Investments in Non-Cash Working Capital

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Chapter 14: Investments in Cash and Marketable Securities

CT 14.1: Do you think technological advances in banking will increase or decrease net float for firms? Are some firms more likely to benefit than others? Explain.

Ans: I think they will decrease net float at large firms. These firms will take advantage of technology to process payments to them faster, while using the same technology to slow down payments to their customers. Smaller firms may also be able to use technology to their advantage while working with customers, but may find themselves on the wrong end when dealing with larger firms. Overall, float in the economy should decrease.

CT 14.2: Assume that you are comparing two firms in the same sector with very large cash balances. MicroTempInc, the first firm, has maintained a return on equity of 35% over the last 5 years of its existence. GenWasteInc, the second firm has had an average return on equity of 22%, but the returns have been dropping significantly each year. In which of these two firms is cash likely to be viewed as value destroying and why?

Ans: Cash is likely to be viewed as potentially value decreasing at GenWaste because of its declining return on equity. Investors will assume that the marginal investments are becoming less attractive, and will worry about the cash going into these investments.

CT 14.3: Assume that a firm invests its cash in private businesses. How would you evaluate whether these investments will increase or decrease the value of the firm?

Ans: The same way that I would judge its investments in publicly traded firms. I would look at the cash invested in the businesses, and the cash returned by these businesses over time. If the present value of the cash inflows from these businesses exceeds the cash invested in these businesses, they will increase value.

CT 14.4: The Home Depot holds less cash than its peer group. Under what conditions is this low cash balance likely to become a liability and why?

Ans: The low cash balance can become a liability if cash is needed for day-to-day operations or for taking advantage of sudden investment opportunities (a takeover opportunity, for instance).

PROBLEMS

Question 3: You are analysing the balance sheet for Bed, Bath and Beyond, a retail firm that sells home furnishings, from February 26,1995 (in millions):

Assets Liabilities

Cash

$6.5

Receivables

3.1

Inventory

108.4

Current Assets

118.0

Fixed Assets

53.8

Total Assets

$171.8

Accounts Payable

$27.5

Other current liabilities

18.6

Current liabilities

46.1

Long Term Debt

16.8

Equity

108.9

Total Liabilities

$171.8

a.Estimate the working capital?

118 - 46.1 = $71.9

b.Estimate the noncash working capital?

$71.9 – 6.5 = $65.4, assuming that other current liabilities do not include short-term borrowings.

c.Estimate the noncash working capital as a percent of revenues. If you were asked to estimate the non-cash working capital needs for a new store for Bed, Bath and Beyond, would you use this ratio? Why or why not?

Non-cash working capital as a percentage of revenues for 1995 is 65.4/440.3 = 14.85%; I would use this to estimate non-cash working capital for a new store, since the entire firm is essentially a conglomeration of stores.

Question 4:

Solution:

- Value of Firm at current working capital ratio FCFF = After-tax Operating income - Change in Working Capital = $10 million (1.05) - ($105 - $100) (.10) = 10

Value of Firm = $10 million / (.11 -.05) = $166.67

- Firm Valuation at different Working Capital Ratios

0%

4.50%

10.45

10.90%

$163.28

10%

5%

10

11%

$166.67

20%

5.20%

9.48

11.11%

$160.41

30%

5.35%

8.93

11.23%

$151.87

40%

5.45%

8.365

11.36%

$141.54

50%

5.50%

7.8

11.50%

$130.00

60%

5.54%

7.23

11.65%

$118.33