Finance Lecture11

MBAM 614 Finance Accounts Receivable and Inventory Management • MBAM614 Class 11 - 1 Summary of Last Class 1. Cash balances are required to pay bills and, in general, conduct business 2. Optimal cash balance is a trade-off between opportunity costs and the uncertainty of future needs 3. There are a variety of ways to manage collections but all aim at reducing the collection time thus freeing up cash for other uses 4. Money markets offer a variety of possible near-cash securities suitable for investing idle cash • MBAM614 Class 11 - 2 1 Agenda 1. 2. 3. 4. 5. Credit and Receivables Terms of Sale Optimal Credit Policy Inventory Management Inventory Management Techniques • MBAM614 Class 11 - 3 Credit Policy A/R, at 15% or more of assets, represent an important part of the assets of most U.S. firms – credit granted to other firms is Trade Credit – credit granted to consumers is Consumer Credit Size of A/R is a function of the firm’s Credit Policy: – Terms of Sale credit/cash, credit period, discount, discount period, credit instrument – Credit Analysis who gets credit (and how much) and who doesn’t – Collection Policy how to get borrowers to pay • MBAM614 Class 11 - 4 2 Cash Flows from Granting Credit Credit sale is made Time Credit period Cash collection Customer mails check Firm Bank deposits credits check firm Accounts Receivable Time spent in Accounts Receivable is Receivables Period. Function of: • Collections Float • Credit Policy • MBAM614 Class 11 - 5 Investment in Receivables Amount invested in receivables depends on – Average Collection Period (or Days Sales in Receivables or Receivables Period) – Average Daily Credit Sales Accounts Receivable = Average Collection Period × Average Daily Credit Sales • MBAM614 Class 11 - 6 3 Terms of Sale Terms of Sale have three components – the credit period – any cash discounts and discount period – the credit instrument Basic form of Terms of Sale is “a/b, net c” which means (take this much off the invoice price)/(if you pay in this many days), (otherwise pay the full invoice price in this many days) E.g 1/10, net 30 means take a 1% discount if you pay within 10 days otherwise pay the full amount within 30 days. • MBAM614 Class 11 - 7 Credit Period The Credit Period is the length of time before the borrower is supposed to pay Two components are Net Credit Period and the Cash Discount Period Invoice Date starts the clock on credit period – usually shipping or billing date – Receipt of Goods (ROG) is a variation – End of Month (EOM) is another – Seasonal Dating is practice of setting invoice date to reflect the “season” of the goods • MBAM614 Class 11 - 8 4 Length of Credit Period Factors affecting the length of credit period chosen are –buyer’s inventory period don’t finance customer’s receivables typically have high turnover –perishability and collateral value –consumer demand seasonality, product maturity, affect turnover low cost/profit, short terms –cost, profitability, and standardization –credit risk –size of the account –competition –customer type high risk means short terms (if any) large customers get better terms (lower costs) credit terms may be used as tool of competition different customer types have different mixture of above factors, ∴ different terms Class 11 - 9 • MBAM614 Cash Discounts Cash discounts (or discounts for early payment) are used for several reasons: – to speed payment thereby reducing collection period and investment in receivables – broaden customer base and increase sales – price discriminate Discounts do not necessarily reduce A/R • MBAM614 Class 11 - 10 5 Cost of Credit From the buyer’s point of view, there is a cost to not accepting discounts since, effectively, the goods could have been obtained by paying earlier The difference in price (foregone discount) is the cost of financing the (discounted) purchase price for the balance of the net or credit period periodic rate = (discount %)/(100 - discount %) APR = (periodic rate) × 365/(net period - discount period) EAR = (1 + periodic rate/100)[365/(net period - discount period)] - 1 • MBAM614 Class 11 - 11 Example: Cost of Credit The City of Malibu can purchase ice salt (for those cold mornings on Malibu Canyon) on terms of 1/15, net 45. What is the cost of credit if the City takes 45 days to pay instead of 15? Periodic Rate For every $1 of salt purchased, the city only pays $0.99 (1% discount) if they pay in 15 days. If they pay in 45 days, they pay an extra $0.01 (full price) - this is the cost of not paying for the additional 30 days. periodic rate = 1/(100 - 1) = $0.01/$0.99 = 1.01% • MBAM614 Class 11 - 12 6 Example: Cost of Credit Annual Percentage Rate 1.01% is the cost of credit over the additional 30 days (45 days - 15 days) and there are 365/30 = 12.167 30 day periods in a year APR = 1.01% × 365/(45 - 15) = 12.29% Effective Annual Rate Accounting for compounding in each period gives EAR = (1 + 0.0101)12.167 - 1 = 1.30 - 1 = 0.13 or 13% • MBAM614 Class 11 - 13 Credit Instruments A Credit Instrument is the basic evidence of indebtedness. Different instruments have different risk Open Account transactions are evidenced by invoice only and are simply recorded on the books Promissory Note is an IOU used when collections problems are foreseen (these are uncommon) Commercial Draft is a pre-arranged promissory note which is sent (with shipping invoices) to customer’s bank – if payable immediately, called a Sight Draft – if payable at some future time, called a Time Draft If firm guarantees payment, becomes a Trade Acceptance which is returned to supplier who can sell it Customer may get Bank to “stamp” it (guarantee it) making it a Banker’s Acceptance • MBAM614 Class 11 - 14 7 Effects of Credit Policy Extending credit has many implications for a firm – Revenue Effects: payment is received later but price and quantity sold may increase – Cost Effects: there are costs to running a credit scheme and collecting receivables – The Cost of Financing: A/R must be financed – Probability of Non-Payment: will always get paid if you sell for cash – Cash Discount: affects payment patterns and amounts • MBAM614 Class 11 - 15 Optimal Credit Policy In principal, an Optimal Credit Policy is one where incremental cash flows from sales are equal to incremental costs of carrying the increase in investment in accounts receivable. It is a trade-off between Carrying Costs: – the required return on receivables – the losses from bad debts – the costs of managing credit and collections Opportunity Costs: – potential profit from lost credit sales • MBAM614 Class 11 - 16 8 Optimal Credit Policy Optimal amount of credit Cost in dollars Total Cost of Credit Carrying Costs Opportunity Costs C* • MBAM614 Amount of Credit Extended Class 11 - 17 Inventory Management Inventories represent significant part of assets of most firms: 15% on average, can exceed 25% for retailers Inventory is usually one of three types: – Raw Materials Inventory is stores of whatever the firm uses as a starting point for production: typically quite liquid – Work-in-Process Inventory is unfinished product somewhere in the production process: not liquid at all – Finished Goods Inventory is stores of product which are ready to sell or ship: typically fairly liquid • MBAM614 Class 11 - 18 9 Inventory Costs Optimal Inventory is a trade-off between costs Carrying Costs - all the direct and opportunity costs of keeping inventory on hand – – – – storage and tracking costs insurance and taxes losses due to obsolescence, deterioration, or theft opportunity cost of capital on the invested amount Shortage Costs - costs associated with having inadequate inventory on hand – restocking costs – costs related to safety reserves (lost sales and customer ill-will) • MBAM614 Class 11 - 19 Economic Order Quantity The best known approach for determining the optimal inventory level is to find the point at which the total carrying and shortage costs of inventory are minimized Not trying to find total inventory over the year (depends on sales) but how much firm should have at any point in time: the average inventory level Depends how much is ordered when inventory is restocked so really trying to determine how much a firm should order at one time. The larger the order size, the higher the average inventory and – the higher the carrying costs – the lower the shortage costs • MBAM614 Class 11 - 20 10 Optimal Inventory Order Size Optimal size of inventory order Cost in $ of holding inventory Total Costs of Holding Inventory Carrying Costs Shortage Costs Q* • MBAM614 Size of inventory order, Q Class 11 - 21 Average Inventory Business Depot sells diskettes at a steady rate. They order Q=3,600 at a time and it takes 4 weeks to sell them. What do their inventory quantities look like over time? Inventory Q=3600 Average Inventory = (Max + Min) / 2 1800 Reorder 0 0 • MBAM614 1 2 3 4 5 6 7 8 9 10 11 12 Time Class 11 - 22 11 Example: Santa Barbara Vineyard The Santa Barbara Vineyard begins each period with 500 pairs of work gloves for their field hands. This stock of gloves is totally depleted each period and reordered. If the carrying cost of gloves is $0.50/pair (per year), what are the carrying costs of SBV’s inventory? Total Carrying Costs = Average Inventory × Carrying Costs per Unit Average Inventory = (500 + 0) / 2 = 250 pair of gloves Total Carrying Costs = (250 pair) × ($0.50/pair) = $125.00 • MBAM614 Class 11 - 23 Example: Santa Barbara Vineyard Each year, the field hands at SBV use 12,000 pairs of gloves. If it costs $15 to reorder gloves, what is SBV’s total restocking cost? Total Restocking Costs = Fixed Cost per Order × Number of Orders Number of Orders = 12,000 gloves / 500 gloves per order = 24 orders Total Restocking Costs = ($15 per order) × (24 orders) = $360.00 Total Inventory Costs = Total Carrying Costs + Total Restocking Costs = $125 + $360 = $485 • MBAM614 Class 11 - 24 12 Economic Order Quantity According to our graph, total inventory costs are minimized when total carrying costs and total restocking costs are equal (assuming no safety stock costs) This order quantity, Q*, is the Economic Order Quantity or EOQ Let – T be the total units of inventory purchased per year – F be the fixed cost per order – CC be the carrying cost per unit per year – Q* be the order quantity at which two costs are equal (EOQ) Q* = 2T × F CC Class 11 - 25 • MBAM614 Example: Santa Barbara Vineyard What is the EOQ for the Santa Barbara Vineyard and how much would they save if they ordered that amount instead of 500 pair per order? 2T × F CC 2(12,000) × ($15) $0.50 Q* = = = 720,000 = 848.5 or approximately 850 pairs per order Total Carrying Costs = (850/2) pair × ($0.50/pair) = $212.50 Total Restocking Costs = $15 per order × (12,000/850) orders = $211.76 Total Inventory Costs = $212.50 + $211.76 = $424.26 a savings of $60.74 (or 12.5%) • MBAM614 Class 11 - 26 13 Example: Baumol Optimal Cash Balance Cash balances are really just inventories of dollars. Suppose the Santa Barbara Vineyard spends $120,000 each month. If T-Bills are yielding 5% and it costs SBV $1000 each time they sell T-Bills, what is SBV’s optimal cash “order quantity”, C*? C* = 2T × F K = 2($1,440,000) × ($1000) 0.05 = 57,600,000,000 = $240,000 or two months of cash per transaction Total Carrying Costs = ($240,000/2) × (0.05) = $6000 Total Restocking Costs = $1000 per trade × ($1,440,000/$240,000) trades = $6000 Total Cash Carrying Costs = $6000 + $6000 = $12,000 This is called the Baumol Optimal Cash Balance Model • MBAM614 Class 11 - 27 Safety Stocks Safety Stocks are the minimum inventories a firm is willing to have on hand. When inventory falls below the safety stock level, inventory is reordered Inventory Q Average Inventory = (Max + Min) / 2 Reorder 0 0 • MBAM614 Safety Stock 1 2 3 4 5 6 7 8 9 10 11 12 Time Class 11 - 28 14 Reorder Points Due to lags between ordering and delivery, firms generally reorder before inventory reaches the safety stock level. Inventory Q Reorder Reorder Point Delivery Time 0 0 • MBAM614 Safety Stock 1 2 3 4 5 6 7 8 9 10 11 12 Time Class 11 - 29 Key Points 1. Granting credit leads to accounts receivable which must be financed there is a cost to granting credit. 2. Credit (from suppliers) is free during the discount period. For the balance of the net period, the cost of credit is the forgone discount. 3. Credit terms are expressed as “a/b, net c” 4. The goal of inventory management is to minimize the total cost of inventory which includes carrying costs and shortage costs 5. The optimal order size, which minimizes the total cost of inventory over time, is given by the Economic Order Quantity (EOQ) Q* = • MBAM614 2T × F CC Class 11 - 30 15 MBAM 614 Finance Mergers and Acquisitions • MBAM614 Class 11 - 31 Agenda 1. Types of Mergers 2. Reasons for a Merger 3. Source of Synergies 4. Cost of an Acquisition 5. Video: Making A Killing in the Futures Markets • MBAM614 Class 11 - 32 16 Mergers & Acquisitions: Terminology Term Merger loosely used to mean all combinations, but there are distinct types – merger or consolidation – acquisition of stock – acquisition of assets The Bidder is the company making an offer to buy all the stock or assets of another firm The Target Firm is the firm being sought The Consideration is the cash or securities offered in an acquisition or merger • MBAM614 Class 11 - 33 Mergers & Consolidations Difference between a merger and consolidation is whether a new firm is created – In a merger, one company is completely absorbed by another (assets and liabilities). The target ceases to exist, buyer continues – In a consolidation, a new firm is created and both firms cease to operate Advantage: legally simple and relatively cheap Disadvantage: needs approval of majority of shareholders which usually requires the co-operation of both managements • MBAM614 Class 11 - 34 17 Acquisition of Stock Take control by buying a majority of the voting stock of a firm with cash, securities, or a combination – Can be accomplished through market transactions or – A Tender Offer - an offer to purchase a portion (or all) of the shares in a target from any shareholder. Often contingent on a minimum portion tendering. – Some considerations: – shareholder vote not required in tender. Shareholders chose to sell or not – tender offers bypass the board and management of the target – may be the only way around unfriendly management – complete absorption requires a merger - often a first step • MBAM614 Class 11 - 35 Acquisition of Assets One firm buys most or all of the assets of another firm – liabilities are not involved (unlike a merger) Transferring title can make process difficult and costly – may be collateral for bank loans – bond covenants probably restrict ability to sell Selling firm may remain in business • MBAM614 Class 11 - 36 18 Takeovers Merger or Consolidation Acquisition Takeovers Proxy Contest Going Private Acquisition of Stock Acquisition of Assets Gaining control by electing the board of directors using proxies Shares are purchased by a small number of investors (or firms) and withdrawn from public trading Leveraged Buyout (LBO) - going private with borrowed money • MBAM614 Class 11 - 37 How Taxes Affect Acquisitions Tax status depends on type of payment to shareholders – Tax-free if acquisition is for a business purpose and there is continuity of equity interest (shareholders in target firm must end up with equity in the bidder) – Taxable, in general, if cash or any security but equity is used in the transaction If taxable, the target’s shareholders may end up paying capital gains taxes, driving up the cost of the acquisition If taxable, target’s assets may be re-valued and “written up” increasing depreciation (and therefore its tax shield) • MBAM614 Class 11 - 38 19 Reasons for M&A Many reasons offered but only one is valid: Synergy If VAB is the value of the combined firm and (VA + VB) is the sum of the firm values, the incremental net gain from combining is ∆V = VAB - (VA + VB). If ∆V > 0, the incremental benefit is called Synergy The value of firm B to firm A is VB* = ∆V + VB If VB* > VB, it is because the acquisition produces positive incremental cash flows, ∆CF, for firm A • MBAM614 Class 11 - 39 Sources of Synergy ∆CF = ∆EBIT + ∆Depreciation - ∆Taxes - ∆Capital requirements = ∆Revenue - ∆Costs - ∆Taxes - ∆Capital requirements Sources of Synergy are: – Revenue Enhancement Marketing gains: advertising, distribution, product mix Strategic benefit: beachhead in new industry Market power: reduced competition, greater market share – Cost Reduction Economies of scale Economies of vertical integration Economies of scope: complementary resources • MBAM614 Class 11 - 40 20 Sources of Synergy – Tax Gains Net operating losses - a firm with significant tax liabilities can use losses of another to reduce them IRS can block acquisitions for tax purposes only Unused debt capacity: use interest tax shield – Changing Capital Requirements might be cheaper to acquire new capacity by buying an existing firm may reduce working capital requirements • MBAM614 Class 11 - 41 M&A Value If firm A acquires firm B then NPV = VB* - (Cost to firm A of acquisition) VB* = ∆V + VB , value to firm A of firm B (with synergies) Common M&A valuation mistakes are – Do not ignore market values use them as a starting point and ask “what will change” – Estimate incremental cash flows only since they are the basis for synergy – Use the correct discount rate appropriate to the risk of the incremental cash flows. Usually, this is the WACC of the target – Be aware of transactions costs - usually substantial • MBAM614 Class 11 - 42 21 Cost of an Acquisition The amount paid above the stand-alone value, VB , is called the Merger Premium Eg. Pizza Shack is proposing to acquire Checkers Pizza and merge with them using a buyout. PS has estimated the incremental value of the acquisition to be $75,000 (this would be synergy). The current market value of Checkers is $375,000 and Checkers’ shareholders are willing to sell for $400,000. The value of Checkers to Pizza Shack is VC* = $375,000 + $75,000 = $450,000 NPV = $450,000 - $400,000 = $50,000 The merger premium paid by PS to Checkers’ shareholders is $400,000 - $375,000 = $25,000 • MBAM614 Class 11 - 43 Example: Cost of an Acquisition Suppose Pizza Shack has a market value of $1,500,000 and 100,000 shares outstanding ($15 per share). What will the value of PS be after the merger if it pays for Checkers with cash? If it pays with stock? What will Pizza Shack’s shares be worth under each alternative? Which is better for Checkers’ shareholders? Cash NPV of acquisition = $50,000 Value of Pizza Shack becomes VPS = VPS + (VCP* - Cost) = $1,500,000 + $50,000 = $1,550,000 Share price = $1,550,000/100,000 shares = $15.50 / share Value to Checkers’ shareholders = $400,000 • MBAM614 Class 11 - 44 22 Example: Cost of an Acquisition Stock Number of shares distributed = $400,000/$15 = 26,667 New firm has 126,667 shares outstanding VPS = VPS + VCP + ∆V = $1,500,000 + $375,000 + $75,000 = $1,950,000 Share price = $1,950,000/126,667 shares = $15.39 / share Value to Checkers’ shareholders = 26,667 * $15.39 = $410,405.13 Because of equity participation, Checkers shareholders share some of the $50,000 NPV! • MBAM614 Class 11 - 45 Cash vs Common Stock When cash is used, the target’s shareholders can’t gain beyond the purchase price (they get the merger premium) – of course, they can’t lose either (less risky) Cash transactions are generally taxable, exchanging stock is generally tax-free There may be control issues surrounding the use of stock since current ownership is diluted • MBAM614 Class 11 - 46 23 Who Wins? When there are synergies from a merger (∆V > 0), both sides can win – target shareholders get the merger premium – bidder shareholders get the NPV effectively, the synergy value is divided – makes sense since target can’t realize synergy gain without bidder and vice versa Evidence suggests both do win – target shareholders make significant gains – target gains more in tender offers than mergers – bidder shareholders earn less on both • MBAM614 Class 11 - 47 Key Points 1. Only reason for a merger is synergies which can arise from - Revenue enhancement - Cost reduction - Tax gains - Changes in Capital Requirements 2. The actual cost of an acquisition depends on the method of payment 3. Both the bidder and the target frequently (and correctly) win • MBAM614 Class 11 - 48 24