Working Capital

6 and the Financing

Decision

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Working Capital Management

• Working capital management is controlling,
managing and financing the investment in the
current assets of a firm
• Most time-consuming job of a financial
manager
• Crucial to long-term success or failure of a
business

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The Nature of Asset Growth

• It is ideal that a firm sells all what it produces or
purchases from its suppliers and matches its cash
receipts with its cash payments.
• However, there are always differences between
production and sales and differences between cash
inflows and cash outflows.
• In addition, sales growth often requires permanent
current assets.
• Often a firm’s internal funds are not sufficient in
financing the buildup in inventory and accounts
receivable. It may require additional external
financing.

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FIGURE 6-1
The nature of
asset growth

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Controlling Assets
• Two possible production alternatives in relation to
sales:
-- level production, which smoothes production schedules and
uses labor and equipment efficiently at a lower cost but leads
to fluctuation in current assets
-- matching sales and production, which eliminates the large
seasonal bulges or sharp reduction in current assets
• However, it is very difficult if not impossible to
match sales and production perfectly
• Most firms employ level production methods. It is
critical to control the fluctuation in current assets

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Figure 6-2
Sales and earnings for McGraw Hill Ryerson, 1998-2008

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Figure 6-3
Current assets at McGraw Hill Ryerson, 2000-2008

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Temporary Assets under Level

Production: An Example

• Yawakuzi Motorcycle Company employs

the level production method to produce
motorcycles while the sales of motorcycles
is seasonal in Canada

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TABLE 6-1
Yawakuzi sales forecast
(in units)

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TABLE 6-2
Yawakuzi's production
schedule and inventory

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TABLE 6-3
Sales forecast, cash receipts and payments,
and cash budget ($ millions)

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TABLE 6-4
Total current assets,
first year ($ millions)

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TABLE 6-5
Cash budget and assets for second year
with no growth in sales ($ millions)

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FIGURE 6-4
The nature of asset growth (Yawakuzi)

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Cash Flow Cycle

• A firm’s ability to quickly convert assets into cash
is referred to as liquidity.
• When a firm’s liquidity is called into question, it
often is difficult to continue in business.
• Liquidity is largely determined by the cash flow
cycle.
• Sales, receivables, and inventory form the basis
for cash flow, but the firm’s other activities can
also affect cash inflows and outflows.

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FIGURE 6-7
Expanded
cash flow
cycle

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Financing Alternatives
1. Hedged Approach:
• Matching the maturities of assets and liabilities (the most
desirable but almost impossible)

2. Conservative Approach/Long-Term Financing:

• Using long-term capital to finance capital assets, permanent
current assets and part of temporary current assets (low risk but
less profitable)

3. Risky Approach/Short-Term Financing :

• Using short-term funds to finance temporary current assets and
part of permanent current assets (more profitable but risky)

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FIGURE 6-8
Matching long-term
and short-term needs

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FIGURE 6-9
Using long-term financing
for part of short-term needs

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FIGURE 6-10
Using short-term financing
for part of long-term needs

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The Financing Decision

A financial manager should balance short-term
versus long-term financing by considering:
1. the composition of the firm’s assets
2. the firm’s willingness to accept risk
3. the risks and potential payoffs from each financing
alternative
4. the term structure of interest rates
5. the volatility of interest rates

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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 banks 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”

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Term Structure of Interest Rates

• Often referred to as a yield curve.

• Shows the relative level of short-term and long-

term interest rates at a point in time.

• Knowledge of changing interest rates and

interest rate theory is extremely valuable to
corporate executives making decisions about
how to time and structure their borrowing
between short-term and long-term debt.

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 Term Structure of Interest Rates
• A yield curve can be upward sloping
(referred to as a normal yield curve), or
“flat”, or downward sloping (an inverted
yield curve).

• The shape of the yield curve tells us

important information about interest rates.

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 Term Structure of Interest Rates
Three theories describe the shape of the yield curve
1. Liquidity Premium Theory:
 States that long-term rates should be higher
than short-term rates.

 Short-term securities have greater liquidity and

therefore, higher rates have to be offered to
long-term bond buyers to entice them to hold
these less liquid securities.

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 Term Structure of Interest Rates
2. Segmentation Theory:
 Treasury securities are divided into market
segments by the various financial institutions
investing in the market.
 Commercial banks prefer short-term securities of
one year or less. Mortgage oriented financial
institutions prefer length securities of between 5
and 7 years. Pension funds and Life insurance
companies prefer long-term 20 to 30 year securities.
 The changing needs, desires and strategies of these
investors tend to strongly influence the nature and
relationship of short-term and long-term interest
rates

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 Term Structure of Interest Rates
3. Expectations Hypothesis:
• States long-term rates reflect the average of
short-term expected rates over the time
period that the long-term security is
outstanding.

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Figure 6-12
Yield Curves showing term structure of interest rates

Source: Bank of Canada, [Link]

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Figure 6-13
Long-term and short-term interest rates

Source: Bank of Canada, [Link]

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The Financing Decision: An Example

The Edwards Corporation needs to finance

$500,000 of working capital (current assets). It
has identified two alternative financing plans.

Plan A, which they deem “risky” and a more

conservative Plan B.

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TABLE 6-7
Alternative financing plans

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TABLE 6-8
Impact of financing plans on earnings

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TABLE 6-9
Expected returns under
different economic conditions

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TABLE 6-10
Expected returns for
high-risk firm

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An Optimal Policy
• The combination of financing patterns (short-term versus
long-term) and asset liquidity produces 4 possible working
capital alternatives:
1. the aggressive firm borrows short term and maintains
relatively low levels of liquidity
2. the more moderate firm compensates for short-term financing
with highly liquid assets
3. the more moderate firm balances low liquidity with long-term
Financing
4. the more conservative firm utilizes long-term financing and
maintains a high degree of liquidity

• Each alternative represents a trade-off between risk and return.

• An appropriate strategy is selected based on the company’s
tolerance for risk.
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TABLE 6-11
Current asset liquidity and asset financing plan

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 Summary and Conclusions
• Working capital management involves
controlling and financing current assets.
• Sales growth requires a firm to increase
investment in current assets.
• The combination of level production and
seasonal sales will result in the buildup of
current assets, which require financing.
• The cash gap in the middle of a cash flow cycle
also requires a firm to seek external financing.

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 Summary and Conclusions
• A hedged financing approach attempts to
match the maturities of debt obligations to
the maturities of assets (to reduce risk).
• Unfortunately, the hedged approach is
very difficult if not impossible to employ.
• A firm has to tailor the various risk-return
trade-offs to meet its own needs.

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