Explain to Desmond Clinton the difference between a call option and a put option..
HORT-TERM FINANCING AND OPTIONS CONTRACT
Gregg, the CFO and the board of directors of Baldwin Inc. have taken enough time to discuss capital budgeting, dividend policy, and capital structure and now want to focus their attention on short-term finance and cash planning of the company. The board is considering the ways to improve the working capital management of the company. They are also discussing various sources of short-term financing and the minimum amount of money to borrow in the short-term to finance inventory and accounts receivable associated with sales growth. Gregg opened the meeting with the statement that the company must investigate its cash cycle and find ways to improve it because he has noticed a deterioration in the cash flow management of the firm.
Gregg was worried that the inventory period of the company has increased from 70 days in the previous year to 80 days in the current year and the accounts receivable period has also increased from 47 days in the previous year to 55 days in the current year whilst the accounts payable period remains the same at 52 days. He explained that if the two components of cash cycle i.e. operating cycle and accounts payable period are not improved, the company might need to borrow $5.5 million short-term next year to fill the gap between short-term cash inflows and cash outflows.
Gregg presented to the board the following ratios to show how the company has performed over the past two years:
Exhibit 1: Asset Utilization Ratios of Baldwin Inc.
( Please see attachment)
The Credit manager of the company, Josh Waters explained that the company can change some aspects of its short-term financial policy and find alternative financing policies to fund current assets to improve its working capital management. Another board member, Jacky Jackson was of the view that cash budget is a primary tool of short-term financial planning that can be used to improve the cash management of Baldwin Inc. She believed that having short-to-medium term cash budget for the next five years can help the company identify its short-term financial needs or opportunities and the required amount needed to borrow for the next five years. In that way the company will be able to arrange for short-term finance in advance to reduce the risk of cash shortages. With the expected improvement in current asset management of the company, some investors believe that the company’s stock price will increase. One investor, Desmond Clinton is of the opinion that buying a call option on the stock will give him the right to purchase more of the stock of the company now at a fixed price before the price of the stock jumps up. The stock price of Baldwin is currently $25. The exercise price is $30 per share. The call option and put option on the company’s stock expires in one year.
The board is determined to improve the company’s short-term financial management policies and wants you to assist them achieve that objective.
1. Using the ratios presented by Gregg, the board chairman wants you to calculate the following and explain what they mean to all the board members:
i). Operating cycle of the company for 2019
ii). Cash cycle of the company for 2019
2. Given the asset utilization ratios, do you think the cash management of Baldwin Inc. has improved or worsened over the past year and why? Suggest two ways to improve the cash cycle of the company
3. The board is concerned that the net working capital might be declining and not meet the $500,000 minimum requirement of the company. The company has a cash balance of $300,000, other current assets of $1.5 million and current liabilities of $1.3 million. Should the board worry about the company’s net working capital?
4. The board wants to adopt a restrictive short-term financial policy to improve on its cash management. Identify three aspects of restrictive short-term financial policy the company should consider.
5. The cash budget shows that the company will need $2 million to finance its working capital needs in next three years. List five sources of short-term financing the company can use to raise the money.
6. Mention to the board three activities that can increase cash of the company and two activities that can decrease cash of the company.
7. Explain to Desmond Clinton the difference between a call option and a put option.