7.0 Working Capital

Question 1

Working Capital Management Definition

Optimal Mix

Answer 1

Optimal Mix of Current Assets and Current Liabilities

• Minimizing COST of LIQUIDITY while guarding against insolvency
• applies to SHORT term decisions

Question 2

Permanent Working Capital

Answer 2

Minimum level of Current Assets

• should INCREASE as firm grows
• generally FINANCED with LONG TERM DEBT
• risky to use short term debt: no able to liquidate when debt come due, interest rate rises, loan may not be renewed

Question 3

Temporary Working Capital (v Permanent)

Answer 3

Fluctuates Seasonally

Question 4

Working Capital Policy

Conservative v Aggressive

Answer 4

Conservative:

• Minimize LIQUIDITY RISK by minimizing INCREASING working capital
• Ensure adequate cash, inventory and supplies and Payables are minimized
• Reflected by higher current and quick ratios

Aggressive:

• seeks to increase PROFITABILITY (accepting reduced liquidity and increased risk of short term cash flow problems)
• LOWER current ratio and quick ratio

Question 5

Implications of carrying EXCESS inventories

Answer 5

OOSI

• Carrying costs rise
• Opportunity Costs of funds invested in inventory
• and Storage Costs, Insurance costs
• obsolescence

Question 6

Cash Management

Answer 6

• must know the motives for carrying cash and weigh against the opportunity cost
• -Understand the cost or benefit of holding cash

Question 7

3 Motives for holding Cash

Answer 7

1. Transactional (a Medium of Exchange)
2. Precautionary (Reserve for Contingencies)
3. Speculative (Take advantage of unexpected opportunities)

Question 8

Optimal Level of Cash

Answer 8

• Because Cash doesn’t earn a return, You only need what is needed to satisfy obligations as they become due
• Balance motives for holding cash v. opportunity cost of missed investments in marketable securities

Question 9

EOQ model for OPTIMAL CASH

Answer 9

Square of 2bT
———————- = Q
i

Q = Optimal
b = fixed cost per transaction (Cost per marketable security transaction)
T = Total demand for cash during the period
i = interest rate on MARKETABLE SECURITIES

Question 10

Annual Benefit of Speeded up Cash Flows

Answer 10

(Daily Cash Receipts x Days of Reduced Float) x Opportunity Cost of Funds less COST

Cost is measured by what the bank charges> A monthly fee annualized

150k w/ 2 days reduction and 1250 fee
(300k x 2) x 8% less 1250 x 12 = 9000

Question 11

Lockbox

Answer 11

Bank Personnel receive and deposit funds

Question 12

Concentration Banking

Answer 12

Depositing to localized branches and then deposit to single bank

Question 13

Slowing your payments

Answer 13

Float = remit day to deduction from account day

If company writes ans receives checks
float = amount of written check not cleared and when received check has cleared.

Question 14

Zero Balance Account
Centralized Accounts Payable
Controlled Disbursement Accounts

Answer 14

Zero balance account that the company maintains only enough to cover checks

Question 15

Compensating Balance Accounts

Answer 15

Non Interest bearing accounts where bank holds. Means unavailable for investment

Question 16

Managing Marketable Securities (Idle cash)

Answer 16

MM
L,S
LR,LY

Idle cash has the opportunity cost of not investing

• Need to match maturities with need for cash
• Liquidity and safety - therefore low yield, low risk

Question 17

Types of securities for Managing Cash

Answer 17

Money Market: Govt and Financial short and med term

Question 18

T-Bills

Answer 18

H,N,N,1

• Safest
• Tax Exempt (State/local),
• Highly Liquid
• 1 year or less
• no coupon

To Discount a T-Bill Multiply Face x percent x (percent of year)

6mos discounted at 4%. 1000 x 4% *50%

Question 19

T-Notes

Answer 19

1-10 Years

-Interest Paid every 6 months

Question 20

T-Bonds

Answer 20

10 Years Plus

-Payment every 6 months

Question 21

Marketable Securities (Backed by…)

Answer 21

Full Faith and Credit of US or Issuing Agency

Question 22

Repurchase Agreements (Repos)

Answer 22

Way for dealers in govt securities to Finance their portfolios

1. Buyer temporarily buys govt securities.
2. Seller agrees to buy back for higher price
3. company essentially give seller a short term loan
4. Overnight to a few days

Question 23

Bankers Acceptances

Answer 23

Drafts by nonfinancial firm on deposits
- Drawer firm sells BA
-Advantage: acceptance by bank is a guaranteed pmt
(buyer of the BA is relying on credit of bank not Drawer)
-Advantage: because backed by bank, very marketable

Question 24

CDs (and negotiable CDS)
Eurodollars
Money Market Mutual Funds

Answer 24

Negotiable CD’s can be sold on secondary market. Cd’s have lower risk than BA and Commercial Paper (low interest)

Eurodollars: Time deposit of USD located in Europe banks

Money Market Mutual Funds: short term, low risk in which checks can be drawn