model might be more attentive to the optimal mix of debt and equity. Such a model might have a ten- or twenty-year time horizon because the discounted values of dividends paid beyond such a time horizon become minuscule.
More sophistication should be introduced to handle liquidity. Cash reserves are set aside for potential shortfalls in satisfying financing charges. Mismatches between the payment of receivables and payment of bills can lead to a liquidity crisis of another type. Although the same line of credit and the cash reserves can be used to keep the suppliers happy, this reduces the company's ability to keep the lenders happy. Furthermore, if a firm does not react fast enough to declining sales, inventories can expand, absorbing the liquidity of a company. Although inventories are considered a current asset, this does not mean that they can be easily liquidated. If the inventory of finished goods is expanding rapidly because marketing cannot sell what production is making, how can a huge overhang of finished goods inventory be considered a current asset? A current asset implies a certain degree of liquidity. Firms have failed, not because of a missed interest payment, but because of not being able to pay the suppliers what they were owed because the company could not sell what it was making from what was purchased from the suppliers. If products cannot be sold as they come off the assembly line, they cannot be sold from the warehouse. Under these conditions, finished goods inventory is not a current asset, but a liability that can destroy a company. A more realistic model simulating the safe loading of debt should take into consideration the impact on a firm's liquidity from changes in the timing of the payment of receivables and from changes in inventory levels as business activity shifts between good and bad times.
It is not the intent of this chapter to provide the final model for determining the safe loading of debt or the optimal mix of equity and debt. The intent is to introduce the concept of looking at the safe loading of debt in terms of cash flow, but not as an average value as flat as the surface of a millpond. The intent is to look at cash flow as waves on an ocean. At times, the surface of the ocean is calm; at other times it is tempestuous. Cash reserves and a line of credit act as stabilizers to keep the financial ship from capsizing in the midst of a storm. But stabilizers cannot save an overburdened vessel. Simulation can help in determining what is a safe load of debt for the safety of vessel and crew and what is the adequate sizing of cash reserves and a line of credit to stabilize the vessel in rough seas.
There are two programs in this appendix. The first is named PEAK and its purpose is to investigate the nature of the probability distribution for gross income for Subsidiary I and Subsidiary II, both individually and combined. The purpose of the second program, DEBT, is to establish the safe level of debt in a conglomerate owning these two subsidiaries.
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Book title: Computer Simulation in Financial Risk Management:A Guide for Business Planners and Strategists. Contributors: Roy L. Nersesian - Author. Publisher: Quorum Books. Place of publication: New York. Publication year: 1991. Page number: 193.
This material is protected by copyright and, with the exception of fair use, may not be further copied, distributed or transmitted in any form or by any means.