1. explain how rapidly expanding sales can drain the cash resources of a firm? 2
ID: 2683998 • Letter: 1
Question
1. explain how rapidly expanding sales can drain the cash resources of a firm? 2. discuss the relative volatility of short- and long- term interest rates? 3. what is the significance to working capital management of matching sales and production? 4. how is a cash budget used to help manage current assets? 5. "the most appropriate financing pattern would be one in which asset buildup and length of financing terms are perfectly matched." discuss the difficulty involved in achieving this financing pattern? 6. by using long-term financing to finance part of temporary current assets, a firm may have less risk but lower returns than a firm with a normal financing plan? 7. a firm that uses short-term financing methods for a portion of permanent current assets is assuming more risk but expects higher returns than a firm with a normal financing plan. Explain? 8. what does the term structure of interest rates indicate?Explanation / Answer
1. Rapidly expanding sales will require a buildup in assets to support the growth. In particular, more and more of the increase in current assets will be permanent in nature. A non-liquidating aggregate stock of current assets will be necessary to allow for floor displays, multiple items for selection, and other purposes. All of these “asset” investments can drain the cash resources of the firm. 2.Figure 6-10 shows the long-run view of short- and long-term interest rates. Normally, short-term rates are much more volatile than long-term rates. 3. If sales and production can be matched, the level of inventory and the amount of current assets needed can be kept to a minimum; therefore, lower financing costs will be incurred. Matching sales and production has the advantage of maintaining smaller amounts of current assets than level production, and therefore less financing costs are incurred. However, if sales are seasonal or cyclical, workers will be laid off in a declining sales climate and machinery (fixed assets) will be idle. Here lies the tradeoff between level and seasonal production: Full utilization of fixed assets with skilled workers and more financing of current assets versus unused capacity, training and retraining workers, with lower financing for current assets. 4. A cash budget helps minimize current assets by providing a forecast of inflows and outflows of cash. It also encourages the development of a schedule as to when inventory is produced and maintained for sales (production schedule), and accounts receivables are collected. The cash budget allows us to forecast the level of each current asset and the timing of the buildup and reduction of each. 5. Only a financial manager with unusual insight and timing could design a plan in which asset buildup and the length of financing terms are perfectly matched. One would need to know exactly what current assets are temporary and which ones are permanent. Furthermore, one is never quite sure how much or short-term or long-term financing is available at all times. Even if this were known, it would be difficult to change the financing mix on a continual basis. 6. By establishing a long-term financing arrangement for temporary current assets, a firm is assured of having necessary funding in good times as well as bad, thus we say there is low risk. However, long-term financing is generally more expensive than short-term financing and profits may be lower than those which could be achieved with a synchronized or normal financing arrangement for temporary current assets. 7. By financing a portion of permanent current assets on a short-term basis, we run the risk of inadequate financing in tight money periods. However, since short-term financing is less expensive than long-term funds, a firm tends to increase its profitability over the long run (assuming it survives). In answer to the preceding question, we stressed less risk and less return; here the emphasis is on risk and high return. 8. The term structure of interest rates shows the relative level of short-term and long-term interest rates at a point in time on U.S. treasury securities. It is often referred to as a yield curve.
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