Fundamentals of Managing Finance Chap 12

In figure 121 we graph a typical firms balance sheet

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Unformatted text preview: orary working capital is treated in Chapter 15. In Figure 12.1, we graph a typical firm’s balance sheet over time. The lines slope upward, representing a growing firm, but the picture would be equally valid if the company were unchanging or declining in size. On both sides of the equal sign, the bottom area represents the long-term: long-term assets on the left and long-term liabilities and equity on the right. Above the first dividing line are the current accounts—current assets and current liabilities—and each of these is subdivided into a permanent and a temporary component. permanent working capital—the level of working capital required at all times Permanent working capital is the base level of working capital, the amount required independent of daily, seasonal, or cyclical variations in business activity. It is made up of permanent current assets and permanent current liabilities. The firm needs its permanent working capital on a continuous basis. Even though a company’s cash, accounts receivable, inventory, etc. turn over more frequently than once per year, and therefore are considered current assets by accounting, there will be some minimum level of each of these resources required at all times. It is impossible to operate without cash for liquidity. Extending trade credit, hence creating accounts receivable and payable, is normal practice in most industries. Some amount of inventory is a requirement for both merchandising and manu1 Elaboration: An alternative usage is to let working capital equal only a firm’s current assets and use the term net working capital to represent current assets minus current liabilities. Chapter 12 Investing in Permanent Working Capital Assets 289 FIGURE 12.1 Levels of assets and claims across time for a growing firm. Current assets and liabilities can be divided into a permanent level plus temporary fluctuations. facturing. Therefore, even though permanent working capital appears on the accounting books in the current accounts, which suggests that it is short-term in nature, it is really a long-term requirement. temporary working capital—increases to working capital due to fluctuations in business activity Temporary working capital is the amount above the base level which results from variations in business activity. It is caused by three simultaneous processes. First, the business cycle increases and decreases the resource needs of all businesses over a multiyear time period. Second, most firms are seasonal, having an annual cycle of activities. Third, daily events impact resource needs since revenues and expenses, and cash inflows and outflows, rarely balance on a day-to-day basis. Receivables and collections follow the pattern of sales. Expenses and payments, on the other hand, are often tied to the day of the month. In contrast to permanent working capital, temporary working capital is short-term in nature. Organizing and Analyzing Permanent Working Capital Data Decisions about the level of permanent working capital are made in the same way as capital budgeting decisions—we identify incremental cash flows, organize them using a cash flow spreadsheet, and apply time value of money analysis. There is only one difference between the two analyses, and it is minor: while plant and equipment have a finite life, working capital can be around for the entire life of an organization. Whenever we do not know how long the change will continue, we make the assumption that the company is a “going concern” with infinite life. 1. Cash Flow Spreadsheet for Permanent Working Capital Decisions Figure 12.2 is a generic cash flow spreadsheet for permanent working capital. Notice that it is identical to the cash flow spreadsheets we used for capital budgeting 2 except that there is no column for “year n,” the last year of the investment’s life. Rather, the right-hand column is labeled “years 1– ,” representing all 2 Cross-reference: 271. The cash flow spreadsheet for capital budgeting decisions was introduced on page 290 Part IV Adding Value FIGURE 12.2 Cash flow spreadsheet for permanent working capital decisions. The right-hand column is labeled “Years 1– ” since these changes often have an indeterminate life. Year 0 Investment Operating cash flows Tax—changed income Net cash flows Years 1– (Cost) or recovery Changed in/(out)flows Tax on above years from the first year of change to the end of the company’s existence. As with the spreadsheet for capital budgeting, this column would have to be separated into several columns if the cash flows from the proposed change differed from year to year. This simplified spreadsheet is intended to illustrate the form of permanent working capital decisions; we will provide more detail as we examine specific working capital items later in this chapter. Because changes to permanent working capital are treated as having an indefinite life, the appropriate time value model to apply to the ongoing cash flows is the perpetuity (perpetual annuity) model.3 Recall that for a perpetuity: PV PMT r and, rearranging the algebra, the interest rate embedded in a perpetuity, which for a permanent working capital decision is the internal rate of return, is: r Examples PMT PV The Value of Permanent Working Capital Cash Flows A proposed change to permanent working capital promises the following cash flows: Year 0 Investment Operating cash flow Tax (35%) Net cash flows Years 1– ($50,000) $10,000 (3,500) ($50...
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This note was uploaded on 03/15/2013 for the course FIN 250 taught by Professor Kim during the Spring '13 term at Medgar Evers College.

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