ch06
TRANSCRIPT
Chapter
6
Working Capital and the Financing Decision
Prepared by: Terry Fegarty Seneca College Revised by: P Chua
McGraw-Hill Ryerson
2003 2003 McGraw-Hill RyersonLimited McGraw-Hill Ryerson Limited
PPT 6-2
Chapter 6 - Outline What
is Working Capital Management? The Nature of Asset Growth Term Structure of Interest Rates Short-Term vs. Long-Term Financing Approaches to Working Capital Financing Summary and Conclusions
2003 McGraw-Hill Ryerson Limited
PPT 6-3
Working Capital ManagementWorking
capital management is financing and controlling the investment in the current assets of a firmSales
growth often leads to a buildup in inventory and accounts receivable. Firm may require additional external financingGoal
is to achieve a balance between liquidity and profitability that contributes positively to the firms value.Crucial
to short-term success or failure of a business 2003 McGraw-Hill Ryerson Limited
Cash Conversion Cycle Operating
Cycle (OC) consists of that period of time measured by the Inventory Holding Period (IHP) or Average Age of Inventory (AAI) and the Average Collection Period (ACP) of accounts receivable.
Cash
Conversion Cycle (CCC) completes the flow of the OC by subtracting the Accounts Payable Period (APP) or Average Payment Period (APP) of accounts payable.
CCC = AAI + ACP - APP 2003 McGraw-Hill Ryerson Limited
Cash Conversion Timeline
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Strategies for Managing Cycle Turn
over inventory as quickly as possible (minimizing IHP). Collect accounts receivable as quickly as possible (minimizing ACP). Pay accounts payable as slowly as possible (maximizing APP).
2003 McGraw-Hill Ryerson Limited
PPT 6-5
Figure 6-1b
The nature of asset growthDollars
Temporary current assets
Permanent current assets
Capital assetsTime period 2003 McGraw-Hill Ryerson Limited
Figure 6-12
PPT 6-23
Yield curves showing Term Structure of Interest Rates
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Figure 6-13
Long-term and short-term interest rates
PPT 6-24
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Short-Term vs. Long-Term Financing Short-term
PPT 6-21
financing is less expensive but riskier
lower interest rates (usually) short-term rates are volatile risk of default if sales slow down risk that bank may not extend / renew loans Long-term
financing is more expensive but less risky
usually higher interest rates, you may pay interest on funds you dont always need you have capital at all times Firm
must decide the appropriate mix 2003 McGraw-Hill Ryerson Limited
Figure 6-8
PPT 6-18
Matching long-term and short-term needs (Balanced Approach)Dollars Temporary current assetsShort-term financing
Permanent current assets Capital assetsTime period
Long-term financing (debt & equity)
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Hedged (Balanced) Approach to Financing
PPT 6-17
Match liquidity (life) of your assets to the maturity (term) of your financing Means your assets will be generating cash when your liabilities come due (this reduces risk)
Balanced Financing
Temporary (seasonal) build-up in inventory and accounts receivable
finance with trade credit, short-term bank loans, short-term notes payable
Permanent (minimum) levels of inventory, receivables + Property and equipment, long-term investments
finance with long-term loans, leases, bonds, capital stock, retained earnings 2003 McGraw-Hill Ryerson Limited
Figure 6-9
PPT 6-19
Using long-term financing for part of short-term needs (Conservative)Dollars Temporary current assetsShort-term financing
Permanent current assets Capital assetsTime period
Long-term financing (debt & equity)
2003 McGraw-Hill Ryerson Limited
Figure 6-10
PPT 6-20
Using short-term financing for part of long-term needs (Aggressive)Dollars
Temporary current assetsShort-term financing
Permanent current assets
Long-term financing (debt & equity)
Capital assetsTime period
2003 McGraw-Hill Ryerson Limited
PPT 6-25
Table 6-7
Alternative financing plansEDWARDS CORPORATIONPlan A Part 1. Current assetsTemporary . . . . . . . Permanent . . . . . . . Total current assets . . . Short-term financing (6%). . Long-term financing (10%) . $250,000 250,000 500,000 125,000 375,000 $500,000 $100,000 $100,000 $125,000 475,000 $600,000
Plan B$250,000 250,000 500,000 375,000 125,000 $500,000 $100,000 $100,000 $375,000 225,000 $600,000 2003 McGraw-Hill Ryerson Limited
Part 2. Capital assetsPlant and equipment . . . . Long-term financing (10%) . Short-term (6%) . . . . . Long-term (10% . . . . .
Part 3. Total financing (summary of parts 1 & 2)
PPT 6-26
Table 6-8
Impact of financing plans on earningsEDWARDS CORPORATION Plan A Earnings before interest and taxes Interest (short-term), 6% $125,000 Interest (long-term), 10% $475,000 Earnings before taxes Taxes (50%) Earnings aftertaxes Plan B Earnings before interest and taxes Interest (short-term), 6% $375,000 Interest (long-term), 10% $225,000 Earnings before taxes Taxes (50%) Earnings aftertaxes
$200,000 7,500 47,500 145,000 72,500 $ 72,500$200,000 22,500 22,500 155,000 77,500 $ 77,500 2003 McGraw-Hill Ryerson Limited
PPT 6-29
Working Capital Financing PlansA conservative (safe or cautious) firm:
L/T financing and high liquidity
A moderate (balanced) firm:S/T financing and high liquidity OR L/T financing and low liquidity
An aggressive (risky) firm:
S/T financing and low liquidity
Appropriate
strategy is determined based on companys tolerance for risk 2003 McGraw-Hill Ryerson Limited
Table 6-11
PPT 6-30
Current asset liquidity and asset financing planAsset Liquidity Financing Plan Low Liquidity Short-term 1 High profit High risk 3 Moderate profit Moderate risk High Liquidity 2 Moderate profit Moderate risk 4 Low profit Low risk
Long-term
2003 McGraw-Hill Ryerson Limited
PPT 6-31
Summary and Conclusions
Working capital management involves the financing and management of current assets, such as cash, accounts receivable, and inventory As sales increase, a business requires additional current assets to support the higher sales volume In a hedged approach to financing, the financial manager tries to time the due dates of liabilities to the receipt of cash from sales Carrying more long-term debt increases the financing available, but involves a higher interest rate Carrying more short-term debt may reduces interest costs, but increases the risk of capital shortages Carrying more liquid current assets improves bill-paying capability, but may reduce potential profits 2003 McGraw-Hill Ryerson Limited