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Financial Strategy-Exam Kit

Financial Strategy-Exam Kit

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Published by: Dhanushka Rajapaksha on Jul 11, 2012
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Two aspects of working capital policy that require managerial decisions are the level of cur-
rent assets and the manner in which they are financed. In conditions of uncertainty enti-
ties must hold some minimum level of cash and inventories based on expected revenues,
plus additional safety stocks. With an aggressive working capital policy, an entity would
hold minimal safety stock. Such a policy would minimise costs, but it could lower reve-
nues because the entity could not respond rapidly to increases in demand. Generally the
expected return is higher under an aggressive investment policy than a conservative policy,
but the risks are higher.

Working capital financing decisions involve the determination of the mix of long-term and
short-term debt. When the yield curve is upward sloping, short-term debt is cheaper than
long-term debt. With an aggressive financing policy, the entity finances part of its perma-
nent asset base with short-term debt. This policy generally provides the highest expected
return because short-term debt costs are typically less than long-term costs, but it is very
risky. Under a conservative financing policy, the entity would have permanent financing
that exceeds its permanent asset base of assets. The conservative policy is the least risky
but it also results in the lowest expected return.

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