Question 5 (a)
Approaches to financing working capital
6 marks
- Time to write
- About 12 minutes
- Topic
- Working capital
Question
Question 5 (a) · 6 marksExplain the different approaches for financing working capital requirement.
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
- ExplainEach point stated, then explained in a line or two.
Write it in this order
- Read; underline the asks; jot your points 1 min
- 1 Hedging approach 2 marks 3 min
- 2 Conservative approach 1 mark 2 min
- 3 Aggressive approach 1 mark 2 min
- 4 Trade-off approach 2 marks 3 min
- Check: every ask answered, key terms underlined 1 min
Short on time? Trim steps 1 and 4 evenly rather than skip one: each is capped at its own marks.
Try it first. About 12 minutes for 6 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.
A firm's working capital need has a permanent part, always present, and a temporary part that rises and falls with the season. The approaches differ in how far each part is financed from long-term and short-term sources.
1. Hedging (matching) approach. The maturity of the source matches the life of the asset: permanent working capital is financed from long-term sources, temporary working capital from short-term sources. Cost is low and profit higher, but the firm must arrange funds often and is exposed to shocks, so risk is higher.
2. Conservative approach. All estimated current asset needs, permanent and temporary, are financed from long-term sources; short-term funds are used only in emergencies. Liquidity is high and risk low, but cost is higher because interest is paid on seasonal needs for the whole period.
3. Aggressive approach. All current asset needs, and even part of the fixed assets, are financed from short-term sources. It is the least costly and most profitable, but also the most risky.
4. Trade-off (balancing) approach. Since hedging is low-cost and high-risk and the conservative approach high-cost and low-risk, a trade-off between them is acceptable: for example, the average of the maximum and minimum requirements is financed from long-term funds and anything above it from short-term funds.
Where the 6 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Hedging approach | 2 |
| 2 | Conservative approach | 1 |
| 3 | Aggressive approach | 1 |
| 4 | Trade-off approach | 2 |
| Total | 6 |
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