Solution manual managerial accounting and finance for hospitality OperationsCHAPTER 12

Working capital represents a firm’s investment in current assets.. Net working capital is current assets minus current liabilities.. Working capital management is the management of a fir

WORKING CAPITAL MANAGEMENT

I Questions

1 Working capital represents a firm’s investment in current assets Net working capital is current assets minus current liabilities

2 Working capital management is the management of a firm’s current assets and current liabilities

3 Working capital management is important because of its impact on reaching the goal of the hotel Working capital management affects not only a hotel’s short-term liquidity and profitability but also its long-short-term growth and survival The manageability of working capital enables the manager to contribute to shareholder wealth maximization

4 The goal of working capital management is to maintain the optimal level of net working capital in order to maximize shareholder wealth

5 Working capital management involves risk-return tradeoffs because the level, composition, and financing of working capital always affect both a firm’s risk and its profitability Decisions involving these risk-return tradeoffs should be examined simultaneously to determine their joint impact on risk and profitability

6 Risk-return tradeoffs are used to categorize working capital management strategies Conservative strategies are characterized by low risk, low return; aggressive strategies by high risk, high return; and moderate strategies by moderate risk, moderate return

7 Risk and profitability are both affected by the level of working capital Too little working capital increases the risk of being unable to meet maturing obligations, but increases expected profitability Too much working capital reduces profitability because it costs money to carry excess working capital, but it also reduces risk

II Practical Problems

PROBLEM 1

1

Plan A (Conservative) (Aggressive) Plan B

) P 480,000

)

720,000

2

Interest

3 Plan A: Interest rates could drop significantly, which would increase the

effective cost of long-term financing at a future point in time

Plan B: Interest rates could increase, increasing the cost of short-term financing

and possibly tightening the availability of short-term funds Profit would decrease

4 (Subjective) Depends upon interest rate forecast

PROBLEM 2

1

Conservative

Amount % of Total Interest Rate Expense Interest

P900,000 x 0.80 = P720,000 x 0.15 = P108,000 Long-term P900,000 x 0.20 = P180,000 x 0.10 = 18,000 Short-term

Total interest charge P126,000

Aggressive

Amount % of Total Interest Rate Expense Interest

P900,000 x 0.30 = P270,000 x 0.15 = P 40,500 Long-term P900,000 x 0.70 = P630,000 x 0.10 = 63,000 Short-term

Total interest charge P103,500 2

Conservative Aggressive

PROBLEM 3

1

Long-term interest expense = 10% [P600,000 + ½ (P350,000)]

= 10% x (P775,000)

= P77,500 Short-term interest expense = 5% [P450,000 + ½ (P350,000)]

= 5% x (P625,000)

= P31,250 Total interest expense = P77,500 + P31,250

= P108,750

Current

assets – permanent current assets = temporary current assets

2 Alternative financing plan

Long-term interest expense = 10% [P600,000 + P350,000

+ ½ (P450,000)]

= 10% (P1,175,000)

= P117,500 Short-term interest expense = 5% [½ (P450,000)]

= 5% (P225,000)

= P11,250 Total interest expense = P117,500 + P11,250

= P128,750

3 The alternative financing plan which calls for more financing by high-cost debt

is more expensive and reduces after-tax income by P14,000 However, we must not automatically reject this plan because of its higher cost since it has less risk The alternative provides the firm with long-term capital which at times will be

in excess of its needs and invested in marketable securities It will not be forced

to pay higher short-term rates on a large portion of its debt when short-term rates rise and will not be faced with the possibility of no short-term financing for a portion of its permanent current assets when it is time to renew the short-term loan

PROBLEM 4

1 Old Rose Café’s working capital equals its current assets which are P10,500 for

2002 and P12,500 for 2003

2 Old Rose Café’s net working capital (current assets – current liabilities) for 2002 and 2003 is:

Year

Current Assets –

Current Liabilities =

Net Working Capital

3 Old Rose Café’s current ratio (current assets / current liabilities) for 2002 and

2003 is:

Year Current Ratio

2002 P10,500 / P8,000 = 1.31 times

2003 P12,500 / P5,000 = 2.50 times

4 A percentage (common-size) statement of Old Rose Café’s current assets for 2002 and 2003 is shown below.

2003 (Percent) (Percent) 2002

Cash 16.0 14.3 Marketable securities 24.0 19.0 Accounts receivable 28.0 23.8 Inventory 28.0 38.1 Prepaid expenses 4.0 4.8 Total current assets 100.0 100.0 The composition of the current assets has become more liquid The percentage

of current assets held in the most liquid assets (cash and marketable securities) increased from 33.3 percent in 2002 to 40.0 percent in 2003

5 Based on the increase in the firm’s current ratio and the shift in the composition

of current assets, the liquidity position of Old Rose Café has improved from

2002 to 2003

PROBLEM 5

Requirement 1

Net Working Capital = P400,000 – P200,000 = P200,000

Current Ratio = P400,000 ÷ P200,000 = 2 times

Requirement 2

Pearly Shells’ return on equity is 12.5 percent (P62,700 / P500,000)

Pearly Shells Hotel Income Statement For the Year Ended December 31, 2002 Net sales P800,000 EBIT (20% of sales) P160,000 Less: Interest expense

Short-term debt (10%) 20,000

Long-term debt (15%) 45,000 Earnings before taxes P 95,000 Less: Income taxes (34%) 32,300 Net income P 62,700

Requirement 3

The net working capital and current ratios for each strategy are shown below

Strategies Current Assets as a Percent of Sales

Current assets (CA) P300,000 P 500,000 P 700,000 Fixed assets 600,000 600,000 600,000 Total assets P900,000 P1,100,000 P1,300,000 Current liabilities (CL)* P180,000 P 220,000 P 260,000 Long-term liabilities 270,000 330,000 390,000 Total liabilities P450,000 P 550,000 P 650,000 Stockholders’ equity (SE) 450,000 550,000 650,000 Total liabilities and equity P900,000 P1,100,000 P1,300,000 Net working capital (CA – CL) P120,000 P280,000 P440,000 Current ratio (CA/CL) 1.7 times 2.3 times 2.7 times

* Assume that all current liabilities are in the form of short-term debt.

Requirement 4

The hotel’s liquidity position, as measured by the amount of net working capital and current ratio, improves when current assets are a higher percentage of sales

Requirement 5

The rate of return on equity for each strategy is shown below:

Strategies Current Assets as a Percent of Sales

Net sales P1,000,000 P1,000,000 P1,000,000 EBIT (18% of sales) 180,000 180,000 180,000 Interest expense

Short-term debt (10%) 18,000 20,000 26,000 Long-term debt (15%) 40,500 49,500 58,500 Earnings before taxes P 121,500 P 110,500 P 95,500

Income taxes (34%) 41,310 37,570 32,470 Net income P 80,190 P 72,930 P 63,030 Return on equity (NI/SE) 17.8% 13.3% 9.7%

Requirement 6

Pearly Shells’ profitability decreases as liquidity increases For example, the firm’s liquidity (current ratio = 2.7 times) is the highest but profitability (ROE = 9.7 percent) is the lowest when current assets are 70 percent of sales

Requirement 7

The return on equity, net working capital, and current ratio for each strategy are shown below

Financing-Mix Strategies Conservative Hedging Aggressive

EBIT P180,000 P180,000 P180,000 Interest expenses

Short-term (10%) 10,000 30,000 45,000 Long-term (15%) 52,500 22,500 0 Earnings before taxes P117,500 P127,500 P135,000 Income taxes (34%) 39,950 43,350 45,900 Net income (NI) P 77,550 P 84,150 P 89,100 Return on equity (NI/SE) 17.2% 18.7% 19.8% Net working capital (CA – CL) P200,000 P0 P(150,000) Current ratio (CA/CL) 3.0 times 1.0 times 0.7 times

Requirement 8

Combining an aggressive current asset strategy with an aggressive financing-mix strategy produces the highest return on equity Higher potential profitability is accompanied by greater risk in the form of lower liquidity Pearly Shells may be unable to meet required payments due to its relatively low level of working capital

In fact, the hotel’s net working capital is negative under this aggressive financing-mix strategy