Working Capital and the Financing Decision

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Chapter 6

• Working Capital and theFinancing Decision

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Chapter 6 - Outline

• What is Working Capital Management?
• Term Structure of Interest Rates
• U.S. Government Securities
• Short-Term vs. Long-Term Financing
• Working Capital Financing Plans

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Working Capital Management

• Working Capital Management is controlling and
  managing the current assets of a firm
• Most time-consuming job of a financial manager
• Crucial to long-term success or failure of a
  business (short term decisions may determine if a
  firm gets to the long run).

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Term Structure of Interest Rates

• The Term Structure of Interest Rates is also
  known as the Treasury Yield Curve
• Graph showing the relationship between S/T and
  L/T interest rates at different maturities
• Reported daily in The Wall Street Journal.
• Normal shape is an upward sloping curve,
  indicating that L/T interest rates are greater
  than S/T interest rates.

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U.S. Government Securities

• Treasury Bills (T-Bills) short-term IOUs
• 3 months to 1 year in maturity
• Treasure Notes intermediate term
• 1 to 10 years in maturity
• Treasury Bonds long term
• 10 to 40 years in maturity

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Long- and Short-Term Annual Interest Rates

• Relative volatility and the historical level of
  short-term and long-term rates

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Short-Term vs. Long-TermFinancing

• Short-term financing is typically less expensive
  but riskier
• Long-term financing is typically more expensive
  but less risky (or safer)
• Firm must decide the appropriate mix
• Similar to the risk-return trade-off

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Are some current assets permanent in nature?
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Toward an Optimal Policy

• A firm should
• Attempt to relate asset liquidity to financing
  patterns, and vice versa
• Decide how it wishes to combine asset liquidity
  and financing needs
• Risk-oriented firm - short-term borrowings and
  low degree of liquidity
• Conservative firm - long-term financing and high
  degree of liquidity

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Are some current assets permanent in nature?
Matching long-termand short-term needs
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Using long-term financingfor part of short-term
needs
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Using short-term financingfor part of long-term
needs
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Working Capital Financing Plans

• An appropriate strategy is determined based on
  the companys tolerance for risk, but all else
  equal, the financing of an asset should be tied
  to how long the asset is likely to be on the
  balance sheet.
• An aggressive (risky) firm
• S/T financing and low liquidity
• A conservative (safe or cautious) firm
• L/T financing and high liquidity
• A moderate (balanced) firm
• S/T financing and high liquidity OR
• L/T financing and low liquidity