Chapter 15 FIN

Chapter 15 FIN - Chapter 15 Managing Current Assets and...

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Chapter 15 Managing Current Assets and Liabilities Working capital: a concept traditionally defined as a firm’s investment in current assets Net working capital: the difference between the firm’s current assets and its current liabilities. The Risk-Return Trade-Off The greater the firm’s reliance on short-term debt or current liabilities in financing its assets, the greater the risk of illiquidity. We see that the risk-return trade-off involves an increased risk of illiquidity versus increased profitability. The advantages of Cureent Liabilities: Return Flexibility - Offers the firm a flexible source of financing. - Can be used to match the timing of a firm’s needs for short-term financing. Interest Costs - Interest rates on short-term debt are lower than on long-term debt for a given borrower. The Disadvantages of Current Liabilities: Risk It subjects the firm to a greater risk of illiquidity for two reasons. 1. Short-term debt, because of its very nature, must be repaid or rolled over more often, so it increases the possibility that the firm’s financial condition might deteriorate to a point at which the needed funds might not be available 2. There is the uncertainty of interest costs from year to year. The Appropriate Level of Working Capital Hedging Principle A working-capital management policy, which states that the cash flow- generating characteristics of a firm’s investments should be matched with the cash flow requirements of the firm’s sources of financing. Very simply, short-lived assets should be financed with short-term sources of financing while long-lived assets should be financed with long-term
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Chapter 15 sources of financing. Permanent and Temporary Assets Permanent Investments: investments that the firm expects to hold longer than one year. The firm makes permanent investments in fixed and current assets Temporary Investments: a firm’s investments in current assets that will be liquidated and not replaced within a period of one year or less. Examples include seasonal expansions in inventories and accounts receivable. Temporary, Permanent, and Spontaneous Sources of Financing Temporary sources of financing consist of current liabilities. Short-term notes payable are the most common example of a temporary source of financing Permanent sources of financing include intermediate-term loans, long- term debt, preferred stock, and common equity Spontaneous sources of financing consist of trade credit and other
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Chapter 15 FIN - Chapter 15 Managing Current Assets and...

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