Question

Return on Assets is a good way to measure the opportunity costs of an investment. If a company has a Return on Assets of 12% and a line of Credit at 6%, how should they manage their cash flow? What is the correct answer? Explanation needed

a) they should use the line of credit to finance expansion and use the cash to cover project level cash flow.

b) They should use the line of credit for project cash flow, and use the company's cash to expand business

c). they should never use debt to finance operation

d). they should get out of the construction business because the RoA is horrible.

Answer 1

Here the company has Return of Assets @ 12% whereas the line of credit costs them 6%. In that case the company should use the line of credit for project cash flow and the company's cash flow to expand business. Because the return on assets of the company is higher when compared to line of credit. Expansion of business requires usually requires huge financial injection in which case the cost of line of credit will shoot up in case of arranging more credit. So it is better to finance expansion through company's cash and meet of project level cash flow using financial leverage of 6% line of credit. Also one should note that the project cash flow requires only limited cash flow as it would have been planned years ago subject to minor deviations whereas expansion would require huge initial investment which could be tolerated only by the RoA and the capital structure of the company will not be affected that much. Option b is the right one.