Minimizing Working Capital Essay
4-1 Minimizing Working Capital Essay
Preparation
For this assessment, you will examine the importance of minimizing working capital, as well as gain a better understanding of the challenges associated with minimizing working capital. Use the Internet and the Capella University Library to gather a minimum of three resources on this topic.
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Instructions
To complete this assessment, research and write an essay on the following:
· Why is it important to minimize working capital?
· What are the challenges in minimizing working capital?
Use at least three research resources to support your ideas.
Other Requirements
· Length: Your paper should be 4 typed, double-spaced pages. In addition, include a title page and references page.
4-2 Unit 4 Problems Assessment
Overview
For this assessment, you will evaluate optimal capital structure and the financial health of a firm.
Instructions
For this assessment, complete Problems 1–5. You may need an HP 10B II Business Calculator to complete the following problems. You may use Word or Excel to complete the assessments throughout this course, but you will find Excel to be most helpful for creating spreadsheets.
Problem 4-1: 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 Ratio |
Projected EPS |
Projected Stock Price |
25% |
$4.20 |
$40.00 |
35% |
$4.45 |
$41.50 |
45% |
$4.75 |
$41.25 |
60% |
$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 4-2: Break-Even Analysis
XYZ Inc. sell photoframes for $20 each. The fixed costs are $60,000, and variable costs are $7 per photoframe.
1. What is the firm’s gain or loss at sales of 6,000 photoframes? At 15,000 photoframes?
2. How would the break-even point be affected if the selling price was raised to $25? How is this analysis significant?
3. 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 4-3: 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 Ratio |
Equity-to-Capital Ratio |
Debt-to-Equity Ratio |
Bond Rating |
Before-Tax Cost of Debt |
0.0 |
1.0 |
0.00 |
A |
6.0% |
0.2 |
0.8 |
0.25 |
BBB |
7.0% |
0.4 |
0.6 |
0.67 |
BB |
9.0% |
0.6 |
0.4 |
1.50 |
C |
11.0% |
0.8 |
0.2 |
4.00 |
D |
14.0% |
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.
1. What would be its WACC at the optimal capital structure? What would the firm’s optimal capital structure be?
2. 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?
3. If Congress were to dramatically increase the corporate tax rate, what effect would this likely have on XYZ’s target capital structure?
Problem 4-4: Receivables Investment
XYZ Inc. sells on terms of 2/10, net 30. Total sales for the year are $1,000,000. Consider 30 percent of the customers take discounts and pay on the 10th day, while the other 70 percent pay, on average, 45 days after their purchases.
1. What is the days’ sale outstanding?
2. Determine the average amount of receivables.
3. For the customers who take the discount, what is the percentage cost of trade credit?
4. For the customers who do not take the discount and pay in 45 days, what is the percentage cost of trade credit?
5. What would happen to XYZ’s account receivable if it created a new collection policy that required all non-discount customers to pay on the 30th day?
Problem 4-5: 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.
1. If XYZ decides to forgo discounts, could it obtain much additional credit?
2. What would be the nominal and effective cost of that credit?
3. What would be the effective cost of the bank loan be 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.
4. Should XYZ use bank debt or additional trade credit? Explain.