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Scott Equipment Organization

Introduction

Liquidity and profitability are the important aspects in the financial management of any organization. Liquidity refers to the ability of a firm to generate positive cash flows to meet its short-term obligations (Prentice Hall, 2001). A firm may decide to fund its operations either through own sources of funds or through borrowed funds. Again, the borrowing may be for short term or long term depending on the cost and requirements of funds for the operations. Nevertheless, both equity and borrowed funds entail some cost to the firm. Similarly, there are certain risks associated with different levels of working capital maintenance. In the given scenario, the objective is to find out the aggressive, moderate and conservative debt-financing scenario for Scott Equipment Organization. Given details are:

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Assets $ million Liabilities $ million
Current Assets 30 Equity Financing 40
Fixed Assets 35 Debt Financing 25
Total Assets 65 Total Liabilities 65

Calculation of Expected Return on Equity, Net Working Capital and Current Ratio

Particulars Aggressive Moderate Conservative
Short term Debt 24 18 12
Long term Debt 1 7 13
Interest Rate Short term 5.5% 5.0% 4.50%
Interest Rate Long term 8.5% 8.0% 7.50%
Sales 60 60 60
EBIT 6 6 6
Interest 1 1.405 1.46 1.515
EBT 4.595 4.54 4.485
Tax (40%) 1.838 1.816 1.794
Net Income 2.757 2.724 2.691
Return on Equity 2 6.89% 6.81% 6.73%
Net Working Capital 3 6 12 18
Current ratio 4 1.25 1.67 2.5
Profitability High Medium Low
Risk High Medium Low
  • Note 1: Interest is calculated as: Short-term debt X Short term rate + Long term debt X Long term rate
  • Note 2: Return on Equity is calculated as Net Income/Equity
  • Note 3: Short-term debt = Current assets – Net Working Capital (which is Current assets – current liabilities)
    • Aggressive $ 30 – $ 6 = $ 24
    • Moderate $ 30 – $ 12 = $ 18
    • Conservative $ 30 – $ 18 = $ 12
  • Note 4: Current Ratio = Current assets – current liabilities

Summary

Aggressive scenario is the position at which the profitability is high as the net income is higher, and consequently the return on equity is the highest. In the aggressive scenario, the risk element would also be higher since there is the low current ratio. This implies lower liquidity and the working capital availability would also be less. The other potential danger of this situation is that the firm will be using a high level of short-term borrowing which will expose the firm to reinvestment rate risk, as the refinancing will be done at a higher rate. Reinvestment rate risk is “The risk that future proceeds will have to be reinvested at a lower potential interest rate” (Investopedia). It may also be the case that the firm may not find refinancing sources for meeting the short-term funds requirements.

References

Investopedia. (n.d.). Reinvestment Risk. Web.

PrenticeHall. (2001). Corporate Finance. Web.

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