Question

3. Long term capital structure of company KL is given below:

Sources of capital Book value ($ 000)

Debts 20,000

Preferred stock 5,000

Common stock 7,500

Reserves (re) 17,500

Total capital 50,000

The interest rate for debt is overall 10%, dividend for common stock is $1.3 and $1.5 for preferred stock per share, respectively. Preferred -and stock price is $10 per share, growth rate is 0.06. Suppose that the average income tax ratio is 25 % and the corporate tax ratio is 20 %, calculate and interpret the WACC of the Company.

4.a. What does it mean, if company’s operating cash flow is negative for a particular period and how does it impact the investment and financing activities of a company? Explain briefly.

4.b. Explain briefly, how could a company’s change in NWC be negative in a given year. What about net capital spending?

4.c. Is it possible for a company to pay dividends when it has a negative net income for the year? Could this happen in the long run? Explain briefly.

Answer 1

4.a. If company's operating cash flow is negative for a particular period means the company will not be able to pay its bills and the company is losing money, for that, company needs to borrow money which is a financing activity or they could raise the investments. As a result, It will increase the debt of the company as the company need to borrow money and raise the additonal capital.

4.b. YES, a company's change in NWC can be negative in a giver year. As:

Chnage in NWC = Ending NWC - Opening NWC. Let's suppose, Ending NWC = $200 and opening NWC = $600, Then, Chnage in NWC = - $400. On the balance sheet this will reflect as decrease in inventory. Net capital spending means the long term assets were liquidated by the company instead of purchasing the assets.

4.c. For a particular year, this can happen but in long term it might impact the company's financial image in the market. So, the company would maintain a positive income to pay dividends to the shareholders.