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Accounting 2e 2006 Michael Jones. Chapter 22 ... Accounting 2e 2006 Michael Jones. Cost of Capital I. Cost at which a business raises funds ...

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Chapter 22

The Management of Working Capital and Sources of Finance

the management of working capital and sources of finance
The Management of Working Capital and Sources of Finance

1. Introduction

2. Nature of Sources of Finance

3. Short-term Financing

      • Internal financing
      • External financing
  • Long-term Financing
      • Internal financing
      • External financing

5. Cost of Capital

6. Conclusion

  • Sources of finance vital
  • May be internal or external
  • Businesses aim to optimise the use of their funds
  • Try to minimise short-term borrowings and finance long-term infrastructure as cheaply as possible
nature of sources of finance
Nature of Sources of Finance
  • Sources of finance: internal or external, short-term or long-term
  • If short-term should use for operational activities
  • If long-term should fund longer term infrastructure assets
short term financing i
Short-Term Financing I
  • Management of working capital
  • Reduce amount of short-term finance used for day-to-day operations
short term financing ii internal financing
Short-Term Financing IIInternal Financing

a. Cash

b. Debtors

i. Debtors collection model

Seeks to maintain the optimal level of debtors by

balancing extra revenue from increased sales

with increased costs (e.g., credit control, bad


short term financing v internal financing
Short-Term Financing VInternal Financing

c. Stock

  • Often extremely important asset
  • A buffer against excess demand
  • Stock control against theft and deterioration

ii. Economic Order Quantity

Determines optimal order quantity which minimises the costs of ordering and holding stock

short term financing vii internal financing
Short-Term Financing VIIInternal Financing

c. Stock

  • Just-in-Time
  • Japanese stock control technique
  • Stock timed to arrive just before use
  • But no stock buffer for unexpected emergencies
short term financing viii external financing
Short-Term Financing VIIIExternal Financing
  • Cash
  • Borrow from bank via loans or overdrafts
  • Debtors
  • Debt Factoring
  • Subcontract debtors to debt factoring companies
  • Company no need for credit control staff and receives an advance from debt factor
  • Debt factoring company charges for services
  • Invoice Discounting
  • In effect, a loan secured on debtors
  • Company still manages its debtors
  • Stock
  • Possible to sell and buy back stock
long term financing ii internal sources
Long-Term Financing IIInternal Sources
  • Retained profits
  • An alternative to external financing
  • Business finances itself out of past successes
  • Shareholders trade dividends today for future growth
long term financing iii external sources
Long-Term Financing IIIExternal Sources
  • Leasing
  • Same as individual hiring say T.V.
  • Asset owned by lessor, but used by company
  • Company pays lessor
  • Saves company finding capital to purchase asset
  • Company pays more than original purchase price
  • Source of assets, not source of finance
  • Share Capital
  • Raise substantial finance by share or loan capital
  • Types of share issue

i. Rights - existing shareholders can buy more

ii. Public - direct offer to public

iii. Placing - place with financial institution

long term financing iv external sources
Long-Term Financing IVExternal Sources
  • Loan Capital
  • Long-term borrowing
  • Loan interest an expense
  • Loans secured on assets
  • Loan holders not owners of company
cost of capital i
Cost of Capital I
  • Cost at which a business raises funds
  • Two sources of funds:

i. Debt

ii. Equity

  • Debt normally cheaper
  • Each source of finance has an associated cost of capital
  • A business’s overall cost of capital is its weighted average cost of capital
cost of capital ii
Cost of Capital II

D. Ebt finances her college course as follows:

General expenses, by credit card £3,000 at 25% interest p.a.

Accommodation, by bank loan £4,000 at 10% interest p.a.

Car, by loan from uncle £3,000 at 5% interest p.a.

What is D. Ebts overall weighted average cost of capital?

Source of Proportion Cost of Weighted average

Finance capital cost of capital (WACC)

£ % %

Credit card 3,000 30 25 7.5

Bank loan 4,000 40 10 4.0

Personal loan 3,00030 5 1.5


cost of capital iii
Cost of Capital III

Costco plc

  • 800,000 £1 ordinary shares currently quoted at £2.50 each. Dividend 20p per share.
  • £200,000 debt currently worth £1,000,000. Loan interest £60,000.

Calculate Costco plc’s weighted average cost of capital.

Source of Market Proportion Cost of Weighted average

finance value % capital cost of capital

Equity £2,000,000 66.67 8%* 5.33%

Debt £1,000,00033.33 6%** 2.00%


* (£0.20÷£2.50)


Helpnote: We need market value not original cost

  • Sources of finance essential
  • Short-term sources of finance (cash, debtors and stock)
  • Long-term sources of capital fund infrastructure activities
  • Four main long-term sources: retained profits, leasing, share capital and loan capital