The document discusses working capital management, its components, and financing policies, outlining concepts such as current assets, cash conversion cycle, and cash budgets. It also explores capital structure theories, particularly the Modigliani-Miller theory, which posits that a firm's value is independent of its capital structure under certain assumptions, and contrasts this with the trade-off and pecking order theories that consider financial distress and asymmetric information. Additionally, the document highlights the implications of capital structure decisions on agency costs and business risk.

1. Working Capital Management
Chapter 15
Working Capital Terminology
Working capital: current assets.
Net working capital:
current assets - current liabilities.
Net operating working capital:
current assets - (current liabilities - notes payable).
Working capital management:
controlling cash, inventories, and A/R, plus short-term liability
management.
2
Working Capital Financing Policies
Aggressive: Use short-term financing to finance permanent
assets.
Moderate: Match the maturity of the assets with the maturity of
the financing.
Maturity Matching, or “Self-Liquidating”, approach
Conservative: Use permanent capital for permanent assets and
temporary assets.

2. 3
Cash Conversion Cycle
The cash conversion cycle focuses on the length of time
between when a company makes payments to its creditors and
when a company receives payments from its customers.
4
Cash Conversion Cycle
15-5
5

3. Cash Budget
Forecasts cash inflows, outflows, and ending cash balances.
Used to plan loans needed or funds available to invest.
Can be daily, weekly, or monthly, forecasts.
Monthly for annual planning and daily for actual cash
management.
6
Cash and Marketable Securities
Currency
Demand Deposit
Marketable Securities
Inventories
Supplies
Raw materials
Work in process
Finished goods
Accounts Receivable: Credit Policy
Credit Period: How long to pay? Shorter period reduces days
sales outstanding (DSO) and average A/R, but it may discourage
sales.

4. Cash Discounts: Lowers price. Attracts new customers and
reduces DSO.
Credit Standards: Restrictive standards tend to reduce sales,
but reduce bad debt expense. Fewer bad debts reduce DSO.
Collection Policy: How tough? Restrictive policy will reduce
DSO but may damage customer relationships.
9
Accounts Payable: Trade Credit
Trade credit is credit furnished by a firm’s suppliers.
Trade credit is often the largest source of short-term credit,
especially for small firms.
Spontaneous, easy to get, but cost can be high.
10
period
deferral
Payables
period
collection
Average
period

5. conversion
Inventory
CCC
-
+
=
Capital Structure Policy
Chapter 13
Learning Objectives
Understand the difference between business risk and financial
risk.
Use the technique of break-even analysis.
Understand capital structure theories.
Business Risk
Business Risk is the variation in the firm’s expected earnings
attributable to the industry in which the firm operates.
Determinants of business risk:
The stability of the domestic economy
The exposure to, and stability of, foreign economies
Sensitivity to the business cycle
Competitive pressures in the firm’s industry

6. Operating Risk
Operating risk is the variation in the firm’s operating earnings
that results from firm’s cost structure (mix of fixed and variable
operating costs).
Earnings of firms with higher proportion of fixed operating
costs are more vulnerable to change in revenues.
5
Operating Leverage
Operating leverage is the change in EBIT caused by a change in
quantity sold.
The higher the proportion of fixed costs relative to variable
costs, the greater the operating leverage.
6
Higher operating leverage leads to more business risk: small
sales decline causes a larger EBIT decline.
Sales
$
Rev.

7. TC
F
QBE
EBIT
}
$
Rev.
TC
F
QBE
Sales

8. 7
Operating Breakeven
Q is quantity sold, F is total fixed cost, V is variable cost per
unit, TC is total cost, and P is price per unit.
Operating breakeven = QBE
Let EBIT=PQ-VQ-F= 0
QBE = F / (P – V)
Example: F=$200, P=$15, and V=$10:
QBE = $200 / ($15 – $10) = 40.
Financial Risk
Financial Risk is the variation in earnings as a result of firm’s
financing mix or proportion of financing that requires a fixed
return.
Additional business risk concentrated on common stockholders
when financial leverage is used.
Capital Structure Theory
MM theory
Zero taxes
Corporate taxes
Corporate and personal taxes

9. Trade-off theory
Signaling theory
Pecking order
Debt financing as a managerial constraint
Modigliani-Miller (MM) Theory: Zero TaxesFirm UFirm
LEBIT $3,000$3,000Interest 0 1,200NI
$3,000$1,800CF to shareholder$3,000$1,800CF to
debtholder 0$1,200Total CF$3,000$3,000Notice that the
total CF are identical for both firms.
MM Results: Zero Taxes
MM assume: (1) no transactions costs; (2) no restrictions or
costs to short sales; and (3) individuals can borrow at the same
rate as corporations.
MM prove that if the total CF to investors of Firm U and Firm L
are equal, then arbitrage is possible unless the total values of
Firm U and Firm L are equal:
VL = VU.
Because FCF and values of firms L and U are equal, their
WACCs are equal.
Therefore, capital structure is irrelevant.
12
MM Theory: Corporate Taxes
Corporate tax laws allow interest to be deducted, which reduces
taxes paid by levered firms.

10. Therefore, more CF goes to investors and less to taxes when
leverage is used.
In other words, the debt “shields” some of the firm’s CF from
taxes.
13
MM Result: Corporate Taxes
MM show that the total value to Firm L’s investors (VL )is
equal to the total value to Firm U’s investor (VU )plus an
additional amount due to interest deductibility (t*D).
Tax shield of debt= t*D, t=corporate tax rate, D=total debt
VL = VU + t*D
14
Value of Firm, V
0
Debt
VL
VU
Under MM with corporate taxes, the firm’s value increases
continuously as more and more debt is used.
TD

11. MM relationship between value and debt when corporate taxes
are considered.
Miller’s Theory: Corporate and Personal Taxes
Personal taxes lessen the advantage of corporate debt:
Corporate taxes favor debt financing since corporations can
deduct interest expenses.
Personal taxes favor equity financing, since no gain is reported
until stock is sold, and long-term gains are taxed at a lower rate.
16
Trade-off Theory
Capital structure is based on a trade-off between the tax
advantage of debt and the costs of financial distress.
MM theory ignores bankruptcy (financial distress) costs, which
increase as more leverage is used.
At low leverage levels, tax benefits outweigh bankruptcy costs.
At high levels, bankruptcy costs outweigh tax benefits.
An optimal capital structure exists that balances these costs and
benefits.
17
Costs of Financial Distress
What is financial distress?
Bankruptcy
Ch 7: Liquidation

12. Ch 11: Reorganization
Cost of Financial Distress
Direct Costs
Legal and administrative costs
Indirect Costs
Impaired ability to conduct business
Agency Costs
17
18
Tax Shield vs. Cost of Financial Distress
Value of Firm, V
0
Debt
V = Actual value of firm
VU =Value of firm with no debt
Tax Shield=t*D
Distress Costs
VL=Value of firm with corporate
taxes and debt
VL = VU + t*D

13. 19
Signaling Theory
MM assumed that investors and managers have the same
information.
But, managers often have better information. Thus, they would:
Sell stock if stock is overvalued.
Sell bonds if stock is undervalued.
Investors understand this, so view new stock sales as a negative
signal.
Pecking Order Theory
Theory stating that firms prefer to issue debt rather than equity
if internal finance is insufficient
Internal equity is first choice, external equity is last
Based on asymmetric information
Rules
Use internal financing
Issue the safest security first (debt before external equity)
20
21
Pecking Order Theory
Consider the following story:
The announcement of a stock issue drives down the stock price
because investors believe managers are more likely to issue
when shares are overpriced.

14. Therefore firms prefer internal finance since funds can be raised
without sending adverse signals.
If external finance is required, firms issue debt first and equity
as a last resort.
The most profitable firms borrow less not because they have
lower target debt ratios but because they don't need external
finance.
21
Pecking Order Theory
Implications
Internal equity is “better” than external equity
Debt is preferred to external equity
Financial slack is valuable
No target debt/equity ratio
22
Debt Financing and Agency Costs
One agency problem is that managers can use corporate funds
for non-value maximizing purposes.
The use of financial leverage:
Bonds “free cash flow.”

15. Forces discipline on managers to avoid perks and non-value
adding acquisitions.
A second agency problem is the potential for
“underinvestment”.
Debt increases risk of financial distress.
Therefore, managers may avoid risky projects even if they have
positive NPVs.
Capital Structure Theory – Modigliani and Miller (MM)
Approach
The Modigliani and Miller approach to capital theory, devised
in the 1950s, advocates the capital
structure irrelevancy theory. This suggests that the valuation of
a firm is irrelevant to the capital structure
of a company. Whether a firm is highly leveraged or has a lower
debt component has no bearing on its
market value. Rather, the market value of a firm is solely
dependent on the operating profits of the
company.
The capital structure of a company is the way a company
finances its assets. A company can finance its

16. operations by either equity or different combinations of debt
and equity. The capital structure of a
company can have a majority of the debt component or a
majority of equity, or an even mix of both debt
and equity. Each approach has its own set of advantages and
disadvantages. There are various capital
structure theories that attempt to establish a relationship
between the financial leverage of a company
(the proportion of debt in the company’s capital structure) with
its market value. One such approach is
the Modigliani and Miller Approach.
ASSUMPTIONS OF MODIGLIANI AND MILLER APPROACH
the bankruptcy cost, is nil.
symmetry of information. This means that an
investor will have access to the same
information that a corporation would and investors will thus
behave rationally.
companies.
n cost, such as an underwriting
commission, payment to merchant bankers,

17. advertisement expenses, etc.
The Modigliani and Miller Approach indicates that the value of
a leveraged firm (a firm that has a mix
of debt and equity) is the same as the value of an unleveraged
firm (a firm that is wholly financed by
equity) if the operating profits and future prospects are same.
That is, if an investor purchases shares of
a leveraged firm, it would cost him the same as buying the
shares of an unleveraged firm.
https://efinancemanagement.com/financial-leverage/capital-
structure-and-its-theories
https://efinancemanagement.com/financial-leverage/capital-
structure-and-its-theories
https://efinancemanagement.com/investment-decisions/value-of-
a-firm
https://efinancemanagement.com/financial-leverage/capital-
structure-and-its-theories
https://efinancemanagement.com/financial-leverage
https://efinancemanagement.com/financial-
accounting/corporation
MODIGLIANI AND MILLER APPROACH: TWO
PROPOSITIONS WITHOUT TAXES

18. PROPOSITION 1
With the above assumptions of “no taxes”, the capital structure
does not influence the valuation of a
firm. In other words, leveraging the company does not increase
the market value of the company. It also
suggests that debt holders in the company and equity
shareholders have the same priority, i.e., earnings
are split equally amongst them.
MODIGLIANI AND MILLER APPROACH: PROPOSITIONS
WITH TAXES
M&M Theory 1’s assumption that there are no taxes is
unrealistic. Taxes exist, and interest expense is
tax deductible i.e. the ultimate tax burden of a company with
debt in its capital structure is lower than a
company with zero or lower debt. This brings us to M&M
Theory 2 which relaxes the zero-tax
assumption.
https://efinancemanagement.com/sources-of-
finance/shareholders-vs-stakeholders
Proposition 1

19. In a tax environment, the value of a levered company is higher
than the value of an unlevered company
by an amount equal to the product of absolute amount of debt
and tax rate.
This can be expressed mathematically as follows:
VL = VUL + t × D
Where VL is the value of levered company i.e. company with
some debt in its capital structure, VUL is the
value of an un-levered company i.e. with no or lower debt, t is
the tax rate and D is the absolute amount
of debt.
The Trade-off theory of capital structure
The trade-off theory states that the optimal capital structure is a
trade-off between interest tax shields
and cost of financial distress:
Value of firm = Value if all-equity financed + PV(tax shield) -
PV(cost of financial distress)
The trade-off theory can be summarized graphically. The
starting point is the value of the all-equity

20. financed firm illustrated by the black horizontal line in Figure
10. The present value of tax shields is then
added to form the red line. Note that PV(tax shield) initially
increases as the firm borrows more, until
additional borrowing increases the probability of financial
distress rapidly. In addition, the firm cannot
be sure to benefit from the full tax shield if it borrows
excessively as it takes positive earnings to save
corporate taxes. Cost of financial distress is assumed to increase
with the debt level.
The cost of financial distress is illustrated in the diagram as the
difference between the red and blue
curve. Thus, the blue curve shows firm value as a function of
the debt level. Moreover, as the graph
suggest an optimal debt policy exists which maximized firm
value.
In summary, the trade-off theory states that capital structure is
based on a trade-off between tax savings
and distress costs of debt. Firms with safe, tangible assets and
plenty of taxable income to shield should
have high target debt ratios. The theory is capable of explaining
why capital structures differ between
industries, whereas it cannot explain why profitable companies

21. within the industry have lower debt ratios
(trade-off theory predicts the opposite as profitable firms have a
larger scope for tax shields and therefore
subsequently should have higher debt levels).
The pecking order theory of capital structure
The pecking order theory has emerged as alternative theory to
the trade-off theory. Rather than
introducing corporate taxes and financial distress into the MM
framework, the key assumption of the
pecking order theory is asymmetric information. Asymmetric
information captures that managers know
more than investors and their actions therefore provides a signal
to investors about the prospects of the
firm.
The intuition behind the pecking order theory is derived from
considering the following string of
arguments:
stock price because investors believe
managers are more likely to issue when shares are overpriced.

22. firm to raise funds without sending adverse
signals to the stock market. Moreover, even debt issues might
create information problems if the
probability of default is significant, since a pessimistic manager
will issue debt just before bad news
get out.
This leads to the following pecking order in the financing
decision:
1. Internal cash flow
2. Issue debt
3. Issue equity
The pecking order theory states that internal financing is
preferred over external financing, and if external
finance is required, firms should issue debt first and equity as a
last resort. Moreover, the pecking order
seems to explain why profitable firms have low debt ratios: This
happens not because they have low
target debt ratios, but because they do not need to obtain
external financing. Thus, unlike the trade-off
theory the pecking order theory is capable of explaining
differences in capital structures within
industries.