Question

SHORT-TERM FINANCING AND OPTIONS CONTRACT

Gregg, the CFO and the board of directors of Baldwin Inc. have taken enough time to discuss capital budgeting, dividend policy, and capital structure and now want to focus their attention on short-term finance and cash planning of the company. The board is considering the ways to improve the working capital management of the company. They are also discussing various sources of short-term financing and the minimum amount of money to borrow in the short-term to finance inventory and accounts receivable associated with sales growth. Gregg opened the meeting with the statement that the company must investigate its cash cycle and find ways to improve it because he has noticed a deterioration in the cash flow management of the firm.

Gregg was worried that the inventory period of the company has increased from 70 days in the previous year to 80 days in the current year and the accounts receivable period has also increased from 47 days in the previous year to 55 days in the current year whilst the accounts payable period remains the same at 52 days. He explained that if the two components of cash cycle i.e. operating cycle and accounts payable period are not improved, the company might need to borrow $5.5 million short-term next year to fill the gap between short-term cash inflows and cash outflows.

Gregg presented to the board the following ratios to show how the company has performed over the past two years:

Exhibit 1: Asset Utilization Ratios of Baldwin Inc.

Asset Utilization Ratios	2018	2019
Inventory turnover	5.14 times	4.5 times
Inventory period	70 days	80 days
Accounts Receivable period	47 days	55 days
Accounts Payable period	52 days	52 days
Operating cycle	117 days	?
Cash cycle	65 days	?

The Credit manager of the company, Josh Waters explained that the company can change some aspects of its short-term financial policy and find alternative financing policies to fund current assets to improve its working capital management. Another board member, Jacky Jackson was of the view that cash budget is a primary tool of short-term financial planning that can be used to improve the cash management of Baldwin Inc. She believed that having short-to-medium term cash budget for the next five years can help the company identify its short-term financial needs or opportunities and the required amount needed to borrow for the next five years. In that way the company will be able to arrange for short-term finance in advance to reduce the risk of cash shortages. With the expected improvement in current asset management of the company, some investors believe that the company’s stock price will increase. One investor, Desmond Clinton is of the opinion that buying a call option on the stock will give him the right to purchase more of the stock of the company now at a fixed price before the price of the stock jumps up. The stock price of Baldwin is currently $25. The exercise price is $30 per share. The call option and put option on the company’s stock expires in one year.

The board is determined to improve the company’s short-term financial management policies and wants you to assist them achieve that objective.

4.       The board wants to adopt a restrictive short-term financial policy to improve on its cash management. Identify three aspects of restrictive short-term financial policy the company should consider.

Answer 1

1. A restrictive short-term financing policy entails a low ratio of current assets to sales. This policy relies upon the use of short-term liabilities.
2. If carrying costs are low and/or shortage costs are high, a flexible short-term financing policy is optimal.
3. If carrying costs are high and/or shortage costs are low, a restrictive short-term financing policy is optimal.

On a contrary side, A flexible short-term financing policy maintains a high ratio of current assets to sales. The policy includes limited use of short-term debt and heavy reliance on long-term debt.