Short notes: gross and net working capital, indifference point, arbitrage process

Option (d), EOQ, is outside the current syllabus (paper note); notes are written on (a), (b) and (c).

(a) Gross and Net Working Capital

There are two concepts of working capital:

• Gross working capital is the capital invested in total current assets: cash, marketable securities, receivables, inventories and prepaid expenses. It is a going-concern concept, used by management: it shows the total funds that must be provided for current assets and focuses on how they are financed and used efficiently.
• Net working capital is the excess of current assets over current liabilities. It is an accounting concept: it measures liquidity, the margin of safety for short-term creditors, and the portion of current assets financed by long-term funds. It may be positive or negative.

Both are needed: gross working capital for managing the level of current assets, net working capital for judging liquidity and the financing mix. For example, with current assets of ₹5,00,000 and current liabilities of ₹3,00,000, gross working capital is ₹5,00,000 and net working capital ₹2,00,000.

(b) The Indifference Point

The indifference level of EBIT is the EBIT at which two financial plans give the same EPS. Below it the plan with less debt (more equity) gives the higher EPS; above it the plan with more debt does, because the fixed interest is spread over fewer shares.

It is found by equating the EPS of the plans: (X − I₁)(1 − t) ÷ N₁ = (X − I₂)(1 − t) ÷ N₂, where X is the indifference EBIT, I the interest and N the number of shares under each plan (preference dividends are deducted after tax when present). Example: plan A issues 20,000 shares; plan B issues 10,000 shares and borrows ₹10 lakh at 10%. Then X ÷ 20,000 = (X − 1,00,000) ÷ 10,000, so X = ₹2,00,000. If the expected EBIT exceeds ₹2,00,000, plan B (debt) is better. The analysis helps choose the capital structure, together with the financial break-even point.

(c) The Arbitrage Process

Arbitrage is buying a security in one market and selling it at a higher price in another, so that prices reach equilibrium. Modigliani and Miller use it to show that two firms identical except in capital structure must have the same value:

1. Investors in the overvalued firm (usually the levered one) sell their shares;
2. they borrow personally in proportion to that firm's debt (personal leverage replaces corporate leverage);
3. they buy the shares of the undervalued firm, earning the same return with a lower outlay and the same risk.

The selling lowers the overvalued firm's price and the buying raises the other's, until the values are equal; there is then neither advantage nor disadvantage in using debt. The process rests on perfect markets, no taxes and investors who can borrow on the same terms as firms.