9.2 Lecture_18_Thursday_24_Sept

9.2 Lecture_18_Thursday_24_Sept - Lecture 18: Current Asset...

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Unformatted text preview: Lecture 18: Current Asset Management Policies Policies + Financing of Current Assets 1 Ways of Looking at Current Assets Cash Receivables Inventory Permanent CA Temporary CA 2 The Nature of Current Assets Temporal Categories of Current Asset: • Temporary Current Assets Required _____________________________ TCA Permanent Current Assets Level of CA needed on hand ______________ This is a minimum level PCA 3 • How the Asset Classes fit together $$ Dollars Fixed Assets Time 4 What level of current assets should a firm carry ? • • • Relaxed (Conservative) Policy Medium (Moderate) Policy Restrictive (Aggressive) Policy 5 Relaxed (Conservative) CA Policy $$ Dollars PCA0 FA Time 6 Relaxed current asset policy: High inventory level reduces lost sales High cash balances reduce liquidity risk Idle assets not generating returns • • Current Ratio looks good, but…… CA⇑ ⇒ TA ⇑ ⇒ NPAT/TA ⇓ ie, ROA ⇓ Reduction in immediate cash flow • ____________________________________ 7 Restrictive current asset policy: Fewer idle assets • CA ⇓ ⇒ TA ⇓ ⇒ NPAT/TA ⇑ ie, ROA ⇑ And lower funding costs • Improvement in immediate cashflow Less CA to be funded by a “source of funds” BUT Low inventory level _______________________ Low cash balances raise liquidity risk • Poor CR ratio and Poor Quick Ratio ! 8 Aggressive (Restrictive) CA Policy $$ Dollars PCA0 FA Time 9 Problem 1: Problem Chip Ltd’s choice of CA Policies Chip Scenario Receivables Inventory CA = NFA TA = Sales M E A 100 100 200 400 600 1000 0.05 500 B 150 150 300 400 700 1000 0.05 500 C 200 200 400 400 800 1000 0.05 500 Identify each policy and calculate the TATO, ROA and ROE for each. 10 Solution 1 Policy A is ___________________ • • • CA is __________________________ Policy B is ____________________ CA is ___________________________ Policy C is ____________________ S TA 1, 000 ≈ 600 ; TATOB = 1, 000 ≈ 700 CA is ___________________________ TATO = TATOA = ; TATOC = 1, 000 = 800 11 . Solution 1 continued NPAT ROA = TA 50 ROAA = ≈ 600 50 ; ROAB = ≈ 700 50 ; ROAC = = 800 NPAT 50 ROE = = = E 500 TA NPAT Sales TA Note : exactly offsets TATO given that ROE = × × E Sales TA E NPAT Sales TA = 0.05 ( all 3 policies ) and × = Sales TA E 12 Problem 2: Problem Chips Ltd with Opportunity Cost of Lost Sales Chips Calculate TATO, ROA and ROE if: SalesA = 700 SalesB = 850 SalesC = 1,000 (All else remains the same as in Problem 1) 13 Solution 2 NPAT = S × M = S × 0.05 NPATA = 700 × 0.05 NPATB = 850 × 0.05 = = NPATC = 1, 000 × 0.05 = TATO = S TA ; TATOB = ; TATOC = TATOA = 14 Solution 2 continued NPAT ROA = TA ROAA = ROAB = ROAC = . ROE = NPAT E ROE A = ROEB = ROEC = . 15 Problem 3: Liquidity Risk of Chips Ltd Consider the liquidity risk of Chip Ltd under the three scenarios if the firm has Current liabilities of $200 16 Solution 3 = CA CR CL and and and and CA − Inventory QR = CL QRA = QRB = QRC = 17 CRA = CRB = CRC = Optimal current asset investment is where marginal return from last $ of current asset investment ____________ $ Marginal return CA* Current assets 18 Current Asset Financing policies How are current asset needs to be financed ? • In terms of temporary CA and permanent CA Three Policies (as before) • • • Conservative Policy The “minimise our risks” approach Asset­Matching Policy The “middle of the road” approach Aggressive Policy The ________________________________ 19 (a) Conservative approach to Financing Finance a portion of temporary current assets with long­term sources. TCA TCA PCA 20 Conservative approach to Financing Finance a portion of temporary current assets with long­term sources. Advantages • __________________________________________ Disadvantages • • Using more expensive long­term finance But the trade­off between risk and return is: 21 (b) Maturity-matching approach to (b) Financing Financing Advantages • Reduces risk that firm unable to meet maturing obligations But not as much as the Conservative Financing Policy Reduces the percentage of return to investors (ROA) But not as much as the Conservative Financing Policy 22 Disadvantage • Maturity-matching approach to Financing Finance PCA with permanent sources Finance TCA with temporary sources. TCA TCA PCA 23 (c) Aggressive approach to Financing Finance all of temporary current assets Finance some of permanent current assets • • • • • with temporary sources. With temporary sources too! Advantages greater use ______________________________ Disadvantages increased liquidity risk short­term interest rates more volatile 24 Aggressive approach to Financing Finance all TCA and some PCA with temporary sources TCA TCA PCA 25 Combining CA and CL Decisions Conservative Combination Strategy High level of current assets • • • • Conservative CA management policy Low usage of short­term finance Conservative CA financing policy Results: _____________________________________ Low liquidity risk 26 Conservative Combination Strategy Why are ROA and ROE low? High funding costs • For a rising yield curve: rd on long­term debt is higher than the rd on Notes Payable or on L* _______________________________________ Long­term funding costs are locked in place for a longer time • If market interest rates drop, _____________________ _____________________________________________. The firm carries more Inventory, Accounts Receivable (and maybe cash too), which all needs to be funded. • The Dupont Equation from Lecture 12 fits here TATO component 27 NPAT ROE = E NPAT Sales TA = × × TA E Sales 28 Aggressive Combination Strategy Low level of current assets High usage of short­term finance • • • • Aggressive (Restrictive) CA management Aggressive CA financing policy Results: High ROA and high ROE __________________________________ 29 Aggressive Combination Strategy Why are ROA and ROE high? Low cost of funding • For a rising yield curve: rd on Notes Payable and on L* is low … relative to the rd on long­term debt L* has (within limits) no interest cost The rd on Notes Payable is __________________ ________________________________________ • If market interest rates drop, the firm is able to take advantage of that drop. The firm carries a bare minimum of Inventory, Accounts Receivable (and cash) • The Dupont Equation fits here TATO component 30 Moderate Combination Strategy Also called: “ Asset­matching Combination Strategy” Average level of current assets • Medium CA management policy Average usage of short­term finance • Asset­matching CA financing policy Results: • • • Average funding costs Average ROA and average ROE _____________________________ 31 Strategies regarding MS holdings MS policy part of liquidity management policy: 1. Conservative strategy 2. Aggressive strategy 32 1. Conservative liquidity policy 1. (wrt Marketable Securities) (wrt For PCA and some TCA use • long­term funding For remaining TCA, use short­term funding Thus far, this is just the Conservative But in addition… approach to Financing (See Slide 15) Invest ___________________________________ _________________________________________ • i.e., TCA ⇓ Sell MS to meet Temporary Current Asset requirements when more Inventory & Receivables are needed: • i.e., TCA ⇑ 33 Conservative Liquidity Policy (wrt MS) Funds flow from TCA funded by ST Debt to MS to TCA funded by ST Debt... LT Funding TCA TCA PCA LT Sourcing 34 2. Aggressive liquidity policy (wrt MS) Permanent current assets funded by • MS ______________________________ Borrow short­term to meet TCA needs Long­term funding and some short­term funding 35 ...
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