Introduction
Capital management is when a company adjusts and maintains its cash flows in order to manage working capital. The latter is of high importance since it measures an enterprise’s liquidity and effectiveness. It is also used to fund current operations and investments in the future. The working capital can be estimated by deducting current liabilities from current assets (Boone et al., 2019). This presentation addresses such issues as working capital management techniques, risks associated with capital projects, and the lease versus buy problem. Moreover, financing strategies and their impact on the cost of capital will be further discussed.
Effective Management Techniques
Working capital considers current assets (cash, inventories, accounts receivable) and current liabilities (accounts payable, short-term debts). Capital management is generally based on such key performance ratios as collection, current, and inventory turnover. Several effective tools are used to manage components of current assets to maintain the optimum level of working capital/provide a balance between the company’s assets and liabilities (Kumar, 2019). Under the carrying and shortage costs approach, the optimum level of working capital can be found at the point where the carrying and shortage costs intersect. This point also represents the lowest total cost possible and optimal current assets.
Moreover, companies apply various working capital financing policies to maintain a needed amount of working capital. The list of standard policies includes hedging policy (uses both long-term and short-term sources of financing), conservative policy (prefers long-term sources), aggressive policy (short-term debt to invest in current assets), and highly aggressive policy (“What are the 3,”2020). The latter is the riskiest one, while the conservative policy is the safest but fails to utilize funds optimally. The cash budgeting technique is used to determine the cash requirements by forecasting future payments and receipts. Economic Order Quantity (EOQ) helps manage inventories by calculating the proper order quantity by considering other important factors (annual sales, price, and carrying costs).
Alternative Capital Projects
Companies require a significant return from investments to keep their finances positive. Investors should forecast and compare capital projects’ cash inflows and outflows to make a decision. Several methods and approaches help evaluate alternative capital projects according to their profitability and feasibility. Internal Rate of Return is a tool used in a discounted cash flow analysis. It considers the time value of money and gives an insight into annual returns over time. Net Present Value (NPV) also considers the time value of money and compares cash outflows over the project’s period and the present value of cash inflows (Kumar, 2019).
A project is desirable and attractive if it has a positive NPV. Return on Investment compares the increased investment to the accounting profit increase, while Payback gives the number of years needed to recoup spent money on the project. Both of them are criticized for ignoring the time value of money.
Capital projects are long-term and capital-intensive investments that may negatively impact business liquidity. For that reason, companies may increase the volume of cash flow by investing in real estate trusts or partnering with private/ public investors. What is more, if the building or space is not used, a firm can lease or rent it out. They also may share a vacant space with other organizations or providers.
Risks Associated with Capital Projects
In terms of capital budgeting, managers have to consider multiple risk factors. Some of them derive from a project itself, such as a change in customers’ requirements and availability of inputs leading to differences in estimated and actual outcomes (Kumar, 2019). Others come from the economy and industry due to changing policies, regulations, technology, or suppliers’ bargaining power affecting the project’s expected rate of return. Market risk relates to changes in the tastes of customers that affect anticipated cash flows and revenues. International risk is the risk that a particular government may change its favorable economic policy to an adverse one.
Lease Vs. Buy
Business owners should address the question of whether to buy or rent the asset by following a three-step model. Structuring requires finding the lease structure that best fits the company’s financial objectives and time expectations. The pricing stage is designed to determine the best structure in terms of price. The final step is to compare two scenarios (lease and buy one) using NPV and decide which one is better.
In general, businesses are expected to consider such factors as capital (low-intensive for leasing, high-intensive for buying), ownership (ultimate and limited), and term (no term and fixed-term). What is more, if a company seeks higher tax benefits, it should choose the leasing option since lease payments are tax-deductible (Boone et al., 2019). However, under a finance lease, the lessor keeps some of the rewards associated with the asset, while buying option requires the owner’s full responsibility for all rewards and risks.
Financing Strategies & Cost of Capital
Capital cost is the rate of return/ opportunity cost of making an investment in the project. It is widely applied in capital budgeting by business owners to decide whether to pursue a particular project. Experienced managers will consider investment options if the expected return of the initiative exceeds the cost of the capital.
Companies with an excellent operating cash flow can fund their initiatives internally. This option is the safest one, but it postpones paying dividends to shareholders. Equity issuance requires selling stock shares to raise the cash needed for investments. Although it may be a great solution for enterprises with tiny operating and profit margins, this financing option dilutes shareholders’ existing holdings (Boone et al., 2019). On the contrary, debt financing relies on money borrowing to raise funds and has the highest financial risk due to interest and repayment obligations.
Benefits of Debt Financing
Under deb financing, business owners do not transfer a portion of their ownership to shareholders as they have to do when issuing equity. In other words, they continue to enjoy full ownership and be free to make any decisions they want. Another benefit is the ability to retain profits since the borrower is only obliged to repay the principal together with a pre-decided interest (Aziz & Abbas, 2019). Management is free to operate because the lender does not have a right to interfere with the business. Debt financing is also known for higher tax deductions from business income taxes and the availability of low-interest rates.
Risks of Debt Financing
Business owners are obliged to repay the loan at the terms agreed upon even if their enterprise or project turns out to be a failure. Debt financing is usually not available for new and small companies due to accessibility issues. If a company delays its loan payments or entirely fails to pay, its credit rating deteriorates and decreases the chance of securing loans in the future (Aziz & Abbas, 2019). Moreover, excessive short and long-term debts are associated with decreased performance due to their high expense.
Summary
- Management techniques: Working Capital Financing Policy, Cash Budgeting, Carrying Cost and Shortage Cost, EOQ.
- Capital project risks: project-specific, market, competition, international, economic, industry-specific risks, and company-specific risks.
- Lease vs. buy: depends on available capital, ownership, term, risk & reward, tax benefits.
- Types of financing: equity issuance, debt financing, and operating cash flow.
- Benefits of debt financing: maintaining ownership, retaining profits, no external interference, tax deductions.
- Risks of debt financing: obligation to repay a debt in any case, accessibility issues, credit rating, decreases performance.
References
Aziz, S., & Abbas, U. (2019). Effect of debt financing on firm performance: a study on non-financial sector of Pakistan. Open Journal of Economics and Commerce, 2(1), 8-15.
Boone, L. E., Kurtz, D. L., & Berston, S. (2019). Contemporary business (18th ed.). Wiley.
Kumar, V. R. (2019). Financial management for CA intermediate. McGraw Hill.
What are the 3 working capital financing policies?. (2020). Web.