Value-Based Liquidity Management

Transcription

1 Value-Based Liquidity Management unifying commentary to papers previously published as: [1] Corporate inventory management with value maximization in view. [G. Michalski, autorstvo = 100%], Agricultural Economics 1, 54/2008(5), ISSN: X, 2008, s [2] Operational risk in current assets investment decisions: Portfolio management approach in accounts receivable, [G. Michalski, autorstvo = 100%], Agricultural Economics 2, 54/2008(1), ISSN: X, 2008, s [3] Planning Optimal from the Firm Value Creation Perspective. Levels of Operating Cash Investments, [G. Michalski, autorstvo 100%], Romanian Journal of Economic Forecasting 3, 13(1)/2010, ISSN: , Institute of Economic Forecasting, Bucharest 2010, s [4] Portfolio management approach in trade credit decision making, [G. Michalski, autorstvo = 100%], Romanian Journal of Economic Forecasting 4 3/2007, ISSN: , Institute of Economic Forecasting, Bucharest 2007, ss [5] Value-Based Inventory Management, [G. Michalski, autorstvo = 100%], Romanian Journal of Economic Forecasting 5 9(1)/2008, ISSN: , Institute of Economic Forecasting, Bucharest 2008, s [6] Inventory Management Optimization as Part of Operational Risk Management, [G. Michalski, autorstvo = 100%], Journal of Economic Computation and Economic Cybernetics Studies and Research 6, ISSN: X, vol 43 nr 4/2009, p [7] Effectiveness of investments in operating Cash, [G. Michalski, autorstvo = 100%], Journal of Corporate Treasury Management, ISSN: , vol. 3, iss. 1, December 2009, p Grzegorz Michalski PhD Wroclaw University of Economics ul. Komandorska 118/120, p.z-2, KFPiZW PL Wroclaw, Poland & Academy of Management and Administration in Opole ul. Niedziałkowskiego 18, Opole, Poland Grzegorz.Michalski@ue.wroc.pl ABSTRACT The firm choosing between various solutions in liquid assets needs to decide what level of risk is acceptable for her owners and capital suppliers. That choice results with financing consequences, especially in cost level. In this unifying commentary, we consider that relation between risk and expected benefits from the liquid assets decision and its results on financing costs for the firm. KEY WORDS: liquidity value, short-run financial management, financial liquidity, liquid assets, working capital JEL CLASSIFICATION: G31, L31, M21 1 Czasopismo z listy: Journal Citation Reports/Thomson Reuters MASTER JOURNAL LIST: Science Citation Index Expanded oraz Social Sciences Citation Index (źródło: ) 2 Czasopismo z listy: Journal Citation Reports/Thomson Reuters MASTER JOURNAL LIST: Science Citation Index Expanded oraz Social Sciences Citation Index (źródło: ) 3 Czasopismo z listy: Journal Citation Reports/indeksowane przez Thomson Reuters MASTER JOURNAL LIST: Social Sciences Citation Index (źródło: ) 4 Czasopismo z listy: Journal Citation Reports/indeksowane przez Thomson Reuters MASTER JOURNAL LIST: Social Sciences Citation Index (źródło: ) 5 Czasopismo z listy: Journal Citation Reports/indeksowane przez Thomson Reuters MASTER JOURNAL LIST: Social Sciences Citation Index (źródło: ) 6 Czasopismo z listy: Journal Citation Reports/Thomson Reuters MASTER JOURNAL LIST: Science Citation Index Expanded oraz Social Sciences Citation Index (źródło: ) str. 1

2 INTRODUCTION Financing of the liquid assets has its cost depending on risk linked with liquid assets strategies used by the financed firm. If we have higher risk, we will have higher cost of financing (cost of capital) and as result other firm value growth. There are no free lunches. Cost of financing of liquid assets depends on kind of financing, next on level of liquid assets in relation to sales and last but not least management risk sensitivity. According to kind of financing we have three strategies: - aggressive strategy with the most risky but the cheapest, mainly short-term financing, - compromise strategy with compromise between risk and costs of financing and - conservative strategy with the most expensive long-term financing and with the smallest level of risk. Choosing between various levels of liquid assets in relation to sales, we use one from three strategies: - restrictive strategy when management use the most risky but the cheapest, the smallest as possible, level of liquid assets, - moderate strategy when management moderate between risk and costs of holding liquid assets, and - flexible strategy when management use the most expensive and rather high levels of liquid assets wanting to hedge the firm before risk of shortage of liquid assets. Risk sensitivity depends on position of the firm in its business branch. If the risk sensitivity should be higher, then more smart is to choose more flexible and more conservative solutions to have better results. It works in opposite direction also, the safe firms with near to monopoly positions can use more restrictive and more aggressive strategies to have better results. Company s property consists of total assets, i.e. fixed assets and current assets known also as liquid assets. We can see that property as fixed capital and liquid assets also. Generally liquid assets equal to current assets is defined as a sum of inventory, short term receivables (including all the accounts receivable for deliveries and services regardless of the maturity date) and short-term investments (cash and its equivalents) as well as shortterm prepaid expenses [Mueller 1953; Graber 1948; Khoury 1999; Cote 1999]. Money tied in liquid assets serve enterprise as protection against risk [Merton 1999, p. 506; Lofthouse 2005; p ; Parrino 2008, p , Poteshman 2005, s ] but that money also are considered as an investment. It is because the firm resigns from instant utilization of resources for future benefits [Levy 1999, p. 6; Reilly 1992, p. 6; Fabozzi 1999, p. 214]. In that paper the terms: current assets and liquid assets are treated as approximately equivalent and interchangeable [Michalski 2004]. Liquid assets level is the effect of processes linked to the production organization or services realization. So, it results from the processes that are operational by nature and therefore correspond to the willingness to produce on time products and services that are probably desired by customers [Baumol 1952, Beck 2005, Beranek 1963, Emery 1988, Gallinger 1986, Holmstrom 2001, Kim 1998, Kim 1978, Lyn 1996, Tobin 1958, Stone 1972, Miller 1966, Miller 1996, Myers 1998, Opler 1999, Rutkowski 2000]. It exerts influence mainly on the inventory level and belongs to the area of interest of operational management [Peterson 1979, s ; Orlicky 1975, s.17-19; Plossl 1985, s ]. Nevertheless, current assets are also the result of active customer winning and maintaining policy [Bougheas 2009]. Such policy is executed by finding an offer and a specific market where the product or service is sold. This policy consequences are reflected in the final products inventory level and accounts receivable in short term. Among the motivating factors for investing in current assets, one may also mention uncertainty and risk. Due to uncertainty and risk, it is necessary to stock up circumspect (cautionary) cash, material and resources reserves that are inevitable in maintaining the continuity of production and producing final goods. Many firms act in a fast changing environment where the prices of needed materials and resources are subject to constant change. Other factors like exchange rates for instance, are very changeable, too. It justifies keeping additional cash sources allotted for realization of built-in call options (American type) by buying the raw materials more cheap than the long term expected equilibrium price would suggest. Company s relationships with suppliers of materials, resources and services that are necessary to produce and sell final products usually result in adjourning the payments. Such situation creates Accounts payable and employees (who are to some extent internal services providers). Similarly, enterprise charged with obligatory payments will eventually face tax burdens. We will call both categories of obligations the non financial current obligations in order to differentiate between them and current obligations that result from taking on financial obligations, e.g. short term debt. Required payments postponement exerts impact on reducing the demand for these company s resources that are engaged in current asset financing. Current assets reduced by non financial current obligations (non financial short term obligations) are called net current assets. Net current assets are the resources invested by the company in current assets equated with the capital tied in these assets. str. 2

3 LIQUID ASSETS FINANCING STRATEGIES AND COST OF FINANCING Net current assets (as a synonym for net liquid assets), i.e. current assets reduced by non financial current liabilities, are the sources tied by the firm during its realization of operational cycle. If it is required by the character of business, sources tied in liquid assets may be quite huge sums. This paper aims at analyzing the influence of investment in net liquid assets on enterprise value represented by a sum of future free cash flows discounted by the cost of financing the enterprise and next reflecting on the difference between investments in net current assets and operational investments in fixed assets in terms of their effects on enterprise value growth. Current assets investment strategies are the set of criteria and specific code of conduct revolved around attaining multiplication of owners wealth. Company s management implement such strategies into practice while making the crucial decisions concerning obtaining sources for financing current and future needs and defining ways and directions of utilization of these sources, taking into consideration at the same time: opportunities, limitations and business environment that are known to the board today. The same set of strategies come in consequence of market conditions and personal inclinations of the board members who are representatives of the owners (first of all their attitude to risk). Based on this attitude, the board defines appropriate structure of current assets and financing sources. It is possible to apply one of the three liquid assets financing strategies (or their variations): aggressive, compromise or conservative. Aggressive strategy consists in the significant part of the enterprise fixed demand and the whole enterprise variable demand on liquidity-linked financing sources coming from short term financing. Figure 1. Aggressive liquid assets financing strategy The Compromise version of liquid assets financing strategy aims at adjusting the needed financing period to the duration of period for which the enterprise needs these assets. As a result, the fixed share of current assets financing is based on long term capital. However, the variable share is financed by short term capital. Figure 2. Compromise liquid assets financing strategy The conservative liquid assets financing strategy leads to the situation where both the fixed and the variable level of current assets is maintained on the basis of long term financing. str. 3

4 Figure 3. Conservative liquid assets financing strategy LIQUID ASSETS FINANCING STRATEGY TO RISK RELATION There is a relationship between the three above mentioned approaches based on the relation between expected benefit and risk (fig. 4). In case of capital providers for companies that have introduced this specific strategy it is usually linked with diversified claims to the rate of return from the amount of capital invested in the firm. Figure 4. Diversified levels of expected benefits connected with different liquid assets financing strategies. Where: Cns conservative strategy, Cmp Compromise strategy, Agr aggressive strategy, b base situation, o situation better than expected, p situation worse than expected. Source: Author s study. The connection of these claims with the chosen way of financing may be insignificant (as it is shown on figure 5 or in variant 1 of the example beneath). Nevertheless, it also might be important to such a considerable degree that it will have an effect on the choice of strategy (figures 6 and 7). Example. XYZ board of directors is pondering over the choice of current assets financing strategy. What is the best strategy provided that the aim of the management board is to minimize cost of financing liquid assets and maximize enterprise value? Equity/engaged capital ratio is 40% {E/(E+D) = 40%}. Anticipated annual sales revenues (CR) are Forecasted earnings before interest and taxes (EBIT) for XYZ will amount to about 50% of sales revenues (CR). Fixed assets (FA) will be going for around 1400, current assets (CA) will be constituting almost 30% of forecasted sales revenues (CR), property renewing will be close to its use (NCE = CAPEX), and changes in relations of net liquid assets constituents will be close to zero and might be omitted (ΔNWC = 0). The company may implement one of the three liquid assets financing strategies: the conservative one with such a relation of str. 4

5 long run debt to short run debt that (D s /D l = 0,1), Compromise one (D s /(D l ) = 1) or the aggressive one (D s /(D l ) = 2). Accounts payable will be equal to 50% of current assets. It is necessary to consider the influence of each strategy on the cost of enterprise financing capital rate and on enterprise value. In the first variant, one must assume that capital providers seriously consider while defining their claims to rates of return the liquid assets financing strategy chosen by the company they invested in. Let us also assume that the correction factor CZ function graph connected with strategy choice is even and linear (fig. 5). Fig. 5. The shape of correction factor CZ line as a function of D s /D l. Source: Author s study. CZ1 variant. We assume here that capital providers take into consideration the company s liquid assets financing strategy while defining their claims as regards the rates of return. Of course, aggressive strategy is perceived as more risky and therefore depending on investors risk sensitivity level, they tend to ascribe to the financed company applying aggressive strategy an additional expected risk premium. To put it simply, let us assume that ascribing the additional risk premium for applied liquid assets financing strategy is reflected in the value of β coefficient. For each strategy, the β coefficient will be corrected by the corrective coefficient CZ corresponding to that specific strategy in relation to the situation D k /D d = 0. XYZ risk premium will amount to 9% (1+CZ) in relation of equity to foreign long term capital and 12% (1+CZ) in relation of equity to short term debt level. Risk free rate is 4%, rate of return on market portfolio is 18%. If Our company is a representative of A sector for which the non-leveraged risk coefficient β u = On the basis of Hamada relation, we can estimate the equity cost rate that is financing that enterprise in case of each of the three strategies in the first variant. Where: T effective tax rate, D enterprise financing capital coming from creditors (D s +D l ), E enterprise financing capital coming from owners, β risk coefficient, β u risk coefficient linked with assets maintained by the firm (for an enterprise that has not applied the system of financing by creditors capital), β l risk coefficient for an enterprise that applying the system of financing by creditors capital (both the financial and operational risks are included). For aggressive strategy (CZ = 0.2): Where: CZ risk premium correction factor dependent on the net liquid assets financing strategy For compromise strategy (CZ = 0.1): For conservative strategy (CZ = 0.01): Thanks to that information, we can calculate cost of equity rates for every variant. str. 5

6 Where: k rate of return expected by capital donors and at the same time (from company s perspective) enterprise cost of financing capital rate, k e for capital coming from owners (cost of equity rate), k m for average rate of return on typical investment on the market, k RF for risk free rate of return whose approximation is an average profitability of Treasury bills in the country where the investment is made. Hence, since the risk premium for XYZ accounts for 9% (1+CZ) in relation of equity to foreign long term capital, we can get long term debt cost rate: Where: k dl for capital coming from long term creditors, And consequently for short term: Where: k ds for capital coming from short term creditors, As a result, cost of capital rate will amount to: However, for each strategy, this cost rate will be on another level (calculations in the table below). Table 1. Cost of capital and changes in enterprise value depending on the choice of strategy: Aggressive Compromise Conservative Sales revenues (CR) Fixed assets (FA) Current assets (CA) Total assets (TA) = Total liabilities (TL) (AP) Engaged capital (E+D) Equity (E) Long term debt (D l ) Short term debt (D s ) Earnings before interest and taxes (EBIT) Net operational profit after taxation (NOPAT) Free cash flows from 1 to n period (FCF 1..n ) Free cash flows in 0 (FCF o ) Risk premium correction factor CZ Risk coefficient β l Equity cost (k e ) 24% 22.3% 20.8% Cost of long term debt (k dl ) 13.2% 12.4% 11.7% Cost of short term debt (k ds ) 9.6% 9.1% 8.7% Cost of capital financing enterprise (CC) 14.8% 14.2% 13.9% Enterprise value growth ( V) Source: Author s study str. 6

7 As it is shown in the table, cost of enterprise financing capital rates are different for different approaches to liquid assets financing. The lowest rate is observed in conservative strategy. What results in the highest expected growth of enterprises value: In the CZ2 variant, we will also assume that capital providers while defining their claims to rates of return take into consideration the company s liquid assets financing strategy to a lesser extent. Obviously, the aggressive strategy is perceived as more risky and therefore, depending on their risk sensitivity, they tend to ascribe an additional risk premium for an enterprise that implemented this type of strategy. Fig. 6. Correction line depending on the D s /D l relation in the second variant Source: Author s study. For conservative strategy, XYZ risk premium is equal to 9% (1+CZ) in relation of equity to long term debt and 12% (1+CZ) in relation of equity to short term debt. Risk free rate of return is 4%, rate of return on market portfolio is 18%. Our company is a representative of a sector for which non-leveraged risk coefficient β u = On the basis of Hamada relation, we may estimate the cost rate of equity financing this enterprise in case of each of the three strategies. We are given all necessary information to assess cost of enterprise financing capital rate for the firm applying the given type of liquid assets financing strategy. For each strategy the cost rate CC will be on another level (calculations in the table below). Table 2. Cost of capital and changes in enterprise value depending on the choice of strategy in variant CZ2 Aggressive Compromise Conservative Sales revenues (CR) Fixed assets (FA) Current assets (CA) Total assets (TA) = Total liabilities (TL) Accounts payable (AP) Engaged capital (E+D) Equity (E) Long term debt (D l ) Short term debt (D s ) Earnings before interest and taxes (EBIT) Net operational profit after taxation (NOPAT) Free cash flows from 1 to n (FCF 1..n ) Free cash flows in 0 (FCF o ) str. 7

8 Risk premium correction CZ Risk coefficient β l Equity cost (k e ) 21% 20.8% 20.7% Long term debt cost (k dl ) 11.8% 11.7% 11.7% Short term debt cost (k ds ) 8.8% 8.7% 8.7% Capital cost of capital financing the enterprise (CC) 13.15% 13.30% 13.81% Enterprise value growth ( V) Source: Author s study. As it is shown in table 2, taking into consideration the risk premium resulting from implementation of a certain liquid assets financing strategy has an additional impact on the enterprise financing capital. Enterprise financing capital cost rates are different for different approaches to liquid assets financing. In this variant, the lowest level is observed in aggressive strategy. As a consequence, the highest enterprise value growth is characteristic for this type of strategy. In the third CZ3 variant, we also assume that capital providers to a lesser extent consider while defining their claims to rates of return the liquid assets financing strategy chosen by the company they invested in. Fig. 7. Correction line depending on the D k /D d relation in the CZ3 variant Source: Author s study. For conservative strategy, XYZ risk premium amounts to 9% (1+CZ) in relation of equity to long term debt level and 12% (1+CZ) in relation of equity to short term debt. Risk free rate is 4%, rate of return on market portfolio is 18%. Our company is a representative of sector W for which non-leveraged risk coefficient β u = On the basis of Hamada relation we may estimate enterprise financing equity cost rate in case of each of the three strategies. We have all necessary information to assess the enterprise financing capital cost for the firm applying the given type of liquid assets financing strategy. For each strategy, capital cost rate will be on another level (calculations in Table 3). Table 3. Cost of capital and changes in enterprise value depending on the choice of strategy in the CZ3 variant Agressive Compromise Consevative Sales revenues (CR) Fixed assets (FA) Current assets (CA) Total assets (TA) = Total liabilities (TL) Accounts payable (AP) Engaged capital (E+D) Equity (E) str. 8

9 Long term debt (D l ) Short term debt (D s ) Earnings before interest and taxes (EBIT) Net operational profit after taxation (NOPAT) Free cash flows from 1 to n (FCF 1..n ) Free cash flows from 0 (FCF o ) Risk premium correction CZ Risk coefficient β l Equity cost (k e ) 22% 21.3% 20.7% Lon term debt cost (k dl ) 12.3% 12% 11.7% Short term debt cost (k ds ) 9% 8.9% 8.7% Enterprise financing capital cost (CC) 13.7% 13.6% 13.8% Enterprise value growth ( V) Source: Author s study. As it is shown in table 3, taking into consideration the risk premium resulting from implementation of a certain liquid assets financing strategy has an additional impact on the enterprise financing capital. Enterprise financing capital cost rates are different for different approaches to liquid assets financing. In this variant, the lowest level is observed in aggressive strategy. As a consequence, the highest enterprise value growth is characteristic for this type of strategy. LIQUID ASSETS INVESTMENT STRATEGIES AND COST OF FINANCING Next it is necessary to consider the influence of each strategy of investment in the liquid assets on the rate of cost of capital financing enterprise and that influence on the enterprise value. In the first variant, one must assume that capital providers seriously consider while defining their claims to rates of return the liquid assets investment strategy chosen by the company they invested in. Let us also assume that the correction SZ function graph connected with strategy choice could be even and linear (fig. 8). Fig. 8. The shape of line of correction SZ as a function of CA/CR in the SZ1 variant. Source: Author s study. SZ1 variant. We assume here that capital providers take into consideration the company s liquid assets investment strategy while defining their claims as regards the rates of return. Of course, restrictive strategy is perceived as more risky and therefore depending on investors risk sensitivity level, they tend to ascribe to the financed company applying restrictive strategy an additional expected risk premium. To put it simply, let us assume that ascribing the additional risk premium for applied liquid assets investment strategy is reflected in the value of β risk coefficient. For each strategy, the β risk coefficient will be corrected by the corrective coefficient SZ corresponding to that specific strategy in relation to the CA/CR situation. str. 9

10 The risk free rate is 4%, and rate of return on market portfolio is 18%. If Our company is a representative of A sector for which the non-leveraged risk coefficient β u = On the basis of Hamada relation, we can estimate the equity cost rate that is financing that enterprise in case of each of the three strategies in the SZ1 variant. Where: T effective tax rate, D enterprise financing capital coming from creditors (a sum of short term debt and long term debt D=D s +D l ), E enterprise financing capital coming from owners of the firm, β risk coefficient, β u risk coefficient for an assets of the enterprise that not use debt, β l risk coefficient for an enterprise that applying the system of financing by creditors capital (here we have both asset and financial risk). For restrictive strategy, where CA/CR is 0.3; the SZ risk premium is 0.2: Where: SZ risk premium correction dependent on the liquid assets investment strategy. For moderate strategy, where CA/CR is 0.45 the SZ risk premium is 0.1: For flexible strategy, where CA/CR is 0.6 the SZ risk premium is 0.01: Using that information we can calculate cost of equity rates for each liquid assets investment strategy. For restrictive strategy: ; For moderate strategy: ; And for flexible strategy: Where: k rate of return expected by capital donors and at the same time (from company s perspective) enterprise cost of financing capital rate, k e for cost rate of the equity, k dl for long term debt rate, k ds for short term debt rate, k m for average rate of return on typical investment on the market, k RF for risk free rate of return whose approximation is an average profitability of treasury bills in the country where the investment is made.. In similar way, we can calculate the risk premiums for XYZ alternative rates. We know that long term debt rates differ for 9% (1+SZ) in relation of equity to long term debt. From that we can get long term debt cost rates for each alternative strategy. For restrictive strategy: ; For moderate strategy: ; And for flexible strategy:. str. 10

11 Next we can calculate the risk premiums for XYZ alternative cost of short term rates. We know that short term debt rates differ for 12% (1+SZ) in relation of cost of equity rates to short term debt rates. From that we can get short term debt cost rates for each alternative strategy. For restrictive strategy: ; For moderate strategy: ; And for flexible strategy:. As a result, cost of capital rate will amount to: However, for each strategy this cost rate will be on another level (calculations in the table 4. below). Table 4. Cost of capital and changes in enterprise value depending on the choice of liquid assets investment strategy. Liquid assets investment strategy Restrictive Moderate Flexible Cash Revenues (CR) ,4 Fixed assets (FA) Current assets (CA) Total assets (TA) = Total liabilities (TL) Accounts payable (AP) Capital invested (E+D l +D s ) Equity (E) Long-term debt (D l ) Short-term debt (D s ) EBIT share in CR Earnings before interests and taxes (EBIT) Net operating profit after taxes (NOPAT) Free Cash Flows in 1 to n periods (FCF 1..n ) Initial Free Cash Flows in year 0 (FCF o ) SZ risk Premium correction Leveraged and corrected risk coefficient β l Cost of equity rate (k e ) 24% 22.3% 20.8% Long-term debt rate (k dl ) 13.2% 12.4% 11.7% Short-term debt rate (k ds ) 9.6% 9.1% 8.7% Cost of capital (CC) 14.8% 13.9% 13.1% Firm value growth ( V) Source: Author s study str. 11

12 As it is shown in the table, rates of the cost of capital financing the firm are different for different approaches to liquid assets investment. The lowest rate: CC = 13.1%; is observed in flexible strategy because that strategy is linked with the smallest level of risk but the highest firm value growth is linked with restrictive strategy of investment in net liquid assets. Cost of capital for restrictive strategy of investment in working capital: Expected growth of enterprise value for that strategy:. Cost of capital for moderate strategy of investment in working capital: ; Expected growth of enterprise value for that strategy: ; Cost of capital for flexible strategy of investment in working capital: ; Expected growth of enterprise value for flexible strategy:. In the next, SZ2 variant, we will also assume that capital providers while defining their claims to rates of return take into consideration the company s net working investment strategy to a lesser extent. Obviously, the restrictive strategy is perceived as more risky than moderate and flexible. Depending on their risk sensitivity, they tend to ascribe an additional risk premium for an enterprise that implemented this type of strategy. As presented on fig. 9., investors in SZ2 variant, have stronger risk sensitivity than in SZ1 situation. Fig. 9. The shape of line of correction SZ as a function of CA/CR in the SZ2 variant. Source: Author s study. str. 12

13 In the table 5. There are calculations for variant SZ2. For each strategy the cost of capital rate CC will be on another level. Table 5. Cost of capital and changes in enterprise value depending on the choice of strategy of investment in liquid assets in variant SZ2. Liquid assets investment strategy Restrictive Moderate Flexible Cash Revenues (CR) Fixed assets (FA) Current assets (CA) Total assets (TA) = Total liabilities (TL) Accounts payable (AP) Capital invested (E+D l +D s ) Equity (E) Long-term debt (D l ) Short-term debt (D s ) EBIT share in CR Earnings before interests and taxes (EBIT) Net operating profit after taxes (NOPAT) Free Cash Flows in 1 to n periods (FCF 1..n ) Initial Free Cash Flows in year 0 (FCF o ) SZ risk Premium correction Leveraged and corrected risk coefficient β l Cost of equity rate (k e ) 54% 22.3% 20.7% Long-term debt rate (k dl ) 27% 12.4% 11. 7% Short-term debt rate (k ds ) 18% 9.1% 8.7% Cost of capital (CC) 31.8% 13.9% 13% Firm value growth ( V) Source: Author s study. As it is shown in table 5, taking into consideration the risk premium resulting from implementation of a certain liquid assets strategy has an additional impact on the enterprise financing capital and its rate. Enterprise financing capital cost rates are different for different approaches to liquid assets investment. In this variant SZ2, similarly as to the variant SZ1 presented in table 4., the lowest level of cost of capital is observed in flexible strategy. But, the highest enterprise value growth is characteristic for moderate strategy. In the third, SZ3 variant. The restrictive and moderate strategies are more risky than flexible. Depending on their risk sensitivity, they tend to ascribe an additional risk premium for an enterprise that implemented this type of strategy. As presented on fig. 10., investors in SZ3 variant, have stronger risk sensitivity than in SZ1 and SZ2 situations. str. 13

14 Fig. 10. The shape of line of correction SZ as a function of CA/CR in the SZ3 variant. Source: Author s study. In the table 6. There are calculations for variant SZ3. For each strategy the cost of capital rate CC will be on another level. Table 6. Cost of capital and changes in enterprise value depending on the choice of strategy of investment in liquid assets in the SZ3 variant. Liquid assets investment strategy Restrictive Moderate Flexible Cash Revenues (CR) Fixed assets (FA) Current assets (CA) Total assets (TA) = Total liabilities (TL) Accounts payable (AP) Capital invested (E+D l +D s ) Equity (E) Long-term debt (D l ) Short-term debt (D s ) EBIT share in CR Earnings before interests and taxes (EBIT) Net operating profit after taxes (NOPAT) Free Cash Flows in 1 to n periods (FCF 1..n ) Initial Free Cash Flows in year 0 (FCF o ) SZ risk Premium correction Leveraged and corrected risk coefficient β l Cost of equity rate (k e ) 154% 27.3% 20.7% Long-term debt rate (k dl ) 73% 14.7% 11.7% Short-term debt rate (k ds ) 46% 10.5% 8.7% Cost of capital (CC) 88% 16.7% 13% Firm value growth ( V) Source: Author s study. As it is shown in table 6, taking into consideration the risk premium resulting from implementation of a certain liquid assets investment strategy has an additional impact on the cost of capital. Enterprise financing capital cost rates are different for different approaches to liquid assets investment strategy. In this SZ3 variant, the lowest level of the cost of capital is observed in flexible strategy. But as a consequence, the highest enterprise value growth is characteristic also for this type of strategy, what is differ to results from variants SZ1 and SZ2. Here str. 14

15 we have the highest level of risk sensitivity and as consequence the firm management wanting to maximize the firm value need to prefer more safe solution like flexible strategy. LIQUID ASSETS INVESTMENT-FINANCING STRATEGIES AND COST OF FINANCING Last part of our consideration is influence of each liquid assets strategy both from investment and financing perspective and their influence on cost of financing and that influence on the enterprise value. SZCZ1 variant. In the first SZCZ1 variant, capital suppliers risk sensitivity is on the smallest level. That situation is presented in table 7. Table 7. Cost of capital and changes in enterprise value depending on the choice of liquid assets investment and financing strategies. Liquid assets investment and financing strategy Restrictive- Aggresive Restrictive- Conservative Flexible- Aggressive Flexible- Conservati ve Cash Revenues (CR) Fixed assets (FA) Current assets (CA) Total assets (TA) = Total liabilities (TL) Accounts payable (AP) Capital invested (E+D l +D s ) Equity (E) Long-term debt (D l ) Short-term debt (D s ) EBIT share in CR Earnings before interests and taxes (EBIT) Net operating profit after taxes (NOPAT) Free Cash Flows in 1 to n periods (FCF 1..n ) Initial Free Cash Flows in year 0 (FCF o ) CZ+SZ risk Premium correction Leveraged and corrected risk coefficient β l Cost of equity rate (k e ) 25.4% 24% 24% 20.9% Long-term debt rate (k dl ) 13.8% 13.2% 13.2% 11.8% Short-term debt rate (k ds ) 10% 9.6% 9.6% 8.7% Cost of capital (CC) 15.6% 15.9% 14.8% 14% Firm value growth ( V) Source: Author s study As it is shown in the table 7, rates of the cost of capital financing the firm are different for different approaches to liquid assets investment. The lowest rate: CC = 14%; is observed in flexible-conservative strategy because that strategy is linked with the smallest level of risk but the highest firm value growth is linked with restrictiveaggressive strategy because in variant CZSZ1 we have the firm with the smallest level of risk sensitivity. In the next, CZSZ2 variant, capital suppliers risk sensitivity is on the moderate level. That situation is presented in table 8. Table 8. Cost of capital and changes in enterprise value depending on the choice of liquid assets investment and financing strategies. str. 15

16 Liquid assets investment and financing strategy Restrictive- Aggresive Restrictive- Conservative Flexible- Aggressi ve Cash Revenues (CR) Fixed assets (FA) Current assets (CA) Total assets (TA) = Total liabilities (TL) Accounts payable (AP) Capital invested (E+D l +D s ) Equity (E) Long-term debt (D l ) Short-term debt (D s ) EBIT share in CR Earnings before interests and taxes (EBIT) Net operating profit after taxes (NOPAT) Free Cash Flows in 1 to n periods (FCF 1..n ) Initial Free Cash Flows in year 0 (FCF o ) Flexible- Conservative CZ+SZ risk premium correction Leveraged and corrected risk coefficient β l Cost of equity rate (k e ) 54% 54% 21% 20.7% Long-term debt rate (k dl ) 27% 27% 11.8% 11.7% Short-term debt rate (k ds ) 18% 18% 8.8% 8.7% Cost of capital (CC) 31.8% 34.3% 13.2% 13.8% Firm value growth ( V) Source: Author s study. As it is shown in the table 8, rates of the cost of capital financing the firm are different for different approaches to liquid assets investment. The lowest rate: CC = 13.2%; is observed in flexible-aggressive strategy because that strategy is linked with the smallest level of risk and highest level of cheaper short term debt also the highest firm value growth is linked with flexible-aggressive strategy because in variant CZSZ2 we have the firm with the moderate level of risk sensitivity so previously noted as better restrictive-aggressive is here too risky. In the third, CZSZ3 variant. In the first SZCZ1 variant, capital suppliers risk sensitivity is on the smallest level. That situation is presented in table 9. Table 9. Cost of capital and changes in enterprise value depending on the choice of liquid assets investment and financing strategies. Liquid assets investment and financing strategy Restrictive- Aggresive Restrictive- Conservative Flexible- Aggressi ve Cash Revenues (CR) Fixed assets (FA) Current assets (CA) Total assets (TA) = Total liabilities (TL) Accounts payable (AP) Flexible- Conservative str. 16

17 Capital invested (E+D l +D s ) Equity (E) Long-term debt (D l ) Short-term debt (D s ) EBIT share in CR Earnings before interests and taxes (EBIT) Net operating profit after taxes (NOPAT) Free Cash Flows in 1 to n periods (FCF 1..n ) Initial Free Cash Flows in year 0 (FCF o ) SZ risk Premium correction Leveraged and corrected risk coefficient β l Cost of equity rate (k e ) 154% 154% 22% 20.8 % Long-term debt rate (k dl ) 73% 73% 12.3% 11.7% Short-term debt rate (k ds ) 46% 46% 9% 8.7% Cost of capital (CC) 88% 96% 13.7% 13.9% Firm value growth ( V) Source: Author s study. As it is shown in the table 9, rates of the cost of capital financing the firm are different for different approaches to liquid assets investment. The lowest rate: CC = 13.7%; is observed in flexible-aggressive strategy because that strategy is linked with the smallest level of risk and highest level of cheaper short term debt also the highest firm value growth is linked with flexible-aggressive strategy because in variant CZSZ3 we have the firm with the moderate level of risk sensitivity so previously noted as better restrictive-aggressive is here too risky. SUMMARY AND CONCLUSIONS Depending on the business type that the given enterprise is doing, sensibility to liquid assets financing method risk might vary a lot. Character of business also determines the best strategy that should be chosen whether it will be the conservative strategy (situation closer to the first variant) or aggressive one (situation closer to the first variant) or maybe some of the transitional variants similar to the Compromise strategy. The best choice is that with the adequate cost of financing and highest enterprise value growth. This depends on the structure of financing costs. The lower the financing cost, the higher effectiveness of enterprises activity measured by the growth of its value. The firm choosing between various solutions in liquid assets needs to decide what level of risk is acceptable for her owners and capital suppliers. It was shown in solutions presented in that paper. If the risk sensitivity is higher, will be preferred more safe solution. That choice results with cost of financing consequences. In this paper, we considered that relation between risk and expected benefits from the liquid assets decision and its results on financing costs for the firm. REFERENCES: Baumol W.J., The Transactions Demand for Cash: An Inventory Theoretic Approach, Quarterly Journal of Economics, nr 66, listopad 1952, s Beck S.E., D.R. Stockman, Money as Real Options in a Cash-in-Advance Economy, Economics Letters, 2005, vol. 87, s Beranek W., Analysis for Financial Decisions, R. D. IRWIN, Homewood Bougheas S., Mateut S., Mizen, P., Corporate trade credit and inventories: New evidence of a trade-off from accounts payable and receivable, Journal of Banking & Finance, vol. 33, no. 2, 2009, s Cote J.M., C.K. Latham, The Merchandising Ratio: A Comprehensive Measure of Liquid assets Strategy, Issues in Accounting Education, vol. 14, no. 2, May 1999, s Emery G.W., Positive Theories of Trade Credit, Advances in Liquid assets Management, JAI Press, vol. 1, 1988, s Fabozzi F.J., Investment Management, Prentice Hall, Upper Saddle River Gallinger G., A. J. Ifflander, Monitoring Accounts Receivable Using Variance Analysis Financial Management, zima 1986, str. 17

18 Graber P.J., Assets, The Accounting Review, vol. 23, no. 1, Jan. 1948, s Holmstrom B., J. Tirole, LAPM: a liquidity-based asset pricing model, Journal of Finance, 2001, vol. 56, s {WP6673, National Bureau of Economic Research, Cambridge, 1998}. Khoury N.T., K.V. Smith, P.I. MacKay, Comparing Liquid assets Practices in Canada, the United States and Australia, Revue Canadienne des Sciences de l Administration, vol. 16, no. 1, Mar. 1999, s Kim C-S., D. C. Mauer, A. E. Sherman, The Determinants of Corporate Liquidity: Theory and Evidence, Journal of Financial and Quantitative Analysis, vol. 33, nr 3, Kim Y. H., J. C. Atkins, Evaluating Investments in Accounts Receivable: A Wealth Maximizing Framework, Journal of Finance, vol. 33, nr 2, 1978, s Levy H., D. Gunthorpe, Introduction do Investments, South-Western College Publishing, Cincinnati Lofthouse S., Investment Management, Wiley, Chichester Lyn E. O., G. J. Papaioannou, Liquidity and the Financing Policy of the Firm: an Empirical Test, Advances in Capital Management, Londyn 1996, vol. 3, s Merton R.C, A.F. Perold, Theory of Risk Capital in Financial Firms, w: D.H. Chew, The New Corporate Finance. Where Theory Meets Practice, McGraw-Hill, Boston Michalski G., Leksykon zarządzania finansami, C.H. Beck, Warszawa Miller M.H., D. Orr, A Model of the Demand for Money by Firms, Quarterly Journal of Economics, 1966, nr 80, s Miller T. W., B. K. Stone, The Value of Short-Term Cash Flow Forecasting Systems, Advances in Liquid assets Management, JAI Press Inc., Londyn 1996, vol. 3, s Mueller F.W., Corporate Liquid assets and Liquidity, The Journal of Business of the University of Chicago, vol. 26, no. 3, Jul. 1953, s Myers S. C., R. G. Rajan, The Paradox of Liquidity, Quarterly Journal of Economics 113, nr 3, Cambridge, 1998, s Opler T., R. Stulz, R. Williamson, The determinants and implications of corporate cash holdings, Journal of Financial Economics, vol. 52, no. 1, 1999, s Orlicky J., Material Requirements Planning, McGraw-Hill, New York Parrino R., D.S. Kidwell, Fundamentals of Corporate Finance, Wiley, New York Peterson R., E.A. Silver, Decision Systems for Inventory Management and Production Planning, Wiley, New York Plossl G.W., Production and Inventory Control, Principles and Techniques, Prentice Hall, Englewood Cliffs Poteshman A., R. Parrino, M. Weisbach, Measuring Investment Distortions when Risk-Averse Managers Decide Whether to Undertake Risky Project, Financial Management, vol. 34, Spring 2005, s Reilly F.K., Investments, The Dryden Press, Fort Worth Stone B. K., The Use of Forecasts and Smoothing in Control - Limit Models for Cash Management, Financial Management, 1972, s Tobin J., Liquidity Preference as Behavior Toward Risk, Review of Economic Studies, 1958 r. nr 25, s str. 18

19 ISI Web of Knowledge [v.4.10] - Web of Science 1 z :24 Sign In My EndNote Web My ResearcherID My Citation Alerts My Saved Searches Log Out Help DISCOVER the new Web of Knowledge now! > Search Cited Reference Search Advanced Search Search History Marked List (0) Web of Science with Conference Proceedings Record 1 of 1 Record from Web of Science Operational risk in current assets investment decisions: Portfolio management approach in accounts receivable more options Author(s): Michalski G (Michalski, G.) Source: AGRICULTURAL ECONOMICS-ZEMEDELSKA EKONOMIKA Volume: 54 Issue: 1 Pages: Published: 2008 Times Cited: 2 References: 14 Citation Map Abstract: The basic financial purpose of an enterprise is maximization of its value. Trade credit management should also contribute to the realization of this fundamental aim. Many of the current asset management models that are found in the financial management literature assume book profit maximization as the basic financial purpose. These book profit-based models could be lacking in what relates to another aim (i.e., maximization of the enterprise value). The enterprise value maximization strategy is executed with a focus on risk and uncertainty. This article presents the consequences that can result from operating risk that is related to purchasers using payment postponement for goods and/or services. The present article offers a method that uses the portfolio management theory to determine the level of accounts receivable in a firm. An increase in the level of accounts receivables in a firm increases both net working capital and the costs of holding and managing accounts receivables. Both of these decrease the value of the firm, but a liberal policy in accounts receivable coupled with the portfolio management approach could increase the value. Efforts to assign ways to manage these risks were also undertaken; among them, a special attention was paid to adapting the assumptions from the portfolio theory as well as gauging the potential effect on the firm value. Document Type: Article Language: English Author Keywords: accounts receivable; trade credit management; incremental analysis; value based management; portfolio analysis Cited by: 2 This article has been cited 2 times (from Web of Science). Spicka J, Boudny J, Janotova B The role of subsidies in managing the operating risk of agricultural enterprises AGRICULTURAL ECONOMICS-ZEMEDELSKA EKONOMIKA Aly S, Vrana I Evaluating the knowledge, relevance and experience of expert decision makers utilizing the Fuzzy-AHP AGRICULTURAL ECONOMICS-ZEMEDELSKA EKONOMIKA [ view all 2 citing articles ] Related Records: Find similar records based on shared references (from Web of Science). [ view related records ]

20 ISI Web of Knowledge [v.4.10] - Web of Science 2 z :24 Reprint Address: Michalski, G (reprint author), Wroclaw Univ Econ, Dept Corp Finance & Value Management, Ul Komandorska ,Pok 704-Z, PL Wroclaw, Poland Addresses: 1. Wroclaw Univ Econ, Dept Corp Finance & Value Management, PL Wroclaw, Poland Addresses: Grzegorz.Michalski@ae.wroc.pl Publisher: INST AGRICULTURAL FOOD INFORMATION, SLEZSKA 7, PRAGUE , CZECH REPUBLIC Subject Category: Agricultural Economics & Policy; Economics IDS Number: 271GT ISSN: X References: 14 View the bibliography of this record (from Web of Science). Additional information View the journal's impact factor (in Journal Citation Reports) Suggest a correction If you would like to improve the quality of this product by suggesting corrections, please fill out this form. Record 1 of 1 Record from Web of Science Output Record Step 1: Authors, Title, Source plus Abstract Full Record plus Cited Reference Step 2: [How do I export to bibliographic management software?] View in 简体中文 English 日本語 Please give us your feedback on using ISI Web of Knowledge. Acceptable Use Policy Copyright 2010 Thomson Reuters

21 Operational risk in current assets investment decisions: Portfolio management approach in accounts receivable Operační risk v rozhodování o běžných aktivech: management portfolia pohledávek G. MICHALSKI Wroclaw University of Economics, Wroclaw, Poland Abstract: The basic financial purpose of an enterprise is maximization of its value. Trade credit management should also contribute to the realization of this fundamental aim. Many of the current asset management models that are found in the financial management literature assume book profit maximization as the basic financial purpose. These book profit-based models could be lacking in what relates to another aim (i.e., maximization of the enterprise value). The enterprise value maximization strategy is executed with a focus on risk and uncertainty. This article presents the consequences that can result from operating risk that is related to purchasers using payment postponement for goods and/or services. The present article offers a method that uses the portfolio management theory to determine the level of accounts receivable in a firm. An increase in the level of accounts receivables in a firm increases both net working capital and the costs of holding and managing accounts receivables. Both of these decrease the value of the firm, but a liberal policy in accounts receivable coupled with the portfolio management approach could increase the value. Efforts to assign ways to manage these risks were also undertaken; among them, a special attention was paid to adapting the assumptions from the portfolio theory as well as gauging the potential effect on the firm value. Key words: accounts receivable, trade credit management, incremental analysis, value based management, portfolio analysis Abstrakt: Základním finančním cílem podniku je maximalizace jeho hodnoty. K uskutečnění tohoto cíle by měl přispět rovněž management obchodního úvěru. Mnoho modelů managementu běžných aktiv považuje za hlavní finanční cíl maximalizaci účetního zisku. Tyto modely, založené na účetním zisku, však postrádají další cíl (tedy maximalizaci hodnoty podniku). Strategie maximalizace hodnoty podniku je zaměřena na riziko a nejistotu. Příspěvěk je zaměřen na hodnocení důsledků vyplývajících z využití operačního rizika vzhledem k odložené platbě zákazníků za nákup zboží a/nebo služeb. V příspěvku je uvedena metoda využívající teorii managementu portfolia ke stanovení úrovně výše pohledávek v podniku. Tuto úroveň v podniku zvyšuje jak objem čistého provozního kapitálu, tak náklady na vytváření a řízení účtu pohledávek. Obě tyto veličiny snižují hodnotu podniku, současně však liberální přístup k účtu pohkedávek spolu s využitím managementu portfolia může tuto hodnotu zvýšit. V práci jsou zahrnuty také návrhy způsobů managementu těchto rizik. Specifická pozornost je věnována také měření jejich potenciálního faktu ve vztahu k hodnotě podniku. Klíčová slova: účet pohledávek, management obchodního úvěru, analýza přírůstku, hodnotový management, analýza portfolia The basic financial aim of an enterprise is maximization of its value. At the same time, both theoretical and practical meaning is researched for determinants that increase the enterprise value. Financial literature contains information about numerous factors that influence the enterprise value. Among those contributing factors is the extent of the net working capital and the elements shaping it, such as the level of cash tied up in accounts receivable, inventories, the early settlement of accounts payable, and operational cash balances. The greater part of the classic financial models and proposals relating to the optimum current assets management was constructed with net profit maximization in mind. This is the reason why these 12 AGRIC. ECON. CZECH, 54, 2008 (1): 12 19

22 models need reconstruction in order to make them suitable to firms that want to maximize their value. The decision to extend the trade credit terms is a compromise between limiting the risk of allowing for the payment postponement from unreliable purchasers and gaining new customers by the way of a more liberal enterprise trade credit policy. This decision shapes the level and quality of accounts receivable. The question discussed in this article concerns the possibility of using the portfolio theory in making decisions about selecting which customers should be given trade credit. In this article, we will show that it is possible that the firm can sell on trade credit terms to some customers, who previously were rejected because of a too great operational risk, with a positive outcome of the creation increased firm value. This extension of trade credit is possible only if the firm has purchasers from various branches, and if these branches have different levels of operating risk. The key to success for a firm is to perform the portfolio analysis with the result of a varied portfolio of customers with a spectrum of the managed levels of operating risk. VALUE BASED MANAGEMENT OF ACCOUNTS RECEIVABLE If holding accounts receivable on a level defined by the enterprise provides greater advantages than negative influence, the firm value will grow. Changes in the level of accounts receivable affect the value of the firm. To measure the effects that these changes produce, we use the following formula, which is based on the assumption that the firm present value is the sum of the future free cash flows to the firm (FCFF), discounted by the rate of the cost of capital financing the firm: = n FCFFt V p t (1) k ( ) t= where: V p = firm value growth FCFF t = future free cash flow growth in period t k = discount rate 1 The future free cash flow is expressed as: FCFF t = (CR t CE t NCE) (1 T) + + NCE Capex NWC t (2) where: CR t = cash revenues on sales CE t = cash expenses resulting from fixed and variable costs in time t NCE = non-cash expenses T = effective tax rate NWC = net working growth Capex = capital expenditure resulting from the growth of operational investments (money used by a firm to acquire or upgrade physical assets, such as property, industrial buildings, or equipment) Similar conclusions, related to the results of changes in trade credit policy on the firm value, can be estimated on the basis of economic value added, the extent to which residual profit (the added value) increased the value of the firm during the period: EVA = NOPAT k (NWC + OI) (3) where: EVA = economic value added NWC = net working capital OI = operating investments NOPAT = net operating profit after tax, estimated on the basis of the formula: NOPAT = (CR t CE t NCE) (1 T) (4) The net working capital (NWC) is the part of current assets that is financed with fixed capital. The net working capital (current assets less current liabilities) results from the lack of synchronization of the formal rising receipts and the real cash receipts from each sale. It is also caused by a divergence during the time of rising costs and the time when a firm pays its accounts payable. NWC = CA CL = AAR + INV + G AAP (5) where: NWC = net working cupital CA = current assets CL = current liabilities AAR = average level of accounts receivable INV = inventory G = cash and cash equivalents AAP = average level of accounts payable During the estimation of the free cash flows, the holding and increasing of net working capital ties up money used for financing net working capital. If net working capital increases, the firm must utilize and tie up more money, and this decreases free 1 To estimate the changes in accounts receivable levels, we accept the discount rate equal to the average weighted cost of capital (WACC). Such changes and their results are strategic and long term in their character, although they refer to accounts receivable and the short run area decisions (Maness 1998, s ). AGRIC. ECON. CZECH, 54, 2008 (1):

23 Influence on k Trade credit policy changes influence cost of capital Influence on Trade credit policy changes influence: costs NWC V = p n FCFF t t= 1 ( 1+ k) EVA = NOPAT k ( NWC + IO) t Influence on t Trade credit policy changes influence period of life of the enterprise Figure 1. The trade credit policy influence on firm value FCFF = free cash flows to firm; NWC = net working capital growth; k = cost of the capital financing the firm; t = the lifetime of the firm and time to generate single FCFF Source: own study cash flows. The production level growth necessitates increased levels of cash, inventories, and accounts receivable. Part of this growth will be covered with current liabilities that automatically grow with the growth of production and sales. The remaining cash requirements (that are noted as the net working capital growth, NWC) will require a different form of financing. The trade credit policy decisions changing the terms of trade credit create a new accounts receivable level. Consequently, the trade credit policy has an influence on firm value. This comes as a result of the alternative costs of money tied in accounts receivable and the general costs associated with managing accounts receivable. Both the first and the second involve modification of the future free cash flows and as a consequence, the firm value changes. In Figure 1, we show the influence of the trade credit policy changes on the firm value. These decisions change: future free cash flows (FCFF), life of the firm (t) and rate of the cost of capital financing the firm (k). Changes to these three components influence the creation of the firm value ( Vp). Accounts receivable changes (resulting from changes in the trade credit policy of the firm) affect the net working capital level and also the level of accounts receivable management operating costs in a firm; these operating costs are the result of the accounts receivable level monitoring and recovery charges). Trade credit terms give evidence about the firm trade credit policy. They are the parameters of trade credit and include: the maximum delay in payment by purchasers (trade credit period); the time the purchaser has to pay with a cash discount; the rate of the cash discount. The length of the cash discount period and the maximum delay in payment by purchasers give information about the character of the firm trade credit policy. These trade credit conditions are: ps/os, net ok (6) where: ps = cash discount rate os = cash discount period ok = maximum payment delay period. The terms of a trade credit sale are the result of the firm s management decision made on the basis of the information about factors such as: market competition, the kind of goods or services offered, seasonality and elasticity of demand, price, type of customer, and profit margin from sale. It is important to match the length of the trade credit of a firm to its customer s capabilities. The 14 AGRIC. ECON. CZECH, 54, 2008 (1): 12 19

24 enterprise giving the trade credit should take into account the purchasers inventory conversion cycle as well as its accounts receivable conversion cycle. These two elements make up the operating cycle of a purchaser. The shorter this cycle, the shorter should be the maximum payment delay period offered to the purchaser. The maximum payment delay period for the purchaser is the maximum expected period of accounts receivable cycle for the seller. In order to choose what terms of sale should be proposed to the purchaser, the firm management can use the incremental analysis as final criterion, as well as to compare the influence of these proposals on firm value. Incremental analysis is a tool for estimating the effects of changes in trade credit policy on the enterprise. This analysis usually takes into account three basic elements: (1) Estimation of the results of changes on sales as well as losses resulting from bad debts. (2) Estimation of the changes in the firm accounts receivable level. Accounts receivable growth we have as: AAR = ( ACP ACP ) 1 0 CR0 CR1 CR + VC ACP if CR 1 > CR 0 (7) AAR = ( ACP ACP ) 1 0 CR1 CR1 CR + VC ACP if CR 1 CR 0 where: AAR = accounts receivable growth ACP 0 = receivables collection period before trade credit policy change ACP 1 = receivables collection period after trade credit policy change CR 0 = cash revenue before trade credit policy change CR 1 = cash revenue after trade credit policy change VC = variable costs (in percent from sales incomes) (3) Estimation of the firm value change: EBIT = [(CR 1 CR 0 ) (1 VC) AAR (l 1 CR 1 l 0 CR 0 ) (sp 1 CR 1 w 1 sp 0 CR 0 w 0 )] (8) where: EBIT = earnings before interests and taxes growth k AAR = operating costs of accounts receivable management in a firm l 0 = bad debts loses before trade credit policy change l 1 = bad debts loses after trade credit policy change sp 0 = cash discount before trade credit policy change sp 1 = cash discount after trade credit policy change 0 0 w 0 w 1 = part of purchasers using cash discount before trade credit policy change = part of purchasers using cash discount after trade credit policy change To check how the changes in the accounts receivable level and EBIT influence on firm value, it is possible to use changes in future free cash flows. First we have changes in FCFF in time 0: FCFF 0 = NWC = AAR (9) Next the free cash flows to firm in periods (from 1 to n), as: FCFF 1 n = NOPAT = EBIT (1 T) (10) Example 1. An enterprise CR 0 = VC = 50% CR. Operating costs of accounts receivable management in a firm, k AAR = 20%. WACC = 15%. T = 19%. Before trade credit policy change, half of firm customers pay before delivery. 25% of them use 2% cash discount paying on the 10 th day. The remaining customers pay at the 30 th day. Bad debts losses 3% of CR. The trade credit policy changes (from 2/10, net 30 to 3/10, net 40) considered by firm will result: 40% of firm customers will pay before delivery. 30% of them use 3% cash discount paying on the 10 th day. The remaining customers pay at the 45 th day. Bad debts losses 4% of CR. New CR 1 = The effects of changes in trade credit policy would be felt for 3 years. Because 50% of sale before change of policy is done in cash, 25% on the principle of collected on the 30 th day, 25% on the principle of charge regulated up to the 10 th day, then the ACP 0 is: ACP 0 = = 10 days The ACP 1 after change is: ACP 1 = = 16.5 days That is why the expected increase of the average level of accounts receivable will be: AAR = ( ) = Therefore, in result of the trade credit policy change, the average state of accounts receivable will grow up for Next we have EBIT: AGRIC. ECON. CZECH, 54, 2008 (1):

25 EBIT = % (4% % ) (3% % 2% % = = Using equations nine and ten, we can estimate the firm value growth: V = = As we see, the trade credit policy change will increase the firm value. A similar information is given by estimation of EVA after trade policy change: EVA = % = = As one can see through the discussed case, the first half and then 40% of sales are realized on the principle of cash sale. This results from the fact that those customers who created sales only for cash did not fulfill the requirements relating the risks, which is considered as percentage of the delayed payments. Therefore, the firm stopped offering these purchasers sales on the principle of the trade credit. This was despite the fact that their financing with the trade credit made it possible to notice a much greater activity and larger level of income from sales, than at the trade credit relinquishment. PORTFOLIO THEORY APPROACH IN TRADE CREDIT DECISIONS A portfolio is a set of assets (for example, accounts receivable). The portfolio approach to accounts receivable management can be used by utilizing the rate of profit (rate of advantage from assets) as one of the basic criteria that the firm giving the trade credit should encourage the purchaser to consider when making decisions (Jajuga, Jajuga 1994, pp ). The profit rate resulting from the trade credit can be defined as: R nar where: R nar CR Costs = (11) Costs = profit rate from giving the trade credit to purchasers n CR = cash revenue growth generated from additional sale to n customers instead of the cash sale Costs = growth of costs resulting from offering the trade credit to purchaser n The present rate of profit is realized amid the conditions of risk and uncertainty. The rate of profit changes varies according to the various probabilities. These probabilities result from the customers marketable situations which influence their ability to regulate their accounts payable to the seller in an appropriate manner. The risk measure connected with the accounts receivable of a concrete purchaser varies according to the following equation: V = m i 1 2 p ( R R) (12) i i where: p i = based on historical data probability of R i R i = expected rate of return from accounts receivable from the group of purchasers i The measure of risk also can be defined according to standard deviation: s = V = m i 1 2 p ( R R) (13) i i Both the variation and the standard deviation can be estimated for the historical data of a purchaser. The next element is the correlation of profit from the trade credit given to the purchaser (or to the group of purchasers) in which the profits of the trade credit are given to other purchasers (or to different groups of purchasers). If the firm completes the transactions with more than one group of purchasers, it is possible to distinguish two or more homogeneous groups in relation to the risk and profit from giving the trade credit. In this case, the portfolio approach can be used. These groups can belong to definite trades 2, and a connection does or can exist between the accounts receivables of these groups of purchasers. The measure of such a connection is usually a coefficient of correlation: i = 1 m p ( R R ) ( R R ) i 1i 1 2i 2 i= = (14). s1 s2 where: ρ 1,2 = coefficient of first and second group of accounts receivable correlation R 1 = expected rate of return from accounts receivable of the first group of purchasers 2 In Polish business practice, purchasers coming from one trade group have similar payment because they serve the same market and have similar customers with similar payment habits. 16 AGRIC. ECON. CZECH, 54, 2008 (1): 12 19

26 R A B R 2 = expected rate of return from accounts receivable of the second group of purchasers s 1 = standard deviation for the first group s 2 = standard deviation for the second group R 1i = individual rate of return from accounts receivable of purchaser i from the first group of purchasers R 2i = individual rate of return from accounts receivable of purchaser i from the second group of purchasers p i = probability of individual rate of return from accounts receivable of purchaser i Figure 2. The profit - risk relation for portfolio of accounts receivable for two groups of purchasers if ρ A,B = 1 Source: own study on basis (Jajuga 1994) R A/B 1 Figure 3. The profit risk relation for portfolio of accounts receivable for two groups of purchasers if ρ A,B = ( 1) Source: own study on basis (Jajuga 1994) R A/B 3 A/B 4 A A/B 2 Figure 4. The profit - risk relation for portfolio of accounts receivable for two groups of purchasers if ρ A,B = 0 Source: own study on basis (Jajuga, Jajuga 1994) A B s s B s To show how the portfolio approach can be used in accounts receivable management, we will use the portfolio of two groups of accounts receivable as an example. Example 2. The firm cooperates with two homogenous groups of purchasers. The first group of purchasers delivers its services to industry A, the second group of purchasers serves customers from industry B. Creating a portfolio of two kinds of accounts receivable makes sense only when the correlation between profits from the giving trade credit for these groups is less than 1. Example 2, Case 1. Correlation coefficient between accounts receivable profits from Groups A and B equals 1, ρ A,B = 1. Figure 2 shows that there is no possibility of increasing profit from diversification without increasing risk if ρ A,B = 1 Example 2, Case 2. Coefficient of correlation equals ( 1), ρ A,B = ( 1) Perfect negative correlation. At Point A we offer trade credit only to Group A. At point B we offer trade credit to Group B. If we are following from Point A (and we are enlarging contribution of Group B in accounts receivable portfolio) to A/B 1, the risk s is decreasing and the profit R is increasing. As we see in Figure 3, it makes no sense to possess accounts receivable only from Group A. It is because with identical risk s, the portfolio A/B 2 offers higher profit R. Example 2, Case 3. Coefficient of correlation equals 0, ρ A,B = 0. It is a situation when benefits from giving trade credit to Group A and Group B are not related to each other in any way. In such situation, the only possible way is a partial reduction of risk. The reasonable firm should not choose any portfolio of charge lying on the A A/B 3 line, because it is always possible to find a more profitable equivalent on: A/B 3 A/B 4 line, which with the same risk s gives higher profit R. The skilful construction of two groups of accounts receivable portfolio 3 With admittance of taking both groups simultaneously on trade credit principles AGRIC. ECON. CZECH, 54, 2008 (1):

27 can lead to a considerable reduction of risk. The inclusion to single-asset portfolio second component almost always leads to risk decreasing, sometimes even with the simultaneous profit growth (Brigham 2004, p. 77; Jajuga, Jajuga 1994, p. 119; Jajuga et al. 1997; Jajuga 1993; Wait 2002; Fabozzi 2000; Jajuga, Jajuga 2002). Example 3 (continuation of example 1). After the historical data analysis had been achieved, firm managers noticed that the expected profits were higher and correlated negatively with profits generated from purchases by current customers. This was certainly from allowing trade credit to customers who had made cash purchases because of the high risk during the receivables collection period. These trends lead to the expectation 3 of a lower risk of profits from accounts receivable and growth in profits from sales in general at the same time. A 3% cash discount was proposed for customers who paid within 10 days along with an extension of the payment deadline to 45 days for any remaining customers. As a result, 4% of sales would be paid for in cash while 40% of customers would take advantage of the cash discount by paying by the 10 th day. The remaining customers (46% of sales) would make their payments on the 45 th day. Bad debts = 1% CR. CR 1 = The effect of these changes in trade credit policy would be felt for three years. In addition, VC would be reduced from 50% to 49% thanks to the positive advantages of scales resulting from larger sales (and increased production). So, we have: The firm value will increase. The proposed change will be more profitable than in example 1 without using the portfolio approach. This related information comes from the estimation of EVA growth: EVA = % = = CONCLUSION Accounts receivable management decisions are very complex. On the one hand, too much money is tied up in accounts receivables, because of an extreme liberal policy of giving trade credit. This burdens the business with higher costs of accounts receivable service with the additional high alternative costs. The additional costs are further generated by bad debts from risky customers. On the other hand, the liberal trade credit policy could help to enlarge income from sales. In the article, the problem was linked to the operational risk of purchasers interested in receiving trade credit who, as separately considered groups, may characterize a too high risk level. However, if they are considered as one of several groups of enterprise customers, and if their payment habits are correlated with the payment habits of the remaining groups, what was formerly impossible could become possible and may even turn profitable. The portfolio of assets, like the portfolio of accounts receivables, sometimes presents a lower risk to acceptable advantages than the independently considered groups of purchasers. DSO 2 = = 24.7 days AAR =. 360 ( ) = EBIT = % (1% % ) (3% % 2% %) = From this, we have the following change in the firm value: V = = REFERENCES Brigham E.F., Daves P.R. (2002): Intermediate Financial Management. Mason, South-Western (Thomson Learning). Czekaj J., Dresler Z. (2002): Corporate financial management. Theory fundamentals (in Polish). WN PWN, Warszawa. Fabozzi F.J., Fong G. (2000): Advanced fixed income portfolio management. The state of the art (in Polish). WN PWN, Warszawa. Jajuga K. (1993): Financial capital management (in Polish). Wydawnictwo AE, Wrocław. Jajuga K., Jajuga T. (1994): How to invest in financial assets (in Polish). WN PWN, Warszawa. Jajuga K., Jajuga T. (2002): Investment. Financial instruments. Financial risk. Financial engineering (in Polish). WN PWN, Warszawa. 18 AGRIC. ECON. CZECH, 54, 2008 (1): 12 19

28 Jajuga K., Kuziak K., Markowski P. (1997): Financial investment (in Polish). Wydawnictwo AE, Wrocław. Luenberger D. G. (2003): Investment Science (in Polish). WN PWN, Warszawa. Maness T.S., Zietlow J.T. (1998): Short-Term Financial Management. Dryden Press, Fort Worth. Michalski G. (2004): Lexicon of Financial Management (in Polish). CHBeck, Warszawa Piotrowska M. (1997): Corporate finance: Short-term financial management (in Polish). Wydawnictwo AE, Wrocław. Pluta W., Michalski G. (2005): Short-term capital management (in Polish). CHBeck, Warszawa. Reilly F.K., Brown K.C. (2001): Investment analysis and portfolio management (in Polish). PWE Warszawa. Scherr F.C. (1989): Modern Working Capital Management. Text and Cases. Prentice Hall, Englewood Cliffs. Arrived on 25 th June 2007 Contact address: Grzegorz Michalski, Wroclaw University of Economics, Department of Corporate Finance and Value Management, ul. Komandorska 118/120, pok. 704-Z, PL Wroclaw, Poland AGRIC. ECON. CZECH, 54, 2008 (1):

29 ISI Web of Knowledge [v.4.10] - Web of Science 1 z :29 Sign In My EndNote Web My ResearcherID My Citation Alerts My Saved Searches Log Out Help DISCOVER the new Web of Knowledge now! > Search Cited Reference Search Advanced Search Search History Marked List (0) Web of Science with Conference Proceedings Record 1 of 1 Record from Web of Science Corporate inventory management with value maximization in view more options Author(s): Michalski G (Michalski, G.) Source: AGRICULTURAL ECONOMICS-ZEMEDELSKA EKONOMIKA Volume: 54 Issue: 5 Pages: Published: 2008 Times Cited: 0 References: 9 Citation Map Abstract: The basic financial purpose of the firm is maximization of its value. An inventory management should also contribute to the realization of this basic aim. Many current assets management models which we can find in the literature relating to financial management were constructed with the assumption of book profit maximization as the basic aim. These models could be lacking what relates to another aim, i.e., maximization of the enterprise value. This article presents the value based inventory management model modification. Document Type: Article Language: English Author Keywords: inventory management; value based management; free cash flow Reprint Address: Michalski, G (reprint author), Wroclaw Univ Econ, Dept Corp Finance & Value Management, Wroclaw, Poland Addresses: 1. Wroclaw Univ Econ, Dept Corp Finance & Value Management, Wroclaw, Poland Addresses: grzegorz.michalski@gmail.com Publisher: INST AGRICULTURAL FOOD INFORMATION, SLEZSKA 7, PRAGUE , CZECH REPUBLIC Subject Category: Agricultural Economics & Policy; Economics Cited by: 0 This article has been cited 0 times (from Web of Science). Related Records: Find similar records based on shared references (from Web of Science). [ view related records ] References: 9 View the bibliography of this record (from Web of Science). Additional information View the journal's impact factor (in Journal Citation Reports) Suggest a correction If you would like to improve the quality of this product by suggesting corrections, please fill out this form.

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31 Corporate inventory management with value maximization in view Management aktiv podniku s důrazem na maximalizaci hodnoty G. Michalski Department of Corporate Finance and Value Management, Wroclaw University of Economics, Wroclaw, Poland Abstract: The basic financial purpose of the firm is maximization of its value. An inventory management should also contribute to the realization of this basic aim. Many current assets management models which we can find in the literature relating to financial management were constructed with the assumption of book profit maximization as the basic aim. These models could be lacking what relates to another aim, i.e., maximization of the enterprise value. This article presents the value based inventory management model modification. Key words: inventory management, value based management, free cash flow Abstrakt: Základním finančním cílem podniku je maximalizace jeho hodnoty. Management aktiv má rovněž přispívat k realizaci tohoto základního cíle. Mnohé modely managementu běžných aktiv, které nacházíme v literatuře zabývající se finančním managementem, byly konstruovány s předpokladem základního cíle maximalizace účetního zisku. Tyto modely mnohdy postrádají to, co se vztahuje k dalšímu cíli podniku, tj. k maximalizaci jeho hodnoty. Článek předkládá modifikaci modelu managementu aktiv, založeného na této hodnotě. Klíčová slova: management aktiv, hodnotový management, volný cash flow The basic financial aim of an enterprise is maximization of its value. At the same time, a large both theoretical and practical meaning has the research for determinants increasing the firm value. The financial literature contains information about numerous factors influencing the value. Among those factors, there is the net working capital, and elements creating it, such as the level of cash tied in the account receivable, inventories and operational cash balances. The great part of classic financial models proposals relating to the optimum current assets management was constructed with net profit maximization in view. It is the reason why these models need reconstruction, which will be suitable for firms which want to maximize their value. The estimation of the influence of changes in firm decisions in the sphere of inventory management is a compromise between limiting of risk by having a greater inventory level and limiting a costs of inventory. It is the essential problem of the corporate financial management. The basic financial inventory management aim is holding the inventory on the minimal acceptable level because of its costs. Holding inventory ties the capital used to finance the inventory and links with the inventory storage, insurance, transport, obsolescence, wasting and spoilage costs. On the other hand, the low level of inventory could be source of problems with meeting the supply (Michalski 2004). VALUE BASED INVENTORY MANAGEMENT If advantages from holding the inventory on a level defined by the firm is greater than the negative influence of an alternative costs from its holding, then the firms value will grow. The change of the accounts receivable level affects the firm value. To measure that, we use a formula, basing on an assumption, that the firm value is a sum of the future free cash flows to firm (FCFF) discounted by the cost of capital financing the firm: Agric. Econ. Czech, 54, 2008 (5):

32 (1) where: V p = firm value growth FCFF t = future free cash flow growth in period t k = discount rate 1 The future free cash flow we have as: FCFF t = (CR t CE t NCE) (1 T) + NCE Capex NWC t (2) where: CR t = cash revenues on sales CE t = cash expenses resulting from fixed and variable costs in time t NCE = non cash expenses T = effective tax rate NWC = net working growth Capex = capital expenses resulting from operational investments growth The similar conclusions about the results of the change inventory management policy on the firm value, can be estimated on the basis of an economic value added, informing about the size of the residual profit (the added value) enlarging the value of the firm in the period: EVA = NOPAT k (NWC + OI) (3) where: EVA = economic value added NWC = net working capital OI = long-term operating investments NOPAT = net operating profit after tax estimated on the basis of the formula: NOPAT = (CR t CE t NCE) (1 T) (4) The net working capital (NWC) is the part of current assets, financed with fixed capital. The net working capital (current assets less current liabilities) results from the lack of synchronization of the formal rising receipts and the real cash receipts from each sale. Net working capital also results from the divergence during the time of rising costs and time, from the real outflow of cash when a firm pays its accounts payable. NCW = CA CL = AAR + INV + G AA (5) where: NWC = net working capital CA = current assets CL = current liabilities AAR = accounts receivables INV = inventory G = cash and cash equivalents AAP = accounts payables During estimation of the free cash flows, the holding and increasing of net working capital ties money used Influence on k Inventory changes could influence cost of capital Influence on FCFF Inventory changes influences: costs NWC V = p n FCFF t t= 1 ( 1+ k) EVA = NOPAT k ( NWC + IO) t Influence on t Inventory changes could influence period of life of the enterprise. Figure 1. The inventory management decision influence on firm value FCFF = Free Cash Flows to Firm; NWC = Net Working Capital Growth; k = cost of the capital financing the firm; t = the lifetime of the firm and time to generate single FCFF Source: Pluta, Michalski (2005) 1 To estimate changes in accounts receivable levels, we accept the discount rate equal to the average weighted cost of capital (WACC). Such changes and their results are strategic and long term in their character, although they refer to accounts receivable and short run area decisions (Maness, Zietlow 1998, pp ; Kalberg, Parkinson 1993). 188 Agric. Econ. Czech, 54, 2008 (5):

33 for financing it. If net working capital increases, the firm must tie much money and it decreases free cash flows. The production level growth usually makes the necessity of enlargement of cash levels, inventories, and accounts receivable. Part of this growth will be covered with current liabilities, since current liabilities also usually automatically grow up together with the growth of production. The rest (which is noted as net working capital growth) will require other form of financing (Sartoris, Hill 1983). The inventory management policy decisions create the new inventory level in the firm. It has the influence on the firm value. It is the result of alternative costs of the money tied in inventory and generally of costs of the inventory managing. Both the first and the second involve modification of the future free cash flows, and in consequence the firm value changes. In Figure 1, we have the influence of inventory management decisions on the firm value. These decisions change the future free cash flows (FCFF). These decisions could also influence the life of the firm (t) (by the operational risk, which is the result of possibility to break production cycles if the inventory level is too low), and rate of the cost of capital financing the firm (k). The changes of these three components have influence on the creation the firm value (ΔVp) Figure 1. Inventory changes (resulting from changes in the inventory management policy of the firm) affect the net working capital level and as well the level of operating costs of the inventory management in a firm. These operating costs are the result of storage, insurance, transport, obsolescence, wasting and spoilage of inventory) (Scherr 1989). EOQ AND VBEOQ The economic order quantity model is a model which maximizes the firm income by the total inventory costs minimization (Figure 2). To form the EOQ model, we have two equations: (6) where: EOQ = economic order quantity P = demand for the product/inventory in the period (year, month) K z = cost per order event K u = holding cost per unit in the period (year, month) C = holding cost factor v = purchase cost per unit The holding cost factor (K u ) is a result of costs (Sier-pińska, Wędzki 2002, p. 112): Alternative costs (price of money tie in inventory), Storage, insurance, transport, obsolescence, wasting and spoilage costs. (7) where: TCI = total costs of inventory Q = order quantity = minimal stock z b Example 1. P = kg, K z = 31$, v = 2$ / 1kg, C = 25%. Effective tax rate, T = 20%. Cost of capital financing the firm WACC = k = 15%. z b = 300 kg. First we estimate EOQ: Next we estimate the average inventory level: $ Figure 2. EOQ and VBEOQ model Source: Kalberg, Parkinson 1993, p. 538 Agric. Econ. Czech, 54, 2008 (5):

34 $ If we rather order kg than EOQ = kg: $ We will have a greater TCI, but if we check how it influences the firm value, we will see that if we decide to order less than EOQ suggest, we will increase the firm value: TCI 5000 = = 2 $ $ INV 5000 = = 224 $ NWC = INV $ The EOQ model minimizes operational inventory costs, but in firm management we also have alternative costs of holding inventories. These costs need that we order less than EOQ if we want to maximize the firm value. Knowing that we can use VBEOQ model: (8) where: k = cost of capital financing the firm (WACC) VBEOQ = value based economic order quantity For Alfa data, we have: $ TCI 3948 = = $ $ INV 3948 = = $ $ POQ and VBPOQ The production order quantity model (POQ) is the EOQ modification which we can use when we have grater production possibilities than market capacity (Figure 3). The POQ could be estimated as (Sariusz-Wolski 2002, p. 162): (9) where: POQ = production order quantity K z = switch of production cost P = demand intensity (how much we can sell annually) v = cost per unit m = maximum annual production ability c = holding cost factor (10) where: Q = production quantity TCI = total costs of iventories (11) where: INV = average inventory level Example 2. Maximum demand, P = kg, m = kg annually. WACC = k = 15%, C = 25%, T = 19%. K z = $, v = 0.8$. First we estimate POQ: $ Next, we check how the firm value is influenced by the change of production quantity to 90% POQ, = kg: 190 Agric. Econ. Czech, 54, 2008 (5):

35 Figure 3. POQ and VBPOQ Source: Sariusz-Wolski 2002, p. 162 $ $ $ Table 1. VBPOQ Q TCI TCI INV INV V Source: own study NWC = ( FCF 0 ) = ZAP Q=6 797 Q = = = = ( ) $ $ As we can see, if we produce less than POQ suggest, it will create additional value. If we want to sign VBPOQ, we can use the Table 1. VBPOQ will be kg. From the table we see also that the costs TCI for VBPOQ will be greater than for the POQ, but the VBPOQ ties less money in inventories what is source of benefits in alternative costs. To estimate the VBPOQ, we also could use the equation (12). CONCLUSION Maximization of the wealth of its owners is the basic financial aim in the management of enterprise. Inventory management must contribute to the realization this aim. In the article, we have seen the value based EOQ model and value based POQ model modifications. Inventory management decisions are a complex case. On one side, too much money ties in inventory burdens the enterprise with (12) Agric. Econ. Czech, 54, 2008 (5):

36 the high costs of inventory service and additionally high alternative costs. From the other side, the higher inventory stock could help to enlarge incomes from sales because purchasers have a greater flexibility in making purchase decisions. In the article the problem connected with the optimal economic order quantity and production order quantity was discussed. Value based modifications of these two models could help managers to make better, value creating decisions in the inventory management. References Kalberg J.G, Parkinson K.L. (1993): Corporate Liquidity: Management and Measurement. IRWIN, Homewood. Luenberger D.G. (2003): Teoria inwestycji finansowych. WN PWN, Warszawa. Maness T.S., Zietlow J.T. (1998): Short-Term Financial Management. Dryden Press, Fort Worth. Michalski G. (2004): Lexicon of corporate finance (in Polish). CHBeck, Warszawa. Pluta W., Michalski G. (2005): Short-run financial management (in Polish). CHBeck, Warszawa. Sartoris W., Hill N. (1983): A generalized cash flow approach to short-term financial decisions. Journal of Finance, 38 (2): Scherr F.C. (1989): Modern Working Capital Management. Text and Cases. Prentice-Hall International Editions, Englewood Cliffs, New Jersey. Sierpińska M., Wędzki D. (2005): Financial liquidity management (in Polish). WN PWN, Warszawa. Sariusz-Wolski Z. (2002): Inventory management (in Polish). PWE, Warszawa. Arrived on 12 nd February 2008 Contact address: Grzegorz Michalski, Wroclaw University of Economics, Department of Corporate Finance and Value Management, ul. Komandorska 118/120, p. Z-2, KFPiZW, PL Wroclaw, Poland grzegorz.michalski@gmail.com 192 Agric. Econ. Czech, 54, 2008 (5):

37 Assistant professor Grzegorz MICHALSKl, PhD Wroclaw University of Economics, Department of Corporate Finance and Value Management PL53345 Wroclaw, Poland INVENTORY MANAGEMENT OPTIMIZATION AS PART OF OPERATIONAL RISK MANAGEMENT Abstract: The basic financial purpose of an enterprise is maximization of its value. Inventory management.should also contribute to realization of this fundamental aim. The enterprise value maximization strategy is executed with a focus on risk and uncertainty. This article presents the consequences for the recipients firm that can result from operating risk that is related to delivery risk generated by the suppliers. The present article offers a method that uses portfolio management theory to chose the suppliers. Keywords: Corporate liquidity, firm value, delivery risk. JEL Classifications: G39, G32, Gil, Ml 1, D81 1. Introduction Current assets i.e. the sum of inventories, accounts receivable, short-term investment (cash and equivalents) and short term accruals [Mueller 1953; Graber 1948; Khoury 1999; Cote 1999] are for the firm collateral/protection against risk [Merlon 1999, p. 506; Ramniceanu 2007, Lofthouse 2005; p ; Parrino 2008, p , Poteshman 2005, p ] and at the same time a investment [Levy 1999, p. 6; Reilly 1992, p. 6; Fabozzi 1999, p. 214]. Current assets level is a result of kind of production organisation [Baumoi 1952, Beck 2005, Beranek 1963, Emery 1988, Gallinger 1986, Holmstrom 2001, Kim 1998, Kim 1978, Lyn 1996, Tobin 1958, Stone 1972, Miller 1966, Miller 1996, Myers 1998, Opler 1999]. As a result of it, the firm maintain adequate level of inventories and it is linked rather with operational management than with fmancial decisions [Peterson 1979, p ; Orlicky 1975, p.17-19; PlossI 1985, p , Fulga 2008, Shah 2008, Shah 2007]. At the same time current assets are the result of active policy of gaining and holding the firm clients. [Bougheas 2009]. The firm offer should be suited to demand and character of the firm clients. The inventory levels are also a result of this policy. The basic financial purpose of an enterprise is maximization of its value [Morard 2009]. Inventory management should also contribute to realization of this fundamental aim. Many of the current asset management models that are found in financial management literature assume book profit maximization as the basic fmancial purpose. These book profit-based models could be lacking in what it

38 Grzegorz Michalski to another aim (i.e., maximization of enterprise value). The enterprise value maximization strategy is executed with a focus on risk and uncertainty. This article presents the consequences for the recipients firm that can result from operating risk that is related to delivery risk generated by the suppliers. The present article offers a method that uses portfolio management theory to chose the suppliers. When entrepreneur chooses the tradesman, should concentrate his attention, not only at basic knowledge about the contracting party individual shape parameters (i.e. the tradesman financial situation), but also on information from inventory management models. The Economic Order Quantity model of inventory management is used to mark the optimum size of delivery and to choose the cheapest deliverer [Coculescu 2007]. Both of these choices should guarantee minimization of total costs of investments in inventories. Invenro)-} Le\ el Q Figure 1. Economic Order Quantity Model where: LIL - Low Inventory Level (Precautionary Inventory Level); AIL-Average Inventory Level; HIL - High Inventory Level; Q - Order Quantity (Q = HIL - In Fig 1. it is shown the way the EOQ (and VBEOQ) model works. Q could be calculated as: 2xPxK. \2xPxK. (I) where: EOQ ~ target (optimal) order quantity {economic order quantity), P - yearly demand for optimized inventories, K, - creating inventories costs (fixed cost of one order), K^ - operating costs of maintaining inventories (without costs of maintaining safety/precautionary inventories LIL\ Ca - percentage rate of operating costs of maintaining inventories (with financial/alternative costs of capital and without costs of maintaining safety/precautionary inventories LIL), v - unit price (cost) of ordered inventories. 214

39 Inventory- Management Optimization as Part of Operational Risk Management The percentage share of retaining the reserves comes from the fact that the costs of retaining the reserves increase proportionally to the level of reserves In the enterprise. Its share is a sum ofthe following costs: alternative (resulting from the possibility of their potential use somewhere else but without cost of capital financing firm), storage, logistics and internal transport within the factory ofthe reserves, insurance, decay. P (0 ^^^ where; TCI- total reserves costs, Q - magnitude ofthe part of delivery, zt - the level of safety margin. From the point of view of maximizing the enterprise value a part ot deliverv can be determined based on the formula for VBEOQ: VBEOQ = ^ V X ^jt + C X ^^lwhere: A: - alternative cost (equal to the enterprise financing capita! [Dragota 2008, Triandafil 2008]), VBEOQ - optimal magnitude of single order from the point of view of maximizing the enterprise value, C - percentage rate of operating costs of maintaining inventories (without financial/alternative costs of capital and without costs of maintaining safety/precautionary inventories LIL). T: (5) { where: K, - tax-deductible creating inventories costs (fixed cost of one order), K, - non- tax-deductible creating inventories costs (fixed cost of one order), C - percentage rate of tax-deductible operating costs of maintaining inventories (without fmancial/altemative costs of capital and without costs of maintainmg safety/precautionary inventories LIL), C' - percentage rate of non-tax-deductible operating costs of maintaining inventories (without financial/alternative costs of capital and without costs of maintaining safety/precautionary inventories LIL). And: Q ts The problem, we are going to deal with in this paper is to select a counterpart amongst the suppliers in a situation where the parameters we know cany the risk resulting from deliveries out of schedule. Example 1. Enterprise X producing special fireproof curtains uses raw material D-18. The annual demand for this raw material is 8000 m\ There are two suppliers (A and B) on the market offering similar delivery terms. The price ofthe material for both of them is 3000$ for m\ the lead-time is 20 days, the cos^^f

40 Grzegorz Michalski inventory retaining is 38%, the cost of enterprise financing capita! is 30%, effective tax rate is 19%, the costs of ordering is 200$ and the cost of lack of reserves is $. The analysis of recommendation given by the companies showed that both suppliers were not equally reliable. Supplier A was nearly perfect, supplier B often did not deliver on time, he happened to show up 4 days before the agreed date, but equally often used to come 8 days later. Based on the gathered data it was estimated the standard deviation of the delivery time in case of supplier A was 4 days, and for supplier B 6 days. In order to evaluate who is more reliable it is necessary to determine the safety margin for supplier A and then for supplier B. The next step is to check the impact of suppliers risk on the enterprise value. We assume that the enterprise in order to estimate the optimal order magnitude uses the VBEOQ. mode! VBEOQ, = VBEOQ, = 2x(l-0.19)x200x80Q0 ^ ^"^ ^' p000( x(l-0.19)) Differences in reliability of deliveries have a great impact on different levels of safety margins required for suppliers A and B. For this purpose the following formula is used [Piotrowska 1997, 57]: O 2, CxßX5XVX^/2^ =, -2x5 xln V where: s - standard deviation for reserves usage, Kb^ ~ cost of lack of inventory reserves. In order to use the formula it is necessary to exchange the deviation of delivery time to deviation of raw material use. It is known average daily use is 8000/360 = 22.2 m\ Therefore 4 days deviation for delivery date is equal to deviation of use equal to 88.8 m'. Therefore, for such a situation the safety margin will be equal to: x In this case, the level of resources tied in the reserves is: í5z^-» ] = $, Next case reflects a situation in which the entrepreneur uses the services from company B. So the standard deviation will be 6x(8000/360) = m^ Therefore reserves safety margin will he: x37.7xl33.3x3000xV2x3.1416,,,, xln =531m^ 8000x

41 Inventory Management Optimization as Part of Operational Risk Management In this case the level of resources tied in the reserves is: Comparing this magnitude to the level of reserves in situation where one would have used supplier A it is obvious that the increase of money resources tied in the reserves will be: = $. ^ A-*B The last stage is to compare what impact the risk generated by the counterparts - suppliers has on the value of the enterprise. Therefore we estimate the level of total costs of reserves: TCI ^ ^52^x200 4-[ x3000x0.38 = 37.7 I, 2 ; ^ 8000 ^200 + f^ + 53llx3000x0.38 = $, ' 37.7 I 2 J,^, = = $. Obtained results will be used for estimation of fluctuations in the enterprise value: ( l)x (1-0.19).noiici«A t'.,^^ = ^^ p-^ ^ = $. It is apparent that it is better to select counterpart - supplier A because selection of supplier B may result in destruction of enterprise value. 2. Suppliers' portfolio Usually the enterprise's suppliers have materials and stock from the same source. It happens though, that their sources of supply are different and therefore the risk of deliveries related to individual suppliers is different, f such a thing occurs, it may be possible to use elements taken from the portfolio theory' for supplier's evaluation. Sometimes the counterparts, who although may be have virtues who exclude them from being suppliers of services in the beginning (like supplier B in example B). it may be possible that having considered the risk of the buyer it may turn out that on the contrary they decrease or stabilize the risk level. Portfolio is a set of assets (for example in a non accountant sense: suppliers). The theory of portfolio management is based on the rate of advantages drawn from buying from particular supplier, informing about the relation of advantage generated by such a purchase to the outlay related to such a purchase [Ratiu-Suciu 2007]. The measure allowing the measurement of risk connected to costs from particular buyer may be defined as this variation: 217

42 Grzegorz Michalski (8) where: p, - probability of occurrence of the given situation estimated from historical data. In connection to the information about what potential advantages might be brought by giving a loan to a particular buyer, it is possible to estimate the variation coefficient: : s c = R The next element is a correlation of benefits from purchase from particular supplier with benefits from this purchase from other suppliers. The correlation coefficient is usually the measure of such a correlation: (9) (10) where: ^'^ - correlation coefficient of benefits from purchase from the first and second supplier; R, - expected rate of benefits from purchasing from first supplier; R2 - o expected rate of benefits from purchasing from the second supplier; S) - standard deviation for the first supplier S2 - standard deviation for the second supplier; Rij - possible rates of benefits from the purchases from the first supplier; Rîi - possible rates of benefits from the purchases from the second supplier; p, - probability of occurrence of possible rates of benefits from supplies. 3. Portfolio of two suppliers (groups of suppliers). Example 2. The enterprise uses two suppliers. On of them operates in sector A, the other represents sector B. The use of portfolio idea is useful when the correlation between the benefits from purchases from these suppliers is negative. We can follow this in the picture below. 218 Figure 2. Relation between beneilt and risk for portfolio of two.suppliers at different correlation coefficients (equal to I, (-1) or 0).

43 Inventory Management Optimization as Part of Operational Risk Management Case 1. The correlation coefficient between benefits from purchases from supplier A and B equals to 1. The picture shows that at positive correlation near to I there is no possibility to seek advantages resulting from diversification. Case 2. Correlation coefficient equal to -1. Ideal negative correlation. All possible portfolios at correlation coefficient equal to -1 are contained on the broken line A-A/B.-A/Bj-B. Points "A" and "B" represent single-components portfolios (eg. Using only supplier A). As we see, when we move away from point "A" and increase the share of deliveries performed by "B" the risk S decreases and benefits R increases. This happens until point A/Bi. If this share is exceeded the risk of portfolio will increase together with the increase of income. As we see it is no substantiated to have only supplier A in the portfolio because at identical risk portfolio A/B2 offers greater benefits. Case 3. Correlation coefficient equals 0. It is a situation in which the benefits from supplier A and supplier B are not connected to each other. In this situation only partial risk reduction is possible. Reasonable entrepreneur should not select any ofthe portfolios of dues lying on A-A/B3 arc, because it always possible to find more advantageous complement on A/Bj - A/B4 arc which at the same risk s yields higher benefits R. 4. Using the elements of portfolio theory for selection of suppliers Skilful construction of portfolio of two (groups) of suppliers may lead to a considerable reduction of risk. Inclusion of second component into singlecomponent portfolio (which like in example 1 so far consisted of only one better supplier A and accepting deliveries from less risky supplier) nearly always leads to reduction of risk, sometimes even at simultaneous increase of benefit rate of portfolio. Example 3. (Continuation of the previous example) After assessment of supplier A and B, the entrepreneur noticed that the delays connected to services provided by suppliers A and B arc negatively correlated with each other, because their sources of supply are different when troubles with deliveries from first source can be expected, the other source does not pose a risk of such difficulties. Thanks to that we can expect a decrease of risk of non forward deliveries. Both suppliers acquire the material D-18 based on different technologies. Therefore one can expect that the impact of deliveries risk on the receiver can be decreased due suing the service of both suppliers, because the con-elation of distribution of forward deliveries of suppliers A and B is negative and is equal to The orders will be placed in quantities and frequency resulting from VBEOQ model. The orders will be realized by both suppliers: A and B equal shares of 18,85 m". ln order to estimate new level of safety margin it is necessary to use the equation determining the total standard deviation: where: 57 - total standard deviation, SA - standard deviation of the first distribution, SB - standard deviation ofthe second distribution, p^^^g - con-elation coefficient between the first and second distribution. 219

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