Working Capital Manageme nt

Weekend Assignment: 3
Ankit Khandelwal 2010036 PGDM (FT)

Chapter 22 Working Capital Management

If S/I = 5 , how much cash is freed up? Inventory = S/5 =

Cash Freed = $5,000,000 - $2,000,000 = $3,000,000. 22-2 DSO = 17; Credit Sales/Day = $3,500; A/R = ? DSO =
A/R S/365
A /R

17 = $3,500 A/R = 17 $3,500 = $59,500.

22-3 Nominal cost of trade credit =

= 0.0309 24.33 = 0.7526 = 75.26%. Effective cost of trade credit = (1.0309)24.33 - 1.0 = 1.0984 = 109.84%. 22-4 Effective cost of trade credit = (1 + 1/99)8.11 - 1.0 = 0.0849 = 8.49%. 22-5 Net purchase price of inventory = $500,000/day. Credit terms = 2/15, net 40. $500,000 15 = $7,500,000.

3 36 5 9 7 3 0- 1 5

22-6 a. 0.4(10) + 0.6(40) = 28 days. b. $912,500/365 = $2,500 sales per day. $2,500(28) = $70,000 = Average receivables. c. 0.4(10) + 0.6(30) = 22 days. $912,500/365 = $2,500 sales per day. $2,500(22) = $55,000 = Average receivables. Sales may also decline as a result of the tighter credit. This would further reduce receivables. Also, some customers may now take discounts further reducing receivables.

22-7 a.

1 35 6 = 73.74%. 99 5
2 36 5 = 14.90%. 98 50
3 36 5 = 32.25%. 97 35

b. c. d. e.

2 36 5 = 21.28%. 98 35
2 36 5 = 29.80%. 98 25

22-8 a.

3 36 5 = 45.15%. 97 45 - 20

Because the firm still takes the discount on Day 20, 20 is used as the discount period in calculating the cost of nonfree trade credit. b. Paying after the discount period, but still taking the discount gives the firm more credit than it would receive if it paid within 15 days.

22-9 Sales per day =

$4,562 ,500 = $12,500. 365

Discount sales = 0.5($12,500) = $6,250. A/R attributable to discount customers = $6,250(10) = $62,500. A/R attributable to nondiscount customers: Total A/R Discount customers A/R Nondiscount customers A/R $437,500 62,500 $375,000

Days sales outstandin g A/R $375 ,000 = = = 60 days. nondiscoun t customers Sales per day $6,250

Alternatively, DSO = $437,500/$12,500 = 35 days. 35 = 0.5(10) + 0.5(DSONondiscount) DSONondiscount = 30/0.5 = 60 days. Thus, although nondiscount customers are supposed to pay within 40 days, they are actually paying, on average, in 60 days. Cost of trade credit to nondiscount customers equals the rate of return to the firm: Nominal rate =
2 36 5 = 0.0204(7.3) = 14.90%. 98 60 - 10

Effective cost = (1 + 2/98)365/50 - 1 = 15.89%. 22-10Accounts payable: Nominal cost =

EAR cost = (1.03093)4.5625 - 1.0 = 14.91%.

22-11a.

C ash conversion cycle

Inventory conversion period

Receivable + collection period

Payables deferral period

= 75 + 38 - 30 = 83 days. b. Average sales per day = $3,421,875/365 = $9,375. Investment in receivables = $9,375 38 = $356,250. c. Inventory turnover = 365/75 = 4.87 . 22-12a. Inventory conversion period = 365/Inventory turnover ratio = 365/5 = 73 days. Receivables collection period = DSO = 36.5 days.
C ash conversion cycle Inventory Receivable + collection period s Payables deferral period

= conversion
period

= 73 + 36.5 - 40 = 69.5 days. b. Total assets = Inventory + Receivables + Fixed assets = $150,000/5 + [($150,000/365) 36.5] + $35,000 = $30,000 + $15,000 + $35,000 = $80,000. Total assets turnover = Sales/Total assets = $150,000/$80,000 = 1.875 . ROA = Profit margin Total assets turnover = 0.06 1.875 = 0.1125 = 11.25%. c. Inventory conversion period = 365/7.3 = 50 days. Cash conversion cycle = 50 + 36.5 - 40 = 46.5 days. Total assets = Inventory + Receivables + Fixed assets = $150,000/7.3 + $15,000 + $35,000 = $20,548 + $15,000 + $35,000 = $70,548. Total assets turnover = $150,000/$70,548 = 2.1262 . ROA = $9,000/$70,548 = 12.76%.

22-13a. Return on equity may be computed as follows: Tight Current assets (% of sales Sales) $1,200,000 Fixed assets 1,000,000 Total assets $2,200,000 Debt (60% of assets) $1,320,000 Equity 880,000 Total liab./equity $2,200,000 240,000 105,600 134,400 53,760 80,640 9.16% EBIT (12% $2 million) Interest (8%) Earnings before taxes Taxes (40%) Net income Return on equity Moderate Relaxed $ 900,000 1,000,000 $1,900,000 $1,140,000 760,000 $1,900,000 $ 240,000 $1,000,000 1,000,000 $2,000,000 $1,200,000 800,000 $2,000,000 $

$ 240,000

91,200 $ 148,800

96,000 $

$ 144,000

59,520 $ 89,280 11.75%

57,600 $

$ 86,400

10.80%

b. No, this assumption would probably not be valid in a real world situation. A firms current asset policies, particularly with regard to accounts receivable, such as discounts, collection period, and collection policy, may have a significant effect on sales. The exact nature of this function may be difficult to quantify, however, and determining an optimal current asset level may not be possible in actuality.

c. As the answers to Part a indicate, the tighter policy leads to a higher expected return. However, as the current asset level is decreased, presumably some of this reduction comes from accounts receivable. This can be accomplished only through higher discounts, a shorter collection period, and/or tougher collection policies. As outlined above, this would in turn have some effect on sales, possibly lowering profits. More restrictive receivable policies might involve some additional costs (collection, and so forth) but would also probably reduce bad debt expenses. Lower current assets would also imply lower liquid assets; thus, the firms ability to handle contingencies would be impaired. Higher risk of inadequate liquidity would increase the firms risk of insolvency and thus increase its chance of failing to meet fixed charges. Also, lower inventories might mean lost sales and/or expensive production stoppages. Attempting to attach numerical values to these potential losses and probabilities would be extremely difficult.

22-14a. I. $60,000 40,000 40,000

Collections and Purchases: December January Sales Purchases Payments *November purchases = $140,000.

February $160,000 40,000 140,000*

$40,000 40,000 40,000

$60,000 40,000 4,800 2,000 --$46,800 $13,200

II. Gain or Loss for Month: Receipts from sales Payments for: Purchases Salaries Rent Taxes Total payments Net cash gain (loss) III. Cash Surplus or Loan Requirements: Cash at start of month Cumulative cash Target cash balance Cumulative surplus cash or total loans to maintain $6,000 target cash balance

$160,000 140,000 4,800 2,000 12,000 $158,800 $ 1,200

$40,000 40,000 4,800 2,000 --$46,800 ($ 6,800)

(5,200) 8,000 6,000

400

1,600 $

$ 1,600 ($ 5,200) 6,000

6,000

2,000

($ 4,400) ($11,200)

b. If the company began selling on credit on December 1, then it would have zero receipts during December, down from $160,000. Thus, it would have to borrow an additional $160,000, so its loans outstanding by December 31 would be $164,400. The loan requirements would build gradually during the month. We could trace the effects of the changed credit policy on out into January and February, but here it would probably be best to simply construct a new cash budget.

22-15a.

Average accounts payable

$3,6 0 ,0 0 5 0 35 d s 6 ay

10 days = $10,000

10 =

$100,000. b. There is no cost of trade credit at this point. The firm is using free trade credit. c.
Average payables (net of discount)

$3,650 ,000 30 = $10,000 30 = $300,000. 365

Nominal cost = (2/98)(365/20) = 37.24%, or $74,490/($300,000 - $100,000) = 37.25%. Effective cost = (1 + 2/98)365/20 - 1 = 0.4459 = 44.59%. d. Nominal rate =
2 36 5 = 24. 83 %. 98 40 - 10

Effective cost = (1 + 2/98)365/30 - 1 = 0.2786 = 27.86%. 22-16Trade Credit Terms: 2/10, net 30. But the firm plans delaying payments 35 additional days, which is the equivalent of 2/10, net 65.
Discount percent 365 Discount Days credit Discount Nominal cost = 100 percent is outstandin g period 2 36 5 2 36 5 = = 0.0204 (6. 6364 ) = 13. 54 % . = 100 - 2 65 - 10 98 55

Effective cost = (1 + 2/98)365/55 - 1 = 14.35%.

22-17a. Size of bank loan = (Purchases/Day)(Days late) =

= ($600,000/60)(60 - 30) = $10,000(30) = $300,000. Alternatively, one could simply recognize that accounts payable must be cut to half of its existing level, because 30 days is half of 60 days. b. Given the limited information, the decision must be based on the rule-of-thumb comparisons, such as the following: 1. Debt ratio = ($1,500,000 + $700,000)/$3,000,000 = 73%. Raattamas debt ratio is 73 percent, as compared to a typical debt ratio of 50 percent. The firm appears to be undercapitalized. 2. Current ratio = $1,800,000/$1,500,000 = 1.20. The current ratio appears to be low, but current assets could cover current liabilities if all accounts receivable can be collected and if the inventory can be liquidated at its book value. 3. Quick ratio = $400,000/$1,500,000 = 0.27. The quick ratio indicates that current assets, excluding inventory, are only sufficient to cover 27 percent of current liabilities, which is very bad. The company appears to be carrying excess inventory and financing extensively with debt. Bank borrowings are already high, and the liquidity situation is poor. On the basis of these observations, the loan should be denied, and the treasurer should be advised to seek permanent capital, especially equity capital.