INVENTORY MANAGEMENT TECHNIQUES

While the total ordering costs can be decreased by increasing the size of order, the carrying costs increase with the increase in order size indicating the need for a proper balancing of these two types of costs behaving in opposite directions with changes in order size.

Again, if a company wants to avert stock-out costs it may have to maintain larger inventories of materials and finished goods, which will result in higher carrying costs. Here also proper balancing of the costs becomes important.

Thus, the importance of effective inventory management is directly related to the size of the investment in inventory. To manage its inventories effectively, a firm should use a systems approach to inventory management. A systems approach considers in a single model all the factors that affect the inventory.

ECONOMIC ORDER QUANTITY

The economic order quantity (EOQ) refers to the optimal order size that will result in the lowest total of order and carrying costs for an item of inventory given its expected usage, carrying costs and ordering cost. By calculating an economic order quantity, the firm attempts to determine the order size that will minimize the total inventory costs.

Total inventory cost = Ordering cost + Carrying cost
Total ordering costs = Number of orders x Cost per order
= $ U / Q X F

Where
U = Annual usage
Q = Quantity ordered
F = Fixed cost per order
The total carrying costs = Average level of inventory x Price per unit x Carrying cost (percentage)

Total carrying costs
= $ Q / 2 x P x C
= $ QPC over 2

Where
Q = Quantity ordered
P = Purchase price per unit
C = Carrying cost as %

As the lead-time (i.e., time required for procurement of material) is assumed to be zero an order for replenishment is made when the inventory level reduces to zero.
The level of inventory will be equal to the order quantity (Q units) to start with. It progressively declines (though in a discrete manner) to level O by the end of period 1. At that point an order for replenishment will be made for Q units. In view of zero lead-time, the inventory level jumps to Q and a similar procedure occurs in the subsequent periods. As a result of this the average level of inventory will remain at (Q/2) units, the simple average of the two end points Q and Zero.

From the above discussion the average level of inventory is known to be (Q/2) units.
From the previous discussion, we know that as order quantity (Q) increases the total ordering costs will decrease while the total carrying costs will increase. The economic order quantity, denoted by Q*, is that value at which the total cost of both ordering and carrying will be minimized. It should be noted that total costs associated with inventory
T= $ UF / Q + $QPC / 2

Where the first expression of the equation represents the total ordering costs and the second expression the total carrying costs.

The total cost curve reaches its minimum at the point of intersection between the ordering costs curve and the carrying costs line. The value of Q corresponding to it will be the economic order quantity Q*. We can calculate the EOQ formula.

Behavior of costs associated with inventory for changes in order quantity. For order quantity Q to become EOQ the total ordering costs at Q should be equal to the total carrying costs.

Using the notation, it amounts to stating:
UF/Q + QPC / 2 (i.e.) 2UF = Q²PC or Q² = 2UF / PC units
To disguish EOQ from other order quantities, we can say:
2 UF*
EOQ = Q* PC

In the above formula, when `U' is considered as the annual usage of material, the value of Q* indicates the size of the order to be placed for the material, which minimizes the total inventory-related costs. When `U' is considered as the annual demand Q* denotes the size of production run.

Suppose a firm expects a total demand for its product over the planning period to be 10,000 units, while the ordering cost per order is $100 and the carrying cost per unit is $2. Substituting these values, EOQ = 2 x10, 000 x100 = 1000 units. 2

Thus, if the firm orders in 1000-unit lot size, it will minimize its total inventory costs.

Inflation affects the EOQ: model in two major ways. First, while the EOQ model can be modified to assume constant price increases, many times major price increases occur only once or twice a year and are announced ahead of time.
Read more about Inflation point information

REORDER POINT SUBSYSTEM

In the EOQ model discussed we have made the assumption that the lead-time for procuring material is zero. Consequently, the reorder point for replenishment of stock occurs when the level of inventory drops down to zero. In view of instantaneous replenishment of stock the level of inventory jumps to the original level from zero level. In real life situations one never encounters a zero lead-time. There is always a time lag from the date of placing an order for material and the date on which materials are received. As a result the reorder level is always at a level higher than zero, and if the firm places the order when the inventory reaches the reorder point, the new goods will arrive before the firm runs out of goods to sell. The decision on how much stock to hold is generally referred to as the order point problem, that is, how low should the inventory be depleted before it is reordered.

The two factors that determine the appropriate order point are the procurement or delivery time stock which is the Inventory needed during the lead time (i.e., the difference between the order date and the receipt of the inventory ordered) and the safety stock which is the minimum level of inventory that is held as a protection against shortages.

Therefore Reorder Point = Normal consumption during lead-time + Safety Stock.

Several factors determine how much delivery time stock and safety stock should be held. In summary, the efficiency of a replenishment system affects how much delivery time is needed. Since the delivery time stock is the expected inventory usage between ordering and receiving inventory, efficient replenishment of inventory would reduce the need for delivery time stock. And the determination of level of safety stock involves a basic trade-off between the risk of stock-out, resulting in possible customer dissatisfaction and lost sales, and the increased costs associated with carrying additional inventory.

Another method of calculating reorder level involves the calculation of usage rate per day, lead time which is the amount of time between placing an order and receiving the goods and the safety stock level expressed in terms of several days' sales.

Reorder level = Average daily usage rate x lead-time in days.

From the above formula it can be easily deduced that an order for replenishment of materials be made when the level of inventory is just adequate to meet the needs of production during lead-time.

If the average daily usage rate of a material is 50 units and the lead-time is seven days, then Reorder level =Average daily usage rate x Lead time in days = 50 units x 7 days = 350 units

When the inventory level reaches 350 units an order should be placed for material. By the time the inventory level reaches zero towards the end of the seventh day from placing the order materials will reach and there is no cause for concern.

Learn about safety stock - Once again in real life situations one rarely comes across lead times and usage rates that are known with certainty. When usage rate and/or lead time vary, then the reorder level should naturally be at a level high enough to cater to the production needs during the procurement period and also to provide some measure of safety for at least partially neutralizing the degree of uncertainty.

The Reorder Point Formula - Even in a relatively simple situation considered in the example above, the amount of calculations involved for arriving at the reorder level is large. In real life situations the assumption of independence in the probability distributions made in the example above may not be valid and the number of time periods may also be large. In such cases the approach adopted earlier can become much more complex.

STOCK-LEVEL SUBSYSTEM

This stock level subsystem keeps track of the goods held by the firm, the issuance of goods, and the arrival of orders. It maintains records of the current level of inventory. For any period of time, the current level is calculated by taking the beginning inventory, adding the inventory received, and subtracting the cost of goods sold. Whenever this subsystem reports that an item is at or below the reorder-point level, the firm will begin to place an order for the item.

BASIC ACCOUNTS RECEIVABLE MANAGEMENT

The foundation behind account receivables is your policies and procedures for sales. For example, do you have a credit policy? When and how do you evaluate a customer for credit? If you look at past payment histories, you should be able to ascertain who should get credit and who shouldn't. Additionally, you need to establish sales terms. For example, is it beneficial to offer discounts to speed-up cash collections? What is the industry standard for sales terms? There are several questions that have to be answered in building the foundation for managing accounts receivables.

A system must be in place to track accounts receivables. This will include balance forwards, listing of all open invoices, and generation of monthly statements to customers. An aging of receivables will be used to collect overdue accounts. You must act quickly to collect overdue accounts. Start by making phone calls followed by letters to upper-level managers for the Customer. Try to negotiate settlement payments, such as installments or asset donations. If your collection efforts fail, you may want to use a collection agency.

Also remember that the collection process is the art of knowing the customer. A psychological understanding of the customer gives you insights into what buttons to push in collecting the account. One of the biggest mistakes made in the collection process is a "sticks only" approach. For some customers, using a carrot can work wonders in collecting the overdue account. For example, in one case the company mailed a set of football tickets to a customer with a friendly note and within weeks, they received full payment of the outstanding account.

Measurement is another component within account receivable management. Traditional ratios, such as turnover will measure how many times you were able to convert receivables over into cash.



Example: Monthly sales were $ 50,000, the beginning monthly balance for receivables was $ 70,000 and the ending monthly balance was $ 90,000. The turnover ratio is:
.625 ($ 50,000 / (($70,000 + $ 90,000)/2)). Annual turnover is .625 x 360 / 30 or 7.5 times. If you divide 360 (bankers year) by 7.5, you get 48 days on average to collect your account receivables. You can also measure your investment in receivables. This calculation is based on the number of days it takes you to collect receivables and the amount of credit sales.

Example: Annual credit sales are $ 100,000. Your invoice terms are net 30 days. On average, most accounts are 13 days past due. Your investment in accounts receivable is:
(30 + 13) / 365 x $ 100,000 or $ 11,781.

Example: Average monthly sales are $ 10,000. On average, accounts receivable are paid 60 days after the sales date. The product costs are 50% of sales and inventory-carrying costs are 10% of sales. Your investment in accounts receivable is:
2 months x $ 10,000 = $ 20,000 of sales x .60 = $ 18,000.

Measurements may need to be modified to account for wide fluctuations within the sales cycle. The use of weights can help ensure comparable measurements.

Example: Weighted Average Days to Pay = Sum of ((Date Paid - Due Date) x Amount Paid) / Total Payments

Example: Best Possible Days Outstanding = (Current A/R x # of Days in Period) / Credit Sales for Period

Receivable Management also involves the use of specialist. After-all, you need to spend most of your time trying to lower your losses and not trying to collect overdue accounts. A wide range of specialist can help:

- Credit Bureau services to review and approve new customers.
- Deduction and collection agencies
- Complete management of billings and collections

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WORKING CAPITAL MANAGEMENT

Working capital, also known as net working capital, is a financial metric which represents operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.
A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable and cash.
Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:
accounts receivable (current asset)
inventory (current assets), and
accounts payable (current liability)
The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long term assets. Common types of short-term debt are bank loans and lines of credit.
An increase in working capital indicates that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors.
Implications on M&A: The common commercial definition of working capital for the purpose of a working capital adjustment in an M&A transaction (ie for a working capital adjustment mechanism in a sale and purchase agreement) is equal to:
Current Assets - Current Liabilities excluding deferred tax assets/liabilities, excess cash, surplus assets and/or deposit balances.
Cash balance items often attract a one-for-one purchase price adjustment.
Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Decision criteria
By definition, working capital management entails short term decisions - generally, relating to the next one year period - which are "reversible". These decisions are therefore not taken on the same basis as Capital Investment Decisions (NPV or related, as above) rather they will be based on cash flows and / or profitability.
One measure of cash flow is provided by the cash conversion cycle - the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.
In this context, the most useful measure of profitability is Return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; Return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. See Economic value added (EVA).
Management of working capital
Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. These policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.
Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials - and minimizes reordering costs - and hence increases cash flow; see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic production quantity
Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa);
Short term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

GROSS DOMESTIC PRODUCT

GDP is defined as the market value of all final goods and services produced domestically in a single year and is the single most important measure of macroeconomic performance. A related measure of the economy's total output product is gross national product (GNP), which is the market value of all final goods and services produced by a nation in a single year.
GDP or GNP? The difference between GDP and GNP is rather technical. GDP includes only goods and services produced by a nation's own citizens and firms. Goods and services produced outside a nation's boundaries by the nation's own citizens and firms are included in GNP but are excluded from GDP. Goods and services produced within a nation's boundaries by foreign citizens and firms are excluded from GNP but are included in GDP. Typically, there is not much difference in the reported values of GDP and GNP; so one may use either statistic to measure overall macroeconomic activity. The rest of this section will therefore focus on GDP.
Measuring GDP: the expenditure and income approaches. There are two ways of measuring GDP, the expenditure approach and the income approach. The expenditure approach is to add up the market value of all domestic expenditures made on final goods and services in a single year. Final goods and services are goods and services that have been purchased for final use or goods and services that will not be resold or used in production within the year.Intermediate goods and services, which are used in the production of final goods and services, are not included in the expenditure approach to GDP because expenditures on intermediate goods and services are included in the market value of expenditures made on final goods and services. Including expenditures on both intermediate and final goods and services would lead to double counting and an exaggeration of the true market value of GDP.
Total expenditure on final goods and services is broken down into four large expenditure categories, according to the type of good or service purchased. The sum total of these four expenditure categories equals GDP. These four expenditure categories are
1. Consumption expenditures: Personal consumption expenditures on goods and services comprise the largest share of total expenditure. Consumption good expenditures include purchases of nondurable goods, such as food and clothing, and purchases of durable goods, such as appliances and automobiles. Consumption service expenditures include purchases of all kinds of personal services, including those provided by barbers, doctors, lawyers, and mechanics.
2. Investment expenditures: Investment expenditures can be divided into two categories: expenditures on fixed investment goods and inventory investment. Fixed investment goods are those that are useful over a long period of time. Expenditures on fixed investment goods include purchases of new equipment, factories, and other nonresidential housing as well as purchases of new residential housing. Also included in fixed investment expenditures is the cost of replacing existing investment goods that have become worn out or obsolete. The market value of all investment goods that must be replaced in a single year is referred to as the depreciation for that year. Inventory goods are final goods waiting to be sold that firms have on hand at the end of the year. The year-to-year change in the market value of firms' inventory goods is considered an investment expenditure because these inventory goods will eventually yield a flow of consumption or production services.
3. Government expenditures: Government expenditures on consumption and investment goods and services are treated as a separate category in the expenditure approach to GDP. Examples of government expenditures include the hiring of civil servants and military personnel and the construction of roads and public buildings. Social security, welfare, and other transfer payments are not included in government expenditures. Recipients of transfer payments do not provide any current goods or services in exchanges for these payments. Hence, government expenditures on transfer payments do not involve the purchase of any new goods or services and are therefore excluded from the calculation of government expenditures.
4. Net exports: Exports are goods and services produced domestically but sold to foreigners, while imports are goods and services produced by foreigners but sold domestically. In the expenditure approach to GDP, expenditures on exports are added to total expenditures, while expenditures on imports are subtracted from total expenditures. Alternatively, one can calculate net exports, which is defined as expenditures on exports minus expenditures on imports, and add the value of net exports to the nation's total expenditures.
The income approach to measuring GDP is to add up all the income earned by households and firms in a single year. The rationale behind the income approach is that total expenditures on final goods and services are eventually received by households and firms in the form of wage, profit, rent, and interest income. Therefore, by adding together wage, profit, rent, and interest income, one should obtain the same value of GDP as is obtained using the expenditure approach.
There are two types of expenditures, however, that are included in the expenditure approach to GDP measurement but do not provide households or firms with any form of income:depreciation expenditures and indirect business taxes. Depreciation expenditures, made to replace existing but deteriorated investment goods, do increase the incomes of those providing the replacement goods, but they also decrease the profit incomes of those purchasing the replacement goods. The result is that aggregate income remains unchanged. Indirect business taxes consist of sales taxes and other excise taxes that firms collect but that are not regarded as a part of firms' incomes. Consequently, indirect business taxes are not included in the income approach to GDP measurement but are included in the expenditure approach.
The difference between the expenditure and income approaches to GDP measurement is illustrated in Figure 1 .



Figure 1 The expenditure and Income approaches to GDP measurement


GDP is defined as the total market value of all expenditures made on consumption, investment, government, and net exports in one year. If one subtracts depreciation and indirect business taxes from these expenditures, one arrives at national income, which is the sum of all wage, profit, rent, and interest incomes earned in the same year.
Growth rate of GDP. The value of GDP by itself is not very interesting. What is interesting is the annual growth rate, or year-to-year percentage change, in the value of GDP. To calculate the percentage change in a statistic, such as GDP, one needs to know the value of the statistic at two dates in time. Suppose that the value of GDP last year was YL and the value of GDP in the current year is YC. Then, the percentage change, or growth rate, of GDP is given by


Yc - Yl/ Yl X 100


This formula is valid for calculating the percentage change in any statistic, not just the percentage change in GDP.
A positive growth rate of GDP implies that the economy is expanding, while a negative growth rate of GDP implies that the economy is contracting. An expanding economy is said to be in aboom, while a contracting economy is said to be in a recession.

THE LM CURVE

The LM curve, named because it shows positions at which the demand for money (L for liquidity preference) equals money supply (M), completes the model. In the quantity theory of money we have already met a model of the market for money balances. The quantity theory asserted that velocity was constant, or
(1) MV = Y
which can be rewritten as:
(2) M= (1/V)Y = kY.
Equation 2 says that the amount of money that people hold is a fraction of income. This equation is always true; k will take whatever value needed to make it true. In England in the early 19th century, this equation was altered and made into a demand-for-money equation. The average amount of money people want to hold depends on the amount of spending they expect to do. Thus people who expect to spend a great deal will, on the average, want to hold larger cash balances than those who expect to spend only a little. The "on the average" in the last sentence is important. If a person holds $1400 on Monday and nothing the rest of the week, he has an average weekly holding of $200.
Making these alterations in equation 2 gives:
(3) Money demand = k(expected income)
The k in this equation should not move much or else the equation does not tell us much about how people act. This equation is unlike equation 2 because it makes a statement about how people want to act, while equation 2 tells us how they do act.
The writings of John Maynard Keynes made economists reconsider the traditional demand-for-money function. Keynes argued that there were three reasons why people hold money. They hold cash for transactions purposes, which is what the quantity theory had always said. They also hold money for precautionary reasons, so that in an emergency they would have a ready source of funds. Finally, they hold money for speculative purposes. The speculative motive arose from the effects of interest rates on the price of bonds. When interest rates rise, the price of bonds falls. Thus when people think interest rates are unusually low, they would prefer to hold their assets in the form of money. If they invested in bonds and the interest rate rose, they would suffer a loss. Hence the amount of money people would want to hold should be inversely related to the rate of interest. People will want to hold more money (liquidity) when interest rates are low than when they are higher.
Keynes' introduction of the interest rate into the demand for money has survived, but not for the reasons he gave. Keynes was thinking in terms of a two-asset world: money, which earned no interest but which was liquid and had no danger of a capital loss, and bonds, which earned interest but which were not as liquid and which could yield a capital loss. If one thinks not in terms of a two-asset world, but in terms of the range of assets that actually exist in the world, there is no reason to hold cash balances for either precautionary or speculative purposes. There are assets that are both very liquid and that earn interest, such as savings accounts and Treasury bills, and these are a better form in which to hold assets for these purposes.
Though Keynes' explanation of why interest rates influence the demand for money is flawed, other explanations are sound. Money held for transactions purposes is much like inventory that businesses hold. Holding inventories either ties up funds on which a business could earn interest, or uses borrowed funds on which it must pay interest. Thus if a firm can sell $100,000 of its inventory, it has $100,000 in cash that it can either invest to earn interest or pay off debt on which it must pay interest. The cost of inventories increases as interest rates rise or as the size of inventories increases.
However, there are also costs to holding inventories that are too low. If inventories are too small, a business may run out of items and lose sales. Further, if inventories are held at low levels, the business will need to reorder often, and there are usually costs to reordering. Thus the business must balance these costs that rise as inventories increase with the other costs that fall as inventories increase. The problem can be solved elegantly using calculus, but you should be able to see intuitively that a rise in interest rates will decrease the optimal size of inventories, and a rise in the cost of reordering will increase the optimal size.
When people hold cash balances, they hold their assets in a form that earns either no interest (coin and currency and some deposits on which checks can be written) or less interest than is possible in accounts on which no checks can be written.1 If interest rates rise on non-money assets relative to money, the cost of holding money in terms of interest foregone rises, and one would expect people to try to economize on cash. A business, for example, could shift money from checking accounts into t-bills. It would be worthwhile to make more transactions into and out of interest-bearing assets to take advantage of the higher interest rates. When interest rates are very low, these transactions may not be worthwhile, and the business may be willing to let money lie idle for short periods in checking accounts.
In a nutshell, the argument boils down to the store-of-value function of money. Money becomes a less desirable way to hold wealth when interest rates on other assets rises, and as a result people will hold smaller cash balances. These considerations lead us to a revised demand for money function. Instead of equation 3, the demand for money should be:
(4) Md = kYe + wi.
The demand for money, or the average amount of money people want to hold, depends positively on expected transactions and negatively on the interest rate. The coefficient w should be a negative number because with higher interest rates people should want to hold smaller cash balances.
To complete this part of the model, we need a money-supply equation and an equilibrium condition. A simple money-supply equation is that money stock is determined outside the system by policy. The logical equilibrium condition is that the market for money balances is in equilibrium when money supply equals money demand.
To see how this part of the model functions, imagine that interest rates are very low. When interest rates are very low, people have no special reason to avoid holding idle cash, and will hold considerable amounts. If they hold lots of cash idle, the fixed amount of money cannot support very much spending. Lots of idle cash means that the representative dollar is not being spent very frequently.
On the other hand, if interest rates are very high, holding idle cash is costly, and people will try to keep their holdings low. This means that they will spend money rapidly, or that the velocity of money will be high. With higher interest rates the same fixed quantity of money will support more spending than it did when interest rates were low and people were holding idle cash balances.
The LM curve illustrated above shows the relationship discussed in the last two paragraphs. The curve tells how much spending some fixed amount of money will support. When interest rates are high, as at i*, money is spent rapidly and supports a lot of spending, y*. When interest rates are low, at i#, the money stock supports less spending or y#. Connecting these two points to represent what happens at other interest rates generates the LM curve.

THE LM CURVE

The LM curve, named because it shows positions at which the demand for money (L for liquidity preference) equals money supply (M), completes the model. In the quantity theory of money we have already met a model of the market for money balances. The quantity theory asserted that velocity was constant, or
(1) MV = Y
which can be rewritten as:
(2) M= (1/V)Y = kY.
Equation 2 says that the amount of money that people hold is a fraction of income. This equation is always true; k will take whatever value needed to make it true. In England in the early 19th century, this equation was altered and made into a demand-for-money equation. The average amount of money people want to hold depends on the amount of spending they expect to do. Thus people who expect to spend a great deal will, on the average, want to hold larger cash balances than those who expect to spend only a little. The "on the average" in the last sentence is important. If a person holds $1400 on Monday and nothing the rest of the week, he has an average weekly holding of $200.
Making these alterations in equation 2 gives:
(3) Money demand = k(expected income)
The k in this equation should not move much or else the equation does not tell us much about how people act. This equation is unlike equation 2 because it makes a statement about how people want to act, while equation 2 tells us how they do act.
The writings of John Maynard Keynes made economists reconsider the traditional demand-for-money function. Keynes argued that there were three reasons why people hold money. They hold cash for transactions purposes, which is what the quantity theory had always said. They also hold money for precautionary reasons, so that in an emergency they would have a ready source of funds. Finally, they hold money for speculative purposes. The speculative motive arose from the effects of interest rates on the price of bonds. When interest rates rise, the price of bonds falls. Thus when people think interest rates are unusually low, they would prefer to hold their assets in the form of money. If they invested in bonds and the interest rate rose, they would suffer a loss. Hence the amount of money people would want to hold should be inversely related to the rate of interest. People will want to hold more money (liquidity) when interest rates are low than when they are higher.
Keynes' introduction of the interest rate into the demand for money has survived, but not for the reasons he gave. Keynes was thinking in terms of a two-asset world: money, which earned no interest but which was liquid and had no danger of a capital loss, and bonds, which earned interest but which were not as liquid and which could yield a capital loss. If one thinks not in terms of a two-asset world, but in terms of the range of assets that actually exist in the world, there is no reason to hold cash balances for either precautionary or speculative purposes. There are assets that are both very liquid and that earn interest, such as savings accounts and Treasury bills, and these are a better form in which to hold assets for these purposes.
Though Keynes' explanation of why interest rates influence the demand for money is flawed, other explanations are sound. Money held for transactions purposes is much like inventory that businesses hold. Holding inventories either ties up funds on which a business could earn interest, or uses borrowed funds on which it must pay interest. Thus if a firm can sell $100,000 of its inventory, it has $100,000 in cash that it can either invest to earn interest or pay off debt on which it must pay interest. The cost of inventories increases as interest rates rise or as the size of inventories increases.
However, there are also costs to holding inventories that are too low. If inventories are too small, a business may run out of items and lose sales. Further, if inventories are held at low levels, the business will need to reorder often, and there are usually costs to reordering. Thus the business must balance these costs that rise as inventories increase with the other costs that fall as inventories increase. The problem can be solved elegantly using calculus, but you should be able to see intuitively that a rise in interest rates will decrease the optimal size of inventories, and a rise in the cost of reordering will increase the optimal size.
When people hold cash balances, they hold their assets in a form that earns either no interest (coin and currency and some deposits on which checks can be written) or less interest than is possible in accounts on which no checks can be written.1 If interest rates rise on non-money assets relative to money, the cost of holding money in terms of interest foregone rises, and one would expect people to try to economize on cash. A business, for example, could shift money from checking accounts into t-bills. It would be worthwhile to make more transactions into and out of interest-bearing assets to take advantage of the higher interest rates. When interest rates are very low, these transactions may not be worthwhile, and the business may be willing to let money lie idle for short periods in checking accounts.
In a nutshell, the argument boils down to the store-of-value function of money. Money becomes a less desirable way to hold wealth when interest rates on other assets rises, and as a result people will hold smaller cash balances. These considerations lead us to a revised demand for money function. Instead of equation 3, the demand for money should be:
(4) Md = kYe + wi.
The demand for money, or the average amount of money people want to hold, depends positively on expected transactions and negatively on the interest rate. The coefficient w should be a negative number because with higher interest rates people should want to hold smaller cash balances.
To complete this part of the model, we need a money-supply equation and an equilibrium condition. A simple money-supply equation is that money stock is determined outside the system by policy. The logical equilibrium condition is that the market for money balances is in equilibrium when money supply equals money demand.
To see how this part of the model functions, imagine that interest rates are very low. When interest rates are very low, people have no special reason to avoid holding idle cash, and will hold considerable amounts. If they hold lots of cash idle, the fixed amount of money cannot support very much spending. Lots of idle cash means that the representative dollar is not being spent very frequently.
On the other hand, if interest rates are very high, holding idle cash is costly, and people will try to keep their holdings low. This means that they will spend money rapidly, or that the velocity of money will be high. With higher interest rates the same fixed quantity of money will support more spending than it did when interest rates were low and people were holding idle cash balances.
The LM curve illustrated below shows the relationship discussed in the last two paragraphs. The curve tells how much spending some fixed amount of money will support. When interest rates are high, as at i*, money is spent rapidly and supports a lot of spending, y*. When interest rates are low, at i#, the money stock supports less spending or y#. Connecting these two points to represent what happens at other interest rates generates the LM curve.
The addition of interest rates to the quantity theory allows fiscal policy to have effects within the logic of the quantity theory. If, for example, the government reduces taxes, thereby raising its deficit, it must borrow more. This added borrowing increases the demand for loanable funds and the price of these funds, which is the interest rate, should rise. The higher interest rate makes holding idle funds more expensive, and should result in an increased velocity of money

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EDUCATION IS OUR NATION'S SWORD

THE IS CURVE

In the simple income-expenditure model there was no explanation for what determined investment--it was imply assumed fixed. However, investment decisions are not arbitrary, but are determined by businessmen calculating the costs and benefits of additions to their capital stock and inventories, and by consumers calculating the costs and benefits of purchasing houses. Thus the model will be a better model if it can incorporate reasons for investment rather than leaving it outside the model.
Though the calculations determining the amounts of various categories of investment are each a bit different, all involve the interest rate. We will consider only the sort of calculation behind the decision to purchase new machinery, and will leave the decisions about inventory and housing to more advanced courses.
When a business decides whether or not to invest in new equipment, it estimates as best it can the future returns that will flow from the new equipment. Then it must compare these benefits to the costs of the investment. Suppose, for example, that a business can buy a new machine that it believes will add output worth $20,000 each year for five years. One might assume that the firm would decide to buy the machine if it costs less than $100,000. For example, if the machine costs $95,000, the firm could make a profit of $5000. However, this conclusion is wrong because it ignores the interest rate and the concept of present value.
If the firm must borrow the $95,000 in the above example and the interest rate is 10%, the machine would never earn enough to pay both the original cost and the interest on that cost. One could use the first year's returns of $20,000 to pay off part of the debt, but in the first year the amount owed would have grown by 10% or $9500. Thus after one year the business would owe $95,000-$20,000 + 9500 = $84,500. Continuing with future years, one sees that the business will lose money by purchasing the machine.
One might at this point argue that the conclusion would be different if the firm financed the machine from retained earnings. The argument is wrong. The firm has a choice of investing its $95,000 either in the machine or in a financial asset that will earn interest. Unless the firm is run by fools (in which case its future is not bright), it will use its funds where returns are highest.
In determining how much to invest, the firm must consider both the cost of the machinery and the cost of financing the investment. This latter cost depends on the interest rate. It also considers the potential returns on the investment, which depends on expected future spending in the economy. Thus in 1933, when there was massive unemployment of men and machines, there were few investment purchases which could have offered much of a return in future years. Even if the cost of financing new investment had been close to zero (it was not for most businesses, though it was for the government--interest rates that a borrower faces depend on how risky he seems to the lender), it would have made no sense for most businesses to add equipment. They already had plenty idle, and it served no purpose to build more to sit idle.
One could also argue that interest rates should affect consumption. Changes in interest rates affect the benefits from saving and the cost of borrowing. They also affect the value of financial wealth, and wealth should affect consumption. A rise in the interest rate causes the value of existing bonds to fall and a fall in the interest rate causes the value of existing bonds to rise. However, to keep the discussion simple, we will continue assuming that consumption is unaffected by changes in interest rates.
The modification that the above discussion makes to the simple income-expenditure model is illustrated below. In this table there are two columns that show investment. One column shows what investment will be at each level of income if the interest rate is 5%, while the other shows what investment will be if the interest rate is 4%. If the interest rate is 5%, equilibrium income is 600. If the interest rate drops to 4%, equilibrium income will rise to 700. Similarly, different levels of investment would exist for all other levels of interest rates, and for each interest rate, there would be an equilibrium level of income. We expect that lower interest rates would spur investment, and thus be associated with higher levels of equilibrium income.
The Income-Expenditure Model when Investment Depends on Interest Rate
Income Taxes Spend Save Government Spends Investment@5% Investment@4%
500 20 450 30 20 45 60
600 20 530 50 20 50 65
700 20 610 70 20 55 70
800 20 690 90 20 60 75

When we construct a graph showing equilibrium income is for each level of interest rate, we get a curve similar to that graphed below. It is called the IS curve, and its name comes from the condition for equilibrium when there is no government in the model: investment (I) must equal savings (S).

The addition of the interest rate to the income-expenditure model opens a way for monetary policy to influence spending within the logic of this model. When the central bank allows the banking system to create more money, banks increase their lending. This additional supply of funds reduces interest rates. Lower interest rates increase investment, which has a multiplier effect on total spending. A contraction of money will have opposite results.

CAPITAL BUDGETING

Capital budgeting (or investment appraisal) is the planning process used to determine whether a firm's long term investments such as new machinery, replacement machinery, new plants, new products, and research development projects are worth pursuing. It is budget for major capital, or investment, expenditures.

Many formal methods are used in capital budgeting, including the techniques such as

• Net present value
• Profitability index
• Internal rate of return
• Modified Internal Rate of Return
• Equivalent annuity

These methods use the incremental cash flows from each potential investment, or project. Techniques based on accounting earnings and accounting rules are sometimes used - though economists consider this to be improper - such as the accounting rate of return, and "return on investment." Simplified and hybrid methods are used as well, such as payback period and discounted payback period.

Net Present Value:

Each potential project's value should be estimated using a discounted cash flow (DCF) valuation, to find its net present value (NPV). (First applied to Corporate Finance by Joel Dean in 1951; see also Fisher separation theorem, John Burr Williams: Theory.) This valuation requires estimating the size and timing of all of the incremental cash flows from the project. These future cash flows are then discounted to determine their present value. These present values are then summed, to get the NPV. See also Time value of money. The NPV decision rule is to accept all positive NPV projects in an unconstrained environment, or if projects are mutually exclusive, accept the one with the highest NPV(GE)

The NPV is greatly affected by the discount rate, so selecting the proper rate - sometimes called the hurdle rate - is critical to making the right decision. The hurdle rate is the minimum acceptable return on an investment. It should reflect the riskiness of the investment, typically measured by the volatility of cash flows, and must take into account the financing mix. Managers may use models such as the CAPM or theAPT to estimate a discount rate appropriate for each particular project, and use the weighted average cost of capital (WACC) to reflect the financing mix selected. A common practice in choosing a discount rate for a project is to apply a WACC that applies to the entire firm, but a higher discount rate may be more appropriate when a project's risk is higher than the risk of the firm as a whole.

Internal rate of return:

The internal rate of return (IRR) is defined as the discount rate that gives a net present value (NPV) of zero. It is a commonly used measure of investment efficiency.

The IRR method will result in the same decision as the NPV method for (non-mutually exclusive) projects in an unconstrained environment, in the usual cases where a negative cash flow occurs at the start of the project, followed by all positive cash flows. In most realistic cases, all independent projects that have an IRR higher than the hurdle rate should be accepted. Nevertheless, for mutually exclusive projects, the decision rule of taking the project with the highest IRR - which is often used - may select a project with a lower NPV.

In some cases, several zero NPV discount rates may exist, so there is no unique IRR. The IRR exists and is unique if one or more years of net investment (negative cash flow) are followed by years of net revenues. But if the signs of the cash flows change more than once, there may be several IRRs. The IRR equation generally cannot be solved analytically but only via iterations.

One shortcoming of the IRR method is that it is commonly misunderstood to convey the actual annual profitability of an investment. However, this is not the case because intermediate cash flows are almost never reinvested at the project's IRR; and, therefore, the actual rate of return is almost certainly going to be lower. Accordingly, a measure called Modified Internal Rate of Return (MIRR) is often used.

Despite a strong academic preference for NPV, surveys indicate that executives prefer IRR over NPV, although they should be used in concert. In a budget-constrained environment, efficiency measures should be used to maximize the overall NPV of the firm. Some managers find it intuitively more appealing to evaluate investments in terms of percentage rates of return than dollars of NPV.

       Equivalent annuity method: 

The equivalent annuity method expresses the NPV as an annualized cash flow by dividing it by the present value of the annuity factor. It is often used when assessing only the costs of specific projects that have the same cash inflows. In this form it is known as the equivalent annual cost(EAC) method and is the cost per year of owning and operating an asset over its entire lifespan.

It is often used when comparing investment projects of unequal lifespans. For example if project A has an expected lifetime of 7 years, and project B has an expected lifetime of 11 years it would be improper to simply compare the net present values (NPVs) of the two projects, unless the projects could not be repeated.

The use of the EAC method implies that the project will be replaced by an identical project.

Alternatively the chain method can be used with the NPV method under the assumption that the projects will be replaced with the same cash flows each time. To compare projects of unequal length, say 3 years and 4 years, the projects are chained together, i.e. four repetitions of the 3 year project are compare to three repetitions of the 4 year project. The chain method and the EAC method give mathematically equivalent answers.

The assumption of the same cash flows for each link in the chain is essentially an assumption of zero inflation, so a real interest rate rather than a nominal interest rate is commonly used in the calculations.

Real options analysis:

Real options analysis has become important since the 1970s as option pricing models have gotten more sophisticated. The discounted cash flow methods essentially value projects as if they were risky bonds, with the promised cash flows known. But managers will have many choices of how to increase future cash inflows, or to decrease future cash outflows. In other words, managers get to manage the projects - not simply accept or reject them. Real options analysis try to value the choices - the option value - that the managers will have in the future and adds these values to the NPV.

              Ranked Projects:

The real value of capital budgeting is to rank projects. Most organizations have many projects that could potentially be financially rewarding. Once it has been determined that a particular project has exceeded its hurdle, then it should be ranked against peer projects (e.g. - highestProfitability index to lowest Profitability index). The highest ranking projects should be implemented until the budgeted capital has been expended.

Dividend Decision

Dividend
Meaning: Dividend is that part of the profits of a company which is distributed amongst its shareholders.
Definition:  "Dividend is a distribution to shareholders out of profits or reserves available for this purpose."

Nature of Dividend Decision The dividend decision of the firm is crucial for the finance manager because it determines: 1. the amount of profit to be distributed among the shareholders, and 2. the amount of profit to be retained in the firm. There is a reciprocal relationship between cash dividends and retained earnings. While taking the dividend decision the management take into account the effect of the decision on the maximization of shareholders' wealth. Maximizing the market value of shares is the objective. Dividend pay out or retention is guided by this objective. Dividend Policy Factors Affecting Dividend Policy: 1. External Factors 2. Internal Factors External Factors Affecting Dividend Policy 1. General State of Economy: In case of uncertain economic and business conditions, the management may like to retain whole or large part of earnings to build up reserves to absorb future shocks. In the period of depression the management may also retain a large part of its earnings to preserve the firm's liquidity position. In periods of prosperity the management may not be liberal in dividend payments because of availability of larger profitable investment opportunities. In periods of inflation, the management may retain large portion of earnings to finance replacement of obsolete machines. 2. State of Capital Market: Favourable Market: liberal dividend policy. Unfavourable market: Conservative dividend policy.

3. Legal Restrictions:
Companies Act has laid down various restrictions regarding the declaration of dividend:

• Dividends can only be paid out of:
• Current or past profits of the company.
• Money provided by the State/ Central Government in pursuance of the guarantee given by the Government.
• Payment of dividend out of capital is illegal.
• A company cannot declare dividends unless:
• It has provided for present as well as all arrears of depreciation.
• Certain percentage of net profits has been transferred to the reserve of the company.
• Past accumulated profits can be used for declaration of dividends only as per the rules framed by the Central Government

4. Contractual Restrictions:
Lenders sometimes may put restrictions on the dividend payments to protect their interests (especially when the firm is experiencing liquidity problems)
Example:
A loan agreement that the firm shall not declare any dividend so long as the liquidity ratio is less than 1:1.
The firm will not pay dividend more than 20% so long as it does not clear the loan.


Internal Factors affecting dividend decisions
1. Desire of the Shareholders:
Though the directors decide the rate of dividend, it is always at the interest of the shareholders.
Shareholders expect two types of returns:
[i]  Capital Gains: i.e., an increase in the market value of shares.
[ii] Dividends: regular return on their investment.

Cautious investors look for dividends because,
[i]   It reduces uncertainty (capital gains are uncertain).
[ii]  Indication of financial strength of the company.
[iii] Need for income: Some invest in shares so as to get regular income to meet their living expenses.

2. Financial Needs of the Company:
If the company has profitable projects and it is costly to raise funds, it may decide to retain the earnings.

3. Nature of earnings:
A company which has stable earnings can afford to have an higher divided payout ratio

4. Desire to retain the control of management:
Additional public issue of share will dilute the control of management.

5. Liquidity position:
Payment of dividend results in cash outflow. A company may have adequate earning but it may not have sufficient funds to pay dividends


Stability of Dividends
The term stability of dividends means consistency in the payment of dividends. It refers to regular payment of a certain minimum amount as dividend year after year.

Even if the company's earnings fluctuate from year to year, its dividend should not. This is because the shareholders generally value stable dividends more than fluctuating ones.

Stable dividend can be in the form of:
1. Constant dividend per share
2. Constant percentage
3. Stable rupee dividend plus extra dividend


Significance of Stability of Dividend
1. Desire for current income
2. Sign of financial stability of the company
3. Requirement of institutional investors
4. Investors confidence in the company


Danger of Stable Dividend Policy
Stable dividend policy may sometimes prove dangerous. Once a stable dividend policy is adopted by a company, any adverse change in it may result in serious damage regarding the financial standing of the company in the mind of the investors.


Forms of Dividend
1. Cash Dividend:
The normal practice is to pay dividends in cash.
The payment of dividends in cash results in cash outflow from the firm. Therefore the firm should have adequate cash resources at its disposal before declaring cash dividend.

2. Stock Dividend:
The company issues additional shares to the existing shareholders in proportion to their holdings of equity share capital of the company.
Stock dividend is popularly termed as 'issue of bonus shares.'
This is next to cash dividend in respect of its popularity.

3. Bond Dividend:
In case the company does not have sufficient funds to pay dividends in cash it may issue bonds for the amount due to shareholders.
The main purpose of bond dividend is postponement of payment of immediate dividend in cash. The bond holders get regular interest on their bonds besides payment of the bond money on the due date.
[Bond dividend is not popular in India]

4. Property Dividend:
This is a case when the company pays dividend in the form of assets other than cash. This may be in the form of certain assets which are not required by the company or in the form of company's products.
[This type of dividend is not popular in India]


Bonus Shares
When the additional shares are allotted to the existing shareholders without receiving any additional payment from them, is known as issue of bonus shares.
Bonus shares are allotted by capitalizing the reserves and surplus.

Issue of bonus shares results in the conversion of the company's profits into share capital. Therefore it is termed as capitalization of company's profits.
Since such shares are issued to the equity shareholders in proportion to their holdings of equity share capital of the company, a shareholder continues to retain his/ her proportionate ownership of the company.

Issue of bonus shares does not affect the total capital structure of the company. It is simply a capitalization of that portion of shareholders' equity which is represented by reserves and surpluses.

It also does not affect the total earnings of the shareholders