Chap006 - Chapter 06: Working Capital and the Financing...

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Chapter 06: Working Capital and the Financing Decision Chapter 6 Working Capital and the Financing Decision Discussion Questions 6-1. Explain how rapidly expanding sales can drain the cash resources of a firm. Rapidly expanding sales will require a buildup in assets to support the growth. In particular, more and more of the increase in current assets will be permanent in nature. A non-liquidating aggregate stock of current assets will be necessary to allow for floor displays, multiple items for selection, and other purposes. All of these “asset” investments can drain the cash resources of the firm. 6-2. Discuss the relative volatility of short- and long-term interest rates. Figure 6-10 shows the long-run view of short- and long-term interest rates. Normally, short-term rates are much more volatile than long-term rates. 6-3. What is the significance to working capital management of matching sales and production? If sales and production can be matched, the level of inventory and the amount of current assets needed can be kept to a minimum; therefore, lower financing costs will be incurred. Matching sales and production has the advantage of maintaining smaller amounts of current assets than level production, and therefore less financing costs are incurred. However, if sales are seasonal or cyclical, workers will be laid off in a declining sales climate and machinery (fixed assets) will be idle. Here lies the tradeoff between level and seasonal production: Full utilization of fixed assets with skilled workers and more financing of current assets versus unused capacity, training and retraining workers, with lower financing for current assets. 6-4. How is a cash budget used to help manage current assets? A cash budget helps minimize current assets by providing a forecast of inflows and outflows of cash. It also encourages the development of a schedule as to when inventory is produced and maintained for sales (production schedule), and accounts receivables are collected. The cash budget allows us to forecast the level of each current asset and the timing of the buildup and reduction of each. 6-1
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Chapter 06: Working Capital and the Financing Decision 6-5. “The most appropriate financing pattern would be one in which asset buildup and length of financing terms is perfectly matched.” Discuss the difficulty involved in achieving this financing pattern. Only a financial manager with unusual insight and timing could design a plan in which asset buildup and the length of financing terms are perfectly matched. One would need to know exactly what current assets are temporary and which ones are permanent. Furthermore, one is never quite sure how much or short- term or long-term financing is available at all times. Even if this were known, it would be difficult to change the financing mix on a continual basis.
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