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Working Capital and Expenses

Macs Ltd was founded in 1980 sales growth has been reinforced over the past 7 years, by the growing demand from home computer users for a quality paper to print colour photographs and reproductions.
The firm has kept up with manufacturing and marketing requirements. However, its financial management system has remained as it was originally developed. Macs Ltd now realises that to remain in business, it must revamp the financial system. Fred, a chartered accountant, has been employed as chief financial officer and has concluded that the development of a rational working capital policy is essential. He has decided to examine three alternative policies:

1. A conservative policy, which calls for holding relatively large amounts of cash and inventories, and for using only long-term debt. 2. An aggressive policy, which calls for minimising the amount of cash and inventories held, and for using only short-term debt. This policy would result in the smallest investment in net working capital. 3. A moderate (or maturity matching) policy, which falls between the two extremes.
Fred initially plans to hold the level of accounts receivable constant. That is, it would be the same under each of the three policies. Fred has also concluded that the company's $6 million of net fixed assets is sufficient to meet the demands of a wide range of sales, regardless of what is done in the working capital area.
Table 1 shows Fred's estimates of the firm's balance sheet under the three working capital policies.
Macs' shares sell at about book value. All three working capital policies are consistent with the company's target capital structure that calls for a debt ratio in the range of 45% to 55%. Thus it is the level of the current assets and the maturity structure of the debt, not the capital structure, that affects the decision. Fred's best estimate of debt costs is 7.5% for short-term debt and 10% for long-term debt.
The choice of working capital policy will affect some of the company's costs. Variable costs are expected to be 50% of sales regardless of which working capital policy is adopted. Fixed costs are likely to be a function of the level of current assets held - the greater the level of current assets, the greater the fixed costs. This is because of: the need to hold the larger inventories in high-cost, dehumidified warehouses higher insurance costs.

Fred expects annual fixed costs to be $4,000,000 under the aggressive policy, $4,500,000 under a moderate policy, and $5,000,000 with the conservative policy.
Working capital policy will also affect the firm's ability to respond to varying economic conditions. In an average economy, Macs' sales would be highest if the firm used a conservative policy with high levels of inventories, cash and marketable securities. Macs could respond immediately to incoming orders and, therefore, not lose sales because of stockouts. If higher sales occurred because of the conservative policy, then accounts receivable would also be higher, even if credit standards and credit terms were unchanged.1

1 Note that working capital policy actually consists of two independent decisions: (1) the level of current assets, and (2) the way in which the current assets are financed. In this case, to simplify the numerical analysis, the two independent decisions are treated as dependent. Thus, a conservative policy implies a conservative financing policy, along with large holdings of current assets. Similarly, an aggressive policy signifies a heavy use of short-term debt along with relatively small holdings of current assets.

Conversely, expected sales are lowest under an aggressive policy, when the firm would have low levels of cash, inventories and receivables.
The different policies would also cause sales to react differently to changing economic conditions. In a strong economy, the conservative approach with its higher inventories would be best for generating increased sales. An aggressive policy would make it difficult for Macs to respond to increased demand. Table 2 contains Fred's best estimates of the sales levels under the alternative policies for three different states of the economy.

For ease of calculation, assume Macs' tax rate to be 30%.

Questions

3. Construct pro forma income statements for each working capital policy assuming a weak economy, an average economy, and a strong economy. Use this data to calculate ROEs and basic earning power ratios (EBIT/total assets). How can this data be used to decide on the optimal working capital policy? Can you choose a working capital policy on the basis of the information generated thus far?
[11 marks]

4. Assume there is a 25% chance of a weak economy, a 50% chance of an average economy, and a 25% chance of a strong economy. What is the expected ROE under each policy? How do the policies compare in terms of relative riskiness? (Hint: riskiness can be expressed in terms of standard deviation and coefficient of variation.)
[7 marks]

And monetary policy shortly after Macs has made its working capital policy decision. Any long-term debt outstanding would be locked in at 10%, but Macs would have to roll over any short-term debt outstanding at the new rate, which has risen to 11%. Assuming an average economy, what would be the resulting ROE under each policy? Do these results affect your previous conclusions about the relative riskiness of the three alternatives?
Hint:
(a) Calculate the increase in interest expense (long-term and short-term) for the three working capital policies by comparing the previous cost of debt with the new rate. Comment on it. (3 marks)
(b) Calculate the change in ROE under an average economy for the three working capital policies due to change in short-term interest rate. Comment on it. (3 marks)
(c) Calculate the change in the coefficient of variation under an average economy for the three working capital policies due to change in short-term interest rate. Comment on it.
(3 marks)

6. Like most companies of its size, Macs has two primary sources of short-term debt: trade credit and bank loans. One supplier, which furnihes Macs with $800,000 (gross) of materials a year, offers terms of 2/10, net 60.
(a) What are Macs' net daily purchases from this supplier? (Use a 365-day year.)
(2 marks)
(b) (i) What is the average level of Macs' accounts payable to this supplier, assuming the discount is taken?
(2 marks)
(ii) What is the average payables balance if the discount is not taken? (2 marks)
(iii) What are the dollar amounts of free credit and costly credit from this supplier?
(2 marks)
(c) (i) What is the approximate percentage cost of the costly credit? (2 marks)
(ii) What is the effective annual percentage cost? (2 marks)
(d) What conclusions do you reach from this analysis? (2 marks)

7. In discussing a possible loan with the firm's banker, Fred learned that the bank would be willing to lend Macs up to $5,000,000 for one year at a 10% nominal, or stated, rate. Fred failed to ask the banker about the specific terms of the loan. Assume that Macs will borrow $2,500,000.
(a) (i) What would the effective interest rate be on the loan if it is a simple interest loan?
(1 mark)
(ii) If the banker offered to lend the money for 6 months, but with a guaranteed renewal at the same 10% simple interest rate, would this be as good, better, or worse than a straight one year loan at 10% simple interest? Explain. (2 marks)
(b) What would be the effective interest rate if the loan is a discount loan? What face amount would be needed to provide Macs with $2,500,000 of available funds? [Hint: A discount loan deducts the interest from the face amount of the loan in advance.]
(3 marks)
(c) Assume that the loan terms call for an installment loan with add-on interest and 12 equal monthly payments, with the first payment due at the end of the first month.
(i) What would Macs' monthly payments be? (2 marks)
(ii) What would the approximate percentage cost of this loan be? (2 marks)
(iii) What would be its effective annual rate? (2 marks)
(iv) Would this type of loan be suitable if Macs needed all of the money for the entire year? What type of asset is most suitably financed by an installment-type loan?
(2 marks)
(d) Assume that the bank charges simple interest, but it requires a 20% compensating balance.
(i) Suppose Macs does not carry any cash balances at that bank. How much would the firm have to borrow to obtain the needed $2,500,000 while meeting its compensating balance requirement? What is the effective annual percentage rate on this loan?
(3 marks)
(ii) Suppose Macs currently carries an average cash balance of $75,000 at the bank, and that those funds can be used as a part of the compensating balance requirement. What effect does this have on the amount borrowed, and on the cost of the loan? (3 marks)
(iii) Return to the scenario in which Macs currently maintains its working cash balances in another bank. Assume that the bank from which Macs would borrow pays 5% simple interest on all cheque account balances. What would the effective percentage cost of the loan be in this situation? (3 marks)

8. Assume that you have had some additional discussions with Fred, in which he has told you he would like more information on the ROE and the riskiness of the alternative working capital policies under different sets of assumptions. He has asked you, first, to assume that sales are independent of working capital policy, and then to determine the expected ROE and standard deviation of ROE if the sales estimates for each working capital policy are $11,000,000 for a weak economy, $13,000,000 for an average economy, and $14,500,000 for a strong economy.
He has also asked you to assume that a different manufacturing process is used, causing the mix of fixed and variable costs to change. Using the original sales estimate, he wants to know what the expected ROE and standard deviation of ROE will be under the three policies if variable costs increase to 70% of sales (in all cases), and fixed costs decrease to $1,000,000 under the aggressive policy, $1,500,000 under the moderate policy, and $2,000,000 under the conservative policy.
How would your answers to these and similar questions be used by top managers as they make the working capital policy decision? [8 marks]

9. What is your recommendation regarding a working capital policy for Macs? In what form should the company raise short-term debt? You do not have enough information to make a definitive statement when answering this question, but assume Fred wants you to make a preliminary recommendation that can be modified later if necessary.[8 marks]

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Solution Summary

This solution answers questions regarding working capital and expenses.

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