Chapter 6: Working Capital and Financing Decision Flashcards
Current Assets can be
Self liquidating or permanent
Nature of Asset Growth
Key: matching production schedules with accurate sales forecast.
Differences result in:
Unexpected buildup.
Reduction in inventory, affecting receivables and cash flow
Purpose of working capital mgmt
Financing and management of current assets of firm.
Current assets change constantly, requiring decisions made by management.
Short-term decisions on working capital determines whether a firms gets to long term.
Requires immediate action.
Fixed vs Current asset levels
Fixed grow slowly - increase productivity capacity, replace old equipment
Current assets fluctuate depening on - level of productions vs level sales
What is level production?
Equal monthly production used to smooth out production schedules and employ manpower and equipment more efficiently and at a lower cost.
Consequence: current assets go up/down when sales/productions not equal
Patterns of financing Ideal =
Assets buildup + length of financing perfect matched
all current assets financed by current/short term liabilities (ap, loans, commercial paper)
Permanent current + fixed asssets by long term (debt and equity)
Why use an alternative financing plan?
Challenge of constructing financial plan is categorizing current assets into temporary and permanent.
Predicting exact timing of asset liquidation is difficult.
Difficult to determine amount of short-term and long-term financing available.
Alternative Financing : Long term
Info: Can assure adequate capital at all times.
Long term used to finance - fixed assets, permanent assets, and part of temp/current assets
Short term for remainder of temp/current assets
Alternative Financing : Short term
Info: Many small businesses do not have total access to long-term financing.
Rely on short-term bank and trade credit.
Advantage: Interest rates are lower.
Short term used for - temp current assets + part of perm working capital
Long term - fixed assets + remainder perm assets
Term structure of interest rates: what is yield curve
Yield curve—shows relative level of short-term and long-term interest rates.
Normal = up
U.S. government securities used; free of default risks.
Corporate debt securities move in same direction as U.S. government securities.
Have higher interest rates due to more financial risk.
Yield curves for both securities change daily to reflect.
Current competitive conditions.
Expected inflation.
Changes in economic conditions.
3 theories describing yield curve shape
Liquidity premium theory: Long-term rates should be higher than short-term rates.
Incentive to hold less liquid and more price-sensitive securities.
Market segmentation theory: Treasury securities are divided into market segments by various financial institutions investing in market.
Expectations hypothesis: Yields on long-term securities are function of short-term rates.
avg of expected short term
Short term financing is _____ during tight money periods
difficult to find, high rates
Expected Value
A representative value from a probability distribution arrived at by multiplying each outcome by the associated probability and summing up the values.
Normal return * probability
+ Tight money return * probability = Expected value of return A vs B
Types of time / liquidy = risk
Short + Low liquiud = high profit + risk
Long + High = low profit + risk
Long + low / Short + high = moderate
Working capital management is primarily concerned with the management and financing of
current assets.
Which of the following is a reason for diminishing liquidity in modern corporations?
Just-in-time inventory programs.
Better utilization of cash via computers.
Increased use of point-of-sale terminals.
Retail companies like Target and Macy’s exhibit sales patterns that are most typically influenced by
seasonality
Pressure to increase current asset buildup often results from
rapidly expanding sales.
Revenue for all e-commerce has grown dramatically during 2020-2021 due to the COVID-19 pandemic. Which of the following include reasons for this growth?
Motivations by young consumers
Changing behavior of physical retailers
Consumer desire for independence from physical shopping
When actual sales are greater than forecasted sales
inventory will decline.
production schedules might have to be revised upward.
accounts receivable will rise
Samuelson will produce 20,000 units in January using level production. If each unit costs $500 to manufacture, what is the dollar value of ending inventory in January if beginning inventory is 10,000 units and January sales are 15,000?
Beginning Inventory + Production − Sales = Ending Inventory
10,000 + 20,000 − 15,000 = 15,000 units × $500 cost = $7,500,000
A firm will usually increase the ratio of short-term debt to long-term debt when
the term structure is inverted and expected to shift down.
An inverted yield curve would suggest that
interest rates are expected to fall.
Riley Company is considering a short-term or long-term financing plan of $4,000,000 assets. It expects the following one-year interest rates over the next three years: 6.5%, 7.75%, and 9%. The long-term interest rate will be 7.5% during those three years. What will be the difference in interest costs over the three years?
long term 30,000 less costly
A “normal” term structure of interest rates would depict
long-term rates are higher than short-term rates.
The term structure of interest rates
changes daily to reflect current competitive conditions in the money and capital markets.
Genetech has $4,000,000 in assets. It has decided to finance 30% with long-term financing (9% rate) and 70% with short-term financing (7%) rate. Assuming a 21% tax rate, what will its annual after-tax interest costs be?
Annual after−tax interest costs=($4,000,000)(0.3)(0.09)×(100%−21%)+($4,000,000)(0.7)(0.07)×(100%−21%)=$240,160
The theory of the term structure of interest rates, which suggests that long-term rates are determined by the average of short-term rates expected over the time that a long-term bond is outstanding, is the
expectations hypothesis.
An aggressive working capital policy would have which of the following characteristics?
A high ratio of short-term debt to long-term sources of funds
Which of the following combinations of asset structures and financing patterns is likely to create the least volatile earnings?
Liquid assets and heavy long-term borrowing
Hicks Health Clubs, Incorporated expects to generate an annual EBIT of $750,000 and needs to obtain financing for $1,200,000 of assets. Its tax bracket is 40%. If the firm uses short-term debt, its rate will be 7.5%, and if it uses long-term debt, its rate will be 9%. By how much will their earnings after taxes change if they choose the more aggressive financing plan instead of the more conservative plan?
Change in EAT=(difference in interest rates)×(assets)×(1−t)
=(0.015×$1,200,000×0.6)
= $10,800
Which of the following techniques allows explicit consideration of more than one possible outcome?
expected value
