Page 227 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes
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Caution If all capital is circulating capital, so that it is completely used up within a period,
then no capital built up during the previous period can be brought over into next period.
In this special case, the theory of capital and the theory of investment become one and the
same thing.
With fixed capital, the story is different – and more complicated as there seems to be two
decisions that must be addressed: the amount of capital and the amount of investment. These are
different decisions. One is about the desired level of capital stock. The other is about the desired
rate of investment flow. The decisions governing one will inevitably affect the other, but it is
not necessarily the case that one is reducible to the other.
There are effectively two ways of thinking about investment. At the risk of annoying some
people, we shall refer to these as the “Hayekian” and “Keynesian” perspectives. The Hayekian
perspective conceives of investment as the adjustment to equilibrium and thus the optimal
amount of investment is effectively a decision on the optimal speed of adjustment. A firm may
decide it needs a factory (the “capital stock” decision), but its decision on how fast to build it,
how much to spend each month building it, etc. – effectively, the “investment” decision – is a
separate consideration. Naturally, the capital decision influences the investment decision.

Example: A firm which has ` 10 crore of capital and decides that it needs ` 15 crore of
capital, therefore requires investment of ` 5 crore. But if this adjustment can be done “instantly”,
then there is really no actual investment decision to speak of. We just change the capital stock
automatically. The capital decision governs everything.

However, if for some reason, instant adjustment is not possible, then the investment story
begins to matter. How do we distribute ` 5 billion adjustment in the above example? Do we
invest in an even flow over time, like ` 1 crore this week, another ` 1 crore next week, and so on?
Or do we invest in descending increments, e.g. invest ` 1 crore this week, ` 50 lacs next week,
` 30 lacs the week after that, etc. and approach the ` 5 crore mark asymptotically? Or should we
invest in ascending increments, e.g. ` 10 lac this week, ` 50 lac next week, etc.?
Delivery costs, changing prices of suppliers, fluctuating interest rates and financing costs, and
other such considerations, make some adjustment processes more desirable than others. These
different patterns of “approaching” the desired ` 5 crore adjustment in capital stock and the
considerations that enter into determining which adjustment pattern to follow is what lies at the
heart of the Hayekian approach to investment theory.

The Hayekian approach is shown heuristically in Figure 13.1, where we start at capital stock K
0
and then, at t*, we suddenly change our desired capital stock from K to K*. The figure depicts
0
four alternative investment paths from K towards K*.
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Path I represents “instant” adjustment type of investment (i.e. all investment happens at once at
t* and no more investment afterwards). Path I’ represents an “even flow” adjustment path, with
investment happening at a steady rate after t* until K* is reached. Path I’’ is the asymptotic
investment path (gradually declining investment), while path I’’’ depicts a gradually increasing
investment path. All paths, except for the first instant one, imply that “investment” flows will be
happening during the periods that follow t*. Properly speaking, then, investment theory in the
Hayekian perspective is concerned with analyzing and comparing paths such as I’ , I’’ and I’’’ .

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