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Working Capital ManagementCourse Code: FIN 6407
Working Capital Management
Working Capital Management
Working Capital Management
Maintenance of short-term assets and liabilities at a level that minimizes costs
and maximizes benefits
Working Capital Management
Working Capital? Assets and Liabilities required to operate business on
day to day basis Excess of current assets over current liabilities It is a financial metric that represents operating
liquidity available to the business Working capital is considered a part of operating
capital A measure of both a company's efficiency and its
short-term financial health
Working Capital Management
Any asset or liability items liquidating itself or getting converted into cash within operating cycle period, is a current item; the rest are non-current
But the controversy is, the operating cycle or the natural business year, may be different in different types of businesses
Operating cycle may count on raw materials in store, work-in-progress, finished goods in store, receivables. Trade creditors, etc.
Working Capital Management
Working Capital?
Gross Working Capital = Current Assets
Net Working Capital = Current Assets –
Current Liabilities, reflects the amount of funds
needed to support routine operations
Working Capital Management
Working Capital?Current Assets and Current Liabilities of the Balance Sheet
Working Capital Management
Working Capital and Fund Requirement
Maintaining working capital requires permanent commitment of funds
Firms will always have minimum level of inventory, accounts receivable, cash and accounts payable
Spontaneous financing arises automatically with inventory and expenses
Principles of Modern Finance
• Shareholder Wealth Maximization• Cash flow Decision Making
Working Capital Management
Shareholders Wealth Maximization
Increasing the market value of shares hold by stockholders
Through
Working Capital Management
Cash flow Decision Making
Taking actions that influence firm’s cash flows Public information regarding cash flows
influence market values of shares Marginal Cash flows associated with a
financial decision Cash flows further in the future less than
flows closer to the present
Through
Working Capital Management
The risk and time pattern can be addressed via the use of net present value with risk-adjusted discount rate (k)k = risk-free rate + risk premium
Working Capital Management
• In the risk-adjusted discount rate, net present value procedure, the value of the cash flow is computed as:
Net Present Value = tt kNCFE )1/()(
mriskpremiuRk f
Suppose that a marginal cash flow of $ 10000 is expected to occur two periods in the future, the risk-free rate is 6 percent per period and the risk premium for a flow of this level is 9 percent per year. What is the Net Present Value?
Working Capital Management
Firm’s policies regarding financial decision also affect stakeholders like bondholders, employees, suppliers, customers, etc.
These things affect firm’s cost of fund, labor expenses and sales revenue.
All together are reflected on market prices of shares.
Working Capital Management
Risk and Financial Decision Making
Assess [measured or estimates] the amount and types of risks
Address [account] the assessed risks in decision making
Finance deals risk in two ways:
Working Capital Management
Assessing Risks Total risk is assessed by sensitivity analysis and
simulation analysis Sensitivity analysis assess the relation
between an input variable and an important output variable of a financial analysis algorithm
Simulation analysis is an attempt to assess the total risks of outcomes based on variation in all uncertain input variables taken simultaneously
Working Capital Management
Total risk is composed of
Diversifiable risks Non-diversifiable risks
Working Capital Management
Working Capital Management
Diversifiable Risks
Risks particular to an individual asset Avoidable to some extent
Non-Diversifiable Risk
Inherent economic risk common to all assets
Market risk or general risk Affects security price Beta is the measure of non-diversifiable
risk
Working Capital Management
)(/)( mmii RVARRRCOVb
• Where ß is the beta of project i• is the covariance of the
return on the project with the market portfolio
• is the variance of the return on the market portfolio
)( miRRCOV
)( mRVAR
Working Capital Management
A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns..
Working Capital Management
Beta is measured by regressing the returns on these shares with those of the market as a whole
When firm’s project returns do not vary as much as market returns, tend to have beta less than 1
Firm’s whose projects returns vary much more with market returns tend to have common shares beta greater than 1
New projects should have beta same as current average projects
Working Capital Management
Addressing Risks
Risk must be priced to reflect shareholders risk aversion
Or A hedging strategy must be formulated to
remove the risk
Working Capital Management
Pricing of risks uses net present value involved the determination of the appropriate risk premium to discount the risky cash flows
Working Capital Management
Approaches Determine Risk Premium
Benchmark risk-adjusted discount rates Capital Asset Pricing Model (CAPM)
Working Capital Management
Reflect total risks or risk premiumDetermine the appropriate risk premium by comparing the risk of the marginal cash flow with that of traded assets and employing the markets required returns for traded assets of comparable risks
Benchmark risk-adjusted discount rates:
Working Capital Management
Analyst starts with the market’s required return on assets of known risk to compare withLike: other firm’s cost of capital
Benchmark risk-adjusted discount rates:
Working Capital Management
The Capital-Assets-Pricing Model (CAPM)
The risk premium used to determine the appropriate discount rate should be based on the non-diversifiable risk not the total risk.CAPM formula to obtain the required rate of return of share holders. The CAPM formula is: )( fmifi RRbRR
Where, is the required return on the equity investment
is the expected return on the market portfolio
is the risk-free rate and is the measure of non-diversifiable risk
iR
mR
ib
Working Capital Management
• A project with estimated beta of 1.4, the risk-free rate of interest is 6 percent per year and the expected return on a fully diversified portfolio of assets is 13 percent. The firms capital structure includes 40 percent interest-bearing debt and the rest equity, new issues of debt are expected to yield 9 percent. The firm is 33 percent marginal tax bracket. Find out the required return on equity and required return of the project.
Working Capital Management
Working Capital Management
Hedging
Hedging is a saving for a rainy dayA method of controlling risk
Working Capital Management
• Carrying cash is partly a hedging strategy• Financial instruments either may be used in hedging strategy or may not• As a hedge against uncertainty, the firm can keep a mix of cash, marketable securities, and a reserve line of credit
Working Capital Management
Example
*** Compute the ratios (page 20)