2. The Columbia Manufacturing Company has been iked by it wants to renew all or any portion of its present borrowing against the credit line. The most recent balance sheet is shown as follows (in millions of dollars): Current auet Foxed sets $55.00 100.00 Total $155.00 Accounts payable $15.00 Note payable 20.00 Long-term debt 50.00 Equity 70.00 Total daima $155.00 Columbia's most recent income statement is shown as follows (in millions of dollars): Earnings before interest and taxes Interest (notes payable) Interest (long-term debt) Earnings before taxes Taxes (48%) Net income Return on equity $30.00 1.60 4.50 23.90 11.47 $12.43 17.76% The bank has informed Columbia that because its current ratio violates the minimum 2:1 stipulation, the credit line will be renewed at an interest rate that is three percentage points higher than the "prime" rate. Columbia would be able to renew any amount up to $20 million. Columbia is considering two alternatives to renewing the credit line. One is to borrow $20 million in long-term debt and completely repay the credit line borrowing The second would be to borrow $10 million on a long-term basis and renew $10 million on the credit line. In the coming year, the economic environment could be, in the words of Columbia's management, salutory, adequate, or illusive. Each economic environment outcome would have a different effect on the decision variables being considered here, as indicated. Salutory Adequate Illusive Earnings before interest and taxes (millions) $37.00 $32.00 $28.00 Prime rate 8% 7% 6% Long-term rate, $20 million principal 11% 11% 11%. Long-term rate, $10 million principal 10% 10% 10% h 108 PART MANAGEMENT OF CURRENT ASSETS (a) Amume that the economic environment turns out to be "adequate." Columb is $32 million. Also assume that the applicable credit line rate would apply for the total year. That is, for the "adequate" outcome, the credit line borrowing rate would be 10 percent Compute the return on equity for the following three financing shernative for the "adequate outcome (1) renew $20 million at the bank (2) borrow 120 million on a long-term basis; and (3) renew $10 million at the bank and borrow $10 million on a long-term basis. Which financing almative appears to be beat Why? Take into account all of the preceding information in computing your newer (b) Recompute your calculations in part (a) by auming that (1) lutory occur and (2) "lusive" outcome occurs What influer do the environment outcome appear to have on the desirability of the various alnative (c) If the economic environment outcomes occur randomly over the next 10 years and the related outcomes for credit line interest rates and EBIT remain the same indicated previously, which outcome would be mon desirable? Why? [The answer a descriptive not quantitative. Asume that the use of any long-term debe is made only in the initial year considered in parts (a) and (b)) SELECTED DANE, WILLIAM, Hiking Capital Management. Belmont, Calif: Wadsworth Publishing Co. REFERENCES ANSWERS TO SPOT QUIZZES Inc, 1966 COABOOM, ROGER A, "Let's Reassess the Profitability-Liquid Tradeoff Financial Ext Vol. 39 (May 1971), pp. 46-51 GLAUTER, M. W. E., "Towards a Reformulation of the Theory of Working Capital," Journal of Business Finance, Vol. 3 (Spring 1971), pp. 37-42 Kaur, W. D., "Working Capital Management Satisficing Versus Optimization," Financial Management, Vol. I (Spring 1972), pp. 33-40. MEITA, DILEEP R., Working Capital Management. Englewood Cliffs, NJ: Prentice-Hall, Inc, 1974. MERVILLE, LJ, and L. A. TAVI, "Optimal Working Capital Policies A Chance-Constrained Programming Approach," Journal of Financial and Quantitative Analysis, Vol. 8 (January 1973), pp. 47-60. SMITH, Kerr V., Management of Working Capital. St. Paul, Minn.: West Publishing, 1974 Characteristics of Working Capital Q: F (Both current anets and current liabilities are considered.) Q2: F (Working capital amounts to approximately half of a typical firm's total amen) Q3: T (Low levels of working capital imply low levels of total anets, low equity and consequently higher return on equity.) Q4: F (Low levels of net working capital imply impaired ability to meet current financial obligations.) Q5 T (Working capital serves to match the needs of buyers and sellers.) Financing Current Auets Q1: T (Definitional) Q2: P (Excess funds can be invested temporarily.) Q T (The aggressive approach tends to be risky.) Q4 T (Risk levels associated with various working capital management policies have to be compared with the returns generated.)