Corporate Finance PDF

BM2305 CORPORATE FINANCE Managing working capital ensures businesses have sufficient liquidity to meet their short-term requirements, such as day-to-day operations, including paying salaries and wages, suppliers, and utilities. A very profitable company may be...

BM2305 CORPORATE FINANCE Managing working capital ensures businesses have sufficient liquidity to meet their short-term requirements, such as day-to-day operations, including paying salaries and wages, suppliers, and utilities. A very profitable company may become insolvent if it does not have the cash to pay for its daily operations. Working Capital Management (BPP Learning Media, 2021) Working capital is the capital available for conducting the day-to-day operations of an organization, usually the excess of current assets over current liabilities. Managing working capital may vary among different businesses across industries. For example, retailing companies receive most of their sales in cash while paying their suppliers on account. It allows retailers to have significant cash in their banks. Hence, their working capital management goal is to invest the excess liquidity in maximizing the return on excess cash. On the other hand, an importer and wholesale business may need to extend credit to their retailing buyers. Hence, they must prepare a cash flow forecast to anticipate funding requirements and resort to short-term financing. The goal of working capital management is to ensure that a company's cash level is appropriate to meet the working capital requirements of the entity. The level of cash should not be too low or too high. Low cash levels run the risk of bankruptcy while having too much cash in the business does not maximize the return on assets since cash does not earn interest on its own unless invested in a bank. Hence, a business pursuing an aggressive working capital policy will hold the minimum cash and use short- term financing to meet working capital requirements. While this results in higher returns, it also carries a higher risk. On the other hand, a business that opts for a conservative policy will hold higher levels of cash to ensure the company's working capital requirements are funded. This option yields less risk but also results in lower returns. Cash Conversion Cycle (Brigham, 2020) The Cash Conversion Cycle (CCC), also known as the working capital cycle, is the time a company spends on inventory until it converts it back to cash. Three (3) main periods contribute to the theoretical cash conversion cycle: 1. Inventory conversion period, i.e., the time it takes to hold the inventory from when it is purchased until sold. 2. Average collection period, i.e., the time it takes to collect from customers when it was sold. 3. Average payment period, i.e., the time it takes to pay suppliers from inventory acquisition. CCC = Inventory conversion period + Average collection period – Average payment period 05 Handout 1 *Property of STI  [email protected] Page 1 of 6  BM2305 Figure 1: The Cash Conversion Cycle (Brigham et al., 2017, p.649) Illustration: ABC Company buys raw materials from suppliers that allow the company 2.5 months of credit. The raw materials remain in inventory for one (1) month, and it takes two (2) months to produce the goods. The goods are sold upon completion, but it takes the customers an average of 1.5 months to pay. Required: Calculate the theoretical CCC. Solution: 1 month + 2 months +1.5 months – 2.5 months = 2.0 months. Once the theoretical CCC is established, we can calculate the actual CCC from the financial statements by using the following ratios: 1. Inventory conversion period 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑖𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑏𝑎𝑙𝑎𝑛𝑐𝑒 𝐼𝑛𝑣𝑒𝑛𝑡𝑜𝑟𝑦 𝑐𝑜𝑛𝑣𝑒𝑟𝑠𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 = 365 𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 2. Average collection period 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑅 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑐𝑜𝑙𝑙𝑒𝑐𝑡𝑖𝑜𝑛 𝑝𝑒𝑟𝑖𝑜𝑑 = 365 𝑥 𝑆𝑎𝑙𝑒𝑠 𝑜𝑛 𝑎𝑐𝑐𝑜𝑢𝑛𝑡 3. Average payment period 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝐴𝑃 𝐵𝑎𝑙𝑎𝑛𝑐𝑒 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑝𝑎𝑦𝑚𝑒𝑛𝑡 𝑝𝑒𝑟𝑖𝑜𝑑 = 365 𝑥 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑠𝑜𝑙𝑑 The actual cash conversion cycle can be compared with the targeted or theoretical cash conversion cycle, with the overall objective of reducing the CCC. Why reduce CCC? Reducing CCC would free up the cost of funds in the working capital. A longer CCC requires more financial resources, so it is in the management's best interest to reduce the CCC as much as possible. The following options may be considered to reduce CCC: 1. Shorten the inventory conversion cycle by reducing the waiting time between production or more efficient production systems (Just-in-time). Lower inventory levels, however, may lead to delays in fulfilling customer orders. 05 Handout 1 *Property of STI  [email protected] Page 2 of 6  BM2305 2. Delay payment to suppliers at the expense of loss of discounts and supplier confidence. 3. Reduce credit period given to customers, which may mean offering discounts or stricter credit- granting policy, which may also lead to loss of customers. Management must carefully consider these decisions, weighing the cost and benefit. Illustration: The XYZ Company’s partial balance sheet and income statement will illustrate the computation of the total cash conversion cycle for the year 20X2. XYZ Company Balance Sheet December 20X2 and 20X1 Assets 20X2 20X1 Cash and Cash Equivalents P3,722,100 P3,778,700 Accounts Receivable 5,258,300 4,582,100 Inventory 1,302,703 1,194,378 Prepaid Expenses 5,926,850 6,433,800 Total Current Assets P16,209,953 P15,988,978 Land 11,843,800 10,521,350 Buildings 17,250,050 15,250,300 Leasehold Improvements 27,875,200 22,985,550 Equipment 1,264,946 1,118,210 Total Noncurrent Assets P58,233,996 P49,875,410 Total Assets P74,443,949 P65,864,388 Accounts Payable 1,240,926 1,152,764 Total Current Liabilities P1,240,926 P1,152,764 Bonds Payable 6,438,759 5,428,115 Total Noncurrent Liabilities P6,438,759 P5,428,115 Total Liabilities P7,679,685 P6,580,879 XYZ Company Income Statement For the years ended December 31, 20X2 and 20X1 20X2 20X1 Sales (all on account) P21,039,000 P16,117,600 Cost of Goods Sold 12,665,500 10,154,100 Gross Profit P8,373,500 P5,963,500 Selling Expenses 2,987,550 2,224,250 Administrative Expenses 1,893,500 1,418,350 Total Expenses 4,881,050 3,642,600 Income before Taxes 3,492,450 2,320,900 Income Taxes 649,600 475,800 Net Income P2,842,850 P1,845,100 05 Handout 1 *Property of STI  [email protected] Page 3 of 6  BM2305 1. Inventory Conversion Period = 365 X Ave. Inventory Cost of Goods Sold 365 X P1,248,541 P12,665,500 = 36 days 2. Average Collection Period = 365 X Ave. AR Balance Sales on Account 365 X P4,920,200 P21,039,000 = 85 days 3. Average Payment Period = 365 X Ave. AP Balance Cost of Goods Sold 365 X P1,196,845 P12,665,500 = 34 days 4. Cash Conversion Cycle = Inventory + Average - Average Conversion Period Collection Period Payment Period = 36 days + 85 days - 34 days = 87 days XYZ Company collects cash in 87 days from the time the inventory is sold to the customer. Short-term Financing (Brigham, 2020) A company's current assets can be further classified into permanent current assets (the minimum levels of inventory and receivables) and fluctuating current assets, whose balances may vary from period to period. A moderate policy on working capital management will match fluctuating current assets with short-term financing, while permanent current and noncurrent assets will be matched by long-term funding. Trade payables Obtaining credit terms from suppliers is normal practice and may be considered a form of interest-free borrowing. However, the discount for early payment would be lost. Hence, the company must consider the value of the discount and the length of the terms provided. They must compare this with the cost of capital to determine whether or not it is worthwhile to pay the supplier early or to forego the discount but pay much later. 05 Handout 1 *Property of STI  [email protected] Page 4 of 6  BM2305 Discounting of Post-dated checks (PDCs) A company may sell its PDCs at a discount to the bank to enable it to receive cash beforehand. Bank loans Bank loans are the usual source of short-term and long-term financing. A bank loan stipulates the interest and the terms of payment. Hence, making budgeting more straightforward and more predictable. It is recommended for a one-time need for financing. Credit line This type of working capital loan offered by a bank will be available to the company for drawing within a year. It is recommended when the company has a recurring need for financing to meet a series of funding requirements to finance its working capital. Export Finance Foreign trade may raise special financing problems due to the length of time of shipments due to delays, complexity in paperwork, and customs clearances. Sellers (exporters) usually want to receive payment as early as possible. An exporter can accomplish this by insisting on full payment before shipping the orders. However, the buyers might need credit terms. There are several ways to address this: 1. Bills of exchange 2. Export factoring 3. Forfaiting 4. Documentary credits (Letters of Credit) Cost of Capital (Brigham, 2020) Companies need capital to perform market research, develop new products, and acquire machinery, manufacturing facilities, and information technology infrastructure to expand. When evaluating capital budgeting decisions, the cost of capital is useful in assessing whether it is worth investing in a project, given the relevant costs and benefits it will provide. A decision is prudent if a company invests in a project that generates more value than the cost of capital. The cost of capital represents the minimum rate of return that a company must earn before generating value for the company. This minimum rate also called the hurdle rate, represents the cost of funds. Raising funds has a cost, whether obtained using debt (loans) or equity (issuance of share capital). Most companies use a combination of debt and equity to finance their funding requirements. Hence, the cost of capital is the weighted average of the company’s cost of debt and equity. It is also called the weighted average cost of capital (WACC). 𝑊𝐴𝐶𝐶 = (% 𝑜𝑓 𝑑𝑒𝑏𝑡) 𝑥 (𝑐𝑜𝑠𝑡 𝑜𝑓 𝑑𝑒𝑏𝑡)𝑥 (1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒) + (% 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘)𝑥 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑝𝑟𝑒𝑓𝑒𝑟𝑟𝑒𝑑 𝑠𝑡𝑜𝑐𝑘) + (% 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘)𝑥 (𝐶𝑜𝑠𝑡 𝑜𝑓 𝑐𝑜𝑚𝑚𝑜𝑛 𝑠𝑡𝑜𝑐𝑘) A Financial Management course extensively covers computing for the cost of capital (WACC). In Management Reporting, the focus is on the applications of cost of capital in recommending management decisions. 05 Handout 1 *Property of STI  [email protected] Page 5 of 6  BM2305 Illustration: STI Company has the following capital structure and costs of capital. Capital Structure Costs of Capital Debt 45% After-Tax Cost of Debt 6% Preference Shares 2% Cost of Preference Shares 10.3% Ordinary Shares 53% Cost of Ordinary Shares 13.5% Computation of WACC: WACC = Cost of Debt + Cost of Preference Shares + Cost of Ordinary Shares = (45% x 6%) + (2% x 10.3%) + (53% x 13.5%) = 2.7% + 0.21% + 7.16% = 10.07% The Weighted Average Cost of Capital, as computed, is 10.07%. The capital structure percentages (45%, 2%, and 53%) represent the proportions of the debt or equity out of the total capital structure. References BPP Learning Media. (2021). CIMA Operational Paper. Retrieved from www.bpp.com: https://www.bpp.com/courses/accountancy-and-tax/professional-qualifications/cima/operational Brigham, E. (2020). Financial Management: Theory and Practice. Cengage. 05 Handout 1 *Property of STI  [email protected] Page 6 of 6