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Overview of Working Capital Management
Every noble acquisition is attended with risks; he who
fears to encounter the one must not expect to obtain the
other.
PIETRO METASTASIO
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
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© Pearson Education Limited 2008
ANSWERS TO QUESTIONS
1. Working capital management encompasses the administration of the firm’s current assets --
namely, cash and marketable securities, receivables, and inventory -- and the financing
2. In broad terms, the profitability and risk associated with current assets are a function of the
level, composition, and financing of these assets. As the level of current assets increases (a
3. The difference in the industries that accounts for the level of current assets in each is that
utilities cannot store their product for future consumption. Therefore, the inventory held by
4. When we speak of working capital, we mean current assets. Therefore, “temporary”
5. If a firm adopts a hedging (maturity matching) approach to financing, each asset would be
6. In general, short-term debt carries a lower explicit cost of capital. The decision to finance
the permanent component of working capital with short-term debt may result in higher
7. The use of permanent financing for short-term needs may result in inefficient operation of
the firm. During periods of slow operation in the seasonal cycle, the firm will be unable to
8. No. Increasing the level of current assets past some level may actually increase risk as a
Chapter 8: Overview of Working Capital Management
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9. While short-term rates exceeding long-term rates makes the long-term financing method
more attractive at the particular moment involved, it does not necessarily make it more
attractive over a period of time. The above phenomenon is usually associated with times
10. An increase in the risk of the firm occurs from several sources. First, if sinking fund or
amortization payments are required for the debt, the larger amortization payments of a
Second, if no amortization payments are required (i.e., the principal is due in a lump sum),
shortening the maturity structure results in rolling the debt over more frequently. The firm
Increasing the firm’s liquidity increases the safety margin against adverse cash flow
11. Too large an investment in working capital lowers the firm’s profitability without a
12. A margin of safety to offset uncertainty can be provided by increasing the level of current
SOLUTIONS TO PROBLEMS
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
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© Pearson Education Limited 2008
b.
Current Fixed Total Return on
Profit Assets Assets Assets Assets
$28,000 $10,000 $100,000 $110,000 25.45%
28,000 25,000 100,000 125,000 22.40%
c. The implicit assumption in (b) above is that the level of working capital has no impact
b. Finance $14 million of working capital with permanent sources of funds. Finance fixed
Chapter 8: Overview of Working Capital Management
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3. a.
1st
Quarter
2nd
Quarter
3rd
Quarter
4th
Quarter Total
Alternative 1:
Alternative 2:
Term Loan Cost ($500,000 at 13.5%) $67,500
Alternative 3:
Term Loan Cost ($1,000,000 at 13.5%) 135,000
Alternative 1 is lowest in cost because the company borrows at a lower rate, 12 percent versus
13.5 percent, and because it does not pay interest on funds employed when they are not needed.
b. While alternative 1 is cheapest it entails financing the expected build up in permanent
funds requirements ($500,000) on a short-term basis. There is a risk consideration in
Alternative 2 involves borrowing the expected increase in permanent funds requirements
Alternative 3, the most conservative financing plan of the three, involves financing on a
Van Horne and Wachowicz, Fundamentals of Financial Management, 13th edition, Instructor’s Manual
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© Pearson Education Limited 2008
SOLUTIONS TO SELF-CORRECTION PROBLEMS
1. a.
Policy
Existing 2 3
Sales (millions) $10.0 $10.0 $10.0
The before-tax net profit margin is unchanged, as sales and earnings before interest and taxes
(EBIT) are the same regardless of the liquidity policy employed.
b.
Policy
2 3
The “cost” of financing additional current assets could be reduced by the amount that could be
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Cash and Marketable Securities Management
Money is like muck, not good except it be spread.
FRANCIS BACON
