Working capital management Flashcards
What is the Weighted Average Cost of Capital?
It is the average percentage annual rate or return required by investors to reward them for their investment. It is also the discount rate firms use to appraise investments.
What is unsystematic risk and is this counted for in WACC?
It is risk that can be diversified away. It is not counted for in WACC as it is avoidable.
What is sytematic risk?
Risk that cannot be diversified away.
What is systematic business risk?
The systematic risk assosiated with the buisiness activities or varibaility in earnings.
What is systematic financial risk?
The riskiness of the organisations financial structure. Ie. High levels of gearing.
Who is exposed to greater levels of risk?
A: Shareholders
B: Debt holders
A: Shareholders
What are the 2 methods of calculating cost of equity?
- Dividend model
- Capital asset pricing model
What is the dividend model of calculating the cost of equity based on?
The dividends currently paid to shareholders.
What is the Capital Asset Pricing model of calculating the cost of equity based on?
Returns being earned by investors in other similar projects.
When would we use the Dividend model for calculating cost of equity?
When we are appraising a project that has similar business risk to the companies existing business and will not significantly change gearing.
When would we use the Capital Asset Pricing model for calculating cost of equity?
When investing in a project that is significantly more or less risky than its existing business.
What is the ex div share price?
The share price excluding dividend
What is the Cum Div share price?
The share price including dividend
If a dividend is about to be paid, is the current share price cum div or ex div?
Cum div as the share price just before the dividend will be inclusive of it as the market takes all factors into consideration.
Debentures are very similar to preference shares in that they pay a fixed rate of interest. What is the key difference?
With debentures, interest payments are allowable, whereas dividend payments of preference shares are not.
How is the cost of debt for an irredeemable debenture calculated?
(Interest payable x (1-tax rate)) / Market price of debentures
How do we calculate the cost of equity on redeemable debentures?
It is equal to the IRR on the cashflow that would arise if the company was to buy back the debentures.
What cashflows could arise as a result of buying back a redeemable debenture?
- Initial outlay on buying back
- Savings on interest
- Increase in tax
- Savings on final repayment and interest.
How do we calculate the cost of non-marketable (ie non-debenture) debt in when calculating cost of debt?
Interest rate x (1-tax rate) .
It is just the interest rate adjusted for tax allowance
What are the steps to calculating the WACC?
- Calculate the cost of capital for each individual source of capital
- Establish the market value of each source of capital and the total market value of the company
- Calculate the proportion of each source of capital to the value of the company
- Find the sum of the weighted cost of each source
What is the formula for Inventory period in days?
(Inventory/cost of sales) x 365
What is the formula for trade recievebles period in days?
(Receivables / Sales revenue) x365
What is the formula for trade payable period in days?
(Payables/Purchases) x365
What is the current ratio?
Current assets / current liabilities
What is the quick ratio?
Current assets less inventory / current liabilities
What are the 2 possible approches to working capital management policies?
- Conservative
- Agressive
What is the conservative approach to working capital management?
Examples of how the working capital may look.
- Hold large amounts of current assets
- Inventories kept high
- Receivables are high as there are long credit periods to attravt more customers
- Payables are low to maintain good relationships with suppliers
What is the Aggressive approach to working capital management?
Examples of how the working capital may look
- Current assets are reduced to a minimum level
- Inventory is kept low to avoid waste
- Receivables are tightly controlled with robust credit policies
- Payables are kept high so that cash is kept within the organisation as long as possible.
What are the 2 inventory control models?
- Reorder level
- Economic order quantity
What are 4 assumptions of the economic order quantity model?
- Constant and continuous usage of inventory
- All demand is known and met
- Ordering costs are constant and do not vary with quantity ordered
- Holding costs for one unit can be accuratly measured.
WHat is the formula for reorder level?
Maximum lead time X Maximum demand per time unit
What to models can we use to estimate the appropriate amount of cash to hold?
- The Baumol cash model
- The Miller-Orr model
What is the Baumol cash model?
It is the same as the economic order quantity model and also suffers from the same weaknesses
Name 4 assumptions amde in the economic order quantity model of inventory management.
- That inventory usage is constant and continuous
- All demand is know and met
- Ordering costs are constant and do not vary with quantity ordered
- Inventory replenishment is instantanious
How many forulas is needed for the Miller -Orr model and what does each one represent?
There are 3 formulas for the miller-orr model. Z represents the target balance, H the upper limit and W teh average balance.
In the Miller- Orr model, how do we convert a yearly opportunity cost of holding cash into a daily?
(365rout(1+Rate))-1
