Introduction to Corporate Finance

Ross et al.: Fundamentals

of Corporate Finance, Sixth

Edition, Alternate Edition

VII. Short−Term Financial

Planning and Management

19. Short−Term Finance
    and Planning

© The McGraw−Hill^677

Companies, 2002

650 PART SEVEN Short-Term Financial Planning and Management

FIGURE 19.2

Carrying Costs and

Shortage Costs

Carrying costs increase with the level of investment in current assets. They

include the costs of maintaining economic value and opportunity costs.

Shortage costs decrease with increases in the level of investment in current

assets. They include trading costs and the costs related to being short of the

current asset (for example, being short of cash). The firm's policy can be

characterized as flexible or restrictive.

Short-term financial policy: the optimal investment in current assets

Dollars

Amount of

current assets (CA)

Shortage costs

Carrying costs

Total cost of

holding current assets

Minimum point

CA*

CA* represents the optimal amount of current assets.

Holding this amount minimizes total costs.

A flexible policy is most appropriate when carrying costs are low relative to

shortage costs.

A. Flexible policy

CA*

Shortage costs

Carrying costs

Total cost

Minimum

point

Dollars

Amount of

current assets (CA)

A restrictive policy is most appropriate when carrying costs are high relative

to shortage costs.

Shortage costs

Carrying

costs

Total cost

Minimum point

B. Restrictive policy

Dollars

Amount of

CA* current assets (CA)