1. Explain the Walker s and Trade off approaches to working capital investment.

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1 MS 41 Working Capital Management ASSIGNMENT Course Code : MS-41 Course Title : Working Capital Management Assignment No. : MS-41/TMA /SEM-I/ Coverage : All Blocks 1. Explain the Walker s and Trade off approaches to working capital investment. Answer: Walker in his study (1964) made a pioneering effort to develop a theory of working capital management by empirically testing, though partially, three propositions based on risk-return tradeoff of working capital management. Walker studied the effect of the change in the level of working capital on the rate of return in nine industries for the year 1961 and found the relationship between the level of working capital and the rate of return to be negative. On the basis of this observation, Walker formulated three following propositions: Proposition I If the amount of working capital is to fixed capital, the amount of risk the firm assumes is also varied and the opportunities for gain or loss are increased. Walker further

2 stated that if a firm wished to reduce its risk to the minimum, it should employ only equity capital for financing of working capital; however by doing so, the firm reduced its opportunities for higher gains on equity capital as it would not be taking advantage of leverage. In fact, the problem is not whether to use debt capital but how much debt capital to use, which would depend on management attitude towards risk and return. On the basis of this, he developed his second proposition. Proposition II The type of capital (debt or equity) used to finance working capital directly affects the amount of risk that a firm assumes as well as the opportunities for gain or loss.walker again suggested that not only the debt-equity ratio, but also the maturity period of debt would affect the risk-return trade-off. The longer the period of debt, the lower be the risk. For, management would have enough opportunity to acquire funds from operations to meet the debt obligations. But at the 50same time, longterm debt is costlier. On the basis of this, he developed his third proposition: Proposition III The greater the disparity between the maturities of a firm s debt instruments and its flow of internally generated funds, the greater the risk and vice-versa. Thus, Walker tried to build-up a theory of working capital management by developing three prepositions. However, Walker tested empirically the first proposition only. Walker s Study would have been more useful had he attempted to test all the three propositions. 2. Discuss the motives for holding cash. Explain the Baumol Model and Miller and Orr Model. Answer: The term cash is a surprisingly imprecise concept. The economic definition of cash includes currency, savings account deposits at banks, and undeposited cheques. However,

3 financial managers often use the term cash to include short-term marketable securities. Short-term marketable securities are frequently referred to as cash equivalents and include Treasury bills, certificates of deposit, and repurchase agreements. There are two primary reasons for holding cash. First, cash is needed to satisfy the transactions motive. Transaction-related needs come from normal disbursement and collection activities of the firm. The disbursement of cash includes the payment of wages and salaries, trade debts, taxes and dividends. Cash is collected from sales from operations, sales of assets, and new financing. The cash inflows ( collections) and outflows ( disbursements) are not perfectly synchronized, and some level of cash holdings is necessary as a buffer. If the firm maintains too small a cash balance it may run out of cash. If so, it must sell marketable securities or borrow. Selling marketable securities and borrowing involve trading costs. its Another reason to hold cash is for compensating balances. Cash balances are kept at banks to compensate for banking services rendered to the firm. The cash balance for most firms can be thought of as consisting of transaction balances and compensating balances. However, it would not be correct for a firm to add the amount of cash required to satisfy transaction needs to the amount of cash needed to satisfy its compensatory balances to produce a target cash balance. The Baumol Model William Baumol was the first to provide a formal model of cash management incorporating opportunity costs and trading costs.1 His model can be used to establish the target cash balance. Suppose Golden Socks plc began week 0 with a cash balance of C = 1.2 million, and outflows exceed inflows by 600,000 per week. Its cash balance will drop to zero at the end of week 2, and its average cash balance will be C/2 = 1.2 million/2 = 600,000 over the two-week period. At the end of week 2 Golden Socks must replace its cash either by selling marketable securities or by borrowing. If C were set higher, say at 2.4 million, cash would last four weeks before the firm would need to sell marketable securities, but the firm s average cash balance would increase to 1.2 million (from 600,000).

4 would If C were set at 600,000, cash would run out in one week, and the firm would need to replenish cash more frequently, but its average cash balance fall from 600,000 to 300,000. Because transaction costs must be incurred whenever cash is replenished (for example, the brokerage costs of selling marketable securities), establishing large initial cash balances will lower the trading costs connected with cash management. However, the larger the average cash balance, the greater the opportunity cost (the return that could have been earned on marketable securities). Limitations The Baumol model represents an important contribution to cash management. The limitations of the model include the following: 1 The model assumes the firm has a constant disbursement rate. In practice, disbursements can be only partially managed, because due dates differ, and costs cannot be predicted with certainty. 2 The model assumes there are no cash receipts during the projected period. In fact, most firms experience both cash inflows and outflows daily. 3 No safety stock is allowed. Firms will probably want to hold a safety stock of cash designed to reduce the possibility of a cash shortage or cash-out. However, to the extent that firms can sell marketable securities or borrow in a few hours, the need for a safety stock is minimal. The Baumol model is possibly the simplest and most stripped-down, sensible model for determining the optimal cash position. Its chief weakness is that it assumes discrete, certain cash flows. We next discuss a model designed to deal with uncertainty.

5 The Miller Orr Model Merton Miller and Daniel Orr developed a cash balance model to deal with cash inflows and outflows that fluctuate randomly from day to day.2 In the Miller Orr model both cash inflows and cash outflows are included. The model assumes that the distribution of daily net cash flows (cash inflow minus cash outflow) is normally distributed. On each day the net cash flow could be the expected value or some higher or lower value. We shall assume that the expected net cash flow is zero. The model operates in terms of upper ( U) and lower ( L) control limits and a target cash balance ( Z). The firm allows its cash balance to wander randomly within the lower and upper limits. As long as the cash balance is between U and L, the firm makes no transaction. When the cash balance reaches U, such as at point X, the firm buys U Z units (e.g. euros or pounds) of marketable securities. This action will decrease the cash balance to Z. In the same way, when cash balances fall to L, such as at point Y (the lower limit), the firm should sell Z L securities and increase the cash balance to Z. In both situations cash balances return to Z. Management sets the lower limit, L, depending on how much risk of a cash shortfall the firm is willing to tolerate. to be Like the Baumol model, the Miller Orr model depends on trading costs and opportunity costs. The cost per transaction of buying and selling marketable securities, F, is assumed

6 fixed. The percentage opportunity cost per period of holding cash, R, is the daily interest rate on marketable securities. Unlike in the Baumol model, the number of transactions per period is a random variable that varies from period to period, depending on the pattern of cash inflows and outflows. As a consequence, trading costs per period depend on the expected number of transactions in marketable securities during the period. Similarly, the opportunity costs of holding cash are a function of the expected cash balance per period. Given L, which is set by the firm, the Miller Orr model solves for the target cash balance, Z, and the upper limit, U. Expected total costs of the cash balance return policy ( Z, U) are equal to the sum of expected transaction costs and expected opportunity costs. The values of Z (the return cash point) and U (the upper limit) that minimize the expected total cost have been determined by Miller and Orr: Here * denotes optimal values, and s 2 is the variance of net daily cash flows. The average cash balance in the Miller Orr model is 3. What are advances? Explain the modes of creating charge over assets. Answer: such Definition of Advance is Sums paid or received before the fulfillment of an obligation, as supply of goods or provision of services

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9 Reference: The Banking Theory by Rajesh 4. What are the commercial paper? Discuss the existing guidelines issued by RBI to regulate issuance of commercial papers. Answer: Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note. CP as a privately placed instrument, was introduced in India in 1990 with a view to enabling highly rated corporate borrowers to diversify their sources of short-term borrowings and to provide an additional instrument to investors. Subsequently, primary dealers and satellite dealers were also permitted to issue CP to enable them to meet their short-term funding requirements for their operations. directions/guidelines on the subject : Who can issue Commercial Paper (CP) 2. Corporates, primary dealers (PDs) and satellite dealers (SDs), and the all-india financial institutions (FIs) that have been permitted to raise short-term resources under the umbrella limit fixed by Reserve Bank of India are eligible to issue CP.

10 3. A corporate would be eligible to issue CP provided - (a) the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore; (b) company has been sanctioned working capital limit by bank/s or all-india financial institution/s; and (c) the borrowal account of the company is classified as a Standard Asset by the financing bank/s/ institution/s. Rating Requirement 4. All eligible participants shall obtain the credit rating for issuance of Commercial Paper from either the Credit Rating Information Services of India Ltd. (CRISIL) or the Investment Information and Credit Rating Agency of India Ltd. (ICRA) or the Credit Analysis and Research Ltd. (CARE) or the FITCH Ratings India Pvt. Ltd. or such other credit rating agency (CRA) as may be specified by the Reserve Bank of India from time to time, for the purpose. The minimum credit rating shall be P-2 of CRISIL or such equivalent rating by other agencies. The issuers shall ensure at the time of issuance of CP that the rating so obtained is current and has not fallen due for review. Maturity 5. CP can be issued for maturities between a minimum of 15 days and a maximum upto one year from the date of issue. Denominations 6. CP can be issued in denominations of Rs.5 lakh or multiples thereof. Amount invested by single investor should not be less than Rs.5 lakh (face value). Limits and the Amount of Issue of CP 7. CP can be issued as a "stand alone" product. The aggregate amount of CP from an issuer shall be within the limit as approved by its Board of Directors. Banks and FIs will, however, have the flexibility to fix working capital limits duly taking into account the resource pattern of companies financing including CPs. 8. An FI can issue CP within the overall umbrella limit fixed by the RBI i.e., issue of CP together with other instruments viz., term money borrowings, term deposits, certificates of deposit and inter-corporate deposits should not exceed 100 per cent of its net owned funds, as per the latest audited balance sheet. 9. The total amount of CP proposed to be issued should be raised within a period of two weeks from the date on which the issuer opens the issue for subscription. CP may be issued on a single date or in parts on different dates provided that in the latter case, each CP shall have the same maturity date. Every CP issue should be reported to the Chief General Manager, Industrial and Export

11 Credit Department (IECD), Reserve Bank of India, Central Office, Mumbai through the Issuing and Paying Agent (IPA) within three days from the date of completion of the issue, incorporating details as per Schedule II. 10. Every issue of CP, including renewal, should be treated as a fresh issue. Who can act as Issuing and Paying Agent (IPA) 11. Only a scheduled bank can act as an IPA for issuance of CP. Investment in CP 12. CP may be issued to and held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, Non- Resident Indians (NRIs) and Foreign Institutional Investors (FIIs). However, investment by FIIs would be within the limits set for their investments by Securities and Exchange Board of India (SEBI). Mode of Issuance 13. CP can be issued either in the form of a promissory note (Schedule I) or in a dematerialised form through any of the depositories approved by and registered with SEBI. As regards the existing stock of CP, the same can continue to be held either in physical form or can be demateralised, if both the issuer and the investor agree for the same. 14. CP will be issued at a discount to face value as may be determined by the issuer. 15. No issuer shall have the issue of Commercial Paper underwritten or coaccepted. Preference for Dematerialised form 16. While option is available to both issuers and subscribers, to issue/hold CP in dematerialised or physical form, issuers and subscribers are encouraged to prefer exclusive reliance on dematerialised form of issue/holding. Banks, Financial Institutions, PDs and SDs are advised to invest and hold CPs only in dematerialised form, as soon as arrangements for such dematerialisation are put in place. Payment of CP 17. The initial investor in CP shall pay the discounted value of the CP by means of a crossed account payee cheque to the account of the issuer through IPA. On maturity of CP, when the CP is held in physical form, the holder of the CP shall present the instrument for payment to the issuer through the IPA. However, when the CP is held in demat form, the holder of the CP will have to get it redeemed through the depository and receive payment from the IPA.

12 Stand-by Facility 18. In view of CP being àstand alone product, it would not be obligatory in any manner on the part of banks and FIs to provide stand-by facility to the issuers of CP. Banks and FIs would, however, have the flexibility to provide for a CP issue, credit enhancement by way of stand-by assistance/credit backstop facility, etc., based on their commercial judgement and as per terms prescribed by them. However, these should be within the prudential norms as applicable and subject to specific approval of the Board. Procedure for Issuance 19. Every issuer must appoint an IPA for issuance of CP. The issuer should disclose to the potential investors its financial position as per the standard market practice. After the exchange of deal confirmation between the investor and the issuer, issuing company shall issue physical certificates to the investor or arrange for crediting the CP to the investor's account with a depository. Investors shall be given a copy of IPA certificate to the effect that the issuer has a valid agreement with the IPA and documents are in order (Schedule III). Role and Responsibilities 20. The role and responsibilities of issuer, IPA and CRA are set out below : (a) Issuer With the simplification in the procedures for CP issuance, issuers would now have more flexibility. Issuers would, however, have to ensure that the guidelines and procedures laid down for CP issuance are strictly adhered to. (b) Issuing and Paying Agent (IPA) (i) IPA would ensure that issuer has the minimum credit rating as stipulated by the RBI and amount mobilised through issuance of CP is within the quantum indicated by CRA for the specified rating. (ii) IPA has to verify all the documents submitted by the issuer viz., copy of board resolution, signatures of authorised executants (when CP in physical form) and issue a certificate that documents are in order. It should also certify that it has a valid agreement with the issuer (Schedule III). (iii) Original documents verified by the IPA should be held in the custody of IPA.

13 (c) Credit Rating Agency (CRA) (i) Code of Conduct prescribed by the SEBI for CRAs for undertaking rating of capital market instruments shall be applicable to them (CRAs) for rating CP. (ii) Further, the credit rating agency would henceforth have the discretion to determine the validity period of the rating depending upon its perception about the strength of the issuer. Accordingly, CRA shall at the time of rating, clearly indicate the date when the rating is due for review. (iii) While the CRAs can decide the validity period of credit rating, CRAs would have to closely monitor the rating assigned to issuers vis-a-vis their track record at regular intervals and would be required to make its revision in the ratings public through its publications and website. 21. Fixed Income Money Market and Derivatives Association of India (FIMMDA), as a self-regulatory organisation (SRO) for the fixed income money market securities, may prescribe, for operational flexibility and smooth functioning of CP market, any standardised procedure and documentation that are to be followed by the participants, in consonance with the international best practices. Till such time, the procedures/documentations prescribed by IBA should be followed. 22. Violation of these guidelines will attract penalties prescribed in the Act by the RBI and may also include debarring from the CP market. Non-applicability of Certain Other Directions 23. Nothing contained in the Non-Banking Financial Companies Acceptance of Public Deposits (Reserve Bank) Directions, 1998 shall apply to any non-banking financial company (NBFC) insofar as it relates to acceptance of deposit by issuance of CP, in accordance with these Guidelines. Reference: 5. What are the different forms of trade credit? Discuss the various determinants of trade credit. Answer: Trade credit (accounts receivable and accounts payable) is both an important source and use of funds for manufacturing firms in India. This paper empirically investigates the determinants of trade credit in

14 the Indian context. The empirical evidence presented suggests that strong evidence exists in support of an inventory management motive for the existence of trade credit. Highly profitable firms are found to both give and receive less trade credit. Firms with greater access to bank credit offer less trade credit to their customers. On the other hand, firms with higher bank loans receive more trade credit. Holdings of liquid assets have a positive influence on both accounts receivable and accounts payable. Trade credit is a form of short-term financing, wherein a supplier will fulfill an order without requiring cash up front or on delivery. Instead, the supplier will extend trade credit terms specifying time frames within which the payment is due. Though several types of trade credit terms are commonly used, including net10, net30, net60 or net 90, suppliers can specify just about any terms to suit a customer s particular business model. Businesses often seek different types of trade credit from suppliers in order to conserve cash flow, while suppliers may extend different types of trade credit to help customers best sell their product. Furthermore, many suppliers will also extend trade credit and build in discounts for repayment ahead of the due date specified in the agreement, giving the customer various options depending on whether sales are slow or good. Theories of trade credit Metzler (1960) was possibly the first to point out that large firms use trade credit instead of direct price reductions to push sales in periods when monetary conditions were tight. Further, he argued that firms would accumulate liquid balances in periods of loose monetary policy and utilize these to extend trade credit in periods when monetary conditions were tight. These macroeconomic implications of trade credit have been recently further investigated by Guariglia and Mateut (2006) and Mateut, Bougheas and Mizen (2006) who conclude that in the UK trade credit increases in periods when monetary policy is tight and bank lending falls. The possibility that sellers who have easier access to the capital market may have an incentive

15 to offer trade credit to their buyers (who may not have access to capital markets on the same terms) was first pointed out by Schwartz (1974). The supplier s greater ability to raise funds is used to pass credit to their customers. If banks are the main source of credit then this suggests that firms offering trade credit would borrow from banks and pass this on as accounts receivable (on their books of accounts) to the buyers. Cunat (2007) argues that firms offering trade credit may have an advantage over banks in enforcing debt repayment in a situation where it is difficult for the buyer to find alternative suppliers and it is costly for the seller to find alternative customers. This condition would be met if the product in question has some technological specificity. This advantage arises because suppliers can threaten buyers with stoppage of supplies of the intermediate good which in turn would hit production. (a) firms with higher stock of inventories would have lower accounts receivables and accounts payables. (b) profitability will be positively related to both accounts payable and accounts receivable. (c) The relationship of accounts receivable and accounts payable with riskiness of a firm and its liquidity position is indeterminate. (d) Accounts receivables would be positively related to bank loans i.e. they are compliments. Accounts payable can either be positively or negatively related to bank loans. The empirical literature has unearthed quite a few robust relationships between extent of trade credit offered and received and various firm characteristics. A large variety of variables measuring various firm characteristics have been used to explain inter firm variations in both accounts receivable and accounts payable. Determinants of credit policy The following are the aspects of credit policy: 1. Level of credit sales required to optimise the profit. 2. Credit period i.e. duration of credit, whether it may be 15 days or 30 or 45 days etc. 3. Cash discount, discount period and seasonal offers. 4. Credit standard of a customer : 5 C s of credit :

16 a. Character of the customer i.e. willingness to pay. b. Capacity ability to pay. c. Capital financial resources of a customer. d. Conditions special conditions for extension of credit to doubtful customers and prevailing economic and market conditions and; e. Collateral security. 5. Profits. 6. Market and economic conditions. 7. Collection policy. 8. Paying habits of customers. 9. Billing efficiency, record-keeping etc. 10. Grant of credit size and age of receivables For more IGNOU Solved Assignments visit Get Daily Updates by Facebook:

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