MANAGEMENT CONSULTANCY - Solutions Manual

CHAPTER 15

WORKING CAPITAL AND

THE FINANCING DECISION

I. Questions

1. 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.

2. 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 part of current
assets are temporary and what part are permanent. Furthermore, one is
never quite sure how much short-term or long-term financing is available
at all times. Even if there were known, it would be difficult to change
the financing mix on a continual basis.

3. By establishing a long-term financing arrangement for temporary current

assets, a firm is assured of having necessary funding in good times as
well as bad, thus we say there is low risk. However, long-term financing
is generally more expensive than short-term financing and profits may be
lower than those which could be achieved with a synchronized or normal
financing arrangement for temporary current assets.

4. By financing a portion of permanent current assets on a short-term basis,

we run the risk of inadequate financing in tight money periods.
However, since short-term financing is less expensive than long-term
funds, a firm tend to increase its profitability over the long run

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Chapter 15 Working Capital and the Financing Decision

(assuming it survives). In answer to the preceding question, we stressed

less risk and less return; here the emphasis is on risk and high return.

5. The term structure of interest rates shows the relative level of short-term
and long-term interest rates at a point in time. It is often referred to as a
yield curve.

II. Multiple Choice

1. C 11. D 21. C
2. D 12. A 22. D
3. B 13. C 23. B
4. C 14. D
5. C 15. B
6. C 16. C
7. B 17. A
8. A 18. D
9. C 19. A
10. B 20. C

Supporting Computations for nos. 15 through 18:

INCOME STATEMENTS FOR YEAR ENDED DECEMBER 31, 2000

(THOUSANDS OF PESOS)

Pia Press Chico Publishing

EBIT P 30,000 P 30,000 P 30,000 P 30,000
Interest 12,400 14,400 10,600 18,600
Taxable income P 17,600 P 15,600 P 19,400 P 11,400
Taxes (40%) 7,040 6,240 7,760 4,560
Net income P 10,560 P 9,360 P 11,640 P 6,840
Equity P100,000 P100,000 P100,000 P100,000
Return on equity 10.56%15 9.36%17 11.64%16 6.84%18

III. Problems

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 Working Capital and the Financing Decision Chapter 15

PROBLEM 1 (NICK & ASSOC.)

1.
Plan A Plan B
(Conservative) (Aggressive)
Short-term (20%) P 240,000 (40%) P 480,000
Long-term (80%) 960,000 (60%) 720,000
P1,200,000 P1,200,000

2.
EBIT P325,000 P325,000
Interest
Short-term @ 8.5% (20,400) (40,800)
Long-term @ 11% (105,600) (79,200)
EBT 199,000 205,000
Taxes @ 40% 79,600 82,000
Net income P119,400 P123,000

3. Plan A: Interest rates could drop significantly, which would increase the
effective cost of long-term financing at a future point in time.

Plan B: Interest rates could increase, increasing the cost of short-term

financing and possibly tightening the availability of short-term funds.
Profit would decrease.

4. (Subjective) Depends upon interest rate forecast.

PROBLEM 2 (CAIMITO COMPANY)

ALTERNATIVE BALANCE SHEETS

Restricted Moderate Relaxed

(40%) (50%) (60%)
Current assets P1,200,000 P1,500,000 P1,800,000
Fixed assets 600,000 600,000 600,000
Total assets P1,800,000 P2,100,000 P2,400,000
Debt P 900,000 P1,050,000 P1,200,000
Equity 900,000 1,050,000 1,200,000
Total liabilities and P1,800,000 P2,100,000 P2,400,000

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equity

ALTERNATIVE INCOME STATEMENTS

Restricted Moderate Relaxed

Sales P3,000,000 P3,000,0000 P3,000,000
EBIT 450,000 450,000 450,000
Interest (10%) 90,000 105,000 120,000
Earnings before taxes P 360,000 P 345,000 P 330,000
Taxes (40%) 144,000 138,000 132,000
Net income P 216,000 P 207,000 P 198,000
ROE 24.0% 19.7% 16.5%

PROBLEM 3 (MALINIS SURGICAL INSTRUMENTS CO.)

1. Most aggressive

Low liquidity P2,000,000 x 18% = P360,000

Short-term financing - 2,000,000 x 10% = 200,000
Anticipated return P160,000

2. Most conservative

High liquidity P2,000,000 x 14% = P280,000

Long-term financing - 2,000,000 x 12% = 240,000
Anticipated return P 40,000

3. Moderate approach

Low liquidity P2,000,000 x 18% = P360,000

Long-term financing - 2,000,000 x 12% = 240,000
P120,000

or

High liquidity P2,000,000 x 14% = P280,000

Short-term liquidity - 2,000,000 x 10% = 200,000
P 80,000

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4. You may not necessarily select the plan with the highest return. You
must also consider the risk inherent in the plan. Of course, some firms
are better able to take risks than others. The ultimate concern must be
for maximizing the overall valuation of the firm through a judicious
consideration of risk-return options.

PROBLEM 4 (ATIS SYSTEMS, INC.)

1.
Temporary current assets P300,000
Permanent current assets 200,000
Fixed assets 400,000
Total assets P900,000

Conservative

% of Interest Interest
Amount Total Rate Expense
P900,000 x 0.80 = P720,000 x 0.15 = P108,000 Long-term
P900,000 x 0.20 = P180,000 x 0.10 = 18,000 Short-term
Total interest charge P126,000

Aggressive

% of Interest Interest
Amount Total Rate Expense
P900,000 x 0.70 = P270,000 x 0.15 = P40,500 Long-term
P900,000 x 0.30 = P630,000 x 0.10 = 63,000 Short-term
Total interest charge P103,500

2.
Conservative Aggressive
EBIT P180,000 P180,000
- Int. 126,000 103,500

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EBT 54,000 76,500

Tax 40% 21,600 30,600
EAT P 32,400 P 45,900

PROBLEM 5 (MANGOSTEEN, INC.)

1.
Current permanent current temporary current
assets assets = assets
P800,000 P350,000 = P450,000

Long-term interest expense = 10% [P600,000 + (P350,000)]

= 10% x (P775,000)
= P77,500

Short-term interest expense = 5% [P450,000 + (P350,000)]

= 5% x (P625,000)
= P31,250

Total interest expense = P77,500 + P31,250

= P108,750

Earnings before interest and taxes P200,000

Interest expense 108,750
Earnings before taxes P 91,250
Taxes (30%) 27,375
Earnings after taxes P 63,875

2. Alternative financing plan

Long-term interest expense = 10% [P600,000 + P350,000

+ (P450,000)]
= 10% (P1,175,000)

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= P117,500

Short-term interest expense = 5% [ (P450,000)]

= 5% (P225,000)
= P11,250

Total interest expense = P117,500 + P11,250

= P128,750

Earnings before interest and taxes P200,000

Interest expense 128,750
Earnings before taxes P 71,250
Taxes (30%) 21,375
Earnings after taxes P 49,875

3. The alternative financing plan which calls for more financing by high-
cost debt is more expensive and reduces after-tax income by P14,000.
However, we must not automatically reject this plan because of its
higher cost since it has less risk. The alternative provides the firm with
long-term capital which at times will be in excess of its needs and
invested in marketable securities. It will not be forced to pay higher
short-term rates on a large portion of its debt when short-term rates rise
and will not be faced with the possibility of no short-term financing for a
portion of its permanent current assets when it is time to renew the short-
term loan.

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