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Financial Management (Part 2 - Financing)

by Dr.Sahanon Tungbenchasirikul

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Copyrights With regard to Copyright Act B.E. 2537 (1994): • All elements in the presentation (i.e., words, clauses, sentences, pictures, symbols, tables, and trademarks) are obtained from textbooks, academic journals, websites, and other sources of knowledge. These have been claimed to have copyrights. • The presentation is solely used for academic, not for any commercial, purposes.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Part 2 - Financing • Capital Structure Decision • Debt Financing • Equity Financing • Dividend Decision • Working Capital Management

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Capital Structure Decision

by Dr.Sahanon Tungbenchasirikul

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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The Holistic Model of Corporate Plan Corporate Plan The Firm’s Financial Needs

Profit/Loss Statement Vision, Mission Value Add

Goals & Strategies Competitive Advantages

Total Costs

Balance Sheet Current Liabilities Assets (1)

• Overall Budget Requirements • Overall Manpower Requirements • Key Project Investments • Key Business Support Requirements • Financial Projections

Creditors Sources of Funds

(1) Fixed Assets

Equities

(2)

(3)

Cash Flow Statement

Shareholders Remuneration

• Operating cash flow

• Retained earning

• Investing cash flow

• Dividend

• Financing cash flow

• Debt repayment

Financial Management by Dr. Sahanon Tungbenchasirikul © Source: Sahanon Tungbenchasirikul ©

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Capital Structure Decision •

A Firm’s Optimal Capital Structure is the mix of debt and equity that is supposed to maximize the shareholders’ wealth (stock price) over the long-term.

Senior Executives (e.g. Chairman of the Board, President, CEO, CFO, Financial Controller, Financial Manager) shall have a specific target capital structure in their minds, even though such target might change over time.

Capital Structure vary across firms within the same industry and across different industries (as we shall see in this chapter).

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Capital Structure Capital Structure Policy involves a trade-off between risk and return: •

Using more debt raises the risk borne by stockholders.

Using more debt generally leads to a higher expected rate of return on equity (i.e. ROE).

Higher risk tends to lower shareholders’ wealth, but a higher expected ROE raises it.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Capital Structure Debt DebtCapital Capital (Business (BusinessLoan) Loan)

Equity EquityCapital Capital (Preferred (Preferred&&Common CommonStocks) Stocks)

Capital Capital Employed Employed Capital employed must be remunerated.

Interests remunerate bankers/creditors.

Financial Management by Dr. Sahanon Tungbenchasirikul Š

Dividends remunerate shareholders.

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Capital Structure The Firm’s Balance Sheet

Capital Structure Liabilities

Debt Capital (Bankers/Creditors)

Total Assets Equities

Equity Capital (Preferred & Common Stockholders)

Total Assets = Liabilities + Equities Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Factors Affect A Firm’s Capital Structure • Business Risk & Financial Risk • Tax Position • Financial Flexibility • Managerial Conservatism or Aggressiveness • Growth Opportunities

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Capital Structure: Business & Financial Risk Business Risk is the risk inherent in the firm’s operations if it used no debt. The greater the firm’s business risk, the lower its optimal debt ratio. Financial Risk is the additional risk placed on the common stockholders as a result of the firm’s decision to use debt.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Capital Structure: Tax Position Tax Position (Benefit). The major reason for using debt is that interest payment is deductible, which lowers the effectives cost of debt. However, if most of a firm’s income is already sheltered from taxes by depreciation tax shields, by interest payment of previous debt, or by tax loss carry-forwards, the firm’s tax payment will be low. Hence, additional debt will not be at great tax benefit effects as it should be.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Capital Structure: Financial Flexibility Financial Flexibility. It is the ability to raise capital on reasonable terms under adverse conditions. Corporate treasurers (CFO, Financial Controller, Financial Manager) understand that a steady supply of capital is necessary for stable operations, which is crucial for long-term success. On this basis, the future need for funds and the consequences of a fund shortage influence the target capital structure. The greater the future need for funds and the worse the consequences of a fund shortage, the stronger the balance sheet should be (a firm must have good financial discipline reflecting via a good balance sheet). Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Capital Structure: Conservative/Aggressive Managerial Conservatism or Aggressiveness. Some senior financial managers are more aggressive than others, hence, some firms are more inclined to use high proportion of debt in order to boost sales and profits. This factor could significantly affect target capital structure of the firm.

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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6.1 Capital Structure: Growth Opportunities Growth Opportunities. Firms with high sales growth tends to use debt to drive sales and profits. The higher the growth rate, the higher the need for external funding sources. As discussed in chapter 3, a firm’s operating value (Corporate Value) equals the value of its asset-in-place plus its growth opportunities.

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Influencing Factors of Business Risk Business Risk is the risk inherent in the firm’s operations if it used no debt. The greater the firm’s business risk, the lower its optimal debt ratio. Business Risk depends on a number of factors: • Demand variability. • Sales price variability. • Input cost variability. • Ability to adjust output prices for changes in input costs. • Ability to develop new products in a timely, cost-effective manners. • Foreign risk exposure. • Operating leverage. Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Capital Structure: Operating Leverage

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Capital Structure: Operating Leverage

Overall Business Risk

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Financial Risk Summary Financial Risk is the additional risk placed on the common stockholders as a result of the firm’s decision to use debt. The higher the percentage of debt, the riskier the debt. Thus, the higher the interest rate, lenders will charge to compensate risks. On this basis, the use of debt, or financial leverage, concentrates the firm’s business risk on its stockholders. Change in the use of debt will raise ROE or earning per share (EPS).

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Determining Optimal Capital Structure The Optimal Capital Structure shall maximizes the price of the firm’s common stock. This generally needs a debt ratio that maximizes expected earning per share (EPS). To outline the Optimal Capital Structure, senior executives must choose the capital structure that maximizes the firm’s stock price. Since it is difficult to estimate the impact of change in capital structure on stock price, we adopt the corporate valuation model, which displays the value of operations in terms of the present value of future expected cash flow: ∞

FCFt V= ∑ − − − (1) t t = 1 (1 + WACC) Financial Management by Dr. Sahanon Tungbenchasirikul ©

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A Checklist for Capital Structure Decisions •

Sales Stability. A firm, which sales are relatively stable can take more debt than companies with unstable sales. For example, utility companies, which have stable demand, can use more financial leverage.

•

Asset Structure. Firms, which assets are suitable as security for loans, tends to take more debt. For example, real estate companies usually employ high financial leverage since their general-purpose assets (e.g. lands) can be recognized as the good collateral. By contrast, high technological firms (e.g. Hard Disk Drive) usually employ internal funding, since their special-purpose assets are not viewed as good collateral.

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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A Checklist for Capital Structure Decisions •

Operating Leverage. A firm, which has low operating leverage (i.e. a low proportion of fixed assets to run its business), tends to employ financial leverage or keep relatively high D/E ratio (e.g. modern trade firms, commercial banks). By contrast, firms with high operating leverage (i.e. a high proportion of fixed assets to run its business), tends to limit financial leverage or maintain moderate D/E ratio (e.g. petroleum producers, computer electronic producers).

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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A Checklist for Capital Structure Decisions •

Growth Rate. A firm, which continually has a high growth rate for several years, needs more debt to meet investment requirements and expand business operations. By contrast, firms with stable sales tend to conservatively employ internal funding sources (e.g. retained earning, operating cash flow), since their need for new investments and business expansions is low.

Profitability. Firms with very high profit margin or high rate of return on investment tend to adopt less debt. Very profitable firms (e.g. TESCO, CPALL) do not need high external debt.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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A Checklist for Capital Structure Decisions •

Taxes. Interest payment is a tax deducible expense and deductions are most valuable to firms with high tax rates. For example, firms with high operating leverage (e.g. petroleum exploration and production, construction contractors).

Control. The effect of debt versus equity on management’s control position can influence capital structure. If owner holds a majority voting right (common stock holding 50%+) and does not need to raise equity to finance new investments, he/she tends to employ debt. By contrast, if the firm’s financial health is in a dangerous position, issuing and selling new common stocks is supposed to better the firm’s survival potential.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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A Checklist for Capital Structure Decisions •

Management Attitudes. Senior executives (owners) can exercise their judgment about proper capital structure. Some senior executives tend to be more conservative and in turn use less debt. By contrast, aggressive senior executives use more debt in pursuit of higher profits.

Lender and Rating Agency Attitudes. Both lenders and rating agencies can influence the firm’s financial structure. In order to execute new investments and expand business operations, companies, which possess good credit ratings, can easily access to external debt with cheap interest rate.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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A Checklist for Capital Structure Decisions •

Financial Flexibility. Firms often maintain financial flexibility, which implies maintaining a sufficient reserve borrowing capability. A sufficient reserve borrowing capability is judgmental, but clearly displays that firms can secure their sources of funds in both good and bad situation. For example, some public corporations keep low D/E ratio for a long period, and later employ more debt to finance new investments and expand business operations.

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Variations in Capital Structure •

Capital structure varies across firms within the same industry and across different industries.

•

Variations in the use of financial leverage (debt) have been evident in Stock Exchange of Thailand (SET). Some companies remain conservative, using less debt and relying more on internal sources of funds. Others are more aggressive, employing more debt and relying more on external sources of funds. Differences in capital structure indicate that players can form a sensible mix of debt and equity, but also foster their business investments and operations with an appropriate cost of capital (i.e. WACC).

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Capital Structure of Commercial Banks Commercial Bank’s Balance Sheet

Capital Structure Current

Liabilities

Assets Long-term Loan Fixed Assets

Equities

Debt Capital (Depositors & Investors & Lenders) Equity Capital (Preferred & Common Stockholders)

Total Assets = Liabilities + Equities Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Capital Structure of Modern Trade Firms Modern Trade’s Balance Sheet

Capital Structure Current Assets

Fixed Assets

Current Liabilities

Long-term Loan Equities

Debt Capital (Suppliers & Lenders) Equity Capital (Preferred & Common Stockholders)

Total Assets = Liabilities + Equities Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Capital Structure of Manufacturing Firms Manufacturing’s Balance Sheet Current Current

Liabilities

Assets Long-term Loan

Capital Structure Debt Capital (Suppliers & Lenders & Investors)

Fixed Assets Equities

Equity Capital (Preferred & Common Stockholders)

Total Assets = Liabilities + Equities Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Capital Structure of Media Firms Media Firm’s Balance Sheet Current Current Assets

Fixed Assets

Liabilities Long-term Loan

Equities

Capital Structure Debt Capital (Suppliers & Lenders & Investors)

Equity Capital (Preferred & Common Stockholders)

Total Assets = Liabilities + Equities Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Debt and Equity Financing

by Dr.Sahanon Tungbenchasirikul

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Money Market and Capital Market Summary Financial Market

Money Market

Short-term Funding Sources < 1 Year

Debt/Capital Market

Medium and Long-Term Funding Sources > 1 Year

Equity Instruments Debt Instruments (Government)

- Public Company Common Shares

- Maturity Date < 1 Year

- Limited Company Shares

- Treasury Bills, Government Bond with Repurchasing (Repo)

- Preferred Shares or Property Funds

Short-term Debt Instruments (Private)

Long-term Debt Instruments

- Interbank Loan

- Private Bond, Convertible Bond, Long-term Loan, Longterm Government Bond

- Private Repurchasing (Repo)

- Structure Note

- Short-term Loan, BE, PN, OD, LG, LC TR, PC

- Securitization e.g. CDO (Collateralized Debt Obligation)

Derivative Instruments - Swaps, Options, Futures

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Debt Financing Raising Funds via Debt Instruments Primary Market (SEC)

Financial Advisors/ Bond Selling Agent

Bond Selling

Companie s/SOEs

Money (Debt)

Purchasing Bond

Bond Investors

Initial Public Offering (IPO) or Private Placement (PP) Interest Income

Interest Payment

Secondary Market

Commercial Banks

Financial Management by Dr. Sahanon Tungbenchasirikul Š

BEX/ThaiBMA

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Debt Financing Raising Funds: Credit Products Lending Money

Financial Institutions

Credit Products • Short-term Loan • Long-term Loan • Project Loan • Trade Finance • Bridging Loan

Companies

Debt Repayment (Principal & Interest)

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Equity Financing Raising Funds via Equity Instruments Primary Market (SEC)

Companies

Financial Advisors/ Selling Agent

Initial Public Offering (IPO)

Investors

Secondary Market

Security Companies

Financial Management by Dr. Sahanon Tungbenchasirikul Š

SET

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Dividend Decision

by Dr.Sahanon Tungbenchasirikul

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Dividend Decision Dividend policy involves three fundamental issues: •

What fraction of earnings should be distributed?

Should he distribution be in the form of cash dividends or stock repurchases?

Should the firm maintains a steady, stable dividend growth rate?

The optimal dividend policy strikes a balance between current dividends and future growth so as to maximize the firm’s shareholders’ wealth.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Dividend Decision

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Dividend Decision

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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The Impacts of Dividend Decision

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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The Impacts of Dividend Decision

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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The Core Principle of Dividend Payment

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Dividend vs. Capital Gain Target Payout Ratio, which is the percentage of net profit To be paid out as cash dividends, should be based on investors’ preferences for dividends vis-à-vis capital gains: •

Requires the firms to distribute income as cash dividends or

Want to either repurchase stock or keep all net profit with the firm.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Dividend vs. Capital Gain Shareholders’ preference can be considered in terms of the Constant Growth Stock Valuation Model:

D1 P0 = − − − − ( 2) (k s − g ) ks

= required annual rate of return on equity

P0 = the market price of a common stock D1 = annual dividend payment at time 1 g

= expected dividend growth rate or capital gains yield

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Dividend vs. Capital Gain From formula (1), we observe that: • If the company increases the payout ratio (D 1) will cause the stock price (P0) to raise. •If the company pays high dividends, it is likely to be short of capital for future investments. This will cause the stock price to decrease.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Investor Preference Theory 1. Dividend Irrelevance Theory 2. Bird-in-the-Hand Theory 3. Tax Preference Theory 4. Information Content or Signaling Hypothesis 5. Clientele Effect

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Investor Preference Theory Theory Dividend Irrelevance Theory

Key Explanations •

The dividend policy does not affect the required rate of return on equity (ks).

The firm’s value is determined only by its basic earning power and its business risk. The value of the firm depends on the revenue produced by its assets, not on how this income is split between dividends and retained earnings.

Bird-in-the-Hand • Theory

The required rate of return on equity (ks) decreases as the dividend payout is increased because investors are less certain of receiving the capital gains, which are supposed to result from retaining earnings, than they are receiving dividend payments. Investors value a dollar of expected dividends more highly than a dollar of expected capital gains.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Investor Preference Theory Theory Tax Preference Theory

Key Explanations •

Wealthy investors might require the companies to retain and use earning to support new business investment projects and business expansions. Earning growth would presumably lead to stock price increases, and thus lower-taxed capital gains would be substituted for higher-taxed dividends. Taxes are not paid on the gain until a firm’s stocks are sold. Thanks to time value effects, a dollar of taxes paid in the future has a lower effective cost than a dollar paid today. If a firm’s stocks are held by someone until he/she dies, no capital gain taxes are collected on this basis.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Investor Preference Theory Theory Information Content or Signaling Hypothesis

Key Explanations •

An increase in the dividend is often accompanied by an increase in the price of a firm’s stocks. By contrast, a firm’s dividend cut generally induce a firm’s stock price decline. This implies that investors prefer dividends to capital gains. Firms are reluctant to cut dividends and do not raise dividends unless they anticipate higher earnings in the future. A higher – than - expected dividend increase is a signal to investors that the firm’s management forecast good future earnings. By contrast, a firm’s dividend reduction, or a smaller – than - expected increase, is a signal that management is forecasting poor earning in the future. There is a vital information, or signaling, content in dividend announcements.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Investor Preference Theory Theory

Key Explanations

Clientele Effect • • •

A firm’s will attract investors who like the firm’s dividend payout policy. Different groups, or clienteles, of stockholders prefer different dividend payout policies. Retired individuals, pension funds, and university funds might prefer cash income, thus they may want the firm to payout a high percentage of its earnings. Stockholders in their peak earning years might prefer reinvestment, since they have less need for current investment income and would simply reinvest dividends received, after first paying income taxes on those dividends. Thus, investors who want current investment income should own common stocks of high dividend payout firms and vice versa.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Dividend Payment & Stock Repurchase •

Cash Dividend – the most popular practice.

Stock Dividend – increase stock trade volume in secondary market and its liquidity. Increase in the number of stock will often induce stock price dilution effect (in many cases, EPS grows insignificantly or constant).

Stock Split – a proportionate increase in the number of common stock owned. Normally, existing shareholders will gain more common stocks under stock split package.

Stock Repurchase – the firm, which has excess cash could repurchase its own stock instead of paying a cash dividend. Likewise, the firm can use a stock repurchase to change the degree of financial leverage.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Working Capital Management

by Dr.Sahanon Tungbenchasirikul

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Working Capital Management Working Capital Management is the administration and control of current assets and current liabilities.

Working Capital Policy provides the target levels for each classification of current assets and specifies the method of financing.

Net Working Capital is current asset minus current liabilities.

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Working Capital Management Current Assets -

Current Liabilities

Cash Marketable Securities Inventory (INV) Account Receivable (AR) Other Short-term Assets

-

Short-term Loan Account Payable (AP) Accrual Expenses Current Portion of Longterm Loan (CPLTL) - Other Short-term Liabilities

Working Capital Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Cash Conversion Cycle AR

Sales

INV

Profit

Collection

Sales Forecasting

AP

Ordering

Cash

Payment

AR, INV, & AP are the key drivers of Working Capital need. Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Cash Conversion Cycle: Financial Needs Ratio

Formula

Definition

Inventory Day on Hand = INVDOH

[Inventory / COGS] x 360 = XX Days

Indicates the average number of days in inventory holding period.

Account Payable Day on Hand = APDOH

[Account Payable / COGS] x 360 = XX Days

Indicates the average number of days in the supplier payment period.

Account Receivable Day on Hand = ARDOH

[Account Receivable / Revenue] x 360 = XX days

Indicates the average number of days in the collection period.

Financial Needs (FN)

FN = ARDOH + INVDOH – APDOH = XX days FN > 0 --> Need more cash FN < 0 --> No need cash

Indicates the average number of days that the firm needs financial support to maintain its liquidity.

Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Cash Conversion Cycle: Operating Cycle Operating Cycle Order Placed

Inventory Sold

Order Received

INVDOH (1) Inventory Conversion Period (1)

Cash Collected

ARDOH (2) Receivables Conversion Period (2)

Operating Cycle = (1) + (2) In general, manufacturing industries are likely to have longer operating cycle than service industries, especially modern trade industries.

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Cash Conversion Cycle: Financial Needs Order Placed

Inventory Sold

Order Received

INVDOH (1) Inventory Conversion Period (1)

Cash Collected

ARDOH (2) Receivables Conversion Period (2)

Financial Needs = (1) + (2) – (3) APDOH (3) Financial Needs Supplier Credit Period (3)

Order Made Financial Management by Dr. Sahanon Tungbenchasirikul ©

Cash Paid to Supplier 59


Cash Conversion Cycle Calculation Example: John Lion wants to calculate “Operating Cycle” and “Financial Need” of Company A. He collects data as follows: 1. Sales Revenue

= 12,000 MB

2. Cost of Goods Sold (COGS) = 6,000 MB 2. Account Receivable (AR)

=

1,000 MB

3. Inventory (INV)

=

1,400 MB

3. Account Payable (AP)

=

500 MB

504-610 by Dr. Sahanon Tungbenchasirikul ©

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Cash Conversion Cycle Calculation Ratio Account Receivable Day on Hand = ARDOH

Formula [AR / Sales] x 360 = XX Days

Solution ARDOH = [ 1,000 / 12,000] x 360 = 30 Days

Inventory Day on Hand [INV / COGS] x 360 = XX Days = INVDOH

INVDOH = [ 1,400 / 6,000] x 360 = 84 Days

Account Payable Day on Hand = APDOH

APDOH = [ 500 / 6,000] x 360 = 30 Days

[AP / COGS] x 360 = XX Days

Operating Cycle = ARDOH + INVDOH = 114 Days Financial Needs = ARDOH + INVDOH – APDOH = 84 Days Hence, this company requires short-term financial support ~ 84-90 days. Capital to satisfy financial needs can be short-term loan, long-term loan, or shareholder’s equity. Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Short-term Cash Conversion Cash Inflow, Borrowing Cash Used in Value Chain

lue Va n( rgi Ma ) ded

Marketing, Sales, and After Sales Services

Ad

Output Storage

Creditors

Ma rgi n( Va lue

Conversion Process

)

Input Storage

ded

Import Inputs

Ad

Technology, Procurement, Human Resources Management, Financial and Budget Management, Planning, Maintenance, and so on.

Cash Generated in Value Chain Cash Outflow, Repayment Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Current Asset Management Capital Needs

The Firm needs capital to finance permanent current assets + temporary current assets. (Seasonal Financial Needs)

T em p

orary

sets s A t n Curre

(Permanent Financial Needs) Permanent Current Assets

(Long-term Financial Needs) Fixed Assets Time (Years)

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Current Asset Management

Current Assets

Current Liabilities

Long-term Liabilities

Fixed Assets

Equity

Financial Management by Dr. Sahanon Tungbenchasirikul ©

• In general, firms in manufacturing industries have positive working capital (WC) to ensure the smooth business operations over the shortterm. • Part of WC comes from long-term funds (either long-term liabilities or shareholders’ equity). • Manufacturing industries requires inventory investments (i.e. raw materials, work –in-process, and finished goods) and give credit-term to customers.

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Current Asset Management Capital Needs

Seasonal Financing Policy

s nt As e r r u C rary o p m Te

ets

e ts rent Ass r u C t n e Perman

Short-term Loan

Long-term Loan + Equity

Fixed Assets Time (Years)

Agricultural Commodity Traders Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Current Asset Management Capital Needs

Aggressive Financing Policy

T

ts Asse t n e rr ry Cu a r o em p

Perma

rrent nent Cu

Short-term Loan

Assets

Long-term Loan

Fixed Assets

Speculators Financial Management by Dr. Sahanon Tungbenchasirikul Š

Equity Time (Years)

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Current Asset Management Capital Needs

Balanced Financing Policy

T

n Curre y r a r em p o

et s t Ass

Short-term Loan

Long-term Loan

Perma

t Assets n e r r u nent C

Equity Fixed Assets Time (Years)

Manufacturing, OEM, REM Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Current Asset Management

Current Assets

Fixed Assets

Current Liabilities

Equity

Financial Management by Dr. Sahanon Tungbenchasirikul ©

• In some cases, firms use shareholders’ equity, instead of longterm loan, to support current asset investments. This implies that such firms have solid financial viability and high “Margin of Safety” or “High Safety Cushion” – liquidity after subtract short-term liabilities > 0 • These kinds of firms have been operating over a long-term with secured customer-base and secured sources of income. Hence, they don’t need to borrow money to expand the business, just use internal funding sources (retained earning or shareholders’ equity). 68


Current Asset Management Capital Needs

Conservative Financing Policy

rary o p m Te

P

ssets A t n Curre

ets ent Ass r r u C t n ermane

Short-term Loan

Equity

Fixed Assets Time (Years)

Very Rich Firms (No Long-Term Debt) Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Current Asset Management

Current Assets

Fixed Assets

Current Liabilities

Long-term Liabilities

Equity

Financial Management by Dr. Sahanon Tungbenchasirikul ©

• Modern trade firms (e.g. Tesco Lotus, Carrefour, BIGC, Tops, CPALL, Se-Education), often have WC < 0. • As modern trade firms sell products with the immediate exchange of cash (i.e. very low account receivable) and can negotiate for free-of-charge credit terms from suppliers (e.g. 15, 30, 45, 60, 90 Days); as a result, they have a plenty of cash in hand and no need to borrow a large amount of loan from financial institutions compared to manufacturing firms. 70


Current Asset Management Capital Needs

Manipulative Financing Policy

rary o p m Te

Perma

ssets A t n Curre

rrent nent Cu

Short-term Loan Assets

Fixed Assets

Long-term Loan

Equity Time (Years)

Modern Trade, High Bargaining Power Firms Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Short-term Financing: Maturity Matching Maturity Matching is at the heart of current asset management. Firms need to manage short-term money to grow business and at the same time can meet debt repayment obligations. Principle of Maturity Matching states that a firm must use short-term debt to finance short-term asset investments and employ long-term debt to invest in fixed assets. In so doing, the firm is likely to secure liquidity in both short-term and long-term and can avoid financial distress in the downside business scenarios. To firms, it is crucial to understand short-term financing sources and exploit them in order to maximize value add from business operations.

Financial Management by Dr. Sahanon Tungbenchasirikul Š

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Short-term Financing: Pros and Cons Pros • Speed. Firms generally can obtain and disburse short-term loan faster than long-term one. • Flexibility. Firms generally use short-term loan to serve seasonal or cyclical financial needs. • Cost. Cost of short-term loan (i.e. interest charge) is normally cheaper than long-term one. Cons • Interest Rate Fluctuation. Interest charge will change with regard to money market volatility. • Economic Recession Effect. Firms, which rely heavily on short-term debt, could easily experience financial distress during the economic recession per iod. Financial Management by Dr. Sahanon Tungbenchasirikul ©

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Short-term Financing Sources • Accruals. Money that firms are supposed to pay in the future, but they can still hold money in hand with free-ofcharge until the payment date. Accruals will report in current liability section of balance sheet (e.g. social security, tax, wage). • Account Payable (Trade Credit). Firms often make purchases from other firms on credit (sometimes, free-ofcharge) and record as account payable. Account payable is a spontaneous source of short-term financing in that it enables firms to keep more liquidity in hand, and in modern trade industry, can enjoy free-of-charge extra cash, which reduce the need of external funding sources.

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Short-term Financing Sources â&#x20AC;˘ Short-term Bank Loans. Bank loans, which generally appear on balance sheets as notes payable, are second important to trade credit as the source of short-term financing for firms. â&#x20AC;˘ Commercial Paper. Commercial paper is unsecured shortterm dent issued by large, financially strong companies. Although the cost of commercial paper is lower than bank loans, it can be used by large companies with exceptionally strong credit rating.

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Financial management part 2