n r Why P144 Aggressive versus conservative seasonal funding

n r Why? P14-4 Aggressive versus conservative seasonal funding strategy cast its total funds requirements f or the coming year as shown in the following table. Month Amount Month Amount January $2,000,000 February 2.000,000 March April May June July August September October November December $12,000,000 2,000,000 4,000,000 6,000,000 9,000,000 14,000,000 9,000,000 5,000,000 4,000,000 3,000,000 a. Divide the firm\'s monthly funds requirement into(1) a permanent component and (2) a seasonal component, and find the monthly average for each of these components. Describe the amount of long-term and short-term financing used to meet the to- tal funds requirement under (1) an aggressive funding strategy and (2) a conser- vative funding strategy. Assume that, under the aggressive strategy, long-term funds finance permanent needs and short-term funds are used to finance seasonal needs. Assuming that short-term. funds cost 5% annually and that the cost of long-term funds is 10% annually, use the averages found in part a to calculate the total cost of each of the strategies described in part b. Assume that the firm can earn 3% on any excess cash balances. b. c. offs associated with the aggressive strategy d. Discuss the profitability-risk trade- and those associated with the conservative strategy tion purchases 1,200,000 units per year of one compo- Tiger Corngra

Solution

a) Month Total funds required Permanent component Seasonal component Excess cash balance under the conservative policy January 2000000 2000000 0 12000000 February 2000000 2000000 0 12000000 March 2000000 2000000 0 12000000 April 4000000 2000000 2000000 10000000 May 6000000 2000000 4000000 8000000 June 9000000 2000000 7000000 5000000 July 12000000 2000000 10000000 2000000 August 14000000 2000000 12000000 0 September 9000000 2000000 7000000 5000000 October 5000000 2000000 3000000 9000000 November 4000000 2000000 2000000 10000000 December 3000000 2000000 1000000 11000000 Total 72000000 24000000 48000000 96000000 Monthly average 6000000 2000000 4000000 8000000 b) 1) Under the aggressive funding strategy, the average of the permanent portion, that is $2000000, would be financed through long term funds and the seasonal portion would be financed through short term funds as and when required and to the extent required. 2) Under the conservative funding strategy, the firm would finance the maximum amount of $14000000 from long term funds. c) Total cost under the aggressive policy = 2000000*10%+4000000*5% = 400000 Total cost under conservative policy = 14000000*10%-8000000*3% (earnings from deposit of excess cash = 1160000 d) As per the total costs calculated above, the aggressive strategy is more attractive as it has lower net interest cost. This is because, the conservative strategy sources the maximum requirement from long term funds entailing a cost of 10%; the excess funds earning only 3%. As regards risk, the conservative policy has less risk as it has the maximum funds at its disposal at all times. In contrast the aggressive policy is more risky, as it will have to make arrangements for a fluctuating seasonal requirement.