Questions Number 3 Please

Case 11 Working Capital Policy Ohio Rubber Works, Inc. Ohio Rubber Works, Inc. was established in the period immediately following World War II Its major customer base in those years was the automobile industry. Because the company was located in northwest Ohio, shipment of its finished products to the automobile assembly plants located in Ohio and Michigan was accomplished with relative case. The company was incorporated in 1947 and had undergone the gradual reshaping through acquisitions and mergers that has characterized so many U.S. firms up to the present. By 1993, the company's customer base was much more varied than it had been during the early years. The products now being made by Ohio Rubber Works, Inc, consisted mainly of industrial hoses and belting (pulleys and conveyer belts) for a variety of industrial uses, from automobile manufacturing to mining. While a substantial amount of the company's output was sold to various intermediaries (wholesalers, jobbers, and the like), a significant amount of revenue was generated by special order materials, especially from the airline industry and the military. As a result of that situation and the general nature of its business, the company was very interested in maintaining control of all aspects of its financial situation. Especially important were the monitoring and control of the firm's working capital. Such control included the relationship between short-term and long-term financing and the effect of each upon the return on stockholder's equity. The company's financial managers were determined to see that the company survived the downsizing, reshaping, and general changes in the manufacturing climate so prevalent in recent years within the United States. Careful attention to the balance sheet, as the company's controller had put it, was considered very important The company's controller, Carol Henning, had recently begun a review of the firm's working capital policy. At present, the firm's financial structure appears as shown in Table 1. The current interest rate on short-term borrowing is 6 percent. The company's long-term debt has a nine percent interest rate. The firm is in the thirty-five percent tax bracket (federal, state and local taxes). Sales for 1993 were $70 million. The 1993 profit margin was 7.65 percent. Henning knew from published industry data that firms in similar lines of business, with similar customer bases, had a return on equity one to three percentage points higher than Ohio Rubber Works Henning wondered whether the firm's working capital policy was overly conservative. Would a more aggressive policy increase the firm's already strong retum on common equity? At present the firm's current assets were financed with long-term debt. Henning was very interested in the effect upon ROE of financing the fluctuating or temporary portion of current assets with short-term debt. In addition, she wanted to add 40 percent of the permanent current assets to those financed short-term. The objective was to examine the effect of this change in policy upon the return to the common stockholders and, if the change was positive, to present 11-1 Ohio Rubber Works, Inc. the plan to the company's finance committee. The finance committee was made up of Henning the corporate treasurer, the vice president of finance, and the controller from the firm's two operating divisions In considering working capital changes relative to financing, Henning reflected upon the actual movement of certain working capital items within the firm. In a situation such as that of Ohio Rubber Works, inventory control was a major concern. The varied product lines and customer types highlighted the need for attention to the effect of inventory upon working capital management of particular interest to firms in this situation is the ratio of inventory to sales, relative to the desired ratio The major aspect of that consideration was maintaining the desired ratio as the business cycle ebbed and flowed in its usual pattern. The sales for Ohio Rubber Works over the past 10 years had been steadily growing. The reverses in sales and carings during this upward trend had been slight, and the desired ratio of inventory to sales had been well maintained. In addition, Henning, as she examined historical data for the company, observed a reasonably consistent cash conversion cycle-one which was not only consistent in terms of trend, but in terms of industry comparisons as well. Industry data were obtained from a variety of published sources, including trade journals. Ohio Rubber Works typically had an inventory conversion period of 42 days. As was typical in the industry, the firm's average collection period for receivables was 45 days. The firm usually operated on . 60-day accounts payable cycle, also standard in the industry TABLE 1 Ohio Rubber Works, Inc. Balance Sheet Year-End 1993 5000s) Current assets $16,000 Current liabilities $3,500 Fixed assets, net $24.000 Long-term debt $14,000 Common equity $22.500 Total assets $40.000 Total liabilities and capital $40.000 NoteTwenty percent of financed current assets are comidered temporary, that is, they fluctuate with the level of sales QUESTIONS 1 Calculate the return on equity (ROE) for the company under the present policy and the proposed policy. Which one yields the higher ROE? (Assume that a present interest of 9 percent is paid on the total amount of long-term debt. That is, the total amount of current assets currently financed with borrowed funds is $14.0 million. Any new financing pattern will total that same amount. Assume also that the change from long- term debt to short-term debt, for a portion of total debt, is "frictionless, which means there are no penalties or fees attached to retirement of a portion of the long-term debt). 11-2 11 Ohio Rubber Works, Inc. 2 Comment upon your findings in Question 1. Consider increased or decreased risk related to the change in policy, and also relative to the change in ROE. Should Henning recommend the change in policy? 3 If the yield curve for 1994 is projected to be steeper than 1993, would this change your answer to Question 2? If so, how would it change your answer? In answering the question, comment upon the meaning of a steeper or less steep yield curve, Case 11 Working Capital Policy Ohio Rubber Works, Inc. Ohio Rubber Works, Inc. was established in the period immediately following World War II Its major customer base in those years was the automobile industry. Because the company was located in northwest Ohio, shipment of its finished products to the automobile assembly plants located in Ohio and Michigan was accomplished with relative case. The company was incorporated in 1947 and had undergone the gradual reshaping through acquisitions and mergers that has characterized so many U.S. firms up to the present. By 1993, the company's customer base was much more varied than it had been during the early years. The products now being made by Ohio Rubber Works, Inc, consisted mainly of industrial hoses and belting (pulleys and conveyer belts) for a variety of industrial uses, from automobile manufacturing to mining. While a substantial amount of the company's output was sold to various intermediaries (wholesalers, jobbers, and the like), a significant amount of revenue was generated by special order materials, especially from the airline industry and the military. As a result of that situation and the general nature of its business, the company was very interested in maintaining control of all aspects of its financial situation. Especially important were the monitoring and control of the firm's working capital. Such control included the relationship between short-term and long-term financing and the effect of each upon the return on stockholder's equity. The company's financial managers were determined to see that the company survived the downsizing, reshaping, and general changes in the manufacturing climate so prevalent in recent years within the United States. Careful attention to the balance sheet, as the company's controller had put it, was considered very important The company's controller, Carol Henning, had recently begun a review of the firm's working capital policy. At present, the firm's financial structure appears as shown in Table 1. The current interest rate on short-term borrowing is 6 percent. The company's long-term debt has a nine percent interest rate. The firm is in the thirty-five percent tax bracket (federal, state and local taxes). Sales for 1993 were $70 million. The 1993 profit margin was 7.65 percent. Henning knew from published industry data that firms in similar lines of business, with similar customer bases, had a return on equity one to three percentage points higher than Ohio Rubber Works Henning wondered whether the firm's working capital policy was overly conservative. Would a more aggressive policy increase the firm's already strong retum on common equity? At present the firm's current assets were financed with long-term debt. Henning was very interested in the effect upon ROE of financing the fluctuating or temporary portion of current assets with short-term debt. In addition, she wanted to add 40 percent of the permanent current assets to those financed short-term. The objective was to examine the effect of this change in policy upon the return to the common stockholders and, if the change was positive, to present 11-1 Ohio Rubber Works, Inc. the plan to the company's finance committee. The finance committee was made up of Henning the corporate treasurer, the vice president of finance, and the controller from the firm's two operating divisions In considering working capital changes relative to financing, Henning reflected upon the actual movement of certain working capital items within the firm. In a situation such as that of Ohio Rubber Works, inventory control was a major concern. The varied product lines and customer types highlighted the need for attention to the effect of inventory upon working capital management of particular interest to firms in this situation is the ratio of inventory to sales, relative to the desired ratio The major aspect of that consideration was maintaining the desired ratio as the business cycle ebbed and flowed in its usual pattern. The sales for Ohio Rubber Works over the past 10 years had been steadily growing. The reverses in sales and carings during this upward trend had been slight, and the desired ratio of inventory to sales had been well maintained. In addition, Henning, as she examined historical data for the company, observed a reasonably consistent cash conversion cycle-one which was not only consistent in terms of trend, but in terms of industry comparisons as well. Industry data were obtained from a variety of published sources, including trade journals. Ohio Rubber Works typically had an inventory conversion period of 42 days. As was typical in the industry, the firm's average collection period for receivables was 45 days. The firm usually operated on . 60-day accounts payable cycle, also standard in the industry TABLE 1 Ohio Rubber Works, Inc. Balance Sheet Year-End 1993 5000s) Current assets $16,000 Current liabilities $3,500 Fixed assets, net $24.000 Long-term debt $14,000 Common equity $22.500 Total assets $40.000 Total liabilities and capital $40.000 NoteTwenty percent of financed current assets are comidered temporary, that is, they fluctuate with the level of sales QUESTIONS 1 Calculate the return on equity (ROE) for the company under the present policy and the proposed policy. Which one yields the higher ROE? (Assume that a present interest of 9 percent is paid on the total amount of long-term debt. That is, the total amount of current assets currently financed with borrowed funds is $14.0 million. Any new financing pattern will total that same amount. Assume also that the change from long- term debt to short-term debt, for a portion of total debt, is "frictionless, which means there are no penalties or fees attached to retirement of a portion of the long-term debt). 11-2 11 Ohio Rubber Works, Inc. 2 Comment upon your findings in Question 1. Consider increased or decreased risk related to the change in policy, and also relative to the change in ROE. Should Henning recommend the change in policy? 3 If the yield curve for 1994 is projected to be steeper than 1993, would this change your answer to Question 2? If so, how would it change your answer? In answering the question, comment upon the meaning of a steeper or less steep yield curve