MOHIT DHAWAN

Roll no – 2314508175

FINANCIAL MANAGEMENT
SEMESTER – III

Assignment Set – 1

1. a) A company expects to receive Rs 120,000 annually for the next 10 years. If

the discount rate is 15%, what is the present value of this annuity?

To calculate the present value of an annuity, we use the Present Value of an Annuity (PVA)
formula:

PVA=P×[1−(1+r)−nr]PVA = P \times \left[ \frac{1 - (1 + r)^{-n}}{r}

\right]PVA=P×[r1−(1+r)−n]

Where:

• PPP = Annual payment (₹120,000)

• rrr = Discount rate (15% or 0.15)
• nnn = Number of years (10 years)

Steps to Calculate the Present Value:

1. Substitute the given values into the formula:

PVA=120,000×[1−(1+0.15)−100.15]PVA = 120,000 \times \left[ \frac{1 - (1 + 0.15)^{-

10}}{0.15} \right]PVA=120,000×[0.151−(1+0.15)−10]

2. Simplify (1+r)(1 + r)(1+r):

1+r=1+0.15=1.151 + r = 1 + 0.15 = 1.151+r=1+0.15=1.15

3. Calculate (1+r)−n(1 + r)^{-n}(1+r)−n:

(1.15)−10=0.247184(1.15)^{-10} = 0.247184(1.15)−10=0.247184

4. Subtract this value from 1:

1−0.247184=0.7528161 - 0.247184 = 0.7528161−0.247184=0.752816

5. Divide by the discount rate rrr:

0.7528160.15=5.018773\frac{0.752816}{0.15} = 5.0187730.150.752816=5.018773
 6. Multiply by the annual payment PPP:

PVA=120,000×5.018773=602,252.24PVA = 120,000 \times 5.018773 =

602,252.24PVA=120,000×5.018773=602,252.24

Final Answer:

The present value of the annuity is ₹602,252.24.

This means that receiving ₹120,000 annually for 10 years is equivalent to receiving a lump sum
of ₹602,252.24 today, assuming a discount rate of 15%.

b) Describe different sources of long-term financing available to a company.

Sources of Long-Term Financing for a Company

Long-term financing refers to funding raised by a company for a period exceeding one year,
typically used to finance capital-intensive projects such as purchasing equipment, expanding
operations, or constructing infrastructure. Companies rely on various long-term financing
sources depending on their needs, cost considerations, and risk tolerance.

1. Equity Financing

This involves raising funds by issuing shares of ownership in the company.

a) Common Shares

• Description: Represents ownership in the company. Shareholders have voting rights and a claim
to profits through dividends.
• Advantages: No obligation to repay or pay interest.
• Disadvantages: Dilution of ownership and control.
• Example: A startup issues common shares to raise funds for expansion.

b) Preferred Shares

• Description: Preferred shareholders receive fixed dividends before common shareholders and
have priority in case of liquidation.
• Advantages: Fixed dividend payout; no voting rights for shareholders.
• Disadvantages: More expensive than debt due to fixed dividend payments.
• Example: A company issues preferred shares to institutional investors.

2. Debt Financing

Debt financing involves borrowing funds that must be repaid with interest over time.
a) Term Loans

• Description: Loans from banks or financial institutions with a fixed repayment schedule and
interest.
• Advantages: Predictable repayment terms; tax-deductible interest.
• Disadvantages: Requires collateral; regular repayments are mandatory.
• Example: A manufacturing firm secures a term loan to purchase machinery.

b) Bonds or Debentures

• Description: Companies issue bonds or debentures to investors, promising periodic interest

payments (coupon) and principal repayment at maturity.
• Advantages: Bonds can attract a wide range of investors; interest is tax-deductible.
• Disadvantages: Fixed interest payments, regardless of profits.
• Example: A government organization issues infrastructure bonds for building highways.

c) Lease Financing

• Description: A company uses assets without purchasing them outright by entering into a lease
agreement.
• Advantages: Preserves cash flow; no large initial investment needed.
• Disadvantages: Can be expensive over the long term.
• Example: An airline leases aircraft instead of purchasing them.

3. Retained Earnings

• Description: Internal financing generated from the company’s profits, reinvested into the
business instead of paying dividends.
• Advantages: No interest or repayment obligations; retains control.
• Disadvantages: Limited to the company’s profitability; opportunity cost of not distributing
dividends.
• Example: A tech company reinvests retained earnings to develop new software.

4. Venture Capital and Private Equity

• Description: Funding provided by venture capitalists or private equity firms in exchange for
equity and a stake in the company.
• Advantages: Large amounts of capital; often accompanied by managerial expertise.
• Disadvantages: Loss of control; high expectations for returns.
• Example: A startup raises funds from a venture capital firm for product development.

5. Long-Term Bank Loans

• Description: Banks provide loans for long-term needs like capital expenditures or expansion.
• Advantages: Structured repayment terms; tax-deductible interest.
• Disadvantages: Collateral may be required; stringent credit checks.
• Example: A retail company obtains a 10-year loan to build new stores.
6. Foreign Direct Investment (FDI)

• Description: Funds received from foreign companies or individuals to set up or expand

operations in a country.
• Advantages: Brings in capital, technology, and expertise.
• Disadvantages: Regulatory requirements; potential foreign control.
• Example: A foreign car manufacturer invests in a plant in India.

7. Project Financing

• Description: Financing obtained specifically for large-scale infrastructure or industrial projects,

backed by the cash flows generated by the project.
• Advantages: Limited risk for sponsors; attracts external investors.
• Disadvantages: Complex and time-consuming arrangements.
• Example: A power company secures project financing for constructing a new power plant.

8. Government Grants and Subsidies

• Description: Financial assistance provided by the government for specific purposes, often to
promote economic growth or development.
• Advantages: No repayment obligation; fosters growth in strategic sectors.
• Disadvantages: Stringent eligibility criteria; limited availability.
• Example: A renewable energy company receives a government subsidy to set up a solar power
plant.

9. Convertible Securities

• Description: Hybrid instruments like convertible bonds or debentures, which can be converted
into equity shares at a later date.
• Advantages: Lower initial interest rates; flexibility for investors.
• Disadvantages: Potential dilution of equity upon conversion.
• Example: A startup issues convertible debentures to early investors.

10. International Financing

• Description: Companies raise funds from international markets through sources like Eurobonds,
foreign currency loans, or external commercial borrowings.
• Advantages: Access to a larger pool of capital; lower interest rates in some markets.
• Disadvantages: Exchange rate risk; regulatory complexities.
• Example: An Indian company issues Eurobonds to raise capital in international markets.

Conclusion

Companies have access to a variety of long-term financing sources depending on their financial
needs, growth objectives, and market conditions. While equity financing avoids repayment
obligations, debt financing offers tax advantages. A balanced approach, combining multiple
sources, helps businesses optimize their capital structure and achieve sustainable growth.

2. a) ABC Corporation forecasts an annual EBIT of $300,000. With $800,000 in 8%

bonds and a 10% cost of equity capital, along with a corporate tax rate of 25%,
determine the firm's value.

To calculate the firm's value, we can use the Net Operating Income (NOI) Approach of
valuation, which follows these steps:

1. Formula for Firm Value

Value of the Firm=Value of Equity+Value of Debt\text{Value of the Firm} = \text{Value of Equity} +

\text{Value of Debt}Value of the Firm=Value of Equity+Value of Debt

a) Value of Debt

The value of debt is typically equal to the face value of the bonds, as long as the bonds are not
trading at a premium or discount.

Value of Debt=800,000 (given)\text{Value of Debt} = 800,000 \,

\text{(given)}Value of Debt=800,000(given)

b) Value of Equity

The value of equity is calculated as:

Value of Equity=Net IncomeCost of Equity\text{Value of Equity} = \frac{\text{Net Income}}{\text{Cost of

Equity}}Value of Equity=Cost of EquityNet Income

Where:

• Net Income is determined as: Net Income=(EBIT−Interest)×(1−Tax Rate)\text{Net Income} =

(\text{EBIT} - \text{Interest}) \times (1 - \text{Tax
Rate})Net Income=(EBIT−Interest)×(1−Tax Rate)

2. Calculate Step-by-Step

a) Interest on Debt
Interest=Debt×Bond Interest Rate\text{Interest} = \text{Debt} \times \text{Bond Interest
Rate}Interest=Debt×Bond Interest Rate Interest=800,000×0.08=64,000\text{Interest} = 800,000 \times
0.08 = 64,000Interest=800,000×0.08=64,000

b) EBIT (Earnings Before Interest and Taxes)

EBIT=300,000 (given)\text{EBIT} = 300,000 \, \text{(given)}EBIT=300,000(given)
c) Net Income
Net Income=(EBIT−Interest)×(1−Tax Rate)\text{Net Income} = (\text{EBIT} - \text{Interest}) \times (1 -
\text{Tax Rate})Net Income=(EBIT−Interest)×(1−Tax Rate)
Net Income=(300,000−64,000)×(1−0.25)\text{Net Income} = (300,000 - 64,000) \times (1 -
0.25)Net Income=(300,000−64,000)×(1−0.25) Net Income=236,000×0.75=177,000\text{Net Income} =
236,000 \times 0.75 = 177,000Net Income=236,000×0.75=177,000

d) Value of Equity
Value of Equity=Net IncomeCost of Equity\text{Value of Equity} = \frac{\text{Net Income}}{\text{Cost of
Equity}}Value of Equity=Cost of EquityNet Income Value of Equity=177,0000.10=1,770,000\text{Value of
Equity} = \frac{177,000}{0.10} = 1,770,000Value of Equity=0.10177,000=1,770,000

3. Firm Value

Value of Firm=Value of Equity+Value of Debt\text{Value of Firm} = \text{Value of Equity} + \text{Value of

Debt}Value of Firm=Value of Equity+Value of Debt
Value of Firm=1,770,000+800,000=2,570,000\text{Value of Firm} = 1,770,000 + 800,000 =
2,570,000Value of Firm=1,770,000+800,000=2,570,000

Final Answer:

The value of ABC Corporation is $2,570,000.

b) Discuss the advantage of the wealth maximization objective of financial

management over profit maximization.

Advantages of Wealth Maximization over Profit Maximization in Financial

Management

In financial management, the ultimate goal is to maximize the value of the firm, which is often
better achieved through the wealth maximization objective rather than the traditional profit
maximization objective. While both objectives aim to enhance the financial performance of the
company, wealth maximization has several advantages that make it a more comprehensive and
long-term goal for financial managers.

1. Focus on Shareholder Value

• Wealth Maximization: The primary aim of wealth maximization is to maximize the

value of the firm for its shareholders by increasing the market price of the company's
shares. It takes into account not only the current profitability but also the future potential
of the company, which is reflected in the stock price.
 • Profit Maximization: Profit maximization focuses on short-term profits, without
considering how those profits will influence shareholder wealth or the long-term
sustainability of the business.

Advantage: Wealth maximization aligns better with the interests of shareholders, who are
concerned about the long-term growth and value of their investments, rather than just short-term
profits.

2. Consideration of Time Value of Money

• Wealth Maximization: Wealth maximization considers the time value of money,

meaning that future cash flows are discounted at an appropriate rate to reflect their
present value. This ensures that decisions are based on the overall value generated over
time.
• Profit Maximization: Profit maximization does not consider the time value of money. It
merely focuses on achieving higher profits in the present period, without recognizing that
profits today are worth more than profits in the future.

Advantage: Wealth maximization provides a more realistic and accurate valuation of

investments, accounting for the time value of money and long-term returns.

3. Risk Consideration

• Wealth Maximization: This approach considers the risk-return trade-off,

acknowledging that higher returns may involve higher risks. Financial managers are
expected to make decisions that maximize the firm’s value while managing risks in the
long run.
• Profit Maximization: Profit maximization does not take risk into account. It may
encourage risky behavior in the pursuit of high profits in the short term, which could
jeopardize the firm’s long-term sustainability.

Advantage: Wealth maximization promotes a balanced approach, considering both returns and
risks to ensure sustainable growth and stability for the company.

4. Long-Term Focus vs. Short-Term Focus

• Wealth Maximization: This objective takes a long-term view of a company’s

performance. It focuses on sustained growth and the creation of wealth over time, rather
than the short-term fluctuations of profits.
• Profit Maximization: Profit maximization often leads to a short-term focus. Managers
may prioritize immediate profits, sometimes at the expense of long-term strategies, such
as reinvestment, research and development, and expansion.

Advantage: Wealth maximization helps build a solid foundation for the future of the firm,
ensuring growth and value creation in the long term. This approach reduces the temptation to
sacrifice long-term goals for short-term gains.
5. Comprehensive Evaluation of Firm's Performance

• Wealth Maximization: This objective incorporates a more holistic evaluation of the

company’s financial health, considering factors like cash flow, risk, and profitability. It
involves analyzing how various decisions impact the firm’s long-term market value and
shareholder wealth.
• Profit Maximization: Profit maximization focuses purely on accounting profits, often
ignoring other important factors such as cash flow, capital structure, and overall business
risks.

Advantage: Wealth maximization provides a more accurate and comprehensive picture of a

company's financial performance, as it considers the effects of various internal and external
factors over time.

6. Incorporation of Capital Costs

• Wealth Maximization: The wealth maximization objective takes into account the firm’s
cost of capital, ensuring that projects undertaken by the firm are expected to generate
returns that exceed the cost of the capital invested.
• Profit Maximization: Profit maximization does not incorporate the cost of capital. It
may lead to decisions that look profitable on paper but fail to generate adequate returns
relative to the capital invested.

Advantage: Wealth maximization ensures that investments contribute positively to the firm's
value and generate returns that justify the capital employed.

7. Impact on Corporate Social Responsibility (CSR)

• Wealth Maximization: The wealth maximization objective encourages firms to consider

social, environmental, and ethical factors, as the long-term value of a firm is influenced
by its reputation and corporate governance practices. Companies that focus on CSR can
build stronger relationships with stakeholders, which enhances the firm's value.
• Profit Maximization: Profit maximization may lead firms to ignore social responsibility
concerns in the pursuit of higher short-term profits, potentially leading to damage to
reputation and long-term sustainability.

Advantage: Wealth maximization encourages responsible business practices, which ultimately

lead to more sustainable growth and shareholder value.

Conclusion

While profit maximization has traditionally been a focus in financial management, the wealth
maximization objective is superior because it:

• Aligns with shareholders' long-term interests.

• Takes the time value of money and risk into account.
 • Encourages decisions that promote sustainable growth and stability.

Wealth maximization ensures that the company’s value is optimized for both shareholders and
stakeholders in the long run, making it a more comprehensive and strategic financial
management approach.

3. PQR Ltd is evaluating a $250,000 investment project that is anticipated to produce

$60,000 annually for the next four years. With a discount rate of 18%, compute the NPV
and provide a recommendation on the project’s financial viability

To calculate the Net Present Value (NPV) of the investment project, we will use the following
formula:

NPV=∑Ct(1+r)t−C0NPV = \sum \frac{C_t}{(1 + r)^t} - C_0NPV=∑(1+r)tCt−C0

Where:

• CtC_tCt = Cash inflows in year ttt

• rrr = Discount rate (18% or 0.18)
• ttt = Time period (1 to 4 years)
• C0C_0C0 = Initial investment ($250,000)

Step-by-Step Calculation:

1. Cash Flows

The annual cash inflow is $60,000 for the next 4 years.

2. Formula for NPV

NPV=60,000(1+0.18)1+60,000(1+0.18)2+60,000(1+0.18)3+60,000(1+0.18)4−250,000NPV =
\frac{60,000}{(1 + 0.18)^1} + \frac{60,000}{(1 + 0.18)^2} + \frac{60,000}{(1 + 0.18)^3} + \frac{60,000}{(1 +
0.18)^4} - 250,000NPV=(1+0.18)160,000+(1+0.18)260,000+(1+0.18)360,000+(1+0.18)460,000−250,000

3. Discount Factor for Each Year:

• Year 1: (1+0.18)1=1.18(1 + 0.18)^1 = 1.18(1+0.18)1=1.18

• Year 2: (1+0.18)2=1.3924(1 + 0.18)^2 = 1.3924(1+0.18)2=1.3924
• Year 3: (1+0.18)3=1.6424(1 + 0.18)^3 = 1.6424(1+0.18)3=1.6424
• Year 4: (1+0.18)4=1.9370(1 + 0.18)^4 = 1.9370(1+0.18)4=1.9370

4. Discounted Cash Inflows:

• Year 1: 60,0001.18=50,847.46\frac{60,000}{1.18} = 50,847.461.1860,000=50,847.46

• Year 2: 60,0001.3924=43,105.48\frac{60,000}{1.3924} = 43,105.481.392460,000=43,105.48
• Year 3: 60,0001.6424=36,532.35\frac{60,000}{1.6424} = 36,532.351.642460,000=36,532.35
• Year 4: 60,0001.9370=30,963.67\frac{60,000}{1.9370} = 30,963.671.937060,000=30,963.67
5. Total Present Value of Cash Inflows:
NPV=50,847.46+43,105.48+36,532.35+30,963.67−250,000NPV = 50,847.46 + 43,105.48 + 36,532.35 +
30,963.67 - 250,000NPV=50,847.46+43,105.48+36,532.35+30,963.67−250,000

6. NPV Calculation:
NPV=161,448.96−250,000=−88,551.04NPV = 161,448.96 - 250,000 = -
88,551.04NPV=161,448.96−250,000=−88,551.04

Recommendation:

The NPV of the investment project is $-88,551.04, which is negative.

Since the NPV is negative, this suggests that the project would not add value to the company.
Based on financial principles, PQR Ltd should not proceed with this project as it would result
in a net loss when accounting for the time value of money.

Assignment Set – 2

4. Calculate the cost of equity for X Ltd, which issued Rs 100 equity shares at a 10%
premium. The expected dividend at year-end is 15%, growing annually at 8%. Also, find
the cost of equity if dividends do not grow.

To calculate the cost of equity for X Ltd, we will use two methods based on the given scenarios:

1. If dividends grow annually (using the Dividend Discount Model with Growth)
2. If dividends do not grow (using the Dividend Discount Model without Growth)

Given Data:

• Dividend (D₁) = 15% of Rs 100 = Rs 15 per share

• Growth rate (g) = 8%
• Premium on issue = 10%, so the price of equity share = Rs 100 + 10% = Rs 110
• Cost of Equity (Ke): This is the rate of return required by the equity shareholders.

1. Cost of Equity when Dividends Grow (Using the Gordon Growth Model)

The Gordon Growth Model (Dividend Discount Model with Growth) is given by:

Ke=D1P0+gKe = \frac{D_1}{P_0} + gKe=P0D1+g

Where:

• D1D_1D1 = Expected dividend at the end of the first year = Rs 15

• P0P_0P0 = Price of the share = Rs 110
• ggg = Growth rate of dividends = 8%
Now, let's substitute the values into the formula:

Ke=15110+0.08Ke = \frac{15}{110} + 0.08Ke=11015+0.08

Ke=0.1364+0.08=0.2164=21.64%Ke = 0.1364 + 0.08 = 0.2164 =
21.64\%Ke=0.1364+0.08=0.2164=21.64%

2. Cost of Equity when Dividends Do Not Grow

If dividends do not grow, the formula used is:

Ke=D1P0Ke = \frac{D_1}{P_0}Ke=P0D1

Where:

• D1D_1D1 = Expected dividend = Rs 15

• P0P_0P0 = Price of the share = Rs 110

Substituting the values:

Ke=15110=0.1364=13.64%Ke = \frac{15}{110} = 0.1364 = 13.64\%Ke=11015

=0.1364=13.64%

Summary:

• Cost of equity (if dividends grow): 21.64%

• Cost of equity (if dividends do not grow): 13.64%

In conclusion, if dividends grow at a rate of 8% annually, the cost of equity is 21.64%. However,
if dividends remain constant (do not grow), the cost of equity reduces to 13.64%.

5. For X Company, which earns Rs 5 per share, capitalized at 10%, and has an 18% return on
investment:
a) Calculate the share price at a 25% dividend payout ratio using Walter’s model.
b) Determine if this is the optimal payout ratio per Walter’s theory.

Walter's Model of Dividend Policy

Walter's model provides a framework for determining the price of a share based on its earnings,
dividend payout ratio, and return on investment (ROI). The formula for the share price using
Walter’s model is:

P=D+E(1−b)rrP = \frac{D + \frac{E(1 - b)}{r}}{r}P=rD+rE(1−b)

Where:

• PPP = Price of the share

 • DDD = Dividend per share (calculated as E×bE \times bE×b, where bbb is the dividend
payout ratio)
• EEE = Earnings per share (Rs 5 per share)
• bbb = Dividend payout ratio (25%)
• rrr = Rate of return on investment (18%)
• kkk = Cost of equity or required rate of return (10%)

a) Calculate the Share Price at a 25% Dividend Payout Ratio

Step 1: Calculate Dividend per Share (D)

The dividend per share is calculated by multiplying the earnings per share (EEE) by the dividend
payout ratio (bbb):

D=E×b=5×0.25=1.25 (Rs per share)D = E \times b = 5 \times 0.25 = 1.25 \, \text{(Rs per
share)}D=E×b=5×0.25=1.25(Rs per share)

Step 2: Apply Walter's Model Formula

Now, substitute the values into the formula:

P=1.25+5(1−0.25)0.100.10P = \frac{1.25 + \frac{5(1 -

0.25)}{0.10}}{0.10}P=0.101.25+0.105(1−0.25)

Step 3: Simplify the Calculation

P=1.25+5×0.750.100.10P = \frac{1.25 + \frac{5 \times

0.75}{0.10}}{0.10}P=0.101.25+0.105×0.75 P=1.25+3.750.100.10P = \frac{1.25 +
\frac{3.75}{0.10}}{0.10}P=0.101.25+0.103.75 P=1.25+37.500.10P = \frac{1.25 +
37.50}{0.10}P=0.101.25+37.50 P=38.750.10=387.50P = \frac{38.75}{0.10} =
387.50P=0.1038.75=387.50

Share Price (P) at 25% Dividend Payout Ratio = Rs 387.50

b) Determine the Optimal Payout Ratio Per Walter’s Theory

Walter’s model suggests that the optimal payout ratio depends on the relationship between the
return on investment (ROI, rrr) and the cost of equity (kkk).

• If the ROI (rrr) is greater than the cost of equity (kkk), then the optimal payout ratio is
0% (i.e., the company should retain all earnings and reinvest them).
• If the ROI (rrr) is less than the cost of equity (kkk), then the optimal payout ratio is
100% (i.e., the company should distribute all earnings as dividends).
• If ROI equals cost of equity, the payout ratio does not affect the value of the firm, and
any payout ratio will be optimal.
In this case:

• r=18%r = 18\%r=18%
• k=10%k = 10\%k=10%

Since ROI (r=18%r = 18\%r=18%) is greater than cost of equity (k=10%k = 10\%k=10%),
according to Walter’s theory, the optimal payout ratio is 0%. This means the company should
retain all of its earnings and reinvest them for growth, as reinvestment will generate a higher
return than distributing the earnings as dividends.

Conclusion:

• Share Price at 25% Dividend Payout Ratio = Rs 387.50

• Optimal Payout Ratio (according to Walter’s theory) = 0%, meaning the company
should retain all its earnings for reinvestment.

6. Differentiate between:

(a) Gross Working Capital and Net Working Capital.

(b) Permanent Working Capital and Temporary Working Capital.

(a) Gross Working Capital vs. Net Working Capital

Gross Working Capital and Net Working Capital are both terms used to describe the capital
available to finance a company’s day-to-day operations, but they differ in their focus.

1. Gross Working Capital (GWC):

o Definition: Gross Working Capital refers to the total amount of a company’s
short-term assets or current assets. This includes all assets that are expected to be
converted into cash within a year, such as cash, accounts receivable, inventory,
and marketable securities.
o Formula: Gross Working Capital=Total Current Assets\text{Gross Working
Capital} = \text{Total Current
Assets}Gross Working Capital=Total Current Assets
o Focus: It represents the total short-term resources available to a business.
o Purpose: It helps in understanding the liquidity and ability of a company to
finance its day-to-day operations.
2. Net Working Capital (NWC):
o Definition: Net Working Capital is the difference between a company’s current
assets and its current liabilities. It measures a company’s short-term financial
health and its ability to pay off its short-term liabilities with its short-term assets.
o Formula: Net Working Capital=Current Assets−Current Liabilities\text{Net
Working Capital} = \text{Current Assets} - \text{Current
Liabilities}Net Working Capital=Current Assets−Current Liabilities
o Focus: It focuses on the actual liquidity position and the ability of a company to
meet its short-term obligations.
 o Purpose: NWC is a critical indicator of a company’s operational efficiency and
financial stability.

Key Difference:

• Gross Working Capital looks at the total value of current assets, while Net Working
Capital subtracts current liabilities from current assets, indicating the company's ability to
cover its short-term debts.

(b) Permanent Working Capital vs. Temporary Working Capital

Permanent Working Capital and Temporary Working Capital are terms that reflect the
different types of working capital requirements a company might have.

1. Permanent Working Capital:

o Definition: Permanent Working Capital refers to the minimum amount of
working capital that a business needs to maintain its day-to-day operations in the
long term. It represents a constant level of working capital required by the
business and does not fluctuate significantly over time.
o Characteristics:
▪ It is the core, essential working capital required for the business to operate.
▪ It is a long-term necessity for sustaining regular operations, such as
keeping a minimum level of inventory or maintaining accounts receivable.
▪ This capital stays relatively fixed, and any excess working capital over the
permanent working capital is considered temporary.
o Example: The basic level of inventory, accounts receivable, and cash needed to
keep the business running at all times.
2. Temporary Working Capital:
o Definition: Temporary Working Capital refers to the additional working capital
required to meet seasonal or cyclical fluctuations in a company’s business
operations. This capital is needed during peak times but is not required during off-
peak periods.
o Characteristics:
▪ It varies depending on business conditions like seasonal demand or
cyclical growth.
▪ It is used for short-term purposes, such as additional inventory needed
during a holiday season or an increase in accounts receivable due to high
sales during certain periods.
▪ Temporary working capital is borrowed or raised to meet the temporary
surge in working capital needs.
o Example: Extra working capital required during the holiday season or for special
sales promotions.

Key Difference:
 • Permanent Working Capital remains stable over time and is essential for regular
business operations, while Temporary Working Capital fluctuates based on seasonal or
cyclical changes in the business environment. Temporary working capital is typically
borrowed or raised temporarily to meet short-term needs.

Summary:

1. Gross Working Capital is the total value of a company’s current assets, while Net
Working Capital is the difference between current assets and current liabilities,
indicating liquidity.
2. Permanent Working Capital is the minimum working capital required for daily
operations on a long-term basis, while Temporary Working Capital is the additional
capital needed to meet short-term, fluctuating business demands.