Lecture 10a Flashcards
How to calculate working capital?
current assets- current liabilities
What are the 3 uses of cash?
Transactions- to meet demands
Precautionary- to meet unforeseen demands
Speculative-to take advantage
What are the 2 problems of holding too much cash?
- Opportunity cost- you loose the opportunity to make a profit
- Loss of purchasing power- inflation
What are 4 problems of insufficient cash in business?
- Supplier frustration
- No contingency cash
- Loss of discounts
- Lower credit rating
- Increased transaction costs
What is the optimal level of cash?
firms will hold cash up until the point where marginal value= marginal cost
What are the factors that will affect the minimum cash balance?
-Cost and ease of obtaining cash
-Variability of cash inflows
-Attitude to risk
What are the factors that affect maximum cash balance?
- The available investment opportunities
- The transaction cost of making an investment
What are the two cash management models?
Baumol model
Miller-Orr model
What does the Baumol model assume?
- The business spends cash at a steady, predictable rate
-It can convert investments into cash instantly and in fixed amounts
-There’s a fixed cost every time it sells investments
-There’s an opportunity cost for holding cash
What is the purpose of Baumol model?
Helps to determine the optimal amount of cash a firm should withdraw (or raise) from investments each time it needs cash, minimising total costs.
What does the height of the vertical line mean in the graph for Baumol model?
Is EOQ- Economic order quantity which denotes the amount by which cash is replenished
What is the purpose of the Miller-Or model?
It is used when cash inflows and outflows are unpredictable. Instead of a fixed withdrawal schedule, this model sets control limits to manage randomness.
When to act in the Miller-Orr model?
Above Upper Limit → invest excess
Below Lower Limit → sell investments
Between limits → do nothing
Miller-Orr vs. Baumol: key difference?
Baumol assumes predictable cash flows, Miller-Orr handles random / unpredictable cash flows with control limits.
What are the three factors affecting the extent to which cash levels should be able to vary?
Variability of cash flows
Transaction costs
Rate of interest
What a4e the weaknesses of the Miller-Or model?
-It assumes cash flows are unpredictable
- This may be unrealistic for ordinary businesses but is realistic for new technology based firms such as the pharmaceutical industries
Why might a firm grant credit to customers?
As a marketing tool to increase sales
What are the 4 key costs of trade credit?
- Foregone interest
- Opportunity cost
- Administrative cost
- Risk of bad debts
What are the 5C’s of credit?
- Character- willingness to pay
- Capacity- ability to pay
- Capital-available wealth
- Collateral-security of debt
- Conditions-economic environment
Name 2 sources of information for credit checking?
- Credit bureau reports
- trade references
What is credit scoring?
A technique for assessing credit worthiness on weighted factors such as income
Name 4 measures a firm can take in its credit collection policy?
- Pre-emptory letters
- Reminder letters
- Retain title until paid
- Legal action
