Page 222 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 13: Integration of Working Capital and Capital Investment Process

As finished goods inventories are increased, each successive increment recaptures less lost sales Notes
and therefore less lost contribution. At levels A and B, E(R) appears to be quite attractive. Policy
D, returning only 4.8 per cent after taxes, does not seem attractive. Which policy should
Southeastern adopt? The answer depends on the target or required rate of return on investment
in inventories.
An important feature of the analysis above is that it examines the incremental return on successive
increments of inventory. To move from the current policy to level D would require a total
investment of ` 6,68,000. This investment would generate additional operating profit of ` 9600,
an E(R) of 14.4 per cent. However, the E(R) on the last increment, from level C to level D, is only
4.8 per cent. By looking at several increments, we can better determine the point at which
marginal E(R) falls below the required rate within increments; the figures in table represent
averages. The marginal E(R) on the last rupee of investment in increment B is quite a bit lower
than the average E(R), 22.8 per cent, on increment B as a whole.

At the aggregate level of the manufacturing sector both in 1975 and in 1982 working capital
declined sharply; some components, such as accounts receivables and inventories even fell
considerably relative to sales. The decline in working capital affects investment directly since it
implies a fall in internal funds, and indirectly by raising the cost of external funds.
Bernanke and Gertler (1988) and Gertler (1989) argue that the agency cost of external finance
depends on the quality of the balance sheet of the firm. When its liquidity decreases or when
prospects concerning future sales deteriorate, the cost of external finance rises. Eckstein and
Sinai (1986) found that at the end of the recession and at the beginning of a recovery firms try to
rebuild their debt capacity by accumulating short-term financial assets in order to be able to
borrow at acceptable rates when they need funds for investment. According to them this
re-liquefaction characterizes a separate phase of the business cycle that precedes the period in
which firms start to invest again.
A firm will also reduce inventories of materials during the recession as it will produce less.
It is conceivable that firms also save working capital in order to make sure that it can carry out
an investment plan that takes years without interruption due to lack of cash. Depending on the
structure of the adjustment costs, working capital has still another effect on the investment
process beyond those mentioned above. It will be used to smooth investments in the case of
convex adjustment costs. If a fixed costs component dominates, investments decisions will seem
irreversible.
As Whited (1991) points out the height of the opportunity costs of reversing the investment
decision varies with the cost of external finance which in turn depends on the availability of
working capital inter alia. From the irreversibility literature we know that the higher the sunk
costs, the longer a firm will wait to execute its investment plan ceteris paribus. Thus the size of
the stock of working capital influences the timing (delay) of investment. Notice that working
capital can be used for smoothing investment because it is in contrast to physical capital perfectly
reversible. The amount of working capital that firms will hold for instance in order to make sure
that investment plans don’t have to be interrupted depends among other things on their reputation
in capital markets.
For firms that are regarded as being of both high long term and high short term credit quality,
Calomiris et al. (1994) find that they have lower stocks of inventories and financial working
capital and in addition that these stocks are less sensitive to cash flow fluctuations. The latter
finding is interpreted by them as follows. Firms of higher credit quality don’t need to accumulate
working capital as a buffer against fluctuations in cash flow as they can easily obtain external
funds at favorable terms. Furthermore they show that given a high (long term) bond rating,
only firms of large size, with low earnings variance, high cash flows and/or large stocks of

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