Chapter 14

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Chapter 14

  1. 1. Chapter 15 Working Capital Management
  2. 2. Working Capital Management <ul><li>What is working capital? </li></ul><ul><li>Working capital is defined as a firm’s total investment in current assets. </li></ul><ul><li>What is net working capital? </li></ul><ul><li>Net working capital is the difference between its current assets and current liabilities. </li></ul>
  3. 3. Working Capital Management <ul><li>What is the appropriate amount of current assets for the firm to carry? </li></ul><ul><li>How should the current assets be financed? </li></ul>Working capital management involves two basic questions:
  4. 4. <ul><li>Current Assets </li></ul><ul><li>Cash, marketable securities, inventory, accounts receivable </li></ul><ul><li>Long-Term Assets </li></ul><ul><li>Equipment, buildings, land </li></ul>Risk-Return Tradeoff <ul><li>Which earn higher rates of return? </li></ul><ul><li>Which help avoid risk of illiquidity? </li></ul>
  5. 5. <ul><li>Current assets earn low returns, but help reduce the risk of illiquidity. </li></ul>Risk-Return Tradeoff
  6. 6. <ul><li>Current Liabilities </li></ul><ul><li>Short-term notes, accrued expenses, accounts payable </li></ul><ul><li>Long-Term Debt and Equity </li></ul><ul><li>Bonds, preferred stock, common stock </li></ul>Risk-Return Tradeoff <ul><li>Which are more expensive? </li></ul><ul><li>Which help avoid risk of illiquidity? </li></ul>
  7. 7. <ul><li>Current liabilities are less expensive, but increase the risk of illiquidity. </li></ul>Risk-Return Tradeoff
  8. 8. <ul><li>A rule of thumb for guiding a firm’s working capital decision is the hedging principle. </li></ul><ul><li>It states that financing maturity should follow the cash flow-producing characteristics of the asset being financed. </li></ul>Hedging Principle
  9. 9. <ul><li>Should the total amount of a firm’s current assets equal to that of its current liabilities? </li></ul><ul><li>When applying the hedging principle, we should think in terms of the distinction between permanent and temporary assets, as opposed to the accounting fixed and current asset categories. </li></ul>Hedging Principle
  10. 10. <ul><li>Permanent assets are investments in assets that the firm expects to hold for a period longer than one year. </li></ul><ul><li>Permanent assets include the firm’s fixed assets as well as its minimum level of current assets. </li></ul>Permanent and Temporary Assets
  11. 11. <ul><li>Temporary assets are composed of current assets that will be liquidated and not replaced within the current year. </li></ul>Permanent and Temporary Assets
  12. 12. <ul><li>Spontaneous sources of financing include accounts payable, wages and salaries payable, accrued interest, and accrued taxes. </li></ul><ul><li>Asset needs of the firm not financed by spontaneous sources should be financed in accordance with the following rules: </li></ul>Hedging Principle
  13. 13. <ul><li>Permanent assets are financed with permanent sources such as long-term debt, preferred stock and common equity. </li></ul><ul><li>Temporary assets are financed with temporary sources, such as short-term bank loans and commercial papers. </li></ul>Hedging Principle
  14. 14. Time Period Dollar Amount Fixed Assets Permanent Current Assets Current Assets Permanent plus spontaneous financing Temporary financing

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