1. Chapter 9 Working Capital Policy

2. Importance of Working Capital Management Net working capital = current assets – current liabilities Net working capital = “circulating capital” There is urgency to working capital decisions because of close relationship between sales growth and growth of working capital

3. Importance of Working Capital Management Large size of working capital accounts makes working capital policy important First line of defense in response to revenue downturn is good working capital management Effective working capital management is important for survival

4. Short-term versus Long-term Financing Short-term debt is riskier than long-term debt due to interest-rate risk and renewal risk Short-term debt generally is less expensive and more flexible Match loan maturities with asset maturities Classic rule for going broke is to “borrow short and invest long” Permanent growth in level of net working capital requires a source of permanent financing

5. Term Structure of Interest Rates Yield to maturity = average annual compound rate of return by lender Term structure of interest rates shows relationship between yield to maturity and term to maturity In a “normal” yield curve, short-term debt yield is less than long-term (see Exhibit 9.1)

6. Term Structure of Interest Rates Yield curve is not always “normal” (see Exhibit 9.2) Liquidity preference: long-term rates should be higher than short-term rates due to borrowers’ preference to borrow long and lenders’ preference to lend short

7. Term Structure of Interest Rates Expectations hypothesis: yield curve is the result of market participants’ future expectations about the term structure; the average annual compound rates of return expected on short- term investments over the term of the long-term investment Market segmentation theory: term structure results from supply of and demand for money in each market segment

8. Relative Magnitude of Working Capital Investment Aggressive policy maintains low level of current assets and high levels of current liabilities Two major benefits to an aggressive policy: –Minimizing current assets increases ROI –Short-term debt is less expensive than long-term debt Conservative policy maintains higher levels of current assets and is less aggressive in employing short-term debt

9. Inventory Control Policy Aggressive policy minimizes inventory investment, leading to increased ROI Aggressive policy increases possibility of production shortages due to inventory shortages and lost sales due to stockouts Economic order quantity model is detailed in chapter 10

10. Credit Policy Policy variables for management of accounts receivable need to be established Terms under which credit will be offered need to be set up To whom credit will be offered also must be decided There is a relationship between accounts receivable and short-term liability structure

11. Accounts Payable Payment Policy Determine payment terms and whether or not to take discounts Assess cost and availability of money versus imputed interest rate of missed discounts Payment policy has an impact on credit rating