Overall Working Capital Policy - Financial Management

Until now, this chapter has analyzed the working capital investment and financing decisions independent of one another in order to examine the profitability–risk trade-offs associated with each, assuming that all other factors are held constant. Effective working capital policy, however, also requires the consideration of the joint impact of these decisions on the firm’s profitability and risk.

Referring to Burlington Resources again, assume that the company is 60 percent debt financed (both short-term and long-term) and 40 percent financed with common stock. Also, it is evaluating three alternative working capital investment and financing policies. The aggressive policy would require a relatively small investment in current assets, $35 million, and a relatively large amount of short-term debt, $30 million. The conservative policy would require a relatively large investment in current assets, $45 million, and a relatively small amount of short-term debt, $10 million. The firm is also considering a middle -ofthe- road approach, which would involve a moderate investment in current assets, $40 million, and a moderate amount of short-term debt, $20 million.

shows the data for each approach. The aggressive working capital policy is expected to yield the highest return on shareholders’ equity, 15.4 percent, whereas the conservative policy is expected to yield the lowest return, 11.3 percent. The net working capital and current ratio are lowest under the aggressive policy and highest under the conservative policy, indicating that the aggressive policy is the riskiest. The moderate policy yields an expected return and risk level somewhere between the aggressive and the conservative policies.

Whereas this type of analysis will not directly yield the optimal working capital investment and financing policies a company should choose, it can give the financial manager some insight into the profitability-risk trade-offs of alternative policies.With an understanding of these trade-offs, the financial manager should be able to make better decisions concerning the working capital policy that will lead to a maximization of shareholder wealth.


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