- 20 Marks
Question
a) The Treasury Department of LCM Ltd is preparing financial plans for the ensuing financial year. Annual credit sales revenue is projected to be GH¢500 million while the cost of sales is expected to be GH¢260 million. Its current assets are composed of inventory and trade receivables, while its current liabilities comprise trade payables and bank overdraft. The following targets have been set:
- Receivables turnover days: 90 days
- Payables turnover days: 30 days
- Operating cycle: 150 days
- Current ratio: 1.1 times
The company’s long-term capital consists only of owners’ equity. The composition and size of long-term capital are expected to remain the same for the ensuing year. The opportunity cost of equity capital is 20%, and the interest rate on the bank overdraft is 18%.
Required:
i) Compute the amount of bank overdraft the company will need in the ensuing year. (6 marks)
ii) Compute the net working capital of the company for the ensuing financial year. (2 marks)
iii) Compute the cost of financing working capital (in GH¢). (3 marks)
iv) Identify the working capital financing policy LCM Ltd is employing. (4 marks)
b) Risk can be hedged through a variety of derivative instruments such as futures, options, and swaps. Each derivative instrument presents its advantages and disadvantages.
Required:
In reference to the above statement, justify why a company would choose a currency futures contract over a currency option contract in hedging currency exposure. (5 marks)
Answer
a)
i) Computation of the amount of bank overdraft:
Operating cycle = ITD + RTD
150 days = ITD + 90 days
ITD = 60 day
ii) Computation of the net working capital:
Net working capital = Current assets – Current liabilities
Net working capital = GH¢166,027,397 – GH¢150,933,997 = GH¢15,093,400
(2 marks)
iii) Computation of the cost of financing working capital:
Total cost of financing working capital = GH¢23,321,544 + GH¢3,018,680 = GH¢26,340,224
iv) Identification of the working capital financing policy:
LCM Ltd is likely employing an aggressive working capital financing policy because over 90% of its current assets are financed with short-term financing, which is characteristic of an aggressive policy that emphasizes short-term financing to minimize costs but increases risk.
(Marks allocation: Overview of working capital financing policies = 2 marks, Identification of policy = 2 marks)
b) Justification for using currency futures over options:
The primary advantage of using a currency futures contract over a currency option contract for hedging is the absence of a non-refundable premium. In a futures contract, there is no premium to pay upfront, as required with an options contract. Instead, futures involve a margin deposit, and any unused margin is refundable. However, with futures, there is an obligation to trade at the agreed price regardless of market movements, which can be a disadvantage if the market moves unfavorably.
(5 marks)
- Topic: Hedging with options, Working Capital Management
- Series: JULY 2023
- Uploader: Theophilus