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

2. 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

3. 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

4. 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.

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

6. 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

7. 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

8. 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

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

10. 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

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

12. 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)

13. 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 - 12- month sales forecast is issued –Result: Level production and seasonal sales combine to produce fluctuating inventory

14. 1-14 Yawakuzi Sales Forecast (in units)

15. 1-15 Yawakuzi’s Production Schedule and Inventory

16. 1-16 Sales Forecasts, Cash Receipts, and Payments, and Cash Budget

17. 1-17 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

18. 1-18 Total Current Assets, First Year ($millions)

19. 1-19 Yawakuzi’s Nature of Asset Growth

20. 1-20 Cash Budget and Assets for II Year With No Growth in Sales ($millions) Graphic presentation of the current asset cycle.

21. 1-21 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

22. 1-22 Matching Long-Term and Short- Term Needs

23. 1-23 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

24. 1-24 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

25. 1-25 Using Long-Term Financing for Part of Short-Term Needs

26. 1-26 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

27. 1-27 Using Short-Term Financing for Part of Long-Term Needs

28. 1-28 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

29. 1-29 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

30. 1-30 Long- and Short-Term Annual Interest Rates Relative volatility and the historical level of short-term and long-term rates

31. 1-31 Alternative Financing Plans A Decision Process: Comparing alternative financing plans for working capital

32. 1-32 Impact of Financing Plans on Earnings

33. 1-33 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

34. 1-34 Expected Returns under Different Economic Conditions

35. 1-35 Expected Returns for High Risk Firms

36. 1-36 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

37. 1-37 Net working capital as a percentage of sales—S&P Industrials

38. 1-38 Asset Liquidity and Financing Assets