Q2a - December 2011

Explain the meaning of the term ‘cash operating cycle’ and discuss the
relationship between the cash operating cycle and the level of
investment in working capital. Your answer should include a discussion
of relevant working capital policy and the nature of business
operations.

The cash operating cycle is the average length of time between paying
trade payables and receiving cash from trade receivables. It is the sum
of the average inventory holding period, the average production period
and the average trade receivables credit period, less the average trade
payables credit period. Using working capital ratios, the cash
operating cycle is the sum of the inventory turnover period and the
accounts receivable days, less the accounts payable days.

The relationship between the cash operating cycle and the level of
investment in working capital is that an increase in the length of the
cash operating cycle will increase the level of investment in working
capital. The length of the cash operating cycle depends on working
capital policy in relation to the level of investment in working capital,
and on the nature of the business operations of a company.

Working capital policy

Companies with the same business operations may have different

levels of investment in working capital as a result of adopting different
working capital policies. An aggressive policy uses lower levels of
inventory and trade receivables than a conservative policy, and
so will lead to a shorter cash operating cycle.

A conservative policy on the level of investment in working capital, in

contrast, with higher levels of inventory and trade receivables, will lead
to a longer cash operating cycle. The higher cost of the longer cash
operating cycle will lead to a decrease in profitability while also
decreasing risk, for example the risk of running out of inventory.

Nature of business operations

Companies with different business operations will have different cash

operating cycles. There may be little need for inventory, for example, in
a company supplying business services, while a company selling
consumer goods may have very high levels of inventory. Some
companies may operate primarily with cash sales, especially if they sell
direct to the consumer, while other companies may have substantial
levels of trade receivables as a result of offering trade credit to other
companies

(b) Discuss the key elements of a trade receivables management policy.

(b) The key elements of a trade receivables policy are credit analysis, credit control and
receivables collection.

Credit analysis
Credit analysis helps a company to minimise the possibility of bad debts by
offering credit only to customers who are likely to pay the money they owe.
Credit analysis also helps a company to minimise the likelihood of customers paying
late, causing the company to incur additional costs on the money owed, by indicating
which customers are likely to settle their accounts as they fall due. Credit analysis, or
the assessment of creditworthiness, is undertaken by analysing and evaluating
information relating to a customer’s financial history. This information may be
provided by trade references, bank references, the annual accounts of a company or
credit reports provided by a credit reference agency. The depth of the credit analysis
will depend on the potential value of sales to the client, in terms of both order size and
expected future trading. As a result of credit analysis, a company will decide on
whether to extend credit to a customer.

Credit control
Having granted credit to customers, a company needs to ensure that the agreed
terms are being followed. The trade receivables management policy will stipulate the
content of the initial sales invoice that is raised. It will also advise on the frequency with
which statements are sent to remind customers of outstanding amounts and when they
are due to be paid. It will be useful to prepare an aged receivables analysis at regular
intervals (e.g. monthly), in order to focus management attention on areas where action
needs to be taken to encourage payment by clients.

Receivables collection
Ideally, all customers will settle their outstanding accounts as and when they fall due.
Any payments not received electronically should be banked quickly in order to
decrease costs and increase profitability. If accounts become overdue, steps should
be taken to recover the outstanding amount by sending reminders, making customer
visits and so on. Legal action could be taken if necessary, although only as a last
resort.
(c) Explain the different types of foreign currency risk faced by a multinational
company.
Foreign currency risk can be divided into transaction risk, translation risk and economic
risk.
Transaction risk
This is the foreign currency risk associated with short-term transactions, such
as receiving money from customers in settlement of foreign currency accounts
receivable. The risk here is that the actual profit or cost associated with the future
transaction may be different from the expected or forecast profit or cost. The expected
profit on goods or service sold on credit to a foreign client, for example, invoiced
in the foreign currency, could be decreased by an adverse exchange rate
movement.
Transaction risk is therefore cash exposure, since cash transactions are affected
by it. This type of foreign currency risk is usually hedged.

Translation risk
This is the foreign currency risk associated with the consolidation of foreign
currency denominated assets and liabilities. Movements in exchange rates can
change the value of such assets and liabilities, resulting in unrealised foreign
currency losses or gains when financial statements are consolidated for
financial reporting purposes. These gains and losses exist only on paper and do
not have a cash effect. Translation exposure is often referred to as accounting
exposure. Translation exposure can be hedged using asset and liability management,
but hedging this type of foreign currency risk may be deemed unnecessary.

Economic risk
This is the foreign currency risk associated with longer-term movements in
exchange rates. It refers to the possibility that the present value of a company’s
future cash flows may be affected by future exchange rate movements, or that
the competitive position of a company may be affected by future exchange rate
movements. From one point of view, transaction exposure is short-term economic
exposure. All companies face economic exposure and it is difficult to hedge against.

Required:

Discuss the effect of a substantial rise in interest rates on the financing

cost of BQK Co and its customers, and on the capital investment
appraisal decision-making process of BQK Co.
A substantial increase in interest rates will increase the financing costs
of BQK Co and its customers. These will affect the discount rate used
in the investment appraisal decision-making process and the value of
project variables.

Customer financing costs

Each customer finances their house purchase through a long-term

personal loan from their bank. A substantial rise in interest rates will
increase the borrowing costs of existing and potential customers of
BQK Co, and will therefore increase the amount of cash they pay to
buy one of the houses.

Company financing costs

The cost of debt of BQK Co will change with interest rates in the
economy. A substantial rise in interest rates will therefore lead to
a substantial increase in the cost of debt of the company. This
will lead to an increase in the weighted average cost of capital
(WACC) of BQK Co, the actual increase depending on the relative
proportion of debt compared to equity in the company’s capital
structure.

The cost of equity will also increase as interest rates rise,

contributing to the increase in the WACC. Since most companies
have a greater proportion of equity finance as compared to debt
finance, the increase in the cost of equity is likely to have a more
significant effect on the WACC than the increase in the cost of
debt.

Effect on the capital investment appraisal process

Since the business of the company is building houses, the WACC of

the company is likely to be the discount rate it uses in evaluating
investment decisions such as the one under consideration. An
increase in WACC will therefore lead to a decrease in the NPV of
investment projects and some projects may no longer be
attractive.

In order to make the investment project more attractive, the prices

of the houses offered for sale might have to increase. This could
make the houses more difficult to sell and lead to increased costs
due to slower sales.

Houses could also be more difficult to sell as customers would be

more reluctant to commit themselves to long-term personal loans
when interest rates are historically high.

Construction and infrastructure costs might increase as suppliers seek

to pass on their higher borrowing costs.

Overall, income per year could decrease and the time period for
the investment might need to be extended to accommodate the
slower sales process.

Required:

Discuss whether the dividend growth model or the capital asset pricing model
should be used to calculate the cost of equity. (5 marks)

The dividend growth model calculates the apparent cost of equity in the
capital market, provided that the current market price of the share, the current
dividend and the future dividend growth rate are known. While the current
market price and the current dividend are readily available, it is very difficult
to find an accurate value for the future dividend growth rate.

A common approach to finding the future dividend growth rate is to calculate

the average historic dividend growth rate and then to assume that the future
dividend growth rate will be similar. There is no reason why this assumption
should be true.

The capital asset pricing model tends to be preferred to the dividend growth
model as a way of calculating the cost of equity as it has a sound theoretical
basis, relating the cost of equity or required return of well-diversified
shareholders to the systematic risk they face through owning the shares of a
company.

However, finding suitable values for the variables used by the capital asset
pricing model (risk-free rate of return, equity beta and equity risk premium)
can be difficult