Working capital management Intoduction

Working Capital ManagementCourse Code: FIN 6407

Working Capital Management



Maintenance of short-term assets and liabilities at a level that minimizes costs

and maximizes benefits


Working Capital? Assets and Liabilities required to operate business on

day to day basis Excess of current assets over current liabilities It is a financial metric that represents operating

liquidity available to the business Working capital is considered a part of operating

capital A measure of both a company's efficiency and its

short-term financial health


Any asset or liability items liquidating itself or getting converted into cash within operating cycle period, is a current item; the rest are non-current

But the controversy is, the operating cycle or the natural business year, may be different in different types of businesses

Operating cycle may count on raw materials in store, work-in-progress, finished goods in store, receivables. Trade creditors, etc.


Working Capital?

Gross Working Capital = Current Assets

Net Working Capital = Current Assets –

Current Liabilities, reflects the amount of funds

needed to support routine operations


Working Capital?Current Assets and Current Liabilities of the Balance Sheet


Working Capital and Fund Requirement

Maintaining working capital requires permanent commitment of funds

Firms will always have minimum level of inventory, accounts receivable, cash and accounts payable

Spontaneous financing arises automatically with inventory and expenses

Principles of Modern Finance

• Shareholder Wealth Maximization• Cash flow Decision Making


Shareholders Wealth Maximization

Increasing the market value of shares hold by stockholders

Through


Cash flow Decision Making

Taking actions that influence firm’s cash flows Public information regarding cash flows

influence market values of shares Marginal Cash flows associated with a

financial decision Cash flows further in the future less than

flows closer to the present

Through


The risk and time pattern can be addressed via the use of net present value with risk-adjusted discount rate (k)k = risk-free rate + risk premium


• In the risk-adjusted discount rate, net present value procedure, the value of the cash flow is computed as:

Net Present Value = tt kNCFE )1/()(

mriskpremiuRk f

Suppose that a marginal cash flow of $ 10000 is expected to occur two periods in the future, the risk-free rate is 6 percent per period and the risk premium for a flow of this level is 9 percent per year. What is the Net Present Value?


Firm’s policies regarding financial decision also affect stakeholders like bondholders, employees, suppliers, customers, etc.

These things affect firm’s cost of fund, labor expenses and sales revenue.

All together are reflected on market prices of shares.


Risk and Financial Decision Making

Assess [measured or estimates] the amount and types of risks

Address [account] the assessed risks in decision making

Finance deals risk in two ways:


Assessing Risks Total risk is assessed by sensitivity analysis and

simulation analysis Sensitivity analysis assess the relation

between an input variable and an important output variable of a financial analysis algorithm

Simulation analysis is an attempt to assess the total risks of outcomes based on variation in all uncertain input variables taken simultaneously


Total risk is composed of

Diversifiable risks Non-diversifiable risks



Diversifiable Risks

Risks particular to an individual asset Avoidable to some extent

Non-Diversifiable Risk

Inherent economic risk common to all assets

Market risk or general risk Affects security price Beta is the measure of non-diversifiable

risk


)(/)( mmii RVARRRCOVb

• Where ß is the beta of project i• is the covariance of the

return on the project with the market portfolio

• is the variance of the return on the market portfolio

)( miRRCOV

)( mRVAR


A measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns..


Beta is measured by regressing the returns on these shares with those of the market as a whole

When firm’s project returns do not vary as much as market returns, tend to have beta less than 1

Firm’s whose projects returns vary much more with market returns tend to have common shares beta greater than 1

New projects should have beta same as current average projects


Addressing Risks

Risk must be priced to reflect shareholders risk aversion

Or A hedging strategy must be formulated to

remove the risk


Pricing of risks uses net present value involved the determination of the appropriate risk premium to discount the risky cash flows


Approaches Determine Risk Premium

Benchmark risk-adjusted discount rates Capital Asset Pricing Model (CAPM)


Reflect total risks or risk premiumDetermine the appropriate risk premium by comparing the risk of the marginal cash flow with that of traded assets and employing the markets required returns for traded assets of comparable risks

Benchmark risk-adjusted discount rates:


Analyst starts with the market’s required return on assets of known risk to compare withLike: other firm’s cost of capital

Benchmark risk-adjusted discount rates:


The Capital-Assets-Pricing Model (CAPM)

The risk premium used to determine the appropriate discount rate should be based on the non-diversifiable risk not the total risk.CAPM formula to obtain the required rate of return of share holders. The CAPM formula is: )( fmifi RRbRR

Where, is the required return on the equity investment

is the expected return on the market portfolio

is the risk-free rate and is the measure of non-diversifiable risk

iR

mR

ib


• A project with estimated beta of 1.4, the risk-free rate of interest is 6 percent per year and the expected return on a fully diversified portfolio of assets is 13 percent. The firms capital structure includes 40 percent interest-bearing debt and the rest equity, new issues of debt are expected to yield 9 percent. The firm is 33 percent marginal tax bracket. Find out the required return on equity and required return of the project.



Hedging

Hedging is a saving for a rainy dayA method of controlling risk


• Carrying cash is partly a hedging strategy• Financial instruments either may be used in hedging strategy or may not• As a hedge against uncertainty, the firm can keep a mix of cash, marketable securities, and a reserve line of credit


Example

*** Compute the ratios (page 20)

Working capital management Intoduction

Business

Transcript of Working capital management Intoduction