BAFN 200 principles of finance
1. Explain the principal motives for
holding cash
The finance profession recognizes the three primary reasons offered by economist John Maynard Keynes to explain why firms hold cash. The three reasons are for the purpose of speculation, for the purpose of precaution, and for the purpose of making transactions. All three of these reasons stem from the need for companies to possess liquidity. Speculation
The finance profession recognizes the three primary reasons offered by economist John Maynard Keynes to explain why firms hold cash. The three reasons are for the purpose of speculation, for the purpose of precaution, and for the purpose of making transactions. All three of these reasons stem from the need for companies to possess liquidity. Speculation
You
are required to suggest:
Economist Keynes described this reason for holding cash as creating the ability
for a firm to take advantage of special opportunities that if acted upon quickly
will favor the firm. An example of this would be purchasing extra inventory at
a discount that is greater than the carrying costs of holding the inventory,
also the investor here holds up the cash for the transactions such as the
payment of taxes, wages, dividends, and other goods and services which arises
in the ordinary course of business or we can say which is useful in meeting the
day to day requirements of the business. Precaution
Holding cash as a precaution serves as an emergency fund for a firm. If expected cash inflows are not received as expected cash held on a precautionary basis could be used to satisfy short-term obligations that the cash inflow may have been bench marked for,also over here the cash is held to built a safety cushion or we can say a buffer to meet the uncertain cash requirements. And all these depend highly upon the cash inflows and outflow, if these two are predictable then it can become easier for the investor to increase or decrease the amount of cash which has to be held for the precautionary need. Here comes the importance of 'Cash Management' which involves the efficient collection/disbursement and short-term investment needs. With the reference of Cash Budget we can analyze the cash which we are likely to have, when we are likely to have it for and till what duration. Thus the investment of cash is deemed to be a safe and it rarely loses its value for e.g.- bonds, stocks etc.
Transaction
Firms are in existence to create products or provide services. The providing of services and creating of products results in the need for cash inflows and outflows. Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have,so It is observed that in order to take the advantage of the temporary opportunities, for example sudden price fall in the raw material, or an unexpected opportunity to purchase asset at a cheaper deal. One other important situation is when it is likely that the interest rate will increase the investors tend to hold the cash because the value of bonds and stocks fall.
ADVANTAGES
Liquidity Basics
Basic checking, savings and money market accounts are among the most liquid ways to hold your money. Stock and real estate are investment opportunities that tend to have lower liquidity. A liquidity ratio is a way to measure your ability to keep up with household expenses for a certain period of time. Divide cash or easily converted cash assets by your monthly expenses to determine your liquidity ratio -- the number of months' expenses you can cover with your current cash assets. Quick Access
The most significant advantage of liquid cash is that you have quick access to your money as needed. Cash accounts are important to everyday budgeting, but they also come in handy when you have an unexpected bill or need money for car repairs or renovation projects. Keeping your money in less liquid, low-return accounts makes little sense if you have to pay for routine purchase or unexpected bills -- such as car repairs, medical fees and home repair services -- using a high interest rate credit card. Building a rainy day savings fund in a more liquid account can provide protection against this type of situation, giving you quick access to cash. Lower Risk of Loss
Another advantage of keeping your money in more liquid accounts is that they tend to have a lower risk of loss. Typically, more liquid accounts and investments are more conservative. While you could lose cash, bank accounts have very little risk. By budgeting in a way to protect money you need to live on in more liquid accounts, you can invest your excess in more aggressive ways such as stocks, real estate or Forex -- with greater peace of mind. Keeping up with customer demand
If high levels of stock are held, the chances of selling out of any given product is very low as you can restock after, for example, half of the stock sells. This means that you won't lose out on sales due to not having the product in stock. This also encourages repeat custom. Save money on purchase price
This can work in three ways. Firstly, buying in bulk often reduces cost as companies can justify offering a better deal due to the fact that they are managing to clear a lot of stock all at once. Secondly, quite often the earlier you get involved in purchasing stock the cheaper it will be. Finally, shipping in bulk is likely to cost less in the long run than, for example, 10 smaller deliveries.
DISADVANTAGES
Cost of storage
This is a major issue which can often be overlooked. Keeping 5 of each product on sale would take up a fair amount of space, but bulk buying and having 100 or even more of each product would be very costly in terms of storage. For most products, the storage area would have to be secure, clean, damp free and free from mice and rats. This cost would need to be accounted for before purchasing high quantities. Stock may perish
High levels of perishable stock, which may go out of date, is never really advised unless research has shown high levels are required. Out of date products are a sure way of losing money. Limited Returns
One disadvantage of more liquid accounts is limited investment return opportunities. Holding cash yields no investment return aside from standard rates of inflation over time. Basic checking and savings accounts usually have very minimal interest yields. Banks offer better returns in exchange for longer access to your funds. Certificates of deposit, for instance, commonly yield annual returns slightly higher than regular savings accounts, but you cannot withdraw the funds without penalty for the term of the CD -- anywhere from six months to several years. Good stock investments can produce nice returns, but you have to sell the stock and wait for the trade to settle to get cash.
2. How should the firm manage its inventory, accounts receivable, and accounts payable in order to reduce the length of its cash conversion cycle? The firm should have the least amount of inventory possible (as long as there are no stockouts which result in lost sales), the least amount of accounts receivable (collect accounts receivable quickly) and the greatest amount of accounts payable (stretch payments as long as possible).
Holding cash as a precaution serves as an emergency fund for a firm. If expected cash inflows are not received as expected cash held on a precautionary basis could be used to satisfy short-term obligations that the cash inflow may have been bench marked for,also over here the cash is held to built a safety cushion or we can say a buffer to meet the uncertain cash requirements. And all these depend highly upon the cash inflows and outflow, if these two are predictable then it can become easier for the investor to increase or decrease the amount of cash which has to be held for the precautionary need. Here comes the importance of 'Cash Management' which involves the efficient collection/disbursement and short-term investment needs. With the reference of Cash Budget we can analyze the cash which we are likely to have, when we are likely to have it for and till what duration. Thus the investment of cash is deemed to be a safe and it rarely loses its value for e.g.- bonds, stocks etc.
Transaction
Firms are in existence to create products or provide services. The providing of services and creating of products results in the need for cash inflows and outflows. Firms hold cash in order to satisfy the cash inflow and cash outflow needs that they have,so It is observed that in order to take the advantage of the temporary opportunities, for example sudden price fall in the raw material, or an unexpected opportunity to purchase asset at a cheaper deal. One other important situation is when it is likely that the interest rate will increase the investors tend to hold the cash because the value of bonds and stocks fall.
ADVANTAGES
Liquidity Basics
Basic checking, savings and money market accounts are among the most liquid ways to hold your money. Stock and real estate are investment opportunities that tend to have lower liquidity. A liquidity ratio is a way to measure your ability to keep up with household expenses for a certain period of time. Divide cash or easily converted cash assets by your monthly expenses to determine your liquidity ratio -- the number of months' expenses you can cover with your current cash assets. Quick Access
The most significant advantage of liquid cash is that you have quick access to your money as needed. Cash accounts are important to everyday budgeting, but they also come in handy when you have an unexpected bill or need money for car repairs or renovation projects. Keeping your money in less liquid, low-return accounts makes little sense if you have to pay for routine purchase or unexpected bills -- such as car repairs, medical fees and home repair services -- using a high interest rate credit card. Building a rainy day savings fund in a more liquid account can provide protection against this type of situation, giving you quick access to cash. Lower Risk of Loss
Another advantage of keeping your money in more liquid accounts is that they tend to have a lower risk of loss. Typically, more liquid accounts and investments are more conservative. While you could lose cash, bank accounts have very little risk. By budgeting in a way to protect money you need to live on in more liquid accounts, you can invest your excess in more aggressive ways such as stocks, real estate or Forex -- with greater peace of mind. Keeping up with customer demand
If high levels of stock are held, the chances of selling out of any given product is very low as you can restock after, for example, half of the stock sells. This means that you won't lose out on sales due to not having the product in stock. This also encourages repeat custom. Save money on purchase price
This can work in three ways. Firstly, buying in bulk often reduces cost as companies can justify offering a better deal due to the fact that they are managing to clear a lot of stock all at once. Secondly, quite often the earlier you get involved in purchasing stock the cheaper it will be. Finally, shipping in bulk is likely to cost less in the long run than, for example, 10 smaller deliveries.
DISADVANTAGES
Cost of storage
This is a major issue which can often be overlooked. Keeping 5 of each product on sale would take up a fair amount of space, but bulk buying and having 100 or even more of each product would be very costly in terms of storage. For most products, the storage area would have to be secure, clean, damp free and free from mice and rats. This cost would need to be accounted for before purchasing high quantities. Stock may perish
High levels of perishable stock, which may go out of date, is never really advised unless research has shown high levels are required. Out of date products are a sure way of losing money. Limited Returns
One disadvantage of more liquid accounts is limited investment return opportunities. Holding cash yields no investment return aside from standard rates of inflation over time. Basic checking and savings accounts usually have very minimal interest yields. Banks offer better returns in exchange for longer access to your funds. Certificates of deposit, for instance, commonly yield annual returns slightly higher than regular savings accounts, but you cannot withdraw the funds without penalty for the term of the CD -- anywhere from six months to several years. Good stock investments can produce nice returns, but you have to sell the stock and wait for the trade to settle to get cash.
2. How should the firm manage its inventory, accounts receivable, and accounts payable in order to reduce the length of its cash conversion cycle? The firm should have the least amount of inventory possible (as long as there are no stockouts which result in lost sales), the least amount of accounts receivable (collect accounts receivable quickly) and the greatest amount of accounts payable (stretch payments as long as possible).
It will important to read
out following chapters:
The Cash Cycle
A firm's cash cycle is the length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory. A firm's cash conversion cycle (CCC):
cash conversion cycle= Inventory Days + Accounts Receivable Days - Accounts Payable Days
Days = Inventory / Average Daily COGS Inventory
Accounts Receivable Days = Accounts Receivable / Average Daily Sales
Accounts Payable Days = Accounts Payable / Average Daily COGS
3. Data Given
Demand (D)=300,000
Ordering cost per order (O) = 20,000
Holding cost (H) = 1000
i. Optimal number of items that should comprise each of this firm's orders. The optimal number of items are obtained by using Economic Order Quantity (EOQ) which is given by Economic Order Quantity = [(2 x Order cost per order x Demand)/Holding cost]½
= [ (2 x 20,000 x 300,000)/ 1,000] ½
= (12,000,000) ½
= 3464.10
Therefore the optimal number of items that should be comprised in each of the firm's order is 3464 units.
A firm's cash cycle is the length of time between when the firm pays cash to purchase its initial inventory and when it receives cash from the sale of the output produced from that inventory. A firm's cash conversion cycle (CCC):
cash conversion cycle= Inventory Days + Accounts Receivable Days - Accounts Payable Days
Days = Inventory / Average Daily COGS Inventory
Accounts Receivable Days = Accounts Receivable / Average Daily Sales
Accounts Payable Days = Accounts Payable / Average Daily COGS
3. Data Given
Demand (D)=300,000
Ordering cost per order (O) = 20,000
Holding cost (H) = 1000
i. Optimal number of items that should comprise each of this firm's orders. The optimal number of items are obtained by using Economic Order Quantity (EOQ) which is given by Economic Order Quantity = [(2 x Order cost per order x Demand)/Holding cost]½
= [ (2 x 20,000 x 300,000)/ 1,000] ½
= (12,000,000) ½
= 3464.10
Therefore the optimal number of items that should be comprised in each of the firm's order is 3464 units.
Some related topics are here also:
ii. how many orders will be made per year?
orders per year = total demand per year/ Number of units comprised in each
firm's order = 300,000 units/ 3464 units
= 86.61
Therefore, the orders per year will be 87 orders.
iii. The total inventory cost of this raw material
TC = ( Q X H)/ 2 + (D X O)/ Q
= (3464 X 1000)/2 + (300,000 X 20,000)/ 3464
= 1,732,000 + 1,732101
= 3,464,101
Therefore, total inventory cost is 3,464,101 Tshs
= 86.61
Therefore, the orders per year will be 87 orders.
iii. The total inventory cost of this raw material
TC = ( Q X H)/ 2 + (D X O)/ Q
= (3464 X 1000)/2 + (300,000 X 20,000)/ 3464
= 1,732,000 + 1,732101
= 3,464,101
Therefore, total inventory cost is 3,464,101 Tshs
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