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Source: The Journal of Financial and Quantitative Analysis, Vol. 8, No. 1 (Jan., 1973), pp.

47-59

Published by: Cambridge University Press on behalf of the University of Washington

School of Business Administration

Stable URL: http://www.jstor.org/stable/2329747

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Quantitative Analysis

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JOURNAL OF FINANCIAL AND QUANTITATIVE ANALYSIS

January 1973

The current assets and current liabilities of a firm are the stock reflec-

tions of closely interrelated operational and financial cash flows. The net

effect of these combined flows must be recognized in searching for the optimal

of models for short-term investment and borrowing decisions do not allow for

gramming problem.

The decision variables of the model are the alternative packages of credit

demand for a firm's products. They affect the units demanded by each buyer as

well as the set of potential buyers. A demand distribution can thus be related

to each credit policy.

each of the components tends to be discrete. In the model, each set of credit

terms (each credit policy) that can be initiated by the firm is assumed to be

'i=l

[91 .

47

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Included in the broad classification of inventory policy is the production

Credit policies, through their demand impact, become determinants of

1 1 -

where:

Xi {O? 1} integer,

y. = {O, 1} integer.

1 1 1

(yi = 1.0) due to the constraints. Since only one credit policy (xi) is allowed

for all time periods (j), the following constraint prohibits two or more credit

(lb) xi = 1.0

i=l1

If more than one inventory policy is allowed for each credit policy (xi)

then a new set of policy variables can be defined:,[yim m1 where Yim is the

th imm=1 hee

m possible inventory policy which can be implemented under credit policy x.

The analog constraint to (la) under a variable inventory policy set becomes

m=l

1 m

M

-x. + 2 Z y. < 1.0

1 lm-

m=l

48

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where:

xi = {O, 11 integer,

Yim = O } integer.

(h.. ) where:

jim

h.m is the cash flow out to inventory in time period j for inventory

3im

policy m associated with credit policy i.

the credit-related demand to sales, thus allowing the definition of a cash-flow

31

d.. is the cash flow in from accounts receivable in time period j for

31

credit policy i.

Since the values of d.. are derived from distributions of demand and possible

31

collection experience, they are stochastic parameters of the problem. The h.jim

are also stochastic because production cash flows will vary with replenishment

the nature of the commitment. Working capital investments may be divided into

support surges in demand that are not expected to last,such as seasonal swings.

minimum activity level where credit terms are the most stringent possible and

49

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and policy increments -- is treated deterministically on an annual basis. Financ-

EFi is the permanent level of cash plus accounts receivable for policy x.i

EIV is the permanent level of inventory for policy xi.

If F and IV are the minimum permanent levels of cash-receivables and inventory,

0 0

respectively, and AF* and AIV* are the incremental changes in permanent cash-

receivables and inventory resulting from policy xi, then the following relation-

ships result:

1 0 2.

and

EIV. = IV + AIV*.

1 0 1

Zk' funds for deterministic permanent working capital needs drawn from

source k.

If, at the beginning of the planning period, the firm has an existing

level of investment in permanent working capital (EF , EIV ), then the financing

I P ~ ~~~~c c

of the required level of incremental permanent working capital for policy xi can

be accomplished by the constraints below:

I K

i=1 k=l

I K'

-E AIV x + Z z > EIV - IV

i=l 1 1 k'=l k c o

Here the AFi and AIVi are the amounts by which cash-receivables and inventory

must be changed to achieve the appropriate levels of incremental permanent work-

irng capital under policy xi. The A's may be positive or negative. The prime

notation used with the z 's indicates that some of the possible total sources of

50

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sources, although commercial paper or line of credit would be the preferred

expected to grow at the same rate as the working capital investment. Under these

circumstances, high cost reserve short-term credit sources, such as passing cash

cash management and temporary working capital financing are treated stochastical-

ly and the permanent levels of sources and uses of funds are derived determin-

istically.

subject to

I I M

(3b) Pr(-Z d. .x. E E h.. y + v. - 1+ p )v.

i=l i - i m-l jim im j L j-1

j B j-1 k-l jk k j - j

j = 1, ..., J

I K

(3c) -E AF x + E z > EF - F

i=l k=l c o

I K'

i=l ~~k' =1 '

m=l

1 1

m=l

Z x. = 1.0;

i=l 1

51

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(3e) xi = {0? } i = 1, ..., I

Yim = {, 1} i = 1, ..., I

m =, ..., M

b. > 0 j 1, ..., j

z. >0o

where:

H. = CE. + D. + T. + Pit

CE. = long-term capital expenditures for time period j,

J

D. = cash dividend payment for time period j,

J

T. = taxes paid in time period j,

J

P. = net long-term financing cash flow for time period j,

J

and where:

gjk is the amount of cash flow associated with source k in time period j

(%),

J

near cash for all periods j (%),

7Bj

for all periods j (%).

The goal of the model is to maximize the expected value of the investment

in near cash assets at the horizon and to minimize the costs of financing work-

The first set of constraints (3b) allows for the temporary investment and

its financing. Cash flows are assumed to be stochastic for each policy xi. The

v. determines the level of cash invested in near cash assets in period j while

the b. specifies the amount of borrowing for temporary uses occurring in period

j. Either v. or b., but not both, may be positive in a given time period.

(presented earlier as (la) and (lb)) are used to regulate the relationship

between the credit policy and the inventory policy. Thus, this model maximizes

the value of the funds left in the system at a set future time after considering

long-term capital investments, dividends, and taxes, and allowing for the

52

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commitment of additional funds to the system for permanent and temporary working

capital investments.

The borrowing cost parameters, ck and gjk, both relate to borrowing from

source k. If the cash-flow impacts of borrowing from source k occur at the end

of the horizon, then ck is positive and gjk = 0 for all j. If, however, the

permanent financing sources require interest and/or principal repayments within

the time horizon, then gjk is negative for some or all j and ck is set equal

to zero in the objective function. Having gjk in the constraints allows for

situations in which a selected permanent financing source flows cash into the

firm; this cash is invested over one or more periods following its receipt.

Consequently, any portion of the receipt not used in those periods is held in

Selection of the planning horizon would depend on both the maximum credit

temporary requirements are experienced over the long-term operations of the firm.

For example, if the need for temporary funds is encountered once in every 12-

month period while the longest credit period allowable is 18 months, then the

required every 12 months, then the planning horizon should be set at no less

than 12 months.

programming problem. The integer variables (xi, yim) specify the credit and

inventory poicies. The continuous variables (v., bit zj'k

) determine the optimal

level of investment in near cash assets and the financing of both temporary

equivalent must be developed. Using a recursion relationship for v. and bj, and

noting the a. = 1.0 (j = 1, ..., J) because v. and b. are stochastic, it is

J J I J I M

(4a) MAX. E{ {= { H + E E d,. x. + h.. y.

j=l 3 j=l i=l 31 1 j=l i=l m=l jim im

J K _J-

j-lk-l gjk k 0 b0 PL L

j=l k=l 3- =1

Cooper, and Kortanek [3].

53

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j j Ii j I M

[ ( ZHt + Z E d . x + Z E h yi

t=l t=l i=l ti j t=l i=l m=l tim im

j K

+ z E g ztkzk + v0 bo

t=l k=l

j j I j I M

+ | ( Z Ht + Z Z d X. + Z Z h yi

t=1 t=1 i=1 ti ' t=1 i=1 m=1 tim im

j K

+ k tk k v- b) I]

t=l k=1

_J-1 j j I j I M

Bp . Ht i d . x. E E h m y.

B =11 t= t t=1 i 1 l t=l i= M1 1 tm

j K

E gtk

t=l

zk - v0 + bo )

k=1

j j I j I M

t=H1

|t t d=

t-l ti xit=l

i-l i hi-l

mm-l

tim Yim

j K

t gtk k v0 +b) I

t=l k=l

subject to

I K

(4b) - Z AF x + zk > EF -F

i=l k=l c 0

I K'

i=1 1 k'=l k- c o

M

(4c) 2x.E- y < 1.0

m=l

54

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M

-x

1 +11fl

2 Z yi < 1.0 i = 1, ..., I

m=l

xi 1.0,

1=11

m =, ..., M

zk > 0 k 1, K

v. > 0 j

b. > 0 j = 1, ..., J.

3 -

to convert the model to a linear form. The nonlinearity results from the

absolute factors in the pL and pB terms in the objective function. If, for

each j, additional continuous variables w. and wD are introduced, then the

3 3 ~~~th

following constraints force w. and w* to be equal to the j term in the pL

and pB terms, respectively.

j j I j I M

j K

+ Z Z g z - w. + w*= b - v.

t=1 k=l 0 0

(5b) w. > 0

3 -

w* > 0.

If constraints of the form given by (5) are included for the j = 1, ....

J-1 terms appearing in the PL and pB terms given in (4), then the equivalent

problem to (4) in mixed-integer-linear form is:

55

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J _ J I J I M

(6a) MAX. E{Tr} =Tr= Z H + Z d.. x. + Z Z h y.

j=-1 j=1 i=l 3 1 j=l i=l m=1 3jim im

J K J-1

+ E E + v -b + E W.

j =1 k=l i k k O bo +L Z= w

j-lk-1 - i -1

J-1 J-1

PB E Wj* PB WZ *

j=J 3 j=1

subject to

j _ j I _ j I M j K

(6b) ZH + Zdt x +Z Z Eh ti im + kz

t=l t=1 i= i t=l i=l m-l tim t=l k=l

- w. + w* = b - v j=1, ,J-1,

J j 0 0

J - J J

I K

(6d) -Z AF x .+ Z z > EF -F

i=l 1 1 k=l k 0

I K'

i=l k '=1 k-kc o

M

(6e) 2x - Z y. < 1.0

1 m

m=l

M

-xY + 2 E y. < 1.0, I

m=l

I

Z x, = 1.0,

11

(6f) xi = {, 1} i = 1, . , I

56

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yi = {O l} i = 1, ..., I

m=l, ...,M

wi > 0 j = 1, ..., J 1

J -

W)* > 0 j = 1, ..., J - 1

capital model under an assumed level of near cash assets (v > 0) or with initial

the model through constraint (6c) and the addition of the pB term in the objective

function. If the amount of temporary funds borrowed exceeds K. (for a given j),

then w~* is forced to be equal to this excess by (6c). The interest cost pB on

j B

this excess (w** > 0) is the difference between the absolute amount paid on

J_

the excess and PB' since w' equals the total amount of temporary funds borrowed

which includes the excess amount costed at pB in the objective function. It may

be noted that if wt is zero or positive and less than K., then wt* will equal

zero by the condition w** > 0 in (6f) along with the negative coefficient in

The parameters to the model in (6) depend only on the specification and/

possible credit and inventory policies, (2) the potential sources and costs of

capital for current asset investment, (3) a cash-flow projection for the firm

as a whole, and (4) some knowledge of the production cycle and credit-related

about the proper management of the firm's working capital. The optimal accounts-

receivable policy is specified and the appropriate inventory policy for that

credit policy is also indicated. The model determines the amount and type of

capital funds required for investment in current assets over the given planning

horizon such that overall costs to the firm are minimized. Through the two-

57

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IV. Conclusions

offered, inventory decisions, and short-term borrowing each impact the optimal

policies of the others because of the linkages among their associated cash

flows. The credit terms offered by a firm influence demand. Inventory policies

and production schedules translate this demand into sales and, at the same time,

establish the cash commitment to inventories. The same credit policies that

influence demand set the timing and the amount of expected cash returns. These

their stochastic aspects, spatially and over time has been enhanced by the

paper allows for the integrated planning of optimal working capital policies

in a chance-constrained format.

In the model, the working capital investment is divided into its permanent

The final result is a readily solvable model that provides the structure within

which management can relate the complex set of credit and inventory policies in

58

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REFERENCES

[1] Archer, Stephen H. "A Model for the Determination of Firm Cash Balances."

JQ?rnal oQ Fingncial and Quantitative Analysis, vol. 1 (March 1966),

pp. 1-11.

[2] Benishay, Haskel. "A Stochastic Model of Credit Sales Debt." Journal of the

American Statistical Association, vol. 61 (December 1966), pp. 1010-1027.

[3] Byrne, R.F.; A. Charnes; W.W. Cooper; and K.O. Kortanek. "A Discrete

Probability Chance-Constrained Capital Budgeting Model II." Opsearch,

vol. 6 (December 1969), pp. 226-261.

[4] Charnes, A., and W.W. Cooper. "Deterministic Equivalents for Optimizing

and Satisficing Under Chance Constraints." Operations Research,

vol. 2 (January-February 1963), pp. 18-39.

Journal of Financial and Quantitative Analysis,, vol. 5 (December 1970),

pp. 421-444.

[6] Miller, Merton H., and Daniel Orr. "A Model of the Demand for Money by

Firms." Quarterly Journal of Economics, vol. 53 (August 1966), pp. 413-435.

[7] Orgler, Yair E. "An Unequal-Period Model for Cash Management Decisions."

Management Science, vol. 16 (October 1969), pp. 77-92.

[8] Robichek, A.A.; D. Teichroew; and J.M. Jones. "Optimal Short-Term Financing

Decision." Management Science, vol. 12 (September 1965), pp. 1-36.

[9] Tavis, L.A. "Finding the Best Credit Policy." Business Horizons,

(October 1970), pp. 33-40.

Position." Engineering Economist, vol. 14 (Winter 1969), pp. 71-89.

Economist, vol. 9 (January-February 1964), pp. 21-35.

59

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