1. Working capital is a metric that shows the operating liquidity at the disposal of the company. It shows the short-term financial health of the company. Effects of neglecting working capital include low levels of liquidity, inadequate levels of inventory, penalties due to late payments and bankruptcy. Techniques involved include debtors’ management, inventory management, cash management, and short-term financing. The techniques will help the management keep abreast with the immediate cash flow needs.
2. The two different classes of stock will have different component costs. Thus, the cost of capital will be calculated by deriving the cost and weight for each type of stock separately. The method described will ensure that the accountant captures all the accurate details of each class of stock including its weight and cost.
3. The new line of business will constitute more than half of the company’s operations within the next three years. Furthermore, the expansion into this line of business needs to be done quickly. For this reason, it is essential that the company develop a new rate of return for debt to be used in the financing of the new line of business. The firm’s existing cost of debt may not be able to adequately cover all the requirements of the new line of business.
4. A divisional cost of capital is developed for companies that have multiple business units, with each division having its own cost of capital. If new projects are assigned to the wrong division, then this will vary the division’s cost of capital. If the risk of the division is significantly different from the risk of the project, the project will be analyzed using a misleading divisional cost of capital.
5. The IRR would give the right accept/reject answer at all of the interest rates in the range, if the projects were mutually exclusive and their NPV profiles crossed at all points. The reason for the right accept/reject answer being given at every interest rate is because at these points, the investors or the management would be indifferent towards the two projects at any rate.
6. The Adjusted Present Value refers to the calculation of the Net Present Value assuming that the entire project was being financed through equity alone. The NPV is then adjusted for interest and tax advantages of the form of financing used. Thus, if the company were to use APV as the main metric in analyzing capital budgeting projects, the benchmark value of this rule would be:
Accept project if APV≥-CF0
Reject project if APV<-CF0
7. Discount credit is a financial technique utilized by companies when they are having cash flow issues. The cash flow shortages are often because of the terms of payment granted to the customers by the businesses. The discount credit is thus used to cater to working capital and cash flow needs because of late payments from the customers. The discount credit often comes with a high administrative burden and that is why it rarely used as a source of short-term finance.
8. An increase for inventory on hand will result in a decrease in the firm’s profitability. This is especially the case if there is an increase in inventory but no change in the sales. The reason for the decline in profits will be the additional carrying costs owing to the increased inventory. If sales do not increase then the company is not making a profit even with increases in inventory.
9. Asset based loans are secured financial lending instruments given to companies. The ABLs are usually cheaper than unsecured loans for most firms and they offer more money to the firm when compared to unsecured loans. However, the major drawback of asset-based loans is that failure to make re-payments can result in the company losing the asset that it had used as guarantee.