d

exshyffer ous less

IfS

hshyits 11 194 ershylat

)ut leshyng be ~s-

173Chapter 6 Working Capital and the Financing Decision

Figure 6-11 Percentage of working capital to sales for the Standard amp Poors Industrials

Percent

16

14 -

12

10

8

6

4

2

o 1993 1994 1995 1996 1997 1998

I 1999

I 2000

I 2001 2002 2003 2004

Source Standard amp Poors Financial Analysts Handbook 2005

As previously indicated the firm should attempt to relate asset liquidity to financing patterns and vice versa In Table 6-11 a number of working capital alternatives are presented Along the top of the table we show asset liquidity along the side the type of financing arrangement The combined impact of the two variables is shown in each of the four panels of the table

Asset liquidity

Financing Plan Low Liquidity High Liquidity

Short-term

1

High profit

High risk

2

Moderate profit

Moderate risk

Long-term 3

Moderate profit

Moderate risk

4 Low profit

Low riSK

Toward an Optimal Policy

Table 6-11 Asset liquidity and financing assets

to

It- In using Table 6-11 each firm must decide how it wishes to combine asset liquidity

Is and financing needs The aggressive risk-oriented firm in Panel 1 will borrow short I term and maintain relatively low levels of liquidity hoping to increase profit It will

lD benefit from low-cost financing and high-return assets but it will be vulnerable to a credit crunch The more conservative firm following the plan in Panel 4 will utilize

Chapter 6 Working Capital and the Financing Decision

Summary Working capital management involves the financing and controlling of the current assets of the firm These current assets include cash marketable securities accounts receivshyable and inventory A firms ability to properly manage current assets and the associated liability obligations may detennine how well it is able to survive in the short run

Because a firm with continuous operations will always maintain minimum levels of current assets management must be able to distinguish between those current assets

CaseSthat are permanent and those that are temporary or cyclical In order to determjne the Gale Force Surfing permanent or cyclical nature of current assets the financial manager must give careful Working capital-Level vs attention to the growth in sales and the relationship of the production process to sales seasonal production

Level production in a seasonal sales environment increases operating efficiency but it also calls for more careful financial planning

In general we advocate tying the maturity of the financing plan to the maturity of the current assets That is finance short-term cyclical current assets with short-term liabilities and permanent current assets with long-term sources of funds In order to carry out the companys financing plan with minimum cost the financial manager must keep an eye on the general cost of borrowing the term structure of interest rates the relative volatility of short- and long-term rates and predict if possible any change in the direction of interest rate movements

Because the yield curve js usually upward sloping long-term financing is genershyally more expensive than short-term financing This lower cost in favor of short-term financing must be weighed against the risk that short-term rates are more volatile than long-term rates Additionally jf long-term rates are expected to rise the financial manager may want to lock in long-term financing needs before they do

The firm has a number of risk-return decisions to consider Though long-term financing provides a safety margin for the availability of funds its higher cost may reduce the profit potential of the firm On the asset side carrying highly liquid curshyrent assets assures the bill-paying capability of the firm-but detracts from profit potential Each firm must tailor the various risk-return trade-offs to meet its own needs The peculiarities of a firms industry will have a major impact on the options open to its management

working capital management 153 self-liquidating assets 154 permanent current assets 154 temporary current assets 154 level production 154 point-of-sales terminals 158 term structure of interest rates

(yield curve) 167

List of Terms liquidity premium theory 167 market segmentation theory 167 expectations hypothesis 167 basis points 169 tight money 171 expected value 171

Discussion 1 Explain how rapidly expanding sales can drain the cash resources of a firm Questions 2 Discuss the relative volatility of short- and long-term interest rates

176 Part 3 Working Capital Management

3 What is the significance to worlGng capital management of matching sales and production

4 How is a cash budget used to help manage current assets

5 The most appropriate financing pattern would be one in which asset buildup and length of financing terms are perfectly matched Discuss the difficulty involved in achieving this financing pattern

6 By using long-term financing to finance part of temporary current assets a firm may have less risk but lower returns than a firm with a normal financing plan Explain the significance of this statement

7 A firm that uses short-term financing methods for a portion of permanent current assets is assuming more risk but expects higher returns than a firm with a normal financing plan Explain

8 What does the term structure of interest rates indicate

9 What are three theories for describing the shape of the term structure of interest rates (the yield curve) Briefly describe each theory

10 Since the mid-1960s corporate liquidity has been declining What reasons can you give for this trend

Practice Problems and 1 Meyer Electronics expects sales next year to be $3000000 if the economy is

Solutions strong $1200000 if the economy is steady and $800000 if the economy is weak Mr Meyer believes there is a 30 percent probability the economy will be strong a 60 percent probability of a steady economy and a 10 percent probability of a weak economy What is the expected level of sales for the next year

2 Otis Resources is trying to develop an asset-financing plan The firm has $200000 in temporary current assets and $500000 in permanent current assets Otis also has $300000 in fixed assets

a Construct two alternative financing plans for the firm One of the plans should be conservative with 70 percent of assets financed by long-term sources and the rest financed by short-term sources The other plan should be aggressive with only 20 percent of assets financed by long-term sources and the remaining assets financed by short-term sources The current interest rate is 12 percent on long-term funds and 5 percent on short-term financing Compute the annual interest payments under each plan

b Given that Otiss earnings before interest and taxes are $234000 calculate earnings after taxes for each of your alternatives Assume a tax rate of 35 percent

Solutions 1

Expected State of Economy Sales Probability Outcome

Strong $3000000 30 $ 900000

Steady 1200000 60 720000

Weak 800000 10 80000

Expected level of sales = $1700000

Chapter 6 Working Capital and the Financing Decision

ld 2 a Temporary current assets

Permanent current assets

Fixed assets

Total assets

$ 200000

500000

300000

$1000000

rID

Conservative Plan

rent

mal

Total Assets

$1000000

1000000

Percent of Total

Long term (70)

Short term (30)

Dollar Amount

$700000

300000

Interest Rate

12

05

Interest Expense

$84000

15000

Total Interest $99000

In Aggressive Plan

Total Percent of Dollar Interest Interest Assets Total Amount Rate Expense

$1000000 Long term (20) $200000 12 $24000

1000000 Short term (80) 800000 05 40000

Total Interest $64000

ility

b Conservative Aggressive

~ts EBIT $234000 $234000

I 99000 64000

EBT 135000 170000

Tax 35 47250 59500

d EAT $ 87750 $110500

es

rest

Ilg All problems are available in Homework Manager Please see the preface for more information au Problems

te 1 Austin Electronics expects sales next year to be $900000 if the economy is

strong $650000 if the economy is steady and $375000 if the economy is Expected value

weak The firm believes there is a 15 percent probability the economy will be strong a 60 percent probability of a steady economy and a 25 percent probability of a weak economy

ST6-1

What is the expected level of sales for next year

2 Sharpe Knife Company expects sales next year to be $1500000 if the Expected alue economy is strong $800000 if the economy is steady and $500000 if tbe economy is weak Mr Sharpe believes there is a 20 percent probability the economy will be strong a 50 percent probability of a steady economy and a 30 percent probability of a weak economy What is the expected level of sales for the next year

- -

-rshy

-ff L~ampb-s~+ -tu Wf-~ r------I

fAee~VN T v ~

~Vy~

-hc~l~~s Z~ p~- CyrM ~~~J ~~~~

= L + ~ i ~ J L ~yjf cA f

) j - - ) - - - ] ~

- ~ - ~- -- --

l ~ ~ V)(1

c A M AcAo n ~ + n 5 j c

~

L--ej QxL4 G n St2(Vo-J-v-ECO If S

~3Ie~~l-e

-__ Met +Gh ed -- 4) Com hind Con(e~I J~

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AjJ(t~~ =faN 0 d

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M-+e-k~ct p -- C 4

lJSeA3t 1lt i S-r raf1e1 -= sLr+ t-VIV) ~J~k

Jc~t c I LT c f(le-~ 0 (fA + f CA) A-lt~ -t -fs

~t ~b i~IV) CC Vi Czwtt Lfe ~

6~4-ry V~~ bull 0- I lt ~-or If- -fGr VV ~ VCll G (j

AV1j ) ~~e I~ It J itl -pna-l-t c ~

-=pound~plusmne=ej==-8Y- S fVLlrr~L ~~ ====oJ- poundeJ fu (9 f ~ tlr I Y1 1ewr

I yecvr J- 6J j f) f 1(tV 2 = S

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D~e-~ ~ lrecW rJvrn f ~~ -Ii ~ Lcrfe

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)-~ ~ tr~ y J~ +lt10 ) 7- ~ y )

reuroolt ~(~t - LVo +s-1a + (10 )3 c r oX

~-rlff ~~ v lo + fo +- 0 +71)y~ 5)-

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~ tear eevvv +ct [( I 0 L) )( ( I 0 5)] ~ -I 0 oy ~ ~ 8

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-

Chapter 6 Working Capital and the Financing Decision

Summary Working capital management involves the financing and controlling of the current assets of the firm These current assets include cash marketable securities accounts receivshyable and inventory A firms ability to properly manage current assets and the associated liability obligations may detennine how well it is able to survive in the short run

Because a firm with continuous operations will always maintain minimum levels of current assets management must be able to distinguish between those current assets

CaseSthat are permanent and those that are temporary or cyclical In order to determjne the Gale Force Surfing permanent or cyclical nature of current assets the financial manager must give careful Working capital-Level vs attention to the growth in sales and the relationship of the production process to sales seasonal production

Level production in a seasonal sales environment increases operating efficiency but it also calls for more careful financial planning

In general we advocate tying the maturity of the financing plan to the maturity of the current assets That is finance short-term cyclical current assets with short-term liabilities and permanent current assets with long-term sources of funds In order to carry out the companys financing plan with minimum cost the financial manager must keep an eye on the general cost of borrowing the term structure of interest rates the relative volatility of short- and long-term rates and predict if possible any change in the direction of interest rate movements

Because the yield curve js usually upward sloping long-term financing is genershyally more expensive than short-term financing This lower cost in favor of short-term financing must be weighed against the risk that short-term rates are more volatile than long-term rates Additionally jf long-term rates are expected to rise the financial manager may want to lock in long-term financing needs before they do

The firm has a number of risk-return decisions to consider Though long-term financing provides a safety margin for the availability of funds its higher cost may reduce the profit potential of the firm On the asset side carrying highly liquid curshyrent assets assures the bill-paying capability of the firm-but detracts from profit potential Each firm must tailor the various risk-return trade-offs to meet its own needs The peculiarities of a firms industry will have a major impact on the options open to its management

working capital management 153 self-liquidating assets 154 permanent current assets 154 temporary current assets 154 level production 154 point-of-sales terminals 158 term structure of interest rates

(yield curve) 167

List of Terms liquidity premium theory 167 market segmentation theory 167 expectations hypothesis 167 basis points 169 tight money 171 expected value 171

Discussion 1 Explain how rapidly expanding sales can drain the cash resources of a firm Questions 2 Discuss the relative volatility of short- and long-term interest rates

176 Part 3 Working Capital Management

3 What is the significance to worlGng capital management of matching sales and production

4 How is a cash budget used to help manage current assets

5 The most appropriate financing pattern would be one in which asset buildup and length of financing terms are perfectly matched Discuss the difficulty involved in achieving this financing pattern

6 By using long-term financing to finance part of temporary current assets a firm may have less risk but lower returns than a firm with a normal financing plan Explain the significance of this statement

7 A firm that uses short-term financing methods for a portion of permanent current assets is assuming more risk but expects higher returns than a firm with a normal financing plan Explain

8 What does the term structure of interest rates indicate

9 What are three theories for describing the shape of the term structure of interest rates (the yield curve) Briefly describe each theory

10 Since the mid-1960s corporate liquidity has been declining What reasons can you give for this trend

Practice Problems and 1 Meyer Electronics expects sales next year to be $3000000 if the economy is

Solutions strong $1200000 if the economy is steady and $800000 if the economy is weak Mr Meyer believes there is a 30 percent probability the economy will be strong a 60 percent probability of a steady economy and a 10 percent probability of a weak economy What is the expected level of sales for the next year

2 Otis Resources is trying to develop an asset-financing plan The firm has $200000 in temporary current assets and $500000 in permanent current assets Otis also has $300000 in fixed assets

a Construct two alternative financing plans for the firm One of the plans should be conservative with 70 percent of assets financed by long-term sources and the rest financed by short-term sources The other plan should be aggressive with only 20 percent of assets financed by long-term sources and the remaining assets financed by short-term sources The current interest rate is 12 percent on long-term funds and 5 percent on short-term financing Compute the annual interest payments under each plan

b Given that Otiss earnings before interest and taxes are $234000 calculate earnings after taxes for each of your alternatives Assume a tax rate of 35 percent

Solutions 1

Expected State of Economy Sales Probability Outcome

Strong $3000000 30 $ 900000

Steady 1200000 60 720000

Weak 800000 10 80000

Expected level of sales = $1700000

Chapter 6 Working Capital and the Financing Decision

ld 2 a Temporary current assets

Permanent current assets

Fixed assets

Total assets

$ 200000

500000

300000

$1000000

rID

Conservative Plan

rent

mal

Total Assets

$1000000

1000000

Percent of Total

Long term (70)

Short term (30)

Dollar Amount

$700000

300000

Interest Rate

12

05

Interest Expense

$84000

15000

Total Interest $99000

In Aggressive Plan

Total Percent of Dollar Interest Interest Assets Total Amount Rate Expense

$1000000 Long term (20) $200000 12 $24000

1000000 Short term (80) 800000 05 40000

Total Interest $64000

ility

b Conservative Aggressive

~ts EBIT $234000 $234000

I 99000 64000

EBT 135000 170000

Tax 35 47250 59500

d EAT $ 87750 $110500

es

rest

Ilg All problems are available in Homework Manager Please see the preface for more information au Problems

te 1 Austin Electronics expects sales next year to be $900000 if the economy is

strong $650000 if the economy is steady and $375000 if the economy is Expected value

weak The firm believes there is a 15 percent probability the economy will be strong a 60 percent probability of a steady economy and a 25 percent probability of a weak economy

ST6-1

What is the expected level of sales for next year

2 Sharpe Knife Company expects sales next year to be $1500000 if the Expected alue economy is strong $800000 if the economy is steady and $500000 if tbe economy is weak Mr Sharpe believes there is a 20 percent probability the economy will be strong a 50 percent probability of a steady economy and a 30 percent probability of a weak economy What is the expected level of sales for the next year

- -

-rshy

-ff L~ampb-s~+ -tu Wf-~ r------I

fAee~VN T v ~

~Vy~

-hc~l~~s Z~ p~- CyrM ~~~J ~~~~

= L + ~ i ~ J L ~yjf cA f

) j - - ) - - - ] ~

- ~ - ~- -- --

l ~ ~ V)(1

c A M AcAo n ~ + n 5 j c

~

L--ej QxL4 G n St2(Vo-J-v-ECO If S

~3Ie~~l-e

-__ Met +Gh ed -- 4) Com hind Con(e~I J~

~SamprJt-t C()c1f dJ

L oLAJ VS~~ 10 i f )~rt -~ Ftn041 ~ n) +j~ v S (A ~y__ 0 Ia I f L() -J -- -ft f fOW c d

AjJ(t~~ =faN 0 d

S lor t - icon F ClN cj )~ t ~~ r ~J~l- ~ i11

LolAJ v ~ 05~ io i f LOj -- -euror W) -F (0fA C ~

M-+e-k~ct p -- C 4

lJSeA3t 1lt i S-r raf1e1 -= sLr+ t-VIV) ~J~k

Jc~t c I LT c f(le-~ 0 (fA + f CA) A-lt~ -t -fs

~t ~b i~IV) CC Vi Czwtt Lfe ~

6~4-ry V~~ bull 0- I lt ~-or If- -fGr VV ~ VCll G (j

AV1j ) ~~e I~ It J itl -pna-l-t c ~

-=pound~plusmne=ej==-8Y- S fVLlrr~L ~~ ====oJ- poundeJ fu (9 f ~ tlr I Y1 1ewr

I yecvr J- 6J j f) f 1(tV 2 = S

11 eJAK T-(Si II J f~J I Vn J degf~ 1 0 j j poundtJvV 1- Bi ll vt 5j d f 1~ y = 7 ~

D~e-~ ~ lrecW rJvrn f ~~ -Ii ~ Lcrfe

VnJrvr1h~ e r ~o -LJ ree ~ J ( r ) Tilt I v~VB( ( r ~~

c) SIlfk c(CuI~()YI S (s liJl-fy t-eo- re+)

)-~ ~ tr~ y J~ +lt10 ) 7- ~ y )

reuroolt ~(~t - LVo +s-1a + (10 )3 c r oX

~-rlff ~~ v lo + fo +- 0 +71)y~ 5)-

JI) ~eDWI eJ r ic fv ~V CcIwIcJi c S CZ-xcd- 0mcf nWI be~

~ tear eevvv +ct [( I 0 L) )( ( I 0 5)] ~ -I 0 oy ~ ~ 8

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--

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-l~~~

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10--rtf JAJw4 ~ -j -g~r-D k lt

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~ut W AJY~ct

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J~M~ ~ 70Dk

LplNf --k

[ (S l

- ~4

ISok~ a) T - 6)Oc

- S7s-k gto~ r CVX bSO lc

IVT 57gt c- Z-_-------JJ ~ 7~kl

~ S~

Vl (v+vW ~

-

176 Part 3 Working Capital Management

3 What is the significance to worlGng capital management of matching sales and production

4 How is a cash budget used to help manage current assets

5 The most appropriate financing pattern would be one in which asset buildup and length of financing terms are perfectly matched Discuss the difficulty involved in achieving this financing pattern

6 By using long-term financing to finance part of temporary current assets a firm may have less risk but lower returns than a firm with a normal financing plan Explain the significance of this statement

7 A firm that uses short-term financing methods for a portion of permanent current assets is assuming more risk but expects higher returns than a firm with a normal financing plan Explain

8 What does the term structure of interest rates indicate

9 What are three theories for describing the shape of the term structure of interest rates (the yield curve) Briefly describe each theory

10 Since the mid-1960s corporate liquidity has been declining What reasons can you give for this trend

Practice Problems and 1 Meyer Electronics expects sales next year to be $3000000 if the economy is

Solutions strong $1200000 if the economy is steady and $800000 if the economy is weak Mr Meyer believes there is a 30 percent probability the economy will be strong a 60 percent probability of a steady economy and a 10 percent probability of a weak economy What is the expected level of sales for the next year

2 Otis Resources is trying to develop an asset-financing plan The firm has $200000 in temporary current assets and $500000 in permanent current assets Otis also has $300000 in fixed assets

a Construct two alternative financing plans for the firm One of the plans should be conservative with 70 percent of assets financed by long-term sources and the rest financed by short-term sources The other plan should be aggressive with only 20 percent of assets financed by long-term sources and the remaining assets financed by short-term sources The current interest rate is 12 percent on long-term funds and 5 percent on short-term financing Compute the annual interest payments under each plan

b Given that Otiss earnings before interest and taxes are $234000 calculate earnings after taxes for each of your alternatives Assume a tax rate of 35 percent

Solutions 1

Expected State of Economy Sales Probability Outcome

Strong $3000000 30 $ 900000

Steady 1200000 60 720000

Weak 800000 10 80000

Expected level of sales = $1700000

Chapter 6 Working Capital and the Financing Decision

ld 2 a Temporary current assets

Permanent current assets

Fixed assets

Total assets

$ 200000

500000

300000

$1000000

rID

Conservative Plan

rent

mal

Total Assets

$1000000

1000000

Percent of Total

Long term (70)

Short term (30)

Dollar Amount

$700000

300000

Interest Rate

12

05

Interest Expense

$84000

15000

Total Interest $99000

In Aggressive Plan

Total Percent of Dollar Interest Interest Assets Total Amount Rate Expense

$1000000 Long term (20) $200000 12 $24000

1000000 Short term (80) 800000 05 40000

Total Interest $64000

ility

b Conservative Aggressive

~ts EBIT $234000 $234000

I 99000 64000

EBT 135000 170000

Tax 35 47250 59500

d EAT $ 87750 $110500

es

rest

Ilg All problems are available in Homework Manager Please see the preface for more information au Problems

te 1 Austin Electronics expects sales next year to be $900000 if the economy is

strong $650000 if the economy is steady and $375000 if the economy is Expected value

weak The firm believes there is a 15 percent probability the economy will be strong a 60 percent probability of a steady economy and a 25 percent probability of a weak economy

ST6-1

What is the expected level of sales for next year

2 Sharpe Knife Company expects sales next year to be $1500000 if the Expected alue economy is strong $800000 if the economy is steady and $500000 if tbe economy is weak Mr Sharpe believes there is a 20 percent probability the economy will be strong a 50 percent probability of a steady economy and a 30 percent probability of a weak economy What is the expected level of sales for the next year

- -

-rshy

-ff L~ampb-s~+ -tu Wf-~ r------I

fAee~VN T v ~

~Vy~

-hc~l~~s Z~ p~- CyrM ~~~J ~~~~

= L + ~ i ~ J L ~yjf cA f

) j - - ) - - - ] ~

- ~ - ~- -- --

l ~ ~ V)(1

c A M AcAo n ~ + n 5 j c

~

L--ej QxL4 G n St2(Vo-J-v-ECO If S

~3Ie~~l-e

-__ Met +Gh ed -- 4) Com hind Con(e~I J~

~SamprJt-t C()c1f dJ

L oLAJ VS~~ 10 i f )~rt -~ Ftn041 ~ n) +j~ v S (A ~y__ 0 Ia I f L() -J -- -ft f fOW c d

AjJ(t~~ =faN 0 d

S lor t - icon F ClN cj )~ t ~~ r ~J~l- ~ i11

LolAJ v ~ 05~ io i f LOj -- -euror W) -F (0fA C ~

M-+e-k~ct p -- C 4

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Chapter 6 Working Capital and the Financing Decision

ld 2 a Temporary current assets

Permanent current assets

Fixed assets

Total assets

$ 200000

500000

300000

$1000000

rID

Conservative Plan

rent

mal

Total Assets

$1000000

1000000

Percent of Total

Long term (70)

Short term (30)

Dollar Amount

$700000

300000

Interest Rate

12

05

Interest Expense

$84000

15000

Total Interest $99000

In Aggressive Plan

Total Percent of Dollar Interest Interest Assets Total Amount Rate Expense

$1000000 Long term (20) $200000 12 $24000

1000000 Short term (80) 800000 05 40000

Total Interest $64000

ility

b Conservative Aggressive

~ts EBIT $234000 $234000

I 99000 64000

EBT 135000 170000

Tax 35 47250 59500

d EAT $ 87750 $110500

es

rest

Ilg All problems are available in Homework Manager Please see the preface for more information au Problems

te 1 Austin Electronics expects sales next year to be $900000 if the economy is

strong $650000 if the economy is steady and $375000 if the economy is Expected value

weak The firm believes there is a 15 percent probability the economy will be strong a 60 percent probability of a steady economy and a 25 percent probability of a weak economy

ST6-1

What is the expected level of sales for next year

2 Sharpe Knife Company expects sales next year to be $1500000 if the Expected alue economy is strong $800000 if the economy is steady and $500000 if tbe economy is weak Mr Sharpe believes there is a 20 percent probability the economy will be strong a 50 percent probability of a steady economy and a 30 percent probability of a weak economy What is the expected level of sales for the next year

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