[ Music ] >> Heitor Almeida: So this is the solution to assignment two, okay? Question one is about the -- a tradeoff that a CFO faces when trying to decide whether to borrow today, right, or waiting to borrow in the future. The benefit of waiting to borrow in the future is that this is going to save some interest payments for the company, right? If you borrow today, you're going to have to start paying interest today, as we discussed in the lecture notes; however, there is an important point that borrowing today is going to protect the company from future risks, right? As we discussed in the notes, you know, in the lecture notes, companies can never be sure about what's the future situation of financial markets, the company's own financial situation may deteriorate, so there is this idea of precautionary borrowing, right? The idea of precautionary borrowing, which is that borrowing today and saving cash may be a way to protect the company from these financing risks. So these are the issues that you should have discussed in question one, okay? This very important idea in assignment two, which is why, you know, why should we think of something like accounts receivable as an investment? The idea, of course, is that having accounts receivable helps the business, right? It increases demand for the company's product because consumers are going to appreciate having some time to pay for your good, okay? However, it ties up cash, right? If you increase accounts receivable, it's going to take longer for cash to come in the company, right? Therefore, increasing accounts receivable is exactly like an investment. The company's spending cash, right, today, right, you're forgoing cash inflows today in order to generate more cash tomorrow. So this is the key idea that you should have understood and you should have used it to answer question two. Question three is about seasonality, right? So it's an example where the company needs short-term financing because of seasonality, and here, the optimal solution, the natural solution is to borrow in the beginning of the year and repay at the end of the year. As we discussed in the lecture notes, a bank credit line or a bank loan is going to be a very natural solution to a problem like that, okay? If the company has problems raising a bank loan, then you're going to have to think about other alternatives, such as increasing your cash holdings, right? Having higher cash is another solution; of course, that is going to require the company to raise cash somewhere. So you're going to have to issue additional external financing or save some cash from operations. Finally the third option is to change operations, right? So you might have to delay capital expenditures, cut some expenses, increase accounts payable and things like that. Of course, companies should try to avoid changing operations if you can solve a seasonality problem with a simple financial transaction, like a bank loan. Question four is about accounts payable, right? The liquidity risk that arises from accounts payable. Here is a specific example about the farm, right? And clearly the risk, the liquidity risk that the farm suffers, that it is exposed to, is that the suppliers may demand payment before they actually provide the necessary supplies for next year's harvest. Right? If you think about it, in this case, right, the farmer will have to pay for last year's supplies, right, that you financed last year; on top of that, you're going to have to buy the supplies for next year ahead of time. So the farm, in that case, might face a liquidity shortage. Right? That's exactly the notion of liquidity risk that we emphasized in module two, right? If the company has an open credit line with a bank, that's exactly the point at which it can use, if the farm has a credit line, right, what the farmer would do is to draw on the credit line, right, today, right, to buy the supplies for next year, right, and then repay the credit line at the end of the year when the crop comes in. So that would be a natural solution. Notice, though, that this is not a long-term solution, right? When next year comes, the farmer's going to have to refinance either the credit line or accounts payable, right? Otherwise, you're going to have the same problem in future years, okay? So really the right way for the financial -- for a financial manager to think about the situation is, you know, try to solve the long-term -- the short-term problem, but also think about the long-term, okay? And so you would have to think about, am I going to be able to refinance accounts payable? Should I finance my credit line? And of course, the alternative that is in question three is -- are to inject more cash in the business, right? So it might be the case that the farmer is going to have to save some cash, right? Or maybe even change operations. Okay? And then we go to question five, which was the numerical question of this assignment. As we discussed in the instructions, this is very important for our course, for our class, because we are using this example in module three to develop what is probably the most important concept in corporate finance, which is the notion of net present value, okay? So the particular example that we're going to talk about is related to module two, because it's going to consider the tradeoff that companies face when determining the amount of accounts receivable that they have, okay? And if you think about it, this is a choice a variable for companies, right? What they can do, as we can show you in the numbers, is to try to speed up the collection of receivables, and of course, that might generate the effects on the business. So this is a very simplified example, but which I think gets at the fundamental tradeoff of how companies determine accounts receivable, okay? So that's the current situation, right? At the beginning of the year, the company collects 80%. And it's selling $1 billion a year, right? Since you only collect 800, then you're going to generate receivables equal to 200. So here you have on the table the cash flows, right? So you have an 800 million cash flows today and then at the end of the year, you're going to collect the receivables that you generated today. Okay? The new system is identical, right, but with faster collection, right, and lower sales, okay? So that's the tradeoff: you're going to collect 90% now, so 882, which is 90% of 980, and generate 10% in receivables; but notice that the key thing here is that the sales went down. Why did the sales go down? Well, because consumers, you know, like having time to pay, so that's the idea that investing in -- that receivables is an investment, right? Having more receivables is going to increase your sales, right? So let's try to see if we can get at the tradeoff. Before we do that, we have to figure out what happens at the second year, the beginning of the second year or the end of the first year, right? So the company in the old situation, you are again selling a billion dollars, right? We assume that sales are constant. Collecting 80% today and generating new receivables. So have a look here at the table; that's what it looks like, right? So you collect 800 at the end of the year, generate receivables for the end of the following year, okay, but now notice that you have the $200 million in receivables that were generated today, right? Today these receivables were generated and they are collected at the end of the year. So the difference is that the collection today is 800, but the collection at the end of the year is going to be a billion dollars, right? So it's the 800 immediate sales plus the 200 million that you collect from receivables that you generated a year ago, okay? Same thing for the new system with different numbers, right? In the new system, you collect 882 today, and then, and when the end of the year comes, you generate new sales, which again give you 882, but you collect the -- you collect the receivables from the previous year. So the total sales is $980 million, okay? The total sales is $980 million. Okay? The total sales and the total cash flow at the end of the year. Right? And then if we think about future years, then what you quickly figure out is that the same thing is going to keep on happening, right? In the existing system, right, at the end of next year, you're going to generate an additional 800 million, okay, and then you're going to collect the receivables that were generated in the previous year, right? So you're going to have a total cash flow of $1 billion, okay? In terms of the new system, what happens is that, at the end of next year, you again generate $980 million in sales, get 90% of that, which is 882 today, and then collect the receivables that were generated last period, okay, which means that your total cash flow is $980 million. So what's the tradeoff? The cool thing is, you know, after doing all these calculations, now we can see the tradeoff in numbers, okay? So, and you should have been able to see that as well as you were working in the assignment, right? So what's the tradeoff? It's easy to see here. If you move to the new system, right, if you go from the top to the bottom, what will happen is that you're going to have higher cash flow today; the cost is that you're going to have lower cash flow, you know, next year at the end of the year and then at the end of the following year as well. So future cash flows go down, right? This is very related to the fundamental notion of what determines accounts receivable, right? As we discussed, an investment in accounts receivable, it means that you are forgoing cash today in order to generate higher cash flow in the future, and I think now you can see this idea here with the numbers. Okay? So in words, that's what we have, right? That's the tradeoff. And it's interesting now -- I mean, we are not really ready to make a decision, okay, because we haven't talked about net present value yet. It turns out that we have a tool in finance, in corporate finance, that allow us to, you know, to calculate a number that is going to summarize the consequences of a decision like that for shareholder value. This number is net present value, and this is one of the main goals of module three: to develop, calculate and apply the concept of net present value.