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Unformatted text preview: CHAPTER 15 Introduction to Working-Capital Management Orientation : In this chapter, we introduce working-capital management in terms of managing the firms liquidity. Specifically, net working capital is defined as the difference in current assets and current liabilities. The hedging principle is offered as one approach to addressing the firms liquidity problems. In this chapter, we also discuss sources of short-term financing that must be repaid within one year. I. Managing current assets A. The firms 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 firms investment in assets is an important determinant of the firms liquidity. That is, the greater the firms investment in current assets, other things remaining the same, the greater the firms 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 firms funds to a relatively low-yielding (in comparison to fixed assets) investment. II. Managing the firms use of current liabilities A. The greater the firms use of current liabilities, other things being the same, the less will be the firms liquidity. 235 B. There are a number of advantages associated with the use of current liabilities for financing the firms asset investments. 1. Flexibility . Current liabilities can be used to match the timing of a firms short-term financing needs exactly. 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 years 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 firms 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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- Spring '08