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4.3 Striking a balance

Investment in working capital has both costs and benefits. The costs include the cost of the firm's investment in receivables is the interest that could have been earned if customers had paid their bills earlier. The firm also forgo interest income when it holds cash balances rather than putting the money in banks to earn risk free rate of return. The cost of holding inventory includes not only the opportunity cost of capital but also storage and insurance costs and the risk of spoilage or obsolescence. All of these costs encourage firms to hold current assets to a minimum.

On the other hand if there is shortage of raw materials and the firm is not able to produce finished goods in time, the firm will incur shut down costs which has very bad implications. The firm might even lose potential customers in the process.

So the firm needs to strike a balance between the cost of carrying working capital and shutdown costs. The sum of carrying costs and shutdown costs should be minimised.

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