Chapter McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Working Capital and the Financing Decision 6

1-2 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

1-3 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

1-4 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.

1-5 The Nature of Asset Growth (cont’d)

1-6 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

1-7 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

1-8 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

1-9 Quarterly Sales and Earnings Per Share for McGraw Hill

1-10 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

1-11 Quarterly Sales and Earnings Per Share, Target and Limited Brands

1-12 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)

1-13 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 month sales forecast is issued –Result: Level production and seasonal sales combine to produce fluctuating inventory

1-14 Yawakuzi Sales Forecast (in units)

1-15 Yawakuzi’s Production Schedule and Inventory

1-16 Sales forecast, cash receipts and payments, and cash budget OctNovDecJanFebMarAprMayJuneJulyAugSept Sales (units) ,0002,0002,0002,0001, Sales $0.9$0.45$ $1.8$3.0$6.0$6.0$6.0$3.0$1.5 (unit price, $3,000) Sales Forecast ($ millions) 50% cash.45 $.225 $ $0.9 $1.5 $3.0 $3.0$3.0$1.5$.75 50% cash from prior month’s sales.75* Total cash receipts $ $0.300 $ $0.9 $2.4 $4.5 $6.0 $6.0$4.5 $2.25 *Assumes September sales of $1.5 million. Cash Receipts Schedule ($ millions) PPT 6-11

1-17 Constant production of 800 units/month (cost $2,000 per unit) $1.6$1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 Overhead Dividends & interest – – – – – – – – – – 1.0 – Taxes.3 – –.3 – –.3 – –.3 – – Total cash payments $2.3$2.0$2.0$2.3$2.0 $2.0 $2.3 $2.0 $2.0 $2.3 $3.0 $2.0 Cash flow $ (1.1) $ (1.325) $ (1.7) $ (2.225 ) $(2.0) $(1.1) $.1 $2.5$4.0 $3.7$1.5$.25 Beginning cash.25† Cumulative cash balance $(.85)$(1.075)$(1.45)$(1.975)$(1.75)$(.85)$.35$2.75$4.25$3.95$2.6 $2.85 Monthly loan or (repayment) (0.1) (2.5) (4.0) (2.85) – – Cumulative loan – – – Ending cash balance OctNovDecJanFebMarAprMayJuneJulyAugSept Cash Payments Schedule ($ millions) Cash Budget ($ millions; required minimum balance is $0.25 million ) PPT 6-12 Sales forecast, cash receipts and payments, and cash budget †Assumes cash balance of $0.25 million at the beginning of October and that this is the desired minimum cash balance.

1-18 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

1-19 Total Current Assets, First Year ($millions)

1-20 Cash Budget and Assets for II Year With No Growth in Sales ($millions)

1-21 Yawakuzi’s Nature of Asset Growth

1-22 Hedged Approach to Financing 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 PPT 6-17

1-23 Matching Long-Term and Short- Term Needs

1-24 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

1-25 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

1-26 Using Long-Term Financing for Part of Short-Term Needs

1-27 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 finance: Temporary current assets Part of the permanent working capital needs

1-28 Using Short-Term Financing for Part of Long-Term Needs

1-29 Short-Term vs. Long-Term Financing Short-term 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 don’t always need –you have capital at all times Firm must decide the appropriate “mix” PPT 6-21

1-30 Term Structure of Interest Rates The Term Structure of Interest Rates is also known as the Yield Curve A graph showing the interest rate for Government of Canada securities with different maturity dates Normally, long-term rates are higher than short- term rates

1-31 A. Flat yield curve, March 1999 PPT 6-12

1-32 A. Normal yield curve, July 1993 PPT 6-12

1-33 C. Inverted yield curve, December 1989 PPT 6-12

1-34 Long- and Short-Term Annual Interest Rates Relative volatility and the historical level of short-term and long-term rates

1-35 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

1-36 Alternative Financing Plans A Decision Process: Comparing alternative financing plans for working capital

1-37 Impact of Financing Plans on Earnings

1-38 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

1-39 Expected Returns under Different Economic Conditions

1-40 Expected Returns for High Risk Firms

1-41 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

1-42 Asset Liquidity and Financing Assets