solved ASSESSMENTS 7 AND 8 CONTEXT Since Assessments 7 and 8

ASSESSMENTS 7 AND 8 CONTEXT
Since Assessments 7 and 8 address interrelated issues of longer-term investments as well as working capital, this document provides helpful background for both assessments.
Financing Long-Term Investments
Every company will make long-term investments, usually invoking the capital budgeting process to determine which investments are the most lucrative. Financing those investments becomes the domain of capital structure—how do we raise the money to fund the investments needed to maximize our shareowner value? It is important to maintain a balance of debt and equity such that the overall cost of capital is minimized. In this way, shareowner wealth is improved by the investment itself and by how the investment is financed.
Central Questions for Corporations in Regard to Shareholders
How Much Equity is Right?
Almost all corporations access long-term capital markets, bonds and stock in particular. The reason to access capital other than common stock is because it is usually less expensive than equity. Therefore, if you can borrow at 10 percent and earn 15 percent on the money, you just made money for the shareowners and your stock price should go up.
But too much debt, though it may be cheaper in appearance, carries risk. A key characteristic of that risk is that the interest payments must be made in good times and in bad. Conseco is a recent example on a long list of successful companies that took on too much debt (in Conseco’s case, to finance acquisitions) and ultimately could not meet its interest payments, which resulted in bankruptcy.
Using debt to enhance shareowner wealth is called financial leverage. It is the art of knowing how much of other people’s money to use to maximize your return to shareowners. If you use too little financial leverage, it means you are not taking the opportunity to create earnings; if you use too much, you could wind up bankrupt.
How Much Income Should Shareowners Receive?
As much as possible if you ask them, and after all, they are the owners. But, as much as possible does not necessarily mean the income must all be in cash. Shareowners get their return in two basic forms: dividends and capital gains from changes in the stock price, a lot of which has to do with how effectively management can invest the earnings not paid out in dividends. Financial managers therefore have to decide what percentage of profits are to be paid out to the owners and how much they will reinvest.
A lot goes into this analysis, including shareowner preferences. These preferences may be affected by the recent debacles in which several large companies’ managers were not good stewards of the shareowners’ money.
Answers to Management Questions
The answers to these management questions should be guided by the principle of maximizing shareowner wealth. There are many tools that management uses, but often theory and philosophy dominate these tools. Two identical companies might take very different courses because of managerial preference. It is certainly possible to be successful by being either conservative or aggressive. In the end, it is the management of the company that determines the success of the business. This success depends on management’s ability to exercise sound judgment when considering these fundamental philosophies.
What is Working Capital?
You have examined capital markets and capital budgeting. Then, the focus was on longer term investing and the financing of those investments. Turn your attention to the money needed to run the business daily. If you can appreciate the dilemma of having to pay for the raw materials and labor that go into your product long before you actually sell it and collect the money from that sale, you will understand the role of working capital.
Working capital is simply the short-term capital needed to run the business day-to-day–that is, to pay the bills, make your products, and run your business. We are generally talking about short-term assets like cash in the bank, short-term investments (also known as near-cash), inventory, and accounts receivable. When you deduct the short-term liabilities (such as accounts payable, accrued payroll, and the short-term portion of long-term debt), then you have net working capital.
The Importance of Net Working Capital
Though it may seem more tactical and therefore less glamorous than the strategic nature of long-term investments, financial managers (and managers in general) spend most of their time on the daily business operation. As someone once said, “If you don’t get the short-term right, then the long-term doesn’t matter.”
One way to determine the health of a company is to look at the net working capital. If it is negative, chances are that the company might not be able to cover its near-term obligations from readily available funds. From the work you did on financial ratio analysis, this would manifest in a current ratio of less than 1.0.
The company may have to raise some additional working capital to remain solvent. Yet as sound as this may seem, consider the recent trend toward zero working capital. Money that is owed you but not received or inventory that has been paid for but not sold is not really very useful, yet this is what working capital is (along with cash in the bank, which also is not really a great investment). Therefore, the more recent theory is that companies should minimize working capital, even to the point where net working capital is negative—this is a good thing to have.
How Do You Get Negative Net Working Capital?
If you think about what net working capital is, it becomes clear how to minimize it:

Cash

You should not have any more cash or cash equivalents than you need for things like compensating balances (for example, the cash banks may require if you take a loan, avoiding service charges) and meeting immediate commitments. You can usually borrow for temporary spikes in cash demand.

Accounts Receivable

Ideally, have your customer pay in advance or at the same time as shipped. If you cannot get payment until after the sale (which is usually the case), then provide trade credit terms that provide an incentive for early payment. Example: 2/10, net 30 means the customer gets a 2 percent credit if paid within 10 days or else the total amount is due in 30 days. Essentially you are charging 2 percent interest for 20 days—pretty substantial, but not uncommon in many industries. This will get the money in sooner and therefore reduce the accounts receivable. (Of course, this is a double-edged sword in that you are giving up a lot of the invoice just to get the money in a little earlier.)

Inventory

In the past several years, a concept of just-in-time (JIT) inventory management has come into being. It means, as the name implies, that you do not get the stuff until you really need it so it has minimal shelf time. A lot has to go well for this to work because there is little margin for error, but some companies are getting it down to the point where parts are shipped at the point of sale and all show up the next day for assembly. There is quite a bit going on around this in supply chain management (SCM), which is currently a major area of study in most companies to manage the supply of the product.

Accounts Payable

The longer you can avoid paying someone the better. You want this account as large as possible without damaging your standing with your vendors. On the other hand, you might say it is not how big it gets, but how long you can postpone buying materials, and that is an even better strategy. If you go back to what was said about JIT, then you are not really buying your materials and components until the last minute, so you are in effect postponing the trade debt. Therefore, you are deferring the ultimate payment without protracting the credit period and possibly straining your vendor relationships. (As for employee payroll, there usually is not much you can do here except run lean; of course, almost all companies pay employees in arrears, which is okay, and some companies intentionally drag their feet on paying expenses, which has both a positive cash impact and a questionable ethic.)
By following these broad strategies, a company can reduce working capital.
So What?
Inventory represents cash you once had. Accounts receivable represents cash you would like to have. Accounts payable represents cash you would like to hang onto a little longer. When you reduce net working capital, you create a one-time windfall, which can be put to better use buying things you need or acquiring new sites or facilities. In addition, however you put that cash to work generates ongoing earnings each year. Many companies that get this right have been known to generate $100 million or more; so suddenly they have a lot of money to invest, and if those investments earn the 20 percent or so that investors are typically looking for, there is another $20 million each year.
What Makes It All Work?
Ever since Deming and Juran (two of the original quality gurus in the 1950s and 1960s), American companies, who fell behind in quality management, have been improving in this respect. In particular, Japan adopted the concepts of total quality management (TQM) in the 1950s when Deming, an American who was unsuccessful at getting American corporations’ attention, took his disciplined approaches to Japan, known at the time for poor quality. Within a decade or two, there was suddenly a quality crisis in America; not because our quality had slipped, but because Japanese and, predictably, other foreign nations’ quality had vastly improved under the principles of TQM. TQM is beyond the scope of our course, but it suffices to say that it is about eliminating errors from your manufacturing or other business processes, finding where errors occur, determining their causes, and eliminating those causes.
If you can rely upon your processes, you can be aggressive at minimizing the waste and, with the use of predictable technology, become an efficient operation that almost always has a reduced or even negative net working capital.
Complete four problems for this assessment.
For this assessment, complete Problems 1–4 evaluating optimal capital structure and the financial health of a firm. You may solve the problems algebraically, or you may use a financial calculator or an Excel spreadsheet. In addition to your solution to each computational problem, you must show the supporting work leading to your solution to receive credit for your answer. Note the following:

You may need an HP 10B II business calculator.
You may use Word or Excel, but you will find Excel to be most helpful for creating spreadsheets.
If you choose to solve the problems algebraically, be sure to show your computations.
If you use a financial calculator, show your input values.
If you use an Excel spreadsheet, show your input values and formulas.

Problem 1: Optimal Capital Structure
XYZ Inc. is setting its target capital structure. The CFO of XYZ Inc. believes that the optimal debt-to-capital ratio is between 25 percent and 60 percent. Her staff derived following the projections. Various debt levels were considered.
Debt/Capital Ratio Projected EPS Projected Stock Price
Dept/Capital RatioProjected EPSProjected Stock Price25%$4.20$40.0035%$4.45$41.5045%$4.75$41.2560%$4.50$40.59
Assuming that the firm uses only debt and common equity, what is XYZ’s optimal capital structure? At what debt-to-capital ratio is the company’s WACC minimized?
Problem 2: Break-Even Analysis
XYZ Inc. sells photoframes for $20 each. The fixed costs are $60,000, and variable costs are $7 per photoframe.

What is the firm’s gain or loss at sales of 6,000 photoframes? At 15,000 photoframes?
How would the break-even point be affected if the selling price was raised to $25? How is this analysis significant?
If the selling price was raised to $25 but variable costs rose to $13 a unit, what would happen to the break-even point?

Problem 3: WACC and Optimal Capital Structure
This problem is easiest to complete in Excel. Structure consists of only debt and common equity. XYZ’s finance department staff created the following table showing the firm’s debt cost at different debt levels:
Debt-to-Capital RatioEquity-to-Capital RatioDebt-to-Equity RatioBond RatingBefore-Tax Cost of Debt0.01.00.00A6.0%0.20.80.25BBB7.0%0.40.60.67BB9.0%0.60.41.50C11.0%0.80.24.00D14.0%
XYZ uses the CAPM to estimate its cost of common equity and estimates that the risk-free rate is 4 percent, the market risk premium is 7 percent, and its tax rate is 35 percent. XYZ estimates that if it had no debt, its “unlevered” beta would be 1.5.

What would be its WACC at the optimal capital structure? What would the firm’s optimal capital structure be?
If XYZ’s managers anticipate that the company’s business risk will increase in the future, what effect would this likely have on the firm’s target capital structure?
If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on XYZ’s target capital structure?

Problem 4: Cost of Trade Credit and Bank Loan
XYZ Inc. buys $10 million of materials (net of discounts) on terms of 3/5, net 60, and it currently pays on the 5th day and takes discounts. XYZ plans to expand, which will mean additional financing.

If XYZ decides to forgo discounts, could it obtain much additional credit?
What would be the nominal and effective cost of that credit?
What would be the effective cost of the bank loan if the company could get the funds from a bank at a rate of 8 percent and if the interest was paid monthly? All of this should be based on a 365-day year.
Should XYZ use bank debt or additional trade credit? Explain.