Study assignment

6

Working Capital and the Financing Decision

LEARNING OBJECTIVES

LO 6-1	Working capital management involves financing and controlling the current assets of the firm.
LO 6-2	Management must distinguish between current assets that are easily converted to cash and those that are more permanent.
LO 6-3	The financing of an asset should be tied to how long the asset is likely to be on the balance sheet.
LO 6-4	Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates.
LO 6-5	Risk, as well as profitability, determines the financing plan for current assets.
LO 6-6	Expected value analysis may sometimes be employed in working capital management.

The rapid growth of business firms in the last two decades has challenged the ingenuity of financial managers to provide adequate financing. Rapidly expanding sales may cause intense pressure for inventory and receivables buildup—draining the cash resources of the firm. As indicated in  Chapter 4 , “Financial Forecasting,” a large sales increase creates an expansion of current assets, especially accounts receivable and inventory. Some of the increased current assets can be financed through the firm’s retained earnings, but in most cases internal funds will not provide enough financing and some external sources of funds must be found. In fact, the faster the growth in sales, the more likely it is that an increasing percentage of financing will be external to the firm. These funds could come from the sale of common stock, preferred stock, long-term bonds, short-term securities, and bank loans, or from a combination of short- and long-term sources of funds.

There is also the problem of seasonal sales that affects many industries such as soft drinks, toys, retail sales, and textbook publishing. Seasonal demand for products makes forecasting cash flows and receivables and inventory management difficult. The Internet and cloud computing are beginning to alleviate some of these problems and help management make better plans.

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If you have had a marketing course, you have heard about supply chain management. Well, financial executives are also interested in the supply chain as an area where the Internet can help control working capital through online software. McDonald’s Corporation of Big Mac fame formed eMac Digital to explore opportunities in business-to-business (B2B) online ventures. One of the first things on the agenda was to have eMac Digital help McDonald’s reduce costs. McDonald’s wanted to create an online marketplace where restaurants can buy supplies online from food companies. McDonald’s, like Walmart, Harley-Davidson, and Ericsson, has embraced supply chain management using web-based procedures. The goal is to squeeze out inefficiencies in the supply chain and thereby lower costs. One of the big benefits is a reduction in inventory through online communications between the buyer and supplier, which speeds up the ordering and delivery process and reduces the amount of inventory needed on hand. These systems may also be able to attract a large number of suppliers to bid on the company’s business at more competitive prices.

Retailers like Walmart require suppliers to ship their goods with radio frequency identification chips (RFID) embedded in their shipments. These chips eliminate processing delays, reduce theft, and result in better inventory management. From the financial manager’s viewpoint, anything that can reduce inventory levels without creating out-of-stock situations will reduce the amount of money needed to finance inventory. You can read more about Walmart and RFID chips in the nearby Finance in Action box.

Working capital management involves the financing and management of the current assets of the firm. The financial executive probably devotes more time to working capital management than to any other activity. Current assets, by their very nature, are changing daily, if not hourly, and managerial decisions must be made. “How much inventory is to be carried, and how do we get the funds to pay for it?” Unlike long-term decisions, there can be no deferral of action. While long-term decisions involving plant and equipment or market strategy may well determine the eventual success of the firm, short-term decisions on working capital determine whether the firm gets to the long term.

In this chapter, we examine the nature of asset growth, the process of matching sales and production, financial aspects of working capital management, and the factors that go into development of an optimum policy.

The Nature of Asset Growth

Any company that produces and sells a product, whether the product is consumer or manufacturer oriented, will have current assets and fixed assets. If a firm grows, those assets are likely to increase over time. The key to current asset planning is the ability of management to forecast sales accurately and then to match the production schedules with the sales forecast. Whenever actual sales are different from forecast sales, unexpected buildups or reductions in inventory will occur that will eventually affect receivables and cash flow.

In the simplest case, all of the firm’s current assets will be self-liquidating assets (sold at the end of a specified time period). Assume that at the start of the summer you buy 100 tires to be disposed of by September. It is your intention that all tires will be sold, receivables collected, and bills paid over this time period. In this case, your working capital (current asset) needs are truly short term.

Now let us begin to expand the business. In stage two, you add radios, seat covers, and batteries to your operation. Some of your inventory will again be completely liquidated, while other items will form the basic stock for your operation. To stay in business, you must maintain floor displays and multiple items for selection. Furthermore, not all items will sell. As you eventually grow to more than one store, this “permanent” aggregate stock of current assets will continue to increase. Problems of inadequate financing arrangements are often the result of the businessperson’s failure to realize the firm is carrying not only self-liquidating inventory, but also the anomaly of “permanent” current assets.

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Finance in ACTION Technology A Great Inventory Tracking System May Be Helping You

RFID (radio frequency identification technology), a system that has been around since World War II and was used by the military to keep track of airplanes, continues to gain traction in inventory/supply chain management. RFID chips have been used in trains, ships, and trucks to track shipment containers. They are also used in automatic toll systems that allow drivers to pass through tolling areas without stopping. The state of Michigan has used these chips to track livestock; marathon officials have used them to track a runner’s time; and the Defense Department has used them to track the shelf life of their food rations. Additionally, they are now being used to make sure that shipping containers entering U.S. ports have not been tampered with after inspection.

Hewlett-Packard, in a business briefing paper, indicates that there may be as much as $45 billion of excess inventory in the retail supply chain that is unaccounted for at any given time. In short, RFID chips can help a company track goods and make sure that the right goods get to the right places on time. More sophisticated chips can be reused and can even record a sale. For example, if an expensive piece of jewelry is sold with a chip attached, when the chip is decommissioned, the sale automatically shows up in the store’s computer system.

In 2005, Walmart mandated that by the end of 2007, its 300 largest suppliers must have RFID chips in each pallet of goods shipped to its distribution centers. Procter & Gamble was one of the first companies to comply and found the system beneficial in managing its own inventory, reducing out-of-stock inventory levels, and preventing inventory theft or theft of goods in transit. For manufacturers of expensive products such as pharmaceuticals, theft reduction can be a significant cost saving. P&G noted that when comparing bar codes to RFID chips, it took 20 seconds to manually tally bar-code data on a pallet versus five seconds to read RFID technology. P&G states that it earned a return on its RFID investment in the millions of dollars.

According to the RFID Journal’s January 7, 2013, issue, 19 of the top 30 U.S. retailers are involved at some level with RFID chips, but full utilization of these chips has a long way to go before they are used throughout their stores for all products. Many specialty retailers are beginning to use RFID technology; American Apparel has adopted RFID technology at all 280 of its stores.

A rather unique use of these chips is for high-value poker chips at casinos. In 2010, a robber came into the Bellagio in Las Vegas and left with $1.5 million in poker chips. Little did he know that the chips had embedded RFID chips, and as soon as he walked out of the casino, the chips became worthless and unable to be used anywhere.

The movement from stage one to stage two of growth for a typical business is depicted in  Figure 6-1 . In panel A, the buildup in current assets is temporary—while in panel B, part of the growth in current assets is temporary and part is permanent. (Fixed assets are included in the illustrations, but they are not directly related to the present discussion.)

Controlling Assets—Matching Sales and Production

In most firms, fixed assets grow slowly as productive capacity is increased and old equipment is replaced, but current assets fluctuate in the short run, depending on the level of production versus the level of sales. When the firm produces more than it sells, inventory rises. When sales rise faster than production, inventory declines and receivables rise.

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Figure 6-1   The nature of asset growth

A. Stage I: Limited or no growth

B. Stage II: Growth

As discussed in the treatment of the cash budgeting process in  Chapter 4 , some firms employ level production methods to smooth production schedules and use manpower and equipment efficiently at a lower cost. One consequence of level production is that current assets go up and down when sales and production are not equal. Other firms may try to match sales and production as closely as possible in the short run. This allows current assets to increase or decrease with the level of sales and eliminates the large seasonal bulges or sharp reductions in current assets that occur under level production.

Seasonal industries can be found in manufacturing, retailing, electricity, and natural gas. Demand is uneven in these industries, and many exhibit a seasonal demand. For example, electricity producers have more demand in the summer for air conditioning while natural gas companies have more demand in the winter for heating. One small manufacturing company that exhibits this type of seasonal demand is Briggs and Stratton Corporation from Wauwatosa, Wisconsin.

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Briggs and Stratton is the largest maker of 3.5 to 25 horsepower air-cooled gasoline engines. Chances are if you’ve ever mowed a lawn, your lawnmower had a Briggs and Stratton engine. Their motors can be found in pressure washers, compressors and pumps, garden tillers, generators, small tractors, lawnmowers, and outboard marine engines, and about 30 percent of the company’s overall sales are in the international market.

Briggs and Stratton’s fiscal year ends in June, and  Figure 6-2  demonstrates both the seasonality of sales and the leverage impact on earnings per share that we discussed in  Chapter 5 . Because Briggs sells most of its products to other manufacturers who use the engines as part of their finished products, a large percentage of sales must occur early in the year in order to produce the garden equipment that would be in demand in spring and summer. We can see from  Figure 6-2  that sales are lowest in the July to September quarter, followed by the September–December quarter. Peak sales are in the third quarter, beginning in January and ending in March. There are carryover sales in the April to June quarter, which is the second best period for Briggs and Stratton.

Figure 6-2   Quarterly sales and earnings per share for Briggs and Stratton

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Notice that the first quarter of the year always generates negative earnings per share as the costs of production outweigh the revenue produced. This is most likely caused by the costs of building inventory. Earnings in the second and fourth quarter are small, with most of the earnings coming in the peak sales period of the third quarter. For example in 2013, Briggs and Stratton earned $0.90 billion for the year with $0.89 billion coming in the third quarter; in 2014 the firm earned $0.82 billion with $0.81 billion coming in the third quarter. The seasonal nature of the company’s sales can be exacerbated by inventory buildup at the end user and a fall in orders for the next season. The company has made acquisitions in recent years to diversify its product line and to smooth out sales and earnings. The future will tell if these acquisitions succeed.

Retail firms such as Target and Macy’s also have seasonal sales patterns.  Figure 6-3  on the next page shows the quarterly sales and earnings per share of these two companies, with the quarters ending in April, July, October, and January. These retail companies do not stock a year or more of inventory at one time. They are selling products that are either manufactured for them by others or manufactured by their subsidiaries. Most retail stores are not involved in deciding on level versus seasonal production but rather in matching sales and inventory. Their suppliers must make the decision to produce on either a level or a seasonal basis. Since the selling seasons are very much affected by the weather and holiday periods, the suppliers and retailers cannot avoid inventory risk. The fourth quarter for retailers, which begins in November and ends in January, is their biggest quarter and accounts for as much as half of their earnings. You can be sure that inventory not sold during the Christmas season will be put on sale during January.

Both Target and Macy’s show seasonal peaks and troughs in sales that will also be reflected in their cash balances, accounts receivable, and inventory. Notice in  Figure 6-3  that Target is growing slightly faster than Macy’s, which has a rather flat trendline. Even so, Macy’s peak earnings per share are higher than Target’s earnings per share when the fourth quarter sales peak out. Both companies illustrate the impact of leverage on earnings as discussed in  Chapter 5 , but we can tell that Macy’s has higher leverage because its EPS rises and falls with sales more than Target’s EPS (bottom of  Figure 6-3 ). We shall see as we go through the chapter that seasonal sales can cause asset management problems. A financial manager must be aware of these problems to avoid getting caught short of cash or unprepared to borrow when necessary.

Many retail-oriented firms have been more successful in matching sales and orders in recent years because of new, computerized inventory control systems linked to online point-of-sales terminals. These point-of-sales terminals allow either digital input or use of optical scanners to record the inventory code numbers and the amount of each item sold. At the end of the day, managers can examine sales and inventory levels item by item and, if need be, adjust orders or production schedules. The predictability of the market will influence the speed with which the manager reacts to this information, while the length and complexity of the production process will dictate how fast production levels can be changed.

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Figure 6-3   Quarterly sales and earnings per share, Target and Macy’s

Temporary Assets under Level Production—An Example

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To get a better understanding of how current assets fluctuate, let us use the example of the Yawakuzi Motorcycle Company, which manufactures and sells in the snowy U.S. Midwest. Not too many people will be buying motorcycles during October through March, but sales will pick up in early spring and summer and will again trail off during the fall. Because of the fixed assets and the skilled labor involved in the production process, Yawakuzi decides that level production is the least expensive and the most efficient production method. The marketing department provides a 12-month sales forecast for October through September ( Table 6-1 ).

Table 6-1   Yawakuzi sales forecast (in units)

Total sales of 9,600 units at $3,000 each = $28,800,000 in sales.

After reviewing the sales forecast, Yawakuzi decides to produce 800 motorcycles per month, or one year’s production of 9,600 divided by 12. A look at  Table 6-2  shows how level production and seasonal sales combine to create fluctuating inventory. Assume that October’s beginning inventory is one month’s production of 800 units. The ending inventory level is computed for each month and then multiplied by the production cost per unit of $2,000.

Table 6-2   Yawakuzi’s production schedule and inventory

The inventory level at cost fluctuates from a high of $9 million in March, the last consecutive month in which production is greater than sales, to a low of $1 million in August, the last month in which sales are greater than production.  Table 6-3  combines a sales forecast, a cash receipts schedule, a cash payments schedule, and a brief cash budget to examine the buildup in accounts receivable and cash.

In  Table 6-3 , the sales forecast is based on assumptions in  Table 6-1 . The unit volume of sales is multiplied by a sales price of $3,000 to get sales dollars in millions. Next, cash receipts represent 50 percent collected in cash during the month of sale and 50 percent from the prior month’s sales. For example, in October this would represent $0.45 million from the current month plus $0.75 million from the prior month’s sales.

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Table 6-3   Sales forecast, cash receipts and payments, and cash budget

*Assumes a cash balance of $0.25 million at the beginning of October and that this is the desired minimum cash balance.

Cash payments in  Table 6-3  are based on an assumption of level production of 800 units per month at a cost of $2,000 per unit, or $1.6 million, plus payments for overhead, dividends, interest, and taxes.

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Finally, the cash budget in  Table 6-3  represents a comparison of the cash receipts and cash payments schedules to determine cash flow. We further assume the firm desires a minimum cash balance of $0.25 million. Thus in October, a negative cash flow of $1.1 million brings the cumulative cash balance to a negative $0.85 million and $1.1 million must be borrowed to provide an ending cash balance of $0.25 million. Similar negative cash flows in subsequent months necessitate expanding the bank loan. For example, in November there is a negative cash flow of $1.325 million. This brings the cumulative cash balance to −$1.075 million, requiring additional borrowings of $1.325 million to ensure a minimum cash balance of $0.25 million. The cumulative loan through November (October and November borrowings) now adds up to $2.425 million. Our cumulative bank loan is highest in the month of March.

We now wish to ascertain our total current asset buildup as a result of level production and fluctuating sales for October through September. The analysis is presented in  Table 6-4 . The cash figures come directly from the last line of  Table 6-3 . The accounts receivable balance is based on the assumption that accounts receivable represent 50 percent of sales in a given month, as the other 50 percent is paid for in cash. Thus the accounts receivable figure in  Table 6-4  represents 50 percent of the sales figure from the second numerical line in  Table 6-3 . Finally, the inventory figure in  Table 6-4  is taken directly from the last column of  Table 6-2 , which presented the production schedule and inventory data.

Table 6-4   Total current assets, first year ($ millions)

Total current assets (last column in  Table 6-4 ) start at $3.3 million in October and rise to $10.35 million in the peak month of April. From April through August, sales are larger than production, and inventory falls to its low of $1 million in August, but accounts receivable peak at $3 million in the highest sales months of May, June, and July. The cash budget in  Table 6-3  explains the cash flows and external funds borrowed to finance asset accumulation. From October to March, Yawakuzi borrows more and more money to finance the inventory buildup, but from April forward it eliminates all borrowing as inventory is liquidated and cash balances rise to complete the cycle. In October, the cycle starts over again; but now the firm has accumulated cash it can use to finance next year’s asset accumulation, pay a larger dividend, replace old equipment, or—if growth in sales is anticipated—invest in new equipment to increase productive capacity.  Table 6-5  presents the cash budget and total current assets for the second year. Under a simplified no-growth assumption, the monthly cash flow is the same as that of the first year, but beginning cash in October is much higher than the first year’s beginning cash balance, and this lowers the borrowing requirement and increases the ending cash balance and total current assets at year-end. Higher current assets are present despite the fact that accounts receivable and inventory do not change.

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Table 6-5   Cash budget and assets for second year with no growth in sales ($ millions)

Figure 6-4  on the next page is a graphic presentation of the current asset cycle. It includes the two years covered in  Tables 6-4  and  6-5  assuming level production and no sales growth.

Patterns of Financing

The financial manager’s selection of external sources of funds to finance assets may be one of the firm’s most important decisions. The axiom that all current assets should be financed by current liabilities (accounts payable, bank loans, commercial paper, etc.) is subject to challenge when one sees the permanent buildup that can occur in current assets. In the Yawakuzi example, the buildup in inventory was substantial at $9 million. The example had a logical conclusion in that the motorcycles were sold, cash was generated, and current assets became very liquid. What if a much smaller level of sales had occurred? Yawakuzi would be sitting on a large inventory that needed to be financed and would be generating no cash. Theoretically, the firm could be declared technically insolvent (bankrupt) if short-term sources of funds were used but were unable to be renewed when they came due. How would the interest and principal be paid without cash flow from inventory liquidation? The most appropriate financing pattern would be one in which asset buildup and length of financing terms are perfectly matched, as indicated in  Figure 6-5 .

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Figure 6-4   The nature of asset growth (Yawakuzi)

In the upper part of  Figure 6-5  we see that the temporary buildup in current assets (represented by teal) is financed by short-term funds. More importantly, however, permanent current assets and fixed assets (both represented by blue) are financed with long-term funds from the sale of stock, the issuance of bonds, or retention of earnings.

Figure 6-5   Matching long-term and short-term needs

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Alternative Plans

Only a financial manager with unusual insight and timing could construct a financial plan for working capital that adhered perfectly to the design in  Figure 6-5 . The difficulty rests in determining precisely what part of current assets is temporary and what part is permanent. Even if dollar amounts could be ascertained, the exact timing of asset liquidation is a difficult matter. To compound the problem, we are never quite sure how much short-term or long-term financing is available at a given time. While the precise synchronization of temporary current assets and short-term financing depicted in  Figure 6-5  may be the most desirable and logical plan, other alternatives must be considered.

Long-Term Financing

To protect against the danger of not being able to provide adequate short-term financing in tight money periods, the financial manager may rely on long-term funds to cover some short-term needs. As indicated in  Figure 6-6 , long-term capital is now being used to finance fixed assets, permanent current assets, and part of temporary current assets.

Figure 6-6   Using long-term financing for part of short-term needs

By using long-term capital to cover part of short-term needs, the firm virtually assures itself of having adequate capital at all times. The firm may prefer to borrow a million dollars for 10 years—rather than attempt to borrow a million dollars at the beginning of each year for 10 years and pay it back at the end of each year.

Short-Term Financing (Opposite Approach)

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This is not to say that all financial managers utilize long-term financing on a large scale. To acquire long-term funds, the firm must generally go to the capital markets with a bond or stock offering or must privately place longer-term obligations with insurance companies, wealthy individuals, and so forth. Many small businesses do not have access to such long-term capital and are forced to rely heavily on short-term bank and trade credit.

Furthermore, short-term financing offers some advantages over more extended financial arrangements. As a general rule, the interest rate on short-term funds is lower than that on long-term funds. We might surmise then that a firm could develop a working capital financing plan in which short-term funds are used to finance not only temporary current assets, but also part of the permanent working capital needs of the firm. As depicted in  Figure 6-7 , bank and trade credit as well as other sources of short-term financing are now supporting part of the permanent capital asset needs of the firm.

Figure 6-7   Using short-term financing for part of long-term needs

The Financing Decision

Some corporations are more flexible than others because they are not locked into a few available sources of funds. Corporations would like many financing alternatives in order to minimize their cost of funds at any point. Unfortunately, not many firms are in this enviable position through the duration of a business cycle. During an economic boom period, a shortage of low-cost alternatives exists, and firms often minimize their financing costs by raising funds in advance of forecast asset needs.

Not only does the financial manager encounter a timing problem, but he or she also needs to select the right type of financing. Even for companies having many alternative sources of funds, there may be only one or two decisions that will look good in retrospect. At the time the financing decision is made, the financial manager is never sure it is the right one. Should the financing be long term or short term, debt or equity, and so on?

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Figure 6-8  is a decision-tree diagram that shows many of the financing choices available to a chief financial officer. A decision is made at each point until a final financing method is chosen. In most cases, a corporation will use a combination of these financing methods. At all times the financial manager will balance short-term versus long-term considerations against the composition of the firm’s assets and the firm’s willingness to accept risk. The ratio of long-term financing to short-term financing at any point in time will be greatly influenced by the term structure of interest rates.

Figure 6-8   Decision tree of the financing decision

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Term Structure of Interest Rates

The term structure of interest rates is often referred to as a yield curve. It shows the relative level of short-term and long-term interest rates at a point in time. Knowledge of changing interest rates and interest rate theory is extremely valuable to corporate executives making decisions about how to time and structure their borrowing between short- and long-term debt. Generally, U.S. government securities are used to construct yield curves because they are free of default risk and the large number of maturities creates a fairly continuous curve. Yields on corporate debt securities will move in the same direction as government securities, but will have higher interest rates because of their greater financial risk. Yield curves for both corporations and government securities change daily to reflect current competitive conditions in the money and capital markets, expected inflation, and changes in economic conditions.

Three basic theories describe the shape of the yield curve. The first theory is called the liquidity premium theory and states that long-term rates should be higher than short-term rates. This premium of long-term rates over short-term rates exists because short-term securities have greater liquidity and, therefore, higher rates have to be offered to potential long-term bond buyers to entice them to hold these less liquid and more price-sensitive securities. The market segmentation theory (the second theory) states that Treasury securities are divided into market segments by the various financial institutions investing in the market. Commercial banks prefer short-term securities of one year or less to match their short-term lending strategies. Savings and loans and other mortgage-oriented financial institutions prefer the intermediate length securities of between 5 and 7 years, while pension funds and life insurance companies prefer long-term 20- to 30-year securities to offset the long-term nature of their commitments to policyholders. The changing needs, desires, and strategies of these investors tend to strongly influence the nature and relationship of short-term and long-term interest rates.

The third theory describing the term structure of interest rates is called the expectations hypothesis. This theory explains the yields on long-term securities as a function of short-term rates. The expectations theory says long-term rates reflect the average of short-term expected rates over the time period that the long-term security is outstanding. Using a four-year example and simple averages, we demonstrate this theory in  Table 6-6 . In the left-hand panel of the table, we show the anticipated one-year rate on T-bill (Treasury bill) securities at the beginning of each of four years in the future. Treasury bills are short-term securities issued by the government. In the right-hand panel, we show the two-, three- and four-year averages of the one-year anticipated rates.

Table 6-6   The expectations theory

1-year T-bill at beginning of year 1 = 4%
1-year T-bill at beginning of year 2 = 5%	2-year security (4% + 5%)/2 = 4.5%
1-year T-bill at beginning of year 3 = 6%	3-year security (4% + 5% + 6%)/3 = 5.0%
1-year T-bill at beginning of year 4 = 7%	4-year security (4% + 5% + 6% + 7%)/4 = 5.5%

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For example, the two-year security rate is the average of the expected yields of two one-year T-bills, while the rate on the four-year security is the average of all four one-year rates. 1  In this example, the progressively higher rates for two-, three-, and four-year securities represent a reflection of higher anticipated one-year rates in the future. The expectations hypothesis is especially useful in explaining the shape and movement of the yield curve. The result of the expectations hypothesis is that, when long-term rates are much higher than short-term rates, the market is saying it expects short-term rates to rise. When long-term rates are lower than short-term rates, the market is expecting short-term rates to fall. This theory is useful to financial managers in helping them set expectations for the cost of financing over time and, especially, in making choices about when to use short-term debt or long-term debt.

In fact, all three theories of the term structure just discussed have some impact on interest rates. At times, the liquidity premium or segmentation theory dominates the shape of the curve, and at other times, the expectations theory is the most important.

Figure 6-9  shows a Treasury yield curve that is published by the St. Louis Federal Reserve Bank in National Economic Trends, a weekly online publication that can be directly accessed on  www.stlouisfed.org . The bottom axis shows time periods (months and years) and the vertical axis indicates rates. In this figure, there are three curves: December 2013, December 2014, and the curve for the week ending January 2, 2015. We can see that long-term yields have dropped between year-end 2013 and 2014 and that the latest yield curve at the beginning of 2015 was the same as year-end 2014. Using the January 2015 curve (the dotted red line), we can see that yields rise from close to zero percent for three-month Treasury bills, to 1.7 percent for five-year Treasury notes, and continue up to 2.2 percent for 10-year Treasury bonds. This upward-sloping yield curve has the normal shape. The increase in rates from the three-month to the 10-year yield is 0.5 percent or 50 basis points. (A basis point represents 1/100th of one percent.)

Figure 6-9   Treasury yield curve

*The treasury yield curve for December 2014 is almost identical to that for the week ending 1/2/2015.

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The Federal Reserve has kept all interest rates low, with short-term rates extremely low. This action by the Fed is intended to help the economy recover from the most serious recession since the Great Depression. By keeping the cost of borrowing low, the Fed hopes to stimulate the economy. As the economy recovers, the yield curve will shift up and become less steep.

An upward-sloping yield curve is considered normal, but the difference between short-term and long-term rates has often been quite wide, such as in October 1993 when short-term rates were less than 3 percent and long-term rates were close to 7 percent. Generally, the more upward-sloping the yield curve, the greater the expectation that interest rates will rise. When faced with a downward-sloping, or inverted, yield curve, the expectation would be the opposite. A good example of this occurred in September 1981 when short-term rates were over 17 percent and long-term rates were close to 15 percent. A little over one year later, in December 1982, short-term rates were 8 percent and long-term rates were about 10.5 percent. This example also illustrates that interest rates can move dramatically in a relatively short time (in this case, 15 months).

In designing working capital policy, the astute financial manager is interested in not only the term structure of interest rates but also the relative volatility and the historical level of short-term and long-term rates.  Figure 6-10  covers a 25-year period and demonstrates that short-term rates (red) are more volatile than long-term rates (blue). This volatility is what makes a short-term financing strategy risky.  Figure 6-10  also shows that interest rates follow the general trend of inflation as measured by the consumer price index (black). Note that prices declined during the recession of 2007–2009, which is what is expected as demand declines. As inflation goes up or down, so do interest rates. While this relationship seems simple, it explains financial managers’ and lenders’ preoccupations with forecasting inflation. However, most economists will admit to the uncertainty of forecasting. While we can see that short- and long-term interest rates are closely related to each other and to inflation, the record of the professionals for accurate interest rate predictions for periods longer than a few months is spotty at best.

Figure 6-10 Long- and short-term annual interest rates

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How should the financial manager respond to fluctuating interest rates and changing term structures? When interest rates are high and expected to decline, the financial manager generally tries to borrow short term (if funds are available). As rates decline, the chief financial officer will try to lock in the lower rates with heavy long-term borrowing. Some of these long-term funds will be used to reduce short-term debt, and the rest will be available for future expansion of plant and equipment and working capital if necessary.

A Decision Process

Assume we are comparing alternative financing plans for working capital. As indicated in  Table 6-7 , $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 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 6-7 , 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 6-7   Alternative financing plans

EDWARDS CORPORATION
	Plan A	Plan B
Part 1. Current assets
Temporary	$250,000	$250,000
Permanent	250,000	250,000
Total current assets	$500,000	$500,000
Short-term financing (6%)	500,000	150,000
Long-term financing (10%)	0	350,000
	$500,000	$500,000
Part 2. Fixed assets
Long-term financing (10%)	$100,000	$100,000
Part 3. Total financing (summary of parts 1 and 2)
Short term (6%)	$500,000	$150,000
Long term (10%)	100,000	450,000
	$600,000	$600,000

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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 6-8 . 2  Assuming the firm generates $200,000 in earnings before interest and taxes, Plan A will provide aftertax earnings of $80,000, while Plan B will generate only $73,000.

Table 6-8   Impact of financing plans on earnings

EDWARDS CORPORATION
Plan A
Earnings before interest and taxes	$200,000
Interest (short term), 6% × $500,000	30,000
Interest (long term), 10% × $100,000	10,000
Earnings before taxes	$160,000
Taxes (50%)	80,000
Earnings after taxes	$ 80,000
Plan B
Earnings before interest and taxes	$200,000
Interest (short term), 6% × $150,000	9,000
Interest (long term), 10% × $450,000	45,000
Earnings before taxes	$146,000
Taxes (50%)	73,000
Earnings after taxes	$ 73,000

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 6-8 ). Let us now assume that under disruptive tight money conditions, Plan A would provide a $15,000 lower return than Plan B because of high short-term interest rates. These conditions are summarized in  Table 6-9 , and an expected value of return is computed. The expected value represents the sum of the expected outcomes under the two conditions.

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Table 6-9   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 6-10 . Plan A’s expected return is now $4,400 less than that of Plan B.

Table 6-10 Expected returns for high-risk firm

Shifts in Asset Structure

For large U.S. nonfinancial corporations as represented by Standard & Poor’s, the percentage of net working capital (Current assets − Current liabilities) divided by sales declined from about 23 percent in the mid-1960s to its current level of 17 percent.

Figure 6-11  depicts the combined net working capital ratio and the current ratio for five large industrial companies: Caterpillar, United Technologies, 3M, Boeing, and ExxonMobil. These financially strong companies exhibit the same pattern as that of the S&P industrials. During a recession, sales decline or stay even, but cash, receivables, and inventory fall and short-term debt may rise, causing a large decline in the net working capital to sales ratio. As the firm’s profitability increases during the upswing, cash, receivables, and inventory rise, and short-term debt may fall or be replaced by low-cost long-term debt in the low-interest rate environment of a recession. These two effects cause the ratio to rise.  Figure 6-11  clearly shows the cyclical nature of working capital to sales. The ratio bottoms out in the recession of 2008 and makes a steady increase as these companies build up their cash balances and inventories. Because of the uncertainty surrounding the economy, many companies opted to hold larger cash balances for future stock repurchases, mergers, or dividend increases.

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Figure 6-11 Net working capital as a percentage of sales and the current ratio

However, the low current ratios of between 1.2 and 1.5 since 2000 (right scale) can be traced to more efficient inventory management such as just-in-time inventory programs, point-of-sales terminals, more efficient cash management, electronic cash flow transfer systems, and the ability to sell accounts receivable through the securitization of assets (more fully explained in the next chapter).

Toward an Optimal Policy

As previously indicated, the firm should attempt to relate asset liquidity to financing patterns, and vice versa. In  Table 6-11 , 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.

In using  Table 6-11 , 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 panel 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).

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Finance in ACTION Managerial Working Capital Problems in a Small Business

Many small businesses that are seasonal in nature have difficult financing problems. This is particularly true of retail nursery (plants) stores, greeting card shops, boating stores, and so on. The problem is that each of these businesses has year-round fixed commitments, but the business is seasonal. For example, Calloway’s Nursery, located in the Dallas–Ft. Worth Metroplex, as well as in Houston, does approximately half of its business in the April to June quarter, yet it must make lease payments for its 18 retail outlets every month of the year. The problem is compounded by the fact that during seasonal peaks it must compete with large national retail chains such as Lowe’s and Home Depot that can easily convert space allocated to nursery products to other purposes when winter comes. While Calloway’s Nursery can sell garden-related arts and crafts in its off-season, the potential volume is small compared to the boom periods of April, May, and June.

Seasonality is not a problem that is exclusive to small businesses. However, its effects can be greater because of the difficulty that small businesses have in attracting large pools of permanent funds through the use of equity capital. The smaller business firm is likely to be more dependent on suppliers, commercial banks, and others to provide financing needs. Suppliers are likely to provide the necessary funds during seasonal peaks, but are not a good source of financing during the off-season. Banks may provide a line of credit (a commitment to provide funds) for the off-season, but the small firm can sometimes find it difficult to acquire bank financing. This has become particularly true with the consolidation of the banking industry through mergers. Twenty years ago, the small businessperson was usually on a first-name, golf-playing basis with the local banker who knew every aspect of his or her business. Now a loan request may have to go to North Carolina, Ohio, California, New York, or elsewhere for final approval.

The obvious answer to seasonal working capital problems is sufficient financial planning to ensure that profits produced during the peak season are available to cover losses during the off-season. Calloway’s Nursery and many other small firms literally predict at the beginning of their fiscal period the movement of cash flow for every week of the year. This includes the expansion and reduction of the workforce during peak and slow periods, and the daily tracking of inventory. However, even such foresight cannot fully prepare a firm for an unexpected freeze, a flood, the entrance of a new competitor into the marketplace, a zoning change that redirects traffic in the wrong direction, and so on.

Thus the answer lies not just in planning, but in flexible planning. If sales are down by 10 percent, then a similar reduction in employees, salaries, fringe benefits, inventory, and other areas must take place. Plans for expansion must be changed into plans for contraction.

www.calloways.com

Table 6-11 Asset liquidity and financing assets

	Asset Liquidity
Financing Plan	Low Liquidity	High Liquidity
Short term	1 High profit High risk	2 Moderate profit Moderate risk
Long term	3 Moderate profit Moderate risk	4 Low profit Low risk

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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 firms, 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 two chapters, we will examine the various methods for managing the individual components of working capital. In  Chapter 7 , we consider the techniques for managing cash, marketable securities, receivables, and inventory. In  Chapter 8 , we 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 a firm with continuous operations will always maintain minimum levels of current assets, management must be able to distinguish between current assets that are permanent and those that are temporary or cyclical. To determine the permanent or cyclical nature of current assets, the financial manager must give careful attention to the growth in sales and the relationship of the production process to sales. Level production in a seasonal sales environment increases operating efficiency, but it also calls for more careful financial planning.

In general, we 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.

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LIST OF TERMS

working capital management  159

self-liquidating assets  159

permanent current assets  159

temporary current assets  160

level production  161

point-of-sales terminals  163

term structure of interest rates (yield curve)  173

liquidity premium theory  173

market segmentation theory  173

expectations hypothesis  173

basis points  175

tight money  177

expected value  177

DISCUSSION QUESTIONS

1. Explain how rapidly expanding sales can drain the cash resources of a firm. (LO6-3)

2. Discuss the relative volatility of short- and long-term interest rates. (LO6-4)

3. What is the significance to working capital management of matching sales and production? (LO6-3)

4. How is a cash budget used to help manage current assets? (LO6-1)

5. “The most appropriate financing pattern would be one in which asset buildup and length of financing terms are perfectly matched.” Discuss the difficulty involved in achieving this financing pattern. (LO6-5)

6. By using long-term financing to finance part of temporary current assets, a firm may have less risk but lower returns than a firm with a normal financing plan. Explain the significance of this statement. (LO6-5)

7. A firm that uses short-term financing methods for a portion of permanent current assets is assuming more risk but expects higher returns than a firm with a normal financing plan. Explain. (LO6-3)

8. What does the term structure of interest rates indicate? (LO6-4)

9. What are three theories for describing the shape of the term structure of interest rates (the yield curve)? Briefly describe each theory. (LO6-4)

10. Since the mid-1960s, corporate liquidity has been declining. What reasons can you give for this trend? (LO6-1)

PRACTICE PROBLEMS AND SOLUTIONS

Expected value

(LO6-6)

1. Meyer Electronics expects sales next year to be $3,000,000 if the economy is strong, $1,200,000 if the economy is steady, and $800,000 if the economy is weak. Mr. Meyer believes there is a 30 percent probability the economy will be strong, a 60 percent probability of a steady economy, and a 10 percent probability of a weak economy. What is the expected level of sales for the next year?

Alternative financing plans (LO6-5)

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2. Otis Resources is trying to develop an asset financing plan. The firm has $200,000 in temporary current assets and $500,000 in permanent current assets. Otis also has $300,000 in fixed assets.

a. Construct two alternative financing plans for the firm. One of the plans should be conservative, with 70 percent of assets financed by long-term sources and the rest financed by short-term sources. The other plan should be aggressive, with only 20 percent of assets financed by long-term sources and the remaining assets financed by short-term sources. The current interest rate is 12 percent on long-term funds and 5 percent on short-term financing. Compute the annual interest payments under each plan.

b. Given that Otis’s earnings before interest and taxes are $234,000, calculate earnings after taxes for each of your alternatives. Assume a tax rate of 35 percent.

Solutions

1. 

2. a.

Temporary current assets	$   200,000
Permanent current assets	500,000
Fixed assets	300,000
Total assets	$1,000,000

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b.

	Conservative	Aggressive
EBIT	$234,000	$234,000
I	99,000	64,000
EBT	$135,000	$170,000
Tax 35%	47,250	59,500
EAT	$  87,750	$ 110,500

PROBLEMS

 Selected problems are available with Connect. Please see the preface for more information.

Basic Problems

Expected value

(LO6-6)

1. Gary’s Pipe and Steel Company expects sales next year to be $800,000 if the economy is strong, $500,000 if the economy is steady, and $350,000 if the economy is weak. Gary believes there is a 20 percent probability the economy will be strong, a 50 percent probability of a steady economy, and a 30 percent probability of a weak economy. What is the expected level of sales for next year?

Expected value

(LO6-6)

2. Sharpe Knife Company expects sales next year to be $1,550,000 if the economy is strong, $825,000 if the economy is steady, and $550,000 if the economy is weak. Mr. Sharpe believes there is a 30 percent probability the economy will be strong, a 40 percent probability of a steady economy, and a 30 percent probability of a weak economy. What is the expected level of sales for the next year?

External financing

(LO6-1)

3. Tobin Supplies Company expects sales next year to be $500,000. Inventory and accounts receivable will increase $90,000 to accommodate this sales level. The company has a steady profit margin of 12 percent with a 40 percent dividend payout. How much external financing will Tobin Supplies Company have to seek? Assume there is no increase in liabilities other than that which will occur with the external financing.

External financing

(LO6-1)

4. Antivirus Inc. expects its sales next year to be $2,500,000. Inventory and accounts receivable will increase $480,000 to accommodate this sales level. The company has a steady profit margin of 15 percent with a 35 percent dividend payout. How much external financing will the firm have to seek? Assume there is no increase in liabilities other than that which will occur with the external financing.

Level versus seasonal production

(LO6-1)

5. Antonio Banderos & Scarves makes headwear that is very popular in the fall–winter season. Units sold are anticipated as follows:

October	1,250
November	2,250
December	4,500
January	3,500
	11,500 units

If seasonal production is used, it is assumed that inventory will directly match sales for each month and there will be no inventory buildup.

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However, Antonio decides to go with level production to avoid being out of merchandise. He will produce the 11,500 items over four months at a level of 2,875 per month.

a. What is the ending inventory at the end of each month? Compare the units sales to the units produced and keep a running total.

b. If the inventory costs $8 per unit and will be financed at the bank at a cost of 12 percent, what is the monthly financing cost and the total for the four months? (Use 1 percent or the monthly rate.)

Level versus seasonal production

(LO6-1)

6. Bambino Sporting Goods makes baseball gloves that are very popular in the spring and early summer season. Units sold are anticipated as follows:

March	3,250
April	7,250
May	11,500
June	9,500
	31,500 units

If seasonal production is used, it is assumed that inventory will directly match sales for each month and there will be no inventory buildup.

The production manager thinks the preceding assumption is too optimistic and decides to go with level production to avoid being out of merchandise. He will produce the 31,500 units over four months at a level of 7,875 per month.

a. What is the ending inventory at the end of each month? Compare the unit sales to the units produced and keep a running total.

b. If the inventory costs $12 per unit and will be financed at the bank at a cost of 12 percent, what is the monthly financing cost and the total for the four months? (Use 0.01 as the monthly rate.)

Short-term versus longer-term borrowing

(LO6-3)

7. Boatler Used Cadillac Co. requires $850,000 in financing over the next two years. The firm can borrow the funds for two years at 12 percent interest per year. Mr. Boatler decides to do forecasting and predicts that if he utilizes short-term financing instead, he will pay 7.75 percent interest in the first year and 13.55 percent interest in the second year. Determine the total two-year interest cost under each plan. Which plan is less costly?

Short-term versus longer-term borrowing

(LO6-3)

8. Biochemical Corp. requires $550,000 in financing over the next three years. The firm can borrow the funds for three years at 10.60 percent interest per year. The CEO decides to do a forecast and predicts that if she utilizes short-term financing instead, she will pay 8.75 percent interest in the first year, 13.25 percent interest in the second year, and 10.15 percent interest in the third year. Determine the total interest cost under each plan. Which plan is less costly?

Intermediate Problems

Short-term versus longer-term borrowing

(LO6-3)

9. Sauer Food Company has decided to buy a new computer system with an expected life of three years. The cost is $150,000. The company can borrow $150,000 for three years at 10 percent annual interest or for one year at 8 percent annual interest.Page 186

How much would Sauer Food Company save in interest over the three-year life of the computer system if the one-year loan is utilized and the loan is rolled over (reborrowed) each year at the same 8 percent rate? Compare this to the 10 percent three-year loan. What if interest rates on the 8 percent loan go up to 13 percent in year 2 and 18 percent in year 3? What would be the total interest cost compared to the 10 percent, three-year loan?

Optimal policy mix

(LO6-5)

10. Assume that Hogan Surgical Instruments Co. has $2,500,000 in assets. If it goes with a low-liquidity plan for the assets, it can earn a return of 18 percent, but with a high-liquidity plan, the return will be 14 percent. If the firm goes with a short-term financing plan, the financing costs on the $2,500,000 will be 10 percent, and with a long-term financing plan, the financing costs on the $2,500,000 will be 12 percent. (Review  Table 6-11  for parts a, b, and c of this problem.)

a. Compute the anticipated return after financing costs with the most aggressive asset financing mix.

b. Compute the anticipated return after financing costs with the most conservative asset financing mix.

c. Compute the anticipated return after financing costs with the two moderate approaches to the asset financing mix.

d. Would you necessarily accept the plan with the highest return after financing costs? Briefly explain.

Optimal policy mix

(LO6-5)

11. Assume that Atlas Sporting Goods Inc. has $840,000 in assets. If it goes with a low-liquidity plan for the assets, it can earn a return of 15 percent, but with a high-liquidity plan the return will be 12 percent. If the firm goes with a short-term financing plan, the financing costs on the $840,000 will be 9 percent, and with a long-term financing plan, the financing costs on the $840,000 will be 11 percent. (Review  Table 6-11  for parts a, b, and c of this problem.)

a. Compute the anticipated return after financing costs with the most aggressive asset financing mix.

b. Compute the anticipated return after financing costs with the most conservative asset financing mix.

c. Compute the anticipated return after financing costs with the two moderate approaches to the asset financing mix.

d. If the firm used the most aggressive asset financing mix described in part a and had the anticipated return you computed for part a, what would earnings per share be if the tax rate on the anticipated return was 30 percent and there were 20,000 shares outstanding?

e. Now assume the most conservative asset financing mix described in part b will be utilized. The tax rate will be 30 percent. Also assume there will only be 5,000 shares outstanding. What will earnings per share be? Would it be higher or lower than the earnings per share computed for the most aggressive plan computed in part d?

Matching asset mix and financing plans

(LO6-3)

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12. Colter Steel has $4,200,000 in assets.

Temporary current assets	$1,000,000
Permanent current assets	2,000,000
Fixed assets	1,200,000
Total assets	$4,200,000

Short-term rates are 8 percent. Long-term rates are 13 percent. Earnings before interest and taxes are $996,000. The tax rate is 40 percent.

If long-term financing is perfectly matched (synchronized) with long-term asset needs, and the same is true of short-term financing, what will earnings after taxes be? For a graphical example of perfectly matched plans, see  Figure 6-5 .

Impact of term structure of interest rates on financing plans

(LO6-4)

13. In Problem 12, assume the term structure of interest rates becomes inverted, with short-term rates going to 11 percent and long-term rates 5 percentage points lower than short-term rates. If all other factors in the problem remain unchanged, what will earnings after taxes be?

Conservative versus aggressive financing

(LO6-5)

14. Guardian Inc. is trying to develop an asset financing plan. The firm has $400,000 in temporary current assets and $300,000 in permanent current assets. Guardian also has $500,000 in fixed assets. Assume a tax rate of 40 percent.

a. Construct two alternative financing plans for Guardian. One of the plans should be conservative, with 75 percent of assets financed by long-term sources, and the other should be aggressive, with only 56.25 percent of assets financed by long-term sources. The current interest rate is 15 percent on long-term funds and 10 percent on short-term financing.

b. Given that Guardian’s earnings before interest and taxes are $200,000, calculate earnings after taxes for each of your alternatives.

c. What would happen if the short- and long-term rates were reversed?

Alternative financing plans

(LO6-5)

15. Lear Inc. has $840,000 in current assets, $370,000 of which are considered permanent current assets. In addition, the firm has $640,000 invested in fixed assets.

a. Lear wishes to finance all fixed assets and half of its permanent current assets with long-term financing costing 8 percent. The balance will be financed with short-term financing, which currently costs 7 percent. Lear’s earnings before interest and taxes are $240,000. Determine Lear’s earnings after taxes under this financing plan. The tax rate is 30 percent.

b. As an alternative, Lear might wish to finance all fixed assets and permanent current assets plus half of its temporary current assets with long-term financing and the balance with short-term financing. The same interest rates apply as in part a. Earnings before interest and taxes will be $240,000. What will be Lear’s earnings after taxes? The tax rate is 30 percent.

c. What are some of the risks and cost considerations associated with each of these alternative financing strategies?

Expectations hypothesis and interest rates

(LO6-4)

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16. Using the expectations hypothesis theory for the term structure of interest rates, determine the expected return for securities with maturities of two, three, and four years based on the following data. Do an analysis similar to that in  Table 6-6 .

1-year T-bill at beginning of year 1	6%
1-year T-bill at beginning of year 2	7%
1-year T-bill at beginning of year 3	9%
1-year T-bill at beginning of year 4	11%

Expectations hypothesis and interest rates

(LO6-4)

17. Using the expectations hypothesis theory for the term structure of interest rates, determine the expected return for securities with maturities of two, three, and four years based on the following data. Do an analysis similar to that in the right-hand portion of  Table 6-6 .

1-year T-bill at beginning of year 1	5%
1-year T-bill at beginning of year 2	8%
1-year T-bill at beginning of year 3	7%
1-year T-bill at beginning of year 4	10%

Advanced Problems

Interest costs under alternative plans

(LO6-3)

18. Carmen’s Beauty Salon has estimated monthly financing requirements for the next six months as follows:

January	$8,500
February	2,500
March	3,500
April	$8,500
May	9,500
June	4,500

Short-term financing will be utilized for the next six months. Here are the projected annual interest rates:

January	9.0%
February	10.0%
March	13.0%
April	16.0%
May	12.0%
June	12.0%

a. Compute total dollar interest payments for the six months. To convert an annual rate to a monthly rate, divide by 12. Then multiply this value times the monthly balance. To get your answer, add up the monthly interest payments.

b. If long-term financing at 12 percent had been utilized throughout the six months, would the total-dollar interest payments be larger or smaller? Compute the interest owed over the six months and compare your answer to that in part a.

Break-even point in interest rates

(LO6-3)

19. In Problem 18, what long-term interest rate would represent a break-even point between using short-term financing as described in part a and long-term financing? (Hint: Divide the interest payments in 18a by the amount of total funds provided for the six months and multiply by 12.)

Cash receipts schedule

(LO6-1)

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20. Eastern Auto Parts Inc. has 15 percent of its sales paid for in cash and 85 percent on credit. All credit accounts are collected in the following month.

Assume the following sales:

January	$ 65,000
February	55,000
March	100,000
April	45,000

Sales in December of the prior year were $75,000.

Prepare a cash receipts schedule for January through April.

Level production and related financing effects

(LO6-3)

21. Bombs Away Video Games Corporation has forecasted the following monthly sales:

January	$ 100,000
February	93,000
March	25,000
April	25,000
May	20,000
June	35,000
July	$ 45,000
August	45,000
September	55,000
October	85,000
November	105,000
December	123,000
Total annual sales = $756,000

Bombs Away Video Games sells the popular Strafe and Capture video game. It sells for $5 per unit and costs $2 per unit to produce. A level production policy is followed. Each month’s production is equal to annual sales (in units) divided by 12.

Of each month’s sales, 30 percent are for cash and 70 percent are on account. All accounts receivable are collected in the month after the sale is made.

a. Construct a monthly production and inventory schedule in units. Beginning inventory in January is 25,000 units. (Note: To do part a, you should work in terms of units of production and units of sales.)

b. Prepare a monthly schedule of cash receipts. Sales in the December before the planning year are $100,000. Work part b using dollars.

c. Determine a cash payments schedule for January through December. The production costs of $2 per unit are paid for in the month in which they occur. Other cash payments, besides those for production costs, are $45,000 per month.

d. Prepare a monthly cash budget for January through December using the cash receipts schedule from part b and the cash payments schedule from part c. The beginning cash balance is $5,000, which is also the minimum desired.

Level production and related financing effects

(LO6-3)

22. Esquire Products Inc. expects the following monthly sales:

January	$28,000
February	19,000
March	12,000
April	14,000
May	$ 8,000
June	6,000
July	22,000
August	26,000
September	$29,000
October	34,000
November	42,000
December	24,000
Total sales = $264,000

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Cash sales are 40 percent in a given month, with the remainder going into accounts receivable. All receivables are collected in the month following the sale. Esquire sells all of its goods for $2 each and produces them for $1 each. Esquire uses level production, and average monthly production is equal to annual production divided by 12.

a. Generate a monthly production and inventory schedule in units. Beginning inventory in January is 12,000 units. (Note: To do part a, you should work in terms of units of production and units of sales.)

b. Determine a cash receipts schedule for January through December. Assume that dollar sales in the prior December were $20,000. Work part b using dollars.

c. Determine a cash payments schedule for January through December. The production costs ($1 per unit produced) are paid for in the month in which they occur. Other cash payments (besides those for production costs) are $7,400 per month.

d. Construct a cash budget for January through December using the cash receipts schedule from part b and the cash payments schedule from part c. The beginning cash balance is $3,000, which is also the minimum desired.

e. Determine total current assets for each month. Include cash, accounts receivable, and inventory. Accounts receivable equal sales minus 40 percent of sales for a given month. Inventory is equal to ending inventory (part a) times the cost of $1 per unit.

WEB EXERCISE

1. Target was mentioned in the chapter as a company that has a high degree of seasonality (and associated working capital issues). Let’s use the Internet to examine the seasonality. Go to  www.target.com . Scroll to the bottom of the page, and under the “About Target” heading, click on “Investor Relations.” At the top of the page, hold your mouse over “Investors” and select “Analyst Coverage” from the drop-down menu. Scroll down to “Analyst Forecasts” and “Actuals.” You will see historical and projected data for both quarterly and annual periods.

2. Based on the observed data, which of the four quarters (Qs) is normally best for Target? Why?

3. Which quarter is normally the worst? This may be a close call.

4. Taking the most recent year in which four quarters of data are shown, what percentage of total fiscal year earnings does the best quarter represent?

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1 Using a geometric mean return rather than a simple average return creates a more exact rate of return. For example, for the four-year security a geometric return would provide a return of 5.494 percent rather than the 5.5 percent simple average in  Table 6-6 . The calculation would be as follows:

[(1.04) × (1.05) × (1.06) × (1.07)]1/4 − 1 = .05494

2 Common stock is eliminated from the example to simplify the analysis.