Question 3 (a)
Approaches to financing working capital
4 marks
- Time to write
- About 8 minutes
From an older CBCS paper
Question
Question 3 (a) · 4 marksDiscuss the different approaches to the financing of working capital. 4
Reworded from the university paper; the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- DiscussEach point named and explained, not just listed.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Hedging approach 1 mark 2 min
- 2 Conservative approach 1 mark 2 min
- 3 Aggressive approach 1 mark 2 min
- 4 Trade-off 1 mark 1 min
Try it first. About 8 minutes for 4 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Working capital has a permanent part (the minimum level of current assets always needed) and a temporary part (the seasonal and fluctuating need). The approaches differ in how much of each is financed long-term and short-term.
1. Hedging (matching) approach. Permanent working capital is financed from long-term sources and temporary working capital from short-term funds, matching the life of the source to the life of the need. It keeps the cost of financing low, but the firm must arrange funds frequently and is exposed to sudden shocks.
2. Conservative approach. The entire estimated investment in current assets is financed from long-term sources; short-term sources are used only for emergencies. Liquidity is higher and risk lower, but the cost is higher, because interest is paid even on the seasonal requirement for the whole period.
3. Aggressive approach. The entire current-asset requirement, and even part of the fixed assets, is financed from short-term sources: the finance mix is riskier, less costly and more profitable.
Trade-off. Hedging means low cost, high profit and high risk; the conservative approach means high cost, low profit and low risk. Neither extreme is efficient, so firms choose a trade-off, for example financing the average of the maximum and minimum requirements from long-term funds and the excess from short-term funds.
Where the 4 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Hedging approach | 1 |
| 2 | Conservative approach | 1 |
| 3 | Aggressive approach | 1 |
| 4 | Trade-off | 1 |
| Total | 4 |
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