MLI28C060 - Corporate Finance Seminar 11. Question 1. Define working capital. Why is it’s management so important to firms?

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Presentation transcript:

MLI28C060 - Corporate Finance Seminar 11

Question 1. Define working capital. Why is it’s management so important to firms?

Value = + + ··· + FCF 1 FCF 2 FCF ∞ (1 + WACC) 1 (1 + WACC) ∞ (1 + WACC) 2 Free cash flow (FCF) Market interest rates Firm’s business riskMarket risk aversion Firm’s debt/equity mix Cost of debt Cost of equity Weighted average cost of capital (WACC) Sales revenues Operating costs and taxes Required investments in operating capital − − = Determinants of Intrinsic Value: Working Capital and FCF

Working Capital Current assets – Current liabilities It measures how much in liquid assets a company has available to build its business. A short term loan which provides money to buy earning assets. Allows to avail of unexpected opportunities. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable and cash. An increase in working capital indicates that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors.

Why working Capital is important? Investment in Current Assets (CA) represents a substantial portion of total investment. Investment in Current Assets (CA) and level of Current Liabilities (CL) have to be geared quickly to changes in sales.

Net Working Capital CA – CL Referred as ‘point of view of an Accountant’. It indicates liquidity position of a firm & suggests the extent to which working capital needs may be financed by permanent sources of funds.

CONSTITUENTS OF WORKING CAPITAL CURRENT ASSETS  Inventory  Sundry Debtors  Cash and Bank Balances  Loans and advances CURRENT LIABILITIES  Sundry creditors  Short term loans  Provisions

Characteristics of Current Assets Short Life Span I.e. cash balances may be held idle for a week or two, thus a/c may have a life span of days etc. Swift Transformation into other Asset forms I.e.each CA is swiftly transformed into other asset forms like cash is used for acquiring raw materials, raw materials are transformed into finished goods and these sold on credit are convertible into A/R & finlly into cash.

Question 2. What is the matching principle and why is it important?

Matching Principle If a firm finances a long term asset(like machinery) with a S-T Debt then it will have to be periodically finance the asset which will be risky as well as inconvenient. i.e. maturity of sources of financing should be properly matched with maturity of assets being financed. Thus Fixed Assets & permanent CA should be supported with L-T sources of finance & fluctuating CA by S-T sources.

MATCHING PRINCIPLE