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Corporate Finance

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Corporate Finance ­FIN 622
Lesson 27
The following topics will be discussed in this lecture.
Classification of working capital
Current Assets Financing ­ Hedging approach
Short term Vs long term financing
Risk of short & long term financing
Trade off of short & long term financing
Classifications of Working Capital
Working capital or current assets can be classified according to
-  Components: like inventory, cash, securities, receivables
-  Time basis: it may be temporary or permanent.
Temporary working capital is the amount of investment in current assets that varies according to the
seasonal requirements. For example, consider an ice cream manufacturing firm. During the months of May
­ September the manufacturer has to keep the maximum inventory to support high level sales. During off-
season like from November to January the sales are extremely low and lower investment in inventory is
required. Now consider if a festival like Eid or Christmas is falling during December and this would result
in high sales, then a temporary increase in inventory would be required to support this sale level.
Permanent working capital is the minimum investment in current assets that is required support long-term
minimum need. Permanent working capital resembles to fixed assets in two aspects. First the dollar
investment is long term despite contradiction that assets being financed are called `current'. Second, for a
growing firm, the need to increase the minimum permanent working capital is the same as of fixed assets.
However, there is a case of difference between the permanent working capital and fixed asset ­ that is the
later always changing constantly.
Like permanent working capital, temporary working capital also comprises of current assets in a constantly
changing form. However, because the need for this part of the firm's total current assets is seasonal, we
want to consider financing this level of current assets from a source which can itself be seasonal or
temporary in nature. In the next section we pick up the problem of how to finance current assets.
Short Term & Long Term Mix
Investment in current asset does involve a trade off between the risk and profitability. As a matter of fact
the current liabilities side of working capital does not consist of active decision variables in the sense; you
cannot defer payment to creditors beyond certain limits. Same is true for accrued expenses like electricity,
payroll etc. There's no big room for playing with current liabilities which are also termed as spontaneous
source of finance. As the underlying investment in current assets grows, accounts payable and accruals also
tend to grow, in part financing the increase in assets. The issue here is how to handle assets not supported
by spontaneous financing. This is termed as residual financing requirements ­ that is net investment after
deducting spontaneous financing.
Current Assets Financing ­ Hedging Approach
Under this approach each asset would be offset with a financing instrument of the same maturity. Short
term seasonal investment requirements should be financed through short term loans and permanent current
asset and all fixed assets should be financed through long term loan and equity. This can be illustrated from
the following figure:
Corporate Finance ­FIN 622
This shows that financing will be employed even when it is not needed. With a hedging approach to
financing, the borrowing and payment schedule for short term financing would be arranged to correspond
to the expected swings in current assets less spontaneous financing.
The rational behind hedging policy that if long term loans are used to finance the short term or temporary
current assets then the firm will be paying interest when the funds are not actually needed. It is clear from
the graphical view of the hedging policy that loans will only be employed during the seasonal need period.
Hedging approach to financing suggests that apart from current installments on long term debt, a firm
should not employ current borrowings during seasonal troughs for asset needs as per the above figure. As
the seasonal need asset arises it will borrow on short term basis. This loan will be used to pay off the
borrowing with the cash released as the recently financed temporary assets were eventually reduced. For
example, a seasonal increase in inventory for Eid selling will be financed with a shot term loan. As the
inventory was reduced through sales, debtors will be built up. The cash needed to repay the loan would
come from the collection from debtors. In this way financing will only be employed when needed.
Thus loan to support seasonal need would generate necessary fund to repayment in normal course of
operation. This is known as self-liquidating principle.
Short Term Vs Long Tem Financing
Although the exact maturity matching of future cash flow and debt repayments is possible under conditions
of certainty but it is not appropriate when surrounded by uncertainty. Net cash flow will be off from the
estimates keeping in view the firm's business risk. Resultantly the schedule of maturities of debt is very
significant in assessing the risk-profitability trade off.
In general the shorter the maturity schedule of a firm's debt, the greater the risk that fir firm will default on
principal and interest payment. Suppose a firm seeks a short term loan for capital expenditure. The cash
flows from the capital expenditure will not be sufficient in the short run to pay off the loan. As a result, the
company bears the risk that the lender may not renew the loan at maturity. This refinancing risk could be
reduced in the first place by financing the plant on a long term basis ­ the expected loan term future cash
flows being sufficient to retire the debt in an orderly manner. Thus committing funds to a long term asset
and borrowing short term carries the risk that the firm may not be able to renew it loan. If the company is
surrounded by bad times, the creditors might regard renewal as too risky and demand immediate payment.
Apart from refinancing risk, uncertainty is there associated with interest cost. When firm finances with long
term loans it is aware of exact interest cost over the period of time for which loans are needed. If it uses
short term loans then it is uncertain of interest cost. Secondly, we are well aware that short term interest
Corporate Finance ­FIN 622
rates fluctuate more than long term. A firm forced to finance its short term debt in a period of high interest
rates may pay on overall interest cost on short term loan that is higher than it would have been originally on
long term loan. In short not knowing the short term interest cost of loans is to some extent a risk to the
The Risk Vs Cost Trade off:
The risk between long and short term financing should be balanced against the interest costs. The longer
the maturity schedule of loan, the more expensive will be the financing. Further to this, the firm will be
paying interest cost on loans when the loans / debts are not needed. Therefore, there are cost inducements
to finance funds requirements on a short term basis.
Eventually we can work out the trade off between risk and profitability. As per our discussion over last
couple of pages, we know that short term loans have greater risk than long term loans but are comparatively
cheap. The margin of safety would depend on the variance between the cash flow and payment of debt.
Also, margin of safety will depend on the risk preference of the management.
The management will finance a part of its expected seasonal investment, less payables and accruals on long
term basis. If there's no deviation in cash flow as estimated, the firm will pay interest on excess debt during
seasonal dips when the funds are not needed. Peak season requirements can be financed through long term
loan. The higher the long term loans the more conservative financing policy and therefore, the higher
interest cost.
Under aggressive policy the firm would finance part of its permanent current asset with short term debts.
This would require that firm must renew the debt at maturity, which represents some risk to the firm. The
greater the portion of permanent assets financed with short term loans, the more aggressive the policy is. In
this case, the expected margin of safety linked with firm's policy can be negative, positive or even zero.
Now we are in a position to sum up our discussion or conservative and aggressive policies. Here are the
salient features of both policies with regard to investment in current assets:
Conservative Policy:
o  Firm finances a part of seasonal fund requirements less accounts payable on long term basis.
o  If cash flow estimates do not deviate far from actual, it will pay interest on debt when actually
funds are not needed.
o  Higher the long term financing line, more conservative policy and higher cost.
Aggressive Policy:
Part of permanent current assets is financed with short term debt.
The company must arrange renewal of short term debt. It involves risk.
The greater portion of permanent current assets is financed with short term debt, more
aggressive policy it is.
Expected margin of safety regarding ST <> LT financing can be positive, negative or
neutral. Later would be hedging policy.
Margin of safety can be increased by increasing the liquid assets.
Risk of cash insolvency can be reduced by stretching the maturity schedule of debt or
carrying larger amounts of current assets
Table of Contents:
  4. Discounted Cash Flow, Effective Annual Interest Bond Valuation - introduction
  5. Features of Bond, Coupon Interest, Face value, Coupon rate, Duration or maturity date
  8. Capital Budgeting Definition and Process
  9. METHODS OF PROJECT EVALUATIONS, Net present value, Weighted Average Cost of Capital
  12. ADVANCE EVALUATION METHODS: Sensitivity analysis, Profitability analysis, Break even accounting, Break even - economic
  13. Economic Break Even, Operating Leverage, Capital Rationing, Hard & Soft Rationing, Single & Multi Period Rationing
  14. Single period, Multi-period capital rationing, Linear programming
  15. Risk and Uncertainty, Measuring risk, Variability of return–Historical Return, Variance of return, Standard Deviation
  16. Portfolio and Diversification, Portfolio and Variance, Risk–Systematic & Unsystematic, Beta – Measure of systematic risk, Aggressive & defensive stocks
  17. Security Market Line, Capital Asset Pricing Model – CAPM Calculating Over, Under valued stocks
  18. Cost of Capital & Capital Structure, Components of Capital, Cost of Equity, Estimating g or growth rate, Dividend growth model, Cost of Debt, Bonds, Cost of Preferred Stocks
  19. Venture Capital, Cost of Debt & Bond, Weighted average cost of debt, Tax and cost of debt, Cost of Loans & Leases, Overall cost of capital – WACC, WACC & Capital Budgeting
  20. When to use WACC, Pure Play, Capital Structure and Financial Leverage
  21. Home made leverage, Modigliani & Miller Model, How WACC remains constant, Business & Financial Risk, M & M model with taxes
  22. Problems associated with high gearing, Bankruptcy costs, Optimal capital structure, Dividend policy
  23. Dividend and value of firm, Dividend relevance, Residual dividend policy, Financial planning process and control
  24. Budgeting process, Purpose, functions of budgets, Cash budgets–Preparation & interpretation
  25. Cash flow statement Direct method Indirect method, Working capital management, Cash and operating cycle
  26. Working capital management, Risk, Profitability and Liquidity - Working capital policies, Conservative, Aggressive, Moderate
  27. Classification of working capital, Current Assets Financing – Hedging approach, Short term Vs long term financing
  28. Overtrading – Indications & remedies, Cash management, Motives for Cash holding, Cash flow problems and remedies, Investing surplus cash
  29. Miller-Orr Model of cash management, Inventory management, Inventory costs, Economic order quantity, Reorder level, Discounts and EOQ
  30. Inventory cost – Stock out cost, Economic Order Point, Just in time (JIT), Debtors Management, Credit Control Policy
  31. Cash discounts, Cost of discount, Shortening average collection period, Credit instrument, Analyzing credit policy, Revenue effect, Cost effect, Cost of debt o Probability of default
  32. Effects of discounts–Not effecting volume, Extension of credit, Factoring, Management of creditors, Mergers & Acquisitions
  33. Synergies, Types of mergers, Why mergers fail, Merger process, Acquisition consideration
  34. Acquisition Consideration, Valuation of shares
  35. Assets Based Share Valuations, Hybrid Valuation methods, Procedure for public, private takeover
  36. Corporate Restructuring, Divestment, Purpose of divestment, Buyouts, Types of buyouts, Financial distress
  37. Sources of financial distress, Effects of financial distress, Reorganization
  38. Currency Risks, Transaction exposure, Translation exposure, Economic exposure
  39. Future payment situation – hedging, Currency futures – features, CF – future payment in FCY
  40. CF–future receipt in FCY, Forward contract vs. currency futures, Interest rate risk, Hedging against interest rate, Forward rate agreements, Decision rule
  41. Interest rate future, Prices in futures, Hedging–short term interest rate (STIR), Scenario–Borrowing in ST and risk of rising interest, Scenario–deposit and risk of lowering interest rates on deposits, Options and Swaps, Features of opti
  43. Calculating financial benefit–Interest rate Option, Interest rate caps and floor, Swaps, Interest rate swaps, Currency swaps
  44. Exchange rate determination, Purchasing power parity theory, PPP model, International fisher effect, Exchange rate system, Fixed, Floating
  45. FOREIGN INVESTMENT: Motives, International operations, Export, Branch, Subsidiary, Joint venture, Licensing agreements, Political risk