3.5 Permanent and temporary working capital
3.5.4 How working capital investment influences firm value
According to Smith (1980) working capital management is important because it influences firm profitability, risk and value. Luo et al. (2009) state that good working capital management can lower the cost of equity, increasing the equity value. Efficient management of working capital
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reduces a firm’s chances of being financially distressed or getting bankrupt. The reduction of probable bankruptcy/distress costs also lowers the firm’s cost of capital, resulting in a higher firm value. As a result, firms have target level of working capital which maximises value and profitability (Deloof, 2003, Howorth and Westhead, 2003, de Almedia and Eid, 2013).
Damodaran (2001) notes that working capital investment impacts on three areas that ultimately affect firm value, namely, cash flows, liquidity risk and operations as shown in Figure 4. He further argues that increasing current assets involve a trade-off between the negative effects on cash flows, the positive effects on reducing liquidity risk and the positive effect of potentially increasing sales. Working capital investments affect the operations of the firm as they influence its ability to meet customer demands for its goods and services.
FIGURE 4: THREE IMPACT AREAS OF WORKING CAPITAL INVESTMENT THAT ULTIMATELY AFFECT FIRM VALUE
Adapted from Michalski (2008) p.188
Working capital investment policy
influences the period of life the
business 𝛥𝑉𝑝= ∑∆𝐹𝐶𝐹𝐹𝑡
(1 + 𝑘)𝑡
𝑁
𝑡=1
𝐸𝑉𝐴 = 𝑁𝑂𝑃𝐴𝑇 − 𝑘 ˟ 𝑁𝑊𝐶 + 𝐶𝑎𝑝𝑒𝑥) Working capital
investment influence - Costs
- ΔNWC
Working capital investment policy influences the risk profile of the
firm (its cost of capital) Influence on k
Influence on FCFF Influence on t
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When the firm has low working capital investment levels, it is able to turn over its working capital faster and generate more cash flows, thereby increasing its value. As working capital investment levels increase, more funds are locked-up in working capital, hampering its ability to generate more cash flows. Thus increases in working capital investment reduce cash flows since money tied up in working capital cannot be invested elsewhere; compromising firm value.
While low working capital investments enable the firm to increase its value via increased working capital turnover, the firm faces a high liquidity risk (resulting in problems in paying liabilities on time). At higher levels of working capital investment, the firm faces low risk. A more detailed discussion on this subject is provided in the section on working capital investment policies and firm value.
3.5.4.1 Aggressive working capital investment policy and firm value
Holding low working capital investments (pursuing an aggressive working capital policy), ceteris paribus, promotes firm profitability and value and implies high liquidity which also reduces the firm’s risk. It minimises working capital investments by reducing the time inventory held on hand, accelerating collections from customers and delaying payments to suppliers. Low investments in working capital result in a short working capital cycle and indicate that the firm is receiving payments from its customers timeously while delaying payments to suppliers close to the due date. It is a sign of more efficient internal operations and a greater availability of internal resources and suggests a good liquidity condition (Gentry et al., 1979).
Aggressive working capital management results in low carrying costs which increase the value of the firm, see Figure 2. Low working capital investment levels allow managers to reduce investments in unprofitable assets such as cash holdings and inventory; this impacts positively on the firm’s returns (García-Teruel and Martínez-Solano, 2007). Reducing investments in current assets also enables firms to free up more funds from daily operations and channel them to expansion projects because it generates savings, and reduces financing costs for the firm through less reliance on expensive external funds, resulting in a lower required return on
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capital and a higher firm value (Poirters, 2004, Raheman and Nasr, 2007, Filbeck and Krueger, 2005b, Lin et al., 2012).
Luo et al. (2009) argue that a faster working capital turnover rate should lead to higher expected cash flows because the funds freed up from the working capital cycle can be invested again to generate additional income. Jose et al. (1996) support this view by arguing that a shorter CCC corresponds to a higher present value of net cash flows from a firm’s assets.
There are adverse effects of holding low working capital investment levels. Low inventory levels may result in disruptions to production, an inability to satisfy customer needs (lost revenues due to stock-outs), lost sales and a loss of customer goodwill (Damodaran, 2001, Firer et al., 2012). When a firm pursues a strict credit policy it forgoes sales that would have been generated from customers who prefer to buy on credit. Holding low cash on hand may result in the inability to pay maturing obligations (cash-outs). Thus low working capital investments reduce the value of the firm.
3.5.4.2 Conservative working capital investment policy and firm value
Pursuing a flexible working capital investment policy (maintaining a high level of current assets) may also increase firm value and profitability. Large inventory levels and a liberal credit policy may enhance a firm’s sales and achieve higher firm value and profitability (Deloof and Jegers, 1996, Blinder and Maccini, 1991, Salek, 2005). Trade credit stimulates clients to purchase goods when demand is low, helps firms to build lasting relationships with their clients, enables clients to verify the product(s)’ quality before payment and reduces information asymmetry between the seller and the buyer (Cunat, 2007, Emery, 1984, Ng et al., 1999). Keeping large amounts of inventory minimises the likelihood of disruptions in operations and losses due to non- availability of stocks, and hedges against price increases (Blinder and Maccini, 1991, Deloof, 2003). Disruptions in production and supply can be very costly. Firer et al. (2012) give the example of TOYOTA (one of the world’s most celebrated case studies of the Just-In-Time (JIT) inventory management technique). The company is believed to have lost approximately ¥200
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billion ($2.4 billion) due disruptions caused by an earthquake and tsunami in 2011. Early payments to suppliers reduce supplier financing benefit the firm through cash discounts (Ng et al., 1999, Wilner, 2000, Baños‐Caballero et al., 2010).
Holding a high amount of working capital (in particular cash and marketable securities) enables a firm to meet its obligations more easily, which lowers its liquidity and default risk, increases its borrowing capability, lowers the cost of capital and increases its value (Samiloglu and Demirgunes, 2008). Therefore, holding large working capital investments increases both the short-term (profitability) and long-term (firm value maximisation) the firm’s financial performance. According to this school of thought, decreasing working capital increases the firm’s liquidity risk and increases its costs of borrowing, which lowers the firm’s value compared with a firm with a higher amount of working capital. By maintaining large cash holdings, firms can minimise underinvestment costs as internal resources enable it to take advantage of investment opportunities without going to the capital market where funds are expensive (Martínez-Sola et al., 2013a). For this strategy to be effective, the benefits resulting from a high working capital investment level must offset the reduction in profitability and value; otherwise, both firm profitability and value might decrease if the costs of large current assets investments rise at a faster rate than the gains of maintaining a high level of inventory and extending more credit to customers.
High working capital investment level has the following major disadvantages: it carries a financing cost, lost opportunities (as funds will be tied-up in inventories and receivables) (Deloof, 2003) and the high probability of bankruptcy (Shin and Soenen, 1998). Raw materials, work-in-progress and finished goods do not earn any income and incur carrying costs such as storage, insurance, deterioration, obsolescence and opportunity costs (Gitman et al., 2010).
The free cash flow hypothesis advanced by Jensen (1986) states that executives of cash rich businesses are likely to invest in projects that do not benefit shareholders; this compromises the value creation goal. Thus high cash levels cost shareholders and reduce firm value through
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agency costs and low money market returns. Marketable securities earn low returns on the money market and are, at best, a zero NPV investment for a tax paying firm, due to the corporate tax payable on the interest received from such an investment (Brealey et al., 2008).
This means that the rate of return on cash invested in marketable securities will be less than the business' cost of capital. Sagner (2007) found that as of mid-2006, a typical US public company had a weighted average required rate of return of about 11.5% and a company with cash or near cash investments could only earn about 5% on these assets at prevailing rates, thus incurring a direct loss of about 6.5% on such assets without any possible strategic gain.
Holding large amounts of assets that yield sub-optimal returns should increase the cost of equity as shareholders demand a better return on their investment; this increases the required return and decreases the share price.
Trade credit involves the additional administrative expenses of setting up and running a credit department (Mian and Smith, 1994) and exposes the firm to default risk as some clients may not pay (Salek, 2005).
Dev (2001) contends that a firm’s working capital management practices influence its credit risk, which is a key driver of shareholder value creation. While poor working capital management (reflected by the slow collection of receivables, overstocking inventory and slow payments to suppliers) increases the credit risk of the firm, thereby increasing its cost of capital and compromising shareholder value, efficient working capital management improves the company’s cash flows and creditworthiness and increases shareholder value.
3.5.5 EMPIRICAL STUDIES ON WORKING CAPITAL INVESTMENT AND FIRM VALUE