Lecturenote - 972275618FM II Final Edited

WOLLO UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ACCOUNTING AND FINANCE
DISTANCE MODULE FOR DEGREE PROGRAM
FINANCIAL MANAGEMENT PART II

(ACFN2102)
Prepared By: Seid Muhammed (MSc.)

Mohammed Adem (MSc.)
Editor: Birtukan Kasiye (MSc.)
Distance Education Program

i 2019
Wollo University
College of Business and Economics
Department of Accounting and Finance
Financial Management Part II (ACFN2102)
Prepared By: Seid Muhammed (MSc.)
Mohammed Adem (MSc.)
Editor: Birtukan Kasiye (MSc.)
i
Preface
Dear Students!
Why This Course? Like the other disciplines, the accounting course offers something similar: To
understand a business, you have to understand the financial insides of a business organization.
An accounting course will help you understand the essential financial components of businesses.
Whether you are looking at a large multinational company or a single-owner simple shop,
accounting helps to know about the company’s financial position and operating result for a
given period. Thus, knowing the concept of financial management will help you to understand
how to run the business without interruptions and also to maintain the balance between fixed
and short term finances. As an employee, a manager, an investor, a business owner, or a
director of your own personal finances—any of which roles you will have at some point in your
life—you will be much the wiser for having taken this course.
Why This Module? This module contains features to help you learn best, whatever your learning
style. To understand what your learning style is, spend about enough time until you grasp the
principles and concepts of financial management. Then, look at and workout the self-
examination questions provided at the end of each chapters. This is one course where doing is
learning, and the more time you spend on the doing questions, the more likely you are to learn
the essential concepts, techniques, and methods of Finance.
Structures of the Module: the course - Financial Management II – has two parts (Part I and
Part II). In this module part II is covered and part I has been covered in financial management I
which is the prerequisite for this module. Hence, Financial Management Part I is the basis for
this module and for the other courses of Accounting and Finance. In this module about five
chapters included (Chapter Dividend Policy and Theory, Chapter 2: Principles of Working
Capital Management, Chapter 3: Cash and liquidity Management, Chapter 4: Receivable
management, Chapter 5. Thus you are expected to better understand each chapter before
proceeding to the next chapter.
i
About the Course
Course Code AcFn2102
Course Title Financial Management II
Degree Program BA Degree in Accounting and Finance
Module Corporate Finance
ETCTS Credits 5
Credit Hour 3
The aim of the course is to expose students to the basic concepts and
techniques of Financial Management. This course enhances students
understanding of corporate finance and to improve their ability to make
decisions in the firm. The course emphasizes on financial decision
Course Objectives &
making within the firm and also
Competences to be
to familiarize students with the basics of investment, financing and
Acquired
dividend decisions that are the central thematic areas of finance
profession
This course is a continuation of Financial Management I. It emphasizes
on building and applying financial models, following the principle of
financial management, for planning and decision making purposes. It
explains with the help of the language of financial accounting, how top
management conducts systematic analysis, builds innovative plans,
Course Description
understands and manages risk, and creates more profit, cash and value
for the organization. Topics included are: Introduction to a modeling
approach, financial accounting as the foundation for financial models,
cash flow models for planning, the cost of capital, capital budgeting and
strategy, and investment decisions and portfolio theory.
Evaluation Type Weight
Assignment 35%
Tutorial Attendance 5%
Final exam 60%
Total 100%
ii
Table of Contents Page
Preface .............................................................................................................................................. i
About the Course ..............................................................................................................................ii
CHAPTER ONE:..............................................................................................................................1
DIVIDEND POLICY AND THEORY .............................................................................................1
11..TYPES OF DIVIDENDS ................................................................................................................... 2
1.2.FACTORS INFLUENCING DIVIDEND POLICY........................................................................... 8
1.3.ESTABLISHING DIVIDEND POLICY .......................................................................................... 12
1.4.TYPES OF DIVIDEND POLICY .................................................................................................... 13
Residual-dividend policy: ................................................................................................................... 13
Stable dividend-per-share policy ........................................................................................................ 13
A compromise policy .......................................................................................................................... 14
Summary ........................................................................................................................................ 18
Self-Examination Questions ............................................................................................................. 19
CHAPTER TWO: .......................................................................................................................... 21
PRINCIPLES OF WORKING CAPITAL MANAGEMENT ......................................................... 21
2.1. DEFINITION OF WORKING CAPITAL ...................................................................................... 23
2.2. Component of Working Capital....................................................................................................... 27
2.3.OPERATING AND CASH CONVERSION CYCLE ..................................................................... 28
Figure 2.1: The Operating Cycle.............................................................................................................. 29
2.4.PERMANENT AND VARIABLE WORKING CAPITAL ............................................................. 33
2.5. DETERMINANTS OF WORKING CAPITAL MANAGEMENT ................................................ 33
2.6.FINANCING CURRENT ASSETS ................................................................................................. 39
Summary ........................................................................................................................................ 44
SELF Examination Questions ......................................................................................................... 45
CHAPTER THREE:....................................................................................................................... 47
CASH AND LIQUIDITY MANAGEMENT ................................................................................... 47
3.1.INTRODUCTION ............................................................................................................................ 47
3.2.Cash Management versus Liquidity Management............................................................................ 49
3.3. UNDERSTANDING FLOAT ......................................................................................................... 51
iii
3.4 MEASURING FLOAT........................................................................................................................... 55
3.5 CASH COLLECTION AND CONCENTRATION ......................................................................... 57
3.6 MANAGING CASH DISBURSEMENT ......................................................................................... 59
3.7 INVESTING IDLE CASH ............................................................................................................... 60
3.8DETERMINING THE TARGET CASH BALANCE....................................................................... 62
Summary ........................................................................................................................................ 65
Self-Examination Questions ............................................................................................................ 67
CHAPTER FOUR: RECEIVABLE MANAGEMENT ................................................................... 69
4.1.INTRODUCTION ............................................................................................................................ 69
4.2.TERMS OF SALE ............................................................................................................................ 71
4.4. CREDIT ANALYSIS ...................................................................................................................... 76
4.5.COLLECTION POLICY .................................................................................................................. 77
Summary ........................................................................................................................................ 79
SELF-EXAMINATION QUESTIONS............................................................................................ 80
CHAPTER FIVE: INVENTORY MANAGEMENT ....................................................................... 81
5.1.INTRODUCTION ............................................................................................................................ 81
5.2.MEANING AND NATURE OF INVENTORY .............................................................................. 81
5.4.BENEFITS AND COSTS OF HOLDING INVENTORY ............................................................... 82
5.5.INVENTORY MANAGEMENT TECHNIQUES ........................................................................... 85
Summary ........................................................................................................................................ 90
Model Examination Question ......................................................................................................... 91
iv
CHAPTER ONE:
DIVIDEND POLICY AND THEORY
Dear learner! The financial manager must take careful decisions on how the profit should be
distributed among shareholders. It is very important and crucial part of the business enterprise,
because these decisions are directly related with the value of the business enterprise and
shareholder’s wealth. Like financing decision and investment decision, dividend decision is also
a major part of the financial manager. When the business enterprises decide dividend policy, they
have to consider certain factors such as retained earnings and the nature of shareholder of the
business enterprise.
A decision interrelated to investment and financing decisions involves dividend policy. The
dividend decision, as determined by a firm’s dividend policy, has an effect on the amount of
earnings a firm pays out versus the amount it retains and reinvests. Interactions exist among
investment, financing, and dividend decisions. When a firm changes its dividend payment, it
may also have to change one of these other policies. By lowering the amount of dividends paid, a
firm can retain more funds for investment purposes and avoid having to raise as much external
financing. Financial managers typically pay careful attention to their choice of dividend policy
for their firm.
OBJECTIVES OF THE CHAPTER
After studying this chapter, you should be able to:
 Explain what a dividend is and describe the different types of dividends;
Identify key factors influencing a firm’s dividend decision;
Describe factors that managers consider when setting the dividend

policies of their firms;
Explain what a stock repurchase is and how companies repurchase their stock;
Define stock dividends and stock splits, and explain how they differ from other types of
dividends and from stock repurchases
1
11..TYPES OF DIVIDENDS
Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
dividends are classified into:
Cash dividend
Stock dividend
Bond dividend
Property dividend
Cash Dividend
If the dividend is paid in the form of cash to the shareholders, it is called cash dividend. It is paid
periodically out the business enterprises EAIT (Earnings after interest and tax). Cash dividends
are common and popular types followed by majority of the business enterprises. Cash dividends
return profits to the owners of a corporation.
When cash dividend is distributed, both total assets and net worth of the company decrease.
Total assets decrease as cash decreases and net worth decreases as retained earnings decrease.
The market price per share also decreases in most cases by the amount of cash dividend
distributed. Market price per share after cash dividend = Marker price per share before cash
dividend - dividend per share.
The basic types of cash dividends are as follows:
A. Regular cash dividend

B. Extra cash dividend
C. Special dividend
D. Liquidating dividend
2
Regular Cash Dividend
It is the dividend that is normally expected to be paid by the firm. The most common type of
cash dividend is a regular cash dividend, which is a cash payment made by a firm to its
stockholders in the normal course of business. Most dividend paying companies issue a regular
cash dividend four times a year.
Extra Cash Dividend
A nonrecurring dividend paid to shareholders in addition to the regular dividend. It may or may
not be repeated in the future.
Special Dividends
A special dividend, like an extra dividend, is a one-time payment to stockholders. It is tend to be

considerably larger than extra dividend and to occur less frequently. They are used to distribute
unusually large amounts of cash.
Liquidating Dividend
Another form of dividend is a liquidating dividend, which is any dividend not based on
earnings. It is a dividend that is paid to stockholders when a firm is liquidated. It implies a return
of the stockholders’ investment rather than of profits. For example, liquidating dividends may
result from selling off all or part of the business and distributing the funds to shareholders.
Stock Dividend
Stock dividend – is a payment of additional shares of stock to shareholders. It is often used in

place of or in addition to a cash dividend. It is one type of “dividend” that does not involve the
distribution of value.
When a company pays a stock dividend, it distributes new shares of stock on a pro-rata basis to
existing stockholders.
3
The only thing that happens when the stock dividend is paid is that the number of shares each
stockholder owns increases and their value goes down proportionately.
The stockholder is left with exactly the same value as before.
Due to stock dividend, retained earnings decrease, common stock and paid in capital increase.
The stock dividend does not affect the equity position of stockholders. Market price per share
and earnings per share after stock dividend will decrease.
Marker price per share after stock dividend =

Market price per share before stock dividend
1  stock dividend in fracton
Activity
Question 1: What is Dividend?
Advantages
The important benefits derived from stock dividend or issue of bonus shares are as follows:
It preserves the company's liquidity as no cash leaves the company.
The shareholders receive a dividend which can be converted into cash whenever he wishes
through selling the additional shares.
It broadens the capital base and improves image of the company.
It reduces the marker price of the shares, rendering the shares more marketable.
It is an indication to the prospective investors about the financial soundness of the company.
The shareholders can take the advantage of tax saving from stock dividend.
4
Disadvantages
The future rate of dividend will decline.
The future market price of share falls sharply after bonus issue.
Issue of bonus shares involves lengthy legal procedures and approvals.
Bond Dividend
Bond dividend is also known as script dividend. If the company does not have sufficient funds to
pay cash dividend, the company promises to pay the shareholder at a future specific date with the
help of issue of bond or notes.
Property Dividend
Property dividends are paid in the form of some assets other than cash. It will distribute under the
exceptional circumstance. .
Activity
Question 2: What are the types of Dividends?
Benefits and Costs of Dividends
The benefits associated with dividends are as follows:
Dividends may attract investors who prefer to receive income directly from their investments.
However, the tax costs of dividends may drive away other investors.
Dividends can function as a signal to investors that the company is performing well and has
higher than expected cash flows.
Dividends can help align manager and stockholder incentives. By issuing dividends and raising
capital through equity issues (rather than internal funds), managers are subject to more scrutiny.
This increases the incentives for managers to perform well.
5
Dividends reduce equity claims on the company; this can help managers achieve the target
capital structure suggested by the trade-off theory.
Some costs associated with dividends include:
Taxes: Dividends have historically taxed at a higher rate than other forms of income.
Reinvestment costs: Investors who don’t intend to spend the cash must pay the transactions costs
associated with reinvesting (brokerage fees, etc.).
Increased cost of debt: By reducing the amount of equity through a dividend issue, the firm
becomes more leveraged. If the increase is significant, this could increase the risk associated
with the company and increase the cost of debt should the company desire to borrow.
Dividend Payment Procedure
A corporation’s board of directors is ultimately responsible for a firm’s dividend policy. This
policy could vary from zero to 100 percent payout of earnings. A corporation has no legal
obligation to declare a dividend. After the board declares a dividend, the declared cash dividend
becomes a liability and the corporation has a legal obligation to make the payment. Once the
board sets the dividend, the procedure for paying the dividend is routine. In chronological order,
the four important dates associated with a dividend payment are as follows.
Declaration date. The declaration date is the date when the board of directors announces the
dividend payment.
Ex-dividend date. The ex-dividend date is the cut-off date for receiving the dividend. That is,
the ex-dividend date is the first date on which the right to the most recently declared dividend no
longer goes along with the sale of the stock. Companies and exchanges report the ex-dividend
date to remove any ambiguity about who will receive a dividend after the sale of a stock.
Investors who buy the stock before the ex-dividend date are entitled to the dividend, while those
who buy shares on or after the ex-dividend date are not.
Record date. The record date is the date on which an investor must be a shareholder of record to
be entitled to the upcoming dividend. The brokerage industry has a convention that new
6
shareholders are entitled to dividends only if they buy the stock at least two business days before
the record date. This rule allows time for the transfer of the shares and gives the company
sufficient notice of the transfer to ensure that new stockholders receive the dividend. Therefore, a
stock sells ex-dividend two business days, not calendar days, before the record date. The board
of directors sets the record date, which is typically several weeks after the declaration date.
Payment date. The payment date is the date when the firm mails the dividend checks to the
shareholders of record. This date is usually several weeks after the record date.
Example 1
On June 30, 2009, XYZ Company declared a dividend of Br. 5 per share, payable on September
1 to the holders of record on August 1. Show the XYZ’s dividend payment procedure.
Solution
Declaration date: June 30, 2009 on which XYZ Company's board of directors declared a
dividend of Br. 5 per share.
Ex-dividend date: July 30, 2009 after which dividends are entitled with the seller of the stock.
The record date: August 1, 2009 on which company makes a list of shareholders who are entitled
to receive dividend.
7
Payment date: September 1, 2009 on which XYZ Company mails the cheque of dividends to the
shareholder.
2 days
30-6-2009 30-7-2009 1-8-2009 1-9-2009
Declaration date Ex-dividend date Holder-of-record date Payment date
1.2.FACTORS INFLUENCING DIVIDEND POLICY

Dividend policy is concerned with determining the proportion of firm's net income to be
distributed in the form of dividend and the proportion of earnings to be retained for investment
purpose. A firm's dividend policy is influenced by a number of factors. Some of the major
factors influencing the firm's dividend policy are as under:
Some of the major factors influencing the firm's

dividend policy are as under:
A. Profitable Position of the Firm
B. Sources of Finance
C. Stability of Earnings
D. Legal Constrains
E. Liquidity Position
F. Growth Rate of the Firm
G. Tax Policy
H. Access to the Capital Market
I. Desire of Shareholders
J. Cost of External Financing
K. Degree of Control
8
Profitable Position of the Firm
Dividend decision depends on the profitable position of the business enterprise. When the firm
earns more profit, they can distribute more dividends to the shareholders.
Sources of Finance
If the firm has finance sources, it will be easy to mobilize large finance. The firm shall not go for
retained earnings.
Stability of Earnings
The stability of earnings also effects the dividend policy decision. If the earnings of a firm are
relatively stable, the firm is more likely to payout a higher percentage of earnings than the firm
which has fluctuating earnings.
Legal Constrains
There are certain legal rules that may limit the amount of dividends a firm may pay. Following
are the rules relating to dividend payment:
Net profit rule: According to this rule, dividends can be paid out of present or past earnings.
Amount of dividends cannot exceed the accumulated profits. If there is accumulated loss, it must
be set off out of the current earnings before paying out any dividends.
Insolvency rule: According to this rule, a firm cannot pay the dividends when its liabilities
exceed assets. When the firm's liabilities exceed its assets, the firm is considered to be financially
insolvent. The firm, financially insolvent, is prohibited by law to pay dividends.
Capital impairment rule: - According to this rule, a firm cannot pay dividend out of its paid up
capital. The dividend payout that impairs capital is considered illegal.
9
Liquidity Position
In order to pay dividend, a company requires cash, and, therefore, the availability of cash
resources within the company will be a factor in determining dividend payments. Generally, the
greater the cash position and overall liquidity of a company, the greater is the ability to pay
dividends. A company must have adequate cash available as well as retained earnings to pay
dividends. The liquidity position of the company will influence the dividend payout of a
particular year.
Liquidity position of the firms leads to easy payments of dividend. If the firms have high
liquidity, the firms can provide cash dividend otherwise, they have to pay stock dividend.
Growth Rate of the Firm
High growth rate implies that the firm can distribute more dividends to its shareholders.
Tax Policy
Tax policy of the government also affects the dividend policy of the firm. When the government
gives tax incentives, the company pays more dividends.
Access to the Capital Market
The company, which has a good access to capital market, can follow a liberal dividend policy
because this type of the company can raise the required funds from the capital market.
Desire of Shareholders
Dividend policy is affected by the desire of shareholders. Shareholders may be interested either
in dividend income or capital gain. Wealthy shareholders may be interested in capital gain as
against dividend income because of low tax rate on capital gain. Whereas the shareholders,
whose sources of income is dividend only, are interested in dividend income and would not be
interested in capital gain.
10
Cost of External Financing
The cost of external financing will have impact on the dividend payout of a company. In
situations, where the external funds are costlier, a firm may resort to low dividend payout and
use the internal funds for financing its business.
Degree of Control
One of the important influencing factors on dividend policy is the objective of maintaining
control over the company by the existing management or shareholders. The management who
wish to maintain close control over the company will not much depend on the external sources of
finance, and they maintain a low dividend payout policy and the funds generated from operations
would be used for working capital and capital investment needs of the firm.
Tax Position of Shareholders
The tax position of shareholders also influences dividend policy. The company owned by
wealthy shareholders having high income tax bracket tend toward lower dividend payout where
as the company owned by small investors tend toward higher dividend payout.
Example 2
How would each of the following changes tend to affect dividend payout ratio, other things held
constant?
An increase in personal income tax rate.
A decline in investment opportunities.
An increase in corporate profit.
A rise in interest rate.
Solution:
An increase in the personal income tax rate would lower the dividend payout ratio because
shareholders with high income tax bracket prefer capital gain rather than dividend income.
11
A decline in investment opportunities would lead to high dividend payout ratio because less
retention is required to support investment opportunities.
A permanent increase in corporate profit would lead to increase in dividend payout because the
firm has more earnings to distribute dividend.
An increase in interest rate would lead to low dividend payout because retained earnings may be
a relatively attractive way of financing new investment.
Activity
Question 3: Discuss the major factors influencing the firm's dividend policy?
1.3. ESTABLISHING DIVIDEND POLICY

Dividend policy is an important topic because dividends represent major cash outlays for many
corporations. Dividends are at the heart of the difficult choice that management must make in
allocating their capital resources: reinvesting the money within the company or distributing it to
shareholders. Although paying dividends directly benefits stockholders, it also affects the firm’s
ability to retain earnings to exploit growth opportunities. Dividend policy provides guidelines for
balancing the conflicting forces surrounding the dividend payment versus retention decision.
Dividend policy refers to the payout policy that management follows in determining the size and
pattern of distributions to shareholders over time. The dividend policy question centers on the
percentage of earnings that a firm should pay out.
A finance manager’s objective for the company’s dividend policy is to maximize owner wealth
while providing adequate financing for the company. When a company’s earnings increase,
management does not automatically raise the dividend. Generally, there is a time lag between
increased earnings and the payment of a higher dividend. Only when management is confident
12
that the increased earnings will be sustained will they increase the dividend. Once dividends are
increased, they should continue to be paid at the higher rate.
1.4. TYPES OF DIVIDEND POLICY
Dividend policy depends upon the nature of the firm, type of shareholder and profitable position.
On the basis of the dividend declaration by the firm, the dividend policy may be classified under
the following types:
Residual Dividend approach
Dividend stability
A Compromise
Residual-dividend policy: Residual dividend policy is based on the assumption that investors
prefer to have a firm retain and reinvest earnings rather than pay out them in dividends. Under
residual dividend policy, a firm pays dividend only after meeting its investment need. Under
residual dividend policy, if the net income exceeds the portion of equity financing, then the
excess of net income over equity need is paid as dividend. The company does not pay any
dividend when net income is less than or equal to equity need for financing the investment
proposals. In case, net income is not sufficient to meet equity need, the company should raise
deficit amount by external equity.
When a company’s investment opportunities are not stable, management may want to consider a
fluctuating dividend policy. With this kind of policy the amount of earnings retained depends
upon the availability of investment opportunities in a particular year. Dividends paid represent
the residual amount from earnings after the company’s investment needs are fulfilled.
Stable dividend-per-share policy. Stable dividend policy means payment of certain minimum
amount of dividend regularly. Many companies use a stable dividend-per-share policy since it is
looked upon favorably by investors. Dividend stability implies a low-risk company. Even in a
year that the company shows a loss rather than profit the dividend should be maintained to avoid
negative connotations to current and prospective investors. By continuing to pay the dividend,
13
the shareholders are more apt to view the loss as temporary. Some stockholders rely on the
receipt of stable dividends for income. A stable dividend policy is also necessary for a company
to be placed on a list of securities in which financial institutions (pension funds, insurance
companies) invest. Being on such a list provides greater marketability for corporate shares.
A compromise policy. A compromise between the policies of a stable dollar amount and a
percentage amount of dividends is for a company to pay a low dollar amount per share plus a
percentage increment in good years. While this policy affords flexibility, it also creates
uncertainty in the minds of investors as to the amount of dividends they are likely to receive.
Stockholders generally do not like such uncertainty. However, the policy may be appropriate
when earnings vary considerably over the years. The percentage, or extra, portion of the dividend
should not be paid regularly; otherwise it becomes meaningless.
Activity
Question 4: what is dividend policy?
Practical Considerations in Setting a Dividend Policy
A company’s dividend policy is largely a policy about how the excess value in a company is
distributed to its stockholders.
It is extremely important that managers choose their firms’ dividend polices in a way that
enables them to continue to make the investments necessary for the firm to compete in its
product markets.
Managers should consider several practical questions when selecting a dividend policy:
Over the long term, how much does the company’s level of earnings (cash flows from
operations) exceed its investment requirements? How certain is this level?
14
Does the firm have enough financial reserves to maintain the dividend payout in periods when
earnings are down or investment requirements are up?
Does the firm have sufficient financial flexibility to maintain dividends if unforeseen
circumstances wipe out its financial reserves when earnings are down?
Can the firm raise equity capital quickly if necessary?
If the company chooses to finance dividends by selling equity, will the increased number of
stockholders have implications for control of the company?
REPURCHASE OF STOCK
Stock repurchase is method in which a firm buy back shares of its own stock, thereby decreasing
shares outstanding, increasing earnings per share, and, often increasing the stock price. It is an
alternative to cash dividends. In a stock repurchase, the company pays cash to repurchase shares
from its shareholders. These shares are usually kept in the company's treasury and then resold
when the company needs money.
If a firm has excess cash, it may purchase its own stock leaving fewer shares outstanding,
increasing the earning per share and increasing the stock price. It may be an alternative to paying
cash dividends. The benefits to the shareholders are the same under cash dividend and stock
repurchase. In the absence of personal income taxes and transaction costs, both cash dividend
and stock repurchase have no any difference to shareholders. Capital gain arising from
repurchase should equal the dividend otherwise would have been paid.
Share can be repurchased in different ways. A company can repurchase its shares through
authorized brokers on the open market. Shares can be also repurchased by making a tender offer
which will specify the purchases price, the total amount and the period within which shares will
be bought back. Similarly, a company can purchase a block of shares from one large holder on a
negotiated basis.
15
Advantages of repurchase of stock
A firm can use idle cash to repurchase stock if it has less investment opportunities.
Dividend and earnings per share will be increased through stock repurchase.
Stock repurchase will result in increase in the share value.
The buying shareholders will benefit since the company generally offer a price higher than the
current market price of the share.
When shares are undervalued in the market, a company can buy back shares at higher price to
move up the current share price.
If a company has high proportion of equity in its capital structure, if can reduce equity capital by
buying back its shares to achieve target capital structure.
The promoters of the company benefit by consolidating their ownership and control over
companies through stock repurchase. They do not sell their shares to the company rather make
the share repurchase attractive for others.
Repurchase of stock can remove a large block of stock that is overhanging the market and
keeping the price per share down.
In a hostile takeover, a company may buy back its shares to reduce the availability of shares and
make take over difficult.
Stockholders are given a choice of whether or not to sell their stock to the firm.
Disadvantages of stock repurchase
Shareholders may not be indifferent between dividends and capital gains, and the price of stock
might benefit more from cash dividends than from repurchase.
The remaining shareholder may lose if the company pays excessive price for the shares under the
stock repurchase scheme.
16
Stock repurchase may signal to investors that the company does not have long - term growth
opportunities to utilize the cash.
The buyback of shares may be useful as a defense against hostile takeover only in case of cash
rich companies.
STOCK SPLIT
A stock split is a method to reduce the market price per share by giving certain number of share
for one old share. Due to stock split, number of outstanding shares increase and par value and
marker price of the stock decrease. A stock split affects only the par value, market value and the
number of outstanding shares. However, net worth of the company remains unaltered.
With a stock split, shareholder's equity account does not change, but the par value per share
changes. The earnings per share will be diluted and market price per share fall proportionately
with a stock split. But, the total value of the holdings of a shareholder remains unaffected by a
stock split. Following are the reasons for splitting a firm's ordinary shares:
Stock split results in reduction in market price of the share. It helps in increasing the
marketability and liquidity of a company's shares.
Stock splits are used by the company management to communicate to investors that the company
is expected to earn higher profits in future.
Stock split is used to give higher dividends to shareholders.
Activity
Question 5: what does mean stock split?
17
Summary
The term dividend usually refers to cash paid out of earnings. It may also be termed as the part
of the profit of a business enterprise, which is distributed among its shareholders. Dividends are
paid either in cash or stock. If a payment is made from sources other than current or accumulated
retained earnings, the term distribution, rather than dividend, is used.
A dividend is a direct payment from a corporation to its stockholders. Corporations commonly
pay dividends in cash, but occasionally they pay dividends in stock, property, or some other
asset. All dividends, except for stock dividends, reduce the total stockholders’ equity in the
corporation.
Dividend may be distributed among the shareholders in the form of cash or stock. Hence,
dividends are classified into: Cash dividend, Stock dividend, Bond dividend and Property
dividend. The basic types of cash dividends are: Regular cash dividend, Extra cash dividend,
Special dividend and Liquidating dividend.
In chronological order, the four important dates associated with a dividend payment are as
follows.
Declaration date. The declaration date is the date when the board of directors announces the
dividend payment.
Ex-dividend date. The ex-dividend date is the cut-off date for receiving the dividend.
Record date. The record date is the date on which an investor must be a shareholder of record to
be entitled to the upcoming dividend. Payment date. The payment date is the date when the
firm mails the dividend checks to the shareholders of record. This date is usually several weeks
after the record date.
Some of the major factors influencing the firm's dividend policy are as under:
Profitable position of the firm, sources of finance,stability of earnings,growth rate of the firm, tax
policy,access to the capital market,desire of shareholders,cost of external financing,degree of
control, and tax position of shareholders
18
Self-Examination Questions
Part 1: Choose the best answer from the given alternatives
If the dividend is paid in the form of cash to the shareholders, it is called:
Cash dividend Bond dividend
Stock dividend Property dividend
Which one of the statement is incorrect?
When cash dividend is distributed, both total assets and net worth of the company decrease.
Total assets decrease as cash decreases and net worth decreases as retained earnings decrease.
The market price per share decreases in most cases by the amount of cash dividend
All none
The most common type of cash dividend is known as
Regular cash dividend Special dividend
Extra cash dividend Liquidating dividend
Which of the following is the advantage derived from issuance of stock dividends
The shareholders can take the advantage of tax saving from stock dividend.
It broadens the capital base and improves image of the company.
It reduces the marker price of the shares, rendering the shares more marketable.
All
The date when the board of directors announces the dividend payment is:
Ex-dividend date Payment date
Declaration date. Record date.
Part II: Discussion Question

Discuss the cost and benefits of dividends
Discuss the major factors determining payment of dividends
Answer: 1A 2D 3A 4D 5B
19
CHAPTER TWO:
PRINCIPLES OF WORKING CAPITAL MANAGEMENT
Dear learner After studying this chapter, you should be able to:
Understand Meaning, Concepts and Types of working capital
 Define the operating and cash cycles, explain how they are used, and be
able to compute their values for a firm.
Describe the factors affecting working capital.
Describe the working capital financing policies.
INTRODUCTION
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.
Working capital is the capital required for day-to-day working of the concerned organization.
Capital
Fixed capita Working capital
21
Fixed capital means that capital, which is used for long-term investment of the business
concern. For example, purchase of permanent assets. Normally it consists of non-recurring in
nature.
Working Capital is another part of the capital which is needed for meeting day to day
requirement of the business concern. For example, payment to creditors, salary paid to workers,
purchase of raw materials etc., normally it consists of recurring in nature. It can be easily
converted into cash. Hence, it is also known as short-term capital.
Definitions
According to the definition of Mead, Baker and Malott, “Working Capital means Current
Assets”.
According to the definition of J.S.Mill, “The sum of the current asset is the working capital of a
business”.
According to the definition of Weston and Brigham, “Working Capital refers to a firm’s
investment in short-term assets, cash, short-term securities, accounts receivables and
inventories”.
According to the definition of Bonneville, “Any acquisition of funds which increases the current
assets, increase working capital also for they are one and the same”.
According to the definition of Shubin, “Working Capital is the amount of funds necessary to
cover the cost of operating the enterprises”.
According to the definition of Genestenberg, “Circulating capital means current assets of a

company that are changed in the ordinary course of business from one form to another, for
example, from cash to inventories, inventories to receivables, receivables to cash”.
22
2.1. DEFINITION OF WORKING CAPITAL
Meaning of working capital
Working capital refers to the firm’s investment in two types of assets.
First, working capital means a business’s investment in short-term assets needed to operate over
a normal business cycle. This meaning corresponds to the required investment in cash, accounts
receivable, inventory, and other items listed as current assets on the firm’s balance sheet.
Second, broader meaning of working capital is the company’s overall non-fixed asset
investments. Businesses often need to finance activities that do not involve assets measured on
the balance sheet. For example, a firm may need funds to redesign its products or formulate a
new marketing strategy, activities that require funds to hire personnel rather than acquiring
accounting assets.
The term working capital has several meanings in business and economic development finance.
In accounting and financial statement analysis, working capital is defined as the firm’s short-
term or current assets and current liabilities.
Just as working capital has several meanings, firms use it in many ways. Most fundamentally,
working capital investment is the lifeblood of a company. Without it, a firm cannot stay in
business.
Working capital is an operational necessity. A firm needs to invest in short-term current assets
such as stocks (raw materials, work-in-progress and finished product) and also needs debtors to
allow it to perform its day-to-day operations. This investment in current assets is for the short
term, as raw materials will be bought, converted into finished product, and sold to customers
who ultimately will pay.
For many businesses this cycle will be completed within a short timeframe, and will be repeated
many times over during the year.
The investment in current assets requires to be financed and a primary source of this financing is
the firm’s current liabilities, particularly the credit received from suppliers.
23
A firm’s total capital is found from its balance sheet by subtracting its total liabilities from its
total assets. This is represented by the balance sheet equation:
Assets−Liabilities=Capital
Working capital is the kind of short-term capital required to finance a firm on a day-to day basis.
It is a key measure of business liquidity. The more working capital a firm has, the less risk there
is of the firm not being able to pay its creditors when the bills become due. Conversely the less
working capital a firm has, the greater the risk of the firm not being able to pay its creditors when
the bills are due.
Working capital, also known as circulating capital, is the amount of money which a business
needs to survive on a day-to-day basis. It should be sufficient to cover:
paying creditors (without difficulty);
allowing trade credit to debtors;
Carrying adequate stocks.
The key questions are: is the level of working capital positive? Is it sufficient in relation to
current liabilities?
Sufficient working capital is needed, not only to be able to pay bills on time (e.g. wages and
suppliers), but also to be able to carry sufficient stocks and also to allow debtors a period of
credit to pay what they owe.
Working capital- the capital required for day to day working of the concerned organization. It
is, sometimes called gross working capital, simply refers to current assets used in operations.
Working capital often referred to the capital which circulates on the business. It means that
working capital flows into cash over a short period of time. Fixed capital period of time, when
the assets converted into cash, then this cash is invested in the purchase of inventory. If we sell
the inventory on cash, so cash sale will be created. If we sell it on credit, so receivable will be
created. And these receivable will be converted into cash at about within a period of month.
24
CONCEPTS OF WORKING CAPITAL
Gross Net Working

working Capital Capital
Gross Working Capital (GWC)
GWC refers to the firm’s total investment in current assets. Current assets are the assets which
can be converted into cash within an accounting year (or operating cycle) and include cash,
short–term securities, accounts receivable, and stock (inventory). GWC focuses on (i)
Optimization of investment in current (ii) Financing of current assets. GWC also referred as
“Economics Concept” since assets are employed to derive rate of return.
25
Net Working Capital (NWC)
NWC refers to the difference between current assets and current liabilities. Current liabilities
(CL) are those claims of outsiders which are expected to mature for payment within an
accounting year and include accounts payable, bills payable and outstanding expenses. NWC
focuses on (i) Liquidity position of the firm (ii) Judicious mix of short–term and long–term
financing.
NWC can be positive or negative.
Positive NWC = C > CL
Negative NWC = C < CL
Activity
Question 1: what are the components of Working capital?
26
2.2. Component of Working Capital
Working capital constitutes various current assets and current liabilities. This can be illustrated
by the following chart.
Working capital
Current asset Current liability
Cash in hand Bills payable
Cash at bank outstanding expenses
Bill receivables Short term loans advances
Accounts Receivables Dividend payable
Inventories Bank overdraft
Prepaid expenses Provision for taxation
Accrued incomes
Short-term Investments
27
2.3.OPERATING AND CASH CONVERSION CYCLE
Two tools to measure the working capital management efficiency are the operating cycle and the
cash conversion cycle.
Operating Cycle
The operating cycle begins when the firm receives the raw materials it purchased and ends when
the firm collects cash payments on its credit sales.
Two measures—accounts receivable period and inventory period—help determine the operating
cycle.
Inventory period shows how long the firm keeps its inventory before selling it.
It is the ratio of the inventory balance to the daily cost of goods sold.
The quicker a firm can move out its raw materials as finished goods, the shorter the duration
when the firm holds it inventory, and the more efficient it is in managing its inventory.
Accounts receivable period estimates how long it takes on average for the firm to collect its
outstanding accounts receivable balance. This ratio is also called the average collection period
(ACP).
An efficient firm with good working capital management should have a low average collection
period compared to its industry.
The operating cycle is calculated by summing the Inventory period and the Accounts
receivable period.
(Operating cycle = inventory period + accounts receivable period)
Cash Conversion Cycle
The cash conversion cycle is related to the operating cycle, but it does not start until the firm
actually pays for its inventory.
28
The cash conversion cycle is the length of time between the cash outflow for materials and the
cash inflow from sales.
To measure the cash conversion cycle, we need another measure called the payables period.
Payable period shows how long a firm takes to pay off its suppliers for the cost of inventory.
The cash conversion cycle is then calculated by summing the accounts receivable period and the
inventory period and subtracting the payables period.
Figure 2.1: The Operating Cycle
AN ILLUSTRATION
We can illustrate the process with data from Real Time Computer Corporation (RTC), which in
early 2001 introduced a new minicomputer that can perform one billion instructions per second
and that will sell for $250,000. RTC expects to sell 40 computers in its first year of production.
The effects of this new product on RTC’s working capital position were analyzed in terms of the
following five steps:
29
1. RTC will order and then receive the materials it needs to produce the 40 computers it expects
to sell. Because RTC and most other firms purchase materials on credit, this transaction will
create an account payable. However, the purchase will have no immediate cash flow effect.
2. Labor will be used to convert the materials into finished computers. However, wages will not
be fully paid at the time the work is done, so, like accounts payable, accrued wages will also
build up.
3. The finished computers will be sold, but on credit. Therefore, sales will create receivables, not
immediate cash inflows.
4. At some point before cash comes in, RTC must pay off its accounts payable and accrued
wages. This outflow must be financed.
5. The cycle will be completed when RTC’s receivables have been collected. At that time, the
company can pay off the credit that was used to finance production, and it can then repeat the
cycle.
The cash conversion cycle model, which focuses on the length of time between when the
company makes payments and when it receives cash inflows, formalizes the steps outlined
above.
The following terms are used in the model:
1. Inventory conversion period, which is the average time required to convert materials into
finished goods and then to sell those goods. Note that the inventory conversion period is
calculated by dividing inventory by sales per day. For example, if average inventories are $2
million and sales are $10 million, then the inventory conversion period is 73 days:
30
Thus, it takes an average of 73 days to convert materials into finished goods and then to sell
those goods.
2. Receivables collection period, which is the average length of time required to convert the
firm’s receivables into cash, that is, to collect cash following a sale. The receivables collection
period is also called the days sales outstanding (DSO), and it is calculated by dividing accounts
receivable by the average credit sales per day. If receivables are $657,534 and sales are $10
million, the receivables collection period is:
Thus, it takes 24 days after a sale to convert the receivables into cash.
3. Payables deferral period, which is the average length of time between the purchase of
materials and labor and the payment of cash for them. For example, if the firm on average has 30
days to pay for labor and materials, if its cost of goods sold are $8 million per year, and if its
accounts payable average $657,534, then its payables deferral period can be calculated as
follows:
The calculated figure is consistent with the stated 30-day payment period.
31
4. Cash conversion cycle, which nets out the three periods just defined and which therefore
equals the length of time between the firm’s actual cash expenditures to pay for productive
resources (materials and labor) and its own cash receipts from the sale of products (that is, the
length of time between paying for labor and materials and collecting on receivables). The cash
conversion cycle thus equals the average length of time a dollar is tied up in current assets.
We can now use these definitions to analyze the cash conversion cycle.
Each component is given a number, and the cash conversion cycle can be expressed by this
equation:
To illustrate, suppose it takes Real Time an average of 73 days to convert raw materials to
computers and then to sell them, and another 24 days to collect on receivables. However, 30 days
normally elapse between receipt of raw materials and payment for them. In this case, the cash
conversion cycle would be 67 days:
32
2.4. PERMANENT AND VARIABLE WORKING CAPITAL
Permanent or fixed working capital
A minimum level of current assets, which is continuously required by a firm to carry on its
business operations, is referred to as permanent or fixed working capital. It is part of total current
assets which is not changed due to variation in sales. It is considered permanent because the level
is constant, not because the assets are not sold.
Fluctuating or variable working capital
The extra working capital needed to support the changing production and sales activities of the
firm is referred to as fluctuating or variable working capital. It is the additional asset required to
meet the variations in sales above the permanent level. Additional current assets are needed
during the peak time. It increases with growth of business.
2.5. DETERMINANTS OF WORKING CAPITAL MANAGEMENT

Firm should have neither low nor high working capital. Low working capital involves more risk
and more returns, high working capital involves less risk and less returns. Risk here refers to
technical insolvency while returns refer to increased profits/earnings. The amount of working
capital is determined by wide variety of factors.
Nature of Business: The working capital requirement of firm depends on the nature of the
business. For example, firm involved in sale of services rather than manufacturing or firm is
allowing only cash sales. In the first instance, no investment is required in either raw materials or
WIP or finished goods, while in the second instance there exists no receivables as there is
immediate realization of cash. Hence the requirement of working capital will be lower.
Seasonality of Operations: If the product of the firm has seasonal demand like refrigerators, the
firms need high working capital in the periods of summer, as the demand for the refrigerators is
more and the firm needs low working capital in the periods of winter, as the demand for the
product is low.
Production Cycle: The term production cycle refers to the time involved in the manufacture of
goods. It covers the time span between the procurement of the raw materials and the completion
33
of the manufacturing process leading to the production of goods. As funds are necessarily tied up
during the production cycle, the production cycle has bearing on the quantum of working capital.
The longer the time span of production cycle, the larger will be the funds tied up and therefore
the larger the working capital needed and vice versa.
Production Policy: The quantum of working capital is also determined by production policy. In
case of the firms having seasonal demand of the products like refrigerators, air coolers etc. The
production policy of the firm determines the amount of working capital requirement. If the firm
has production policy to carry production at steady level to meet the peak demand, this will
result in large accumulation of finished goods (inventories) during the off–seasons and the abrupt
sale during the peak season. The progressive accumulation of finished goods will naturally
require an increasing amount of working capital. If the firm has production policy to produce
only when there is demand then the firm needs low working capital during the slack season and
high working capital during season.
Credit Policy: The level of the working capital is also determined by the credit policy, as the
firm’s credit policy determines the amount of receivables. If the firm has liberal credit policy,
then the firm needs high working capital and the firm needs low working capital if the
company’s credit policy does not allow it to extend credit to the buyers.
Market Conditions: The working capital requirements are also determined by the market
conditions. In case of the high degree of competition prevailing in the market the firm has to
maintain larger inventories as customers are not inclined to wait for the product. This needs
higher working capital requirements. If there is good demand for the product and the competition
is weak, firm can manage with smaller inventory of finished goods, as customers can wait for the
product if it is not available in the market. Thus, firm can manage with low inventory and will
need low working capital requirements.
Conditions of Supply: The availability of raw materials and spares also determine the level of
working capital. If there is ready availability of raw materials and spares, firm can maintain
minimum inventory and need less working capital. If the supply of raw materials is
unpredictable, then the firm has to acquire stocks as and when they are available for ensuring
34
continuous production. Thus, the firm needs to maintain larger inventory average and needs
larger requirement of working capital.
Activity
Question 1: what are the factors that affect Working capital?
35
36
37
38
2.6. FINANCING CURRENT ASSETS
A firm may adopt different financing policies for its current assets. There are three types of
financing:
Long-term financing: - Sources of long term financing include ordinary share capital,
preference share capital, debentures (bonds), long-term borrowing from financial institutions and
reserves, and surplus (retained earnings).
Short-term financing: - Obtained for a period less than one year. It is arranged in advance from
banks, and other suppliers of short-term finance in the money market. It includes working capital
funds from banks, public deposits, commercial paper, factoring receivables, etc.
Spontaneous financing: - Refers to the automatic sources of short-term funds arising in the
normal course of a business. Trade credit and outstanding expenses are examples of spontaneous
financing. There is no explicit cost of spontaneous financing. A firm is expected to utilize these
sources of finance to the fullest extent.
Depending on the mix of short and long-term financing, the approach followed by a company
may be referred to as:
39
Matching (hedging) approach: Match the maturity of the assets with the maturity of the
financing.
Conservative approach: Use permanent capital for permanent assets and temporary assets.
Aggressive approach: Use short–term financing to finance permanent assets.
40
41
Let's view the characteristics of each approach I detail.
Matching (hedging) approach: This approach tries to balance risk and return concerns.
Temporary current assets that are only going to be on the balance sheet for short time should be
financed with short–term debt, current liabilities. Modular permanent current assets and long–
term fixed assets that are going to be on the balance sheet for long time should be financed from
long–term debt and equity sources.
The firm has moderate amount of net working capital. It is relatively amount of risk balanced by
relatively moderate amount of expected return. In the real world, each firm must decide on its
balance of financing sources and its approach to working capital management based on its
particular industry and the firm's risk and return strategy.
Conservative approach: As the name itself suggests, under the approach the finance manager
does not undertake risk. As result, all the working capital needs are primarily financed by long
term sources and the use of short term sources may be restricted to unexpected and emergency
situation only. The working capital policy of firm is called conservative policy when all or most
of the working capital needs are met by the long term sources and thus the firm avoids the risk of
insolvency.
So, under the conservative approach, the working capital is primarily financed by long term
sources. The larger the portion of long term sources used for financing the working capital, the
more conservative is said to be the working capital policy of the firm. In case, the firm has no
temporary working capital need then the idle long term funds can be invested in marketable
securities. This will help the firm to earn some income. The firm uses small amount of short term
sources to meet its peak level working capital needs. It also stores liquidity in the form of
marketable securities in slack season. Long–term financing is generally more expensive than
short–term financing.
Aggressive approach: Low level of investment more short–term financing is used to finance
current assets. Support low level of production & sales Borrowing short–term is considered more
risky than borrowing long–term. Firm risk increases, due to the risk of fluctuating interest rates,
but the potential for higher returns increases because of the generally low–cost financing. This
42
approach involves the use of short–term debt to finance at least the firm's temporary assets, some
or all of its permanent current assets, and possibly some of its long–term fixed assets. (Heavy
reliance on short term debt) The firm has very little net working capital. It is more risky. May be
negative net working capital. It is very risky.
Figure 2.2
Brigham & Houston page, 613
Approaches Profitability Liquidity Risk
Conservative Low High Low
Aggressive High Low High
Matching Moderate Moderate Moderate
43
Summary
Working Capital refers to that part of the firm’s capital, which is required for financing short–
term or current assets such cash marketable securities, debtors and inventories.
Gross Working Capital refers to the firm’s total investment in current assets.
Net Working Capital refers to the difference between current assets and current liabilities.
Permanent Working Capital: The minimum level of investment in current assets that is
required to continue the business without interruption is referred as permanent working capital.
Variable Working Capital: This is the amount of investment required to take care of
fluctuations in business activity or needed to meet fluctuations in demand consequent upon
changes in production & sales as result of seasonal changes.
Cash Conversion Cycle: It is the length of time between the actual cash disbursement on
purchases and labor and cash receipt from the sale of finished product.
Conservative Working Capital Policy: Use permanent capital for permanent assets and
temporary assets
Moderate Working Capital Policy: Match the maturity of the assets with the maturity of the
financing.
Aggressive Working Capital Policy: Use short–term financing to finance permanent assets.
44
SELF Examination Questions
1. Define working capital and give the concept of working capital.
2. Discuss the importance of working capital management.
3. What are the types of working capital? Discuss.
4. What do you mean by cash conversion cycle? How the company can reduce it?
5. Explain the factors affecting working capital.
6. What are the different types of working capital policy firm can adopt? Discuss each
policy in terms of risk and return to the firm.
Problems
1. The Kathmandu Candy Corporation carries an average balance of inventory equal to

Rs.400,000. The company's cost of goods sold averages Rs.4.5 million. What are Kathmandu's
(a) inventory conversion period?
[Ans.: (a) 32 days]
2. Valley Cold Stores generally has inventory that equals Rs.48 mil1ion. If the inventory
turnover for the company is 8, what are its (a) inventory conversion period
[Ans.: (a) 45 days;
3. Sanim Dairy Firm generally carries an amount of receivables equal to Rs.80,000 and its
annual credit sales equal Rs. 2.4 million. What are firm's (a) receivables collection period
(DSO)?
[Ans.: (a) 12 days)]
4. Unique Uniforms generally has accounts receivable that equal Rs.480,000. If User the
accounts receivable turnover for the company is 12, what are its (a) receivables collection period
(DSO) and (b) annual credit sales?
[Ans.: (a) 30 days; (b) Rs.57,60,000]

45
5. At any point in time, Lumbini Ferti1izer generally owes its suppliers Rs.180,00. The
company's cost of goods sold averages Rs.2.52 million. What are Lumbini Fertilizer's (a)
payables deferral period (DPO).
[Ans.: (a) 25.71 days]
6. The Saliford Corporation has an inventory conversion period of 60 days, receivables

collection period of 36 days, and payables deferral period of 24 days.
a) What is the length of the firm's cash conversion cycle?
b) If Saliford's annual sales are Rs.3,960,000 and all sales are on credit, what is the average
balance in accounts receivable?
[Ans.: (a) 72 days; (b) Rs. 396,000;
7. The Flamingo Corporation is trying to determine the effect of its inventory turnover ratio
and days sales outstanding (DSO) on its cash flow cycle. Flamingo's 2008 sales (all on credit)
were Rs.180,000, and it earned net profit of 5 percent, or Rs.9,000. The cost of goods sold equals
85 percent of sales. Inventory was turned over eight times during the year, and the DSO, or
average collection period, was 36 days. The firm had fixed assets totaling Rs.40,000. Flamingo's
payables deferral period is 30 days.
a) Calculate Flamingo's cash conversion cycle.
[Ans.: (a) 51 days;
8. Verbrugge Corporation is leading U.S. producer of automobile batteries. Cerbrugges

turns out 1,500 batteries day at cost of Rs. 6 per battery for materials and labor. It takes the firm
22 days to convert raw materials into batery. Verbrugge allows its customers 40 days in which to
pay for the batteries, and the firm generally pays its suppliers in 30 days.
a) What is the length of Verbrugge's cash conversion cycle?
[Ans.: (a) 32 days;
46
CHAPTER THREE:
CASH AND LIQUIDITY MANAGEMENT
Dear students, after studying this chapter, you should be able to:
Explain the reason for holding cash

Understand the importance of float and how it affects the cash balance.
Understand how to accelerate collections and manage disbursements.
Understand the advantages and disadvantages of holding cash and

some of the ways to invest idle cash
3.1. INTRODUCTION
Cash is an important current asset for the operations of the business. Cash is the basic input
needed to keep the business running on a continuous basis; it is also an ultimate output expected
to be realized by selling the service or product manufactured by the firm. The firm should keep
sufficient cash, neither more nor less. Cash shortage will disrupt the firm’s operations while
excessive cash will simply remain idle, without contributing anything towards the firm’s
profitability. Thus, a major function of the financial manager is to maintain a sound cash
position. Cash Management is concerned with managing of;
Cash flows into and out of the firm,
Cash flows within the firm
Cash balances held by the firm at a point of time by financing deficit or investing surplus. This
can be represented by the following cash management cycle.
The objective in cash management is to keep the investment in cash as low as possible while
maintaining the firm’s efficient operations and to invest the surplus cash funds in profitable
opportunities. To accomplish this objective, managers must determine the target cash balance
47
required to maintain liquidity while minimizing the total costs related to the investment in cash.
Cash management involves three major decision areas:
Determining appropriate cash balances.
Investing idle cash.
Managing collections and disbursements.
The firm’s need to hold cash for the following three motives
I. Transaction motive
II. Precautionary Motive
III. Speculative Motive
Definition of Cash
Cash is the money which a firm can disburse immediately without any restriction. The term cash
includes coins, currency and checques held by the firm, and balances in its bank account.
Generally, when a firm has excess cash, it invests it in marketable securities. This kind of
investment contributes some profit to the firm.
REASONS FOR HOLDING CASH
Transaction Motive:
The transaction motive requires a firm to hold cash to conduct its business in the ordinary course.
It is the need to hold cash to satisfy normal disbursement and collection activities associated with
a firm’s ongoing operations or to pay day-to-day bills. The firm needs cash primarily to make
payments for purchases, wages and salaries, other operating expenses, taxes, dividends etc. The
need to hold cash would not arise if there were perfect synchronization between cash receipts
and payments.
48
Precautionary Motive:
The precautionary motive is the need to hold cash to meet contingencies in future. It provides a
cushion or buffer to withstand some unexpected emergency. The precautionary motive of cash
depends upon the predictability of cash flows. If cash flows can be predicted with accuracy, less
cash will be maintained for emergency.
Speculative Motive:
The speculative motive relates to the holding of cash for investing in profit making opportunities
as and when thk2ey arise. The opportunity to make profit may arise when the security prices
change. The firm will hold cash, when it is expected that interest rate is expected to fall. The firm
will benefit by subsequent fall in interest rates and increase in security prices.
Firms do not need to actually hold cash to meet the speculative demand for money. They can
usually satisfy the speculative motive for holding cash through using reserve borrowing ability
and marketable securities. This is similar to using credit cards instead of cash to make purchases.
Activity
Question 1: what are the reasons for holding cash?
Costs of Holding Cash
The opportunity cost of holding cash is the return that could be earned by investing the cash in
other assets. However, there is also a cost to converting between cash and other assets. The
optimal cash balance will consider the trade-off between these costs to minimize the overall cost
of holding cash.
3.2.Cash Management versus Liquidity Management

The distinction between liquidity management and cash management is straightforward.
Liquidity management is a fairly broad area that concerns the optimal quantity of liquid assets a
49
firm should have, including accounts receivable and inventory. Cash management deals with the
optimization of the collection and disbursement of cash.
50
3.3. UNDERSTANDING FLOAT
The amount of money you have according to your checkbook can be very different from the
amount of money that your bank thinks you have. The reason is that some of the checks you
have written haven’t yet been presented to the bank for payment. The same thing is true for a
business. The cash balance that a firm shows on its books is called the firm’s book, or ledger,
balance. The balance shown in its bank account as available to spend is called its available, or
collected, balance. It may not be the same as the amount of checks deposited less the amount of
checks paid, because deposits are not normally available immediately. The difference between
the available balance and the ledger balance is called the float, and it represents the net effect of
checks in the process of clearing (moving through the banking system).
Float = Available Balance – Book Balance
Positive float implies that checks that have been written have not yet cleared. The company
needs to make sure that it adjusts the available balance so that it does not think that there is more
money to spend than there actually is.
Disbursement float
Disbursement float – generated by checks the firm has written that have not yet cleared the bank;
arrangements can be made so that this money is invested in marketable securities until needed to
cover the checks.
For Disbursement Float: Available balance at bank – Book Balance > 0
Suppose that the United Carbon Company has $1 million in a demand deposit (checking
account) with its bank. It now pays one of its suppliers by writing and mailing a check for
$200,000. The company’s records are immediately adjusted to show a cash balance of $800,000.
Thus the company is said to have a ledger balance of $800,000. But the company’s bank won’t
learn anything about this check until it has been received by the supplier, deposited at the
supplier’s bank, and finally presented to United Carbon’s bank for payment. During this time
United Carbon’s bank continues to show in its ledger that the company has a balance of $1
million. While the check is clearing, the company obtains the benefit of an extra $200,000 in the
bank. This sum is often called disbursement float, or payment float.
51
Float sounds like a marvelous invention; every time you spend money, it takes the bank a few
days to catch on. Unfortunately, it can also work in reverse. Suppose that in addition to paying its
supplier, United Carbon receives a check for $120,000 from a customer. It first processes the
check and then deposits it in the bank. At this point both the company and the bank increase the
ledger balance by $120,000:
Collection and Net Float
Collection float – generated by checks that have been received by the firm but are not yet
included in the available balance at the bank. Checks received increase book balance before the
bank credits the account
For Collection Float: Available balance at bank – Book balance < 0
52
Net float = Disbursement float + Collection float
Negative float implies that checks that have been deposited are not yet available. The firm needs
to be careful that it does not write checks over the available balance, or the checks may bounce.
Managers need to be more concerned with net float and available balances than with the book
balance.
Have you ever written a check a day or two before receiving a paycheck, even though, on the day
when the check was mailed, their checking account had insufficient funds to cover it. This is an
example of using disbursement float. We recognize that the time for the check to travel through
the mail and then be processed and cleared should allow enough time for the paycheck to clear
our bank. We do need to be careful about this process, however. The check we wrote may go
through the system faster than anticipated, and it may take the paycheck longer to become
available than anticipated. In this case, our check may bounce, or at the very least our credit line
is tapped and we end up paying some unexpected interest charges.
53
Example
You have Br. 3,000 in your checking account. You just deposited Br. 2,000 and wrote a check
for Br. 2,500.
What is the disbursement float? Disbursement float = Br. 2500
What is the collection float? Collection float = - Br. 2000
What is the net float? Net float = 2500 – 2000 = Br. 500
What is your book balance? Book balance = Br. 3000 + 2000 – 2500 = Br. 2500
What is your available balance? Available balance = Br. 3000
Float Management
Float management – speeding up collections (reducing collection float) and slowing down
disbursements (increasing disbursement float).
Delay = mailing time + processing delay + availability delay
The three components of float are:
Mail float – the time the check is in the mail
Processing float – handling time between receipt and deposit
Availability float – time for the check to clear the banking system
Several kinds of delay create float, so people in the cash management business refer to
several kinds of float. Figure 2.5 shows the three sources of float:
• The time that it takes to mail a check.
54
• The time that it takes the company to process the check after it has been received.
• The time that it takes the bank to clear the check and adjust the firm’s account.
3.4 MEASURING FLOAT

Size of float depends on the dollar amount and the time delay.
Suppose you mail a check each month for Br. 1,000 and it takes 3 days to reach its destination, 1
day to process, and 1 day before the bank makes the cash available.
What is the average daily float (assuming 30-day months)?
Method 1: (3+1+1)(1,000)/30 = 166.67
Method 2: (5/30)(1,000) + (25/30)(0) = 166.67
There are two distinct cases: (a) periodic collections and (b) continuous or steady-state
collections.
For periodic collections, average daily float = (check amount*days delay) / (# days in period)
55
Example
Periodic Collections: Suppose a Br. 10,000 check is mailed to Belief Systems, Inc. every two
weeks. It spends two days in the mail, one day at Belief Systems offices and is credited to Belief
Systems’ bank account two days after deposit, for a total delay of five days. Over the 14-day
period, the float is Br. 10,000 for five days and Br. 0 for nine days; then the cycle starts over.
The average float is (5*10,000 + 9*0)/14 = Br. 3,571.43.
Example
Continuous Collections: Suppose average daily checks arriving at Hector Company amount to
Br. 2,000. The checks take an average of three days to arrive in the mail, one day to process and
two days to be credited to the bank account. The total collection delay is six days, and the
average daily float is 6*2000 = Br. 12,000. Eliminating all delays would free up Br. 12,000;
eliminating one day’s delay would free up Br. 2,000.
Cost of the Float
Cost of float – opportunity cost of not being able to use the money
Cost of Collection Float
The benefit of reducing collection delays is directly reflected in the change in average daily float.
Every dollar reduction in average daily float is a dollar freed up for use in perpetuity. The change
in the average daily float that any plan to hasten collections might make is also the most the firm
would be willing to pay for faster collections.
Example
Periodic Collections: What is the most that Belief Systems would pay to speed up collections by
one day? If the collections delay were reduced from five days to four days, the average daily
float would go from Br. 3,571.43 to Br. 2,857.14. So, the most the company would be willing to
pay is 3571.43 – 2857.14 = 714.29.
56
Example
Continuous Collections: How much would Hector save if they reduced their collection delay
from six days to three? The average daily float for three days’ delay is Br. 6,000, so the company
would save 12,000 – 6,000 = Br. 6,000 and this is the most it would be willing to pay.
3.5 CASH COLLECTION AND CONCENTRATION

Components of Collection Time
Collection Time = mailing time + processing delay + availability delay
One of the goals of float management is to try to reduce the collection delay. There are several
techniques that can reduce various parts of the delay.
Cash Collection
Cash collection policies depend on the nature of the business. Firms can choose to have checks
mailed to one or more locations, (reduces mailing time), or allow preauthorized payments. Many
firms also accept online payments either with a credit card, with authorization to request the
funds directly from your bank, or through online bill paying arrangements.
One of the goals of float management is to try to reduce the collection delay. There are several
techniques that can reduce various parts of the delay
Lockboxes
Lockboxes are special post office boxes that allow banks to process the incoming checks and
then send the information on account payment to the firm. They reduce processing time and
often reduce mail time because several regional lockboxes can be used.
57
Lockboxes can reduce mail delay by having customers mail their payments to PO boxes that are
closer to where they live. The processing delay is also reduced because bank employees process
the checks instead of the company doing it and then taking the checks to the bank.
Suppose that you are thinking of opening a lock box. The local bank shows you a map of mail
delivery times. From that and knowledge of your customers’ locations, you come up with the
following data:
Average number of daily payments to lock box = 150
Average size of payment = $1,200
Rate of interest per day = .02 percent
Saving in mailing time = 1.2 days
Saving in processing time = .8 day
On this basis, the lock box would reduce collection float by
150 items per day × $1,200 per item × (1.2 + .8) days saved = $360,000
Invested at .02 percent per day, that gives a daily return of
.0002 × $360,000 = $72
The bank’s charge for operating the lock-box system depends on the number of checks
processed. Suppose that the bank charges $.26 per check. That works out to 150*$.26 = $39.00
per day. You are ahead by $72.00 – $39.00 = $33.00 per day, plus whatever your firm saves
from not having to process the checks itself.
Cash concentration
The practice of moving cash from multiple banks into the firm’s main accounts. This is a
common practice that is used in conjunction with lockboxes.
58
Cash concentration – reduce management time by having a systematic process for moving cash
received in the lock-boxes to a central account. Allows the company to maintain smaller cash
balances overall.
3.6 MANAGING CASH DISBURSEMENT

Increasing disbursement float
Slowing payments by increasing mail delay, processing time or collection time. A firm may not
want to do this from both an ethical standpoint and a valuation standpoint. Slowing payment
could cause a company to forgo discounts on its accounts payable. As we will see later in the
chapter, the cost of forgoing discounts can be extremely high.
Slowing down payments can increase disbursement float – but it may not be ethical or optimal to
do this.
Controlling disbursements
Minimize liquidity needs by keeping a tight rein on disbursements through any ethical means
possible
Zero-balance account
Zero-balance account: maintain a master account; when checks are written on sub-accounts, cash
is transferred from the master account to the sub-account to cover the checks; can maintain a
smaller overall cash balance by utilizing this technique
Controlled disbursement account
Controlled disbursement accounts – the firm is notified on a daily basis how much cash is
required to meet that day’s disbursements and the firm wires the necessary funds.
Controlled disbursement account – cash is transferred to bank account to cover the day’s
anticipated payments
Ethical behavior in this area of cash management is very important. Because transactions occur
frequently and in large amounts, unscrupulous financial managers tend to “cut corners” in this
59
area more often than in some others. Some corporations routinely pay late or take discounts that
they do not qualify for. This hurts the suppliers that the company does business with and may
ultimately hurt the company through a loss of reputation or credit.
Ethical behavior can be summed up in the following rule of thumb proposed by a top executive
at a financial management seminar. When asked about a practice similar to the one described
above, he responded that he followed the “mother rule” when faced with a decision with ethical
consequences – “If you would be comfortable telling your mother what you did, it’s probably
ethical.” Of course, this doesn’t work for everyone, but it does hit home with a lot of students.
3.7 INVESTING IDLE CASH

Temporary cash surpluses
Seasonal or Cyclical Activities
Seasonal or cyclical activities – buy marketable securities with seasonal surpluses, convert
securities back to cash when deficits occur
Planned or Possible Expenditures
Planned or possible expenditures – accumulate marketable securities in anticipation of upcoming

expenses
The goal is to invest temporary cash surpluses in liquid assets with short maturities, low default
risk and high marketability.
60
Seasonal Cash Demands
Characteristics of Short-Term Securities
Corporate treasurers seek to acquire assets with the following characteristics:
Maturity – firms often limit the maturity of short-term investments to 90 days to avoid loss of
principal due to changing interest rates
Default risk – avoid investing in marketable securities with significant default risk
Marketability – ease of converting to cash
Taxability – consider different tax characteristics when making a decision
“Marketability” suggests that large amounts of an asset can be bought or sold quickly with little
effect on the current market price. This characteristic is usually associated with financial markets
that are “broad” and “deep.” Broad markets have a large number of participants; deep markets
have participants that are willing and able to engage in large transactions. The market for U.S. T-
bills epitomizes these characteristics. There are millions of potential buyers and sellers world-
wide, and multi-million dollar transactions are common.
61
Some Different Types of Money Market Securities
Money market – financial instruments with an original maturity of one year or less
Government Treasury bills
Commercial Paper
Certificates of Deposit
Repurchase Agreements
Preferred Stock
3.8DETERMINING THE TARGET CASH BALANCE

Target cash balance – the desired cash balance as determined by the trade-off between carrying
costs and storage costs.
Carrying costs - the opportunity cost of holding too much cash.
Shortage costs – costs associated with holding low levels of cash. Also called adjustment costs.
With a flexible working capital policy, the trade-off is between the opportunity cost of cash
balances and the adjustment costs of buying, selling and managing securities.
The Basic Idea
The objective is to determine the optimal or target cash balance. This occurs when the
opportunity and trading costs are equal.
The BAT Model
The Baumol-Allais-Tobin (BAT) is a classic means of
Define:
C* = optimal cash transfer amount (amount of marketable securities to sell to raise cash)
F = fixed cost of selling securities
62
T = cash needed for transactions over entire planning period
R = opportunity cost of cash (interest rate on marketable securities)
Assume that cash is paid out at a constant rate through time.
Opportunity cost = average cash balance * interest rate = [(C+0)/2]*R
Trading cost = (# of transactions) (cost per transfer) = (T/C*)F
Total cost = opportunity cost + trading cost = (C*/2)R + (T/C*)F
To find the optimal transfer amount, take a first derivative of the cost function relative to C* and
set it equal to zero.
You can also find it by setting opportunity cost = trading cost and solving for C*.
(2𝑇∗𝐹)
C* = √ 𝑅
The Miller-Orr Model: A More General Approach
The Miller-Orr model offers a general approach to handling uncertain cash flows.
The Basic Idea:
U* = upper limit on cash balance
L = lower limit on cash balance
C* = target cash balance
When cash reaches U*, the firm transfers cash (buys securities) in the amount of U* - C*. If cash
falls below L, the firm sells C* - L worth of securities to add to cash.
Using the Model:
Given the variance (2) of cash flow (“cash flow” refers to both the amounts that go into and
come out of the cash balance) per period, the interest rate per period (period may be a day, week,
63
or month as long as the two are consistent), and L, the target balance and upper limit, are given
by:
C* = L + ( ¾ * F * 2/R)1/3
U* = 3C* - 2L
Example: Suppose F = $25, R = 1% per month, and the variance of monthly cash flows is
$25,000,000 per month. Assume a minimum cash balance of $10,000.
C* = 10,000 + ( ¾ (25)(25,000,000)/.01)1/3 = $13,605.62
U* = 3(13,605.62) – 2(10,000) = $20,816.86
Implications of the BAT and Miller-Orr Models
From both:
The higher the interest rate (opportunity cost), the lower the target balance
The higher the transaction cost, the higher the target balance
From Miller-Orr:
The greater the variability of cash flows, the higher the target balance
64
Summary
Cash is an important current asset for the operations of the business. The firm should keep
sufficient cash, neither more nor less. Thus, a major function of the financial manager is to
maintain a sound cash position.
The objective in cash management is to keep the investment in cash as low as possible while
maintaining the firm’s efficient operations and to invest the surplus cash funds in profitable
opportunities. Cash management involves three major decision areas:
Determining appropriate cash balances.
Investing idle cash.
Managing collections and disbursements.
The firm’s need to hold cash may be attributed to the following three motives:
Transaction Motive:
The transaction motive requires a firm to hold cash to conduct its business in the ordinary course.
Precautionary Motive:
The precautionary motive is the need to hold cash to meet contingencies in future
Speculative Motive:
The speculative motive relates to the holding of cash for investing in profit making opportunities
as and when they arise.
Lockboxes
Lockboxes are special post office boxes that allow banks to process the incoming checks and
then send the information on account payment to the firm.
65
Characteristics of Short-Term Securities
Corporate treasurers seek to acquire assets with the following characteristics:
Maturity – firms often limit the maturity of short-term investments to 90 days to avoid loss of
principal due to changing interest rates
Default risk – avoid investing in marketable securities with significant default risk
Marketability – ease of converting to cash
Taxability – consider different tax characteristics when making a decision
66
Self-Examination Questions
PART I: CHOOSE THE BEST ANSWER FROM THE FOLLOWING ALTERNATIVES
Cash Management is concerned with managing of;
Cash flows into and out of the firm,
Cash flows within the firm
Cash balances held by the firm at a point of time by financing deficit or investing surplus.
All of the above
Three major decision areas of cash management involves:
Determining appropriate cash balances. Managing collections and disbursements.
Investing idle cash. All of the above
The transaction motive requires a firm to hold cash to conduct its business in the ordinary course
is known as:
Speculative motive Precautionary motive
Transaction motive Cash motive
PART II: WORK OUT QUESTION
You have Br. 3,000 in your checking account. You just deposited Br. 2,000 and wrote a check
for Br. 2,500.
67
Suppose average daily checks arriving at Hector Company amount to Br. 2,000. The checks take
an average of three days to arrive in the mail, one day to process and two days to be credited to
the bank account. The total collection delay is six days. How much would Hector save if they
reduced their collection delay from six days to three?
ANSWER TO THE MODEL QUESTIONS
D 2. D 3. B
Work out:
Continuous Collections: The average daily float for three days’ delay is Br. 6,000, so the
company would save 12,000 – 6,000 = Br. 6,000 and this is the most it would be willing to pay.
68
CHAPTER FOUR:
RECEIVABLE MANAGEMENT
Dear Students! As we have discussed in chapter two, Working Capital Management includes,
Management of current assets such as: Cash and liquidity, Receivable and inventory
management. We already discussed Cash and Liquidity management in chapter three. In this
chapter we will see some highlights of the Receivable Management.
After studying this chapter, you should be able to:

Understand the key issues related to receivable management;
Understand the impact of cash discounts;
Be able to evaluate a proposed credit policy;
Understand the components of credit analysis.
4.1.INTRODUCTION
Receivables are book debts which an organization is expected to collect in the near future.
Investment in receivables will arise when there is a gap or time lag between point of delivery of
goods and services and when payment is received from customers.
Trade credit is very important to an organization because it helps in protecting organizations’

sales from being eroded by competitors. It also helps to attract potential customers to buy at
favorable terms.
A firm must establish a policy for credit terms given to its customers. A relaxed credit policy
may attract different customers but at a disproportionate increase in costs.
69
CREDIT AND RECEIVABLES
The profitability of a business is dependent upon its ability to successfully sell its products for
more than it costs to produce them. Selling on credit generally attracts customers and increases
sales volume. There are, however, direct and indirect costs to extending credit which must be
weighed against any potential benefits.
The costs associated with granting credit are not trivial. First, there is the chance that the
customer will not pay. Second, the firm has to bear the costs of carrying the receivables. The
credit policy decision thus involves a trade-off between the benefits of increased sales and the
costs of granting credit. In other words, the goal of receivable management is to ensure that the
costs of granting credit are offset by the benefits of higher sales.
Too often, especially during their start-up period, businesses concentrate on generating sales and
pay little attention to the collection of money from debtors. As a result although sales exist on
paper, the cash generated by these sales takes too long to materialize and cash flow problems
occur. Additionally, the longer a debt is outstanding the greater the likelihood it will become bad.
Components of Credit Policy
If a firm decides to grant credit to its customers, then it must establish procedures for extending
credit and collecting. In particular, the firm will have to deal with the following components of
credit policy:
Terms of sale. The terms of sale establish how the firm proposes to sell its goods and services. A
basic decision is whether the firm will require cash or will extend credit. If the firm does grant
credit to a customer, the terms of sale will specify (perhaps implicitly) the credit period, the cash
discount and discount period, and the type of credit instrument.
Credit analysis. In granting credit, a firm determines how much effort to expend trying to
distinguish between customers who will pay and customers who will not pay. Firms use a
number of devices and procedures to determine the probability that customers will not pay, and,
put together, these are called credit analysis.
70
Collection policy. After credit has been granted, the firm has the potential problem of collecting
the cash, for which it must establish a collection policy.
4.2.TERMS OF SALE
Whenever a firm sells a product, the seller spells out the terms and conditions of the sale in a
document called the terms of sale.
The agreement specifies when the cash payment is due and the amount of any discount if early
payment is made.
Trade credit, which is short-term financing, is typically made with a discount for early payment
rather an explicit interest charge.
An offer of “3/10, net 40” means that the selling firm offers a 3 percent discount if the buyer
pays the full amount of the purchase in cash within 10 days of the invoice date. Otherwise, the
buyer has 40 days to pay the balance in full from the date of delivery.
To calculate the cost, we need to determine the interest rate the buyer is paying and convert it to
an equivalent annual rate.
The formula for calculating the EAR for a problem like this is shown below:
365/dayscredit
 Discount 
Effective annual rate = 1+  1
 Discounted price 
Trade credit is a loan from the supplier and it can be a very costly form of credit.
Credit Period
Credit period is the length of time allowed before the credit buyer must pay for credit purchases.
When deciding the credit period offered to customers a firm must consider several factors. A
longer credit period (for example 45 days compared to 30 days offered by competitors) may
generate additional sales; however these must be compared against the additional costs incurred
by the business. These costs might include an increase in bad debts, higher administration costs
71
and bank overdraft charges. If the profits arising from the additional credit period are less than
the costs incurred, the credit period should be reviewed.
There are a number of other factors that influence the credit period. Many of these also influence
our customer’s operating cycles; so, once again, these are related subjects.
Among the most important are:
Perishability and collateral value. Perishable items have relatively rapid turnover and relatively
low collateral value. Credit periods are thus shorter for such goods. For example, a food
wholesaler selling fresh fruit and produce might use net seven days. Alternatively, jewelry might
be sold for 5/30, net four months.
Consumer demand. Products that are well established generally have more rapid turnover. Newer
or slow-moving products will often have longer credit periods associated with them to entice
buyers. Also, as we have seen, sellers may choose to extend much longer credit periods for off-
season sales (when customer demand is low).
Cost, profitability, and standardization. Relatively inexpensive goods tend to have shorter credit
periods. The same is true for relatively standardized goods and raw materials. These all tend to
have lower markups and higher turnover rates, both of which lead to shorter credit periods. There
are exceptions. Auto dealers, for example, generally pay for cars as they are received.
Credit risk. The greater the credit risk of the buyer, the shorter the credit period is likely to be
(assuming that credit is granted at all).
Size of the account. If an account is small, the credit period may be shorter because small
accounts cost more to manage, and the customers are less important.
Competition. When the seller is in a highly competitive market, longer credit periods may be
offered as a way of attracting customers.
Customer type. A single seller might offer different credit terms to different buyers. A food
wholesaler, for example, might supply groceries, bakeries, and restaurants. Each group would
72
probably have different credit terms. More generally, sellers often have both wholesale and retail
customers, and they frequently quote different terms to the two types.
Cash Discount
The last element of the credit policy is cash discount. A small cash discount is often used as an
incentive to encourage early payment by debtors. For example, many firms offer a discount of
two per cent of the invoice value for payment within seven working days of the invoice date.
Cash discounts may also attract new customers who look at cash discount as a form of price
reduction. These benefits, however, must be weighed against the birr cost of the discount before
any decisions are made.
Credit Policy Effects
In evaluating credit policy, there are five basic factors to consider:
Revenue effects. If the firm grants credit, then there will be a delay in revenue collections as
some customers take advantage of the credit offered and pay later. However, the firm may be
able to charge a higher price if it grants credit and it may be able to increase the quantity sold.
Total revenues may thus increase.
Cost effects. Although the firm may experience delayed revenues if it grants credit, it will still
incur the costs of sales immediately. Whether the firm sells for cash or credit, it will still have to
acquire or produce the merchandise (and pay for it).
The cost of debt. When the firm grants credit, it must arrange to finance the resulting receivables.
As a result, the firm’s cost of short-term borrowing is a factor in the decision to grant credit.
The probability of nonpayment. If the firm grants credit, some percentage of the credit buyers
will not pay. This can’t happen, of course, if the firm sells for cash.
The cash discount. When the firm offers a cash discount as part of its credit terms, some
customers will choose to pay early to take advantage of the discount.
73
Total Cost of Granting Credit
The trade-off between granting credit and not granting credit is not hard to identify, but it is
difficult to quantify precisely. As a result, we can only describe an optimal credit policy.
a) Carrying costs
To begin, the carrying costs associated with granting credit come in three forms:
The required return on receivables
The losses from bad debts
The costs of managing credit and credit collections
The cost of managing credit consists of the expenses associated with running the credit
department. Firms that don’t grant credit have no such department and no such expense. These
three costs will all increase as credit policy is relaxed.
b) Shortage costs
It is lost sales due to a restrictive credit policy. If a firm has a very restrictive credit policy, then
all of the associated costs will be low. In this case, the firm will have a “shortage” of credit, so
there will be an opportunity cost. This opportunity cost is the extra potential profit from credit
sales that is lost because credit is refused.
74
Total cost curve
Sum of carrying costs and shortage costs
Optimal credit policy is where the total cost curve is minimized
75
4.4. CREDIT ANALYSIS
Once a firm decides to grant credit to its customers, it must then establish guidelines for
determining who will and who will not be allowed to buy on credit. Credit analysis refers to the
process of deciding whether or not to extend credit to a particular customer. Credit analysis is
important simply because potential losses on receivables can be substantial. It usually involves
two steps: gathering relevant information and determining creditworthiness.
Gathering information
If a firm does want credit information on customers, there are a number of sources. Information
sources commonly used to assess creditworthiness include the following:
Financial statements. A firm can ask a customer to supply financial statements such as balance
sheets and income statements.
Credit reports on the customer’s payment history with other firms. Quite a few organizations sell
information on the credit strength and credit history of business firms.
Banks. Banks will generally provide some assistance to their business customers in acquiring
information on the creditworthiness of other firms.
The customer’s payment history with the firm. The most obvious way to obtain information about
the likelihood of a customer’s not paying is to examine whether they have settled past
obligations (and how quickly).
Determining Creditworthiness
Before extending credit, the credit worthiness of a buyer must be evaluated. Most businesses
measure credit quality and evaluate a customer’s probability of default by examining the five Cs
of credit:
Character
Capacity to repay
Capital
76
Collateral
Conditions
A customer’s character refers to his/her acknowledgement of a moral obligation to paynthe debt

as promised. It may be evaluated by examining the customer’s previous payment habits.
Relevant information may be requested from the customer’s previous suppliers or from credit
reporting agencies. The capacity to pay is the subjective judgment of customer’s ability to repay
the loan. An examination of the financial statements and the business plan of the credit buyer
may aid in making the correct judgment.
The analysis of financial ratios, especially risk ratios such as the debt-to-asset and the current
ratios, will help in measuring capital.
4.5. COLLECTION POLICY

Collection policy refers to actions that the business is willing to take to collect slow-paying
accounts. The length of time a firm is willing to extend credit to its customers and the
“toughness” of the firm in collecting its receivables may influence sales and, ultimately, its
profits, while a “relaxed” collection policy may increase the percentage of bad debt.
The receivable position must be monitored closely by calculating the average collection period
(ACP) and comparing it to the industry average.
Moreover, an aging schedule must be constructed to show how long accounts receivable are
outstanding by dividing the receivables position in age categories and showing the percentage of
receivables in each age group. Then, the firm must decide what actions are appropriate for
collecting the past due accounts. Usually, a letter is sent to remind the credit buyer that the
account is past due, followed by a telephone call if payment is further delayed. Finally, the
services of a collection agency may be necessary.
77
The collection process may be expensive both in terms of out-of-pocket expense and the loss of
business relations. Therefore, making the decision to grant credit is an important and delicate
business function requiring careful handling.
Activity
Question: what are the 5 C’s of receivables?
78
Summary
Receivables are book debts which an organization is expected to collect in the near future.
Investment in receivables will arise when there is a gap or time lag between point of delivery of
goods and services and when payment is received from customers. A firm must establish a policy
for credit terms given to its customers. A relaxed credit policy may attract different customers
but at a disproportionate increase in costs
The credit policy decision involves a trade-off between the benefits of increased sales and the
costs of granting credit. In other words, the goal of receivable management is to ensure that the
costs of granting credit are offset by the benefits of higher sales.
Components of credit policy are:
Terms of sale. The terms of sale establish how the firm proposes to sell its goods and services. A
basic decision is whether the firm will require cash or will extend credit. If the firm does grant
credit to a customer, the terms of sale will specify (perhaps implicitly) the credit period, the cash
discount and discount period, and the type of credit instrument.
Credit analysis. In granting credit, a firm determines how much effort to expend trying to
distinguish between customers who will pay and customers who will not pay. Firms use a
number of devices and procedures to determine the probability that customers will not pay, and,
put together, these are called credit analysis.
Collection policy. After credit has been granted, the firm has the potential problem of collecting
the cash, for which it must establish a collection policy.
Before extending credit, the credit worthiness of a buyer must be evaluated. Most businesses
measure credit quality and evaluate a customer’s probability of default by examining the five Cs
of credit:
Character Collateral
Capacity to repay Conditions
Capital
79
SELF-EXAMINATION QUESTIONS
PART I: CHOOSE THE BEST ANSWER FROM THE FOLLOWING ALTERNATIVES
The basic factors to consider while evaluating credit policy are:
Revenue effects Probability of non repayments
Cost effects All
Which one of the following is the not the components of credit policy?
Terms of sale.
Collection policy
Credit analysis.
All
----------refers to actions that the business is Terms of sale.

willing to take to collect slow-paying
Collection policy
accounts.
Credit analysis.
PART II: Short Answers
What are the five C’s of Receivables
80
CHAPTER FIVE:
INVENTORY MANAGEMENT
Dear learner, after studying this chapter, you should be able to:
Understand the major components of inventory management
Be able to use the EOQ model to determine optimal inventory levels
5.1. INTRODUCTION
A firm's profitability depends on the successful sale of its product or service. For non-service
oriented businesses, sufficient inventories must be available to meet demand. While determining
how many units to have in stock, sales must be predicted and sufficient inventories held to
satisfy the expected demand. Moreover, to prepare for potential sales increases, some level of
"safety stocks" must also be held. The amount of safety stock is determined by comparing the
cost of maintaining this additional inventory against potential sales losses.
Holding inventory levels at less than what is needed to support sales will cost the firm business.
On the other hand, since holding inventory involves costs such as storage and insurance
expenses, excess inventory must also be avoided if minimal cost and maximum profits are
desired.
5.2. MEANING AND NATURE OF INVENTORY

Inventories are stock of product a company is manufacturing for sale and components that make
up the product. The various forms in which inventories exist in a manufacturing company are:
raw materials, work in progress and finished goods.
Raw materials are those basic inputs that are converted into finished products through the
manufacturing process. Raw material inventories are those units which have been purchased and
stored for future productions
Work in progress inventories are semi manufactured products. They represent products that
need more work before they become finished products for sale.
81
Finished goods inventories are those completely manufactured products which are ready for
sale. Stocks of raw materials and work in progress facilitate production while stock of finished
goods is required for smooth marketing operations.
Objectives of Inventory Management
The aim of inventory management is to avoid excessive and inadequate levels of inventories and
maintain sufficient inventory for smooth production and sales operations. Efforts should be made
to place an order at the right time with the right source to acquire the right quantity at the right
price and quality. An effective inventory management should:
Ensure a continuous supply of raw materials to facilitate an interrupted production
Maintain sufficient stocks of raw materials in periods of short supply and anticipate price
changes
Maintain sufficient finished goods inventory for smooth sales operations and efficient customer
service
Minimize the carrying costs and time and control investment in inventories and keep it at
optimum level.
5.4. BENEFITS AND COSTS OF HOLDING INVENTORY

Benefits of Holding Inventory
Firms hold inventory for various reasons, some of which are as follows.
Customer Satisfaction፡- Inventory allows customers to be served quickly and conveniently

(otherwise the firm would have to make everything as the customer requested it).
Economy፡- Inventory can be used so that a firm can buy in bulk, which is usually cheaper.
Flexibility፡- Inventory allows operations to meet unexpected surges in demand.
82
Shock Absorber: - Inventory is insurance if there is an unexpected interruption in supply from
outside the operation or within the operation.
Enables Decoupling: - Inventory allows different parts of the operation to be ‘decoupled’. This
means that they can operate independently to suit their own constraints and convenience while
the stock of items between them absorbs short-term differences between supply and demand. In
many ways this is the most significant advantage of inventory.
Costs of Holding Inventory
The cost of holding inventory is relatively easy to measure and will include: storage, security,
losses due to theft, obsolescence, and goods perishing.
Total inventory costs include:
Carrying Costs
The following costs are generally referred to as the inventory carrying costs.
Value of the capital tied up in inventories
Storage and handling expenses
Insurance
Obsolescence costs
Carrying costs always increase as inventory levels rise.
Ordering Costs
Ordering costs include the administrative costs of placing, tracking, shipping, receiving and
paying for an order. These costs are fixed for every order and remain the same regardless of an
order's size.
For example, consider a retail outlet selling home computers. Three years ago it acquired fifty
state of the art PCs at a cost of Br. 30,000 each. At the time each computer could be sold for Br.
40,000 resulting in a profit of Br. 10,000 per machine. Unfortunately, today fifteen of these
83
models remain in stock. Not only are they taking up valuable space, but also due to rapid
advances in technology they can only be sold for Br. 10,000 each.
When we take into account administration and storage costs this transaction will actually result
in a loss to the firm. We can therefore see the disadvantage of holding excessive levels of stock.
What is less easy to quantify is the cost of not holding sufficient levels of stock to meet the
demand from customers. For example, if a firm has insufficient stock to meet demand, it will
initially result in lost sales. In the longer term it may also damage a business’s goodwill, with
long-standing customers turning to other, more reliable suppliers.
Let’s additional illustration. Suppose that the merchant plans to buy 1 million bricks over the
coming year. Each order that it places costs $90, and the annual carrying cost of the inventory is
$.05 per brick. To minimize order costs, the merchant would need to place a single order for the
entire 1 million bricks on January 1 and would then work off the inventory over the remainder of
the year. Average inventory over the year would be 500,000 bricks and therefore carrying costs
would be 500,000 × $.05 = $25,000. The first row of Table 2.10 shows that if the firm places just
this one order, total costs are $25,090:
Total costs = order costs + carrying costs
$25,090 = $90 + $25,000
To minimize carrying costs, the merchant would need to minimize inventory by placing a large
number of very small orders.
84
Determination of optimal order size.
The above diagram shows the costs of placing 100 orders a year for 10,000 bricks each. The
average inventory is now only 5,000 bricks and therefore the carrying costs are only 5,000 × $.05
= $250. But the order costs have risen to 100 × $90 = $9,000. Each row in Table 2.10 illustrates
how changes in the order size affect the inventory costs. You can see that as the order size
decreases and the number of orders rises, total inventory costs at first decline because carrying
costs fall faster than order costs rise. Eventually, however, the curve turns up as order costs rise
faster than carrying costs fall. Total costs are minimized in this example when the order
size is 60,000 bricks. About 17 times a year the merchant should place an order for 60,000 bricks
and it should work off this inventory over a period of about 3 weeks
5.5. INVENTORY MANAGEMENT TECHNIQUES

Effective inventory management involves turning over inventory as quickly as possible without
losing sales from inventory stock outs. Inventory management is important for two major
reasons. First, inventory represents a sizable investment for some firms and affects their
profitability. Second, managers often cannot correct errors in inventory management quickly
because inventory is the firm’s least liquid current asset.
85
Managers commonly use four inventory management techniques: the ABC system, the economic
order quantity (EOQ) model, the just-in-time (JIT) system, and the materials requirement
planning (MRP) system. We discuss each in turn.
The ABC System
Under the ABC inventory management system, a firm divides its inventory into A, B, and C
groups. The firm places those items with the largest dollar investment in the A group. While the
A group often includes as little as 20 percent of a firm’s total inventory, it may account for as
much as 80 percent of its total investment in inventory. The B group includes inventory items
that account for the next largest inventory investment, and the C group includes a large number
of inventory items that represent a relatively small inventory investment.
Monitoring inventory levels differs among the three groups. Because of its high value in terms of
investment, the A group logically receives the most extensive monitoring. Managers track items
in the A group using a perpetual inventory system that allows for immediate, hourly, or daily
inventory tracking or counts. Managers track items in the B group less frequently, often on a
weekly basis. Items in the C group receive even less attention.
Because the items in the A and B inventory groups represent such large inventory investments,
managers often use more sophisticated inventory management techniques. We discuss one such
technique, the economic order quantity system, in the next section.
86
Economic Order Quality Model
The economic order quantity (EOQ) mathematically determines the minimum total inventory
cost, taking into account reorder costs and inventory-carrying costs. The optimal order size is the
point at which these two effects offset each other. This order size is called the economic order
quantity. There is a neat formula for calculating the economic order quantity. The formula is:
One of the major inventory management problems to be resolved is how much inventory should
be added when inventory is replenished. If the firm is buying raw materials, it has to decide lots
in which it has to be purchased on each replenishment. Determining an optimum inventory level
involves two types of costs
Ordering or Restocking Costs
Carrying costs
The economic order quantity is that inventory level which minimizes the total of ordering and
carrying costs.
Ordering or Restocking Costs
Ordering costs include, cost of requisitioning, purchase ordering, transporting, receiving,

inspecting and storing. Ordering costs increase in proportion to the number of orders placed.
Total restocking cost = (fixed cost per order) x (number of orders) = F(T/Q)
Carrying Costs
Costs for maintaining a given level of inventory are called carrying costs. They include storage,
insurance taxes, deterioration and obsolescence.
87
Total carrying cost = (average inventory) x (carrying cost per unit) = (Q/2)(CC)
Total Cost = Total carrying cost + total restocking cost = (Q/2)(CC) + F(T/Q)
The economic ordering quantity (EOQ) model states that given certain reasonable assumptions,
the order quantity that minimizes total inventory costs.
Example 2; KK Industrial Products sells 2,250 units of inventory per year. The cost of placing
one order is Br. 250, and the cost of carrying a unit of inventory is Br. 50 per year. What are the
EOQ, average inventory, number of orders per year, time interval between orders, total ordering
costs, total carrying costs and annual total costs?
Solution:
2 x 2,250x 250
EOQ 
50
= 150 unit
Average inventory is the Q/2 = 150/2 = 75 units.
Number of orders per year = T/Q = 2,250/150 = 15
Time interval between orders = Q/T = 150/2,250 = 0.0667 years (24.3 days)
Total ordering costs = F(T/Q) = 250(2,250/150) = Br. 3,750
Total carrying costs = C (Q/2) = 50(150/2) = Br. 3,750
Total costs = Ordering costs + Carrying costs = Br. 7500
88
Managing Derived-Demand Inventories
The third type of inventory management technique is used to manage derived-demand

inventories. The demand for some inventory types is derived from or dependent on other
inventory needs. A good example is given by the auto manufacturing industry, in which the
demand for finished products depends on consumer demand, marketing programs, and other
factors related to projected unit sales. The demand for inventory items such as tires, batteries,
headlights, and other components is then completely determined by the number of autos planned.
Materials requirements planning and just-in-time inventory management are two methods for
managing demand dependent inventories.
Materials Requirements Planning
Production and inventory specialists have developed computer-based systems for ordering and/or
scheduling production of demand dependent types of inventories. These systems fall under the
general heading of materials requirements planning (MRP). The basic idea behind MRP is
that, once finished goods inventory levels are set, it is possible to determine what levels of work-
in-progress inventories must exist to meet the need for finished goods. From there, it is possible
to calculate the quantity of raw materials that must be on hand. This ability to schedule
backwards from finished goods inventories stems from the dependent nature of work-in-progress
and raw materials inventories. MRP is particularly important for complicated products for which
a variety of components are needed to create the finished product.
Just-in-Time Inventory Management
In this system the exact day-by-day, or even hour-by-hour, raw material needs are delivered by
the suppliers, who deliver the goods “just in time” for them to be used on the production line.
A big advantage of this system is that there are essentially no raw inventory costs and no
chance of obsolescence or loss to theft.
On the other hand, if the supplier fails to make the needed deliveries, then production shuts
down.
89
Summary
Inventories are stock of product a company is manufacturing for sale and components that make
up the product. The various forms in which inventories exist in a manufacturing company are:
raw materials, work in progress and finished goods. The aim of inventory management is to
avoid excessive and inadequate levels of inventories and maintain sufficient inventory for
smooth production and sales operations. Efforts should be made to place an order at the right
time with the right source to acquire the right quantity at the right price and quality.
Firms hold inventory for various reasons, some of which are as follows.
Customer Satisfaction፡- Inventory allows customers to be served quickly and conveniently

(otherwise the firm would have to make everything as the customer requested it).
Economy፡- Inventory can be used so that a firm can buy in bulk, which is usually cheaper.
Flexibility፡- Inventory allows operations to meet unexpected surges in demand.
Shock Absorber: - Inventory is insurance if there is an unexpected interruption in supply from

outside the operation or within the operation.
Inventory management is important for two major reasons. First, inventory represents a sizable
investment for some firms and affects their profitability. Second, managers often cannot correct
errors in inventory management quickly because inventory is the firm’s least liquid current
asset.Managers commonly use four inventory management techniques: the ABC system, the
economic order quantity (EOQ) model, the just-in-time (JIT) system, and the materials
requirement planning (MRP) system. We discuss each in turn.
90
Model Examination Question
Which one of the following is not an effective inventory management techniques:
Ensure a continuous supply of raw materials to facilitate an interrupted production
Maintain sufficient stocks of raw materials in periods of short supply and anticipate price
changes
Maintain sufficient finished goods inventory for smooth sales operations and efficient customer
service
Maximize the carrying costs and time and control investment in inventories and keep it at
optimum level.
Which one of the following is benefits of holding inventory
Flexibility
Economy፡ All of the above
Customer Satisfaction
Which one of the following is not cost of holding inventory
Carrying cost Selling cost
Ordering cost None of the above
Which one of the following is inventory carrying cost?
Insurance Capital tied up in inventories
Storage and handling expenses All are carrying costs
All are inventory management systems except
The ABC system
The economic order quantity (EOQ)
91
The just-in-time (JIT) system
The materials requirement planning (MRP) system
None of the above
Part Two: Work out
KK Industrial Products sells 2,250 units of inventory per year. The cost of placing one order is
Br. 250, and the cost of carrying a unit of inventory is Br. 50 per year. What are the EOQ,
average inventory, number of orders per year, time interval between orders, total ordering costs,
total carrying costs and annual total costs?
Answer: 1. D 2. D 3. C 4. D 5. E
92
Name________________________________________________________ID__________________
References
1. Anthony G. Puxty, J. Colin, Richard M.S. Wilson; Financial Management: Method and meaning.
2. Block & Hurt, 1989.Foundation of Financial Management. 5th ed.
3. Bodil Dickerson, 1998. Introduction to Financial Management. 4th ed. USA: McGraw hill Co.
4. Dayananda, Ridard Irons, steve Harrison, John Herb Ohan, and Patrick Rowland, Capital Budgeting.
5. Eugene F. Brigham, Louis C.Gapenski, 1993. Intermediate Financial Management. 4th Edition.
Dryden press.
6. Gallagher H. and Andrew M., Fincial Management; Principles and Practice; 4th edition.
7. Harold K. and Gary E., Understand Financial Management: a practical guide.
8. Jae K., Joel G. Shaum’s outline Series; theory and problems, second edition.
9. James C.Van horne, 1998.Financial Management and Policy. 11th ed. Stanford University.
10. Keown & Martin, 1995. Basic Financial Management. 6th ed. University of Phoenix.
11. Peterson, Pamela P. and Frank J. Fabozzi, Capital budgeting process: Financial practice and
education.
12. Scott smart, William L. Megginson, Introduction to Corporate Finance, 7th edition.
13. Yaregal Abegaz, 2007, Fundamentals of Financial Management. 1st ed. Addis Ababa: Accounting
Society of Ethiopia Press.
93
Name________________________________________________________ID__________________
Name________________________________________________________ID__________________
WOLLO UNIVERSITY
College of Business and Economics
Department of Accounting and Finance
Distance assignment for the course
Financial Management _II(AcFn 2011)
Part I: True or false Questions (1.5 points each)
1. Dividends paid represent the residual amount from earnings after the company’s
investment needs are fulfilled.
2. Capital gains arising from the appreciation of the market price of stock have a tax
advantage over dividends.
3. Payment of dividends reduces the chance of uncertainty in stockholders’ minds
about the company’s financial health.
4. Cash dividend may be declared when the cash position of the firm is inadequate
and/or when the firm wishes to prompt more trading of its stock by reducing its
market price.
5. Dividend irrelevance implies that shareholders not prefer current dividend and
there is direct relationship between dividend policy and value of the firm.
6. A stock dividend involves issuing a substantial amount of additional shares and
reducing the par value of the stock on a proportional basis.
Part II: Multiple Choice Questions (1.5 each)
1. Working Capital Policy Basic policy decisions regarding:
A. a target levels for each category of current assets
B. How current assets will be financed.
94 C. a target levels for each category of fixed assets.

D. A and B are answers
1
Name________________________________________________________ID__________________
2. A cycle in which they purchase inventory, sell goods on credit, and then collect
accounts receivable referred to as
A. The cash conversion cycle,
B. Inventory conversion period
C. Receivables Collection Period
D. Payables deferral period
3. The value of the firm is not affected by types of dividend policy under the theory
of:
A. M and M dividend irrelevancy theory
B. Bird in the hand theory
C. Tax preference theory
4. Net working capital is defined as:
A. Current assets minus fixed assets.
B. Current assets minus noninterest- bearing current liabilities.
C. Current assets Net working capital is equal to current assets less current
liabilities.
D. None of the above
5. A policy under which relatively large amounts current assets are carried and
under which sales are stimulated by a liberal credit policy, resulting in a high
level of receivables is:
A. Relaxed fixed Investment Policy
B. Restricted Current Asset Investment Policy
C. Moderate Current Asset Investment Policy
D. Relaxed Current Asset Investment Policy
Part II: Fill in the blank space (1.5 point each)
1. ___________dividends are common and popular types followed by majority of the
business concerns.
2.___________ is the date upon which the stockholder is entitled to receive the dividend.
95
Name________________________________________________________ID__________________
3. ___________is the date that a dividend becomes a legal liability of the corporation.
4_______________refers to shares reacquired by the company.
Part IV: Short Answer Questions (2 points each)
1. Lists the factors affecting the dividend policy
2. Explain the working capital and components of working capital
3. Lists the factors affecting the working capital requirements
4. Describe the factors affecting working capital.
5. Describe the working capital financing policies.
6. Explain the reason for holding cash
7. Discuss how to accelerate collections and manage disbursements.
8. Discuss the components of credit analysis.
9. Discuss the major components of inventory management
96

Lecturenote - 972275618FM II Final Edited

Uploaded by

Copyright:

Available Formats

Lecturenote - 972275618FM II Final Edited

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecturenote - 972275618FM II Final Edited

Uploaded by

Copyright:

Available Formats

WOLLO UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DISTANCE MODULE FOR DEGREE PROGRAM

FINANCIAL MANAGEMENT PART II

Prepared By: Seid Muhammed (MSc.)

Distance Education Program

College of Business and Economics

Department of Accounting and Finance

Financial Management Part II (ACFN2102)

Prepared By: Seid Muhammed (MSc.)

Mohammed Adem (MSc.)

Editor: Birtukan Kasiye (MSc.)

OBJECTIVES OF THE CHAPTER

After studying this chapter, you should be able to:

 Explain what a dividend is and describe the different types of dividends;

Identify key factors influencing a firm’s dividend decision;

Describe factors that managers consider when setting the dividend

The basic types of cash dividends are as follows:

A. Regular cash dividend

Extra Cash Dividend

A special dividend, like an extra dividend, is a one-time payment to stockholders. It is tend to be

Stock dividend – is a payment of additional shares of stock to shareholders. It is often used in

The stockholder is left with exactly the same value as before.

Marker price per share after stock dividend =

Question 1: What is Dividend?

It preserves the company's liquidity as no cash leaves the company.

It broadens the capital base and improves image of the company.

The future rate of dividend will decline.

Issue of bonus shares involves lengthy legal procedures and approvals.

Question 2: What are the types of Dividends?

Benefits and Costs of Dividends

The benefits associated with dividends are as follows:

Some costs associated with dividends include:

Dividend Payment Procedure

30-6-2009 30-7-2009 1-8-2009 1-9-2009

Declaration date Ex-dividend date Holder-of-record date Payment date

1.2.FACTORS INFLUENCING DIVIDEND POLICY

Some of the major factors influencing the firm's

Growth Rate of the Firm

Access to the Capital Market

Tax Position of Shareholders

An increase in personal income tax rate.

A decline in investment opportunities.

An increase in corporate profit.

A rise in interest rate.

1.3. ESTABLISHING DIVIDEND POLICY

1.4. TYPES OF DIVIDEND POLICY

Residual Dividend approach

Question 4: what is dividend policy?

Practical Considerations in Setting a Dividend Policy

Can the firm raise equity capital quickly if necessary?

Stock repurchase will result in increase in the share value.

Disadvantages of stock repurchase

Stock split is used to give higher dividends to shareholders.

Question 5: what does mean stock split?

Part II: Discussion Question

Understand Meaning, Concepts and Types of working capital

Describe the factors affecting working capital.

Describe the working capital financing policies.