Question

How to estimate a firm’s optimal capital structure?

Discuss the long-term consequence of the budget deficit policy by federal government.

What does CCC mean? How to calculate CCC?

Answer 1

1.

The optimal capital structure is estimated by calculating the mix of debt and equity that minimizes the weighted average cost of capital (WACC) of a company while maximizing its market value. The lower the cost of capital, the greater the present value of the firm’s future cash flows, discounted by the WACC. Thus, the chief goal of any corporate finance department should be to find the optimal capital structure that will result in the lowest WACC and the maximum value of the company (shareholder wealth).

The optimal capital structure of a firm is the best mix of debt and equity financing that maximizes a company’s market value while minimizing its cost of capital. In theory, debt financing offers the lowest cost of capital due to its tax deductibility. However, too much debt increases the financial risk to shareholders and the return on equity that they require. Thus, companies have to find the optimal point at which the marginal benefit of debt equals the marginal cost.

2.

A budget deficit is the annual shortfall between government spending and tax revenue. The deficit is the annual amount the government need to borrow. The deficit is primarily funded by selling government bonds (gilts) to the private sector.

Increase in public sector debt

The government will have to borrow from the private sector. In the UK, the Debt Management Office (DMO) sells bonds and gilts to the private sector. The public sector debt is the total amount of debt owed by the government.

Higher debt interest payments

When the government borrows, it offers to pay an interest payment to those who buy the bonds. The interest rate attracts investors to lend the government money.

Increased aggregate demand (AD)

A budget deficit implies lower taxes and increased Government spending (G), this will increase AD and this may cause higher real GDP and inflation. For example, in 2009, the UK lowered VAT in an effort to boost consumer spending, hit by the great recession.

Fund public sector investment

A government may run a budget deficit to finance infrastructure investment. This could include building new roads, railways, more housing and improved telecommunications. This public sector investment can help increase long-run productive capacity and enable a higher rate of economic growth. If growth does improve, then the borrowing can pay for itself. For example, many public sector investment projects can have a rate of return higher than the cost of borrowing

Future – higher taxes and lower spending

In the future, the government may have to increase taxes or cut spending in order to reduce the deficit. After 2010, the coalition government implemented a period of austerity. This involved cutting public sector spending; in particular, areas such as local government, public sector pay saw cuts in government spending – affecting public services and public pay.

3.

The Cash Conversion Cycle (CCC) is a metric that shows the amount of time it takes a company to convert its investments in inventory to cash. The conversion cycle formula measures the amount of time, in days, it takes for a company to turn its resource inputs into cash

Cash Conversion Cycle Formula

The cash conversion cycle formula is as follows:

Cash Conversion Cycle = DIO + DSO – DPO

Where:

• DIO stands for Days Inventory Outstanding
• DSO stands for Days Sales Outstanding
• DPO stands for Days Payable Outstanding

What is Days Inventory Outstanding (DIO)?

Days Inventory Outstanding (DIO) is the number of days, on average, it takes a company to turn its inventory into sales. Essentially, DIO is the average number of days that a company holds its inventory before selling it. The formula for days inventory outstanding is as follows:

Days Sales Outstanding (DSO)

Days Sales Outstanding (DSO) is the number of days, on average, it takes a company to collect its receivables. Therefore, DSO measures the average number of days for a company to collect payment after a sale. The formula for days sales outstanding is as follows:

What is Days Payable Outstanding (DPO)?

Days Payable Outstanding (DPO) is the number of days, on average, it takes a company to pay back its payables. Therefore, DPO measures the average number of days for a company to pay its invoices from trade creditors, i.e., suppliers. The formula for days payable outstanding is as follows: