Modern Working Capital Management Text and Cases Frederick C.Scerr

1. Working Capital Management
Course Code: FIN 6407
Working Capital Management

2. Working Capital Management
Working Capital Management
Maintenance of short-term assets and
liabilities at a level that minimizes costs
and maximizes benefits

3. 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

4. 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.

5. 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

6. Working Capital Management
Working Capital?
Current Assets and Current Liabilities of the Balance Sheet

7. 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

8. Principles of Modern Finance
• Shareholder Wealth Maximization
• Cash flow Decision Making
Working Capital Management

9. Shareholders Wealth
Maximization
Increasing the market value of shares
hold by stockholders
Through
Working Capital Management

10. 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

11. 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

12. • In the risk-adjusted discount rate, net present
value procedure, the value of the cash flow is
computed as:
Net Present Value = t
t kNCFE )1/()( +
mriskpremiuRk f +=

13. 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

14. 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

15. 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

16. 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

17. Total risk is composed of
Diversifiable risks
Non-diversifiable risks
Working Capital Management

18. Working Capital Management
Diversifiable Risks
Risks particular to an individual asset
Avoidable to some extent

19. 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 =

20. • 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
)( mi RRCOV
)( mRVAR

21. 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..

22. 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

23. 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

24. Working Capital Management
Pricing of risks uses net present value
involved the determination of the
appropriate risk premium to discount
the risky cash flows

25. Working Capital Management
Approaches Determine Risk
Premium
Benchmark risk-adjusted discount rates
Capital Asset Pricing Model (CAPM)

26. Working Capital Management
Reflect total risks or risk premium
Determine 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:

27. Working Capital Management
Analyst starts with the market’s
required return on assets of known
risk to compare with
Like: other firm’s cost of capital
Benchmark risk-adjusted
discount rates:

28. 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 −+=

29. 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

30. • 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

31. Working Capital Management
Hedging
Hedging is a saving for a rainy day
A method of controlling risk

32. 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

33. Working Capital Management
Example
*** Compute the ratios (page 20)