CHAPTER 12 WORKING CAPITAL MANAGEMENT I Questions Working capital represents a firm’s investment in current assets Net working capital is current assets minus current liabilities Working capital management is the management of a firm’s current assets and current liabilities Working capital management is important because of its impact on reaching the goal of the hotel Working capital management affects not only a hotel’s shortterm liquidity and profitability but also its long-term growth and survival The manageability of working capital enables the manager to contribute to shareholder wealth maximization The goal of working capital management is to maintain the optimal level of net working capital in order to maximize shareholder wealth Working capital management involves risk-return tradeoffs because the level, composition, and financing of working capital always affect both a firm’s risk and its profitability Decisions involving these risk-return tradeoffs should be examined simultaneously to determine their joint impact on risk and profitability Risk-return tradeoffs are used to categorize working capital management strategies Conservative strategies are characterized by low risk, low return; aggressive strategies by high risk, high return; and moderate strategies by moderate risk, moderate return Risk and profitability are both affected by the level of working capital Too little working capital increases the risk of being unable to meet maturing obligations, but increases expected profitability Too much working capital reduces profitability because it costs money to carry excess working capital, but it also reduces risk 12-2 Solutions Manual - Managerial Accounting and Finance for Hospitality Operations II Practical Problems PROBLEM 1 Short-term (20%) Long-term (80%) Plan A (Conservative) P 240,000 960,000 (40% ) (60% ) Plan B (Aggressive) P 480,000 720,000 P1,200,000 P1,200,000 P 325,000 P 325,000 (20,400) (105,600) 199,000 79,600 P 119,400 (40,800) (79,200) 205,000 82,000 P 123,000 EBIT Interest Short-term @ 8.5% Long-term @ 11% EBT Taxes @ 40% Net income Plan A: Interest rates could drop significantly, which would increase the effective cost of long-term financing at a future point in time Plan B: Interest rates could increase, increasing the cost of short-term financing and possibly tightening the availability of short-term funds Profit would decrease (Subjective) Depends upon interest rate forecast PROBLEM Temporary current assets Permanent current assets Fixed assets Total assets P300,000 200,000 400,000 P900,000 Conservative Amount P900,000 P900,000 % of Total x 0.80 = x 0.20 = P720,000 P180,000 Interest Rate x 0.15 = x 0.10 = Interest Expense P108,000 18,000 Long-term Short-term Working Capital Management Total interest charge P126,000 Interest Rate P270,000 x 0.15 = P630,000 x 0.10 = Total interest charge Interest Expense P 40,500 63,000 P103,500 12-3 Aggressive Amount P900,000 P900,000 % of Total x 0.30 = x 0.70 = Long-term Short-term Conservative P 180,000 126,000 54,000 21,600 P 32,400 EBIT – Interest EBT Tax 40% EAT Aggressive P 180,000 103,500 76,500 30,600 P 45,900 PROBLEM Current assets – permanent current assets = temporary current assets P800,000 – P350,000 = P450,000 Long-term interest expense = = = 10% [P600,000 + ½ (P350,000)] 10% x (P775,000) P77,500 Short-term interest expense = = = 5% [P450,000 + ½ (P350,000)] 5% x (P625,000) P31,250 Total interest expense = = P77,500 + P31,250 P108,750 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes P200,000 108,750 P 91,250 27,375 P 63,875 12-4 Solutions Manual - Managerial Accounting and Finance for Hospitality Operations Alternative financing plan Long-term interest expense = = = 10% [P600,000 + P350,000 + ½ (P450,000)] 10% (P1,175,000) P117,500 Short-term interest expense = = = 5% [½ (P450,000)] 5% (P225,000) P11,250 Total interest expense = = P117,500 + P11,250 P128,750 Earnings before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes P200,000 128,750 P 71,250 21,375 P 49,875 The alternative financing plan which calls for more financing by high-cost debt is more expensive and reduces after-tax income by P14,000 However, we must not automatically reject this plan because of its higher cost since it has less risk The alternative provides the firm with long-term capital which at times will be in excess of its needs and invested in marketable securities It will not be forced to pay higher short-term rates on a large portion of its debt when short-term rates rise and will not be faced with the possibility of no short-term financing for a portion of its permanent current assets when it is time to renew the short-term loan PROBLEM Old Rose Café’s working capital equals its current assets which are P10,500 for 2002 and P12,500 for 2003 Old Rose Café’s net working capital (current assets – current liabilities) for 2002 and 2003 is: Current Current Net Working Year Assets – Liabilities = Capital 2002 P10,500 – P8,000 = P2,500 2003 P12,500 – P5,000 = P7,500 Working Capital Management 12-5 Old Rose Café’s current ratio (current assets / current liabilities) for 2002 and 2003 is: Year 2002 2003 Current Ratio P10,500 / P8,000 = 1.31 times P12,500 / P5,000 = 2.50 times A percentage (common-size) statement of Old Rose Café’s current assets for 2002 and 2003 is shown below Cash Marketable securities Accounts receivable Inventory Prepaid expenses Total current assets 2003 (Percent) 16.0 24.0 28.0 28.0 4.0 100.0 2002 (Percent) 14.3 19.0 23.8 38.1 4.8 100.0 The composition of the current assets has become more liquid The percentage of current assets held in the most liquid assets (cash and marketable securities) increased from 33.3 percent in 2002 to 40.0 percent in 2003 Based on the increase in the firm’s current ratio and the shift in the composition of current assets, the liquidity position of Old Rose Café has improved from 2002 to 2003 PROBLEM Requirement Working Capital Net Working Capital Current Ratio = = = P400,000 P400,000 – P200,000 = P200,000 P400,000 ÷ P200,000 = times Requirement Pearly Shells’ return on equity is 12.5 percent (P62,700 / P500,000) Pearly Shells Hotel Income Statement For the Year Ended December 31, 2002 Net sales EBIT (20% of sales) Less: Interest expense Short-term debt (10%) P800,000 P160,000 20,000 12-6 Solutions Manual - Managerial Accounting and Finance for Hospitality Operations Long-term debt (15%) Earnings before taxes Less: Income taxes (34%) Net income Requirement 45,000 P 95,000 32,300 P 62,700 The net working capital and current ratios for each strategy are shown below Current assets (CA) Fixed assets Total assets Strategies Current Assets as a Percent of Sales 30% 50% 70% P300,000 P 500,000 P 700,000 600,000 600,000 600,000 P900,000 P1,100,000 P1,300,000 Current liabilities (CL)* Long-term liabilities Total liabilities Stockholders’ equity (SE) Total liabilities and equity P180,000 270,000 P450,000 450,000 P900,000 P 220,000 330,000 P 550,000 550,000 P1,100,000 P 260,000 390,000 P 650,000 650,000 P1,300,000 Net working capital (CA – CL) Current ratio (CA/CL) P120,000 1.7 times P280,000 2.3 times P440,000 2.7 times * Assume that all current liabilities are in the form of short-term debt Requirement The hotel’s liquidity position, as measured by the amount of net working capital and current ratio, improves when current assets are a higher percentage of sales Requirement The rate of return on equity for each strategy is shown below: Strategies Current Assets as a Percent of Sales 30% 50% 70% Net sales P1,000,000 P1,000,000 P1,000,000 EBIT (18% of sales) 180,000 180,000 180,000 Interest expense Short-term debt (10%) 18,000 20,000 26,000 Long-term debt (15%) 40,500 49,500 58,500 Earnings before taxes P 121,500 P 110,500 P 95,500 Working Capital Management Income taxes (34%) 41,310 Net income P 80,190 Return on equity (NI/SE) 17.8% P 37,570 72,930 13.3% P 12-7 32,470 63,030 9.7% Requirement Pearly Shells’ profitability decreases as liquidity increases For example, the firm’s liquidity (current ratio = 2.7 times) is the highest but profitability (ROE = 9.7 percent) is the lowest when current assets are 70 percent of sales Requirement The return on equity, net working capital, and current ratio for each strategy are shown below Financing-Mix Strategies Conservative Hedging Aggressive EBIT P180,000 P180,000 P180,000 Interest expenses Short-term (10%) 10,000 30,000 45,000 Long-term (15%) 52,500 22,500 Earnings before taxes P117,500 P127,500 P135,000 Income taxes (34%) 39,950 43,350 45,900 Net income (NI) P 77,550 P 84,150 P 89,100 Return on equity (NI/SE) 17.2% Net working capital (CA – CL) P200,000 Current ratio (CA/CL) 3.0 times 18.7% P0 1.0 times 19.8% P(150,000) 0.7 times Requirement Combining an aggressive current asset strategy with an aggressive financing-mix strategy produces the highest return on equity Higher potential profitability is accompanied by greater risk in the form of lower liquidity Pearly Shells may be unable to meet required payments due to its relatively low level of working capital In fact, the hotel’s net working capital is negative under this aggressive financingmix strategy  ... before interest and taxes Interest expense Earnings before taxes Taxes (30%) Earnings after taxes P200,000 108,750 P 91,250 27,375 P 63,875 12- 4 Solutions Manual - Managerial Accounting and Finance. .. P800,000 P160,000 20,000 12- 6 Solutions Manual - Managerial Accounting and Finance for Hospitality Operations Long-term debt (15%) Earnings before taxes Less: Income.. .12- 2 Solutions Manual - Managerial Accounting and Finance for Hospitality Operations II Practical Problems PROBLEM 1 Short-term