage. This makes supplier relationships extremely important.
     • Supplies come in at regular intervals throughout the production day. Supply is synchronized with production
       demand and the optimal amount of inventory is on hand at any time. When parts move directly from the truck to
       the point of assembly, the need for storage facilities is reduced.
     • Minimizes storage space needed.
     • Smaller chance of inventory breaking/expiring.
Just in time (business)                                                                                                         20


     Within a JIT system
     Just-in-time operation leaves suppliers and downstream consumers open to supply shocks and large supply or
     demand changes. For internal reasons, Ohno saw this as a feature rather than a bug. He used an analogy of lowering
     the water level in a river to expose the rocks to explain how removing inventory showed where production flow was
     interrupted. Once barriers were exposed, they could be removed. Since one of the main barriers was rework,
     lowering inventory forced each shop to improve its own quality or cause a holdup downstream. A key tool to
     manage this weakness is production levelling to remove these variations. Just-in-time is a means to improving
     performance of the system, not an end.
     Very low stock levels means shipments of the same part can come in several times per day. This means Toyota is
     especially susceptible to flow interruption. For that reason, Toyota uses two suppliers for most assemblies. As noted
     in Liker (2003), there was an exception to this rule that put the entire company at risk because of the 1997 Aisin fire.
     However, since Toyota also makes a point of maintaining high quality relations with its entire supplier network,
     several other suppliers immediately took up production of the Aisin-built parts by using existing capability and

     Within a raw material stream
     As noted by Liker (2003) and Womack and Jones (2003), it ultimately would be desirable to introduce synchronised
     flow and link JIT through the entire supply stream. However, none followed this in detail all the way back through
     the processes to the raw materials. With present technology, for example, an ear of corn cannot be grown and
     delivered to order. The same is true of most raw materials, which must be discovered and/or grown through natural
     processes that require time and must account for natural variability in weather and discovery. The part of this
     currently viewed as impossible is the synchronised part of flow and the linked part of JIT. It is for the reasons stated
     raw materials companies decouple their supply chain from their clients' demand by carrying large 'finished goods'
     stocks. Both flow and JIT can be implemented in isolated process islands within the raw materials stream. The
     challenge becomes to achieve that isolation by some means other than carrying huge stocks, as most do today.
     Because of this, almost all value chains are split into a part made-to-forecast and a part that could, by using JIT,
     become make-to-order. Historically, the make-to-order part has often been within the retailer portion of the value
     chain. Toyota took Piggly Wiggly's supermarket replenishment system and drove it at least halfway through their
     automobile factories. Their challenge today is to drive it all the way back to their goods-inwards dock. Of course, the
     mining of iron and making of steel is still not connected to an order for a particular car. Recognising JIT could be
     driven back up the supply chain has reaped Toyota huge benefits and a dominant position in the auto industry.
     Note that the advent of the mini mill steelmaking facility is starting to challenge how far back JIT can be
     implemented, as the electric arc furnaces at the heart of many mini-mills can be started and stopped quickly, and
     steel grades changed rapidly.

     It has been frequently charged that the oil industry has been influenced by JIT.[6][7][8]
     The argument is presented as follows:
           The number of refineries in the United States has fallen from 279 in 1975 to 205 in 1990 and further to 149 in
           2004. As a result, the industry is susceptible to supply shocks, which cause spikes in prices and subsequently
           reduction in domestic manufacturing output. The effects of hurricanes Katrina and Rita are given as an
           example: in 2005, Katrina caused the shutdown of 9 refineries in Louisiana and 6 more in Mississippi, and a
           large number of oil production and transfer facilities, resulting in the loss of 20% of the US domestic refinery
           output. Rita subsequently shut down refineries in Texas, further reducing output. The GDP figures for the third
Just in time (business)                                                                                                         21

           and fourth quarters showed a slowdown from 3.5% to 1.2% growth. Similar arguments were made in earlier
     Beside the obvious point that prices went up because of the reduction in supply and not for anything to do with the
     practice of JIT, JIT students and even oil and gas industry analysts question whether JIT as it has been developed by
     Ohno, Goldratt, and others is used by the petroleum industry. Companies routinely shut down facilities for reasons
     other than the application of JIT. One of those reasons may be economic rationalization: when the benefits of
     operating no longer outweigh the costs, including opportunity costs, the plant may be economically inefficient. JIT
     has never subscribed to such considerations directly; following Waddel and Bodek (2005), this ROI-based thinking
     conforms more to Brown-style accounting and Sloan management. Further, and more significantly, JIT calls for a
     reduction in inventory capacity, not production capacity. From 1975 to 1990 to 2005, the annual average stocks of
     gasoline have fallen by only 8.5% from 228,331 to 222,903 bbls to 208,986 (Energy Information Administration
     data). Stocks fluctuate seasonally by as much as 20,000 bbls. During the 2005 hurricane season, stocks never fell
     below 194,000,000 bbl (30,800,000 m3), while the low for the period 1990 to 2006 was 187,017,000 bbl
     (29,733,300 m3) in 1997. This shows that while industry storage capacity has decreased in the last 30 years, it hasn't
     been drastically reduced as JIT practitioners would prefer. Specialty (SRS)
     Finally, as shown in a pair of articles in the "Oil & Gas Journal", JIT does not seem to have been a goal of the
     industry. In Waguespack and Cantor (1996), the authors point out that JIT would require a significant change in the
     supplier/refiner relationship, but the changes in inventories in the oil industry exhibit none of those tendencies.
     Specifically, the relationships remain cost-driven among many competing suppliers rather than quality-based among
     a select few long-term relationships. They find that a large part of the shift came about because of the availability of
     short-haul crudes from Latin America. In the follow-up editorial, the Oil & Gas Journal claimed that "casually
     adopting popular business terminology that doesn't apply" had provided a "rhetorical bogey" to industry critics.
     Confessing that they had been as guilty as other media sources, they confirmed that "It also happens not to be

     Business models following similar approach

     Vendor-managed inventory
     Vendor-managed inventory (VMI) employs the same principles as those of JIT inventory, however, the
     responsibilities of managing inventory is placed with the vendor in a vendor/customer relationship. Whether it’s a
     manufacturer managing inventory for a distributor, or a distributor managing inventory for their customers, the
     management role goes to the vendor.
     An advantage of this business model is that the vendor may have industry experience and expertise that lets them
     better anticipate demand and inventory needs. The inventory planning and controlling is facilitated by applications
     that allow vendors access to their customer's inventory data.
     Another advantage to the customer is that inventory cost usually remains on the vendor's books until used by the
     customer, even if parts or materials are on the customer's site.
Just in time (business)                                                                                                                            22

     Customer-managed inventory
     With customer-managed inventory (CMI), the customer, as opposed to the vendor in a VMI model, has
     responsibility for all inventory decisions. This is similar to JIT inventory concepts. With a clear picture of their
     inventory and that of their supplier’s, the customer can anticipate fluctuations in demand and make inventory
     replenishment decisions accordingly.

     Early use of a JIT system
     A type of JIT was used successfully in the UK by Perkins to supply F3 engines to Ford from 1957 until 1964.

     [1] A study of the Toyota Production System, Shigeo Shingo, Productivity Press, 1989, p 187
     [2] Gilliland, Michael. "Is Forecasting a Waste of Time?" (http:/ / www. scmr. com/ article/ CA232251. html), Supply Chain Management
         Review, July/August 2002.
     [3] Ruffa, Stephen A., (2008). Going Lean: How the Best Companies Apply Lean Manufacturing Principles to Shatter Uncertainty, Drive
         Innovation, and Maximize Profits, AMACOM (American Management Association)
     [4] Alan Pilkington, “Manufacturing Strategy Regained: Evidence for the Demise of Best-Practice” (http:/ / cmr. berkeley. edu/ search/
         articleDetail. aspx?article=4323), California Management Review, (1998) Vol. 41, No.1, pp.31–42.
     [5] Paul H. Selden (1997). Sales Process Engineering: A Personal Workshop. Milwaukee, WI: ASQ Quality Press. pp. 113–117.
     [6] Bongiorni, Sara. "All in the timing" (http:/ / web. archive. org/ web/ 20040909200301/ http:/ / www. businessreport. com/ newsDetail.
         cfm?aid=127), The Greater Baton Rouge Business Report, 19 July 2004.
     [7] "Online NewsHour: Rising gas prices – April 30, 1996" (http:/ / www. pbs. org/ newshour/ bb/ economy/ gas_hike_4-30. html). . Retrieved
     [8] "Story taken from Time magazine May 13, 1996 Volume 147, No. 20" (http:/ / www. econ. ucsb. edu/ ~tedb/ eep/ news/ gas. html). .
         Retrieved 2007-09-24.

     Further reading
     • Schonberger, Richard J. (1982), Japanese Manufacturing Techniques: Nine Hidden Lessons in Simplicity, Free
       Press, ISBN 0-02-929100-3
     • Editorial, "The Inventory Land Mine", Oil & Gas Journal, Vol 94, Number 29, 15 July 1996.
     • Flinchbaugh, Jamie and Carlino, Andy (2006), The Hitchhiker's Guide to Lean: Lessons from the Road, SME,
       ISBN 0-87263-831-6
     • Goldratt, Eliyahu M. and Fox, Robert E. (1986), The Race, North River Press, ISBN 0-88427-062-9
     • Hirano, Hiroyuki and Makota, Furuya (2006), "JIT Is Flow: Practice and Principles of Lean Manufacturing", PCS
       Press, Inc., ISBN 0-9712436-1-1
     • Liker, Jeffrey (2003), The Toyota Way: 14 Management Principles from the World's Greatest Manufacturer, First
       edition, McGraw-Hill, ISBN 0-07-139231-9.
     • Management Coaching and Training Services, (2006). The Just-In-Time (JIT) Approach. Retrieved June 19, 2006
       from the World Wide Web: (
     • Ohno, Taiichi (1988), Toyota Production System: Beyond Large-Scale Production, Productivity Press, ISBN
     • Ohno, Taiichi (1988), Just-In-Time for Today and Tomorrow, Productivity Press, ISBN 0-915299-20-8
     • Wadell, William, and Bodek, Norman (2005), The Rebirth of American Industry, PCS Press, ISBN
     • Waguespack, Kevin, and Cantor, Bryan (1996), "Oil inventories should be based on margins, supply reliability",
       Oil & Gas Journal, Vol 94, Number 28, 8 July 1996.
     • Womack, James P. and Jones, Daniel T. (2003), Lean Thinking: Banish Waste and Create Wealth in Your
       Corporation, Revised and Updated, HarperBusiness, ISBN 0-7432-4927-5.
Just in time (business)                                                                                                           23

     • Womack, James P., Jones, Daniel T., and Roos, Daniel (1991), The Machine That Changed the World: The Story
       of Lean Production, HarperBusiness, 2003, ISBN 0-06-097417-6.
     Condie, Allan T. "Fordson Dexta 957E's 1957-1964" ISBN 0-907742-71-8

     Economic order quantity
     Economic order quantity is the order quantity that minimizes total inventory holding costs and ordering costs. It is
     one of the oldest classical production scheduling models. The framework used to determine this order quantity is
     also known as Barabas EOQ Model or Barabas Formula. The model was developed by Ford W. Harris in 1913,[1]
     but R. H. Wilson, a consultant who applied it extensively, is given credit for his in-depth analysis.[2]

     EOQ applies only when demand for a product is constant over the year and each new order is delivered in full when
     inventory reaches zero. There is a fixed cost for each order placed, regardless of the number of units ordered. There
     is also a cost for each unit held in storage, sometimes expressed as a percentage of the purchase cost of the item.
     We want to determine the optimal number of units to order so that we minimize the total cost associated with the
     purchase, delivery and storage of the product.
     The required parameters to the solution are the total demand for the year, the purchase cost for each item, the fixed
     cost to place the order and the storage cost for each item per year. Note that the number of times an order is placed
     will also affect the total cost, though this number can be determined from the other parameters.

     Underlying assumptions
     1.   The ordering cost is constant.
     2.   The rate of demand is known, and spread evenly throughout the year.
     3.   The lead time is fixed.
     4.   The purchase price of the item is constant i.e. no discount is available
     5.   The replenishment is made instantaneously, the whole batch is delivered at once.
     6.   Only one product is involved.
     EOQ is the quantity to order, so that ordering cost + carrying cost finds its minimum. (A common misunderstanding
     is that the formula tries to find when these are equal.)

     •      = Purchase Price
     •       = order quantity
     •        = optimal order quantity
     •       = annual demand quantity
     •      = fixed cost per order (not per unit, typically cost of ordering and shipping and handling. This is not the cost of
     •    = annual holding cost per unit (also known as carrying cost or storage cost) (warehouse space, refrigeration,
          insurance, etc. usually not related to the unit cost)
Economic order quantity                                                                                                      24

    The Total Cost function
    The single-item EOQ formula finds the minimum point of the following cost function:
    Total Cost = purchase cost + ordering cost + holding cost
    - Purchase cost: This is the variable cost of goods: purchase unit price × annual demand quantity. This is P×D
    - Ordering cost: This is the cost of placing orders: each order has a fixed cost S, and we need to order D/Q times per
    year. This is S × D/Q
    - Holding cost: the average quantity in stock (between fully replenished and empty) is Q/2, so this cost is H × Q/2


    To determine the minimum point of the total cost curve, partially differentiate the total cost with respect to Q
    (assume all other variables are constant) and set to 0:

    Solving for Q gives Q* (the optimal order quantity):

    Therefore:                   .

    Q* is independent of P; it is a function of only S, D, H.

    Several extensions can be made to the EOQ model, including backordering costs and multiple items. Additionally,
    the economic order interval can be determined from the EOQ and the economic production quantity model (which
    determines the optimal production quantity) can be determined in a similar fashion.
    A version of the model, the Baumol-Tobin model, has also been used to determine the money demand function,
    where a person's holdings of money balances can be seen in a way parallel to a firm's holdings of inventory.[3]
    NOTE: In the example, Q means annual requirement quantity whereas earlier in the article Q meant order quantity.
    This is confusing.

    •   Suppose annual requirement quantity (Q) = 10000 units
    •   Cost per order (CO) = $2
    •   Cost per unit (CU)= $8
    •   Carrying cost %age (CC%)(%age of CU) = 0.02
    •   Carrying cost Per unit = $0.16

    Economic order quantity =

    Economic order quantity = 500 units

    Number of order per year (based on EOQ)

    Number of order per year (based on EOQ) =
    Total cost
Economic order quantity                                                                                                                          25

    Total cost
    Total cost
    If we check the total cost for any order quantity other than 500(=EOQ), we will see that the cost is higher. For
    instance, supposing 600 units per order, then
    Total cost
    Total cost
    Similarly, if we choose 300 for the order quantity then
    Total cost
    Total cost
    This illustrates that the Economic Order Quantity is always in the best interests of the entity.

    [1] Harris, Ford W. (1990, reprint from 1913). "How Many Parts to Make at Once" (http:/ / userhome. brooklyn. cuny. edu/ irudowsky/ CIS10.
        31/ articles/ EOQModel-OriginalPaper. pdf). Operations Research (INFORMS) 38 (6): 947-950. JSTOR 170962. . Retrieved Nov 21 2012.
    [2] Hax, AC and Candea, D. (1984), Production and Operations Management (http:/ / catalogue. nla. gov. au/ Record/ 772207), Prentice-Hall,
        Englewood Cliffs, NJ, pp. 135,
    [3] Andrew Caplin and John Leahy, "Economic Theory and the World of Practice: A Celebration of the (S,s) Model", Journal of Economic
        Perspectives, Winter 2010, V 24, N 1

    Further reading
    • Harris, Ford W. Operations Cost (Factory Management Series), Chicago: Shaw (1915).
    • Wilson, R. H. "A Scientific Routine for Stock Control" Harvard Business Review, 13, 116-128 (1934).

    External links
    • Lot Sizing Models (
    • Simple EOQ Calculator for Android devices (
Discounts and allowances                                                                                                     26

    Discounts and allowances
    Discounts and allowances are reductions to a basic price of goods or services.
    They can occur anywhere in the distribution channel, modifying either the manufacturer's list price (determined by
    the manufacturer and often printed on the package), the retail price (set by the retailer and often attached to the
    product with a sticker), or the list price (which is quoted to a potential buyer, usually in written form).
    There are many purposes for discounting, including; to inales, to move out-of-date stock, to reward valuable
    customers, to encourage distribution channel members to perform a function, or to otherwise reward behaviors that
    benefit the discount issuer. Some discounts and allowances are forms of sales promotion.

    Discount and allowance types
    The most common types of discounts and allowances are listed below.

    Discounts and allowances dealing with payment

    Prompt payment discount
    Trade Discount:
    Deduction in price given by the wholesaler/manufacturer to the retailer at the list price or catalogue price.
    Cash Discount:
    Reduction in price given by the creditor to the debitor is known as cash discount. This discount is intended to speed
    payment and thereby provide liquidity to the firm. They are sometimes used as a promotional device. we also explain
    that discount is relaxation in price

    • 2/10 net 30 - this means the buyer must pay within 30 days of the invoice date, but will receive a 2% discount if
      they pay within 10 days of the invoice date.
    • 3/7 EOM - this means the buyer will receive a cash discount of 3% if the bill is paid within 7 days after the end of
      the month indicated on the invoice date. If an invoice is received on or before the 25th day of the month, payment
      is due on the 7th day of the next calendar month. If a proper invoice is received after the 25th day of the month,
      payment is due on the 7th day of the second calendar month.
    • 3/7 EOM net 30 - this means the buyer must pay within 30 days of the invoice date, but will receive a 3%
      discount if they pay within 7 days after the end of the month indicated on the invoice date. If an invoice is
      received on or before the 25th day of the month, payment is due on the 7th day of the next calendar month. If a
      proper invoice is received after the 25th day of the month, payment is due on the 7th day of the second calendar
    • 2/15 net 40 ROG - this means the buyer must pay within 40 days of receipt of goods, but will receive a 2%
      discount if paid in 15 days of the invoice date. (ROG is short for "Receipt of goods.")
Discounts and allowances                                                                                                       27

    Preferred payment method discount
    Some retailers (particularly small retailers with low margins) offer discounts to customers paying with cash, to avoid
    paying fees on credit card transactions.

    Partial payment discount
    Similar to the Trade discount, this is used when the seller wishes to improve cash flow or liquidity, but finds that the
    buyer typically is unable to meet the desired discount deadline. A partial discount for whatever payment the buyer
    makes helps the seller's cash flow partially.

    Sliding scale
    A discount offered based on one's ability to pay. More common with non-profit organizations than with for-profit

    Forward dating
    This is where the purchaser doesn’t pay for the goods until well after they arrive. The date on the invoice is moved
    forward - example: purchase goods in November for sale during the December holiday season, but the payment date
    on the invoice is January 27.

    Seasonal discount
    These are price reductions given when an order is placed in a slack period (example: purchasing skis in April in the
    northern hemisphere, or in September in the southern hemisphere). On a shorter time scale, a happy hour may fall in
    this category. Generally, this discount is referred to as "X-Dating" or "Ex-Dating". An example of X-Dating would
    • 3/7 net 30 extra 10 - this means the buyer must pay within 30 days of the invoice date, but will receive a 3%
      discount if they pay within 7 days after the end of the month indicated on the invoice date plus an extra 10 days.

    Discounts and allowances dealing with trade

    Bargaining is where the seller and the buyer negotiate a price below the original asking price.

    Trade discount
    Trade discounts, also called functional discounts, are payments to distribution channel members for performing some
    function. Examples of these functions are warehousing and shelf stocking. Trade discounts are often combined to
    include a series of functions, for example 20/12/5 could indicate a 20% discount for warehousing the product, an
    additional 12% discount for shipping the product, and an additional 5% discount for keeping the shelves stocked.
    Trade discounts are most frequent in industries where retailers hold the majority of the power in the distribution
    channel (referred to as channel captains).
    Trade discounts are given to try to increase the volume of sales being made by the supplier.
    The discount described as trade rate discount is sometimes called "trade discount".
Discounts and allowances                                                                                                        28

    Trade rate discount
    A trade rate discount, sometimes also called "trade discount", is offered by a seller to a buyer for purposes of trade or
    reselling, rather than to an end user. For example, a pharmacist might offer a discount for over-the-counter drugs to
    physicians who are purchasing them for dispensing to the physicians' own patients.[1] A seller supplying both trade
    or resellers, and the general public will have a general list price for anybody, and will offer a trade discount to
    bona-fide trade customers.

    Trade-in credit
    Trade-in credit, also called trade-up credit, is a discount or credit granted for the return of something. The returned
    item may have little monetary value, as an old version of newer item being bought, or may be worth reselling as
    second-hand. The idea from a seller's viewpoint is to offer some discount but have the buyer showing some "counter
    action" to earn this special discount. Sellers like this as the discount granted is not just "given for free" and makes
    future price/value negotiations easier. Buyers have the advantage of getting some value for something no longer
    used. Examples can be found in many industries.[2]

    Discounts and allowances dealing with quantity
    These are price reductions given for large purchases. The rationale behind them is to obtain economies of scale and
    pass some (or all) of these savings on to the customer. In some industries, buyer groups and co-ops have formed to
    take advantage of these discounts. Generally there are two types:

    Cumulative quantity discount
    Cumulative quantity discounts, also called accumulation discounts, are price reductions based on the quantity
    purchased over a set period of time. The expectation is that they will impose an implied switching cost and thereby
    bond the purchaser to the seller.

    Non-cumulative quantity discount
    These are price reductions based on the quantity of a single order. The expectation is that they will encourage larger
    orders, thus reducing billing, order filling, shipping, and sales personnel expenses.

    Dependence of price on quantity
    An extreme form of quantity discount is when, within a quantity range, the price does not depend on quantity:
    • if one wants less than the minimum amount one has to be pay for the minimum amount anyway
    • if one wants an amount between two of the fixed amounts on offer, one has to pay for the higher amount
    These also apply in the case of a service with "quantity" referring to time. For example, an entrance ticket for a zoo
    is usually for a day; if one stays shorter, the price is the same. It is a kind of pass for unlimited use of a service
    during a day, where one can distinguish whether or not, when leaving and returning, one has to pay again. Similarly
    a pass can be for another period. In the case of long periods, it is obvious that one can leave and return without
    paying again.
    If one has to buy more than one wants, we can distinguish between the surplus just not being used, or the surplus
    being a nuisance, e.g. because of having to carry a large container.
Discounts and allowances                                                                                                        29

    Discounts and allowances dealing with customer characteristics
    The following discounts have to do with specific characteristics of the customer.

    Disability discount
    A discount offered to customers with what is considered to be a disability.

    Educational or student discount
    These are price reductions given to members of educational institutions, usually students but possibly also to
    educators and to other institution staff. The provider's purpose is to build brand awareness early in a buyer's life, or
    build product familiarity so that after graduation the holder is likely to buy the same product, for own use or for an
    employer, at its normal price. Educational discounts may be given by merchants directly, or via a student discount
    program, such as CollegeBudget in the United States or NUS and in the United Kingdom.

    Employee discount
    A discount offered by a company to employees who buy its products.
    In 2005, the American automakers ran an "employee discount" for all customers promotional campaign in order to
    entice buyers, with some success.

    Military discount
    A discount offered to customers who are or were members of a military service. A discount is the value that deduct
    from a service or from goods.

    Age-related discounts

    Toddler discount, child discount, kid discount
    A discount, or free service, offered to children younger than a certain age, commonly for admission to
    entertainments and attractions, restaurants, and hotels. There may be a requirement that the child be accompanied by
    an adult paying full price. Small children often travel free on public transport, and older ones may pay a substantially
    discounted price; proof of age may be required.

    Young person's discount
    Discounts are sometimes offered to young people below a certain age who are neither children nor in education.[3]

    Senior discount
    A discount offered to customers who are above a certain relatively advanced age, typically a round number such as
    50, 55, 60, 65, 70, and 75; the exact age varies in different cases. The rationale for a senior discount offered by
    companies is that the customer is assumed to be retired and living on a limited income, and unlikely to be willing to
    pay full price; sales at reduced price are better than no sales. Non-commercial organisations may offer concessionary
    prices as a matter of social policy.[4] Free or reduced-rate travel is often available to older people (see, for example,
    Freedom Pass).
Discounts and allowances                                                                                                        30

    Special prices offered to friends of the seller
    A discounted price offered to friends of the salesperson, an attitude which is parodied in the stereotype of a salesman
    saying "It costs [such-and such], but for you..." In Australia, New Zealand, and the UK, discounts to friends are
    known as "mates' rates."[5][6] In French this discount is known as prix d'ami.[7] In Spain this is known as "precio de
    amigo" in Spanish, or "preu d'amic" in Catalan. In German the term "Freundschaftspreis" is commonly used.

    Special prices offered to local residents
    Common in tourist destinations. In Hawai'i, for example, many tourist attractions, hotels, and restaurants charge a
    deeply discounted price to someone who shows proof that they live in Hawai'i; this is known as a "Kama'aina
    discount," after the Hawaiian word for an old-timer or native.[8]

    Discount card
    Sometimes a document, typically a plastic card similar to a payment card, is issued as proof of eligibility for
    discounts. In other cases, existing documents proving status (as student, disabled, resident, etc.) are accepted.
    Documentation may not be required, for example, for people who are obviously young or old enough to qualify for
    age-related discounts.

    A discount, either of a certain specified amount or a percentage to the holder of a voucher, usually with certain
    terms. Commonly, the terms involve the terms of other discounts on this page, such as being valid only if a certain
    quantity is bought or only if the customer is older than a specified age. Coupons are often printed in newspapers,
    brochures, and magazines, or can be downloaded and printed from Worldwide Web pages that can be accessed via
    the Internet.

    A refund of part of sometimes the full price of the product following purchase, though some rebates are offered at
    the time of purchase. A particular case is the promise of a refund in full if applied for in a restricted date range some
    years in the future; the hope is that the promise will lure customers and increase sales, but that the majority will fail
    to meet the conditions for a valid claim.

    Other discounts and allowances
    • Promotional allowances - These are price reductions given to the buyer for performing some promotional
      activity. These include an allowance for creating and maintaining an in-store display or a co-op advertising
    • Brokerage allowance - From the point of view of the manufacturer, any brokerage fee paid is similar to a
      promotional allowance. It is usually based on a percentage of the sales generated by the broker.
Discounts and allowances                                                                                                                                31

    [1] "Business glossary" (http:/ / www. allbusiness. com/ glossaries/ trade-rate/ 4945920-1. html). All Business. . Retrieved 2009-02-07.
    [2] "Example for Trade-In offerings in the Test- and Measurement Industry" (http:/ / savings. tm. agilent. com/ index.
        cgi?PageTradeList:ALIAS=trade_specials& User:LANGUAGE=en). All Business. . Retrieved 2011-05-23.
    [3] Example of young person's discount (http:/ / www. 16-25railcard. co. uk/ ): UK 16-25 railcard offering 1/3 discount on rail travel, and other
        discounts, for an annual fee
    [4] Example of government concession (http:/ / www. tvlicensing. co. uk/ check-if-you-need-one/ for-your-home/ aged-74-and-over-aud3/ ): UK
        residents over 75 are entitled to a free television licence
    [5] Mates' rates program at Intercontinental Hotels (http:/ / springwise. com/ tourism_travel/ interconfriends/ )
    [6] Kwik Fit 'mates rates' by DDB UK (http:/ / www. campaignlive. co. uk/ thework/ 1120246/ )
    [7] (http:/ / www. proz. com/ kudoz/ french_to_english/ other/ 973158-prix_dami_alternative_to_mates_rates. html)
    [8] Honolulu Magazine, June 2009 (http:/ / www. honolulumagazine. com/ Honolulu-Magazine/ June-2009/ Kamaaina-Summer-Discounts/ )

    Further reading
    • Shell, Ellen Ruppel, Cheap: The High Cost of Discount Culture, New York : Penguin Press, 2009. ISBN

    Factoring (finance)
    Factoring is a financial transaction whereby a business sells its accounts receivable (i.e., invoices) to a third party
    (called a factor) at a discount. In "advance" factoring, the factor provides financing to the seller of the accounts in the
    form of a cash "advance," often 70-85% of the purchase price of the accounts, with the balance of the purchase price
    being paid, net of the factor's discount fee (commission) and other charges, upon collection from the account client.
    In "maturity" factoring, the factor makes no advance on the purchased accounts; rather, the purchase price is paid on
    or about the average maturity date of the accounts being purchased in the batch. Factoring differs from a bank loan in
    several ways. The emphasis is on the value of the receivables (essentially a financial asset), whereas a bank focuses
    more on the value of the borrower's total assets, and often also considers, in underwriting the loan, the value
    attributable to non-accounts collateral owned by the borrower. Such collateral includes inventory, equipment, and
    real property,[1][2] That is, a bank loan issuer looks beyond the credit-worthiness of the firm's accounts receivables
    and of the account debtors (obligors) thereon. Secondly, factoring is not a loan – it is the purchase of a financial
    asset (the receivable). Third, a nonrecourse factor assumes the "credit risk", that a purchased account will not collect
    due solely to the financial inability of account debtor to pay. In the United States, if the factor does not assume credit
    risk on the purchased accounts, in most cases a court will recharacterize the transaction as a secured loan.
    It is different from forfaiting in the sense that forfaiting is a transaction-based operation involving exporters in which
    the firm sells one of its transactions,[3] while factoring is a Financial Transaction that involves the Sale of any portion
    of the firm's Receivables.[1][2]
    Factoring is a word often misused synonymously with invoice discounting, known as "Receivables Assignment" in
    American Accounting ("Generally Accepted Accounting Principles"/"GAAP" propagated by FASB)[2] - factoring is
    the sale of receivables, whereas invoice discounting is borrowing where the receivable is used as collateral.[2]
    However, in some other markets, such as the UK, invoice discounting is considered to be a form of factoring
    involving the assignment of receivables and is included in official factoring statistics.[4] It is therefore not considered
    to be borrowing in the UK. In the UK the arrangement is usually confidential in that the debtor is not notified of the
    assignment of the receivable and the seller of the receivable collects the debt on behalf of the factor.
    The three parties directly involved are: the one who sells the receivable, the debtor (the account debtor, or customer
    of the seller), and the factor. The receivable is essentially a financial asset associated with the debtor's liability to pay
    money owed to the seller (usually for work performed or goods sold). The seller then sells one or more of its
    invoices (the receivables) at a discount to the third party, the specialized financial organization (aka the factor),
Factoring (finance)                                                                                                                32

    often, in advance factoring, to obtain cash. The sale of the receivables essentially transfers ownership of the
    receivables to the factor, indicating the factor obtains all of the rights associated with the receivables.[1][2]
    Accordingly, the factor obtains the right to receive the payments made by the debtor for the invoice amount and, in
    nonrecourse factoring, must bear the loss if the account debtor does not pay the invoice amount due solely to his or
    its financial inability to pay. Usually, the account debtor is notified of the sale of the receivable, and the factor bills
    the debtor and makes all collections; however, non-notification factoring, where the client (seller) collects the
    accounts sold to the factor, as agent of the factor, also occurs. There are three principal parts to "advance" factoring
    transaction; (a) the advance, a percentage of the invoice face value that is paid to the seller at the time of sale, (b) the
    reserve, the remainder of the purchase price held until the payment by the account debtor is made and (c) the
    discount fee, the cost associated with the transaction which is deducted from the reserve, along with other expenses,
    upon collection, before the reserve is disbursed to the factor's client. Sometimes the factor charges the seller (the
    factor's "client") both a discount fee, for the factor's assumption of credit risk and other services provided, as well as
    interest on the factor's advance, based on how long the advance, often treated as a loan (repaid by set-off against the
    factor's purchase obligation, when the account is collected), is outstanding.[5] The factor also estimates the amount
    that may not be collected due to non-payment, and makes accommodation for this in pricing, when determining the
    purchase price to be paid to the seller. The factor's overall profit is the difference between the price it paid for the
    invoice and the money received from the debtor, less the amount lost due to non-payment.[2]
    In the United States, under the Generally Accepted Accounting Principles receivables are considered sold, under
    Statement of Financial Accounting Standards No. 140, when the buyer has "no recourse,".[6] Moreover, to treat the
    transaction as a sale under GAAP, the seller's monetary liability under any "recourse" provision must be readily
    estimated at the time of the sale. Otherwise, the financial transaction is treated as a loan, with the receivables used as

    Factoring's origins lie in the financing of trade, particularly international trade. Factoring as a fact of business life
    was underway in England prior to 1400, and it came to America with the Pilgrims, around 1620.[7] It appears to be
    closely related to early merchant banking activities. The latter however evolved by extension to non-trade related
    financing such as sovereign debt.[8] Like all financial instruments, factoring evolved over centuries. This was driven
    by changes in the organization of companies; technology, particularly air travel and non-face to face
    communications technologies starting with the telegraph, followed by the telephone and then computers. These also
    drove and were driven by modifications of the common law framework in England and the United States.[9]
    Governments were latecomers to the facilitation of trade financed by factors. English common law originally held
    that unless the debtor was notified, the assignment between the seller of invoices and the factor was not valid. The
    Canadian Federal Government legislation governing the assignment of moneys owed by it still reflects this stance as
    does provincial government legislation modelled after it. As late as the current century the courts have heard
    arguments that without notification of the debtor the assignment was not valid. In the United States, by 1949 the
    majority of state governments had adopted a rule that the debtor did not have to be notified thus opening up the
    possibility of non-notification factoring arrangements.[10]
    Originally the industry took physical possession of the goods, provided cash advances to the producer, financed the
    credit extended to the buyer and insured the credit strength of the buyer.[11] In England the control over the trade
    thus obtained resulted in an Act of Parliament in 1696 to mitigate the monopoly power of the factors. With the
    development of larger firms who built their own sales forces, distribution channels, and knowledge of the financial
    strength of their customers, the needs for factoring services were reshaped and the industry became more specialized.
    By the twentieth century in the United States factoring was still the predominant form of financing working capital
    for the then high growth rate textile industry. In part this occurred because of the structure of the US banking system
    with its myriad of small banks and consequent limitations on the amount that could be advanced prudently by any
Factoring (finance)                                                                                                              33

    one of them to a firm.[12] In Canada, with its national banks the limitations were far less restrictive and thus factoring
    did not develop as widely as in the US. Even then factoring also became the dominant form of financing in the
    Canadian textile industry.
    Today factoring's rationale still includes the financial task of advancing funds to smaller rapidly growing firms who
    sell to larger more creditworthy organizations. While almost never taking possession of the goods sold, factors offer
    various combinations of money and supportive services when advancing funds.
    Factors often provide their clients four key services: information on the creditworthiness of their prospective
    customers domestic and international, and, in nonrecourse factoring, acceptance of the credit risk for "approved"
    accounts; maintain the history of payments by customers (i.e., accounts receivable ledger); daily management reports
    on collections; and, make the actual collection calls. The outsourced credit function both extends the small firms
    effective addressable marketplace and insulates it from the survival-threatening destructive impact of a bankruptcy
    or financial difficulty of a major customer. A second key service is the operation of the accounts receivable function.
    The services eliminate the need and cost for permanent skilled staff found within large firms. Although today even
    they are outsourcing such backoffice functions. More importantly, the services insure the entrepreneurs and owners
    against a major source of a liquidity crises and their equity.
    In the latter half of the twentieth century the introduction of computers eased the accounting burdens of factors and
    then small firms. The same occurred for their ability to obtain information about debtor’s creditworthiness.
    Introduction of the Internet and the web has accelerated the process while reducing costs. Today credit information
    and insurance coverage is available any time of the day or night on-line. The web has also made it possible for
    factors and their clients to collaborate in realtime on collections. Acceptance of signed documents provided by
    facsimile as being legally binding has eliminated the need for physical delivery of “originals”, thereby reducing time
    delays for entrepreneurs.
    By the first decade of the twenty first century a basic public policy rationale for factoring remains that the product is
    well suited to the demands of innovative rapidly growing firms critical to economic growth.[13] A second public
    policy rationale is allowing fundamentally good business to be spared the costly management time consuming trials
    and tribulations of bankruptcy protection for suppliers, employees and customers or to provide a source of funds
    during the process of restructuring the firm so that it can survive and grow.

    Factoring is a method used by some firms to obtain cash. Certain companies factor accounts when the available cash
    balance held by the firm is insufficient to meet current obligations and accommodate its other cash needs, such as
    new orders or contracts; in other industries, however, such as textiles or apparel, for example, financially sound
    companies factor their accounts simply because this is the historic method of financing. The use of factoring to
    obtain the cash needed to accommodate a firm’s immediate cash needs will allow the firm to maintain a smaller
    ongoing cash balance. By reducing the size of its cash balances, more money is made available for investment in the
    firm’s growth. Debt factoring is also used as a financial instrument to provide better cash flow control especially if a
    company currently has a lot of accounts receivables with different credit terms to manage. A company sells its
    invoices at a discount to their face value when it calculates that it will be better off using the proceeds to bolster its
    own growth than it would be by effectively functioning as its "customer's bank."[14] Accordingly, factoring occurs
    when the rate of return on the proceeds invested in production exceed the costs associated with factoring the
    receivables. Therefore, the trade off between the return the firm earns on investment in production and the cost of
    utilizing a factor is crucial in determining both the extent factoring is used and the quantity of cash the firm holds on
    Many businesses have cash flow that varies. It might be relatively large in one period, and relatively small in another
    period. Because of this, businesses find it necessary to both maintain a cash balance on hand, and to use such
    methods as factoring, in order to enable them to cover their short term cash needs in those periods in which these
Factoring (finance)                                                                                                           34

    needs exceed the cash flow. Each business must then decide how much it wants to depend on factoring to cover short
    falls in cash, and how large a cash balance it wants to maintain in order to ensure it has enough cash on hand during
    periods of low cash flow.
    Generally, the variability in the cash flow will determine the size of the cash balance a business will tend to hold as
    well as the extent it may have to depend on such financial mechanisms as factoring. Cash flow variability is directly
    related to 2 factors:
    1. The extent cash flow can change,
    2. The length of time cash flow can remain at a below average level.
    If cash flow can decrease drastically, the business will find it needs large amounts of cash from either existing cash
    balances or from a factor to cover its obligations during this period of time. Likewise, the longer a relatively low
    cash flow can last, the more cash is needed from another source (cash balances or a factor) to cover its obligations
    during this time. As indicated, the business must balance the opportunity cost of losing a return on the cash that it
    could otherwise invest, against the costs associated with the use of factoring.
    The cash balance a business holds is essentially a demand for transactions money. As stated, the size of the cash
    balance the firm decides to hold is directly related to its unwillingness to pay the costs necessary to use a factor to
    finance its short term cash needs. The problem faced by the business in deciding the size of the cash Balance it wants
    to maintain on hand is similar to the decision it faces when it decides how much physical inventory it should
    maintain. In this situation, the business must balance the cost of obtaining cash proceeds from a factor against the
    opportunity cost of the losing the Rate of Return it earns on investment within its business.[15] The solution to the
    problem is:


    •        is the cash balance
    •          is the average negative cash flow in a given period
    •    is the [discount rate] that cover the factoring costs
    •    is the rate of return on the firm’s assets.[17]
    Other definition from Factoring Chain International:

    How does international factoring work?
    There is nothing complex about factoring. It is simply a unique package of services designed to ease the traditional
    problems of selling on open account. Typical services include investigating the creditworthiness of buyers, assuming
    credit risk and giving 100% protection against write-offs, collection and management of receivables and provision of
    finance through immediate cash advances against outstanding receivables.
    When export factoring is carried out by members of FCI, the service involves a five or six stage operation.
    • The exporter signs a factoring contract assigning all agreed receivables to an export factor. The factor then
      becomes responsible for all aspects of the factoring operation.
    • The export factor chooses an FCI correspondent to serve as an import factor in the country where goods are to be
      shipped. The receivables are then reassigned to the import factor.
    • At the same time, the import factor investigates the credit standing of the buyer of the exporter's goods and
      establishes lines of credit. This allows the buyer to place an order on open account terms without opening letters
      of credit.
    • Once the goods have been shipped, the export factor may advance up to 80% of the invoice value to the exporter.
    • Once the sale has taken place, the import factor collects the full invoice value at maturity and is responsible for
      the swift transmission of funds to the export factor who then pays the exporter the outstanding balance.
Factoring (finance)                                                                                                              35

    • If after 90 days past due date an approved invoice remains unpaid, the import factor will pay 100% of the invoice
      value under guarantee.
    Not only is each stage designed to ensure risk-free export sales, it lets the exporter offer more attractive terms to
    overseas customers. Both the exporter and the customer also benefit by spending less time and money on
    administration and documentation. In all cases, exporters are assured of the best deal in each country. This is because
    export factors never appoint an import factor solely because the company is a fellow member of FCI. Import factors
    are invited to compete for business and those with superior services are selected.
    In some situations, FCI members handle their client's business without involving another factor. This is becoming
    more common in the European Union where national boundaries are disappearing. However FCI members conduct
    their business, one thing remains certain. Their aim is to make selling in the complex world of international trade as
    easy for clients as dealing with local customers.

    Differences from bank loans
    Factors make funds available, even when banks would not do so, because factors focus first on the credit worthiness
    of the debtor, the party who is obligated to pay the invoices for goods or services delivered by the seller. In contrast,
    the fundamental emphasis in a bank lending relationship is on the creditworthiness of the borrower, not that of its
    customers. While bank lending is cheaper than factoring, the key terms and conditions under which the small firm
    must operate differ significantly.
    From a combined cost and availability of funds and services perspective, factoring creates wealth for some but not
    all small businesses. For small businesses, their choice is slowing their growth or the use of external funds beyond
    the banks. In choosing to use external funds beyond the banks the rapidly growing firm’s choice is between seeking
    venture capital (i.e., equity) or the lower cost of selling invoices to finance their growth. The latter is also easier to
    access and can be obtained in a matter of a week or two, whereas securing funds from venture capitalists can
    typically take up to six months. Factoring is also used as bridge financing while the firm pursues venture capital and
    in conjunction with venture capital to provide a lower average cost of funds than equity financing alone. Of course
    one needs to note that Equity capital has the highest cost in the long run, as a firm needs to demonstrate higher return
    on investment for its shareholders Firms can also combine the three types of financing, angel/venture, factoring and
    bank line of credit to further reduce their total cost of funds whilst at the same time improving cash flow.
    As with any technique, factoring solves some problems but not all. Businesses with a small spread between the
    revenue from a sale and the cost of a sale, should limit their use of factoring to sales above their breakeven sales
    level where the revenue less the direct cost of the sale plus the cost of factoring is positive.
    While factoring is an attractive alternative to raising equity for small innovative fast-growing firms, the same
    financial technique can be used to turn around a fundamentally good business whose management has encountered a
    perfect storm or made significant business mistakes which have made it impossible for the firm to work within the
    constraints of their bank covenants. The value of using factoring for this purpose is that it provides management time
    to implement the changes required to turn the business around. The firm is paying to have the option of a future the
    owners control. The association of factoring with troubled situations accounts for the half truth of it being labeled
    'last resort' financing. However, use of the technique when there is only a modest spread between the revenue from a
    sale and its cost is not advisable for turnarounds. Nor are turnarounds usually able to recreate wealth for the owners
    in this situation.
    Large firms use the technique without any negative connotations to show cash on their balance sheet rather than an
    account receivable entry, money owed from their customers, particularly when these show payments being due for
    extended periods of time beyond the North American norm of 60 days or less.
Factoring (finance)                                                                                                                  36

    Invoice sellers
    The invoice seller presents recently generated invoices to the factor in exchange for an amount that is less than the
    value of the invoice(s) by an agreed upon discount and a reserve. A reserve is a provision to cover short payments,
    payment of less than the full amount of the invoice by the debtor, or a payment received later than expected. The
    result is an initial payment followed by a second one equal to the amount of the reserve if the invoice is paid in full
    and on time or a credit to the account of the seller with the factor. In an ongoing relationship the invoice seller will
    get their funds one or two days after the factor receives the invoices. Astute invoice sellers can use a combination of
    techniques to cover the range of 1% to 5% plus cost of factoring for invoices paid within 50 to 60 days or more. In
    many industries, customers expect to pay a few percentage points higher to get flexible sales terms. In effect the
    customer is willing to pay the supplier to be their bank and reduce the equity the customer needs to run their
    business. To counter this it is a widespread practice to offer a prompt payment discount on the invoice. This is
    commonly set out on an invoice as an offer of a 2% discount for payment in ten days. {Few firms can be relied upon
    to systematically take the discount, particularly for low value invoices - under $100,000 - so cash inflow estimates
    are highly variable and thus not a reliable basis upon which to make commitments.} Invoice sellers can also seek a
    cash discount from a supplier of 2% up to 10% (depending on the industry standard) in return for prompt payment.
    Large firms also use the technique of factoring at the end of reporting periods to ‘dress’ their balance sheet by
    showing cash instead of accounts receivable. There are a number of varieties of factoring arrangements offered to
    invoice sellers depending upon their specific requirements. The basic ones are described under the heading Factors

    When initially contacted by a prospective invoice seller, the factor first establishes whether or not a basic condition
    exists, does the potential debtor(s) have a history of paying their bills on time? That is, are they creditworthy? (A
    factor may actually obtain insurance against the debtor’s becoming bankrupt and thus the invoice not being paid.)
    The factor is willing to consider purchasing invoices from all the invoice seller’s creditworthy debtors. The classic
    arrangement which suits most small firms, particularly new ones, is full service factoring where the debtor is notified
    to pay the factor (notification) who also takes responsibility for collection of payments from the debtor and the risk
    of the debtor not paying in the event the debtor becomes insolvent; i.e., nonrecourse factoring. This traditional
    method of factoring puts the risk of non-payment fully on the factor, except if the reason for the factor's failure to
    collect is not related to the financial inability of the account debtor to pay, the sole risk assumed by a nonrecourse
    factor. If the debtor cannot pay the invoice due to insolvency, it is the factor's problem to deal with and the factor
    cannot seek payment from the seller. The factor will only purchase solid credit worthy invoices and often turns away
    average credit quality customers. The cost is typically higher with this factoring process because the factor assumes a
    greater risk and provides credit checking and payment collection services as part of the overall package. For firms
    with formal management structures such as a Board of Directors (with outside members), and a Controller (with a
    professional designation), debtors may not be notified (i.e., non-notification factoring). The invoice seller may not
    retain the credit control function. If they do then it is likely that the factor will insist on recourse against the seller if
    the invoice is not paid after an agreed upon elapse of time, typically 60 or 90 days. In the event of non-payment by
    the customer, the seller must buy back the invoice with another credit worthy invoice. Recourse factoring is typically
    the lowest cost for the seller because they retain the bad debt risk, which makes the arrangement less risky for the
    Despite the fact that most large organizations have in place processes to deal with suppliers who use third party
    financing arrangements incorporating direct contact with them, many entrepreneurs remain very concerned about
    notification of their clients. It is a part of the invoice selling process that benefits from salesmanship on the part of
    the factor and their client in its conduct. Even so, in some industries there is a perception that a business that factors
    its debts is in financial distress.
Factoring (finance)                                                                                                                37

    There are two principal methods of factoring: recourse and non-recourse. Under recourse factoring, the client is not
    protected against the risk of bad debts. On the other hand, the factor assumes the entire credit risk under
    non-recourse factoring i.e., full amount of invoice is paid to the client in the event of the debt becoming bad. Other
    variations include partial nonrecourse, where the factor's assumption of credit risk is limited by time, and partial
    recourse, where the factor and its client (the seller of the accounts) share credit risk. Factors never assume "quality"
    risk, and even a nonrecourse factor can chargeback a purchased account which does not collect for reasons other than
    credit risk assumed by the factor; for example, because the account debtor disputes the quality or quantity of the
    goods or services delivered by the factor's client.

    Invoice payers (debtors)
    Large firms and organizations such as governments usually have specialized processes to deal with one aspect of
    factoring, redirection of payment to the factor following receipt of notification from the third party (i.e., the factor) to
    whom they will make the payment. Many but not all in such organizations are knowledgeable about the use of
    factoring by small firms and clearly distinguish between its use by small rapidly growing firms and turnarounds.
    Distinguishing between assignment of the responsibility to perform the work and the assignment of funds to the
    factor is central to the customer/debtor’s processes. Firms have purchased from a supplier for a reason and thus insist
    on that firm fulfilling the work commitment. Once the work has been performed however, it is a matter of
    indifference who is paid. For example, General Electric has clear processes to be followed which distinguish
    between their work and payment sensitivities. Contracts direct with US Government require an Assignment of
    Claims which is an amendment to the contract allowing for payments to third parties (factors).

    The most important risks of a factor are:
    • Counter party credit risk related to clients and risk covered debtors. Risk covered debtors can be reinsured, which
      limit the risks of a factor. Trade receivables are a fairly low risk asset due to their short duration.
    • External fraud by clients: fake invoicing, mis-directed payments, pre-invoicing, not assigned credit notes, etc. A
      fraud insurance policy and subjecting the client to audit could limit the risks.
    • Legal, compliance and tax risks: large number of applicable laws and regulations in different countries.
    • Operational risks, such as contractual disputes.
    • Uniform Commercial Code (UCC-1) securing rights to assets.
    • IRS liens associated with payroll taxes etc.
    • ICT risks: complicated, integrated factoring system, extensive data exchange with client.
Factoring (finance)                                                                                                                                      38

    Reverse Factoring
    We can see nowadays that there is a new process developing: the reverse factoring, or supply chain finance. It uses
    the strengths of the factoring process, but instead of being started by the supplier, it is the buyer that creates the
    solution toward a factor. That way, the buyer secures the financing of the invoice, and the supplier gets a better
    interest rate.

    [1] J. Downes, J.E. Goodman, "Dictionary of Finance & Investment Terms", Baron's Financial Guides, 2003. Taken from a combination of the
        definitions of a financial asset and accounts receivable
    [2] J. Downes, J.E. Goodman, "Dictionary of Finance & Investment Terms", Baron's Financial Guides, 2003; and J.G.Siegel, N.Dauber &
        J.K.Shim, "The Vest Pocket CPA", Wiley, 2005.
    [3] Please Refer to the Wiki article, forfaiting, for further discussion on cites.
    [4] BCR Publishing, "The World Factoring Yearbook" (http:/ / bcrpub. co. uk/ publications), UK Section.
    [5] J.G.Siegel, N.Dauber & J.K.Shim, "The Vest Pocket CPA", Wiley, 2005.
    [6] This means that the factor cannot obtain additional payments from the seller if the purchased account does not collect due solely to the
        financial inability to pay of the account debtor; however, "quality recourse" still exists. In other words, the nonrecourse factor who assumes
        credit risk bears the credit loss and incurs bad debt if a purchased account does not collect due solely to financial inability of the account
        debtor to pay.
    [7] Four Centuries of Factoring; Hillyer, William Hurd; Quarterly Journal of Economics MIT Press 1939; D. Tatge, D. Flaxman & J. Tatge,
        American Factoring Law (BNA, 2009)
    [8] Bankers and Pashas: International Finance and Economic Imperialism in Egypt; Landes, David S.; Harper Torchbooks 1969
    [9] Factoring, Jones, Owen; Harvard Business Review February 1939 and Factoring as a Financing Device, Silverman, Herbert R.; Harvard
        Business Review, September 1949; D. Tatge, D. Flaxman & J. Tatge, American Factoring Law (BNA, 2009)
    [10] Silverman, Herbert R.; Harvard Business Review, September 1949
    [11] Hillyer
    [12] Silbert HBR Jan/Feb 1952
    [13] Good Capitalism Bad Capitalism and The Economics of Growth and Prosperity; Baumol, William J., Litan, Robert E., and Schramm, Carl J.
        Yale University Press 2007
    [14] EU Federation for Factoring and Commercial Finance (http:/ / euf. eu. com/ factoring/ services/ what-is-factoring/ menu-id-14. html)
    [15] The return on its investment can be estimated by looking at its Net Income Relative to its Total Assets
    [16] William J. Baumol, The Quarterly Journal of Economics, (Nov, 1952), 545-556.
    [17] As a general rule, when cash flow tends to be positive on average. However, as mentioned, there are periods of time in which cash flow can
        be negative (more cash flows out than in).

    External links
    • article ( on invoice
    • United Nations Convention on the Assignment of Receivables in International Trade 2004 (
    • 'Role of "Reverse Factoring" in Supplier Financing of Small and Medium Sized Enterprises' (http://www.
    • 'International Factors Group - The International Association for Factoring ' (
    • 'EU Federation for Factoring and Commercial Finance' - The representative Body for the Factoring and
      Commercial Finance Industry in the EU (
    • Credit Research Foundation - Understanding Commercial Factoring & Credit Insurance (http://www.crfonline.
Capital budgeting                                                                                                              39

    Capital budgeting
    Capital budgeting (or investment appraisal) is the planning process used to determine whether an organization's
    long term investments such as new machinery, replacement machinery, new plants, new products, and research
    development projects are worth pursuing. It is budget for major capital, or investment, expenditures.[1]
    Many formal methods are used in capital budgeting, including the techniques such as
    •   Accounting rate of return
    •   Payback period
    •   Net present value
    •   Profitability index
    •   Internal rate of return
    •   Modified internal rate of return
    •   Equivalent annuity
    •   Real options valuation
    These methods use the incremental cash flows from each potential investment, or project. Techniques based on
    accounting earnings and accounting rules are sometimes used - though economists consider this to be improper -
    such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well,
    such as payback period and discounted payback period.

    Capital Budgeting Definition
    acoording to two Economist Khizar Hayyat And Saqlain Shah:
    capital budgeting is a long term economics decision making it is called capital budgeting Each potential project's
    value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). (First
    applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams:
    Theory.) This valuation requires estimating the size and timing of all the incremental cash flows from the project.
    (These future cash highest NPV(GE).) The NPV is greatly affected by the discount rate, so selecting the proper rate -
    sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the Minimum acceptable
    rate of return on an investment. This should reflect the riskiness of the investment, typically measured by the
    volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM
    or the APT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of
    capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is
    to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's
    risk is higher than the risk of the firm as a whole.

    Internal rate of return
    The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a
    commonly used measure of investment efficiency.
    The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an
    unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed
    by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle
    rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the
    highest IRR - which is often used - may select a project with a lower NPV.
    In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if
    one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of
Capital budgeting                                                                                                               40

    the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved
    analytically but only via iterations.
    One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability
    of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the
    project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure
    called Modified Internal Rate of Return (MIRR) is often used.
    Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV, although they
    should be used in concert. In a budget-constrained environment, efficiency measures should be used to maximize the
    overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of
    percentage rates of return than dollars of NPV.

    Equivalent annuity method
    The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of
    the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows.
    In this form it is known as the equivalent annual cost (EAC) method and is the cost per year of owning and operating
    an asset over its entire lifespan.
    It is often used when comparing investment projects of unequal lifespans. For example if project A has an expected
    lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the
    net present values (NPVs) of the two projects, unless the projects could not be repeated.
    The use of the EAC method implies that the project will be replaced by an identical project.
    Alternatively the chain method can be used with the NPV method under the assumption that the projects will be
    replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the
    projects are chained together, i.e. four repetitions of the 3 year project are compare to three repetitions of the 4 year
    project. The chain method and the EAC method give mathematically equivalent answers.
    The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a
    real interest rate rather than a nominal interest rate is commonly used in the calculations.Y

    Real options
    Real options analysis has become important since the 1970s as option pricing models have gotten more
    sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with the
    promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to
    decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject
    them. Real options analysis try to value the choices - the option value - that the managers will have in the future and
    adds these values to the NPV.
Capital budgeting                                                                                                                     41

    Ranked Projects
    The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially
    be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should
    be ranked against peer projects (e.g. - highest Profitability index to lowest Profitability index). The highest ranking
    projects should be implemented until the budgeted capital has been expended.

    Funding Sources
    When a corporation determines its capital budget, it must acquire said funds. Three methods are ge stock have no
    financial risk but dividends, including all in arrears, must be paid to the preferred stockholders before any cash
    disbursements can be made to common stockholders; they generally have interest rates higher than those of
    corporate bonds. Finally, common stocks entail no financial risk but are the most expensive way to finance capital
    projects.The Internal Rate of Return is very important.

    Need For Capital Budgeting
    1. As large sum of money is involved which influences the profitability of the firm making capital budgeting an
       important task.
    2. Long term investment once made can not be reversed without significance loss of invested capital. The
       investment becomes sunk and mistakes, rather than being readily rectified,must often be born until the firm can be
       withdrawn through depreciation charges or liquidation. It influences the whole conduct of the business for the
       years to come.
    3. Investment decision are the base on which the profit will be earned and probably measured through the return on
       the capital. A proper mix of capital investment is quite important to ensure adequate rate of return on investment,
       calling for the need of capital budgeting.
    4. The implication of long term investment decisions are more extensive than those of short run decisions because
       of time factor involved, capital budgeting decisions are subject to the higher degree of risk and uncertainty than
       short run decision.[2]

    External links and references
    [1] Sullivan, arthur; Steven M. Sheffrin (2003). Economics: Principles in action (http:/ / www. pearsonschool. com/ index.
        cfm?locator=PSZ3R9& PMDbSiteId=2781& PMDbSolutionId=6724& PMDbCategoryId=& PMDbProgramId=12881& level=4). Upper
        Saddle River, New Jersey 07458: Pearson Prentice Hall. pp. 375. ISBN 0-13-063085-3. .
    [2] Varshney, R.L.; K.L. Maheshwari (2010). Manegerial Economics. 23 Daryaganj, New Delhi 110002: Sultan Chand & Sons. pp. 881.
        ISBN 978-81-8054-784-3.

    • Capital Budgeting (
    • International Good Practice: Guidance on Project Appraisal Using Discounted Cash Flow (http://www.ifac.
      org/Members/DownLoads/Project_Appraisal_Using_DCF_formatted.pdf), International Federation of
      Accountants, June 2008, ISBN 978-1-934779-39-2
    • Prospective Analysis: Guidelines for Forecasting Financial Statements (
      cfm?abstract_id=1026210), Ignacio Velez-Pareja, Joseph Tham, 2008
    • To Plug or Not to Plug, that is the Question: No Plugs, No Circularity: A Better Way to Forecast Financial
      Statements (,
      Ignacio Velez-Pareja, 2008
    • A Step by Step Guide to Construct a Financial Model Without Plugs and Without Circularity for Valuation
      Purposes (, Ignacio
      Velez-Pareja, 2008
Capital budgeting                                                                                               42

    • Long-Term Financial Statements Forecasting: Reinvesting Retained Earnings (
      papers.cfm?abstract_id=1286542), Sergei Cheremushkin, 2008
Article Sources and Contributors                                                                                                                                                                   43

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