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Wpisy użytkownika michalskig z dnia 4 sierpnia 2008

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michalskig
 
michalskig: Artykul FIRM VALUE AND NET CURRENT ASSETS INVESTMENTS - KONFERENCJA W CONSTANTA RUMUNIA - LISTOPAD 2008
 

michalskig
 
michalskig: DECREASING NEGATIVE DELIVERY RISK INFLUENCE ON THE RECEPIENT'S FIRM VALUE: PORTFOLIO APPROACH

Grzegorz Michalski
Wroclaw University of Economics,
Department of Corporate Finance and Value Management,
ul. Komandorska 118/120, p. Z-1, KFPiZW;
PL53345 Wroclaw, Poland;
Phone: +48503452860;
Fax: +48717181717,
michalskig@ue.wroc.pl;
michalskig.ue.wroc.pl/



Abstract: The basic financial purpose of an enterprise is maximization of its value. Inventory management should also contribute to realization of this fundamental aim. The enterprise value maximization strategy is executed with a focus on risk and uncertainty. This article presents the consequences for the recipients firm that can result from operating risk that is related to delivery risk generated by the suppliers. The present article offers a method that uses portfolio management theory to chose the suppliers.

Keywords: Corporate liquidity, firm value, delivery risk

JEL Classifications: G39, G32, G11, M11, D81

1. Introduction

The basic financial purpose of an enterprise is maximization of its value. Inventory management should also contribute to realization of this fundamental aim. Many of the current asset management models that are found in financial management literature assume book profit maximization as the basic financial purpose. These book profit-based models could be lacking in what relates to another aim (i.e., maximization of enterprise value). The enterprise value maximization strategy is executed with a focus on risk and uncertainty. This article presents the consequences for the recipients firm that can result from operating risk that is related to delivery risk generated by the suppliers. The present article offers a method that uses portfolio management theory to chose the suppliers.
When entrepreneur chooses the tradesman, should concentrate his attention, not only at basic knowledge about the contracting party individual shape parameters (i.e. the tradesman financial situation), but also on information from inventory management models.
The Economic Order Quantity model of inventory management is used to mark the optimum size of delivery and to choose the cheapest deliverer. Both of these choices should guarantee minimization of total costs of investments in inventories.


Fig 1. Economic Order Quantity model.
where: LIL - Low Inventory Level (Precautionary Inventory Level); AIL – Average Inventory Level; HIL – High Inventory Level; Q – Order Quantity (Q = HIL – LIL).  
source: [2, p. 538].

On fig 1. is shown the way the EOQ (and VBEOQ) model works. Q could be calculated as:
,
(1)
where:    EOQ – target (optimal) order quantity (economic order quantity), P – yearly demand for optimized inventories, Kz – creating inventories costs (fixed cost of one order), Ku – operating costs of maintaining inventories (without costs of maintaining safety/precautionary inventories LIL), Ca – percentage rate of operating costs of maintaining inventories (with financial/alternative costs of capital and without costs of maintaining safety/precautionary inventories LIL), v – unit price (cost) of ordered inventories.

The percentage share of retaining the reserves comes from the fact that the costs of retaining the reserves increase proportionally to the level of reserves In the enterprise. Its share is a sum of the following costs: alternative (resulting from the possibility of their potential use somewhere else but without cost of capital financing firm), storage, logistics and internal transport within the factory of the reserves, insurance, decay.

,
(2)
where: TCI – total reserves costs, Q – magnitude of the part of delivery, zb – the level of safety margin.
From the point of view of maximizing the enterprise value a part of delivery can be determined based on the formula for VBEOQ:

(3)
where:    k – alternative cost (equal to the enterprise financing capital), VBEOQ – optimal magnitude of single order from the point of view of maximizing the enterprise value, C – percentage rate of operating costs of maintaining inventories (without financial/alternative costs of capital and without costs of maintaining safety/precautionary inventories LIL).

,
(4)
And:

(5)
where: K#z – tax-deductible creating inventories costs (fixed cost of one order), K*z – non- tax-deductible creating inventories costs (fixed cost of one order), C# – percentage rate of tax-deductible operating costs of maintaining inventories (without financial/alternative costs of capital and without costs of maintaining safety/precautionary inventories LIL), C* – percentage rate of non-tax-deductible operating costs of maintaining inventories (without financial/alternative costs of capital and without costs of maintaining safety/precautionary inventories LIL).    
And:

(6)

The problem, we are going to deal with in this paper is to select a counterpart amongst the suppliers in a situation where the parameters we know carry the risk resulting from deliveries out of schedule.

Example 1. Enterprise X producing special fireproof curtains uses raw material D-18. The annual demand for this raw material is  8000 m3. There are two suppliers (A and B) on the market offering similar delivery terms. The price of the material for both of them is 3000$ for m3, the lead-time is 20 days, the cost of inventory retaining is 38%, the cost of enterprise financing capital  is 30%, effective tax rate is 19%, the costs of ordering is 200$ and the cost of  lack of reserves is 5000 000$. The analysis of recommendation given by the companies showed that both suppliers were not equally reliable. Supplier A was nearly perfect, supplier B often did not deliver on time, he happened to show up 4 days before the agreed date , but equally often used to come 8 days later.
Based on the gathered data it was estimated the standard deviation of the delivery time in case of supplier A was 4 days, and for supplier B 6 days. In order to evaluate who is more reliable it is necessary to determine the safety margin for supplier A and then for supplier B. The next step is to check the impact of suppliers risk on the enterprise value. We assume that the enterprise in order to estimate the optimal order magnitude uses the VBEOQ. model
m3
Differences in reliability of deliveries have a great impact on different levels of safety margins required for suppliers A and B. For this purpose the following formula is used [3, p. 57]:

(7)
where:    s – standard deviation for reserves usage, Kbz – cost of lack of inventory reserves.

In order to use the formula it is necessary to exchange the deviation of delivery time to deviation of raw material use. It is known average daily use is 8000/360 = 22,2 m3. Therefore 4 days deviation for delivery date is equal to deviation of use equal to  88,8 m3. Therefore, for such a situation the safety margin will be equal to :
m3.
In this case the level of  resources tied in the reserves is:
$,
Next case reflects a situation in which the entrepreneur uses the services from company B. So the standard deviation will be 6×(8000/360) = 133,3 m3.
Therefore reserves safety margin will be:
m3.
In this case the level of  resources tied in the reserves is:
$,
Comparing this magnitude to the level of reserves in situation where one would have used supplier A it is obvious that the increase of money resources tied in the reserves will be:
$.
The last stage is to compare what impact the risk generated by the counterparts – suppliers has on the value of the enterprise. Therefore we estimate the level of total costs of reserves:
$,
$,
$.
Obtained results will be used for estimation of fluctuations in the enterprise value:
$.
It is apparent that it is better to select counterpart – supplier A because selection of supplier B may result in destruction of enterprise value.

2. Suppliers` portfolio

Usually the enterprise’s suppliers have materials and stock from the same source. It happens though, that their sources of supply are different and therefore the risk of deliveries related to individual suppliers is different. f such a thing occurs, it may be possible to use elements taken from the portfolio theory for supplier’s evaluation. Sometimes the counterparts , who although may be have virtues who exclude them from being suppliers of services in the beginning (like supplier B in example B), it may be possible that having considered the risk of the buyer it may turn out that on the contrary they decrease or stabilize the risk level [4, p. 48-52].

Portfolio is a set of assets (for example in a non accountant sense : suppliers). The theory of portfolio management is based on the rate of advantages drawn from buying from particular supplier, informing about the relation of advantage generated by such a purchase to the outlay related to such a purchase.
The measure allowing the measurement of risk connected to costs from particular buyer may be defined as this variation:
     (8)
where: pi – probability of occurrence of the given situation estimated from historical data.
In connection to the information about what potential advantages might be brought by giving a loan to a particular buyer, it is possible to estimate the variation coefficient: :
   (9)
The next element is a correlation of benefits from purchase from particular supplier with benefits from this purchase from other suppliers. The correlation coefficient is usually the measure of such a correlation:
   (10)
where:   - correlation coefficient of benefits from purchase from the first and second supplier; R1 – expected rate of benefits from purchasing from first supplier; R2 – o expected rate of benefits from purchasing from the second supplier; s1 – standard deviation for the first supplier s2 – standard deviation for the second supplier; R1i – possible rates of benefits from the purchases from the first supplier; R2i – possible rates of benefits from the purchases from the second supplier; pi – probability of occurrence of possible rates of benefits from supplies.

3. Portfolio of two suppliers (groups of suppliers).

Example 2. The enterprise uses two suppliers. On of them operates in sector A, the other represents sector B. The use of portfolio idea is useful when the correlation between the benefits from purchases from these suppliers is negative. We can follow this in the picture below.

Fig. 2. Relation between benefit and risk for portfolio of two suppliers at different correlation coefficients (equal to 1, (-1) or 0).
source: own study.

Case 1. The correlation coefficient between benefits from purchases from supplier A and B equals to 1. The picture shows that at positive correlation  near to 1 there is no possibility to seek advantages resulting from diversification.
Case 2. Correlation coefficient equal to –1. Ideal negative correlation. All possible portfolios  at correlation coefficient equal to –1 are contained on the broken line A-A/B1-A/B2-B. Points “A” and “B” represent single-components portfolios (eg. Using only supplier A). As we see, when we move away from point “A” and increase the share of deliveries performed by “B” the risk S decreases and benefits R increases. This happens until point A/B1 . If this share is exceeded the risk of portfolio will increase together with the increase of income. As we see it is no substantiated to have only supplier A in the portfolio because at identical risk portfolio A/B2 offers greater benefits.  
Case 3. Correlation coefficient equals 0. It is a situation in which the benefits from supplier A and supplier B are not connected to each other. In this situation only partial risk reduction is possible. Reasonable entrepreneur should not select any of the portfolios of dues lying on A-A/B3 arc, because it always possible to find more advantageous complement on  A/B3 – A/B4 arc which at the same risk s yields higher benefits R.

4. Using the elements of portfolio theory for selection of suppliers  

Skilful construction of portfolio of two (groups) of suppliers may lead to a considerable reduction of risk. Inclusion of second component into single-component portfolio (which like in example 1 so far consisted of only one better supplier A and accepting deliveries from less risky supplier) nearly always leads to reduction of risk, sometimes even at simultaneous increase of benefit rate of portfolio.
Example 3. (continuation of the previous example) After assessment of supplier A and B , the entrepreneur noticed that the delays connected to services provided by suppliers A and B are negatively correlated with each other, because their sources of supply are different when troubles with deliveries from first source can be expected, the other source does not pose a risk of such difficulties.  Thanks to that we can expect a decrease of risk of non forward deliveries . Both suppliers acquire the material D-18 based on different technologies. Therefore one can expect that the impact of deliveries risk on the receiver can be decreased due suing the service of both suppliers, because the correlation of distribution of forward deliveries of suppliers A and B is negative and is equal to –0.56. The orders will be placed in quantities and frequency resulting from VBEOQ model. The orders will be realized by both suppliers: A and B equal shares of 18,85 m3. . In order to estimate new level of safety margin it is necessary to use the equation determining the total standard deviation [3, p. 60]:

(11)
where:    sT – total standard deviation, sA – standard deviation of the first distribution, sB – standard deviation of the second distribution,   – correlation coefficient between the first and second distribution.

Assuming that one-day deviation is equal to deviation of use equal to 11,1 m3; the safety margin is::

m3.
In this case the level of money resources tied in the reserves will be:
$,
comparing this magnitude to the level of reserves in a situation where we would have used supplier A only it is obvious that the increase of money tied in the reserves will be equal to:
$.
The last stage is to compare what impact the risk generated by the counterparts-suppliers has on the enterprise value. Therefore we estimate the total level of costs of reserves:
$,
$.
Obtained results are used for estimation of changes of the enterprise value.
$.
As we see in particular conditions it is possible to get benefits from using both suppliers (better A and worse B). Such a choice may result in increase of enterprise value.

BIBLIOGRAPHY

[1] Fabozzi F. J., G. Fong, Zarządzanie portfelem inwestycji finansowych przynoszących stały dochód, WN PWN, Warszawa 2000.
[2] Kalberg J. G., K. L. Parkinson, Corporate liquidity: Management and Measurment, IRWIN, Homewood 1993.
[3] Piotrowska M., Finanse spółek. Krótkoterminowe decyzje finansowe, Wydawnictwo AE, Wrocław 1997.
[4] Pritchard C.L., Zarządzanie ryzykiem w projektach. Teoria i praktyka, MT&DC, Wig-Press, Warszawa 2001.
 

michalskig
 
michalskig: FIRM VALUE AND NET CURRENT ASSETS INVESTMENTS

Grzegorz Michalski
Wroclaw University of Economics,
Department of Corporate Finance and Value Management,
ul. Komandorska 118/120, p. Z-1, KFPiZW;
PL53345 Wroclaw, Poland;
Phone: +48503452860;
Fax: +48717181717,
michalskig@ue.wroc.pl;
michalskig.ue.wroc.pl/


Abstract: Maximization of wealth of his owners is the basic financial aim in management of an enterprise. Decisions in net current assets investments should contribute to realization of this aim. Article presents the discussion about relations between firm’s  net current assets (working capital) investment policy and firms value.

Keywords: Current assets, firm value, operational risk

JEL Classifications: M11, D81, O16, P33, P34


1. Introduction
Net current assets, current assets reduced by non finance liabilities represents the means that the enterprise ties during accomplishment of its own operation cycle. If the profile of the business requires it, the means tied in the net current assets may reach quite large sizes. This article presents a definition of an investment in net current assets and its difference from investments in fixed assets. The aim of this article is to discuss in what way investments in net current assets are reflected in the enterprise value expressed as a sum of future free cash flows discounted by the cost of enterprise financing capital and to think over the difference between the investments in net current assets (in the way of impact on the enterprise value) and operational investments in fixed assets.

2. Impact of investments in net current assets on creation of enterprise value
The aim of managing the finances of the company is to maximize the wealth of its owners. It results from the maximization of enterprise value. In its simplest form, the value of the enterprise is determined by the sum of updated by the capital cost expected cash flows which will be generated by the company. This relation can be presented in the form of equation 1:


(1)
where:    Vp – enterprise value, CFt – value of expected free cash flows generated by enterprise’s operating assets during period t ,  k – discount rate arising from the rate of cost rate of enterprise financing capital [2, p. 470-472].

Maximization of enterprise value can be obtained by:
[1] Tending to maximize expected free cash flows estimated by the formula:

(2)
where: CR – cash revenues from sales, EBIT – profit before interests and taxes, Tc – effective tax rate of the enterprise, CE – expense costs (sum of fixed and floating costs), NCE – non expenses costs (eg. depreciation), ∆NWC – increment of net current assets (sum of inventory, dues, money means reduced by commitments towards suppliers), Capex – net investments expenditures.
[2] Minimizing of cost rate of enterprise activity financing capital,
[3] Maximizing of enterprise lifetime (assuming that it will be generating positive cash flows from assets all the time).

As we see,  the parameter in the numerator i.e. free cash flows depends on amongst others cash incomes from sales, level of costs and fluctuations in net current assets. Investments in net current assets enable generating of appropriate incomes from sales but also influence the floating and fixed enterprise costs.
Above formula also implies the need to define appropriate risk level in managing the enterprise’s finances.
Managers increase the value of their enterprises by maximizing of its lifetime (amongst others) assuming that it generates appropriate positive free cash flows and by minimizing the rate of cost of enterprise financing capital. Both of these magnitudes (k and t in equation (1)) are sensitive to risk level connected to enterprise operation and they are affected by (amongst others) investments done in net current assets, as the risk increases, the probability of adequately long, conforming the interests of the owners enterprise lifetime decreases and the probability of its early collapse increases. The rate of capital cost on the other hand is higher when the risk level is higher, because in connection to higher risk of capital providers of capital demand higher expected return rate.
Moreover, the analysed numerator of the equation standing for free cash flows generated by the enterprise (CF) is dependent on the risk affecting future prices of raw materials, volume of sales, competition level, used technology and customer preferences. These elements are affected by the risk which implies that its management afflicts the enterprise value. The level of the risk can be decided by the level of investments in the components of the net current assets.
Investments in current assets (operating capital) in many aspects are different from those which refer to long period. Production enterprises reach their goal which is maximising of owners wealth by production of goods and services. For these goods the receive incomes of cash means. In order to produce these goods the enterprises spend particular money on materials and services enabling their operation. Because the incomes and outcomes of money means are not synchronized, the enterprises must have appropriate means tied in the net current assets. [4, p. 536-537; 3, p. 2].
Because the incomes and outcomes of money are burdened by uncertainty referring to time and size, the level of cash means frozen in the net current assets is dedicated to protect the enterprise against the effects of events such as brakes in sales (if the amount of purchase done by customers exceeds the expectations), brakes in production (if for some reason the intensity of use of resources and materials for production will be higher than expected) or other events having similar effects impossible to expect at the time of making the prognosis of future demands for operating capital [5, p. 530-532].

Impact of particular fields of investment in net current assets is shown in fig 1.


Fig. 1. Effect of investments in net current assets on the enterprise value.
Where: CF – future free cash flows, CR – cash incomes from sales, KS – fixed costs, KZ – variable costs, ∆NWC – net current assets increment, t – enterprise lifetime, Vp – enterprise value, k – cost of enterprise financing capital.
Source: own study.

Current assets management requires that a sufficient balance of cash and other working capital assets: accounts receivables and inventories, should be ensured [Graham 2001, p. 4-6.]. If the level of net current assets is not adequate, it enhances the company's operating risk: loss of liquidity. Maintenance of current (liquid) assets generates costs, thus affecting the company's firm value creation.
If the level of net current assets is too low, then a company may encounter problems with timely repayment of its liabilities, while discouraging clients by an excessively restrictive approach to recovery of receivables or shortages in the offered range of goods. Therefore, the level of net current assets cannot be too low.


Fig. 2. Net current assets level vs. firm value creation (profitability)
source: own study.

At the same time (as we can see at fig. 2), surplus net current assets may negatively affect the company’s firm value creation. This is because upon exceeding the "necessary" level of net current assets, their surpluses, when the market risk remains stable, become a source of ineffective utilisation of resources.
Along with an increased risk of the company’s daily operations, you should increase the level of net current assets to exceed the required levels as this will protect company against negative consequences of unavailable net current assets. It is possible to measure firm value creation of Current assets management decision in two ways. Firstly, it is possible to check how it affects the net profit and its relation to equity, total assets, or another item of assets. Secondly, it is possible to assess firm value creation in relation to value of the company.
Individual elements influencing current assets management decisions affect the level of free cash flows to firm (CF) and thus the value of the company. Let us assume that the company is faced with a decision regarding the level of net current assets. As we know, a higher debtors turnover ratio and inventory turnover ratio (resulting from a more liberal approach to granting a trade credit for the purchasers and offering a shorter turnaround on clients’ orders) will be accompanied by more sales (larger cash revenues) but also higher costs.  
Firm value creation indicates that “medium” liquid (current) assets level is optimal. Again, the optimal variant was one that assumed a “medium” liquid (current) assets level as applying such liquid (current) assets level ensures potentially the highest increase in the company‘s value measured by ∆V.
If the level of net current assets is too low, it downsizes the sales thus discouraging clients with an overly restrictive trade credit policy. On the other hand, excessive exposure to net current assets under the “high” level of net current assets variant generated higher sales revenues than under the “medium” variant, but at the same time the positive result of increase in the sales volumes has been offset by high level of generated costs.

3. Value based strategy in current assets management
The issue discussed here attempts to address the question of which net current assets management strategy should be applied to bring the best results for a specific type of business. Financial decisions of a company always focus on selecting the anticipated level of benefits in conditions of risk and uncertainty. Decisions regarding net current assets management strategy, whether focused on assets (strategy of investing in the net current assets) or liabilities (strategy of financing the net current assets), affect free cash flows and the cost of capital financing the company. The principle of separating financial decisions from operating decisions, i.e. separating consequences of operations from changes in the capital structure, calls for a need to take the net current assets management decision first focusing on assets (it affects free cash flows to the company) and then on liabilities (it affects the structure and cost of capital used for financing the company).    
Management of net current assets aimed at creation of value of the company. If the benefits of maintaining net current assets at the level determined by the company outweigh the negative influence of the alternative cost of such maintenance, then an increase in economic value of the company will be reported.
Interesting from our point of view, determined by the need to obtain the main objective of the company’s financials management, is how a change in the net current assets level may impact the value of the company.
Net current assets is, most generally, the portion of current assets financed with permanent funds. The net current assets is a difference between current assets and current liabilities or a difference between permanent liabilities and permanent assets. It is a consequence of dichotomy between the formal origination of the sales revenue and the actual inflow of funds from recovery of receivables and different times when costs are originated and when the funds covering the liabilities are actually paid out.
When estimating free cash flows, maintaining and increasing net current assets means that the funds earmarked for raising that capital are tied. If the increase is positive, it means ever higher exposure of funds, which reduces free cash flows for the corporation. An increase in production usually means the need to boost inventories, receivables, and cash assets.  A portion of this increase will be most probably financed with current liabilities (which are also usually automatically up along with increased production volumes). The remaining part (indicated as an increase in net current assets) will need an alternative source of financing.
Current asset financing policies are driven by the manner of financing current assets. Any changes to the selected current asset financing policy affect the cost of capital but do not impact the level of free cash flows. The company can choose one of the three policies:
a) an aggressive policy whereby a major portion of the company's fixed demand and the entirety of its volatile demand for financing current assets is satisfied with short-term financing.



Fig. 3. Aggressive strategy
Source: own study

b) a moderate policy aiming to adjust the period when financing is needed to the period when the company requires given assets. As a result of such approach, a fixed portion of current assets is financed with long-term funds, while the volatile portion of these assets is financed with short-term funds.
c) a conservative policy whereby both fixed and volatile levels of current assets are maintained with  long-term financing.


Fig. 4. Conservative strategy
Source: own study

The aggressive policy will most probably mean the highest increase in the economic value of the company. However, this result is not that obvious. This is because an increase in financing with an external short-term capital and a decrease in financing with an external long-term capital (namely shifting from conservative to aggressive policy of financing current assets) means enhanced risk level. Such increased risk level should be reflected in an increased cost of equity. This stems from increased costs of financial difficulties.

The aggressive policy of financing current assets is the least favourable, considering an increased cost of equity.
Policies regarding investments in current assets are applied by the company as measures determining amounts and structure of current assets. There are three major policies available:
a) an aggressive policy whereby the level of tangible assets is minimised and a restrictive approach to merchant lending is applied. Minimising current assets results, on the one hand, in savings which later translate to higher free cash flows. On the other hand, insufficient level of current assets increases the operational risk. Too low inventories may interrupt the production and sales process. Insufficient level of receivables will most often lead to a restrictive merchant lending policy and, consequently, potentially lower sales revenue than in the case of a liberal merchant lending policy. Insufficient transactional cash levels may disrupt settlement of liabilities and as a result negatively affect the company’s reputation.  
b) a moderate policy whereby the level of current assets, and in particular inventories and cash, is held on an average level.
c) a conservative policy whereby a high level of current assets (and especially inventories and cash) is maintained at the company and ensuring a high level of receivables by using a liberal trade creditors recovery policy.

If the company aims at maximising firm value creation (ΔV), it should select the aggressive policy. However, similarly as in the preceding item, it is worth considering the relation between the risk increase and the cost of equity (and probably also external capital). The more aggressive the current asset investment policy, the higher risk. Higher risk, on the other hand, should be accompanied by higher costs of  equity and probably also external capital.
Changes of the policy, from conservative to aggressive, cause an increase in the cost of capital financing the company's operations due to enhancement of risk. It is possible that in specific circumstances, the risk may drive the cost of capital to such a high degree that the aggressive policy will be unfavourable.
In the discussed examples, the company should select a conservative current asset financing strategy and an aggressive current asset investment policy.
The primary objective of financing the company’s operations is to maximise the company's economic value. It can be estimated among others by totalling all the future free cash flows generated by the company, discounted with the cost of capital. Decisions regarding management of net current assets should also serve the purpose of achieving the primary objective, that is maximising the company’s economic value. These decisions may impact both the level of free cash flows and the cost of capital used for financing the company’s operations. The module discusses probably changes of the capital cost rate, resulting from changes in selection of the net current assets management policy and, consequently, the anticipated impact of such decisions on the company's economic value.
The threats of liquidity loss which might be the basis of finance difficulties occurrence, has an effect on the expected enterprise lifetime. Cutting the expected operation time of the enterprise may be accompanied by the decrease of enterprise value. The threats of loss of liquidity can be affected by all elements of short-term finance decisions.
The cost of financing is indirectly connected to the threat of liquidity loss but not only. It is a direct effect of value of liquidity for the enterprise and it (liquidity) is dependent on the type of the enterprise , its managing board, situation on the market and rational management of all elements which are affected by short-term decisions. The increase of financing cost is accompanied by the decrease of enterprise value.

4. Model of assessment of influence of investments in net current assets
Investments in fixed assets are characterized by the fact that as time passes they lose their value due to actual wear out reflected in amortization of fixed means. Current assets as opposed to fixed are not subject to amortization. And because the specific component of assets is kept in the enterprise relatively shortly one can assume that usually it does not lose its value in time. The components of net current assets “flow” through the enterprise similarly to (slower) fixed assets. However their wear out is not the source of creation of the value added services. Fixed assets wear out during the process of processing and adding value to components of the net rotating capital. Hence the process and model of assessment of their influence on the enterprise value is different.
In case of assessment of influence on the enterprise value of the investments in net current assets one may use a general scheme:



(3)
where: ΔNWC0 – increment of net current assets in the starting period resulting from changes in management of one (or more) of components of net current assets (e.g. change in operating cycle influencing the level of reserves),  ΔCRn – increment of cash incomes resulting from changes in net current assets (e.g. change in reserves me result in change of storage area and facilities and then in changes in depreciation allowance), ΔNWCn – changes in net current assets which are effects of change described by ΔNWC0; ΔCapexn – changes in capital expenditures resulting from changes in net current assets (e.g. change in reserves me result in change of storage area and facilities and then in changes in capital investments), k – cost rate of enterprise financing capital (WACC).  

As we see on fig 5. and fig 6, if current assets level (liquidity level) in the firm is greater or smaller than optimum level of liquidity, the intrinsic value of liquidity differ from market value of liquidity.

Fig. 5. Liquidity level greater than optimal liquidity level
where: vi - intrinsic (internal) value of liquidity, vm - market value of liquidity, pp2 - liquidity level (2) for vi < vm; ppopt - optimal liquidity level for vi = vm

As a result of this, non-optimal level of liquidity is changed to optimal level of liquidity, because the firm buy relatively cheaper liquidity on market when liquidity level in firm is too small or sell relatively too expensive liquidity on market when liquidity level in firm is greater than optimal.


Fig. 6. Liquidity level smaller than optimal liquidity level
where: vi - intrinsic (internal) value of liquidity, vm - market value of liquidity, pp1 - liquidity level (1) for vi > vm; ppopt - optimal liquidity level for vi - vm

As we see, changes in net current assets have an effect on the enterprise value and assessment of their influence on the final enterprise efficiency measured by increment of its value is carried out according to a similar scheme as assessment of subjective long-term projects but the sources of generated value added services are different. Investments made by enterprises in the net current assets evaluated from the point of view of accomplishing the basic goal, which is maximizing the value, can be made based on the model presented in formula 3. The article deals with presentation of influence of investments in components of net current assets on the enterprise value and with virtues which make them different to operational long-term investments (investments in subjective assessments).
   

BIBLIOGRAPHY
1.    Graham J.E., Firm Value and Optimal Level of Liquidity, Garland, New York 2001.
2.    Hawawini G., C. Viallet, Finanse menedżerskie, PWE, Warszawa 2007.
3.    Hill N.C., W.L. Sartoris, Short-Term Financial Management: Text and Cases, Prentice Hall, Englewood Cliffs, 1995.
4.    Lee C.F., J.E. Finnerty, Corporate Finance: Theory, Method and Applications, HBJ, Orlando 1990.
5.    Martin J.D., J.W. Petty, A. J. Keown, D. F. Scott, Basic Financial Management, Prentice Hall, Englewood Cliffs, 1991.
 

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