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Optimal Working Capital Policies: A Chance-Constrained Programming Approach

Author(s): L. J. Merville and L. A. Tavis

Source: The Journal of Financial and Quantitative Analysis, Vol. 8, No. 1 (Jan., 1973), pp.
Published by: Cambridge University Press on behalf of the University of Washington
School of Business Administration
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January 1973



L. J. Merville and L. A. Tavis*

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

credit, inventory, or short-term borrowing policies. Yet, the vast majority

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

the interrelationships of this system.

This article presents a time-interlocked planning model wherein optimal

credit, inventory, and borrowing decisions are selected as part of a "short-term

funds subsystem." First, the critical credit-inventory linkage is outlined,

followed by the borrowing component. The model is then formulated in a chance-

constrained programming format with a transformation into a mixed-integer pro-

gramming problem.

I. Credit Term and Inventory Policy Components

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

terms and inventory policies available to management. A credit policy consists

of a number of elements: credit period, cash discount, credit standards,

collection procedures. Together, these elements significantly influence the

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.

The possible range of each credit element, as well as the combinations of

terms, is bounded by industrial standards and management attitudes. Furthermore,

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

finite and countable, denoted by [x.] I


*Indiana University and The University of Texas at Austin, respectively.

1For further discussion of the credit-term demand impact, see L. A. Tavis

[91 .


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Included in the broad classification of inventory policy is the production

or procurement of stocks of commodities to meet anticipated demand. These include

stocks for transactions and for precautionary, anticipatory, or even speculative

purposes. The model inventory policy variables are given by [y i IIl

Credit policies, through their demand impact, become determinants of

inventory policy. In the model, each credit policy triggers an inventory-carrying

requirement over time. A correspondence relationship between credit terms and

inventory-carrying policies can be implemented by the following constraints:

(la) 2xi - Yi < 1.0 i = 1, ..., I

-x + 2y. < 1.0

1 1 -


Xi {O? 1} integer,

y. = {O, 1} integer.

When policy x. is to be implemented (x. = 1.0), then policy y. must be implemented

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

policies from being in solution simultaneously.

(lb) xi = 1.0

Constraint (lb) also forces at least one accounts-receivable policy to be

selected from the available alternatives.

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

(lc) 2xi y. < 1.0 i = i, ..., I

1 m

-x. + 2 Z y. < 1.0
1 lm-


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xi = {O, 11 integer,

Yim = O } integer.

Associated with each inventory policy (yi ) is a set of cash-flow vectors

(h.. ) where:
h.m is the cash flow out to inventory in time period j for inventory
policy m associated with credit policy i.

The availability of finished-goods inventory designated by policy (yi ) converts

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

vector (d,.) for each set of credit terms;

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

Since the values of d.. are derived from distributions of demand and possible
collection experience, they are stochastic parameters of the problem. The h.jim
are also stochastic because production cash flows will vary with replenishment

or withdrawal from reserve balances as well as with anticipated future demand.

II. Borrowing Components

The financing of working capital investment is, of course, dependent upon

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

two components: funds committed on a permanent basis and those committed

temporarily. Permanent working capital increases or decreases as the activity

level of the firm trends upward or downward, respectively. Temporary commitments

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

Permanent working capital may be further divided. There is a basic level

of cash-receivables and inventory required to service demand at the firm's

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

inventory investment is minimized. This minimum commitment would generally be

financed through long-term sources only. In addition, there is a further

commitment of permanent working capital required because of continuing credit

and inventory policies. The financing of this incremental permanent commitment

is not as clear, because it is tied to controllable variables and is a continuing

commitment as long as the inventory and credit policies are maintained.

Alternatively, this investment can be liquidated in one operating cycle through

a change in policies. Intermediate and short-term borrowing would be acceptable

sources of financing for this incremental commitment.

Financing of permanent and temporary needs is allowed in the model. The

commitment of funds to permanent investment -- deriving from both the minimum


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

ing of temporary needs is facilitated by the inclusion of stochastic chance con-

straints for each time period over the time horizon.

Consider the following definitions required for implementing the financing

of the permanent commitment:

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:

(2a) EF. = F + AFM,

1 0 2.

EIV. = IV + AIV*.
1 0 1

The sources of funds for these investments are designated by:

Zk' funds for deterministic permanent working capital needs drawn from
source k.

ck' cash outflows associated with borrowing 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:


(2b) -l AFx + E z k > EF - F and

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

funds for working capital financing may be restricted to particular components

of permanent working capital in their use.

The temporary component of the system would be financed from different


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

source. As demand surges, or as collections slow, these sources could not be

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

discounts, would be called upon. This aspect of the financial environment is

included in a step-function marginal supply curve.

III. The Working Capital E-Model

The working capital model is developed in an horizon E-model format where

cash management and temporary working capital financing are treated stochastical-

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


The working capital model in primal form is given by

(3a) MAX. E{vJ - bJ E c k zk

subject to

(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

-b. + (1 + p )b, - g. H.) > a~

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

j = 1, ..., J

(3c) -E AF x + E z > EF - F
i=l k=l c o

I K'

-l AiVx + Z zk' > EIV - IV

i=l ~~k' =1 '

(3d) 2x; E yi < 1.0


-x + 2 Z y. < 1.0 i = 1, ..., I

1 1

Z x. = 1.0;
i=l 1

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

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

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

z. >0o

Zk > ? k =1, ...,K;


H. = CE. + D. + T. + Pit
CE. = long-term capital expenditures for time period j,
D. = cash dividend payment for time period j,
T. = taxes paid in time period j,
P. = net long-term financing cash flow for time period j,
and where:

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

v. is the amount of capital invested in near cash assets in time period j,


FL represents the average interest earned per period by investing in

near cash for all periods j (%),

b, is the amount borrowed on a seasonal or temporary basis in period j,

F represents the average cost of borrowing per period for source b.

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-

ing capital over the planning period.

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.

Constraints (3c) (presented previously as (2b)) are included to facilitate

the financing of the incremental permanent working capital. Constraints (3d)

(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

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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

near cash earning assets until it is required.

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

period considered feasible by management and the periodicity with which

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

planning horizon should be no shorter than 18 months. Conversely, if the longest

credit period to be given is 90 days and temporary financing is regularly

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

than 12 months.

The working capital model, (3), is a mixed-integer chance-constrained

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

and permanent working capital.

Before model (3) is amenable to solution codes, the deterministic

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

possible to write the model in the following form: 2

(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

2For a discussion of the transformation to this form see Byrne, Charnes,

Cooper, and Kortanek [3].


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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
zk - v0 + bo )

j j I j I M

|t t d=
t-l ti xit=l
i-l i hi-l
tim Yim

j K

t gtk k v0 +b) I
t=l k=l

subject to


(4b) - Z AF x + zk > EF -F
i=l k=l c 0

I K'

- Z AIVx + Z zk > EIV - IV

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

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


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1 +11fl
2 Z yi < 1.0 i = 1, ..., I

xi 1.0,

(4d) xi = {0, }1..., I

Yim = {0, 1} i = 1 ..., I

m =, ..., M

zk > 0 k 1, K

v. > 0 j

b. > 0 j = 1, ..., J.
3 -

Since the problem in (4) is deterministic but nonlinear, it is desirable

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

(5a) E Ht + i E dti xi + i 1 E htim Yim

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:


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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

(6c) wj* > wj* - K. j = 1, , J-1,

J - J J

(6d) -Z AF x .+ Z z > EF -F
i=l 1 1 k=l k 0

I K'

- AIV. x. + Z zk, > EIV -IV

i=l k '=1 k-kc o

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

-xY + 2 E y. < 1.0, I

Z x, = 1.0,

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


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

zk > 0 k =l, ..., K

w. >0 Oj=l1, ..., J=l

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

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

The model given in (6) is the linearized deterministic equivalent working

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

temporary borrowing outstanding (bo > 0).

A two-state upward sloping supply curve for temporary funds is included in

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

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 objective function.

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

or measurement of traditional variables in working capital management: (1) the

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

anticipated demand for the output of the firm.

A solution to (6) provides the financial manager with vital information

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-

stage capital supply curve, it is possible to analyze working capital alternatives

that require temporary funds of extraordinary magnitudes relative to their

incremental costs to the firm.


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IV. Conclusions

Decisions to commit funds to receivables or to inventories as well as to

the financing of these investments must be made simultaneously. Credit terms

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

operational flows and their associated stocks of inventories and receivables

define a financing requirement. With these relationships, optimal working

capital policies can be determined only in a systems context.

The main sources of environmental uncertainty for a firm directly affect

this system. Variability of demand in the short-run can prove to be a major

disruptive force as anticipated cash inflows fail to materialize. When credit

sales are involved, collection uncertainty is introduced into these inflows.

The possibility of relating the components of this system, particularly

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

development of chance-constrained formulations. The model presented in this

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

and temporary components. Permanent commitments associated with trends in basic

demand and demand as incremented by credit policies are treated as deterministic

and cumulative; temporary commitments are included periodically and stochastically

This distinction allows for a more explicit consideration of different sources of

financing. The relatively assured permanent commitments can be financed by con-

tinuing long-term or intermediate-term funds. The step in the short-term

borrowing function incorporates the high cost of incremental borrowing to support

temporary surges in demand. By combining the stochastic aspect with temporary

commitments, consideration is given to the marginal borrowing required to finance

collection delays along with demand surges.

The model was initially formulated as a mixed-integer chance-constrained

programming problem. The deterministic equivalent was developed and converted

to a linear form in order to make it amenable to solution by existing codes.

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

carrying out its short-term planning function.


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