Chap 006
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Transcript of Chap 006
Chapter
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Working Capital and the Financing Decision6
6-2
Chapter Outline
• Working capital management
• Current asset management
• Asset financing
• Long-term versus short-term financing
• Risk and profitability vis-à-vis asset financing
• Expected value analysis may sometimes be employed
6-3
Working Capital Management
• The financing and management of the current assets of a firm– Crucial to achieving long-term objectives of the
firm or its failure– Requires immediate action
6-4
The Nature of Asset Growth
• Effective current assets management requires matching of the forecasted sales and production schedules
• Differences in actual sales and forecasted sales can result in:– Unexpected buildup.– Reduction in inventory, affecting receivables and
cash flow• Firm’s current assets could be:
– Self-liquidating– ‘Permanent’ current assets.
6-5
The Nature of Asset Growth (cont’d)
6-6
Controlling Assets – Matching Sales and Production
• Fixed assets grow slowly with:– Increase in productive capacity– Replacement of old equipment
• Current assets fluctuate in the short run, depending on:– Level of production versus the level of sales
• When production is higher than sales the inventory rises
• When sales are higher than production, inventory declines and receivables increase
6-7
Controlling Assets – Matching Sales and Production (cont’d)
• Cash budgeting process– Level production method
• Smooth production schedules• Use of manpower and equipment efficiently to lower
cost
– Match sales and production as closely as possible in the short run
• Allows current assets to increase or decrease with the level of sales
• Eliminates the large seasonal bulges or sharp reductions in current assets
6-8
Matching Sales and Production-McGraw-Hill Companies, Inc.
• A good example of seasonal sale
• Has significant share of sales and earnings in the third and fourth quarters
• Due to seasonal nature of textbook publishing– Lenders and financial managers need to plan
inventory – Lack of correct inventory planning can lead to
lost sales
6-9
Quarterly Sales and Earnings Per Share for McGraw Hill
6-10
Seasonal Sales Pattern in Target and Limited Brands
• Like publishers, retail companies do not stock inventory for more then a year
• Fourth quarter is the biggest quarter for retailers
• As per the figure, the Target is growing much faster than the Limited Brands
• Even then, in the fourth quarter, peak earnings are almost equal for both the companies
6-11
Quarterly Sales and Earnings Per Share, Target and Limited Brands
6-12
Point-of-Sales Terminals
• Retail-oriented firms use new, computerized inventory control systems linked online– Digital inputs or optical scanners
• Helps adjust orders or production schedules
– Radio Frequency Identification (RFID)
6-13
Temporary Assets under Level Production – An Example
• Yawakuzi Motorcycle Company – Sales fluctuations: High sales demand during
early spring and summer; sales drop during October through March
– Decision: Apply level production method - 12-month sales forecast is issued
– Result: Level production and seasonal sales combine to produce fluctuating inventory
6-14
Yawakuzi Sales Forecast (in units)
6-15
Yawakuzi’s Production Schedule and Inventory
6-16
Sales Forecasts, Cash Receipts, and Payments, and Cash Budget
6-17
Sales Forecasts, Cash Receipts, and Payments, and Cash Budget (cont’d)• Table 6-3 is created to examine the buildup
in accounts receivable and cash– Sales forecast: Based on assumptions taken
earlier (table 6-1)– Cash receipts: 50% cash collected during the
month of sale and 50% pertains to the prior month
– Cash budget: a comparison of cash receipt and payment schedules to determine cash flow
6-18
Total Current Assets, First Year ($millions)
6-19
Yawakuzi’s Nature of Asset Growth
6-20
Cash Budget and Assets for II Year With No Growth in Sales ($millions)• Graphic presentation of the current asset
cycle.
Exercises
11th Edition – Problem 16
13th Edition – Problem 19
6-21
6-22
Patterns of Financing
• Selection of external sources to fund financial assets is an important decision
• The appropriate financing pattern:– Matching of asset buildup and length of
financing pattern
6-23
Matching Long-Term and Short-Term Needs
6-24
Alternative Plans
• It is important to consider other alternatives– The challenge of constructing a financial plan is
to prioritize the current assets into temporary and permanent
– The exact timing of asset liquidation, even in the light of ascertaining dollar amounts is onerous
– It is also difficult to judge the amount of short-term and long-term financing available
6-25
Long-Term Financing
• Firms can be assured of having adequate capital at all times:– Use long-term capital to cover part of the short-
term needs– Long-term capital can be used to finance:
• Fixed assets• Permanent current assets• Part of the temporary current assets
6-26
Using Long-Term Financing for Part of Short-Term Needs
6-27
Short- Term Financing
• Small businesses do not have total access to long-term financing– They rely on short-term bank and trade credit– Advantage: interest rates are lower– Short-term finances are used to finance:
• Temporary current assets• Part of the permanent working capital needs
6-28
Using Short-Term Financing for Part of Long-Term Needs
6-29
Term Structure of Interest Rates
• A yield curve – that shows the relative level of short-term and long-term interest rates – U.S. government securities are popular as they
are free of default risks– Corporate debt securities entail a higher interest
rate due to more financial risks– Yield curves for both securities change daily to
reflect:• Current competitive conditions• Expected inflation• Changes in economic conditions
6-30
Basic Theories - Yield Curve
• Liquidity premium theory– Long-term rates should be higher than short-
term rates
• Market segmentation theory– Treasury securities are divided into market
segments by the various financial institutions investing in the market
• Expectations hypothesis– Yields on long-term securities is a function of
short-term rates
6-31
Long- and Short-Term Annual Interest Rates
• Relative volatility and the historical level of short-term and long-term rates
6-32
Alternative Financing Plans
• A Decision Process: Comparing alternative financing plans for working capital
6-33
Impact of Financing Plans on Earnings
6-34
Varying Condition and its Impact
• Tight money periods– Capital is scarce making short-term financing
difficult to find or may ensue very high rates– Inadequate financing may mean loss of sales or
financial embarrassment
• Expected value– Represents the sum of the expected outcomes
under both conditions
6-35
Expected Returns under Different Economic Conditions
6-36
Expected Returns for High Risk Firms
6-37
Toward an Optimal Policy
• A firm should:– Attempt to relate asset liquidity to financing
patterns, and vice versa– Decide how it wishes to combine asset liquidity
and financing needs• Risk-oriented firm - short-term borrowings and low
degree of liquidity• Conservative firm - long-term financing and high
degree of liquidity
6-38
Net working capital as a percentage of sales—S&P Industrials
6-39
Asset Liquidity and Financing Assets
Exercises:
11th Edition – 1, 10, 20
13th Edition – 1, 13, 17
6-40