Page 138 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 8: Cash Planning

distributions are possible. Then, large number of trials is run. From these trial results, frequency Notes
histograms of the important outcome variables would be developed and these compared to
known probability distributions via goodness-of-fit methods.
To apply simulation analysis in estimating the total uncertainty in cash forecast, one of the
uncertainties that must be quantified is that of the collection rates on accounts receivable.
Uncertainty in the collection rates of receivables is an important component in the overall
uncertainty of the cash forecast. The usual method of estimating these rates is to compute
individual collection rates on various periods’ sales using historic data. Another approach to the
problem aids a quantifying the multivariate uncertainty in these rates. The approach estimates
all the collection rates simultaneously by regressing past sales figures against past collections.
The estimated collection of the sales figures in the regression can be interpreted as the collection
proportions and the standard errors of the estimated regression collection as the uncertainty
inherent in the estimation of this collection proportion.

Self Assessment

State whether the following statements are true or false:

7. Sales uncertainty is the uncertainty regarding the firm’s actual future collection patterns
of receivables.
8. Collection rate uncertainty refers to the risk regarding the firm’s future levels of sales.

9. Production cost uncertainty has to do with the risk of the actual labour and material costs
that go into the making of a product of service.
10. Capital outflow uncertainty is one of the biggest sources of surprises in cash flow
forecasting.

8.4 Hedging vs Interest Rate

To understand the mechanics and alternative in holding, it is first necessary to understand a bit
better why it is of advantage to the firm to hedge. At the end of cash period of the cash forecast,
the firm expects to be in either a surplus or a deficit position. Let us examine the risks and cost
that the firm would face if it did not hedge in cash of these cases. That is, assume that the firm
keeps no cash, near-cash marketable securities, additional borrowing arrangements, or any
other possible hedge.
If the firm is in a period of borrowing, at its maximum available borrowing limits (as determined
by its credit line arrangements), and cash flows turn out to be less than expected (so that borrowing
needs would be greater than expected), the firm would be faced with a substantial problems. All
the solutions to this problem are costly.

Example: The firm could raise cash to cover the deficit by obtaining an emergency loan
from its bank. However, bankers are not very receptive to emergency request of this type, and
this solution could endanger the firm’s relationship with its bank. Alternatively, the firm could
delay one or more types of outflows, such as payments to trade suppliers. This would, of course,
endanger relationships with these suppliers. Another strategy the firm might consider would
be to sell an asset quickly to generate cash: but the rushed sale might net the firm less for the
asset than if it sold the asset in a more considered fashion. In a time of surplus, where the firm
has invested the extra funds in longer-maturity securities (to take advantage of yield curve
effects), and the firm has another alternative: it may sell the investment prior to maturity. But by
purchasing longer-term securities, the firm has subjected itself to interest rate risk; if interest
rates have increased, the return on the investment will be reduced.

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