Working Capital Management Solutions

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 11 Working Capital 19 December 2018
CHAPTER 11
WORKING CAPITAL
Solutions
© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 1

11-1
Included in
Item working
capital
Inventory Yes
[if there is a purchase and responsibility has
goods in transit Yes transferred to the buyer]
promissory notes *
prepaid rent Yes Increase in WC
deferred tax No
#
accounts payable Yes Reduction of net investment in WC
accounts receivable Yes Increase in WC
short-term loans *
bank overdraft *
work in progress Yes Increase in WC
*
Promissory notes, bank overdrafts and short-term loans are interest bearing. These are normally
short-term financing instruments, although a bank overdraft may be used for medium term financing
and the company may renegotiate its short-term loans and reissue promissory notes. In terms of
disclosure in financial statements, these balances are reported under current liabilities and if we
define working capital as current assets less current liabilities, then these balances would be
included. However, the more correct approach is to focus on operating working capital which
consists of accounts receivable, prepaid expenses, inventory and operating cash less accounts
payable. Another reason is that these balances do not include an explicit financing cost. The cost of
trade credit is included in the cost of purchases and sales revenue includes an implicit return for
offering customers credit. Inventory is required to achieve sales. Promissory notes, short-term loans
and bank overdrafts are often used to finance operating working capital.
Example: Rm
Accounts receivable 100
Inventory 80
Accounts payable -120
Net investment in operating working capital 60
Short-term loans -60
0
#
Although we have included accounts payable, it really refers to the term, "net working capital".
Sometimes working capital may refer to the firm's current assets and net working capital is current
assets less accounts payable. We have used the term to mean net working capital which is the way
many firms tend to use the term "working capital" in practice.

11-1 (continued)
Definitions (not required in terms of the question)
DEFINITIONS
Non-current assets are resources acquired by a business in order to generate future benefits.
They may be tangible or intangible and are expected to have a useful life in excess of one year. For
this reason, non-current assets are usually subject to depreciation or amortisation over the useful
lifespan of each asset.
Current assets similarly are resources acquired by a business in order to generate future benefits.
A current asset is usually expected to have a lifespan of less than one year. Current assets
essentially support the fixed assets in that fixed assets such as machinery which generates
products for sale, necessitates investments in inventory, debtors and cash resources in order to
settle with creditors.
Working capital is a term used synonymously with current assets. The name derives from the fact
that current assets comprise items, which require capital investment and which are active in
everyday working activities. The term is also used to indicate current assets less current liabilities.
We have preferred to use the term net working capital when referring to current assets less current
liabilities.
Current liabilities are debts, which are due to be settled in the foreseeable future, usually within
the next twelve months. The dominant current liability is usually creditors, but may include a large
bank overdraft for seasonal liquidity requirements. Also included are usually dividends payable,
taxation payable and accruals.
Net working capital is defined as the difference between current assets and current liabilities. In
most all instances, current assets will exceed current liabilities (however, refer to Woolworths). This
term is synonymous with net working capital or net current assets. It may represent the amount of
current assets which must be financed from interest bearing debt.
11-2
MAJOR WORKING CAPITAL ASSETS
Major current assets of a company, which manufactures high quality office furniture, would firstly be
inventory. This would include inventory of raw materials, inventory of work-in-progress, and
inventory of finished goods. It is likely that at least some sales would be on credit, giving rise to
accounts receivable as a current asset. In addition, there would be cash resources on hand to
meet creditor payments and operating expenses as they fall due.
The assets may be financed to a large extent by accounts payable who will be suppliers of raw
materials. To the extent that such creditors grant delay of payment such as 60 or 90 days, is the
extent to which the current assets are financed by the amount of this current liability. Other current
liabilities also finance current assets, sometimes on a temporary or seasonal basis. A bank overdraft
is another example of financing, which may be used for current assets. To the extent that current
liabilities do not cover current assets, the amount of net working capital, this must be financed from
longer term forms of finance in accordance with the capital structure. If accounts payable and other
non-interest-bearing current liabilities are not sufficient to cover the investment in accounts
receivable and inventory, then a company will be required to use interest bearing debt, whether
short-term or long-term, to finance the net working capital.

11-3
TRADE CREDITORS (ACCOUNTS PAYABLE)
Financing from trade creditors is known as spontaneous financing because it will tend to increase
automatically as the firm increases its sales and purchases to support higher sales. For example,
assume that a firm expects its sales to increase from R120m to R180m in the following year.
Assume that accounts payable tends to be about 10% of Sales, which means that current accounts
payable, will be R12m. As sales increases to R180m, the accounts payable balance will increase
from R12m to R18m, generating increased financing of R6m from creditors.
11-4
A trade creditor provides goods and services on credit to the customer. In order to survive as a
business, the creditor marks the goods or services up and competes on the open market. Should a
client require extended trade credit, the supplier will respond by building the cost of financing the
supply into the price. In this sense, the recipient is paying for the extended credit. Alternatively, the
creditor offers a settlement discount to the client. If the client chooses not to pay within the time
allowed by the settlement discount, the client is in effect, forfeiting a cash flow and bearing the cost.
It is therefore incorrect to imply that financing obtained from creditors is costless.
It is worth noting that capital investment appraisal using the Net Present Value method, discounts
future cash flows by the cost of capital. The future cash flows are the net cash income, after the
deduction of the cost of purchases, which included the reward to creditors. The cost of capital does
therefore not include the cost of trade credit, as that has already been considered in the cost of
purchases.
11-5
WORKING CAPITAL POLICY
The objective of developing a working capital policy is consistent with the principles of investment. It
is to design a policy which best reflects the expected return and risk which the business has decided
is appropriate. Inventory provides a good example. If the business decides to maintain low levels of
inventory, the cost of holding inventory is reduced; boosting returns, but the probability of a stockout
is increased thus enhancing the risk of losing sales, which will depress returns. The ideal inventory
level of the business will finely balance the return and risk parameters. The major issues, which
must be addressed, relate to the risk and return implications for inventory and debtors.
11-6
RAPIDLY EXPANDING SALES
Rapidly expanding sales will drain cash resources through the firm requiring a higher level of
investment in both inventory and accounts receivable. If management wish to increase sales they
will have to increase production levels to cater for the additional demand. Such an increase in
production would require additional raw material inventory and lead to an increase in both work in
progress and finished good inventory. It may even lead to an increase in the investment in plant
and equipment.
Management would also need to extend more credit when sales are increased. This could occur for
two reasons. Firstly, in order to increase sales, management may need a more lax credit policy and
secondly, if cash and credit sales increase in the same proportions there will be a spontaneous
increase in accounts receivable.

11-7
IMPACT OF INFLATION
Working capital is fairly insensitive to levels of inflation as the investment period is normally fairly
short.
Inflation would lead to a higher cost of financing working capital. Adjustments for such a change in
financing costs should be made in establishing an appropriate investment level in working capital.
For example, when using the EOQ, the cost of holding an item of inventory, if expressed as a
percentage of the cost of the item of inventory, would be reduced by the anticipated inflation rate.
Such an adjustment recognises that the hedge against inflation that such a holding provides should
reduce the cost of holding inventory.
11-8
FINANCING WORKING CAPITAL
If management aims towards matching the maturity of the finance with the life of the asset being
financed, then the risk that the firm would be unable to pay off its maturing obligations would be
minimised.
If this concept is extended to working capital, then management would endeavour to match the
maturity structure of current assets and current liabilities. However, a problem arises in forecasting
the life of an asset. If, for example, a firm finances inventory with a two month overdraft and
inventory is not sold within this period, then the company will experience problems with the
repayment of the overdraft.
As there will always be some uncertainty, management should attempt to match asset and liability
maturities based on expected lives. Such an action would give rise to a moderate working capital
policy.
How appropriate the policy is depends on the objectives of management. If management are risk
averse they would probably prefer a conservative working capital policy so as to allow for errors in
estimation of maturity. If management want higher returns and are unconcerned about the
additional risk, they would prefer an aggressive policy, which would achieve such an objective.
11-9
LONG TERM FINANCING
If long-term finance is used to finance both permanent and some proportion of fluctuating current
assets, then business risk will be minimised but at the same time this policy would generate a lower
return.
The return would be lower for two reasons. Firstly, the cost of long-term finance is generally above
that of short-term finance and secondly, the resulting short-term deposits would lead to an increase
in the investment in working capital yielding little or no return.
In deciding whether such a working capital policy is appropriate, management need to consider the
overall risk return relationship and the risk profile of the shareholders.

11-10
FORECASTING
Subjective forecasts are based on management experience and judgement. Objective forecasts are
normally based on historical data or related variables to which mathematical forecasting techniques
are applied.
While the two approaches use very different methodologies, the type of information analysed would
be very similar and results obtained should tend to be supportive of each other rather than be
contradictory. In this manner management can use the alternative approaches as a check on the
forecast made.
Should there be no historical or related information (other variables which are strongly related to the
independent variable), management will be unable to use objective forecasts.
11-11
NKOSI LIMITED
a) Delivery to cash collection = 60 + 30 + 90

= 180 days
Cash payment to cash receipt = 180 - 40
= 140 days
Note: Reference is sometimes made to a working capital cycle of 180 days and a cash to
cash cycle of 140 days. It is clear that financing is required for only 140 days and that the
quantum of finance required is no greater than the cost of sales. The cost of sales in turn is
equal to the cost of raw materials supplied by the creditor plus other costs which are added
on during the manufacturing process.
b) The strategies must relate to changing the time of any of the four components of the working
capital cycle listed in the question. Thus they are the following:
Decrease the time taken from delivery to completed goods by speeding up the
production time.
Decrease the inventory holding time by more aggressive advertising or other business
promotion strategies.
Decrease debtors’ collection period by more effective credit control, or offering
settlement discounts
Increase the creditor settlement period through negotiation with creditors or not taking
settlement discounts offered.
In the latter two cases, there will be a cost involved which must be considered in the light of
all factors relating to working capital management.

11-12
a) Working capital cycle of Thaba Ltd:

Year 1 Year 2 Year 3
Raw materials stockholding

[Raw materials inventory/Purchases] 20.83% 76.04 20.66% 75.39 25.00% 91.25
Less: Finance from suppliers

[Trade creditors/Purchases] 16.67% 60.83 15.00% 54.75 17.50% 63.88
15.21 20.64 27.38
Production time
[Work-in-Process/Cost of sales] 10.00% 36.50 10.00% 36.50 8.50% 31.02
Finished goods inventory - holding

[Finished goods inventory/cost of sales] 11.43% 41.71 13.33% 48.67 13.01% 47.48
Credit given to customers

[Debtors/Sales] 20.0% 73.00 24.0% 87.60 25.0% 91.25
Total working capital cycle (days) 166.42 193.41 197.13
b) Possible actions
¨ Reduce raw materials stockholding. Reviewing slow moving lines and re-order levels
may do this. Inventory control models may be considered if not already in use. More
efficient communication links with suppliers e.g. through computer link-ups, could also help.
Reducing inventory may involve loss of discounts for bulk purchases, loss of cost savings
due to price rises or may lead to production delays due to stock-outs.
¨ Obtain more finance from suppliers by delaying payments. This could result in
deterioration in commercial relationships or even loss of reliable sources of supply.
Discounts may also be lost by this policy.
¨ Reduce work-in-progress by reducing production volume (with resultant problems of loss

of business and the need to cut back on labour resources) or improving production
techniques and efficiency (with the human and practical problems of achieving such
change). Improved plant layout and new production technologies enable companies to
reduce production times. Improved technologies mean that companies will be able to
achieve higher throughput and reduce wastage. This will result in a further reduction in
production times and improved productivity.
¨ Reduce finished goods inventory perhaps by re-organising production schedule and/or

distribution methods. This may affect the efficiency with which customer demand can be
satisfied and result ultimately in reduction in sales. However, improved technologies and
computer link ups with customers mean that companies are able to react more quickly to
changes in demand patterns and produce on demand.
¨ Reduce credit given to customers by invoicing and following up outstanding amounts

more quickly or possibly by offering discount incentives. The main disadvantage would be
the potential for loss of custom as a result of this policy (particularly if it contrasted with
competitors' policies). The cost of discounts may be significant. Further, the company may
decide to factor their debtors or enter into invoice discounting arrangements.

11-13
Fixed Assets 12,000,000 Sales 32,000,000
EBIT to Sales 12% NCA to Sales - old 60%
Debt to Equity ratio 100% NCA to Sales - new 40%
Interest rate 9% Tax rate 28%
Current New
Net Current Assets 19,200,000 12,800,000
Fixed assets 12,000,000 12,000,000
Total Assets 31,200,000 24,800,000
Debt 15,600,000 12,400,000

Equity 15,600,000 12,400,000
Total Liabilities & Equity 31,200,000 24,800,000
Current New
Sales 32,000,000 32,000,000
EBIT 3,840,000 3,840,000
Interest -1,404,000 -1,116,000
Net Income before tax 2,436,000 2,724,000
Taxation -682,080 -762,720
Net Income 1,753,920 1,961,280
ROE 11.2% 15.8%
NCA=60% NCA=40%
Rm Rm
Sales turnover 800 800

EBIT 18 18
Fixed assets 50 50
Current assets 50 15
100 65
Return on Assets 18.0% 27.7%

11-14
STAID, DEMURE AND ROBUST LTD
a) Fixed assets are usually instrumental in producing the goods and services, which generate
the sales. The level of current assets, which comprise mainly inventory, debtors and cash
resources depend upon the working capital policy. It is possible to generate similar turnovers
using similar fixed asset bases, while having different levels of current assets. For example,
Staid Ltd probably maintains higher levels of inventory, debtors and/or cash resources than
Demure Ltd and Robust Ltd. It is further possible that Robust Ltd sells only for cash, thus
dispensing with the need for Debtors. Similarly, Robust Ltd may have a very lean inventory
policy resulting from maintaining much lower levels of inventory. If the lower levels are well
managed and stock-outs are thus kept to a minimum, it may have a negligible impact on
turnover and EBIT.
b)
STAID DEMURE ROBUST

Rm Rm Rm
Sales turnover 800 800 800

EBIT 18 18 18
Fixed assets 50 50 50
Current assets 50 25 15
100 75 65
Return on Assets 18.0% 24.0% 27.7%
As a result of a more aggressive policy toward working capital management, Robust Ltd has
achieved a significantly higher return on total assets. The risks attached to maintaining
relatively low balances in working capital accounts are the following:
Inventory: The risk of stock-outs is higher. In the short-term, this leads to loss of gross
margin that would otherwise have been earned. In the longer term, it may
also lead to customer dissatisfaction and loss of market share to competitors.
Debtors: Limiting credit sales and/or placing pressure on customers to settle within a
short period of time may have the effect of losing customers to competitors.
Cash: Low balances in cash resource accounts can lead to liquidity problems.
These may have to be resolved through high interest sources such as bank
overdraft, or may even lead to an inability to source cash quickly thus creating
a climate of uncertainty amongst those who require payments.

11-15
Rm Interest rate: long-term debt 11%

Temporary current assets 400 Interest rate:short-term debt 8%
Permanent current assets 300 Tax rate 28%
Fixed assets 500 Rm
Total assets 1,200 EBIT 200
a
Conservative Assets LTD & STD % LTD & STD Interest rate Interest
a b axb=c d cxd
Long-term debt 1,200 75% 900 11% 99.00
Short-term debt 1,200 25% 300 8% 24.00
123.00
Aggressive Assets LTD & STD % LTD & STD Interest rate Interest
a b axb=c d cxd
Long-term debt 1,200 56.25% 675 11% 74.25
Short-term debt 1,200 43.75% 525 8% 42.00
116.25
b Earnings Conservative Aggressive
Rm Rm
EBIT 200.000 200.000

Interest -123.000 -116.250
77.000 83.750
Tax -21.560 -23.450
Earnings after tax 55.440 60.300
c If the short and long term rates are reversed, then earnings and interest would be as follows;
Conservative Assets LTD & STD % LTD & STD Interest rate Interest
a b axb=c d cxd
Long-term debt 1,200 75% 900 8% 72.00
Short-term debt 1,200 25% 300 11% 33.00
105.00
Aggressive Assets LTD & STD % LTD & STD Interest rate Interest
a b axb=c d cxd
Long-term debt 1,200 56.25% 675 8% 54.00
Short-term debt 1,200 43.75% 525 11% 57.75
111.75
Earnings Conservative Aggressive
Rm Rm
EBIT 200.00 200.00

Interest -105.00 -111.75
95.00 88.25
Tax -26.60 -24.71
Earnings after tax 68.40 63.54
The conservative policy, under this set of conditions results in a higher earnings after tax
It would thus be preferable with hindsight, to have followed the conservative policy.

11-16
a)
Strong Economy Aggressive Moderate Conservative
Sales 1,000 1,100 1,200

Less: Cost of goods sold -900 -910 -1,020
EBIT 100 190 180
Less: Interest -16 -18 -24
Net income before tax 84 172 156
Less: Taxation -24 -48 -44
Net income 60 124 112
Average Economy Aggressive Moderate Conservative
Sales 900 1,000 1,100

Less: Cost of goods sold -830 -850 -960
EBIT 70 150 140
Net income 39 95 84
Weak Economy Aggressive Moderate Conservative
Sales 800 900 1,000

Less: Cost of goods sold -760 -790 -900
EBIT 40 110 100
Net income 17 66 55
b)
EBIT to Sales
Strong 29% 48% 36%
Average 20% 38% 28%
Weak 11% 28% 20%
Return on Equity
Strong 40% 62% 45%
Average 26% 48% 33%
Weak 12% 33% 22%
c)
The central idea is that while working capital should be managed carefully, there is an optimum level.
If working capital is above the optimum, some assets are being underutilised, and are not contributing
to the profitability of the firm even though revenue may be higher. On the other hand, if working capital
is too tightly managed, the number of sales missed due to stock-outs will rise. This will also affect
customer goodwill, causing a further reduction in sales. Variable costs may also increase if orders for
merchandise have to be placed frequently and for inefficient quantities. If trade credit terms are too
restrictive, sales will also be lost in this way.

11-17
Tax rate 28%
Plan 1 Plan 2 Plan 3
Current assets 22,500,000 22,500,000 22,500,000
Fixed assets 40,000,000 40,000,000 40,000,000
62,500,000 62,500,000 62,500,000
Current liabilities (50% = short-term debt) 0.50 22,500,000 15,000,000 7,500,000

Long term debt 0.12 7,500,000 - 22,500,000
Ordinary equity 32,500,000 47,500,000 32,500,000
62,500,000 62,500,000 62,500,000
Sales 250,000,000 250,000,000 250,000,000
EBIT 40,000,000 40,000,000 40,000,000

Less: Interest on short-term debt 0.10 -1,125,000 -750,000 -375,000
Less: interest on long-term debt -900,000 - -2,700,000
Net income before tax 37,975,000 39,250,000 36,925,000
Taxation -10,633,000 -10,990,000 -10,339,000
Net income after tax 27,342,000 28,260,000 26,586,000
Current ratio 1.00 1.50 3.00

Net working capital = CA-CL 0 7,500,000 15,000,000
Debt ratio = (CL+LTD)/Total assets 48% 24% 48%
Return on equity (Net income after tax/Ordinary
equity) 84% 59% 82%
Debt-equity (interest bearing debt to equity) 58% 16% 81%
Plan 1 gives a slightly higher return than plan 3, the main difference between the two alternatives
being the use of short term rather than long term borrowings. The current ratio, as is to be
expected, is much stronger with plan 3 providing greater assurance that current liabilities will be
paid when due.
Plan 2 is the least risky of the three alternatives, the debt ratio being half that of the other plans.
As a result the return is also the lowest.
Although the debt ratio of Plan 1 and 3 are the same, the debt-equity ratios (if we include only
interest bearing debt) are very different with Plan 3 indicating a higher level of risk.
In deciding which plan to accept management need to consider the risk return relationship and
the risk aversity of the shareholders. We would consider that Plan 1 may be preferable due to the
fact that interest bearing debt forms a smaller part of the financing of the company resulting in a
lower risk profile and yet achieving a high ROE, even though Plan 3 does result in a higher
current ratio.

11-18
a)
Sales 220,000,000
After-tax earnings 0.05 11,000,000
Dividends 0.30 -3,300,000
Retained earnings 7,700,000
Additional plant (40% x R20m) 8,000,000

Additional current assets (50% x R20m) 10,000,000
Total finance required 18,000,000
Less: Retained Income -7,700,000
10,300,000
Less Spontaneous current liabilities [25% x 20m] -5,000,000
Finance required 5,300,000
b)
Limitations of the percentage of sales method:
Current liabilities may not increase spontaneously in proportion to sales
Some current liabilities may increase differently to others
The effect of inflation is not taken into account
The anticipated increase in sales may differ from fixed asset requirements
Current assets may not increase in proportion to sales
Forecast
Statement of
Alternative format % of Sales Financial Position
20.5 20.6
Statement of Financial Position Rm Rm
Plant & Equipment 80 40% 88.0 8.00
Current assets
Cash resources 10 5% 11.0 1.00
Accounts receivable 30 15% 33.0 3.00
Inventory 60 30% 66.0 6.00
180 198.0 18.00
Shareholders Equity 70 [Equity + RI] 77.7 7.70

Long term loans 60 65.3
Current liabilities
Accounts payable 30 15% 33.0 3.00
Accruals 12 6% 13.2 1.20
Taxation due 8 4% 8.8 0.80
180 198.0 12.70
Net financing required 5.30
Sales 10% 200 (1+growth) 220.00
Earnings after tax - 5% of sales 5% 10.0 11.0

Dividends (30cents x R10m) 0.30 -3.0 -3.3
Retained Income 7.0 7.7
Although not required in terms of the question, we have forecast what the balance sheet will look like in 20.6.
We have assumed that the long term debt is the "plug" i.e. we will borrow more or repay loans depending on
our financing requirements. Long term debt was 30% of sales and the increase in the retained earnings should
enable us to borrow an additional 5.3m. We are assuming that cash resources represent operating cash - we
need this level of cash to maintain operations. We have also assumed that depreciation is zero as we have
taken the increase in retained earnings to reflect increased cash flow and in practice we need to add back
depreciation to get back to cash flow.

11-19
REXEL LIMITED
a) Net Income/Sales = R130m/R1000m

= 13%
Dividend payout ratio = 50/156

= 32.051%
b) Net income for 19.8 = 13% x R1200m

= R156m
Retained income = R156m - R50m or R156m x (1-32.051%)
= R106m
Additional assets required = 20% x (R150m - R40m)

= R22m
Alternative format for (b)
Expected sales Rm
Current sales 1,000
Expected sales 1.20 1,200
Increase in sales 200
After-tax earnings expected in 20.8 13% 156

Dividends -50
Retained earnings 106
Additional current assets [150/1000=15%] 15% 30

Total finance required 30
Less Spontaneous current liabilities 40/1000 4% -8
Finance required 22
Financing available from retained earnings 106

Available to invest or distribute to shareholders 84
No additional finance will be required to fund the anticipated growth in the next year. The company will in fact be in a
very liquid position if its forecasts are accurate. It will need to seek additional profitable projects or increase the dividend
or change the capital structure by repaying long term liabilities. There is little point in keeping idle cash resources.
It is important to note that a firm will not be able to sustain a growth rate of 20% per year without additional investment
in property, plant and equipment. Although it may happen for a year or two, that the company has spare capacity from
past over-investment in plant and equipment, the high growth rate will mean that the firm will have to reinvest in fixed
assets and will therefore experience significant cash outflows to finance such capital expenditure.

11-20
EASTERN CAPE TIMBER COMPANY
Non-current assets 25,000,000

Sales 80,000,000 EBIT/Sales 15%
Debt to Assets 40% Interest rate 10%
Tax rate 28%
(a) Aggressive Moderate Conservative
Rm Rm Rm
Current assets = % of sales 40% 50% 60%
Non-current assets 25,000,000 25,000,000 25,000,000

Current assets 32,000,000 40,000,000 48,000,000
Total assets 57,000,000 65,000,000 73,000,000
Equity 34,200,000 39,000,000 43,800,000

Debt 22,800,000 26,000,000 29,200,000
Total debt and equity 57,000,000 65,000,000 73,000,000
Sales 80,000,000 80,000,000 80,000,000

EBIT 12,000,000 12,000,000 12,000,000
Less: interest -2,280,000 -2,600,000 -2,920,000
EBT 9,720,000 9,400,000 9,080,000
Taxation -2,721,600 -2,632,000 -2,542,400
Net income 6,998,400 6,768,000 6,537,600
Return on equity (ROE) [net income/Equity] 20% 17% 15%

Debt Ratio [check] [Debt/Total assets] 40% 40% 40%
Current assets to debt 1.40 1.54 1.64
Interest cover [EBIT/interest] 5.26 4.62 4.11
(b)
The debt ratio is the same for all alternatives as management wishes to maintain a 40% debt
ratio. However, the current asset to debt ratio shows an increase in risk as the firm moves
from a conservative policy to an aggressive policy. The fixed interest-cover ratio declines
under the conservative policy which seems intuitively incorrect as it signals higher risk under
the conservative policy. This results from the decline in EBT caused by the interest charge for
the Conservative company.
It is assumed in this example that the sales would be unaffected by the working capital policy
chosen. This is unlikely as the more aggressive the policy is, the greater the likelihood of
sales being lower. In deciding which plan to accept management need to consider the risk
return relationship and the risk aversity of the shareholders.

11-21
Soap Boxes Ltd
Sales 92,000,000 EBIT to Sales 14%

1
Long term debt to Capital Employed 70% Interest rate 10%
Tax rate 28%
a) Return on Equity Conservative Average Aggressive

70% 50% 30%
Determination of Ordinary Equity
Fixed Assets 30,000,000 30,000,000 30,000,000
Net Current assets [% of sales x sales] 64,400,000 46,000,000 27,600,000
94,400,000 76,000,000 57,600,000
Long term debt 70% -66,080,000 -53,200,000 -40,320,000
Equity 28,320,000 22,800,000 17,280,000
Determination of Earnings
EBIT 12,880,000 12,880,000 12,880,000
Interest [interest rate x long term debt] -6,608,000 -5,320,000 -4,032,000
Earnings after interest 6,272,000 7,560,000 8,848,000
Taxation 28% -1,756,160 -2,116,800 -2,477,440
Earnings after tax 4,515,840 5,443,200 6,370,560
Return on Equity (ROE) 15.9% 23.9% 36.9%

1
Note: Capital Employed is defined as [Total assets - current liabilities]
b)
The more aggressive policy, ie. 30% leads to higher returns. However, as the current asset level is
decreased, presumably some of this reduction comes from accounts receivable. This can be
accomplished only through higher discounts, a shorter collection period, and/or tougher collection
policies. This policy is likely to have some effect on sales, possibly lowering profits. Tighter
receivable policies might involve some additional costs (collection, etc), but would also imply lower
levels of liquid assets; thus, the firm's ability to handle contingencies would be impaired. Higher risk
of inadequate liquidity could increase the firm's risk of insolvency and thus increase its chance of
failing to meet fixed charges. It is true that since the 1990s, companies in practice have been more
willing to reduce investments in accounts receivable and inventory and thereby increase their returns
on assets and equity. The harnessing of improved IT systems has enable companies to reduce their
investment in debtors, inventory and operating cash without experiencing a reduction in sales.
11-22
CHESTER CHEESE
a) The lowest level of current assets occurred in the months of January and February. If it is
assumed that there is no rising trend during the year, then this level of R50 million would
comprise the permanent current assets. The total permanent assets would consist of non-
current assets of R150 million and the permanent current assets of R50 million.
b) The highest level of temporary assets is R70 million. This level occurs in the month of
October.
c) The level of temporary assets in June is R30 million.

11-23
NEW DEAL LIMITED
Fixed assets 50 Sales 170

Long-term debt to capital employed 60% EBIT to Sales 15%
Interest rate on long term debt 10% Tax rate 28%
a)
Net current assets to sales 60% 50% 40%
Plan 1 Plan 2 Plan 3
Non-current assets (fixed assets) 50.0 50.0 50.0
Net current assets 102.0 85.0 68.0
Capital employed 152.0 135.0 118.0
Debt 60% 91.2 81.0 70.8
60.8 54.0 47.2
Sales 170.0 170.0 170.0

EBIT 15% 25.5 25.5 25.5
Interest on long-term debt -9.1 -8.1 -7.1
16.4 17.4 18.4
Tax 28% -4.6 -4.9 -5.2
11.8 12.5 13.3
Return on Equity (ROE) 19.4% 23.2% 28.1%
b)
The highest return on equity is obtained from Plan 3. This relatively higher return is obtained
from a reduction in the level of investment in current assets in areas such as accounts
receivable, inventory, cash balances, etc. An increased level of risk accompanies a lower level
of investment in this type of current asset. Such risk usually manifests itself in the following
ways:
Accounts receivable - lower levels can usually be achieved only through a more stringent
credit policy such as a shorter collection period and more rigorous collection activities.
Attempts to reduce accounts receivable may adversely impact on sales, and therefore on the
level of profitability. In this example it is unrealistic to assume that the level of sales will not be
affected when the accounts receivable are reduced.
Inventory - the possibility of stock-outs increases at lower inventory levels, and will again
adversely affect profitability. Furthermore, variable costs are likely to increase due to frequent
orders and inefficient quantities. The level of sales, as reflected in the example, appears
unrealistic in view of this risk factor - the level is likely to be lower.
Cash balances - the reduced ability to meet contingencies as a result of inadequate funds
could affect the credibility of a firm. Furthermore, the flexibility of financing and ability to take
advantage of special opportunities is adversely affected if cash balances are too low. The
possible need to raise short-term finance on an ad-hoc basis could also lead to the cost of such
periodic short-term needs being relatively higher.

11-24
MONTE MANUFACTURING
Rm April/Oct July
Current assets 60 200
Non-current assets 250 250
Total assets 310 450
Current liabilities 30 170

Long-term liabilities 150 150
Owner's Equity 130 130
310 450
a)
The level of permanent assets is R310 million and the maximum level of temporary
assets is R140 million
b)
The level of permanent current assets is R60 million which would generate
permanent spontaneous current liabilities of R30 million.
c)
The firm's permanent financing would amount to R180 million, R150 million being
long term liabilities and R30 million being permanent current liabilities.
d) Rm Rm
Current liabilities April July
Spontaneous 30 100
Short term borrowings - 70
Total current liabilities 30 170
e)
Temporary financing April July
Spontaneous - 70 [100m-30m]
Short term borrowings - 70
Total temporary financing - 140

11-25
Financing plans Plan 1 Plan 2 Plan 3 Tax rate 28%
Renew 1-yr loan Borrow R24m Loan R12m S-T
long-term and R12m L-T Expected EBIT 16,000,000
Short-term loan 24,000,000 12,000,000 Interest rate ST 8%
Long term loan 24,000,000 12,000,000 Interest rate LT 10%
a) (1) (2) (3)=(1)+(2) (4) (5)=(4)x(3)

Risk-free rate Risk Permium Rate to the Firm Probability Product
Good 3.0% 2.0% 5.0% 0.125 0.63%
Good 5.0% 2.0% 7.0% 0.125 0.88%
Average 5.0% 3.0% 8.0% 0.250 2.00%
Average 7.0% 3.0% 10.0% 0.250 2.50%
Bad 7.0% 5.0% 12.0% 0.125 1.50%
Bad 9.0% 5.0% 14.0% 0.125 1.75%
Expected value 9.25%
b) Plan 1 Plan 2 Plan 3
EBIT 16,000,000 16,000,000 16,000,000
Less: Long-term interest 0 -2,400,000 -1,200,000
Less: short-term interest -2,220,000 0 -1,110,000
13,780,000 13,600,000 13,690,000
Tax -3,858,400 -3,808,000 -3,833,200
Expected Net income 9,921,600 9,792,000 9,856,800
c) Best outcome Worst outcome

EBIT 30,000,000 2,000,000
Interest rate - S-T debt 5% 14%
BEST Plan 1 Plan 2 Plan 3
EBIT 30,000,000 30,000,000 30,000,000
Less: short-term interest -1,200,000 0 -600,000
28,800,000 27,600,000 28,200,000
Tax -8,064,000 -7,728,000 -7,896,000
Expected Net income 20,736,000 19,872,000 20,304,000
WORST Plan 1 Plan 2 Plan 3

EBIT 2,000,000 2,000,000 2,000,000
Less: short-term interest -3,360,000 0 -1,680,000
-1,360,000 -400,000 -880,000
Tax - - -
Expected Net income -1,360,000 -400,000 -880,000
It is difficult to make a choice between the financing options and this will depend on the risk preferences of the
firm. Plan 1 will result in the highest possible Net income but also the greatest loss if the worst scenario occurs.
Plan 2 will result in a lower expected net income in the best scenario but the loss is siginificantly lower in the
worst scenario. If the firm is risk averse, it might select Plan 2 as it minimises the potential loss. A further issue
relates to the use of long term debt. The long term loan will lock in the interest rate but the firm will be
committed in the longer term. The short term loan will result in variable interest costs and the potential of the
firm paying a high interest rate and being vulnerable to interest rate movements. However, we need to analyse
the asset structure of the firm and match the financing to the assets of the firm.
If part of the short-term loan is used to finance inventory and short-term interest rates, then the firm will be able
sell inventory, collect accounts receivable and repay part of the short-term loan if sales and EBIT falls
significantly. Therefore, if this is so, then the use of 50% long-term debt and 50% short-term debt may make
sense.

11-26
Existing JIT Change Cost Raw WIP FG

Situation Situation Saving material
Raw material inventory 9,000,000 1,800,000 7,200,000 1,008,000 1,008,000
WIP - Conversion cost 6,750,000 1,350,000 5,400,000 756,000 756,000
WIP - Material content 13,500,000 2,700,000 10,800,000 1,512,000 1,512,000
Finished Goods 19,800,000 4,950,000 14,850,000 2,079,000 2,079,000
[Note: saving = cost of capital x reduction in investment]
Holding and acquisition
costs (RM)
Fixed 1,000,000 200,000 800,000 800,000
Variable 900,000 126,000 774,000 774,000
Movement and control
costs (WIP)
Fixed 1,400,000 560,000 840,000 840,000
Variable 675,000 81,000 594,000 594,000
Holding and control costs
(FG)
Fixed 1,800,000 720,000 1,080,000 1,080,000
Variable 396,000 49,500 346,500 346,500
Total reduction in costs 9,789,500 2,582,000 3,702,000 3,505,500
Summary
Raw material savings 2,582,000
WIP savings 3,702,000
Finished goods savings 3,505,500
9,789,500
Further potential benefits and costs.
For just-in-time purchasing it is essential that reliable suppliers can be found who will deliver to match the company’s
production schedule.
Any late deliveries may result in stock out costs.
Suppliers may increase costs to compensate for synchronizing their delivery and production schedules.
Alternatively, savings might arise from negotiating long-term contracts with fewer suppliers.
Fewer suppliers should result in a significant drop in administration costs.
The reduction in inventory could provide additional space for production.
The move to a cell layout should enable the company to respond quickly to changes in sales demand – flexible
manufacturing.
Flexible manufacturing should result in greater sales and less inventory obsolescence.
Additional training for the workers.

Set-up costs may increase as the company moves from batch production to producing small or single batches using flow
production techniques.
JIT manufacturing should reduce finished goods inventories since the aim is to produce the required quantities at the
precise time they are required.
Shorter lead times will lead to improved customer goodwill.

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© Carlos Correia: Solutions to Financial Management, 9e, 2019

Ch 11 Working Capital 19 December 2018

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 1

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 2

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 3

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 4

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 5

a) Delivery to cash collection = 60 + 30 + 90

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 6

a) Working capital cycle of Thaba Ltd:

Raw materials stockholding

Less: Finance from suppliers

Finished goods inventory - holding

Credit given to customers

Total working capital cycle (days) 166.42 193.41 197.13

¨ Reduce work-in-progress by reducing production volume (with resultant problems of loss

¨ Reduce finished goods inventory perhaps by re-organising production schedule and/or

¨ Reduce credit given to customers by invoicing and following up outstanding amounts

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 7

Debt 15,600,000 12,400,000

Sales turnover 800 800

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 8

STAID DEMURE ROBUST

Sales turnover 800 800 800

Return on Assets 18.0% 24.0% 27.7%

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 9

Rm Interest rate: long-term debt 11%

EBIT 200.000 200.000

EBIT 200.00 200.00

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 10

Sales 1,000 1,100 1,200

Average Economy Aggressive Moderate Conservative

Sales 900 1,000 1,100

Weak Economy Aggressive Moderate Conservative

Sales 800 900 1,000

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 11

Current liabilities (50% = short-term debt) 0.50 22,500,000 15,000,000 7,500,000

Sales 250,000,000 250,000,000 250,000,000

EBIT 40,000,000 40,000,000 40,000,000

Current ratio 1.00 1.50 3.00

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 12

Additional plant (40% x R20m) 8,000,000

Shareholders Equity 70 [Equity + RI] 77.7 7.70

Earnings after tax - 5% of sales 5% 10.0 11.0

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 13

a) Net Income/Sales = R130m/R1000m

Dividend payout ratio = 50/156

b) Net income for 19.8 = 13% x R1200m

Additional assets required = 20% x (R150m - R40m)

Alternative format for (b)

After-tax earnings expected in 20.8 13% 156

Additional current assets [150/1000=15%] 15% 30

Financing available from retained earnings 106

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 14

Non-current assets 25,000,000

Non-current assets 25,000,000 25,000,000 25,000,000

Equity 34,200,000 39,000,000 43,800,000

Sales 80,000,000 80,000,000 80,000,000

Return on equity (ROE) [net income/Equity] 20% 17% 15%

© Carlos Correia: Suggested solutions to Financial Management, 9e, 2019 15

Sales 92,000,000 EBIT to Sales 14%

a) Return on Equity Conservative Average Aggressive