13 Working capital policy and cash management,

(a) The treasurer of Ripley plc is contemplating a change in financial policy. At present, Ripley’s balance sheet shows that fixed assets are of equal magnitude to the amount of long-term debt and equity financing. It is proposed to take advantage of a recent fall in interest rates by replacing the long-term debt capital with an overdraft. In addition, the treasurer wants to speed up debtor collection by offering early payment discounts to customers and to slow down the rate of payment to creditors.

As his assistant, you are required to write a brief memorandum to other Board members explaining the rationales of the old and new policies and pinpointing the factors to be considered in making such a switch of policy.

(b) Bramham plc, which currently has negligible cash holdings, expects to have to make a series of cash payments (P) of £ 1.5m over the forthcoming year. These will become due at a steady rate. It has two alternative ways of meeting this liability.

First, it can make periodic sales from existing holdings of short-term securities.

According to Bramham’s financial advisers, the most likely average percentage rate of return (i) is 12 per cent over the forthcoming year, although this estimate is highly uncertain. Whenever Bramham sells securities, it incurs a transaction fee (T)

of £25, and places the proceeds on short-term deposit at 5 per cent per annum interest until needed. The following formula specifies the optimal amount of cash raised (Q) for each sale of securities:

The second policy involves taking a secured loan for the full £1.5m over one year at an interest rate of 14 per cent based on the initial balance of the loan. The lender also imposes a flat arrangement fee of £5,000, which could be met out of existing balances. The sum borrowed would be in a notice deposit at 9 per cent and drawn out at no cost as and when required.

Bramham’s Treasurer believes that cash balances will be run down at an even rate throughout the year.

Required:

Advise Bramham as to the most beneficial cash management policy.

Note: ignore tax and time value of money in your answer.

(c) Discuss the limitations of the model of cash management used in (b).