Chapter 6 Discussion Questions 6-1 Explain how rapidly expand ing sales can drain the cash resources of a firm Rapidly expanding sales will require a buildup in assets to support the growth In particular, more and more of the increase in current assets will be permanent in nature. A nonliquid ating aggregate stock of current assets will be necessar to allow for floor displays, multiple items for selection, and other purposes. All of these "asset" investments can drain the cash resources of the firm 6-2. Discuss the relative volatility of short-and long-term interest rates Figure 6-10 shows the long-run view of short- and long-term interest rates normally, short-term rates are much more volatile than long-term rates 6-3 What is the significance to working capital management of matching sales and production? If sales and production can be matched, the level of inventory and the amount of current assets needed can be kept to a minimum; therefore, lower financing costs will be incurred. Matching sales and production has the advantage of maintaining smaller amounts of current assets than level production, and therefore less financing costs are incurred. However, if sales are seasonal or cyclical, workers will be laid off in a declining sales climate and machinery (fixed assets) will be idle. Here lies the tradeoff between level and seasonal production: Full utilization of fixed assets with skilled workers and more financing of current assets versus unused capacity, training and retraining workers, with lower financing for current assets How is a cash bud get used to help manage current assets? A cash budget helps minimize current assets by providing a forecast of inflows and outflows of cash. It also encourages the development of a sched ule as to when inventory is produced and maintained for sales(production schedule), and accounts receivables are collected. The cash budget allows us to forecast the level of each current asset and the timing of the buildup and reduction of each 6-5 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 Only a financial manager with unusual insight and timing could design a plan in which asset buildup and the length of financing terms are perfectly matched S-211 CopyrightC2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-211 Chapter 6 Discussion Questions 6-1. Explain how rapidly expanding sales can drain the cash resources of a firm. Rapidly expanding sales will require a buildup in assets to support the growth. In particular, more and more of the increase in current assets will be permanent in nature. A nonliquidating aggregate stock of current assets will be necessary to allow for floor displays, multiple items for selection, and other purposes. All of these "asset" investments can drain the cash resources of the firm. 6-2. Discuss the relative volatility of short- and long-term interest rates. Figure 6-10 shows the long-run view of short- and long-term interest rates. Normally, short-term rates are much more volatile than long-term rates. 6-3. What is the significance to working capital management of matching sales and production? If sales and production can be matched, the level of inventory and the amount of current assets needed can be kept to a minimum; therefore, lower financing costs will be incurred. Matching sales and production has the advantage of maintaining smaller amounts of current assets than level production, and therefore less financing costs are incurred. However, if sales are seasonal or cyclical, workers will be laid off in a declining sales climate and machinery (fixed assets) will be idle. Here lies the tradeoff between level and seasonal production: Full utilization of fixed assets with skilled workers and more financing of current assets versus unused capacity, training and retraining workers, with lower financing for current assets. 6-4. How is a cash budget used to help manage current assets? A cash budget helps minimize current assets by providing a forecast of inflows and outflows of cash. It also encourages the development of a schedule as to when inventory is produced and maintained for sales (production schedule), and accounts receivables are collected. The cash budget allows us to forecast the level of each current asset and the timing of the buildup and reduction of each. 6-5. "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. Only a financial manager with unusual insight and timing could design a plan in which asset buildup and the length of financing terms are perfectly matched
One would need to know exactly what part of current assets are temporary and what part are permanent. Furthermore, one is never quite sure how much short term or long-term financing is available at all times. Even if this were known, it would be difficult to change the financing mix on a continual basis By using long-term financing to finance part of temporary current assts, a firm may have less risk but lower returns than a firm with a normal financing plan Explain the significance of this statement By establishing a long-term financing arrangement for temporary current assets, a firm is assured of having necessary fund ing in good times as well as bad, thus we say there is low risk. However, long-term financing is genera ally more expensive than short-term financing and profits may be lower than those which could be achieved with a synchronized or normal financing arrangement for temporary current assets 6-7 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 By financing a portion of permanent current assets on a short-term basis, we run the risk of inadequate financing in tight money periods. However, since short-term financing is less expensive than long-term funds, a firm tends to increase its profitability over the long run(assuming it survives). In answer to the preceding question, we stressed less risk and less return; here the emphasis is on risk and high return 6-8 What does the term structure of interest rates indicate? The term structure of interest rates shows the relative level of short -term and long-term interest rates at a point in time. It is often referred to as a yield curve 6-9 What are three theories for describing the shape of the term structure of interest rates( the yield curve)? Briefly describe each theory Liquid ity premium theory, the market segmentation theory, and the pectations theory The liquid ity premium theory indicates 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 buyer to entice them to hold these less liquid and more price sensitive securities CopyrightC 2005 by The McGray-Hill Companies, Inc. S-212
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-212 One would need to know exactly what part of current assets are temporary and what part are permanent. Furthermore, one is never quite sure how much shortterm or long-term financing is available at all times. Even if this were known, it would be difficult to change the financing mix on a continual basis. 6-6. By using long-term financing to finance part of temporary current assts, a firm may have less risk but lower returns than a firm with a normal financing plan. Explain the significance of this statement. By establishing a long-term financing arrangement for temporary current assets, a firm is assured of having necessary funding in good times as well as bad, thus we say there is low risk. However, long-term financing is generally more expensive than short-term financing and profits may be lower than those which could be achieved with a synchronized or normal financing arrangement for temporary current assets. 6-7. 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. By financing a portion of permanent current assets on a short-term basis, we run the risk of inadequate financing in tight money periods. However, since short-term financing is less expensive than long-term funds, a firm tends to increase its profitability over the long run (assuming it survives). In answer to the preceding question, we stressed less risk and less return; here the emphasis is on risk and high return. 6-8. What does the term structure of interest rates indicate? The term structure of interest rates shows the relative level of short-term and long-term interest rates at a point in time. It is often referred to as a yield curve. 6-9. What are three theories for describing the shape of the term structure of interest rates (the yield curve)? Briefly describe each theory. Liquidity premium theory, the market segmentation theory, and the expectations theory. The liquidity premium theory indicates 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 buyer to entice them to hold these less liquid and more price sensitive securities
The market segmentation theory states that Treasury securities are divided into market segments by the various financial institutions investing in the market The changing needs, desires, and strategies of these investors tend to strongly influence the nature and relationship of short-and long-term rates The expectations hypothesis maintains that the yields on long-term securities are a function of short-term rates. The result of the hypothesis is that when long-term rates are much higher than short-term rates, the market is saying that is expects short-term rates to rise. Conversely, when long-term rates are lower than short-term rates, the market is expecting short-term rates to fall 6-10 Since the middle 1960s, corporate liquidity has been declining. What reasons can you give for this trend? The decrease is liquid ity can be traced in part to more efficient inventory management such as just-in-time inventory and point of sales terminals that provide better inventory control. The decline in working capital can also be attributed to electronic cash flow transfer systems, and the ability to sell accounts receivables through securitization of assets(this is more fully explained in the next chapter ) It might also be that management is simply willing to take more liguid ity risk as interest rates declined -213 CopyrightC2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-213 The market segmentation theory states that Treasury securities are divided into market segments by the various financial institutions investing in the market. The changing needs, desires, and strategies of these investors tend to strongly influence the nature and relationship of short- and long-term rates. The expectations hypothesis maintains that the yields on long-term securities are a function of short-term rates. The result of the hypothesis is that when long-term rates are much higher than short-term rates, the market is saying that is expects short-term rates to rise. Conversely, when long-term rates are lower than short-term rates, the market is expecting short-term rates to fall. 6-10. Since the middle 1960s, corporate liquidity has been declining. What reasons can you give for this trend? The decrease is liquidity can be traced in part to more efficient inventory management such as just-in-time inventory and point of sales terminals that provide better inventory control. The decline in working capital can also be attributed to electronic cash flow transfer systems, and the ability to sell accounts receivables through securitization of assets (this is more fully explained in the next chapter). It might also be that management is simply willing to take more liquidity risk as interest rates declined
Problems 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 Solution: Garys Pipe and steel Company apec State of Economy Sales Probability Outcome Stron g 800,000 20 $160.000 Stead 500.000 50 250.000 Weak 350,000 30 105000 Expected level of sales 515,000 Tobin Supplies Company expects sales next year to be $500,000. Inventory and accounts receivable will have to be increased by $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 Solution: Tobin Supplies Company $500.000 Sales 2 Profit margin 60.000 Net income 24.000 Dividends(40%) 36.000 Increase in retained earnings s 90.000 Increase in assets 36.000 Increase in retained earnings S 54.000 External funds needed CopyrightC 2005 by The McGray-Hill Companies, Inc. S-214
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-214 Problems 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? Solution: Gary’s Pipe and Steel Company State of Economy Sales Probability Expected Outcome Strong $800,000 .20 $160,000 Steady 500,000 .50 250,000 Weak 350,000 .30 105,000 Expected level of sales = $515,000 6-2. Tobin Supplies Company expects sales next year to be $500,000. Inventory and accounts receivable will have to be increased by $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. Solution: Tobin Supplies Company $500,000 Sales .12 Profit margin 60,000 Net income – 24,000 Dividends (40%) $ 36,000 Increase in retained earnings $ 90,000 Increase in assets – 36,000 Increase in retained earnings $ 54,000 External funds needed
Shamrock Diamonds expects sales next year to be $3, 000,000. Inventory and accounts receivable will increase $420,000 to accommodate this sales level The company has a steady profit margin of 10 percent with a 25 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 Solution: Shamrock diamonds $3,000.000 Sales Profit margin 300.000 Net income 75000 Dividends(25%) $225,000 Increase in retained earnings 420.00 Increase in assets 225.000 Increase in retained earnings $195000 External funds needed 6-4 Madonna's Clothiers sells scarves that are very popular in the fall-winter season. Units sold are anticipated as October 2.000 November 4.000 January 6000 20 000 units If seasonal production is used, it is assumed that inventory buildup will directly match sales for each month and there will be no inventory buildup The production manager thinks the above assumption is too optimistic and decides to go with level production to avoid being out of merchandise. He will produce the 20,000 units over 4 months at a level of 5,000 per month a. What is the end ing inventory at the end of each month? Compare the units produced to the units sold and keep a running total b. If the inventory costs $7 per unit and will be financed at the bank at a cost of 8%, what is the monthly financing cost and the total for the 4 months? S-215 Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-215 6-3. Shamrock Diamonds expects sales next year to be $3,000,000. Inventory and accounts receivable will increase $420,000 to accommodate this sales level. The company has a steady profit margin of 10 percent with a 25 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. Solution: Shamrock Diamonds $3,000,000 Sales .10 Profit margin 300,000 Net income 75,000 Dividends (25%) $ 225,000 Increase in retained earnings 420,000 Increase in assets –225,000 Increase in retained earnings $195,000 External funds needed 6-4. Madonna’s Clothiers sells scarves that are very popular in the fall-winter season. Units sold are anticipated as: October 2,000 November 4,000 December 8,000 January 6,000 20,000 units If seasonal production is used, it is assumed that inventory buildup will directly match sales for each month and there will be no inventory buildup. The production manager thinks the above assumption is too optimistic and decides to go with level production to avoid being out of merchandise. He will produce the 20,000 units over 4 months at a level of 5,000 per month. a. What is the ending inventory at the end of each month? Compare the units produced to the units sold and keep a running total. b. If the inventory costs $7 per unit and will be financed at the bank at a cost of 8%, what is the monthly financing cost and the total for the 4 months?
6-4. Continued Solution: Madonna’ s Clothiers Units Units Change in Ending Produced Sold inventory Inventory October 50002,000+3,000 3.000 5.0004000 1000 4.000 December 5000800 3.000 1000 Ja anuar 50006,000 1,000 0 b E nouns g Cost per Inventory Inventory Unit(S7) Financing Cost October $3,000$2100 $1,680 Noⅴ ember 4.000 28.000 2,240 December 1,000 7,000 560 January 0 0 $4480 CopyrightC 2005 by The McGray-Hill Companies, Inc. -216
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-216 6-4. Continued Solution: Madonna’s Clothiers a. Units Produced Units Sold Change in inventory Ending Inventory October 5,000 2,000 +3,000 3,000 November 5,000 4,000 +1,000 4,000 December 5,000 8,000 –3,000 1,000 January 5,000 6,000 –1,000 0 b. Ending Inventory Cost per Unit ($7) Inventory Financing Cost October $3,000 $21,000 $1,680 November 4,000 28,000 2,240 December 1,000 7,000 560 January 0 0 0 $4,480
6 Procter Micro-Computers, Inc. requires $1, 200,000 in financing over the next two years. The firm can borrow the funds for two years at 9.5 percent interest er year. Mr. Procter decides to do economic forecasting and determines that if he utilizes short-term financing instead, he will pay 6.55 percent interest in the first year and 10.95 percent interest in the second year. Determine the total two-year interest cost under each plan. Which plan is less costly? Solution: Procter-Mini-Computers, Inc. Cost of Two year fixed Cost financing $1, 200,000 borrowed x.5% per annum x 2 years=$228, 000 interest Cost of Two Year Variable Short-term Financing Ist year $1,200,000x 6.55% per annum= $78,600 interest cost 2nd year $1, 200,000x 10.95% per annum=$131.400 interest cost $210,000 two-year total The short-term plan is less costl -217 Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-217 6-5. Procter Micro-Computers, Inc. requires $1,200,000 in financing over the next two years. The firm can borrow the funds for two years at 9.5 percent interest per year. Mr. Procter decides to do economic forecasting and determines that if he utilizes short-term financing instead, he will pay 6.55 percent interest in the first year and 10.95 percent interest in the second year. Determine the total two-year interest cost under each plan. Which plan is less costly? Solution: Procter-Mini-Computers, Inc. Cost of Two Year Fixed Cost Financing $1,200,000 borrowed x 9.5% per annum x 2 years = $228,000 interest cost Cost of Two Year Variable Short-term Financing 1 st year $1,200,000 x 6.55% per annum = $ 78,600 interest cost 2 nd year $1,200,000 x 10.95% per annum = $131,400 interest cost $210,000 two-year total The short-term plan is less costly
6-6 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 cent annual intel 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 is the total interest cost now compared to the 10 percent, three-year loan? Solution Sauer Food Company If Rates are Constant $150,000 borrowed x 8% per annum x 3 years $36000 interest cost $150,000 borrowed x 10% per annum x 3 years $45.000 interest cost $45,000-$36,000=$9,000 interest savings borrowing short-term If Short-term Rates Change I st year $150,000x.08=$12,000 2nd year $l50,000x.13=$19500 3rd year $150000x.18=$27000 Total=$58.500 $58, 500-$45,000=$13, 500 extra interest costs borrowing short- term CopyrightC 2005 by The McGray-Hill Companies, Inc. S-218
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-218 6-6. 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. 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 is the total interest cost now compared to the 10 percent, three-year loan? Solution: Sauer Food Company If Rates Are Constant $150,000 borrowed x 8% per annum x 3 years = $36,000 interest cost $150,000 borrowed x 10% per annum x 3 years = $45,000 interest cost $45,000 – $36,000 = $9,000 interest savings borrowing short-term If Short-term Rates Change 1 st year $150,000 x .08 = $12,000 $150,000 x .13 = $19,500 $150,000 x .18 = $27,000 2 nd year 3 rd year Total = $58,500 $58,500 – $45,000 = $13,500 extra interest costs borrowing shortterm
Assume Stratton Health Clubs, Inc, has $3,000,000 in assets. If it goes with a low liquid ity plan for the assets, it can earn a return of 20 percent, but with a high liquid ity plan, the return will be 13 percent. If the firm goes with a short term financing plan, the financing costs on the $3,000,000 will be 10 percent, and with a long-term financing plan, the financing costs on the $3,000,000 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 on the most aggressive asset-financing mix b. Compute the anticipated return after financing costs on the most conservative asset-financing mix c. Compute the anticipated return after financing costs on 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 -219 Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-219 6-7. Assume Stratton Health Clubs, Inc., has $3,000,000 in assets. If it goes with a low liquidity plan for the assets, it can earn a return of 20 percent, but with a high liquidity plan, the return will be 13 percent. If the firm goes with a shortterm financing plan, the financing costs on the $3,000,000 will be 10 percent, and with a long-term financing plan, the financing costs on the $3,000,000 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 on the most aggressive asset-financing mix. b. Compute the anticipated return after financing costs on the most conservative asset-financing mix. c. Compute the anticipated return after financing costs on 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
6-7. Continued Solution: Stratton Health Clubs. Inc. a. Most aggressive ow liquidity/high return $3,000,000x20%=$600,000 Short-term financing 3000,000x10%=-300000 Anticipated return $300.000 b. Most conservative High liquidity/low return $3.000.000x13%=$390000 Long-term financing 3.000.000x12%=-360.000 Anticipated return $300 c. Moderate approach Low liquidity $3,000.000x20%=$600.000 Long-term financing 3.000.000x12%=-360.000 $240.000 High liquidity $3,000.000x13%=$390,000 Short-term financing 3000,000×10% 300.000 $90.000 d. You may not necessarily select the plan with the highest return You must also consider the risk inherent in the plan. Of course, some firms are better able to take risks than others The ultimate concern must be for maximizing the overall valuation of the firm through a judicious consideration of risk-return options CopyrightC 2005 by The McGray-Hill Companies, Inc. S-220
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-220 6-7. Continued Solution: Stratton Health Clubs, Inc. a. Most aggressive Low liquidity/high return $3,000,000 x 20% = $600,000 Short-term financing –3,000,000 x 10% = –300,000 Anticipated return $300,000 b. Most conservative High liquidity/low return $3,000,000 x 13% = $390,000 Long-term financing –3,000,000 x 12% = –360,000 Anticipated return $ 30,000 c. Moderate approach Low liquidity $3,000,000 x 20% = $600,000 Long-term financing –3,000,000 x 12% = –360,000 $240,000 Or High liquidity $3,000,000 x 13% = $390,000 Short-term financing –3,000,000 x 10% = –300,000 $ 90,000 d. You may not necessarily select the plan with the highest return. You must also consider the risk inherent in the plan. Of course, some firms are better able to take risks than others. The ultimate concern must be for maximizing the overall valuation of the firm through a judicious consideration of risk-return options
