Week 7

Question 1

NWC:

Answer 1

Net working capital considers currently available resources minus liabilities:

Cash + current assets - current liabilities

Question 2

Cash movement in the firm:

Answer 2

NWC +Non-current assets = non-current liabilities + equity

Cash + current assets + non-current assets = non-current liabilities + current liabilities + equity

cash = -NWC - non-current assets + non-current liabilities + equity

Thus equity and non-current liabilities increase cash in the firm, while NWC and non-current assets decrease.

Question 3

The operating cycle and cash cycle:

Answer 3

See the model in the lecture.

Operating cycle = inventory period + accounts receivables period

Cash cycle = operating cycle - accounts payable period

Cash flows are unsynchronized (happen at different times), and uncertain (future sales and costs are unknown).

Question 4

Size of firm’s investment in current assets:

Answer 4

The first element to consider, is measured relative to total operating revenue.

Flexible approach: maintaining high current assets and include:
1) Make large inventory investments
2) Keep large balances of cash and marketable securities
3) Grant liberal credit terms, leading to high accounts receivable.

Restrictive approach: maintain low assets and include:
1) Small investments
2) Low cash balances
3) no credit sales

Question 5

Carrying costs and shortage costs:

Answer 5

1) Carrying costs - rise with the investment in the current assets. It increases opportunity costs and economic value maintenance costs.
2) Shortage costs - are costs that fall with an increase in the inventory and current assets. For example, Trading/order costs: costs for ordering or raising cash or inventory. Costs related to safety reserves - lost sales, goodwill, and disrupted production.

Question 6

Financing of current assets:

Answer 6

Is measured by looking at the proportion of short-term debt to long-term debt. In a perfect economy, short-term assets are financed with short-term debt (NWC = 0).

Flexible approach - when long-term debt excess the asset requirement, the company can invest the cash in marketable securities.

Restrictive approach - the long-term debt is not enough to cover asset requirements, the firm must borrow and take short-term debt.

Question 7

How to measure the appropriate amount of short-term debt:

Answer 7

1) Cash reserves - flexible strategy implies cash surplus, that is invested. However, the NPV of investment is 0.
2) Maturity hedging - because short-term debt interest rates are volatile, it does not make sense to finance long-term assets with it.
3) Term structure - on average, it is more costly to rely on long-term debt, because the short-term debt overall has lower interest rates.

Question 8

Cash budgeting:

Answer 8

Estimates the inflow and outflow of cash and can tell whether borrowing is needed.

Cash outflows:
Payments to accounts payable
Wages, taxes, and other expenses
Capital expenditures (payments for long-term assets)
Long-term financing (dividend payments, interest)

Question 9

Unsecured bank loan:

Answer 9

Non-committed line of credit - can borrow without paper work up to a specified limit

Committed line of credit - formal legal arrangement, including commitment fee.

Question 10

Secured bank loan:

Answer 10

Security is ensured by accounts receivable or inventory. These insurances can be assigned or factored.

Assignment - has a lien on the receivables or resources
Factoring - the sale of accounts receivable.