Home > Chapter 16
16- Chapter 16
Risk Management and Temporary Working Capital 16-
16-
16A- Appendix 16A
Transferring Money Between Cash and Marketable Securities 16A-
16A-
CHAPTER 16
Risk Management and Temporary
Working Capital
QUESTIONS
1. Why
does hedging reduce risk? Hedging is the balancing of a risky position
with an equal and opposite risky position. Effectively, hedging
creates a portfolio of risky positions in which the elements of the
portfolio are negatively correlated. Although each component remains
risky, the portfolio has far less�and possibly no�risk. Losses in value from one
element of the portfolio are matched by increases in value from other
elements.
2. What
is the difference between hedging across the balance sheet and hedging
individual cash flows? The difference is in which risky positions
are balanced out. Hedging across the balance sheet matches assets
and liabilities by their maturities to ensure that assets will become
liquid as needed to pay the company's liabilities. Hedging individual
cash flows ensures that receipts can be used efficiently and each obligation
has a known cost.
3. What are the four steps in putting working capital on the balance sheet? The four steps represent a logical way to think about filling out the balance sheet in order to (1) only accept investments with positive NPV, (2) maintain the appropriate debt-equity mix, and (3) hedge across the balance sheet. The four steps are generally done in sequence, but are repeated many times as conditions and opportunities change. The sequence is:
(1) Establish balances for each permanent current asset using the incremental techniques presented in Chapter 12.
(2) Establish balances for each permanent current liability by locating all low-cost or free short-term financing opportunities using the effective interest rate analysis presented in Chapter 20.
(3) Add additional permanent debt, both short-term and long-term to hedge the maturities of the assets on the balance sheet.
(4) Respond
to temporary current asset buildups and take advantage of any opportunities
arising from temporary working capital.
4. Why
are the “attractive short-term financing opportunities,” described
in the second step of the four-step process, considered before other
debt financing? These opportunities are considered first simply because
they are less costly. They include such financing sources as wages
payable, taxes payable, and free trade credit. It is always wise
for financial managers to raise financing at the lowest possible cost.
5. How
is the current ratio used in setting the debt maturity mix? Can
you think of any other financial measures
that could also be used in this analysis? The current ratio is often
used as a measure of how to split the amount of debt taken in the third-step
of the four-step process between current and long-term to hedge balance
sheet maturities. Short-term debt is added to the firm's liabilities
until the current ratio reaches a target value; additional debt financing
is long-term. Other measures that could be used are working capital
(current assets minus current liabilities) and the quick ratio.
6. Why
is the debt maturity mix normally simplified to short- vs. long-term
debt? What, if anything, is lost in making this simplification? This
simplification is normally made to be consistent with the way assets
and liabilities are categorized on the balance sheet. However,
simplifying in this way hides the opportunity, and need, to consider
a much finer hedging of assets and liabilities. For example, an
asset that will turn to cash in one month is generally not a good hedge
for ten-month debt, yet both would appear on the balance sheet as current
items. An asset with a 30-year life is generally not a good hedge
for thirteen-month debt, yet both would appear on the balance sheet
as long-term. It is important to look beyond the simplicity of
the balance sheet classification and examine the maturities of assets
and liabilities in more detail.
7. What
role does the debt maturity mix play in the firm's overall risk-return
posture? The debt maturity mix is an important input to a company's
levels of risk and return. In general, short-term liabilities
are less costly than long-term debt, since the yield curve is normally
upward sloping. However, a firm with a high level of short-term
liabilities has less liquidity than one whose debt is of longer maturities.
In summary, a company which weights its debt financing toward the short-term
increases both its return and risk, while a company which weights its
debt financing toward the long-term decreases both its return and risk.
By establishing its debt maturity mix, a company can add or subtract
both risk and return to its risk-return position.
8. Distinguish
between individual asset/liability hedging and maturity-range hedging?
What type of company can do each? Individual asset/liability hedging,
involves matching the maturities of specific assets with specific liabilities.
Each liability is offset with an asset of equal amount and maturity.
While this strategy achieves the maximum risk reduction from hedging,
it is costly, difficult, and time-consuming to do. With maturity-range
hedging, assets and liabilities are grouped by maturity and the groups
are kept roughly equal in size. This policy is far less costly
and more doable than attempting to match every asset and liability.
Effectively, maturity-range hedging is an attempt to back off from individual
asset/liability hedging to find a practical balance sheet hedging policy.
9. What
role do permanent current assets play in maturity-range hedging? Even
though individual current assets turn over within the annual accounting
period, the balance of permanent current assets has a long-term maturity
since it will be on the books for many years. Recognizing this,
we include permanent current assets with noncurrent assets when grouping
assets by maturity for maturity-range hedging.
10. Why do companies deviate from maturity-range hedging? Companies deviate from maturity-range hedging for three primary reasons:
(1) Inability to obtain the desired financing � Small businesses often cannot obtain funds in the maturities needed for hedging purposes. They have difficulty raising long-term capital and tend to weight their financing toward the available shorter-term trade credit and bank financing.
(2) Cost reduction (higher returns) � Some companies elect to use more short-term financing than required for hedging since it is lest costly when yield curves are normal. Other companies elect to use more long-term debt to avoid the costs of repeatedly renewing and renegotiating their financing.
(3) Risk
reduction �
Some companies elect to use more short-term financing than required
for hedging since it gives them a high degree of flexibility in adding
and subtracting debt from the balance sheet should their needs change.
Other companies elect to use more long-term debt to lock in interest
rates, improve their credit ratings, and avoid the danger of bankruptcy
from having to repay debt on an ongoing basis.
11. What
factor(s) enter the decisions about the composition of a portfolio of
marketable securities? The important factor is the maturity of each
security in the portfolio. Marketable securities should be selected
with an eye toward when the money will be needed again in order to insulate
the company from market price fluctuations. In this way, the company
will receive a known face value when each security matures. Since
the values of all marketable securities in an economy are closely tied
to interest rates, it is not possible to use statistical portfolio techniques
(betas) to reduce the risk of this kind of portfolio.
12. Which
financial instruments are most commonly used as marketable securities? A
list is given in Figure 16.9 on page 591. These securities include
U.S. Treasury bills, bonds and notes; bonds issued by other federal
agencies and by state and local governments; bank instruments including
acceptances, negotiable CDs, and repos; financial market instruments
such as commercial paper, Euronotes, and variable-rate preferred stock;
and money market mutual funds combining securities from one or more
issuers. They all share the characteristics of relatively low
risk and high liquidity and marketability.
13. What is meant by the “five Cs”? The five Cs are five words that summarize the criteria for extending credit used by commercial banks. Specifically, they are:
a. Character � does the credit applicant responsibly meet his/her obligations?
b. Capacity � does the credit applicant have the ability to pay?
c. Capital � does the credit applicant have sufficient resources to make payments under adverse conditions?
d. Collateral � does the credit applicant have assets which can be pledged against the loan to provide a “second way out” should payment not be made?
e. Conditions �
what outside factors may make it difficult for the credit applicant
to pay and what is the probability and projected effect of each?
14. In
what way(s) are quality-leading companies changing their approach to
the control of working capital? Quality-leading companies are finding
many ways to improve their production, finance, and management processes
to significantly reduce working capital requirements. The move
toward just-in-time manufacturing is perhaps the most visible of these
improvements reducing the need for inventories�the chapter relates the progress that
one company, American Standard, has made in this regard. Other
changes which have reduced the need for working capital include more
efficient cash management through customer-supplier alignments with
banks, and more efficient handling of receivables and payables by using
electronic data interchange with suppliers and customers.
15. Some
financial professionals consider forward contracts another kind of derivative
security. Why do you think this is so? A derivative security
is a contract whose value is tied to some financial market security,
rate, or price. These financial professionals see forward contracts
as fitting within the definition of a derivative, since the value of
a forward contract depends on the interest or exchange rate it is connected
to. For example, a company which has signed a forward exchange
contract has the obligation to purchase a foreign currency at a specified
exchange rate. Should the foreign currency become more expensive,
the forward contract would become more valuable and vice versa.
16. How
does a forward contract work as a hedging device? A forward contract
locks in an interest rate or exchange rate for a specified future time.
It insulates the company from changes to that rate until the exercise
date of the contract. Consider, for example, a company with an
account receivable of 10,000 Swiss francs due to be collected in 90
days. The company will have to convert the francs to dollars at
that time, but the exchange rate 90 days from now is unknown�hence
the company faces foreign exchange risk. By purchasing a forward
exchange contract, the company can guarantee the rate of exchange and
eliminate the risk. The forward contract, a liability to deliver
10,000 francs in 90 days hedges the account receivable asset, the right
to receive 10,000 francs in 90 days by providing a way for the company
to use the proceeds from the asset and receive a known value.
17. How
does a derivative security work as a hedging device? Financial managers
can use a derivative security to hedge the asset to which the derivative
is connected by creating an opposite exposure to the asset. For
example, a food processor could buy futures on the agricultural products
it will be purchasing in the next few months. If the cost of the
products rises the food processor will have to pay more for them, but
the futures contracts will increase in value as well offsetting the
extra cost and providing the additional money required. The asset
and the derivative position are perfectly negatively correlated in this
strategy: any change in value of the asset will be offset by an opposite
change in value of the derivative security. In the ideal hedge,
the opposite exposure is for the same amount of money as the asset itself,
however, since derivative instruments come in fixed sizes�for
example $10,000 units�it is often difficult to construct
an opposite position of precisely the needed amount.
18. A new finance student was overheard making the following statement: “In efficient financial markets, all hedging devices should be perfect substitutes!” Discuss. In general, alternative hedging devices are reasonably good substitutes for one another. However the student's statement is not quite true for at least three reasons:
(1) Not all hedging instruments convey the same rights and obligations. For example, a forward contract commits the parties to go through with the transaction while an option gives the choice of whether to proceed to the option holder.
(2) Not all hedging devices are taxed the same way.
(3) Money
market hedges appear on the balance sheet as assets and offsetting liabilities
while derivative securities do not.
19. Draw
a flow chart of the four-step working capital process. One (very
simple) possibility:
PROBLEMS
SOLUTION
PROBLEM 161
Recall that the current ratio = Current assets
Current liabilities
Rearranging: Current liabilities = Current assets
Current ratio
and with a target current ratio of 2.5:
Target current liabilities = Current assets
2.5
(a) Permanent current assets = $10 million
Target current liabilities = $10 million = $4 million
2.5
Additional short-term financing needed to meet
target = $4 million
$2 million = $2 million
(b) Permanent current assets = $8 million
Target current liabilities = $8 million = $3.2 million
2.5
Additional short-term financing needed to meet
target = $3.2 million
$2 million = $1.2 million
(c) Permanent current assets = $5 million
Target current liabilities = $5 million = $2 million
2.5
Additional short-term financing needed to meet
target = $0
(d) Permanent current assets = $2 million
Target current liabilities = $2 million = $0.8 million
2.5
The
company has $1.2 million more in short-term financing than target.
It should either reduce current liabilities by this $1.2 million, increase
its permanent current assets to $5 million (see answer to part c)�if
good permanent current asset investments exist, or rethink its 2.5 target
current ratio.
SOLUTION
PROBLEM 162
Recall that the current ratio = _ Current assets
Current liabilities
Rearranging: Current liabilities = Current assets
Current ratio
and with $25 million of permanent current assets:
Target current liabilities = $25 million_
Current ratio
(a) Target current ratio = 1.8
Target current liabilities = $25 million = $13.9 million
1.8
Additional short-term financing needed to meet
target = $13.9 million
$4 million = $9.9 million
(b) Target current ratio = 2.0
Target current liabilities = $25 million = $12.5 million
2.0
Additional short-term financing needed to meet
target = $12.5 million
$4 million = $8.5 million
(c) Target current ratio = 2.4
Target current liabilities = $25 million = $10.4 million
2.4
Additional short-term financing needed to meet
target = $10.4 million
$4 million = $6.4 million
(d) Target current ratio = 2.8
Target current liabilities = $25 million = $8.9 million
2.8
Additional short-term financing needed to meet
target = $8.9 million
$4 million = $4.9 million
SOLUTION
PROBLEM 163
For all four cases:
• Total assets = current + long-term = $25 + $25 = $50 million
• With a target debt ratio of 40%
Liabilities = 40%, so liabilities = 40%(assets)
Assets
Liabilities = 40%($50 million) = $20 million
• Therefore
equity = $50 million $20 million = $30 million
(a) Current debt = 20%($20 million) = $4 million
Long-term
debt = 80%($20 million) = $16 million
(b) Current debt = 40%($20 million) = $8 million
Long-term
debt = 60%($20 million) = $12 million
(c) Current debt = 60%($20 million) = $12 million
Long-term
debt = 40%($20 million) = $8 million
(d) Current debt = 80%($20 million) = $16 million
Long-term
debt = 20%($20 million) = $4 million
(1) Balance sheets
Financing
Assets Mix: a b c d
Equity 30 30 30 30
50 50 50 50 50
(2) Financial half of income statement
Interest expense:
(a) 7%($4 million) + 12%($16 million) = $2.2 million
(b) 7%($8 million) + 12%($12 million) = $2.0 million
(c) 7%($12 million) + 12%($8 million) = $1.8 million
(d) 7%($16 million) + 12%($4 million) = $1.6
million
a b c d
EBIT $5.00 $5.00 $5.00 $5.00
Interest 2.20 2.00 1.80 1.60
EBT 2.80 3.00 3.20 3.40
Taxes (35%) .98 1.05 1.12 1.19
EAT $1.82 $1.95 $2.08 $2.21
(3) Ratios a b c d
ROE = EAT 1.82 = 6.07% 1.95 = 6.50% 2.08 = 6.93% 2.21 = 7.37%
Equity 30 30 30 30
Current = CA 25 = 6.25 25 = 3.13 25 = 2.08 25 = 1.56
CL 4 8 12 16
Note that as the firm moves from more
long-term debt (alternative a) toward more short-term debt (alternative
d), it increases its return on equity but at the cost of greater liquidity
risk as seen in the lower current ratio.
SOLUTION
PROBLEM 164
For all four cases:
• Non-current assets = total current = $400 $250 = $150 million
• With a target debt ratio of 50%
Liabilities = 50%, so liabilities = 50%(assets)
Assets
Liabilities = 50%($400 million) = $200 million
• Therefore equity = $400 million $200 million = $200 million
• With basic earning power = 15%:
EBIT = 15%, so EBIT = 15%(assets)
Assets
EBIT = 15%($400 million) = $60 million
(a) Current debt = 20%($200 million) = $40 million
Long-term
debt = 80%($200 million) = $160 million
(b) Current debt = 40%($200 million) = $80 million
Long-term
debt = 60%($200 million) = $120 million
(c) Current debt = 60%($200 million) = $120 million
Long-term
debt = 40%($200 million) = $80 million
(d) Current debt = 80%($200 million) = $160 million
Long-term
debt = 20%($200 million) = $40 million
(1) Balance sheets
Financing
Assets Mix: a b c d
Equity 200 200 200 200
400 400 400 400 400
(2) Financial half of income statement
Interest expense:
(a) 5%($40 million) + 10%($160 million) = $18 million
(b) 5%($80 million) + 10%($120 million) = $16 million
(c) 5%($120 million) + 10%($80 million) = $14 million
(d) 5%($160 million) + 10%($40 million) = $12
million
a b c d
EBIT $60.0 $60.0 $60.0 $60.0
Interest 18.0 16.0 14.0 12.0
EBT 42.0 44.0 46.0 48.0
Taxes (35%) 14.7 15.4 16.1 16.8
EAT $27.3 $28.6 $29.9 $31.2
(3) Ratios a b c d
ROE = EAT 27.3 = 13.65% 28.6 = 14.30% 29.9 = 14.95% 31.2 = 15.60%
Equity 200 200 200 200
Current = CA 250 = 6.25 250 = 3.13 250 = 2.08 250 = 1.56
CL 40 80 120 160
Note that as the firm moves from more
long-term debt (alternative a) toward more short-term debt (alternative
d), it increases its return on equity but at the cost of greater liquidity
risk as seen in the lower current ratio.
APPENDIX 16A
Transferring Money Between
Cash and Marketable Securities
PROBLEMS
SOLUTION
PROBLEM 16A1
(a) Z =
= = = $182,574
(b) Average cash balance = Z = $182,574 = $91,287
2 2
(c) Transfers per year = N = $20,000,000 = 110
Z $182,574
(d) Transfer frequency = 360 = 360 = every 3.3 days
transfers per year 110
SOLUTION
PROBLEM 16A2
(a) Z =
= = = $136,931
(b) Average cash balance = Z = $136,931 = $68,466
2 2
(c) Transfers per year = N = $5,000,000 = 37
Z $136,931
(d) Transfer frequency = 360 = 360 = every 9.7 days
transfers per year 37
SOLUTION
PROBLEM 16A3
(a) Lower control limit (LCL) = $0 since there is no minimum cash balance requirement.
(b) Zero point (Z) = + LCL
i = (1.05)1/365 1 = .0001337
and
Z = + LCL = + 0
= $69,560
(c) Upper control limit (UCL) = 3Z 2(LCL)
= 3($69,560)
2($0) = $208,680
(d) Average cash balance = 4Z LCL = 4($69,560) 0 = $92,747
3 3
SOLUTION
PROBLEM 16A4
(a) Lower control limit
(LCL) = $25,000, the minimum cash balance required
by the company's bank.
(b) Zero point (Z) = + LCL
i = (1.045)1/365 1 = .0001206
and
Z = + LCL = + 25,000
= $291,916 + 25,000 = $316,916
(c) Upper control limit (UCL) = 3Z 2(LCL)
= 3($316,916) 2($25,000)
= $950,748
50,000 = $900,748
(d) Average cash balance = 4Z LCL = 4($316,916) 25,000 = $414,221
3 3
SOLUTION
PROBLEM 16A5
LCL remains $0
in all cases.
(a) i = (1.03)1/365 1 = .0000810
Z = + LCL = + 0 = $82,207
UCL = 3Z
2(LCL) = 3($82,207) 2($0) = $246,621
Average balance = 4Z LCL = 4($82,207) 0 = $109,609
3 3
(b) i = (1.04)1/365 1 = .0001075
Z =
+ LCL = + 0 = $74,806
UCL = 3Z
2(LCL) = 3($74,806) 2($0) = $224,418
Average balance = 4Z LCL = 4($74,806) 0 = $99,741
3 3
(c) i = (1.06)1/365 1 = .0001597
Z =
+ LCL = + 0 = $65,560
UCL = 3Z
2(LCL) = 3($65,560) 2($0) = $196,680
Average balance = 4Z LCL = 4($65,560) 0 = $87,413
3 3
(d) i = (1.07)1/365 1 = .0001854
Z =
+ LCL = + 0 = $62,378
UCL = 3Z
2(LCL) = 3($62,378) 2($0) = $187,134
Average balance = 4Z LCL = 4($62,378) 0 = $83,171
3 3
Notice that as the interest
rate rises, the company's cash balance falls since it is more lucrative
to keep money in marketable securities.
SOLUTION
PROBLEM 16A6
LCL remains $25,000
in all cases.
(a) Z = + LCL =
+ 25,000 = $256,694
UCL = 3Z
2(LCL) = 3($256,694) 2($25,000) = $720,082
Average balance = 4Z LCL = 4($256,694) 25,000 = $333,925
3 3
(b) Z = + LCL =
+ 25,000 = $290,223
UCL = 3Z
2(LCL) = 3($290,223) 2($25,000) = $820,669
Average balance = 4Z LCL = 4($290,223) 25,000 = $378,631
3 3
(c) Z = + LCL =
+ 25,000 = $339,457
UCL = 3Z
2(LCL) = 3($339,457) 2($25,000) = $968,371
Average balance = 4Z LCL = 4($339,457) 25,000 = $444,276
3 3
(d) Z = + LCL =
+ 25,000 = $359,160
UCL = 3Z
2(LCL) = 3($359,160) 2($25,000) = $1,027,480
Average balance = 4Z LCL = 4($359,160) 25,000 = $470,547
3 3
Notice that as the cost of each cash-securities transaction rises, the company's cash balance rises as well since it becomes more costly to move the cash into marketable securities and back.
All Rights Reserved Powered by Free Document Search and Download
Copyright © 2011