161

CHAPTER 16
Risk Management and Temporary Working Capital
QUESTIONS
1. Why does hedging reduce risk Hedging is the balancing of a risky position with an equal
and opposite risky position. Effectively, hedging creates a portfolio of risky positions in which
the elements of the portfolio are negatively correlated. Although each component remains
risky, the portfolio has far lessand possibly norisk. Losses in value from one element of
the portfolio are matched by increases in value from other elements.
!. Wh"# is #he di$$erence %e#&een hedging "cross #he %"'"nce shee# "nd hedging indi(idu"'
c"sh $'o&s The difference is in which risky positions are balanced out. Hedging across the
balance sheet matches assets and liabilities by their maturities to ensure that assets will become
liquid as needed to pay the companys liabilities. Hedging individual cash flows ensures that
receipts can be used efficiently and each obligation has a known cost.
). Wh"# "re #he $our s#e*s in *u##ing &orking c"*i#"' on #he %"'"nce shee# The four steps
represent a logical way to think about filling out the balance sheet in order to !"# only accept
investments with positive $%&, !'# maintain the appropriate debt(equity mi), and !*# hedge
across the balance sheet. The four steps are generally done in sequence, but are repeated
many times as conditions and opportunities change. The sequence is+
!"# Establish balances for each permanent current asset using the incremental techniques
presented in ,hapter "'.
!'# Establish balances for each permanent current liability by locating all low(cost or free
short(term financing opportunities using the effective interest rate analysis presented in
,hapter '-.
!*# Add additional permanent debt, both short(term and long(term to hedge the maturities of
the assets on the balance sheet.
!.# /espond to temporary current asset buildups and take advantage of any opportunities
arising from temporary working capital.
+. Why "re #he ,"##r"c#i(e shor#-#er. $in"ncing o**or#uni#ies/0 descri%ed in #he second
s#e* o$ #he $our-s#e* *rocess/ considered %e$ore o#her de%# $in"ncing These
opportunities are considered first simply because they are less costly. They include such
financing sources as wages payable, ta)es payable, and free trade credit. 0t is always wise for
financial managers to raise financing at the lowest possible cost.
1. Ho& is #he curren# r"#io used in se##ing #he de%# ."#uri#y .i2 C"n you #hink o$ "ny
o#her $in"nci"' .e"sures #h"# cou'd "'so %e used in #his "n"'ysis The current ratio is
16! Ch"*#er 16
often used as a measure of how to split the amount of debt taken in the third(step of the four(
step process between current and long(term to hedge balance sheet maturities. 1hort(term
debt is added to the firms liabilities until the current ratio reaches a target value2 additional
debt financing is long(term. 3ther measures that could be used are working capital !current
assets minus current liabilities# and the quick ratio.
6. Why is #he de%# ."#uri#y .i2 nor."''y si.*'i$ied #o shor#- (s. 'ong-#er. de%# Wh"#/
i$ "ny#hing/ is 'os# in ."king #his si.*'i$ic"#ion This simplification is normally made to
be consistent with the way assets and liabilities are categori4ed on the balance sheet.
However, simplifying in this way hides the opportunity, and need, to consider a much finer
hedging of assets and liabilities. 5or e)ample, an asset that will turn to cash in one month is
generally not a good hedge for ten(month debt, yet both would appear on the balance sheet as
current items. An asset with a *-(year life is generally not a good hedge for thirteen(month
debt, yet both would appear on the balance sheet as long(term. 0t is important to look beyond
the simplicity of the balance sheet classification and e)amine the maturities of assets and
liabilities in more detail.
3. Wh"# ro'e does #he de%# ."#uri#y .i2 *'"y in #he $ir.4s o(er"'' risk-re#urn
*os#ure The debt maturity mi) is an important input to a companys levels of risk and return.
0n general, short(term liabilities are less costly than long(term debt, since the yield curve is
normally upward sloping. However, a firm with a high level of short(term liabilities has less
liquidity than one whose debt is of longer maturities. 0n summary, a company which weights
its debt financing toward the short(term increases both its return and risk, while a company
which weights its debt financing toward the long(term decreases both its return and risk. 6y
establishing its debt maturity mi), a company can add or subtract both risk and return to its
risk(return position.
5. 6is#inguish %e#&een indi(idu"' "sse#7'i"%i'i#y hedging "nd ."#uri#y-r"nge hedging
Wh"# #y*e o$ co.*"ny c"n do e"ch 0ndividual asset7liability hedging, involves matching
the maturities of specific assets with specific liabilities. Each liability is offset with an asset of
equal amount and maturity. 8hile this strategy achieves the ma)imum risk reduction from
hedging, it is costly, difficult, and time(consuming to do. 8ith maturity(range hedging, assets
and liabilities are grouped by maturity and the groups are kept roughly equal in si4e. This
policy is far less costly and more doable than attempting to match every asset and liability.
Effectively, maturity(range hedging is an attempt to back off from individual asset7liability
hedging to find a practical balance sheet hedging policy.
8. Wh"# ro'e do *er."nen# curren# "sse#s *'"y in ."#uri#y-r"nge hedging Even though
individual current assets turn over within the annual accounting period, the balance of
permanent current assets has a long(term maturity since it will be on the books for many
years. /ecogni4ing this, we include permanent current assets with noncurrent assets when
grouping assets by maturity for maturity(range hedging.
Risk 9"n"ge.en# "nd Te.*or"ry Working C"*i#"' 16)
1:. Why do co.*"nies de(i"#e $ro. ."#uri#y-r"nge hedging ,ompanies deviate from
maturity(range hedging for three primary reasons+
!"# 0nability to obtain the desired financing 1mall businesses often cannot obtain funds in
the maturities needed for hedging purposes. They have difficulty raising long(term capital
and tend to weight their financing toward the available shorter(term trade credit and bank
financing.
!'# ,ost reduction !higher returns# 1ome companies elect to use more short(term financing
than required for hedging since it is lest costly when yield curves are normal. 3ther
companies elect to use more long(term debt to avoid the costs of repeatedly renewing and
renegotiating their financing.
!*# /isk reduction 1ome companies elect to use more short(term financing than required
for hedging since it gives them a high degree of fle)ibility in adding and subtracting debt
from the balance sheet should their needs change. 3ther companies elect to use more
long(term debt to lock in interest rates, improve their credit ratings, and avoid the danger
of bankruptcy from having to repay debt on an ongoing basis.
11. Wh"# $"c#or;s< en#er #he decisions "%ou# #he co.*osi#ion o$ " *or#$o'io o$ ."rke#"%'e
securi#ies The important factor is the maturity of each security in the portfolio. 9arketable
securities should be selected with an eye toward when the money will be needed again in order
to insulate the company from market price fluctuations. 0n this way, the company will receive
a known face value when each security matures. 1ince the values of all marketable securities
in an economy are closely tied to interest rates, it is not possible to use statistical portfolio
techniques !betas# to reduce the risk of this kind of portfolio.
1!. Which $in"nci"' ins#ru.en#s "re .os# co..on'y used "s ."rke#"%'e securi#ies A list is
given in 5igure ":.; on page <;". These securities include =.1. Treasury bills, bonds and
notes2 bonds issued by other federal agencies and by state and local governments2 bank
instruments including acceptances, negotiable ,>s, and repos2 financial market instruments
such as commercial paper, Euronotes, and variable(rate preferred stock2 and money market
mutual funds combining securities from one or more issuers. They all share the characteristics
of relatively low risk and high liquidity and marketability.
1). Wh"# is .e"n# %y #he ,$i(e Cs0 The five ,s are five words that summari4e the criteria for
e)tending credit used by commercial banks. 1pecifically, they are+
". ,haracter does the credit applicant responsibly meet his7her obligations?
%. ,apacity does the credit applicant have the ability to pay?
c. ,apital does the credit applicant have sufficient resources to make payments under
adverse conditions?
d. ,ollateral does the credit applicant have assets which can be pledged against the loan
to provide a @second way outA should payment not be made?
e. ,onditions what outside factors may make it difficult for the credit applicant to pay and
what is the probability and proBected effect of each?
16+ Ch"*#er 16
1+. In &h"# &"y;s< "re =u"'i#y-'e"ding co.*"nies ch"nging #heir "**ro"ch #o #he con#ro' o$
&orking c"*i#"' Cuality(leading companies are finding many ways to improve their
production, finance, and management processes to significantly reduce working capital
requirements. The move toward Bust(in(time manufacturing is perhaps the most visible of
these improvements reducing the need for inventoriesthe chapter relates the progress that
one company, American 1tandard, has made in this regard. 3ther changes which have
reduced the need for working capital include more efficient cash management through
customer(supplier alignments with banks, and more efficient handling of receivables and
payables by using electronic data interchange with suppliers and customers.
11. So.e $in"nci"' *ro$ession"'s consider $or&"rd con#r"c#s "no#her kind o$ deri("#i(e
securi#y. Why do you #hink #his is so A derivative security is a contract whose value is
tied to some financial market security, rate, or price. These financial professionals see forward
contracts as fitting within the definition of a derivative, since the value of a forward contract
depends on the interest or e)change rate it is connected to. 5or e)ample, a company which
has signed a forward e)change contract has the obligation to purchase a foreign currency at a
specified e)change rate. 1hould the foreign currency become more e)pensive, the forward
contract would become more valuable and vice versa.
16. Ho& does " $or&"rd con#r"c# &ork "s " hedging de(ice A forward contract locks in an
interest rate or e)change rate for a specified future time. 0t insulates the company from
changes to that rate until the e)ercise date of the contract. ,onsider, for e)ample, a company
with an account receivable of "-,--- 1wiss francs due to be collected in ;- days. The
company will have to convert the francs to dollars at that time, but the e)change rate ;- days
from now is unknownhence the company faces foreign e)change risk. 6y purchasing a
forward e)change contract, the company can guarantee the rate of e)change and eliminate the
risk. The forward contract, a liability to deliver "-,--- francs in ;- days hedges the account
receivable asset, the right to receive "-,--- francs in ;- days by providing a way for the
company to use the proceeds from the asset and receive a known value.
13. Ho& does " deri("#i(e securi#y &ork "s " hedging de(ice 5inancial managers can use a
derivative security to hedge the asset to which the derivative is connected by creating an
opposite e)posure to the asset. 5or e)ample, a food processor could buy futures on the
agricultural products it will be purchasing in the ne)t few months. 0f the cost of the products
rises the food processor will have to pay more for them, but the futures contracts will increase
in value as well offsetting the e)tra cost and providing the additional money required. The
asset and the derivative position are perfectly negatively correlated in this strategy+ any change
in value of the asset will be offset by an opposite change in value of the derivative security. 0n
the ideal hedge, the opposite e)posure is for the same amount of money as the asset itself,
however, since derivative instruments come in fi)ed si4esfor e)ample D"-,--- unitsit is
often difficult to construct an opposite position of precisely the needed amount.
15. A ne& $in"nce s#uden# &"s o(erhe"rd ."king #he $o''o&ing s#"#e.en#> ,In e$$icien#
$in"nci"' ."rke#s/ "'' hedging de(ices shou'd %e *er$ec# su%s#i#u#es?0 6iscuss. 0n
Risk 9"n"ge.en# "nd Te.*or"ry Working C"*i#"' 161
general, alternative hedging devices are reasonably good substitutes for one another.
However the students statement is not quite true for at least three reasons+
!"# $ot all hedging instruments convey the same rights and obligations. 5or e)ample, a
forward contract commits the parties to go through with the transaction while an option
gives the choice of whether to proceed to the option holder.
!'# $ot all hedging devices are ta)ed the same way.
!*# 9oney market hedges appear on the balance sheet as assets and offsetting liabilities while
derivative securities do not.
18. 6r"& " $'o& ch"r# o$ #he $our-s#e* &orking c"*i#"' *rocess. 3ne !very simple# possibility+
,apital budgeting >ebt(equity mi)
1elect permanent
current assets
Take attractive
short(term financing
Add short(term and
long(term debt to
hit hedging target
Add temporary
working capital
as needed
PRO@AE9S
SOAUTION PRO@AE9 161
/ecall that the current ratio E ,urrent assets
,urrent liabilities
/earranging+ ,urrent liabilities E ,urrent assets
,urrent ratio
and with a target current ratio of '.<+
Target current liabilities E ,urrent assets
'.<
166 Ch"*#er 16
!a# %ermanent current assets E D"- million
Target current liabilities E D"- million E D. million
'.<
Additional short(term financing needed to meet
target E D. million D' million E D' million
!b# %ermanent current assets E DF million
Target current liabilities E DF million E D*.' million
'.<
Additional short(term financing needed to meet
target E D*.' million D' million E D".' million
!c# %ermanent current assets E D< million
Target current liabilities E D< million E D' million
'.<
Additional short(term financing needed to meet
target E D-
!d# %ermanent current assets E D' million
Target current liabilities E D' million E D-.F million
'.<
The company has D".' million more in short(term financing than target. 0t should either
reduce current liabilities by this D".' million, increase its permanent current assets to D<
million !see answer to part c#if good permanent current asset investments e)ist, or
rethink its '.< target current ratio.
SOAUTION PRO@AE9 16!
/ecall that the current ratio E G ,urrent assets
,urrent liabilities
/earranging+ ,urrent liabilities E ,urrent assets
,urrent ratio
and with D'< million of permanent current assets+
Target current liabilities E D'< millionG
,urrent ratio
!a# Target current ratio E ".F
Target current liabilities E D'< million E D"*.; million
".F
Risk 9"n"ge.en# "nd Te.*or"ry Working C"*i#"' 163
Additional short(term financing needed to meet
target E D"*.; million D. million E D;.; million
!b# Target current ratio E '.-
Target current liabilities E D'< million E D"'.< million
'.-
Additional short(term financing needed to meet
target E D"'.< million D. million E DF.< million
!c# Target current ratio E '..
Target current liabilities E D'< million E D"-.. million
'..
Additional short(term financing needed to meet
target E D"-.. million D. million E D:.. million
!d# Target current ratio E '.F
Target current liabilities E D'< million E DF.; million
'.F
Additional short(term financing needed to meet
target E DF.; million D. million E D..; million
SOAUTION PRO@AE9 16)
5or all four cases+
H Total assets E current I long(term E D'< I D'< E D<- million
H 8ith a target debt ratio of .-J
Liabilities E .-J, so liabilities E .-J!assets#
Assets
Liabilities E .-J!D<- million# E D'- million
H Therefore equityE D<- million D'- million E D*- million
!a# ,urrent debt E '-J!D'- million# E D. million
Long(term debt E F-J!D'- million# E D": million
!b# ,urrent debt E .-J!D'- million# E DF million
Long(term debt E :-J!D'- million# E D"' million
!c# ,urrent debt E :-J!D'- million# E D"' million
Long(term debt E .-J!D'- million# E DF million
!d# ,urrent debt E F-J!D'- million# E D": million
Long(term debt E '-J!D'- million# E D. million
165 Ch"*#er 16
!"# 6alance sheets
5inancing
Assets 9i)+ a b c d
,urrent '< ,urrent liabilities . F "' ":
$on(current'< Long(term liabilities ": "' F .
Equity *- *- *- *-
<- <- <- <- <-
!'# 5inancial half of income statement
0nterest e)pense+
!a# KJ!D. million# I "'J!D": million# E D'.' million
!b# KJ!DF million# I "'J!D"' million# E D'.- million
!c# KJ!D"' million# I "'J!DF million# E D".F million
!d# KJ!D": million# I "'J!D. million# E D".: million
a b c d
E60T D<.-- D<.-- D<.-- D<.--
0nterest '.'- '.-- ".F- ".:-
E6T '.F- *.-- *.'- *..-
Ta)es !*<J# .;F ".-< "."' ".";
EAT D".F' D".;< D'.-F D'.'"
!*# /atios a b c d
/3E E EAT ".F' E :.-KJ ".;< E :.<-J '.-F E :.;*J '.'" E K.*KJ
Equity *- *- *- *-
,urrent E ,A '< E :.'< '< E *."* '< E '.-F '< E ".<:
,L . F "' ":
$ote that as the firm moves from more long(term debt !alternative a# toward more short(
term debt !alternative d#, it increases its return on equity but at the cost of greater liquidity
risk as seen in the lower current ratio.
SOAUTION PRO@AE9 16+
5or all four cases+
H $on(current assets E total current E D.-- D'<- E D"<- million
H 8ith a target debt ratio of <-J
Liabilities E <-J, so liabilities E <-J!assets#
Assets
Liabilities E <-J!D.-- million# E D'-- million
H Therefore equityE D.-- million D'-- million E D'-- million
H 8ith basic earning power E "<J+
E60T E "<J, so E60T E "<J!assets#
Risk 9"n"ge.en# "nd Te.*or"ry Working C"*i#"' 168
Assets
E60T E "<J!D.-- million# E D:- million
!a# ,urrent debt E '-J!D'-- million#E D.- million
Long(term debt E F-J!D'-- million#E D":- million
!b# ,urrent debt E .-J!D'-- million#E DF- million
Long(term debt E :-J!D'-- million#E D"'- million
!c# ,urrent debt E :-J!D'-- million#E D"'- million
Long(term debt E .-J!D'-- million#E DF- million
!d# ,urrent debt E F-J!D'-- million#E D":- million
Long(term debt E '-J!D'-- million#E D.- million
!"# 6alance sheets
5inancing
Assets 9i)+ a b c d
,urrent '<- ,urrent liabilities .- F- "'- ":-
$on(current"<- Long(term liabilities ":- "'- F- .-
Equity '-- '-- '-- '--
.-- .-- .-- .-- .--
!'# 5inancial half of income statement
0nterest e)pense+
!a# <J!D.- million# I "-J!D":- million# E D"F million
!b# <J!DF- million# I "-J!D"'- million# E D": million
!c# <J!D"'- million# I "-J!DF- million# E D". million
!d# <J!D":- million# I "-J!D.- million# E D"' million
a b c d
E60T D:-.- D:-.- D:-.- D:-.-
0nterest "F.- ":.- "..- "'.-
E6T .'.- ...- .:.- .F.-
Ta)es !*<J# "..K "<.. ":." ":.F
EAT D'K.* D'F.: D';.; D*".'
!*# /atios a b c d
/3E E EAT 'K.* E "*.:<J 'F.: E "..*-J ';.; E "..;<J *".'E "<.:-J
Equity '-- '-- '-- '--
,urrent E ,A '<- E :.'< '<- E *."* '<- E '.-F '<- E ".<:
161: Ch"*#er 16
,L .- F- "'- ":-
$ote that as the firm moves from more long(term debt !alternative a# toward more short(
term debt !alternative d#, it increases its return on equity but at the cost of greater liquidity
risk as seen in the lower current ratio.
16A1
APPEN6IB 16A
Transferring Money Between Cash and Marketable Securities
PRO@AE9S
SOAUTION PRO@AE9 16A1
!a# L E
'NF
i
C
' '- --- --- <-
-:
! , , #
.
E ** *** *** *** , , , E D"F',<K.
!b# Average cash balance E L E D"F',<K. E D;",'FK
' '
!c# Transfers per year E $ E D'-,---,--- E ""-
L D"F',<K.
!d# Transfer frequency E *:- E *:- E every *.* days
transfers per year ""-
SOAUTION PRO@AE9 16A!
!a# L E
'NF
i
C
' < --- --- K<
-.
! , , #
.
E "F K<- --- --- , , , E D"*:,;*"
!b# Average cash balance E L E D"*:,;*" E D:F,.::
' '
!c# Transfers per year E $ E D<,---,--- E *K
L D"*:,;*"
!d# Transfer frequency E *:- E *:- E every ;.K days
transfers per year *K
SOAUTION PRO@AE9 16A)
!a# Lower control limit !L,L# E D- since there is no minimum cash balance requirement.
!b# Lero point !L# E
*
.
'
*
F
i

I L,L
16A! A**endi2 16A
i E !".-<#
"7*:<
" E .---"**K
and
L E
*
.
'
*
F
i

I L,L E
* :- " --- --- ---
. ---"**K
*
! # , , ,
!. #
I - E D:;,<:-
!c# =pper control limit !=,L# E *L '!L,L#
E *!D:;,<:-# '!D-# E D'-F,:F-
!d# Average cash balance E .L L,L E .!D:;,<:-# - E D;',K.K
* *
SOAUTION PRO@AE9 16A+
!a# Lower control limit !L,L# E D'<,---, the minimum cash balance required by the companys
bank.
!b# Lero point !L# E
*
.
'
*
F
i

I L,L
i E !".-.<#
"7*:<
" E .---"'-:
and
L E
*
.
'
*
F
i

I L,L E
* .- "-- --- --- ---
. ---"'-:
*
! # , , ,
!. #
I '<,---
E D';",;": I '<,--- E D*":,;":
!c# =pper control limit !=,L# E *L '!L,L#
E *!D*":,;":# '!D'<,---#
E D;<-,K.F <-,--- E D;--,K.F
!d# Average cash balance E .L L,L E .!D*":,;":# '<,--- E D.".,''"
* *
SOAUTION PRO@AE9 16A1
L,L remains D- in all cases.
!a# i E !".-*#
"7*:<
" E .----F"-
L E
*
.
'
*
F
i

I L,L E
* :- " --- --- ---
. ----F"-
*
! # , , ,
!. #
I - E DF','-K
Tr"ns$erring 9oney @e#&een C"sh "nd 9"rke#"%'e Securi#ies 16A)
=,L E *L '!L,L# E *!DF','-K# '!D-# E D'.:,:'"
Average balance E .L L,L E .!DF','-K# - E D"-;,:-;
* *
!b# i E !".-.#
"7*:<
" E .---"-K<
L E
*
.
'
*
F
i

I L,L E
* :- " --- --- ---
. ---"-K<
*
! # , , ,
!. #
I - E DK.,F-:
=,L E *L '!L,L# E *!DK.,F-:# '!D-# E D''.,."F
Average balance E .L L,L E .!DK.,F-:# - E D;;,K."
* *
!c# i E !".-:#
"7*:<
" E .---"<;K
L E
*
.
'
*
F
i

I L,L E
* :- " --- --- ---
. ---"<;K
*
! # , , ,
!. #
I - E D:<,<:-
=,L E *L '!L,L# E *!D:<,<:-# '!D-# E D";:,:F-
Average balance E .L L,L E .!D:<,<:-# - E DFK,."*
* *
!d# i E !".-K#
"7*:<
" E .---"F<.
L E
*
.
'
*
F
i

I L,L E
* :- " --- --- ---
. ---"F<.
*
! # , , ,
!. #
I - E D:',*KF
=,L E *L '!L,L# E *!D:',*KF# '!D-# E D"FK,"*.
Average balance E .L L,L E .!D:',*KF# - E DF*,"K"
* *
$otice that as the interest rate rises, the companys cash balance falls since it is more lucrative to
keep money in marketable securities.
SOAUTION PRO@AE9 16A6
16A+ A**endi2 16A
L,L remains D'<,--- in all cases.
!a# L E
*
.
'
*
F
i

I L,L E
* '- "-- --- --- ---
. ---"'-:
*
! # , , ,
!. #
I '<,--- E D'<:,:;.
=,L E *L '!L,L# E *!D'<:,:;.# '!D'<,---# E DK'-,-F'
Average balance E .L L,L E .!D'<:,:;.# '<,--- E D***,;'<
* *
!b# L E
*
.
'
*
F
i

I L,L E
* *- "-- --- --- ---
. ---"'-:
*
! # , , ,
!. #
I '<,--- E D';-,''*
=,L E *L '!L,L# E *!D';-,''*# '!D'<,---# E DF'-,::;
Average balance E .L L,L E .!D';-,''*# '<,--- E D*KF,:*"
* *
!c# L E
*
.
'
*
F
i

I L,L E
* <- "-- --- --- ---
. ---"'-:
*
! # , , ,
!. #
I '<,--- E D**;,.<K
=,L E *L '!L,L# E *!D**;,.<K# '!D'<,---# E D;:F,*K"
Average balance E .L L,L E .!D**;,.<K# '<,--- E D...,'K:
* *
!d# L E
*
.
'
*
F
i

I L,L E
* :- "-- --- --- ---
. ---"'-:
*
! # , , ,
!. #
I '<,--- E D*<;,":-
=,L E *L '!L,L# E *!D*<;,":-# '!D'<,---# E D",-'K,.F-
Average balance E .L L,L E .!D*<;,":-# '<,--- E D.K-,<.K
* *
$otice that as the cost of each cash(securities transaction rises, the companys cash balance rises
as well since it becomes more costly to move the cash into marketable securities and back.