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Working Capital andthe Financing Decision
McGraw-Hill Ryerson McGraw-Hill Ryerson Limited 2000
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Figure 6-1aThe nature of asset growth
A. Stage I: Limited or no Growth
Dollars Temporary current assets
Capital assets
Time period
PPT 6-1
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Figure 6-1bThe nature of asset growth
B. Stage II: GrowthDollars
Temporary current assets
Capital assets
Time period
Permanentcurrent assets
PPT 6-1
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Figure 6-1bThe nature of asset growth
B. Stage II: GrowthDollars
Temporary current assets
Capital assets
Time period
Permanentcurrent assets
PPT 6-1
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Figure 6-2aSales and earnings for McGraw-Hill Ryerson, 1990-1998
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PPT 6-2
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Figure 6-2bSales and earnings for McGraw-Hill Ryerson, 1990-1998
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PPT 6-2
Sources: www.sedar.com www.mcgrawhill.ca Symbol: MHR
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Figure 6-3aSales and earnings for Hudsons Bay Co. and Sears Canada
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PPT 6-2
Sources: www.sedar.com www.hbc.com Symbol: HBC www.sears.ca Symbol: SCC
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Figure 6-3bSales and earnings for Hudsons Bay Co. and Sears Canada
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PPT 6-2
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Accounts receivable0-30 days31-60 days61-90 days91-120 days
Accounts receivable0-30 days31-60 days61-90 days91-120 days
Materials and serviceSuppliers: accts. payableLabor: wages payableOther: expenses
Materials and serviceSuppliers: accts. payableLabor: wages payableOther: expenses
InventoryFinished GoodsGoods in processRaw materials
InventoryFinished GoodsGoods in processRaw materials
SalesGeographical areaProduct or divisionCustomer type
SalesGeographical areaProduct or divisionCustomer type
CustomersCustomers
Short-term lendersChartered banksNon-bank lendersForeign banks and lenders
Short-term lendersChartered banksNon-bank lendersForeign banks and lenders
Government taxesFederal income taxesProvincial taxesOther taxes
Government taxesFederal income taxesProvincial taxesOther taxes
CashCashMarketable securitiesMarketable securities
Interest and dividends
PPT 6-3
Expanded cash flow cycle
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1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
October . 300 January .. 0 April .1,000 July . 2,000
November ..150 February . 0 May ..2,000 August .1,000
December ... 50 March .. 600 June ..2,000 September ..500
Total sales of 9,600 units at $3,000 each = $28,800,000 in sales.
PPT 6-4
Table 6-1Yawakuzi sales forecast (in units)
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InventoryProduction (at cost of
Beginning (level Ending $2,000inventory + production) Sales = inventory per unit)
PPT 6-5
Table 6-2Yawakuzis production schedule and inventory
October 800 800 300 1,300 $2,600,000November 1,300 800 150 1,950 3,900,000December 1,950 800 50 2,700 5,400,000January 2,700 800 0 3,500 7,000,000
February 3,500 800 0 4,300 8,600,000March 4,300 800 600 4,500 9,000,000April 4,500 800 1,000 4,300 8,600,000May 4,300 800 2,000 3,100 6,200,000
June 3,100 800 2,000 1,900 3,800,000July 1,900 800 2,000 700 1,400,000August 700 800 1,000 500 1,000,000September 500 800 500 800 1,600,000
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Table 6-3aSales forecast, cash receipts and payments, and cash budget
Oct Nov Dec Jan Feb Mar Apr May June July Aug Sept
Sales (units) 300 150 50 600 1,000 2,000 2,000 2,000 1,000 500
Sales $0.9 $0.45 $0.15 $1.8 $3.0 $6.0 $6.0 $6.0 $3.0 $1.5(unit price, $3,000)
Sales Forecast ($ millions)
50% cash .45 $.225 $.075 $0.9 $1.5 $3.0 $3.0 $3.0 $1.5 $.7550% cash fromprior months sales .75* 0.450 0.225 0.075 0. 9 1.5 3.0 3.0 3.0 1.50
Total cashreceipts $1.20 0.675 $0.300 $0.075 $0.9 $2.4 $4.5 $6.0 $6.0 $4.5 $2.25
*Assumes September sales of $1.5 million.
Cash Receipts Schedule ($ millions)
PPT 6-6
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Constant productionof 800 units/month(cost $2,000 per unit) $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6 $1.6Overhead .4 .4 .4 .4 .4 .4 .4 .4 .4 .4 .4 .4Dividends & interest 1.0 Taxes .3 .3 .3 .3 Total cashpayments $2.3 $2.0 $2.0 $2.3 $2.0 $2.0 $2.3 $2.0 $2.0 $2.3 $3.0 $2.0
Cash flow $(1.1) $(1.325) $(1.7) $(2.225) $(2.0) $(1.1) $.1 $2.5 $4.0 $3.7 $1.5 $.25Beginning cash .25 .25 .25 .25 .25 .25 .25 .25 .25 .25 1.1 2.60Cumulativecash balance $(.85) $(1.075) $(1.45) $(1.975) $(1.75) $(.85) $.35 $2.75 $4.25 $3.95 $2.6 $2.85Monthly loanor (repayment) 1.1 1.325 1.7 2.225 2.0 1.1 (0.1) (2.5) (4.0) (2.85) Cumulative loan 1.1 2.425 4.125 6.350 8.35 9.45 9.35 6.85 2.85 Ending cash balance .25 .25 .25 .25 .25 .25 .25 .25 .25 1.1 2.6 2.85
Oct Nov Dec Jan Feb Mar Apr May June July Aug Sept
Cash Payments Schedule ($ millions)
Cash Budget ($ millions; required minimum balance is $0.25 million)
PPT 6-6
Table 6-3bSales forecast, cash receipts and payments, and cash budget
Assumes cash balance of $.25 million at the beginning of October and that this is the desired minimum cash balance.
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Table 6-4Total current assets, first year ($ millions)
Accounts Total CurrentCash Receivable Inventory Assets
October $0.25 $0.450 $2.6 $3.30November 0.25 0.225 3.9 4.375December 0.25 0.075 5.4 5.725
January 0.25 0.00 7.0 7.25February 0.25 0.00 8.6 8.85March 0.25 0.90 9.0 10.15
April 0.25 1.50 8.6 10.35May 0.25 3.00 6.2 9.45June 0.25 3.00 3.8 7.05
July 1.10 3.00 1.4 5.50August 2.60 1.50 1.0 5.10September 2.85 0.75 1.6 5.20
PPT 6-7
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Cash flow $0.25 $(1.1) $(1.325) $(1.7) $(2.225 $(2.0) $(1.1) $0.1 $2.5 $4.0 $3.7 $1.5 $0.25Beginningcash 2.60 2.85 1.75 0.425 0.25 0.25 0.25 0.25 0.25 0.25 0.25 3.7 5.2Cumulative 2.85 1.75 0.425 (1.275) (1.975) (1.75) (0.85) 0.35 2.75 4.25 3.95 5.2 5.45cash balance
Monthly loanor (repayment) 1.525 2.225 2.0 1.1 (0.1) (2.5) (4.0) (0.25) Cumulative loan 1.525 3.750 5.75 6.85 6.75 4.25 0.25 . Ending cashbalance $2.85 $1.75 $0.425 $0.25 $0.25 $0.25 $0.25 $0.25 $0.25 $0.25 $3.70 $5.2 $5.45
Sept Oct Nov Dec Jan Feb Mar Apr May June July Aug Sept
Second YearEnd of
First Year
PPT 6-8
Table 6-5aCash budget and assets for second year with no growth in sales($ millions)
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Sept Oct Nov Dec Jan Feb Mar Apr May June July Aug Sept
Second YearEnd of
First Year
Ending cashbalance $2.85 $1.75 $0.425 $0.25 $0.25 $0.25 $0.25 $0.25 $0.25 $0.25 $3.70 $5.2 $5.45Accountsreceivable 0.75 0.45 0.225 0.075 . . 0.95 1.50 3.0 3.0 3.0 1.5 0.75Inventory 1.6 2.6 3.9 5.4 7.0 8.6 9.0 8.6 6.2 3.8 1.4 1.0 1.60Total cur-rent assets $5.2 $4.8 $4.55 $5.725 $7.25 $8.85 $10.15 $10.35 $9.45$7.05 $8.1 $7.7 $7.80
Total Current Assets
PPT 6-8
Table 6-5bCash budget and assets for second year with no growth in sales($ millions)
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Figure 6-6The nature of asset growth (Yawakuzi)
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InventoryCash
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Totalcurrentassets
Accountsreceivable
Inventory
$ millions
PPT 6-9
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Figure 6-7Matching long-term and short-term needs
Dollars
Temporary current assets
Capital assets
Time period
Permanentcurrent assets
Short-termfinancing
Long-termfinancing
(debt & equity)
PPT 6-10
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Figure 6-8Using long-term financing for part of short-term needs
Dollars
Temporary current assets
Capital assets
Time period
Permanentcurrent assets
PPT 6-11
Short-termfinancing
Long-termfinancing
(debt & equity)
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Dollars
Temporary current assets
Capital assets
Time period
Permanentcurrent assets
PPT 6-11
Short-termfinancing
Long-termfinancing
(debt & equity)
Figure 6-9Using short-term financing for part of long-term needs
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Figure 6-11A. Flat yield curve, March 1999
4.00
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6.00
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8.00
9.00
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16
Years
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PPT 6-12
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Figure 6-11(2)A. Normal yield curve, July 1993
PPT 6-12
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Figure 6-11(3)C. Inverted yield curve, December 1989
PPT 6-12
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Figure 6-12Long-term and short-term interest rates
PPT 6-13
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Plan A Plan B Part 1. Current assets
Temporary . . . . . . . $250,000 $250,000Permanent . . . . . . . 250,000 250,000 Total current assets . . . 500,000 500,000
Short-term financing (6%). . 500,000 150,000Long-term financing (10%) . 0 350,000
$500,000 $500,000Part 2. Capital assets
Plant and equipment . . . . $100,000 $100,000Long-term financing (10%) . $100,000 $100,000
Part 3. Total financing (summary of parts 1 & 2)Short-term (6%) . . . . . $500,000 $150,000Long-term (10% . . . . . 100,000 450,000
$600,000 $600,000
Table 6-7Alternative financing plans
EDWARDS CORPORATION
PPT 6-14
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Plan A
Table 6-8Impact of financing plans on earnings
Earnings before interest and taxes $200,000Interest (short-term), 6% $500,000 30,000Interest (long-term), 10% $100,000 10,000
Earnings before taxes 160,000Taxes (50%) 80,000
Earnings aftertaxes $ 80,000
Earnings before interest and taxes $200,000Interest (short-term), 6% $150,000 9,000Interest (long-term), 10% $450,000 45,000
Earnings before taxes 146,000Taxes (50%) 73,000
Earnings aftertaxes $ 73,000
Plan B
PPT 6-14
EDWARDS CORPORATION
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1. Normal Expected higher return Probability of Expectedconditions under Plan A normal conditions outcome
$7,000 .80 = ++++ $5,600
2. Tight Expected lower return Probability ofmoney under Plan A tight money
($15,000) .20 = (3,000)
Expected value of return for Plan A versus Plan B = +$2,600
Table 6-9Expected returns under different economic conditions
EDWARDS CORPORATION
PPT 6-15
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1. Normal Expected higher return Probability of Expectedconditions under Plan A normal conditions outcome
$7,000 .80 = ++++$5,600
2. Tight Expected lower return Probability ofmoney under Plan A tight money
($50,000) .20 = (10,000)
Expected value of return for Plan A versus Plan B = ($4,400)
PPT 6-15
EDWARDS CORPORATION
Table 6-10Expected returns for high-risk firm
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Asset Liquidity
Financing Plan Low Liquidity High Liquidity
1 2Short-term High Profit Moderate profit
High risk Moderate risk
3 4Long-term Moderate profit Low profit
Moderate risk Low risk
PPT 6-16
Table 6-11Current asset liquidity and asset financing plan
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Chapter 6 - Outline LT 6-1
What is Working Capital Management?
Hedged Approach to Financing
Short-Term vs. Long-Term Financing
Term Structure of Interest Rates
Working Capital Financing Plans
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Working Capital Management LT 6-2
Working Capital Management is financing and controllingthe current assets of a firm
Sales growth often leads to a buildup in inventory andaccounts receivable. Firm may require additional externalfinancing
Crucial to short-term success or failure of a business
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Hedged Approach to Financing
Match liquidity (life) of your assets to the maturity (term) of yourfinancing
Means your assets will be generating cash when your liabilities comedue
Balanced FinancingTemporary (seasonal) build-up in inventory and accounts receivable
finance with trade credit, short-term bank loans, short-term notespayable
Permanent (minimum) levels of inventory, receivables +
Property and equipment, long-term investments
finance with long-term loans, leases, bonds, capital stock, retainedearnings
LT 6-3
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Short-Term vs. Long-Term Financing LT 6-4
Short-term financing is less expensive but riskier
lower interest rates
short-term rates are volatile
risk of default if sales slow down
risk that bank may not extend / renew loans
Long-term financing is more expensive but less risky
usually higher interest rates,
you may pay interest on funds you dont always need
you have capital at all times
Firm must decide the appropriate mix
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Term Structure of Interest Rates LT 6-5
The Term Structure of Interest Rates is also known as theYield Curve
A graph showing the interest rate for Government ofCanada securities with different maturity dates
Normally, long-term rates are higher than short-term rates
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Working Capital Financing Plans LT 6-6
A moderate (balanced) firm:
S/T financing and high liquidity OR
L/T financing and low liquidity
An aggressive (risky) firm:
S/T financing and low liquidity
A conservative (safe or cautious) firm:
L/T financing and high liquidity
Appropriate strategy is determined based on companystolerance for risk