Financial management revision question and answer

A working capital policy of any business is critical to its viability as a going concern. The board of directors would ignore the information of such a policy to its great disadvantage.

The finance director of Watu Limited is formulating the company‟s capital policy for next year.
Sales have been protected at Sh.240 million next year. Three alternative policies are under consideration as follows:
1. Maintain current asset level at 40 per cent of projected sales.
2. Maintain current asset level at 50 per cent of projected sales.
3. Maintain current asset level at 60 percent of projected sales.

(a) Discuss the expected impact of policies (1) and (3).
(b) The fixed assets of Watu Limited are Sh.100 million and the company wishes to maintain a 60 percent debt ratio. The cost of capital for Watu Limited is currently 12 percent on both short-term and long-term debt. This is the rate which the firm also applies on its permanent capital structure. The company earns 15 percent on sales.

What is the expected return on equity under each of the three policies above?
(c) Are earnings and level of sales independent of current asset policy in real life? Explain.
(d) What is meant “maturity matching”, in finance?
(a) Policy (i) is an aggressive working capital policy with how ratio of current assets to sales. The expected impact can be:
– Inability to pay creditors bills
– Lost sales and customer goodwill
– Production stoppages
– Higher overall risks but high return.

Policy (iii) is a conservative marketing capital policy with high ratio of current assets to sales. The expected impact can be:-
– lower returns due to high holding costs
– lower risk

(b) Financial Impact of Policies

(c) In real life, the relationship among the variables is rather complex. This is because:-

– Different types of assets affect both risk and returns differently. Increasing cash holding reduces the firms overall risk than a similar increase in inventories.
– Holding more inventories increase the cost of storage and obsolescence.
– Stock – outs will result in loss of customer goodwill which will reduce sales.

(d) Maturity matching means matching assets and liability maturities financing current assets with short-term debt and fixed assets with long-term debt or equity.

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