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FOF IM CHAPTER 15 - 6th

FOF IM CHAPTER 15 - 6th - CHAPTER 15 Working-Capital...

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CHAPTER 15 Working-Capital Management CHAPTER ORIENTATION In this chapter, we introduce working-capital management in terms of managing the firm’s liquidity. Specifically, working capital is defined as the difference in current assets and current liabilities. The hedging principle is offered as one approach to addressing the firm’s liquidity problems. In addition, this chapter deals with the sources of short-term financing that must be repaid within 1 year. CHAPTER OUTLINE I. Managing current assets A. The firm’s investment in current assets (such as fixed assets) is determined by the marginal benefits derived from investing in them compared with their acquisition cost. B. However, the current fixed-asset mix of the firm’s investment in assets is an important determinant of the firm’s liquidity. That is, the greater the firm’s investment in current assets, other things remaining the same, the greater the firm’s liquidity. This is generally true, since current assets are usually more easily converted into cash. C. The firm can invest in marketable securities to increase its liquidity. However, such a policy involves committing the firm’s funds to a relatively low-yielding (in comparison to fixed assets) investment. II. Managing the firm’s use of current liabilities A. The greater the firm’s use of current liabilities, other things being the same, the less will be the firm’s liquidity. B. There are a number of advantages associated with the use of current liabilities for financing the firm’s asset investments. 1. Flexibility . Current liabilities can be used to match the timing of a firm’s short-term financing needs exactly. 208
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2. Interest cost . Historically, the interest cost on short-term debt has been lower than that on long-term debt. C. Following are the disadvantages commonly associated with the use of short- term debt: 1. Short-term debt exposes the firm to an increased risk of illiquidity because short-term debt matures sooner and in greater frequency, by definition, than does long-term debt. 2. Since short-term debt agreements must be renegotiated from year to year, the interest cost of each year’s financing is uncertain . III. Determining the appropriate level of working capital A. Pragmatically, it is impossible to derive the "optimal" level of working capital for the firm. Such a derivation would require estimation of the potential costs of illiquidity which, to date, have eluded precise measurement. B. However, the "hedging principle" provides the basis for the firm’s working- capital decisions. 1. The hedging principle or rule of self-liquidating debt involves the following: Those asset needs of the firm not financed by spontaneous sources (i.e., payables and accruals) should be financed in accordance with the following rule: Permanent asset investments are financed with permanent sources and temporary investments are financed with temporary sources, of financing.
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