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TAITA TAVETA UNIVERSITY
DEPARTMENT OF ACCOUNTING AND FINANCE
FINANCIAL MANAGEMENT
ASSIGNMENT.
QUESTION ONE
A local company XYZ ltd. Has a capital structure of KShs. 9,600, 000 composed
of ordinary share capital, preference shares ,bank Loan and Debentures as
shown below.
Source of capital Amount
Ordinary shares capital (par value Shs. 20) 4,800,
8% preference share capital (par Value 12) 1,920,
18% Bank Loan 1,680,
20% Debenture(par value shs. 90) 1,200,
The market price of the company securities is given as below:
Source of Capital MPS(Shs)
Ordinary Shares 32.
8% preference shares 15.
20% Debenture 90.
The company has maintained payment of ordinary share dividend of Kshs. 4
per share and this is expected to grow at a constant rate into perpetuity. The
company has a policy of a constant payout ratio of 60% and a return on equity
of 12%. The floatation costs on ordinary shares and preference shares is Shs.
4.00 and Shs. 2.00 respectively. Assuming a tax rate of 40%.
Required
a) Determine the weighted average cost of capital (WACC) for the
company. (07 Marks)
b) “In uncertain world in which verbal statements can be ignored or
misinterpreted, dividend action does provide a clear cut means of
making a statement that speaks louder than one thousand words”
Explain these statement using relevant examples. (08 Marks)
QUESTION TWO
Discuss the MM capital structure theory theory highlighting its assumptions
and its prepositions I & II. (15 Marks)
CHAPTER EIGHT
WORKING CAPITAL MANAGEMENT
6.1 Introduction Working capital is a financial metric which represents the amount of day-by-day operating liquidity available to a business. Is the companies’ investment- current assets such as cash in hand and at bank, short term securities like treasury bonds, debtors, stock (excluding obsolete and slow moving stock and damaged stocks), prepayments, bills of exchange in favour of the company etc. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus current liabilities. A company can be endowed with assets and profitability, but short of liquidity, if these assets cannot readily be converted into cash. The firm’s balance sheet provides information about the structure of the firm’s investments on the one hand and the structure of its financing sources on other hand. The structures chosen should consistently lead to the maximization of the value of the owner’s investment in the firm. Important components of the firm’s financial structure include the level of investment in current assets and the extent of current liability financing. The goal of short-term financial management is to manage each of the firm’s current assets (inventory, accounts receivable, cash, and marketable securities) and current liabilities (accounts payable, accruals and notes payable) to achieve a balance between profitability and risk that contributes positively to the firm’s value. This chapter does not discuss the optimal level of current assets and current liabilities that a firm should have. That issue is unresolved in the financial literature. Here we first use net working capital to consider the basic relationship between current assets and current liabilities and then use the cash conversion cycle to consider the key aspects of current asset management.
be avoided. Dangers of holding excessive working capital It ties up the company’s funds which should have otherwise been invested elsewhere to earn a return for the company. Excessive working capital may lead to speculative profits due to high levels of debtors, stock and other receivables. This may lead the management to pursue a liberal dividend policy which may affect liquidity of the company. High levels of working capital may lead to misuse and theft (pilferage) of working capital items like stock, which will amount to big loss of the part of the company. Excessive working capital increase the company’s holding costs like storage/warehousing charges- This reduces co. profits Excessive working capital may lead to liberal credit policy on the part of the company and this will increase the costs of bad debts and opportunity costs. Dangers of holding inadequate working capital The company may experience financial problems and in the extreme, it may be unable to meet its obligations as and when they fall due. This may lead to cut-off of credit facilities from creditors. Interruption of company’s operations hence reduction in profits of stocks outs and low cash balance levels which facilitate day to day operations. Such a situation can lead to loss of sales, this goodwill which may reduce the company’s profits and market share in the industry in the long run. Inadequate working capital increase the company’s costs such as salaries paid to employees who are underutilized, wear and tear of idle machines etc. It may lead to windows dressing- showing fictitious working capital items to impress creditors. This situation can embarrass the company if it cannot meet its obligations as and when they fall due. Gross and Net working capital Gross working capital- Company’s investment is company assets such as debtors stock,
receivables, Prepayments and cash at hand and at bank. Net working capital- is the difference between the company’s investment in current assets and current liabilities i.e. (current assets – current liabilities). (Current liabilities e.g. creditors, overdraft, proposed dividends, accrual, provision for taxation etc.). 6.3 The volume of current assets required The volume of current assets required will depend on the nature of the company’s business. E.g., a manufacturing company may require more stocks than a company in a service industry. As the volume of output by a company increases, the volume of current assets required will also increase. Companies that have high inventory turns and do business on a cash basis (such as a grocery store) need very little working capital. These types of businesses raise money every time they open their doors, then turn around and plough that money back into inventory to increase sales. Since cash is generated so quickly, managements can simply stock pile the proceeds from their daily sales for a short period of time if a financial crisis arises. Since cash can be raised so quickly, there is no need to have a large amount of working capital available. A company that makes heavy machinery is a completely different story. Because these types of businesses are selling expensive items on a long-term payment basis, they can't raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise money for short-term financial crises (by the time it is sold, it may be too late). It's easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties. Given efficient stock holding, debt collection procedure and cash management in working capital investment, there’s still a certain degree of choice in the total volume of C.A required to meet output requirements. Policies of low stock holdings levels, tight credit and minimum cash holdings may be contrasted with policies of high stocks ( to allow for safety /buffer stocks) easier credit and sizeable cash holdings ( e.g. for precautionary measures)
Prices of raw materials for manufacture firms and finished goods for trading firms will affect its working capital needs. If prices of such commodities change abruptly, the firms will tend to hold high levels of working capital. So as to finance increased prices of inputs, sometimes they may hold high levels of stocks for speculative reasons i.e. to benefit in case prices of such goods change in its favour. The opposite is also true. Profitability of a firm A firm with impressive operating trends may not have high-level needs of working capital, as their activities will be self-financing than firm with low profit making. Also, appropriation of profit into such items as tax, div etc will call for high levels of ease to settle these as and when they fall due. Growth stage of a firm A firm passes through 3 stages. Youthful mature and old age stages working capital requirements are different for each of these stages. E.g. a firm in its early stages of its development will need to accumulate large amounts of working capital to support heavy investment in fixed assets. This decrease as the firm grows to maturity. Economic changes / trends Usually demand for firm, goods changes with seasons increasing with peak seasons. Under such situations a firm will need a high investment in stock of raw materials or finished goods stock The management of cash, stocks, debtors and creditors Cash budgets The main purpose of preparing cash budgets are:- (i) To plan /forecast the organizations cash needs or cash surpluses over the budget period (ii) To monitor actual cash inflows/outflows and balances (iii) To identify cash flow problems when they arise so as to identify their causes and take measures to deal with them. How do cash problems arise?
(i) Making losses (ii) Inflation- during inflation, firms need high levels of cash to replace used up assets and worn out assets. (iii) Growth - a growing firm needs to acquire more fixed assets and to support higher amount of stock and debtors on order to support the growth. (iv) Seasonal loss- When a firm has seasonal or cyclical sales, it may have cash flow difficulties at certain times of the year, when (i) Cash inflows are low but ii) cash outflows are high perhaps coz the business is building up its stocks for the next peak sales period. (v) One off items of expenditure There might occasionally be a single non- recovering item of expenditure that creates cash flow problems, such as. a) Repayment of loan capital on maturity of the debt b) The purchase of exceptionally expensive item. 6.5 Methods of easing cash shortages (i) Postponing capital expenditure Some capital expenditure items are more important and urgent than others. It’s imprudent to postpone expenditure on fixes assets which are needed for development and growth of the business. However, some capital expenditure is routine and might be postponable without serious consequences. E.g. routine replacement of motor vehicles. (ii) Accelerating cash inflows, which would otherwise be expected in a later period e.g. press debtors for earlier payment (however this may lead to loss of goodwill and problems with customers). Giving discounts for earlier payment can be a better method. (iii) Reversing past investment decision by selling off assets previous acquired. Some assets are less crucial to a business the others and so if the cash flow problems are severer the option of selling off investment / property might be considered. (iv) Negotiating a reduction in cash outflow , so as to postpone/even reduce payment. This can be done in several ways such as:- a) Negotiating rescheduled loan repayment with a bank
6.7 Strategies for managing the cash conversion cycle A positive cash conversion cycle, means the firm must use negotiated liabilities (such as bank loans) to support its operating assets. Negotiated liabilities carry an explicit cost, so the firm benefits by minimizing their use in supporting operating assets. Simply stated, the goals are to minimize the length of the cash conversion cycle, which minimizes negotiated liabilities. This goal can be realized through application of the following strategies.
- Turn over inventory as quick as possible without stock outs that result in lost sales.
- Collect accounts receivable as quick as possible without losing sales from high-pressure collection techniques.
- Manage mail, processing, and clearing time to reduce them when collecting from customers and to increase them when paying suppliers.
- Pay accounts payable as slowly as possible without damaging the firm’s credit rating. 6.7 Management of Stocks The first component of the cash conversion cycle is the average age of inventory. The objective for managing inventory, as noted earlier, is to turn over inventory as quick as possible without losing sales from stock outs. The financial manager tends to act as an advisor or “watchdog” in matters concerning inventory; he or she does not have direct control over inventory but does provide input to the inventory management process. Reasons for inventory control The aim of inventory control system is to minimize the costs of having stock whilst at the same time maintaining a certain level of customer service. There are disadvantages of having either too little stock or too much. Differing viewpoints about inventory level Differing viewpoints about appropriate inventory levels commonly exist among firms’ finance, marketing, manufacturing and purchasing managers. Each views inventory levels in light of his or her own objectives. The financial manager’s general disposition towards inventory levels is to keep them low, to ensure that the firm’s money is not being unwisely invested in excess resources. The marketing manager, on the other hand, would like to have large inventories of the firms finished products. This would ensure that all orders could be filled quickly, eliminating the need to backorders due to stock outs.
The manufacturing managers’ major responsibility is to implement the production plan so that it results in the desired amount of finished goods of acceptable quality at a low cost. In fulfilling this role, the manufacturing manager would keep raw materials inventories high to avoid production delays. He or she also would favour large production runs for the sake of lower unit production costs, which would result in high finished goods inventories. The purchasing manager is concerned solely with the raw materials inventories. He or she must have on hand, in the correct quantities at the desired times and at a favourable price, whatever raw materials are required by production. Without proper control, in an effort to get quantity discounts or in anticipation of rising prices or a shortage of certain materials, the purchasing manager may purchase larger quantities of resources than are actually needed at the time. Some business attempt to control stocks on a scientific basis by considering the financial effects of each of the interests outlined above and balancing the costs of stock shortages against those of stock holdings. The scientific control of stocks may be analyzed into 3 separate problems. a) The use of economic order quantity (EOQ) model to decide the optimum order size for stocks which would minimize the costs of ordering stocks plus stockholdings costs. b) The offer of discounts for bulk purchase. In this situation, it may be cheaper to buy stocks in large sizes in order to take advantages of discounts c) Uncertainty in the demand for stocks and / or the supply lead-time. In this situation, a company may decide to hold buffer sticks (thereby increasing its working capital investment) in order to reduce or eliminate the possibility of stock-outs. Common Techniques for Managing Inventory (Inventory Models) The purpose of an inventory model is to help management to decide how to plan and control efficiently, to minimize costs. Models may therefore estimate:- a) What is the optimal order size for particular item b) Whether the offer of a bulk purchase discount for large orders should be accepted c) What is the optima re-order level of any item of stock d) How frequently orders should be placed and therefore what the stock turnover period should be Deterministic Model (EOQ Model) It’s the one that all the parameters are known with certainty. In particular, the rate of demand,
Total Cost = (C x D/Q) + h x Q/2) Because the EOQ is defined as the order quantity that minimizes the total cost function, we must solve the total cost function for the EOQ. The resulting equation is: EOQ = √ 2 x D x C h Where = Q is the Economic order quantity C is the cost of making one order D is the usage in units in one year (annual demand) h is the holding cost per unit of stock for one year Although the EOQ model has weaknesses, it is certainly better than subjective decision making. Despite the fact that use of the EOQ model is outside the control of the financial manager, the financial manager must be aware of its utility and must provide k certain inputs, specifically with respect to inventory carrying cost. Record point- Once the firm has determined its economic order quantity; it must determine when to place an order. The reorder point reflects the firm’s daily usage of the inventory item and the number of days needed to place and receive an order. Assuming that inventory is used at a constant rate. The formula for the reorder point is Recorder point = days of lead time x daily usage For example, if a firm knows it takes 3 days to place and receive an order, and if it uses 15 units per day of the inventory item, then the reorder point is 45 units of inventory (3 days x 15 units/day). Thus, as soon as the item’s inventory level falls to the reorder point (45 units, in this case) an order will be placed at the items EOQ. If the estimates of lead time and usage are correct, then the order will arrive exactly as the inventory level reaches zero. However, lead times and usage rates are not precise, so most firms hold safety stock (extra inventory) to prevent stock outs of important items. The EQO or EBQ is the optimal ordering quantity for an item of stock which will minimize costs. The order quantity Q, which will minimize these the total costs, assuming no stock-out
costs, no buffer stocks and no bulk purchase discounts is = √2cd h Illustration The demand for a commodity is 40,000 p.a at a steady rate. It costs sh 200 to place an order and sh 4 to hold a unit for a year. Find the batch size to minimize inventory costs, the number of orders placed per year and the length of the inventory cycle. Solution Q = √2CD = √ 2 x 200 x 40000 h 4 = √4,000,000 = 2,000units This means that there will be 40,000 = 20 orders placed each year, so that the inventory cycle in once every 2,000 (52- 20) = 2.6 weeks Total costs will be = Holding costs + ordering costs = Qh + CD 2 Q = 20 x sh 200 + 200 x 4 2 = 400 + 400 = sh 800 p.a Stochastic Models It’s the one which the supply lead time or the rate of demand for an item is not known with certainty, because it’s not constant. However, the demand or lead-time follows a known
the materials arrive. Likewise, a JIT system requires high quality parts from suppliers. When quality problems arise, production must be stopped until the problems are solved. The goal of the JIT system is manufacturing efficiency. It uses inventory as a tool for attaining efficiency by emphasizing quality of the materials used and their timely delivery. When JIT is working properly, it forces process in efficiencies to surface. 6.8 Management of Debtors (Credit Management) In deciding policy for the optimum level of total debtors, there is a trade off between extending credit so as to increase sales and hence profit and on the other hand the interest and admin cost of carrying debtors and cost of bad debts The following factors should be considered by management when formulating a policy for credit control:- a) The administrative costs of debt collection b) The procedures for controlling credit to individual customers and also debt collection c) The amount of extra capital required to finance an extension of total credit d) The cost of the additional finance required for any increase in the volume of debtors (or savings from a reduction in debtors). This cost might be bank overdraft interest or cost of long term funds( e.g. loan stock or equity) e) Any savings or additional expenses in operating the credit policy ( e.g. the extra work and extra chasing of slow payers) f) The ways in which credit policy can be implemented e.g. credit can be eased by giving debtors a longer period in which to settle their account. The cost of credit would be resulting increase in debtors a discount can be offered for early payment. The cost of the credit policy would then be the cost of the discounts. g) The effect of easily credit might be to (i) Encourage a higher proportion of bad debts (ii) Increase sales volume
Debt collection policy The overall debt collection policy of the firm should be such that the admin costs and other costs incurred in debt collection should not exceed the benefits received from incurring those costs. Some extra spending on debt collection procedures might a) Reduce bad debts losses and b) Reduce the average collection period and therefore cost of the investment in debtors Beyond a certain level of spending, however, additional expenditure or debt collection would not have a sufficiently great effect on reducing losses or the average collection period to justify the extra administrative. Credit control In managing debtors, the credit worthiness of customers needs to be assessed. The risks and costs of a customer defaulting will need to be balanced against the profitability of the business provided by that customer. Involves the initial investigation of potential credit customers and the continuing control of outstanding accounts. The following are the main things to note- a) New customers should give two goods references including one from a bank before being granted credit terms b) Credit rating might be done through evident rating agency c) A new customer’s credit limit should be fixed at a low level and only increases if his payment record subsequently warrants it. d) For large value customers, a file should be maintained for any available financial information about the customers. The file should be reviewed regularly. e) Press comments may give update information about what a company is currently doing f) The department of trade and industry can help and advice on potential overseas trade customers. g) The credit limit for existing customers should be periodically reviewed, but should only be raised at the request of the customers and if his credit rating is good.
iii) Commercial papers etc. Certificate Of Deposit (CD) Is a security issued by a bank, acknowledging that a certain amount of sterling has been deposited with it for a certain period of time (Usually, short term) The CD is issued to the depositor and attracts a stated amount of interest. The depositor will be another bank or a large commercial organization CDs are negotiable and traded on the money markets and if a CD holder wishes to obtain immediate cash, he can sell the CD on the market at any time. This 2 nd hand market in CDs makes them attractive, flexible investment for organization with excess cash. Treasury Bills Are issued weekly by the government to finance short term cash deficiencies in the governments expenditure programme. They are IOUs issued by the government giving a promise to pay a certain amount to their holder on maturity. After which the holder is paid the full value of the bill The Treasury bill doesn’t pay interest but the purchase price of a treasury bill is less than their face value i.e. the amount of the debt that the government will eventually pay on maturity. There is thus an n implied rate of interest in the price at which the bills are traded. The 2nd^ hand value of the Treasury bill in the discount market (the money market in which they are traded varies with comment interest rates but will never exceed the face value of the bill itself. Commercial papers Commercial papers is a special financial instruments consists of unsecured promissory notes with a fixed maturity, typically between 7 days- 3 months (A promissory note is a written promise to pay) which is issued in bearer form (and so is negotiable) and on a discount basis (like a treasury bill, they are issued at a discount and so the rate of interest on the commercial paper is implicit within its sales value.) 6.11 Factoring and invoice discounting Factoring A factor is doer or transactor of business for another, but a factoring organization specializes in
trade debts, and manages the debts of a client (business customer) in the client’s behalf. There are 3 main aspects of factoring, which are: (i) Administration of clients invoicing, sales accounting and debt collection service (ii) Credit protection for the clients debts, whereby the factor takes over the risk of loss from bad debts and so insure the client against such losses (iii) Making payments to the client is advance of collecting the debts also called ( factor financing). A factor services are intended to assist companies that are having problem with either the management r financing of their debtors. Invoice discounting Related to factoring many factors will provide an invoice discounting service It’s the purchase of a selection of invoices at a discount the invoice discounters doesn’t take over the administration of the client’s sales ledger and the arrangement is purely for the advance of cash. A client should only want to have some invoices discounted when he has a temporary cash shortage and so invoice discounting tends to be a one-off deal. The main functions of cash budget one to (i) Ensure that cash is available for revenue exp (ii) Indicate when, where and how much cash will be needed and whether this is permanent or temporary (iii) Preserve liquidity throughout the year
(iv) Reveal surplus cash for investment or expansion of facilities
