Financial Management 2

GMP – 2021-22
Session 1
N.Sivasankaran
ns@xlri.ac.in
Topics for Discussion in S 1-13
• WORKING CAPITAL Management

• Long Term Investment Management / CAPITAL BUDGETING

• Lease vs Buy Decision

• Dividend Decision

• Introduction to Derivatives
MY Expectations
Read & follow the COL

Have active class participation

submit assignments on time

Maintain a learning diary

Evaluation Framework
• End Term = 40 %
• Quizzes ( Average of two ) = 20%
• Assignments ( Group of four) = 20 %
• Class Participation = 20 %
 For Discussion in Session 1
1. Conventional Vs Non-Cash Working Capital

2. Working Capital & Capital Expenditure Decision

3. Optimal Investment in WC

4. Optimal Investment in Inventories

5. EOQ approach in deciding on optimal investment in inventories

1. Conventional vs Non-Cash WC
 What is Working Capital (WC) ?
• Funds required for meeting operating activities

• Focus on
+ Operating requirements

Not on
Investing or Speculative requirements
 What is “Conventional WC”?
• Conventional WC = Total Current Assets – Total Current Liabilities
 What are Non-Cash Current Assets?
• CA excluding cash & cash equivalents and short-term investments

• AR, Inventories and Prepaid expenses

• Why not cash & cash equivalents ?

1. WC deals with operating activities
2. Cash & near cash CA earn fair returns
What are Non- Interest-bearing Current
Liabilities?
• CL Including ( Accounts Payable and Accrued Expenses)

• Excluding ( Short term bank loans and Current Portion of Long-Term

Debt & provisions )
 How to compute Non-Cash WC?
•Non-Cash WC = (Non-Cash CA) – (Non- interest-bearing CL)
 2. WC & CAPEX decision
What is a Capital Expenditure Decision?
 What is the relationship between WC & CB
decision?
Illustration
• Life : 6 years
• WC: 20% of Revenue
• Time of investment: Beginning of the year
• Projected Revenue( in INR cr) : Y1 - 500 : Y2 – 1000 ; Y3- 1200 ;
Y4 – 1300 ; Y5- 1400 ; Y6- 1500

Hurdle rate for the project : 10%

Salvage Value: 100% at the end of life of project
Impact of WC on NPV of Project
Year Revenue WC = 20 % of Delta WC PVIF @ 10% PV of Delta
(in INR Crores) Revenue Investment NWC (in INR
(in INR Crores) (in INR Crores)
Crores)
0 0 ??? ??? 1 ???
1 500 ??? ??? 1/(1.1) = 0.909 ???
2 1000 ??? ??? 0.909/1.1 = 0.826 ???
3 1200 ??? ??? 0.826/1.1= 0.751 ???
4 1300 ??? ??? 0.751/1.1= 0.683 ???
5 1400 ??? ??? 0.683 /1.1= 0.621 ???
6 1500 ??? ??? 0.621/1.1= 0.564 ???
Impact of WC on NPV of Project
Year Revenue WC = 20 % of Delta WC PVIF @ 10% PV of Delta
(in INR Crores) Revenue Investment NWC (in INR
(in INR Crores) (in INR Crores)
Crores)
0 0 0 ??? 1 ???
1 500 100 ??? 1/(1.1) = 0.909 ???
2 1000 200 ??? 0.909/1.1 = 0.826 ???
3 1200 240 ??? 0.826/1.1= 0.751 ???
4 1300 260 ??? 0.751/1.1= 0.683 ???
5 1400 280 ??? 0.683 /1.1= 0.621 ???
6 1500 300 ??? 0.621/1.1= 0.564 ???
Impact of WC on NPV of Project
Year Revenue WC = 20 % of Delta WC PVIF @ 10% PV of Delta
(in INR Crores) Revenue Investment NWC (in INR
(in INR Crores) (in INR Crores)
Crores)
0 0 0 100 1 ???
1 500 100 (200-100) 1/(1.1) = 0.909 ???
=100
2 1000 200 (240-200)=40 0.909/1.1 = 0.826 ???
3 1200 240 20 0.826/1.1= 0.751 ???
4 1300 260 20 0.751/1.1= 0.683 ???
5 1400 280 20 0.683 /1.1= 0.621 ???
6 1500 300 0 0.621/1.1= 0.564 ???
Salvage value
of 300
Impact of WC on NPV of Project
Year Revenue WC = 20 % of Delta WC PVIF @ 10% PV of Delta
(in INR Crores) Revenue Investment NWC (in INR
(in INR Crores) (in INR Crores)
Crores)
0 0 0 100 1 -100
1 500 100 (200-100) 1/(1.1) = 0.909 -91
=100
2 1000 200 (240-200)=40 0.909/1.1 = 0.826 -33
3 1200 240 20 0.826/1.1= 0.751 -15
4 1300 260 20 0.751/1.1= 0.683 -14
5 1400 280 20 0.683 /1.1= 0.621 -12
6 1500 300 0 0.621/1.1= 0.564 169
Salvage value
of 300
NPV -96
Relationship b/w WC & NPV of Projects
3.Optimal Investment in WC
What happens to a firm when it decreases its
investment in WC?
+ Releases Cash
+ Increases CF for Investments
+ Enhances profits and value

- Increases Liquidity Risk ( especially for small firms with fluctuating

fundamentals & during economic turbulence)
- Increases stockout costs
- Increases rate of customer attrition
Is there a limit for reducing WC ?
PROFITABILITY vs LIQUIDITY Trade- Off
Is there a limit for reducing WC ?
PROFITABILITY vs LIQUIDITY Trade- Off