978-1259277160 Chapter 6 Lecture Note

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Working Capital and the

Financing Decision

Author’s Overview

The chapter introduces the student to the topic of working capital management. The emphasis

is on the build-up of current assets and how they can best be financed. Examples of

McGraw-Hill, Target, and Limited Brands are used to show that seasonal earning and sales go

hand in hand. Companies in cyclical or seasonal industries have a more challenging job of

managing their current assets. Such key topics as the impact of production on financing needs

and the differences between temporary and permanent assets are considered. Also, the relative

costs and volatility of short and long-term financing are evaluated with an emphasis on the term

structure of interest rates. The chapter provides the framework from which to move into the

next two chapters, which cover the management of specific short-term assets and sources of

short-term financing.

Chapter Concepts

LO1. Working capital management involves financing and controlling the current assets of the

firm.

LO2. Management must distinguish between those current assets that are easily converted to

cash and those that are more permanent.

LO3. The financing of an asset should be tied to how long the asset is likely to be on the

balance sheet.

LO4. Long-term financing is usually more expensive than short-term financing based on the

theory of the term structure of interest rates.

LO5. Risk, as well as profitability, determines the financing plan for current assets.

LO6. Expected value analysis may sometimes be employed in working capital management.

Annotated Outline and Strategy

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I. Introduction:

A. Working capital management involves the financing and management of the

current assets of the firm.

B. It is the financial manager’s most time-consuming function.

C. Success in managing current assets in the short run is critical for the firm’s

long-run existence.

Finance in Action: A Great Inventory Tracking System May Be Helping You

Radio frequency identification technology (RFID) is now being used by Wal-Mart to keep track

of inventory items. RFID chips allow companies to track goods so that the supply chain is more

efficient. Not only do efficient supply chain operations allow firms to reduce their working

capital requirements, RFID will result in reduced theft losses.

II. The Nature of Asset Growth

A. Changes in current assets may be “temporary” (seasonal) or “permanent.”

1. Current assets by definition are those expected to become cash in one

operating cycle, but the level of the current assets may be “permanent” or

”temporary”.

2. Businesses subject to cyclical sales may have temporary fluctuations in

the level of current assets such as inventory. These temporary current

assets are “self-liquidating.” Their use (or sale) will generate sufficient

cash to pay back the funds borrowed to obtain them.

3. Businesses experiencing permanent growth will see a permanent increase

in current assets such as accounts receivable. The average balance in

accounts receivable will go up and stay up as long as sales are high.

PPT The Nature of Asset Growth (Figure 6-1)

III. Controlling Assets – Matching Sales and Production

A. Both accounts receivable and inventory rise when both sales and production

increase. When sales rise faster than production, inventory declines and

receivables rise.

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B. Level production (matching production and sales over an entire cycle) may cause

large buildups in current assets (inventory) when sales are slack. These

buildups drop rapidly during peak demand periods when sales exceed the level

production output.

C. Figure 6-2 demonstrates the seasonal nature of textbook sales for McGraw-Hill,

while Figure 6-3 illustrates the same principle for Target and Limited Brands. In

both cases, as sales grow over time, these permanent increases in associated

working capital have to be financed.

PPT Quarterly sales and earnings per share for Briggs and Stratton (Figure 6-2)

PPT Quarterly sales and earnings per share, Target and Macy’s (Figure 6-3)

Perspective 6-1: The Yawakuzi example brings into focus, the relationship among level

production, varying levels of sales and current asset financing. Tables 6-1 through 6-5 and

Figure 6-4 are essential to the presentation

PPT Yawakuzi Sales Forecast (Table 6-1)

PPT Yawakuzi’s Production Schedule and Inventory (Table 6-2)

PPT Sales Forecast, Cash Receipts and Payments, and Cash Budget (Table 6-3)

PPT Total Current Assets, First Year (Table 6-4)

PPT Cash Budget and Assets for Second Year with no Growth in Sales (Table 6-5)

PPT The Nature of Asset Growth (Figure 6-4)

IV. Patterns of Financing: Flexible based on management’s willingness to accept risk.

A. Ideally, temporary increases in current assets are financed by short-term funds

and permanent current assets are financed with long-term sources.

PPT Matching Long-Term and Short-Term Needs (Figure 6-5)

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B. Matching short-term funds with short-term assets allows the company to

increase and decrease sources and uses of funds as the company’s sales fluctuate.

C. Many firms, however, choose or are forced to use plans that do not match

financing with asset needs.

D. Financing a high percentage of short-term assets with long-term funds means the

firm will have to pay interest costs on the excess funds even when the funds are

not needed.

PPT Using Long-Term Financing for Part of Short-Term Needs (Figure 6-6)

E. Financing permanent current assets and some long-term assets with short-term

funds is quite risky. Short-term funds will be permanently needed and thus cost

is highly volatile. Also, sources of short-term funds are not always available in

tight credit markets.

PPT Using Short-Term Financing for Part of Long-Term Needs (Figure 6-7)

V. The Financing Decision

A. Figure 6-8 presents the various sources of financing that can be used by a

corporation.

B. The term structure of interest rates indicates the relative cost of short and

long-term financing and is important to the financing decision.

Perspective 6-2: The discussion of the term structure of interest rates provides a good

opportunity to relate the cost of financing to the working capital decision.

C. The relationship of interest rates at a specific point in time for securities of equal

risk but different maturity dates is referred to as the term structure of interest

rates.

D. The term structure of interest rates is depicted by yield curves shown in Figure

6-9.

PPT Long-Term and Short-Term Monthly Interest Rates (Figure 6-10)

E. There are three theories describing the shape of the yield curve.

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1. Liquidity premium theory: presumes that long-term rates should be higher

than short-term rates because long-term securities are less liquid and

more price sensitive.

2. Market segmentation theory: postulates that the yield curve is “shaped”

by the maturity preferences of the various investors. Some institutions

such as commercial banks are primarily interested in short-term

securities. Others such as insurance companies manifest a preference for

much longer-term securities.

3. Expectations hypothesis: maintains that long-term rates reflect the

average of expected short-term rates over the time period that the

long-term security is outstanding. Table 6-6 demonstrates how the

expectations theory can be used to calculate long-term rates given the

expectations of future one year rates.

F. Types of yield curves

1. Normal: upward sloping; shorter maturities have lower required yields.

2. Humped: intermediate interest rates are higher than both the short-term

and long-term rates.

3. Inverted, downward sloping: short-term rates are higher than intermediate

or long-term rates.

4. Yield curves shift upward and downward in response to changes in

anticipated inflation rates and other conditions of uncertainty.

VI. A Decision Process

A. The composition of a firm’s financing of working capital is made within the

risk-return framework.

B. Short-term financing is generally less costly but more risky than long-term

financing. During tight money periods, short-term financing may be unavailable

or very expensive.

PPT Alternative Financing Plans (Table 6-7)

PPT Impact of Financing Plans on Earnings (Table 6-8)

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C. By applying the probabilities of the occurrence of various economic conditions,

an expected value of alternative financing strategies may be computed and used

as a decision basis.

PPT Expected Returns under Different Economic Conditions (Table 6-9)

PPT Expected Returns for High-Risk Firm (Table 6-10)

VII. Shifts in Asset Structure – Since the early 1960’s, business firms have reduced their

liquidity as a result of:

A. Normal economic cycles.

B. Improved inventory management strategies

C. Better utilization of cash balances, through electronic funds transfer.

D. The historical changes in net working capital as a percentage of sales and the

changes in the current ratio are shown in Figure 6-11. We use a composite of five

large industrial companies as a representative example of this shift. Liquidity

improved dramatically after the recession of 2008-09 as the average working

capital to sales rose from about 4 in 2006 to 16 in 2012 as firms repaired their

balance sheets.

VIII. Toward an Optimum Policy

A. An aggressive firm will borrow short term and carry high levels of inventory and

longer-term receivables. Panel 1 in Table 6-11 represents the aggressive firm.

B. The conservative firm (panel 4) will maintain high liquidity and utilize more

long-term financing.

C. Moderate firms compensate for short-term financing with highly liquid assets

(panel 2) or balance low liquidity with long-term financing (panel 3).

PPT Asset Liquidity and Financing Needs (Table 6-11)

D. Risk versus return considerations also affect the composition of the left-hand

side of the balance sheet.

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E. A firm may compensate for high risk on the financing side with high liquidity on

the asset side or vice versa.

Finance in Action: Working Capital Problems in a Small Business

The solution to seasonal working capital problems that plague small businesses is sufficient

flexible planning to ensure that profits produced during the peak season are available to cover

losses during the off-season. This is true because small firms have trouble finding sources of

funds for seasonal needs. This can be tied back into financial markets and the changing

structure of banking.

Other Chapter Supplements

Cases for Use with Foundations of Financial Management

Case 5, Gale Force Surfing working capital-Level vs. seasonal production

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