Foundations of Financial Management: An Analysis (part 18)

“Fortune befriends the bold.”

~Emily Dickinson~

 Working Capital and the Financing Decision (Part D)

by

Charles Lamson

A Decision Process

Assume we are comparing alternative financing plans for working capital. As indicated in Table 7 below, $500,000 of working capital current assets must be financed for the Edwards Corporation. Under Plan A, we will finance all our current asset needs with short-term funds (fourth numerical line), while under Plan B we will finance only a relatively small portion of current assets with short-term money---relying heavily on long-term funds. In either case we will carry $100,000 of fixed assets with long-term financing commitments. As indicated in part 3 of table 7, under Plan A we will finance total needs of $600,000 with $500,000 of short-term financing and $100,000 of long-term financing, whereas with Plan B we will finance $150,000 short-term and $450,000 long-term.

Table 7   Alternative Financing Plans

Plan A carries the lower cost of financing, with interest of 6 percent on $500,000 of the $600,000 required. We show the impact of both plans on bottom line earnings in Table 8. Assuming the firm generates $200,000 in earnings before interest and taxes, Plan A will provide after-tax earnings of $80,000, while Plan B will generate only $73,000.

Table 8 Impact of financing plans on earnings

Introducing Varying Conditions

Although plan A, employing cheaper short-term sources of financing, appears to provide $7,000 more in return, this is not always the case. During tight money periods, when capital is scarce, short-term financing may be difficult to find or may carry exorbitant rates. Furthermore, inadequate financing may mean lost sales or financial embarrassment. For these reasons, the firm may wish to evaluate Plans A and B based on differing assumptions about the economy and the money markets.

Expected Value

Past history combined with economic forecasting may indicate an 80 percent probability of normal events and a 20 percent chance of extremely tight money. Using Plan A, under normal conditions the Edwards Corporation will enjoy a $7,000 superior return over Plan B as previously indicated in Table 8. Let us now assume that under disruptive tight money conditions, Plan A would provide $15,000 lower return than Plan B because of high short-term interest rates. These conditions are summarized in Table 9, and an expected value of return is computed. The expected value represents the sum of the expected outcomes under the two conditions.

Table 9 Expected returns under different economic conditions

We see that even when downside risk is considered, Plan A carries a higher expected return of $2,600. For another firm, XYZ, in the same industry that might suffer $50,000 lower returns during tight money conditions, Plan A becomes too dangerous to undertake, as indicated in Table 10. Plan A's expected return is now $4,400 less than that of Plan B.

Table 10 Expected returns for high-risk firm

Toward an Optimal Policy

As previously indicated, the firm should attempt to relate asset liquidity to financing patterns, and vice versa. In Table 11, a number of working capital alternatives are presented. Along the top of the table we show asset liquidity; along the side, the type of financing arrangement. The combined impact of the two variables is shown in each of the four panels of the table. 

Table 11 Asset liquidity and financing assets

In using table 11, each firm must decide how it wishes to combine asset liquidity and financing needs. The aggressive, risk oriented-firm in Panel 1 will borrow short-term and maintain relatively low levels of liquidity, hoping to increase profit. It will benefit from low-cost financing and high-return assets, but it will be vulnerable to a credit crunch. The more conservative firm, following the plan in Panels 4, will utilize established long-term financing and maintain a high degree of liquidity. In Panels 2 and 3, we see more moderate positions in which the firm compensates for short-term financing with highly liquid assets (2) or balances off low liquidity with precommitted, long-term financing (3).

Each financial manager must structure his or her working capital position and the associated risk-return trade-off to meet the company's needs. For firms whose cash flow patterns are predictable, typified by the public utilities sector, a low degree of liquidity can be maintained. Immediate access to capital markets, such as that enjoyed by large prestigious firm, also allows a greater risk-taking capability. In each case, the ultimate concern must be for maximizing the overall valuation of the firm through a judicious consideration of risk-return options.

In the next several posts, we will examine the various methods for managing the individual components of working capital. We will consider the techniques for managing cash, marketable securities, receivables, and inventory. We will look at trade and bank credit and also at other sources of short-term funds.

Summary

Working capital management involves the financing and controlling of the current assets of the firm. These current assets include cash, marketable securities, accounts receivable, and inventory. A firm's ability to properly manage current assets and the associated liability obligations may determine how well it is able to survive in the short run.

Because the firm with continuous operations will always maintain minimum levels of current assets, management must be able to distinguish between those current assets that are permanent and those that are temporary or cyclical. In order to determine the permanent or cyclical nature of turn set, the Financial Manager must give careful attention to the growth and sales and the relationship of the production process to sales. Level production and a seasonal sales environment increases operating efficiency, but it also calls for more careful financial planning.

In general, the writers of Foundations of Financial Management (Block & Hirt, 2005, p. 166) advocate tying the maturity of the financing plan to the maturity of the current assets. That is, finance short-term cyclical current assets with short-term liabilities and permanent current assets with long-term sources of funds. In order to carry out the company's financing plan with minimum cost, the financial manager must keep an eye on the general cost of borrowing, the term structure of interest rates, the relative volatility of short and long-term rates, and predict, if possible, any change in the direction of interest rate movements.

Because the yield curve is usually upward-sloping, long-term financing is generally more expensive than short-term financing. This lower-cost in favor of short-term financing must be weighed against the risk that short-term rates are more volatile than long-term rates. Additionally, if long-term rates are expected to rise, the financial manager may want to lock in long-term financing needs before they do.

The firm has a number of risk-return decisions to consider. Though long-term financing provides a safety margin for the availability of funds, its higher cost may reduce the profit potential of the firm. On the asset side, carrying highly liquid current assets assures the bill-paying capability of the firm but detracts from profit potential. Each firm must tailor the various risk-return trade-offs to meet its own needs. The peculiarities of a firm's industry will have a major impact on the options open to its management. 

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 161-166*

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