7239Afe The Working Capital Management Assessment Answers
You have been hired as an analyst for Ant Bank and your team is working on an independent assessment of the Fresh Vegies Ltd (FV). FV is a firm that specializes in the production of fresh farm products and especially fruit, vegies and eggs. Your assistant has provided you with the following data for FV Ltd and their industry.
|
Ratio |
2017 |
2016 |
2015 |
Industry Average 2017 |
|
Inventory Turnover |
62.65 |
42.42 |
32.25 |
53.25 |
|
Accounts Receivable Period |
33.08 |
25.55 |
23.40 |
36.25 |
|
Debt to Equity |
0.75 |
0.85 |
0.90 |
0.88 |
|
Payables Turnover |
12.08 |
10.90 |
8.90 |
11.00 |
|
Profit Margin |
0.082 |
0.07 |
0.06 |
0.075 |
|
Quick Ratio |
1.028 |
1.03 |
1.029 |
1.031 |
|
Current Ratio |
1.33 |
1.21 |
1.15 |
1.25 |
- What can you say about the working capital management of FV? Be as complete as possible given the above information, but do not use any irrelevant information.
Problem
You have been employed as a consultant of Wazup Ltd, a company which tunes expensive cars. You find out that
- Wazup pays interest (coupons) of $ 125,000 once every year on its bonds with face value of $ 2,500,000. The bonds mature in exactly 10 years. The current market interest rate (yield) on similar bonds is 5.5%.
- The company’s tax rate is 25%.
- Risk-free rate is 3.5 %.
- In total, there are 2,000,000 ordinary shares issued. Current trading price per share is $ 3.34.
- There are 200,000 non-redeemable preference shares which pay 10% annually (last payment just occurred).
- The preference shares have an original value (face value) of $ 2 each.
- Current market price of a preference share is $ 2.73.
- The market risk premium is 5 %.
- The company’s beta is 2.1.
Based on this information:
- Calculate the company’s cost of equity.
- Calculate the cost of preference shares.
- Calculate the current market value of the company’s debt.
- Calculate the company’s weighted average cost of capital in a world without taxes.
- Calculate the company’s after-tax weighted average cost of capital.
- A manager of Wazup who is not familiar with the Capital Asset Pricing Model would like to know more about the beta factor of 2.1 which you have used for your calculations. Please provide an explanation of the difference between systematic and unsystematic risk. What does it mean that the company’s beta is 2.1?
Problem 3
The Kalkbrenner Ltd is considering whether to make an investment in a new machine with initial outlay of $ 100,000, economic life of four years and no salvage value. This machine will generate annual cash inflows of $ 40,000 per year. Assume that this amount represents also the net accounting profit (before depreciation), the machine is depreciated on a straight-line basis and there are no taxes. The Kalkbrenner Ltd uses a minimum benchmark ARR of 15% and a benchmark payback period of 2 years. The company’s cost of capital is 16%.
- Evaluate the project with the ARR, payback period, NPV and IRR methods of capital budgeting and provide an investment decision according to each of these criteria. Please use the approximation method for calculating the IRR.
- The Kalkbrenner Ltd has as a second alternative a project with initial outlay of $ 120,000, economic life of 3 years and annual inflows of $ 55,000 per year. Both projects are mutually exclusive.
- What is the NPV of the second project?
- Which project should be chosen based on the constant chain of replacement assumption? Hint: Calculate the equivalent annual annuity (EAA).
Problem 4
Assume it is the 20th of August 2017. An Australian-based company with functional currency AUD exports sport equipment to the US. The negotiated contract price for the company’s sales in six months (20th of February 2018) is USD 10 million. The company has costs of AUD 8.8 million. The company is concerned about its foreign exchange rate risk because the AUD/USD exchange rate has been historically quite volatile and has hired you as a risk management advisor.
You obtain following additional information:
- The AUD/USD spot rate on the 20th of August is 0.9200.
- The US six-month interest rate is 3.0%.
- The Australian six-month interest rate is 2.4%.
- An AUD/USD foreign exchange futures contract with the size of AUD 2 million expiring on the 30th of January 2018 is available with futures rate AUD/USD 0.9223.
- The company’s target (ideal) profit margin (profit as percentage of revenue) is 20%.
- The minimum acceptable profit margin below which the company will have difficulties servicing its debt is 14%.
- Following foreign exchange option contracts expiring on the 20th of February 2018 are available:
|
Option type |
Strike rate |
Premium |
|
AUD Call |
0.97 |
15 points |
|
AUD Put |
0.75 |
5 points |
|
AUD Call |
0.88 |
200 points |
|
AUD Put |
0.85 |
100 points |
- What would be the profit margin of the company if the current spot rate is used? What is the critical AUD/USD currency rate for the company? What is the AUD/USD currency rate at which the company achieves exactly its target (ideal) rate?
- What steps would you undertake to analyse the need of this company for hedging? Give two examples of situations in which the company may not need to hedge its FX risks with derivatives.
- What risks is the company exposed to if it decides to use the available futures contract for hedging? Please explain.
- You consider following strategies:
- Hedge 100 % of the revenues with a forward contract.
- Hedge 50 % of the revenues with a forward contract and leave the other 50 % unhedged.
- Meet the target rate and have protection against unfavourable exchange rate movements but fully benefit from favourable exchange rate movements.
- Worst-case protection.
- No hedge at all.
If a strategy includes options, state clearly which option contract should be used. Comment on the advantages and disadvantages of each strategy and calculate the profit margin of the company if the AUD/USD spot exchange rate on the 20th of February 2018 is
- a) 1.05,
- b) 0.85.
What is the effective exchange rate in each case?
If a strategy uses options, take the option premium into account in the way we did this in the lecture. Disregard the time value of money. Assume that there are 180 days in a period of six months.
- Give two examples of low-cost hedging strategies employing financial derivatives, different than the strategies you already discussed. These strategies do not need to be based on the option contracts listed in the table above. You don’t need to do any calculations for these examples.
Answer:
The statement made by the CFO is not correct, as the organisations current ratio and quick ratio is lower than the industry average, which depicts the low accumulation of current assets to support their financial obligations. The reduction in the accumulation of quick assets and increment in current assets directly indicates the increase in inventory position of the company which are not considered highly liquid assets (Heikal, Khaddafi & Ummah, 2014).
Therefore, the statement provided by the CFO is not true, as the company’s overall liquid position declined in comparisons to its industry average. The inventory accumulation of the company has increased drastically from the level of 32.35 in 2015 to 62.65 in 2017, while the values in 2017 I higher than the industry average of 53.25.
2. Identifying about the working capital management of FV:
The working capital management is mainly calculated by subtracting the current assets with current liabilities. Hence, with the accumulation of the current asset is appropriate, as the current liabilities are less than the accumulated assets. This mainly depicts that the organisation maintains adequate current assets for supporting their operations. The current ratio formula directly indicates that current assets of the company is higher than the current liabilities (Aktas, Croci & Petmezas, 2015). This relevantly indicates the positive attributes of the working capital management of the company. Moreover, values of the working capital have mainly increased from 2015 to 2017, which can be identified from the rising values of current ratio.
1. Calculating the company’s cost of equity:
|
Particular |
Values |
|
Market risk premium |
5.00% |
|
Company beta |
2.10 |
|
Risk free rate |
3.50% |
|
Cost of equity |
6.65% |
2. Calculating the cost of preference shares:
10.00%
|
Particular |
Values |
|
Dividend |
40,000 |
|
Net Proceeds |
400,000 |
|
Cost of preference shares |
Calculating the current market value of the company’s debt:
|
Particular |
Values |
|
Interest on bonds |
125,000 |
|
Face Value bond |
2,500,000 |
|
Yield rate |
5.50% |
|
Time |
10 |
|
Market Value of bond |
2,405,780 |
Calculating company’s weighted average cost of capital in a world without taxes:
|
Particular |
Values |
|
Ordinary Share price value |
6,680,000 |
|
Non-redeemable preference shares |
546,000 |
|
Market Value of bond |
2,405,780 |
|
Total value |
9,631,780 |
|
Cost of equity |
6.65% |
|
Cost of preference shares |
10.00% |
|
Interest rate of bond |
5.00% |
|
Weighted Average Cost of Capital |
6.43% |
5. Calculating the company’s after tax weighted average cost of capital:
|
Particular |
Values |
|
Ordinary Share price value |
6,680,000 |
|
Non-redeemable preference shares |
546,000 |
|
Market Value of bond |
2,405,780 |
|
Total value |
9,631,780 |
|
Cost of equity |
6.65% |
|
Cost of preference shares |
10.00% |
|
Interest rate of bond |
5.00% |
|
Tax |
25.00% |
|
Weighted Average Cost of Capital |
6.12% |
Providing the difference between the systematic and unsystematic risk, while depicting about the company’s beta of 2.1:
There are different types of risk, such as systematic and unsystematic risk, which is directly allows the investor for reducing the risk from investment, while increases the level of returns from investment. Systematic risk is the relevant variations, which arise from macroeconomics factors such as interest risk, inflation risk and market risk. These identified risks are directly affecting the return generation capability of the organisation. However, the risk is mainly controllable, where investors can be use different level of theories and measures for curbing the risk from investment. On the contrary, the unsystematic risk is mainly based on the business risk and financial risk of an organisation, which is uncontrollable, as it effects the internal operations of the company.
Therefore, the beta of 2.1 directly indicates the high level of risk, which is affecting profit generation capability of the organisation. The high-risk attribute indicates the volatility in prices change, which will be witnessed when index price changes. The risk attributes of market are at the levels of 1, while the risk of the organisation is 2.1, which indicates that higher return needs to be provided by the company in comparison to the market return. The use of Capital Asset Pricing Model directly helps in depicting the level of returns, which needs to be provided by the stock with certain level of beta or risk. Marshall (2015) stated that with the help of CAPM model investors are able to detect the level of minimum returns, which needs to be provided by the stock.
1. Evaluating the project with ARR, payback period, NPV and IRR methods of capital budgeting, while providing an investment decision according to each of these criteria’s:
|
Year |
Cash flow |
Dis-rate |
Dis-cash flow |
Cum-cash |
|
0 |
(100,000) |
1.00 |
(100,000) |
(100,000) |
|
1 |
40,000 |
0.86 |
34,483 |
(60,000) |
|
2 |
40,000 |
0.74 |
29,727 |
(20,000) |
|
3 |
40,000 |
0.64 |
25,626 |
20,000 |
|
4 |
40,000 |
0.55 |
22,092 |
60,000 |
|
NPV |
11,927 | |||
|
ARR |
60.00% | |||
|
IRR |
22% | |||
|
Payback period |
2.5 |
Years | ||
2.a Identifying the NPV of the second project:
|
Year |
Cash flow |
Dis-rate |
Dis-cash flow |
Cum-cash |
|
0 |
(120,000) |
1.00 |
(120,000) |
(120,000) |
|
1 |
55,000 |
0.86 |
47,414 |
(65,000) |
|
2 |
55,000 |
0.74 |
40,874 |
(10,000) |
|
3 |
55,000 |
0.64 |
35,236 |
45,000 |
|
NPV |
3,524 | |||
|
ARR |
37.50% | |||
|
IRR |
18% | |||
|
Payback period |
2.2 |
Years | ||
2.b Calculating the equivalent annual annuity for choosing the adequate project:
|
Particulars |
Project 1 |
Project 2 |
|
Year |
4 |
3 |
|
Cost of capital |
16% |
16% |
|
NPV |
11,927 |
3,524 |
|
Equivalent Annual Annuity |
$4,262.49 |
$1,569.06 |
From the evaluation of above calculation financial viability of the projects can be identified. In addition, with the calculation of equivalent annual annuity it could be identified that selecting project 1 can be used by the organisation for improving the level of returns from investment. The project selected for the calculation is relevantly helpful and generates the highest revenue from investment. moreover, the NPV, IRR, and ARR of project 1 is higher than project 2, which directly indicates the profits and returns that can be generated from investment (Baum & Crosby, 2014).
1. Identifying the profit margin of the company if the current spot rate is used, while depicting the critical AUD/USD currency rate and portraying the AUD/USD currency rate at which the company achieves exactly its target rate:
|
Particulars |
Value |
|
AUD/USD Spot rate 20-08-2017 |
1.086956522 |
|
Payment in USD |
AUD 10,869,565 |
|
Cost in AUD |
AUD 8,800,000 |
|
Profit in USD |
AUD 2,069,565 |
|
Return on USD |
19.04% |
|
Particulars |
Value |
|
Minimum acceptable profit margin |
14.00% |
|
Cost in AUD |
AUD 8,800,000.00 |
|
Sales |
AUD 10,232,558.14 |
|
Payment in USD |
$ 10,000,000 |
|
Critical AUD/USD |
0.9773 |
|
Particulars |
Value |
|
Target profit (Ideal) |
20.00% |
|
Cost in AUD |
AUD 8,800,000 |
|
Sales |
AUD 11,000,000 |
|
Payment in USD |
$ 10,000,000 |
|
Ideal Profit AUD/USD |
0.9091 |
2. Steps for undertaking the hedging measure taken by the company, while giving two examples in which the company may not need the hedge process:
The changes in valuation of the AUD/USD would directly affect the level of hedging measure, which needs to be maintained by the organisation for reducing the risk from investment. However, the continuous decline in the current currency conversion rate would eventually help in reducing the risk involved in investment. There are two different situations under which no hedging process will be required by the organisation.
The first situation under which the hedging process will not be required is the decline in current AUD/USD value. This will eventually increase the level of income from the transactions that will be generated from currency conversion. However, from the evaluation it is also detected that use of fixed forward rate contract from banks would also help in fixing the level of currency values, which will be used for the conversion. Under this situation there is no need for the hedging process, as the conversion rate of fixed (Mensi, Hammoudeh & Yoon, 2015).
3. Identifying the risk involved for investments in future contract by the organisation:
There is significant risk involved in using the future contract, as the contract will expire in 30-01-2018, while the payment will be received on 20-02-2018, which relevantly increase the gap for 20 days. This difference in transactions period is 20 days, which will directly increase the level of risk from hedging (Dong, Kouvelis & Su, 2014). The hedging process will not be conducted for the duration of 20 days, which will directly increase the level of risk involved in investment. However, values of the future contract are relevantly high, which will negatively affect the level of income that will be converted during 20-02-2018.
4. Considering different hedging strategies that can be used by the organisation:
I. Hedging 100% of the revenue from forward contract:
|
Particulars |
Value |
|
Payment in USD |
$ 10,000,000 |
|
Hedge 100% |
100% |
|
Buying AUD Put |
0.850 |
|
Premium |
0.010 |
|
Spot rate 20-08-2017 (0.92) |
9,300,000 |
|
Spot rate 20-02-2018 (1.05) |
10,500,000 |
|
Loss from hedge |
(1,200,000) |
|
Profit from transaction |
1,300,000 |
|
Total value in currency transaction |
100,000 |
|
Particulars |
Value |
|
Payment in USD |
$ 10,000,000 |
|
Hedge 100% |
100% |
|
Buying AUD Put |
0.850 |
|
Premium |
0.010 |
|
Spot rate 20-08-2017 (0.92) |
9,300,000 |
|
Spot rate 20-02-2018 (0.85) |
8,500,000 |
|
Profit from hedge |
800,000 |
|
Loss from transaction |
(700,000) |
|
Total value in currency transaction |
100,000 |
II. hedging 50% of the profit:
|
Particulars |
Value |
|
Payment in USD |
$ 10,000,000 |
|
Hedge 100% |
50% |
|
Buying AUD Put |
0.850 |
|
Premium |
0.010 |
|
Spot rate 20-08-2017 (0.92) |
4,650,000 |
|
Spot rate 20-02-2018 (1.05) |
5,250,000 |
|
Loss from hedge |
(600,000) |
|
Profit from transaction |
1,300,000 |
|
Total value in currency transaction |
700,000 |
|
Particulars |
Value |
|
Payment in USD |
$ 10,000,000 |
|
Hedge 100% |
50% |
|
Buying AUD Put |
0.850 |
|
Premium |
0.010 |
|
Spot rate 20-08-2017 (0.92) |
4,650,000 |
|
Profit from transaction |
4,250,000 |
|
Profit from hedge |
400,000 |
|
Loss from transaction |
(700,000) |
|
Total value in currency transaction |
(300,000) |
III. Taking protection against unfavourable effect and increasing return from favourable effect:
|
Particulars |
Value |
|
Payment in USD |
$ 10,000,000 |
|
Buying [email protected] |
0.751 |
|
Buying [email protected] |
0.900 |
|
Total income from hedging |
0.150 |
|
Total profit from hedge |
$ 1,495,000 |
IV. Worst-Case Protection:
|
Particulars |
Value |
|
Payment in USD |
$ 10,000,000 |
|
Hedge 100% |
100% |
|
Buying AUD Call |
0.970 |
|
Premium |
0.002 |
|
Spot rate 20-08-2017 (0.92) |
9,215,000 |
|
Spot rate 20-02-2018 (1.05) |
10,500,000 |
|
Profit from hedge |
1,285,000 |
|
Loss from transaction |
(1,300,000) |
|
Total loss in currency transaction |
$ (15,000) |
|
Particulars |
Value |
|
Payment in USD |
$ 10,000,000 |
|
Hedge 100% |
100% |
|
Buying AUD Call |
0.97 |
|
Premium |
0.0015 |
|
Spot rate 20-08-2017 (0.92) |
9,215,000 |
|
Spot rate 20-02-2018 (0.85) |
8,500,000 |
|
Loss from hedge |
(715,000) |
|
Profit from transaction |
700,000 |
|
Total loss in currency transaction |
(15,000) |
V. No Hedge at all:
|
Particulars |
Value |
|
Payment in USD |
$ 10,000,000 |
|
No Hedge |
0 |
|
Spot rate 20-08-2017 (0.92) |
$ 9,200,000 |
|
Spot rate 20-02-2018 (0.85) |
$ 8,500,000 |
|
Loss from transaction |
$ (700,000) |
|
Particulars |
Value |
|
Payment in USD |
$ 10,000,000 |
|
No Hedge |
0 |
|
Spot rate 20-08-2017 (0.92) |
$ 9,200,000 |
|
Spot rate 20-02-2018 (1.05) |
$ 10,500,000 |
|
Profit from transaction |
$ 1,300,000 |
5. Providing two different examples of low-cost hedging strategies, which has not been already discussed:
The use of forward exchange contract and money market operations can be conducted for the hedging purposes. This would eventually help in reducing the level of risk and maximise the profits, which could be generated from the hedging process. Hence, with the use of forward exchange contract the organisation could fix the rate of exchange in which the USD payment can be converted to AUD. This will drastically reduce the risk and maximise the level of returns, which can be generated from the hedging process. The fluctuations in the currency market will have no effect on the conversion price of the payment made in USD, as the contract fixes the rate of exchange in which the conversion will take place after the period of 6 months (Chege & Obwogi, 2018).
The second contract that can be used is the money market hedging process, which helps the organisation to minimise the level of risk involved in currency conversion. The money market process mainly a loan in the payment providing country and loan in payment receiving country. Hence, the organisation needs to take a loan in USA for the amount of the payment, while the amount less interest will be transferred to AUD at spot rate, which nullifies the loss from currency conversion. The same amount transferred to AUD will be deposited in the bank for the time period of the payment, which will bring in interest. This inflow of interest in home country and interest payment in foreign country will reduce the loss that will be conducted during the foreign exchange.
References and Bibliography:
Aktas, N., Croci, E., & Petmezas, D. (2015). Is working capital management value-enhancing? Evidence from firm performance and investments. Journal of Corporate Finance, 30, 98-113.
Awais, M., Hayat, F., Mehar, N., & Ul-Hassan, W. (2015). Do Z-Score and Current Ratio have Ability to Predict Bankruptcy?. Developing Country Studies, 5(13), 30-36.
Baños-Caballero, S., García-Teruel, P. J., & Martínez-Solano, P. (2014). Working capital management, corporate performance, and financial constraints. Journal of Business Research, 67(3), 332-338.
Baum, A. E., & Crosby, N. (2014). Property investment appraisal. John Wiley & Sons.
Bhalla, V. K. (2014). Working capital management. S. Chand Publishing.
Bromiley, P., Rau, D., & Zhang, Y. (2017). Is R & D risky?. Strategic Management Journal, 38(4), 876-891.
Chege, J. M., & Obwogi, T. N. (2018). The Effect Of Currency Risk Internal Hedging Strategies On The Value Of The Firm: Evidence Of Listed Commercial Banks In Kenya. Management and Economic Journal, 315-323.
Deshmukh, N. H., & Joshi, P. V. (2016). Applicability of Sharpe model in varying time frames for small portfolio construction. KHOJ: Journal of Indian Management Research and Practices, 181-188.
Dong, L., Kouvelis, P., & Su, P. (2014). Operational hedging strategies and competitive exposure to exchange rates. International Journal of Production Economics, 153, 215-229.
Garg, M. (2015). Working Capital Management. Educreation Publishing.
Heikal, M., Khaddafi, M., & Ummah, A. (2014). Influence analysis of return on assets (ROA), return on equity (ROE), net profit margin (NPM), debt to equity ratio (DER), and current ratio (CR), against corporate profit growth in automotive in Indonesia Stock Exchange. International Journal of Academic Research in Business and Social Sciences, 4(12), 101.
Marshall, C. M. (2015). Isolating the systematic and unsystematic components of a single stock’s (or portfolio’s) standard deviation. Applied Economics, 47(1), 1-11.
Mensi, W., Hammoudeh, S., & Yoon, S. M. (2015). Structural breaks, dynamic correlations, asymmetric volatility transmission, and hedging strategies for petroleum prices and USD exchange rate. Energy Economics, 48, 46-60.
Utami, W. B. (2017). Analysis of Current Ratio Changes Effect, Asset Ratio Debt, Total Asset Turnover, Return On Asset, And Price Earning Ratio In Predictinggrowth Income By Considering Corporate Size In The Company Joined In LQ45 Index Year 2013-2016. International Journal of Economics, Business and Accounting Research (IJEBAR), 1(01).
Valipour, M., Amin, V., Kargosha, M., & Akbarpour, K. (2015). Forecasting stock systematic risk using Heuristic Algorithms. Journal of Productivity and development, 1(1), 36-41.
Vats, S., & Patel, K. (2017). Ratio Analysis of a Private Limited Company with Relevance to Change in Type of Enterprise-A Case Study of Write Fine Products Pvt. Ltd. Umbragam, Gujarat. Journal of Applied Management-Jidnyasa, 9(2), 37-43.
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