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Working Capital and the Financing Decision

1. Introduction to Working Capital Management
   1. Definition. Working capital management involves the financing and management of the Working Capital Management of the firm( Critical Concept ). See Slide Working Capital Management (47.0K) .
   2. Asset Growth. Over time, a firm's assets will grow as the firm expands. The firm wants as many assets as possible, such as inventory, to be ____( Critical Concept ). But, for a growing firm, there are also temporary current assets and permanent current assets. Temporary current assets can be defined as ____( Key Term ) Permanent current assets , on the other hand, can be defined as ____ ( Key Term ). A firm's operating cycle is generally one year. Examples of temporary current assets might be seasonal buildup of inventory for firms whose products are in more demand at certain times of the year than others. The level of temporary current assets has peaks and valleys during the firm's operating cycle. The retail industry and the Christmas sales season is an example. Check out this article to read about the difficulties firms have in financing seasonal buildups of inventory. Permanent current assets grow over the firm's life. They may include some level of inventory that the firm keeps on hand as safety stock or a certain level of accounts receivable that the firm always has. See Slide 10 (36.0K)
   3. Matching Sales and Production. Current assets of all types fluctuate during the firm's operating cycle more than fixed assets like plant and equipment. Some firms use ____ to smooth production schedules and use manpower and equipment efficiently at a lower cost( Critical Concept ). Other firms attempt to match sales and production requirements across time periods.
2. Patterns of Financing
   1. Using External Funds to Finance Assets. The financial manager's selection of external funds to finance asset buildups is an important decision. In the simplest case, short-term sources of financing should be used to finance all current assets and long-term sources of financing should be used to finance all assets with maturities of more than one year. An example of short term financing would be ____, while an example of long-term financing would be ____( Critical Concept ). Take a look at this article on sources of short-term financing. This article talks about a practical example of a company that obtained long-term financing for some of its fixed assets.
   2. Using Short-Term Financing. In a normal economy, short-term financing is cheaper than long-term financing. However, with short-term financing, you run the risk of having to pay back the debt. Many managers try to use short-term financing for their self-liquidating and temporary current assets. In some cases, short-term financing is appropriate for permanent assets.
   3. Using Long-Term Financing. For fixed assets and some permanent assets, long term financing, such as bonds or common stock, is appropriate.
   4. Goal of the Working Capital Manager. Management's goal regarding working capital should be to ____( Critical Concept ). The decision of management regarding whether to use long term or short term financing is also based, in part, on the term structure of interest rates. The term structure of interest rates shows ________( Key Term ).
3. Term Structure of Interest Rates
   1. The Yield Curve. The term structure of interest rates is depicted graphically by a yield curve. This yield curve simply shows the relationship between interest rates and time to maturity.Three theories describe the shape of the yield curve and the term structure of interest rates. See Slide Term Structure of Interest Rates (62.0K)
   2. Liquidity Premium Theory. The liquidity premium theory states that ________( Critical Concept ). This theory is based on the fact that investors must be compensated for bearing the increased risk of holding long-term securities.
   3. Segmentation Theory. The segmentation theory states that different types of securities are divided into market segments based on their buyers needs. Commercial banks, for example, prefer short-term securities as most of their lending is short term. Savings and loans prefer ____ securities and pension funds prefer ____ securities( Critical Concept ). Further, this theory says that the changing needs of these investors impact interest rates.
   4. Expectations Hypothesis. This is the third theory describing the term structure of interest rates. The expectations hypothesis explains that long-term interest rates are a function of short-term rates. If long-term rates are higher than short-term rates, the market is essentially saying that investors expect interest rates to rise in the long run. All three of these theories explain, to some extent, term structure of interest rates.
4. Determination of a Financing Plan for Working Capital
   1. Managers must determine the mix of long term and short term financing to use to manage their working capital. Whether to use short-term or long-term financing is a function of both the level of interest rates and the firm's own risk preference. If a firm were risk-averse, such as a commercial bank, it would likely have high liquidity and low risk. This type of firm would also have low returns. If a firm is more of a risk-taker, then it would have low liquidity and higher risk; thus, higher return.
   2. Asset Financing Plans. In general, the following relationships should hold.
      1. Short-term Financing with Low Liquidity ____ risk but ____ potential return. .( Critical Concept )
      2. Short-term Financing with High Liquidity. Moderate risk with moderate return.
      3. Long-term Financing with Low Liquidity. Moderate risk with moderate return.
      4. Long-term Financing with High Liquidity. ____ risk but ____ potential return. .( Critical Concept ) See Slide Working Capital Financing Plans (60.0K)