Investments in Non-Cash Working Capital

ASSIGNMENT-1

Chapter 13, 14

Submitted by:

Arihant Jain (16PGP227)

Sai Dayitva Gaur (16PGP230)

Monika Vaswani (16PGP031)

Garima Bisht (16PGP019)

      Chapter 13: Investments in Non-cash Working Capital

                    CC 13.1:What are the sources of economies of scale in working capital management?

                     Ans - There are several potential economies of scale. There are fixed costs associated with managing inventory or collecting on accounts receivable. As these items increase, the costs will decrease as a percent of revenues. Firms may also be able to diversify their risks more when they grant more credit to more customers, and to keep lower inventories as their revenues increase.

                     Financial economies of scale means the company has cheap access to capital. A larger company can get funded from the stock market with an initial public offering. Big firms usually have higher credit ratings. That allows them to get lower interest rates on their bonds.

                     CC 13.2:In the above example, how would your answer change if changing working capital did not affect discount rates?

                      Ans -If the cost of capital did not decrease as working capital increased, the optimal working capital ratio will be lower .The benefits of lowering working capital would be unaffected, but the costs would be lower.

                     CC 13.3:Estimate the average inventory as a function of the carrying cost and the ordering cost. As interest rates increase, what will be the effect be on optimal average inventory?

                      Ans - When interest rates increase, the carrying cost (for inventory) will increase. This will make the optimal order quantity and the optimal inventory lower.

                     CC 13.4: As long as the firm charges a higher interest rate on credit sales than its cost of capital, the firm value will increase with credit sales. Do you agree? Why or why not?

                      Ans -Not necessarily. The sales might come with a very high risk of default by customers. The cost of bad debts can result in lower firm value.

Chapter 14: Investments in Cash and Marketable Securities

                     CC 14.1: As the variance in cash balances increases, what would you anticipate happening to the upper and lower bounds in this model?

                     Ans- As the variance in cash balances increases, the upper bound will become higher and the lower bound lower still. The spread will widen.

                     CC 14.2:The returns on investments shown in figure 14.2 are at a point in time. Would you expect the differences in returns between these investments to change as the level of interest rates rise? Why or why not?

                     Ans- Probably. The most likely scenario is that the spreads will widen as interest rates increase. While the empirical evidence for this is weak in the United States, interest rates have generally moved within a fairly narrow range in the U.S. In countries where interest rates have risen much more dramatically, we see the spreads on riskier investments increasing with rates.

                     CC 14.3: Assume that you are analyzing a firm with very large investments in the equity of other firms, relative to the rest of the firms in the industry. How would you determine whether these investments were creating or destroying value for the firm?

                     Ans- We will compute the excess returns earned by the firm relative to the overall market. And then compute the excess returns earned by the sector (the rest of the firms in the industry) relative to the overall market. The difference between the two excess returns can then be attributed to the investments made by this firm in other firms. (This test does assume that everything else about these firms is the same)

Chapter 13: Investments in Non-cash Working Capital

CT 13.1: Under what conditions would you use the broader measure of working capital (current assets — current liabilities) in estimating cash flows?

Ans: If cash were necessary for the day-to-day operations of the firm, and short-term debt is not counted as part of debt while computing the cost of capital, I would use the broader definition of working capital.

CT 13.2: As inflation and interest rates rise, will the effect of working capital changes on net present value increase or decrease? Explain.

Ans: It will increase. The cash outflows from working capital occur early (as the project is initiated and grows) while the cash inflows occur late (when the working capital is salvaged). As interest rates increase, the present value effect will increase and become more negative.

CT 13.3: Manufacturing firms tend to have high working capital due to inventory needs at every stage in the process. If you were the manufacturer of high-priced goods, would you expect working capital needs to be higher or lower than for a manufacturer of low-priced goods?

Ans: I would expect it to be higher for two reasons. First, the inventory that I have will have a higher cost, because I sell more high-priced goods. Second, the turnover ratios are likely to be lower, since I will sell than a low-priced good manufacturer.

CT 13.4: Assume that you are a retailer who carries hundreds of items in your store. What are some of the factors you would consider in trying to decide which items you should reduce your inventory of?

Ans: I would reduce the inventory on those items where the cost of lost sales is likely to be lowest. Thus, if there are items that are seldom asked for or where I am the sole distributor, I would be more inclined to reduce inventory on these items.