MANAGEMENT CONSULTANCY - Solutions Manual
CHAPT CHAPTER ER 15 WORKING CAPITAL AND THE THE FINAN FINANCIN CING G DECIS DECISIO ION N
I. Questions 1. If sales sales and product production ion can be matched matched,, the level level of invent inventory ory and the amount of current assets needed can be kept to a minimum; therefore, lower lower financing financing costs costs will be incurred. incurred. Matching Matching sales and production production has the advantage of maintaining smaller amounts of current assets than leve levell prod produc ucti tion on,, and and ther theref efor oree less less fina financ ncin ing g cost costss are are incu incurre rred. d. However, if sales are seasonal or cyclical, workers will be laid off in a declining declining sales sales climate and machinery machinery (fixed (fixed assets) will be idle. Here lies the tradeoff tradeoff between level level and seasonal seasonal production: production: Full utilization utilization of fixed assets with skilled workers and more financing of current assets versu versuss unused unused capac capacity ity,, traini training ng and retrai retrainin ning g worke workers, rs, with with lower lower financing for current assets. 2. Only a financial financial manage managerr with unusual unusual insight and timing timing could 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 assets are temporar temporary y and what part are permanent. permanent. Furthermo Furthermore, re, one is never quite sure how much short-term or long-term financing is available at all times. Even Even if there were were known, it would would be difficult to change change the financing mix on a continual basis. 3. By establishing establishing a long-term financing arrangemen arrangementt for temporary temporary current 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 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. 4. By financing financing a portion portion of permanent permanent current current assets assets on a short-term short-term basis, basis, we run run the the risk risk of inad inadeq equa uate te fina financ ncin ing g in tigh tightt mone money y peri period ods. s. However, However, since short-ter short-term m financing financing is less expensive expensive than long-term long-term fund funds, s, a firm firm tend tend to incr increa ease se its its prof profit itab abil ilit ity y over over the the long long run run 15-1
Chapter 15
Working Capital and the Financing Decision
(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. 5. 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. II. Multiple Choice 1. 2. 3. 4. 5.
C D B C C
11. 12. 13. 14. 15.
D A C D B
6. 7. 8. 9. 10.
C B A C B
16. 17. 18. 19. 20.
C A D A C
21. C 22. D 23. B
Supporting Computations for nos. 15 through 18:
I NCOME STATEMENTS FOR YEAR E NDED DECEMBER 31, 2000 (THOUSANDS OF PESOS)
EBIT Interest Taxable income Taxes (40%) Net income Equity Return on equity
Piña Press P 30,000 P 30,000 12,400 14,400 P 17,600 P 15,600 7,040 6,240 P 10,560 P 9,360 P100,000 P100,000 15 17 10.56% 9.36%
III. Problems 15-2
Chico Publishing P 30,000 P 30,000 10,600 18,600 P 19,400 P 11,400 7,760 4,560 P 11,640 P 6,840 P100,000 P100,000 16 18 11.64% 6.84%
Working Capital and the Financing Decision
Chapter 15
PROBLEM 1 (NICK & ASSOC.)
1.
Short-term Long-term
(20%) (80%)
Plan A (Conservative) P 240,000 960,000 P1,200,000
(40%) (60%)
Plan B (Aggressive) P 480,000 720,000 P1,200,000
2. EBIT Interest Short-term @ 8.5% Long-term @ 11% EBT Taxes @ 40% Net income
P325,000
P325,000
(20,400) (105,600) 199,000 79,600 P119,400
(40,800) (79,200) 205,000 82,000 P123,000
3. Plan A : Interest rates could drop significantly, which would increase the effective cost of long-term financing at a future point in time. Plan B : Interest rates could increase, increasing the cost of short-term financing and possibly tightening the availability of short-term funds. Profit would decrease.
4. (Subjective) Depends upon interest rate forecast.
PROBLEM 2 (CAIMITO COMPANY)
ALTERNATIVE BALANCE SHEETS
Current assets Fixed assets Total assets Debt Equity Total liabilities
and
Restricted (40%) P1,200,000 600,000 P1,800,000 P 900,000 900,000 P1,800,000 15-3
Moderate (50%) P1,500,000 600,000 P2,100,000 P1,050,000 1,050,000 P2,100,000
Relaxed (60%) P1,800,000 600,000 P2,400,000 P1,200,000 1,200,000 P2,400,000
Chapter 15
Working Capital and the Financing Decision
equity ALTERNATIVE I NCOME STATEMENTS
Sales EBIT Interest (10%) Earnings before taxes Taxes (40%) Net income ROE
Restricted P3,000,000 450,000 90,000 P 360,000 144,000 P 216,000 24.0%
Moderate P3,000,0000 450,000 105,000 P 345,000 138,000 P 207,000 19.7%
Relaxed P3,000,000 450,000 120,000 P 330,000 132,000 P 198,000 16.5%
PROBLEM 3 (MALINIS SURGICAL INSTRUMENTS CO.)
1. Most aggressive Low liquidity Short-term financing Anticipated return
P2,000,000 x 18% = P360,000 - 2,000,000 x 10% = 200,000 P160,000
2. Most conservative High liquidity Long-term financing Anticipated return
P2,000,000 x 14% = P280,000 - 2,000,000 x 12% = 240,000 P 40,000
3. Moderate approach Low liquidity Long-term financing
P2,000,000 x 18% = P360,000 - 2,000,000 x 12% = 240,000 P120,000 or
High liquidity Short-term liquidity
P2,000,000 x 14% = P280,000 - 2,000,000 x 10% = 200,000 P 80,000 15-4
Working Capital and the Financing Decision
Chapter 15
4. 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.
PROBLEM 4 (ATIS SYSTEMS, INC.)
1. Temporary current assets Permanent current assets Fixed assets Total assets
P300,000 200,000 400,000 P900,000
Conservative
Amount P900,000 P900,000
% of Interest Total Rate x 0.80 = P720,000 x 0.15 = x 0.20 = P180,000 x 0.10 = Total interest charge
Interest Expense P108,000 18,000 P126,000
% of Interest Total Rate x 0.70 = P270,000 x 0.15 = x 0.30 = P630,000 x 0.10 = Total interest charge
Interest Expense P40,500 63,000 P103,500
Long-term Short-term
Aggressive
Amount P900,000 P900,000
Long-term Short-term
2. EBIT - Int.
Conservative P180,000 126,000 15-5
Aggressive P180,000 103,500
Chapter 15
Working Capital and the Financing Decision
EBT Tax 40% EAT
54,000 21,600 P 32,400
76,500 30,600 P 45,900
PROBLEM 5 (MANGOSTEEN, INC.)
1. Current assets
permanent current assets
=
temporary current assets
P800,000
P350,000
=
P450,000
Long-term interest expense = = =
10% [P600,000 + ½ (P350,000)] 10% x (P775,000) P77,500
Short-term interest expense = = =
5% [P450,000 + ½ (P350,000)] 5% x (P625,000) P31,250
Total interest expense
P77,500 + P31,250 P108,750
= =
Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes
P200,000 108,750 P 91,250 27,375 P 63,875
2. Alternative financing plan Long-term interest expense = =
10% [P600,000 + P350,000 + ½ (P450,000)] 10% (P1,175,000) 15-6
Working Capital and the Financing Decision
=
P117,500
Short-term interest expense = = =
5% [½ (P450,000)] 5% (P225,000) P11,250
Total interest expense
P117,500 + P11,250 P128,750
= =
Chapter 15
Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes
P200,000 128,750 P 71,250 21,375 P 49,875
3. The alternative financing plan which calls for more financing by highcost debt is more expensive and reduces after-tax income by P14,000. However, we must not automatically reject this plan because of its higher cost since it has less risk. The alternative provides the firm with long-term capital which at times will be in excess of its needs and invested in marketable securities. It will not be forced to pay higher short-term rates on a large portion of its debt when short-term rates rise and will not be faced with the possibility of no short-term financing for a portion of its permanent current assets when it is time to renew the shortterm loan.
15-7
