Can somebody please answer this with explaination. this is from schweser
Which of the following will mostlikely lead to an increase in typical firms capital investment in current period
a) A need to increase inventory
b) An increase in firms expected marginal tax rate
c) A decrease in market value of firms debt
Thanks a ton
An increase in inventory, since inventory is a capital investment.
A capital investment is any asset that promises future economic benefit, usually exceeding it’s opportunity cost.
An increase in taxes lowers your profit, so it does not directly affect capital.
A decrease in debt lowers your expenses and liabilites, so it’s not a capital investment.
An increase in Inventory is regarded as capital investment, thus an increase in it is equavalent to an increase in Capital Investment.
Precisely! Capital investment can be either working capital, or fixed capital. The financing of this capital is either through debt, or equity. Invested capital on the balance sheet is the sum of all operating assets less the operating liabilities, the financing equivilent of the sum of all debt and equity (if we assume that direct financings for operating assets). Inventory is a current asset, all assets promise future economic benefit, but current assets promise them during one fiscal year. So they do fall under the definition of capital
A decrease of the market value of debt may imply two things that do not increase invested capital:
Interest rates have gone up
Cash was used to pay off debt
Guys answer given is B
Are you sure?
Seems wonky.
Does seem wonky, as I can’t make sense of that answer either.
But I don’t agree that investing in inventory is capital investment though. Investing in inventory doesn’t increase your working capital, it shifts it.
Dr Inventory 100
Cr Cash/AP 100
Inventory is NOT a capital asset. Working capital is unchanged.
Perhaps the idea is that an increase in the marginal tax rate will increase the benefit from depreciation, so a company would want to invest in more fixed assets. But that would make sense only if they expected that the marginal tax rate would decline later.
Does an explanation accompany the answer?
I agree. I think the logic is here to demonstrate that you do not fail to understand that inventory is not capital investment and that a high marginal tax rate could be likely to influence financial officers to invest in capital and use the fiscal leverage effect.
In any case, it seems to assume facts not in evidence.
I think you can proceed by eliminiation :
C:/ is calling debt when its market value is lower capital investment? no. Does market value of debt reduce interests expenses and liberate more cash for financing capital investment? no
A/ is inventory capital investment : no. end of the story.
B/ can a financial officer invest in capital to reduce marginal tax rate? Yes.
Simple set theory?
Of course it is. You are assuming that cash used to buy inventory is operating cash, not excess cash.
We usually seperate operating assets from non-operating assets in deriving working capital. For proper practice at least. Excess cash is a non-operating asset. Their use for the purchase of inventory increase your working capital, and thus increase your capital investment.
Tax shields crossed my mind, but then you have to fit in in your own assumptions.
I’m going to give OP the benefit of doubt. He might have misread the question for what will least likely lead to an increase in typical firms capital investment
^ Mr. Smart you have no idea what you’re talking about. You don’t separate excess cash from operating cash. What is this nonsense? On the higher marginal tax rate piece, you’re more likely to expense things as opex under a higher tax environment. And run higher depreciation rates.
Of course you do.
I’ve never heard that the marginal tax rate was a bottle neck to more capex.
^ No, you really don’t. Absolutely not. I’m not suggesting it is. I’m suggesting the Q is garbage.
Here I share the explanation given in Schweser: " Because a typical firm has both debt and equity financing, an increase in firm tax rate will decrease after tax cost of debt and consequently decrease the firm’s WACC, which can project’s NPV from negative to positive. A decrease in market value of firm’s debt will increase the market yield on the debt, which will increase the after tax cost of debt and firms WACC. Increases in inventory increase CA and WC needs, not capital investment."
The question writer should be hacksawed immediately. I wouldn’t worry about seeing such a garbage Q in your exam. But you should know that inventory is not a capital investment