Topic 7 - WCM 2 Ans 2019-20
Topic 7 - WCM 2 Ans 2019-20
Topic 7 - WCM 2 Ans 2019-20
Question 1.
The three main reasons why companies choose to hold cash are as follows:
(1) Transactions motives: companies need cash in order to remain liquid (solvent) on
a day to day basis. Cash inflows are never perfectly aligned to cash outflows and
hence a balance or 'float' is needed to smooth out the lag between cash coming in
and cash going out. Companies can predict the size of cash balance needed by
forecasting their cashflow and identifying early any period where there are surpluses
or deficits. A cash balance can then be built up to fund a deficit and run down in
times of surplus.
(3) Speculative motives: companies may build up cash reserves so they can act
quickly if an attractive investment opportunity arises, for example the takeover of
another company. Investment opportunities may not exist at the current time, but
funds are held speculatively in case an opportunity emerges. By being able to move
quickly and not having to wait to raise finance companies can often negotiate the
best deals and conclude a deal before competitors become aware.
Question 2.
The factors to be considered when investing surplus funds are as follows:
Treasury bills and short-dated gilts: T-Bills come in 3, 6 and 12-month maturities.
Gilts are longer but ones with less than a year to maturity can be used. This
investment is low risk but also low return
Sterling certificates of deposit: minimum investment of £100,000. Bearer-form
securities with maturities ranging from 28 days through to 5 years. They can be
traded on the money markets and are a liquid security, hence carry lower rates of
interest than term deposits. They are higher risk than treasury bills though so
should have higher yields.
Term deposits: money deposited short-term with banks. Flexible time and size
wise but not always flexible if access to the funds is needed at short notice.
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LECTURE 7
L5 FINANCIAL MANAGEMENT
WORKING CAPITAL MANAGEMENT II
Question 3.
(1) Assuming that offering credit is necessary, or the benefits have been proven
to clearly outweigh the costs the credit worthiness of new customers should
be assessed and reviewed on a regular basis. Relevant information should
be obtained from a variety of sources, including:
Finally, when credit has been granted to a new customer there should be an
initial period of intensive monitoring to ensure that the agreed credit terms are
adhered to. Any non-compliance in the initial credit period may indicate that
long term the customer may turn out to be unreliable and therefore should be
treated with caution.
(2) The key to good credit management is the consistent deployment of clear
credit policies upheld by unambiguous accountability within the company.
The credit terms offered to a customer should be clear to them and they
should be reviewed regularly. Credit limits should be revised downwards if a
customer becomes a default risk but also if the credit limit is not being used
and is above their needs.
The customer should be clear from the outset what will happen if the terms of
the agreement are breached. For example, what compensatory interest will be
charged? and when will debt collection procedures be invoked? A customer's
current credit position should always be reviewed before accepting further
orders.
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LECTURE 7
L5 FINANCIAL MANAGEMENT
WORKING CAPITAL MANAGEMENT II
insurance, the cost of the discount must be considered against the cashflow
benefits and reduced bad debt.
Finally, a company can outsource its credit management and let a factoring
company take care of the whole process. A factoring company should ensure
good credit management as it is their core competence. A factor will provide
cashflow benefits by advancing money against invoiced debt and may also be
able to provide a reduced (or zero) bad debt liability if the arrangement is
agreed 'without recourse'
Question 4.
£ £
Current level of trade receivables = 197,260
(1,600,000 x 45/365)
Question 5.
(a) The cash conversion cycle is the receivables' conversion period (RCP) plus
the inventory conversion period (ICP), less the payables' deferral period
(PDP).
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LECTURE 7
L5 FINANCIAL MANAGEMENT
WORKING CAPITAL MANAGEMENT II
€ €
Reduction in bad debts = 12m x 0.5% = 60,000
Saving in administration costs = 160,000
Benefits 220,000
Increase in financing cost due to advance (1,885)
Annual fee of factor = 12m x 2% = (240,000)
Costs (241,885)
Net benefit (£21,885)
The finance provided by the factor is an accelerated cash flow derived from
trade receivables. It is therefore not appropriate to use it for a long-term
finance need, such as the purchase of non-current assets. Rather, it should
be used for a short-term need, such as the payment of trade payables or
meeting forecast cash needs. In general, the matching of assets and liabilities
is recommended. That said, permanent current assets should be financed
from a long-term source. Overall, the use of the factor cannot be
recommended as it bring no net benefit.
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LECTURE 7
L5 FINANCIAL MANAGEMENT
WORKING CAPITAL MANAGEMENT II
Q3. B £109,544
Using the Baumol model: Q= √((2 × C × S)/i)
OC = (2 x £1,500,000 x £200/(0.05))½ = £109,544
Q4. B 8.2%
Here the equivalent annual discount is given by:
(40 – 10)/365 X 1% = 8.22%
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LECTURE 7