Explain the circumstances under which amber will want to buy each of the options.
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SHORT-TERM FINANCING AND OPTIONS & CORPORATE FINANCE
Buddha Tamang is the manager in charge of short-term finance and planning for Exotic Cuisines Inc, a restaurant chain that specializes in exotic main dishes, using ingredients such as alligator, buffalo, and ostrich. The restaurant operates in the United States and plans to open another chain in an emerging country. The board of the company is considering 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 revenue growth. Buddha met the board in a meeting yesterday and 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.
Buddha was worried that the inventory period of the company increased from 50 days two years ago to 60 days in previous year and the accounts receivable period also increased from 27 days last two years to 30 days the previous year whilst the accounts payable period remains the same at 40 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.
Buddha has collected the following information for Exotic Cuisines Inc for the year 2020.
Item
Beginning
Ending
Inventory
6,000
8,200
Accounts receivable
2,800
3,200
Accounts payable
3,820
5,840
Credit sales for the year just ended were $75,000, and cost of goods sold was $40,000.
Buddha 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.
1. Calculate the following utilization ratios for Exotic Cuisines Inc.
i. inventory period
ii. receivables period
iii. payables period
2. Using the utilization ratios, the board chairman wants you to calculate the following and explain what they mean:
i). Operating cycle of the company for 2020
ii). Cash cycle of the company for 2020
3. The company wants to increase its cash position. Explain to the board if the following activities increase or decrease cash:
i. increasing long-term debt
ii. increasing current liabilities
iii. increasing current assets other than cash
iv. increasing equity (i.e., selling some stock)
v. increasing cash dividend payments
4. The board is concerned that the net working capital might be declining and not meet the $2 million minimum requirement of the company. The company has a cash balance of $3 million and other current assets of $2.8 million and current liabilities of $3.3 million. Should the board worry about the company’s net working capital?
5. The cash budget shows that the Exotic Cuisines will need $2.5 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. Exotic Cuisines Inc. does not want to run short of cash reserves and inventories because of the nature of its business. The board of the company has decided to pursue a flexible short-term financial policy to address this concern. Identify three actions of flexible short-term policy that the board should consider.
7. Amber Bista owns 50,000 shares of Exotic Cuisines. He anticipates a decline in the stock price because of the deteriorating utility ratios, and a rise in covid-19 cases in the United States. But because of the plan to expand the market share in an emerging economy, there is a possibility of improved financial performance. Amber is not certain of the direction of the company’s stock. He wants to use options to hedge his investment risk. Unfortunately, he does not understand options.
i. Explain a call option and a put option to Amber.
ii. Explain the circumstances under which Amber will want to buy each of the options.
