IGCSE Enterprise: Specimen Questions with Answers 27 - 28 of 49

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Case Study: 3

Fazzari and Petersen (1993) argue that investment in working capital is sensitive to cash flow. Their findings show that firms that have larger capacity to generate internal finance have higher current asset levels. Chiou et al. (2006) also provide evidence from Taiwan to point to the influence of cash flow on investment in working capital and suggest that firms with greater cash flow have higher investment in working capital. Hill et al. (2010) show that firms with available internal cash flow capacity and capital market access invest more in working capital. By contrasting the two spectrums of researches, it can be suggested that the level of investment in working capital depends on the cash flow availability of firms (Fazzari et al. , 1988) . As argued by Banos-Caballero et al. (2014) , a positive working capital level needs financing, and therefore cash flow availability plays an important role in the relationship between WCM and firm performance.

These positive and negative influences of NWC on performance suggest that investment in working capital involve a trade-off (Baños-Caballero et al. , 2012; Deloof, 2003) . Therefore, to test the effect of cash flow on the relationship between NWC and performance, I estimate a non-linear regression similar to that of Banos-Caballero et al. (2012) and Banos-Caballero et al. (2014) . In this regard, it can be argued that whilst firms with limited cash flow should strive to achieve a reduction in working capital investment to avoid the need for expensive external finance; on the contrary, firms with available internal cash flow should increase investment in working capital in order to improve performance. Banos-Caballero et al. (2014) conclude in their research that managers should avoid negative effects on firm performance because of additional financing expenses. Internal cash flow can be used to finance investments in working capital without the need to raise costly external finance (Autukaite and Molay, 2011) . Banos-Caballero et al. (2014) examined the functional form of the relation between investment in working capital and corporate performance by taken into account financial constraint and found a convex relationship between investment in working capital and firm performance.

Question 27 (2 of 12 Based on Passage)

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What do you mean by trade-off?

Explanation

An important aspect of a working capital policy is to maintain and provide sufficient liquidity to the firm. Trade-off refers to decision how much working capital be maintained by a firm i.e.. having a large net working capital may reduce the liquidity risk faced by the firm, but it can have negative effect on the cash flows. Therefore, the net effect on the value of the firm should be used to determine the optimal amount of working capital. Working capital decision will change a firm՚s liquidity. For example- a firm can increase its profits by decreasing its cash and marketable securities as they generate low rates of return. However, the firm will be exposed to a higher risk of default or not being able to pay its bill on time if it does not have adequate cash and marketable securities.

Question 28 (3 of 12 Based on Passage)

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Explain the difference between variable cost and fixed cost.

Explanation

The Difference between Variable Cost and Fixed Cost
S. no.Fixed CostVariable Cost
1.Total expenditure incurred by the producer on the purchase or hiring of fixed factors of productionExpenditure incurred by the producer on the use of variable factors of production.
2.Does not change with change in quality of output, remains the same whether the output is zero or maximumChanges with change in quantity of output. Cost is zero when the output is zero.
3.Cost of plant and machinery, wages of permanent staffCost of raw materials, Wages of casual labors

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