CHAPTER 2 The Financial Market Environment 51 52 PART 1 Introduction to Managerial Finance

c. What was the firm’s average tax rate, based on your findings in part a?
Self-Test Problem (Solution in Appendix) d. What is the firm’s marginal tax rate, based on your findings in part a?

LG 6 ST2–1 Corporate taxes Montgomery Enterprises, Inc., had operating earnings of LG 6 P2–2 Average corporate tax rates Using the corporate tax rate schedule given in
$280,000 for the year just ended. During the year the firm sold stock that it held in Table 2.1, perform the following:
another company for $180,000, which was $30,000 above its original purchase a. Calculate the tax liability, after-tax earnings, and average tax rates for the fol-
price of $150,000, paid 1 year earlier. lowing levels of corporate earnings before taxes: $10,000; $80,000; $300,000;
a. What is the amount, if any, of capital gains realized during the year? $500,000; $1.5 million; $10 million; and $20 million.
b. How much total taxable income did the firm earn during the year? b. Plot the average tax rates (measured on the y axis) against the pretax income
c. Use the corporate tax rate schedule given in Table 2.1 to calculate the firm’s total levels (measured on the x axis). What generalization can be made concerning the
taxes due. relationship between these variables?
d. Calculate both the average tax rate and the marginal tax rate on the basis of LG 6 P2–3 Marginal corporate tax rates Using the corporate tax rate schedule given in
your findings. Table 2.1, perform the following:
a. Find the marginal tax rate for the following levels of corporate earnings before taxes:
$15,000; $60,000; $90,000; $200,000; $400,000; $1 million; and $20 million.
Warm-Up Exercises All problems are available in . b. Plot the marginal tax rates (measured on the y axis) against the pretax income
levels (measured on the x axis). Explain the relationship between these variables.
LG 1 E2–1 What does it mean to say that individuals as a group are net suppliers of funds for
financial institutions? What do you think the consequences might be in financial LG 6 P2–4 Interest versus dividend income During the year just ended, Shering Distributors,
markets if individuals consumed more of their incomes and thereby reduced the Inc., had pretax earnings from operations of $490,000. In addition, during the year
supply of funds available to financial institutions? it received $20,000 in income from interest on bonds it held in Zig Manufacturing
and received $20,000 in income from dividends on its 5% common stock holding in
LG 2 E2–2 You are the chief financial officer (CFO) of Gaga Enterprises, an edgy fashion design
Tank Industries, Inc. Shering is in the 40% tax bracket and is eligible for a 70%
firm. Your firm needs $10 million to expand production. How do you think the
dividend exclusion on its Tank Industries stock.
process of raising this money will vary if you raise it with the help of a financial
a. Calculate the firm’s tax on its operating earnings only.
institution versus raising it directly in the financial markets?
b. Find the tax and the after-tax amount attributable to the interest income from
LG 3 E2–3 For what kinds of needs do you a think firm would issue securities in the money Zig Manufacturing bonds.
market versus the capital market? c. Find the tax and the after-tax amount attributable to the dividend income from
the Tank Industries, Inc., common stock.
LG 4 E2–4 Your broker calls to offer you the investment opportunity of a lifetime, the chance to d. Compare, contrast, and discuss the after-tax amounts resulting from the interest
invest in mortgage-backed securities. The broker explains that these securities are income and dividend income calculated in parts b and c.
entitled to the principal and interest payments received from a pool of residential e. What is the firm’s total tax liability for the year?
mortgages. List some of the questions you would ask your broker to assess the risk
of this investment opportunity. LG 6 P2–5 Interest versus dividend expense Michaels Corporation expects earnings before
interest and taxes to be $40,000 for the current period. Assuming an ordinary tax
LG 6 E2–5 Reston, Inc., has asked your corporation, Pruro, Inc., for financial assistance. As a rate of 40%, compute the firm’s earnings after taxes and earnings available for
long-time customer of Reston, your firm has decided to give that assistance. The common stockholders (earnings after taxes and preferred stock dividends, if any)
question you are debating is whether Pruro should take Reston stock with a 5% under the following conditions:
annual dividend or a promissory note paying 5% annual interest. a. The firm pays $10,000 in interest.
Assuming payment is guaranteed and the dollar amounts for annual interest and b. The firm pays $10,000 in preferred stock dividends.
dividend income are identical, which option will result in greater after-tax income
for the first year? LG 6 P2–6 Capital gains taxes Perkins Manufacturing is considering the sale of two nondepre-
ciable assets, X and Y. Asset X was purchased for $2,000 and will be sold today for
$2,250. Asset Y was purchased for $30,000 and will be sold today for $35,000. The
Problems All problems are available in .
firm is subject to a 40% tax rate on capital gains.
a. Calculate the amount of capital gain, if any, realized on each of the assets.
LG 6 P2–1 Corporate taxes Tantor Supply, Inc., is a small corporation acting as the exclusive b. Calculate the tax on the sale of each asset.
distributor of a major line of sporting goods. During 2010 the firm earned $92,500
before taxes. LG 6 P2–7 Capital gains taxes The following table contains purchase and sale prices for the
a. Calculate the firm’s tax liability using the corporate tax rate schedule given in nondepreciable capital assets of a major corporation. The firm paid taxes of 40% on
Table 2.1. capital gains.
b. How much are Tantor Supply’s 2010 after-tax earnings?
 CHAPTER 2 The Financial Market Environment 53 198 PART 2 Financial Tools

Asset Purchase price Sale price Problems All problems are available in .
A $ 3,000 $ 3,400
B 12,000 12,000 LG 1 P5–1 Using a time line The financial manager at Starbuck Industries is considering an
C 62,000 80,000 investment that requires an initial outlay of $25,000 and is expected to result in cash
D 41,000 45,000 inflows of $3,000 at the end of year 1, $6,000 at the end of years 2 and 3, $10,000
E 16,500 18,000 at the end of year 4, $8,000 at the end of year 5, and $7,000 at the end of year 6.
a. Draw and label a time line depicting the cash flows associated with Starbuck
Industries’ proposed investment.
b. Use arrows to demonstrate, on the time line in part a, how compounding to find
a. Determine the amount of capital gain realized on each of the five assets. future value can be used to measure all cash flows at the end of year 6.
b. Calculate the amount of tax paid on each of the assets. c. Use arrows to demonstrate, on the time line in part b, how discounting to find
present value can be used to measure all cash flows at time zero.
LG 5 P2–8 ETHICS PROBLEM The Securities Exchange Act of 1934 limits, but does not pro- d. Which of the approaches—future value or present value—do financial managers
hibit, corporate insiders from trading in their own firm’s shares. What ethical issues rely on most often for decision making? Why?
might arise when a corporate insider wants to buy or sell shares in the firm where he
or she works? LG 2 P5–2 Future value calculation Without referring to the preprogrammed function on your
financial calculator, use the basic formula for future value along with the given
interest rate, r, and the number of periods, n, to calculate the future value of $1 in
each of the cases shown in the following table.

Spreadsheet Exercise
Case Interest rate, r Number of periods, n
Hemingway Corporation is considering expanding its operations to boost its income,
but before making a final decision they have asked you to calculate the corporate tax A 12% 2
consequences of their decision. Currently Hemingway generates before-tax yearly B 6 3
income of $200,000 and has no debt outstanding. Expanding operations would allow C 9 2
Hemingway to increase before-tax yearly income to $350,000. Hemingway can use D 3 4
either cash reserves or debt to finance its expansion. If Hemingway uses debt, it will
have yearly interest expense of $70,000.
LG 1 P5–3 Future value You have $100 to invest. If you can earn 12% interest, about how
TO DO long does it take for your $100 investment to grow to $200? Suppose the interest
Create a spreadsheet to conduct a tax analysis for Hemingway Corporation and rate is just half that, at 6%. At half the interest rate, does it take twice as long to
determine the following: double your money? Why or why not? How long does it take?

a. What is Hemingway’s current annual corporate tax liability? LG 2 P5–4 Future values For each of the cases shown in the following table, calculate the
b. What is Hemingway’s current average tax rate? future value of the single cash flow deposited today at the end of the deposit period
c. If Hemingway finances its expansion using cash reserves, what will be its new if the interest is compounded annually at the rate specified.
corporate tax liability and average tax rate?
d. If Hemingway finances its expansion using debt, what will be its new corporate
tax liability and average tax rate?
e. What would you recommend that the firm do? Why? Case Single cash flow Interest rate Deposit period (years)

Visit www.myfinancelab.com for Chapter Case: The Pros and Cons of Being Publicly A $ 200 5% 20
Listed, Group Exercises, and numerous online resources. B 4,500 8 7
C 10,000 9 10
D 25,000 10 12
E 37,000 11 5
F 40,000 12 9
 CHAPTER 5 Time Value of Money 199 200 PART 2 Financial Tools

Personal Finance Problem

Case Opportunity cost, r Number of periods, n
LG 2 P5–5 Time value You have $1,500 to invest today at 7% interest compounded annually.
a. Find how much you will have accumulated in the account at the end of A 2% 4
(1) 3 years, (2) 6 years, and (3) 9 years. B 10 2
b. Use your findings in part a to calculate the amount of interest earned in (1) the C 5 3
first 3 years (years 1 to 3), (2) the second 3 years (years 4 to 6), and (3) the third D 13 2
3 years (years 7 to 9).
c. Compare and contrast your findings in part b. Explain why the amount of
interest earned increases in each succeeding 3-year period. LG 2 P5–11 Present values For each of the cases shown in the following table, calculate the
present value of the cash flow, discounting at the rate given and assuming that the
Personal Finance Problem cash flow is received at the end of the period noted.
LG 2 P5–6 Time value As part of your financial planning, you wish to purchase a new car
exactly 5 years from today. The car you wish to purchase costs $14,000 today, and
your research indicates that its price will increase by 2% to 4% per year over the Case Single cash flow Discount rate End of period (years)
next 5 years. A $ 7,000 12% 4
a. Estimate the price of the car at the end of 5 years if inflation is (1) 2% per year B 28,000 8 20
and (2) 4% per year. C 10,000 14 12
b. How much more expensive will the car be if the rate of inflation is 4% rather D 150,000 11 6
than 2%? E 45,000 20 8
c. Estimate the price of the car if inflation is 2% for the next 2 years and 4% for
3 years after that.
LG 2 P5–12 Present value concept Answer each of the following questions.
Personal Finance Problem
a. What single investment made today, earning 12% annual interest, will be worth
LG 2 P5–7 Time value You can deposit $10,000 into an account paying 9% annual interest $6,000 at the end of 6 years?
either today or exactly 10 years from today. How much better off will you be at the b. What is the present value of $6,000 to be received at the end of 6 years if the dis-
end of 40 years if you decide to make the initial deposit today rather than 10 years count rate is 12%?
from today? c. What is the most you would pay today for a promise to repay you $6,000 at the
Personal Finance Problem end of 6 years if your opportunity cost is 12%?
d. Compare, contrast, and discuss your findings in parts a through c.
LG 2 P5–8 Time value Misty needs to have $15,000 at the end of 5 years to fulfill her goal of
purchasing a small sailboat. She is willing to invest a lump sum today and leave the Personal Finance Problem
money untouched for 5 years until it grows to $15,000, but she wonders what sort
LG 2 P5–13 Time value Jim Nance has been offered an investment that will pay him $500 three
of investment return she will need to earn to reach her goal. Use your calculator or
years from today.
spreadsheet to figure out the approximate annually compounded rate of return
a. If his opportunity cost is 7% compounded annually, what value should he place
needed in each of these cases:
on this opportunity today?
a. Misty can invest $10,200 today.
b. What is the most he should pay to purchase this payment today?
b. Misty can invest $8,150 today.
c. If Jim can purchase this investment for less than the amount calculated in part a,
c. Misty can invest $7,150 today.
what does that imply about the rate of return that he will earn on the investment?
Personal Finance Problem
LG 2 P5–9 Single-payment loan repayment A person borrows $200 to be repaid in 8 years LG 2 P5–14 Time value An Iowa state savings bond can be converted to $100 at maturity 6 years
with 14% annually compounded interest. The loan may be repaid at the end of any from purchase. If the state bonds are to be competitive with U.S. savings bonds, which
earlier year with no prepayment penalty. pay 8% annual interest (compounded annually), at what price must the state sell its
a. What amount will be due if the loan is repaid at the end of year 1? bonds? Assume no cash payments on savings bonds prior to redemption.
b. What is the repayment at the end of year 4?
Personal Finance Problem
c. What amount is due at the end of the eighth year?
LG 2 P5–15 Time value and discount rates You just won a lottery that promises to pay you
LG 2 P5–10 Present value calculation Without referring to the preprogrammed function on $1,000,000 exactly 10 years from today. Because the $1,000,000 payment is guaran-
your financial calculator, use the basic formula for present value, along with the teed by the state in which you live, opportunities exist to sell the claim today for an
given opportunity cost, r, and the number of periods, n, to calculate the present immediate single cash payment.
value of $1 in each of the cases shown in the following table.
 CHAPTER 5 Time Value of Money 201 202 PART 2 Financial Tools

a. What is the least you will sell your claim for if you can earn the following rates LG 3 P5–19 Future value of an annuity For each case in the accompanying table, answer the
of return on similar-risk investments during the 10-year period? questions that follow.
(1) 6%
(2) 9%
(3) 12% Case Amount of annuity Interest rate Deposit period (years)
b. Rework part a under the assumption that the $1,000,000 payment will be
A $ 2,500 8% 10
received in 15 rather than 10 years.
B 500 12 6
c. On the basis of your findings in parts a and b, discuss the effect of both the size
C 30,000 20 5
of the rate of return and the time until receipt of payment on the present value of
D 11,500 9 8
a future sum.
E 6,000 14 30

Personal Finance Problem

LG 2 P5–16 Time value comparisons of single amounts In exchange for a $20,000 payment a. Calculate the future value of the annuity assuming that it is
today, a well-known company will allow you to choose one of the alternatives (1) An ordinary annuity.
shown in the following table. Your opportunity cost is 11%. (2) An annuity due.
b. Compare your findings in parts a(1) and a(2). All else being identical, which type
of annuity—ordinary or annuity due—is preferable? Explain why.
Alternative Single amount
LG 3 P5-20 Present value of an annuity Consider the following cases.
A $28,500 at end of 3 years
B $54,000 at end of 9 years
C $160,000 at end of 20 years Case Amount of annuity Interest rate Period (years)

A $ 12,000 7% 3
B 55,000 12 15
a. Find the value today of each alternative. C 700 20 9
b. Are all the alternatives acceptable—that is, worth $20,000 today? D 140,000 5 7
c. Which alternative, if any, will you take? E 22,500 10 5

Personal Finance Problem

LG 2 P5–17 Cash flow investment decision Tom Alexander has an opportunity to purchase any a. Calculate the present value of the annuity assuming that it is
of the investments shown in the following table. The purchase price, the amount of (1) An ordinary annuity.
the single cash inflow, and its year of receipt are given for each investment. Which (2) An annuity due.
purchase recommendations would you make, assuming that Tom can earn 10% on b. Compare your findings in parts a(1) and a(2). All else being identical, which type
his investments? of annuity—ordinary or annuity due—is preferable? Explain why.

Personal Finance Problem

LG 3 P5–21 Time value—Annuities Marian Kirk wishes to select the better of two 10-year
Investment Price Single cash inflow Year of receipt annuities, C and D. Annuity C is an ordinary annuity of $2,500 per year for
A $18,000 $30,000 5 10 years. Annuity D is an annuity due of $2,200 per year for 10 years.
B 600 3,000 20 a. Find the future value of both annuities at the end of year 10, assuming that
C 3,500 10,000 10 Marian can earn (1) 10% annual interest and (2) 20% annual interest.
D 1,000 15,000 40 b. Use your findings in part a to indicate which annuity has the greater future value
at the end of year 10 for both the (1) 10% and (2) 20% interest rates.
c. Find the present value of both annuities, assuming that Marian can earn (1) 10%
annual interest and (2) 20% annual interest.
LG 2 P5–18 Calculating deposit needed You put $10,000 in an account earning 5%. After d. Use your findings in part c to indicate which annuity has the greater present
3 years, you make another deposit into the same account. Four years later (that is, value for both (1) 10% and (2) 20% interest rates.
7 years after your original $10,000 deposit), the account balance is $20,000. What e. Briefly compare, contrast, and explain any differences between your findings
was the amount of the deposit at the end of year 3? using the 10% and 20% interest rates in parts b and d.
 CHAPTER 5 Time Value of Money 203 204 PART 2 Financial Tools

Personal Finance Problem b. Would your decision in part a change if you could earn 7% rather than 5% on
LG 3 P5–22 Retirement planning Hal Thomas, a 25-year-old college graduate, wishes to retire your investments over the next 25 years? Why?
at age 65. To supplement other sources of retirement income, he can deposit $2,000 c. On a strictly economic basis, at approximately what earnings rate would you be
each year into a tax-deferred individual retirement arrangement (IRA). The IRA will indifferent between the two plans?
earn a 10% return over the next 40 years.
a. If Hal makes annual end-of-year $2,000 deposits into the IRA, how much will he LG 3 P5–26 Perpetuities Consider the data in the following table.
have accumulated by the end of his sixty-fifth year?
b. If Hal decides to wait until age 35 to begin making annual end-of-year $2,000
deposits into the IRA, how much will he have accumulated by the end of his
Perpetuity Annual amount Discount rate
sixty-fifth year?
c. Using your findings in parts a and b, discuss the impact of delaying making A $ 20,000 8%
deposits into the IRA for 10 years (age 25 to age 35) on the amount accumulated B 100,000 10
by the end of Hal’s sixty-fifth year. C 3,000 6
d. Rework parts a, b, and c, assuming that Hal makes all deposits at the beginning, D 60,000 5
rather than the end, of each year. Discuss the effect of beginning-of-year deposits
on the future value accumulated by the end of Hal’s sixty-fifth year.

Personal Finance Problem Determine the present value of each perpetuity.

LG 3 P5–23 Value of a retirement annuity An insurance agent is trying to sell you an imme-
Personal Finance Problem
diate-retirement annuity, which for a single amount paid today will provide you with
$12,000 at the end of each year for the next 25 years. You currently earn 9% on LG 3 P5–27 Creating an endowment On completion of her introductory finance course, Marla
low-risk investments comparable to the retirement annuity. Ignoring taxes, what is Lee was so pleased with the amount of useful and interesting knowledge she gained
the most you would pay for this annuity? that she convinced her parents, who were wealthy alumni of the university she was
attending, to create an endowment. The endowment is to allow three needy students
Personal Finance Problem to take the introductory finance course each year in perpetuity. The guaranteed
LG 2 LG 3 P5–24 Funding your retirement You plan to retire in exactly 20 years. Your goal is to annual cost of tuition and books for the course is $600 per student. The endowment
create a fund that will allow you to receive $20,000 at the end of each year for the will be created by making a single payment to the university. The university expects
30 years between retirement and death (a psychic told you would die exactly 30 to earn exactly 6% per year on these funds.
years after you retire). You know that you will be able to earn 11% per year during a. How large an initial single payment must Marla’s parents make to the university
the 30-year retirement period. to fund the endowment?
a. How large a fund will you need when you retire in 20 years to provide the b. What amount would be needed to fund the endowment if the university could
30-year, $20,000 retirement annuity? earn 9% rather than 6% per year on the funds?
b. How much will you need today as a single amount to provide the fund calculated
in part a if you earn only 9% per year during the 20 years preceding retirement? LG 4 P5–28 Value of a mixed stream For each of the mixed streams of cash flows shown in the
c. What effect would an increase in the rate you can earn both during and prior to following table, determine the future value at the end of the final year if deposits are
retirement have on the values found in parts a and b? Explain. made into an account paying annual interest of 12%, assuming that no withdrawals
d. Now assume that you will earn 10% from now through the end of your retire- are made during the period and that the deposits are made:
ment. You want to make 20 end-of-year deposits into your retirement account a. At the end of each year.
that will fund the 30-year stream of $20,000 annual annuity payments. How b. At the beginning of each year.
large do your annual deposits have to be?

Personal Finance Problem

Cash flow stream
LG 2 LG 3 P5–25 Value of an annuity versus a single amount Assume that you just won the state lot-
Year A B C
tery. Your prize can be taken either in the form of $40,000 at the end of each of the
next 25 years (that is, $1,000,000 over 25 years) or as a single amount of $500,000 1 $ 900 $30,000 $1,200
paid immediately. 2 1,000 25,000 1,200
a. If you expect to be able to earn 5% annually on your investments over the next 3 1,200 20,000 1,000
25 years, ignoring taxes and other considerations, which alternative should you 4 10,000 1,900
take? Why? 5 5,000
 CHAPTER 5 Time Value of Money 205 206 PART 2 Financial Tools

Personal Finance Problem a. Find the present value of each stream using a 15% discount rate.
LG 4 P5–29 Value of a single amount versus a mixed stream Gina Vitale has just contracted to b. Compare the calculated present values and discuss them in light of the fact that
sell a small parcel of land that she inherited a few years ago. The buyer is willing to the undiscounted cash flows total $150,000 in each case.
pay $24,000 at the closing of the transaction or will pay the amounts shown in the
following table at the beginning of each of the next 5 years. Because Gina doesn’t LG 1 LG 4 P5–32 Value of a mixed stream Harte Systems, Inc., a maker of electronic surveillance
really need the money today, she plans to let it accumulate in an account that earns equipment, is considering selling to a well-known hardware chain the rights to
7% annual interest. Given her desire to buy a house at the end of 5 years after market its home security system. The proposed deal calls for the hardware chain to
closing on the sale of the lot, she decides to choose the payment alternative— pay Harte $30,000 and $25,000 at the end of years 1 and 2 and to make annual
$24,000 single amount or the mixed stream of payments in the following table— year-end payments of $15,000 in years 3 through 9. A final payment to Harte of
that provides the higher future value at the end of 5 years. Which alternative will she $10,000 would be due at the end of year 10.
choose? a. Lay out the cash flows involved in the offer on a time line.
b. If Harte applies a required rate of return of 12% to them, what is the present
value of this series of payments?
Mixed stream c. A second company has offered Harte an immediate one-time payment of
$100,000 for the rights to market the home security system. Which offer should
Beginning of year Cash flow
Harte accept?
1 $ 2,000
2 4,000 Personal Finance Problem
3 6,000 LG 4 P5–33 Funding budget shortfalls As part of your personal budgeting process, you have
4 8,000 determined that in each of the next 5 years you will have budget shortfalls. In other
5 10,000 words, you will need the amounts shown in the following table at the end of the
given year to balance your budget—that is, to make inflows equal outflows. You
expect to be able to earn 8% on your investments during the next 5 years and wish
LG 4 P5-30 Value of mixed streams Find the present value of the streams of cash flows shown to fund the budget shortfalls over the next 5 years with a single amount.
in the following table. Assume that the firm’s opportunity cost is 12%.

End of year Budget shortfall

A B C 1 $ 5,000
Year Cash flow Year Cash flow Year Cash flow 2 4,000
3 6,000
1 -$2,000 1 $10,000 1-5 $10,000/yr
4 10,000
2 3,000 2–5 5,000/yr 6–10 8,000/yr
5 3,000
3 4,000 6 7,000
4 6,000
5 8,000 a. How large must the single deposit today into an account paying 8% annual
interest be to provide for full coverage of the anticipated budget shortfalls?
b. What effect would an increase in your earnings rate have on the amount calcu-
LG 4 P5–31 Present value—Mixed streams Consider the mixed streams of cash flows shown in lated in part a? Explain.
the following table.
LG 4 P5–34 Relationship between future value and present value—Mixed stream Using the
Cash flow stream information in the accompanying table, answer the questions that follow.

Year A B

1 $ 50,000 $ 10,000 Year (t) Cash flow

2 40,000 20,000 1 $ 800
3 30,000 30,000 2 900
4 20,000 40,000 3 1,000
5 10,000 50,000 4 1,500
Totals $150,000 $150,000 5 2,000
 CHAPTER 5 Time Value of Money 207 208 PART 2 Financial Tools

a. Determine the present value of the mixed stream of cash flows using a 5% dis- LG 5 P5–38 Continuous compounding For each of the cases in the following table, find the
count rate. future value at the end of the deposit period, assuming that interest is compounded
b. How much would you be willing to pay for an opportunity to buy this stream, continuously at the given nominal annual rate.
assuming that you can at best earn 5% on your investments?
c. What effect, if any, would a 7% rather than a 5% opportunity cost have on your
analysis? (Explain verbally.) Amount of Nominal annual Deposit period
Case initial deposit rate, r (years), n
LG 4 P5–35 Relationship between future value and present value—Mixed stream The table
A $1,000 9% 2
below shows a mixed cash flow stream, except that the cash flow for year 3 is
B 600 10 10
missing.
C 4,000 8 7
D 2,500 12 4

Year 1 $10,000
Year 2 5,000 Personal Finance Problem
Year 3 LG 5 P5–39 Compounding frequency and time value You plan to invest $2,000 in an individual
Year 4 20,000
retirement arrangement (IRA) today at a nominal annual rate of 8%, which is
Year 5 3,000
expected to apply to all future years.
a. How much will you have in the account at the end of 10 years if interest is com-
pounded (1) annually, (2) semiannually, (3) daily (assume a 365-day year), and
(4) continuously?
Suppose that somehow you know that the present value of the entire stream is b. What is the effective annual rate, EAR, for each compounding period in part a?
$32,911.03, and the discount rate is 4%. What is the amount of the missing cash c. How much greater will your IRA balance be at the end of 10 years if interest is
flow in year 3? compounded continuously rather than annually?
d. How does the compounding frequency affect the future value and effective annual
LG 5 P5–36 Changing compounding frequency Using annual, semiannual, and quarterly com- rate for a given deposit? Explain in terms of your findings in parts a through c.
pounding periods for each of the following, (1) calculate the future value if $5,000 is
deposited initially, and (2) determine the effective annual rate (EAR). Personal Finance Problem
a. At 12% annual interest for 5 years. LG 5 P5–40 Comparing compounding periods René Levin wishes to determine the future value
b. At 16% annual interest for 6 years. at the end of 2 years of a $15,000 deposit made today into an account paying a
c. At 20% annual interest for 10 years. nominal annual rate of 12%.
a. Find the future value of René’s deposit, assuming that interest is compounded
LG 5 P5–37 Compounding frequency, time value, and effective annual rates For each of the (1) annually, (2) quarterly, (3) monthly, and (4) continuously.
cases in the following table: b. Compare your findings in part a, and use them to demonstrate the relationship
a. Calculate the future value at the end of the specified deposit period. between compounding frequency and future value.
b. Determine the effective annual rate, EAR. c. What is the maximum future value obtainable given the $15,000 deposit, the
c. Compare the nominal annual rate, r, to the effective annual rate, EAR. What 2-year time period, and the 12% nominal annual rate? Use your findings in
relationship exists between compounding frequency and the nominal and effec- part a to explain.
tive annual rates?
Personal Finance Problem
LG 3 LG 5 P5-41 Annuities and compounding Janet Boyle intends to deposit $300 per year in a
credit union for the next 10 years, and the credit union pays an annual interest rate
Compounding Deposit of 8%.
Amount of Nominal frequency, m period a. Determine the future value that Janet will have at the end of 10 years, given that
Case initial deposit annual rate, r (times/year) (years) end-of-period deposits are made and no interest is withdrawn, if
A $ 2,500 6% 2 5 (1) $300 is deposited annually and the credit union pays interest annually.
B 50,000 12 6 3 (2) $150 is deposited semiannually and the credit union pays interest semiannually.
C 1,000 5 1 10 (3) $75 is deposited quarterly and the credit union pays interest quarterly.
D 20,000 16 4 6 b. Use your finding in part a to discuss the effect of more frequent deposits and
compounding of interest on the future value of an annuity.
 CHAPTER 5 Time Value of Money 209 210 PART 2 Financial Tools

LG 6 P5–42 Deposits to accumulate future sums For each of the cases shown in the following a. Inflation is expected to average 5% per year for the next 25 years. What will
table, determine the amount of the equal, annual, end-of-year deposits necessary to John’s dream house cost when he retires?
accumulate the given sum at the end of the specified period, assuming the stated b. How much must John invest at the end of each of the next 25 years to have the
annual interest rate. cash purchase price of the house when he retires?
c. If John invests at the beginning instead of at the end of each of the next 25 years,
how much must he invest each year?
Sum to be Accumulation
Case accumulated period (years) Interest rate
LG 6 P5–47 Loan payment Determine the equal, annual, end-of-year payment required each
A $ 5,000 3 12% year over the life of the loans shown in the following table to repay them fully
B 100,000 20 7 during the stated term of the loan.
C 30,000 8 10
D 15,000 12 8
Loan Principal Interest rate Term of loan (years)

Personal Finance Problem A $12,000 8% 3

B 60,000 12 10
LG 6 P5–43 Creating a retirement fund To supplement your planned retirement in exactly
C 75,000 10 30
42 years, you estimate that you need to accumulate $220,000 by the end of 42 years
D 4,000 15 5
from today. You plan to make equal, annual, end-of-year deposits into an account
paying 8% annual interest.
a. How large must the annual deposits be to create the $220,000 fund by the end
of 42 years? Personal Finance Problem
b. If you can afford to deposit only $600 per year into the account, how much will LG 6 P5–48 Loan amortization schedule Joan Messineo borrowed $15,000 at a 14% annual
you have accumulated by the end of the forty-second year? rate of interest to be repaid over 3 years. The loan is amortized into three equal,
annual, end-of-year payments.
Personal Finance Problem a. Calculate the annual, end-of-year loan payment.
LG 6 P5–44 Accumulating a growing future sum A retirement home at Deer Trail Estates now b. Prepare a loan amortization schedule showing the interest and principal break-
costs $185,000. Inflation is expected to cause this price to increase at 6% per year down of each of the three loan payments.
over the 20 years before C. L. Donovan retires. How large an equal, annual, end-of- c. Explain why the interest portion of each payment declines with the passage of
year deposit must be made each year into an account paying an annual interest rate time.
of 10% for Donovan to have the cash needed to purchase a home at retirement?
LG 6 P5–49 Loan interest deductions Liz Rogers just closed a $10,000 business loan that is to
Personal Finance Problem be repaid in three equal, annual, end-of-year payments. The interest rate on the loan
LG 3 LG 6 P5–45 Deposits to create a perpetuity You have decided to endow your favorite university is 13%. As part of her firm’s detailed financial planning, Liz wishes to determine the
with a scholarship. It is expected to cost $6,000 per year to attend the university annual interest deduction attributable to the loan. (Because it is a business loan, the
into perpetuity. You expect to give the university the endowment in 10 years and interest portion of each loan payment is tax-deductible to the business.)
will accumulate it by making equal annual (end-of-year) deposits into an account. a. Determine the firm’s annual loan payment.
The rate of interest is expected to be 10% for all future time periods. b. Prepare an amortization schedule for the loan.
a. How large must the endowment be? c. How much interest expense will Liz’s firm have in each of the next 3 years as a
b. How much must you deposit at the end of each of the next 10 years to accumu- result of this loan?
late the required amount?
Personal Finance Problem
Personal Finance Problem LG 6 P5–50 Monthly loan payments Tim Smith is shopping for a used car. He has found one
LG 2 LG 3 P5–46 Inflation, time value, and annual deposits While vacationing in Florida, John priced at $4,500. The dealer has told Tim that if he can come up with a down pay-
Kelley saw the vacation home of his dreams. It was listed with a sale price of ment of $500, the dealer will finance the balance of the price at a 12% annual rate
LG 6
$200,000. The only catch is that John is 40 years old and plans to continue working over 2 years (24 months).
until he is 65. Still, he believes that prices generally increase at the overall rate of a. Assuming that Tim accepts the dealer’s offer, what will his monthly (end-of-
inflation. John believes that he can earn 9% annually after taxes on his investments. month) payment amount be?
He is willing to invest a fixed amount at the end of each of the next 25 years to fund b. Use a financial calculator or spreadsheet to help you figure out what Tim’s
the cash purchase of such a house (one that can be purchased today for $200,000) monthly payment would be if the dealer were willing to finance the balance of
when he retires. the car price at a 9% annual rate.
 CHAPTER 5 Time Value of Money 211 212 PART 2 Financial Tools

LG 6 P5–51 Growth rates You are given the series of cash flows shown in the following table. LG 6 P5–54 Rate of return—Annuity What is the rate of return on an investment of $10,606 if
the company will receive $2,000 each year for the next 10 years?
Cash flows
Personal Finance Problem
Year A B C LG 6 P5–55 Choosing the best annuity Raina Herzig wishes to choose the best of four
1 $500 $1,500 $2,500 immediate-retirement annuities available to her. In each case, in exchange for
2 560 1,550 2,600 paying a single premium today, she will receive equal, annual, end-of-year cash
3 640 1,610 2,650 benefits for a specified number of years. She considers the annuities to be equally
4 720 1,680 2,650 risky and is not concerned about their differing lives. Her decision will be based
5 800 1,760 2,800 solely on the rate of return she will earn on each annuity. The key terms of the four
6 1,850 2,850 annuities are shown in the following table.
7 1,950 2,900
8 2,060
Annuity Premium paid today Annual benefit Life (years)
9 2,170
10 2,280 A $30,000 $3,100 20
B 25,000 3,900 10
C 40,000 4,200 15
a. Calculate the compound annual growth rate between the first and last payment
D 35,000 4,000 12
in each stream.
b. If year-1 values represent initial deposits in a savings account paying annual
interest, what is the annual rate of interest earned on each account? a. Calculate to the nearest 1% the rate of return on each of the four annuities
c. Compare and discuss the growth rate and interest rate found in parts a and b, Raina is considering.
respectively. b. Given Raina’s stated decision criterion, which annuity would you recommend?

Personal Finance Problem Personal Finance Problem

LG 6 P5–52 Rate of return Rishi Singh has $1,500 to invest. His investment counselor suggests LG 6 P5–56 Interest rate for an annuity Anna Waldheim was seriously injured in an indus-
an investment that pays no stated interest but will return $2,000 at the end of 3 years. trial accident. She sued the responsible parties and was awarded a judgment of
a. What annual rate of return will Rishi earn with this investment? $2,000,000. Today, she and her attorney are attending a settlement conference with
b. Rishi is considering another investment, of equal risk, that earns an annual the defendants. The defendants have made an initial offer of $156,000 per year for
return of 8%. Which investment should he make, and why? 25 years. Anna plans to counteroffer at $255,000 per year for 25 years. Both the
offer and the counteroffer have a present value of $2,000,000, the amount of the
Personal Finance Problem judgment. Both assume payments at the end of each year.
LG 6 P5–53 Rate of return and investment choice Clare Jaccard has $5,000 to invest. Because a. What interest rate assumption have the defendants used in their offer (rounded
she is only 25 years old, she is not concerned about the length of the investment’s to the nearest whole percent)?
life. What she is sensitive to is the rate of return she will earn on the investment. b. What interest rate assumption have Anna and her lawyer used in their coun-
With the help of her financial advisor, Clare has isolated four equally risky invest- teroffer (rounded to the nearest whole percent)?
ments, each providing a single amount at the end of its life, as shown in the fol- c. Anna is willing to settle for an annuity that carries an interest rate assumption
lowing table. All of the investments require an initial $5,000 payment. of 9%. What annual payment would be acceptable to her?

Personal Finance Problem

Investment Single amount Investment life (years) LG 6 P5–57 Loan rates of interest John Flemming has been shopping for a loan to finance the
A $ 8,400 6 purchase of a used car. He has found three possibilities that seem attractive and
B 15,900 15 wishes to select the one with the lowest interest rate. The information available with
C 7,600 4 respect to each of the three $5,000 loans is shown in the following table.
D 13,000 10

a. Calculate, to the nearest 1%, the rate of return on each of the four investments Loan Principal Annual payment Term (years)
available to Clare. A $5,000 $1,352.81 5
b. Which investment would you recommend to Clare, given her goal of maximizing B 5,000 1,543.21 4
the rate of return? C 5,000 2,010.45 3
 CHAPTER 5 Time Value of Money 213 634 PART 7 Short-Term Financial Decisions

a. Determine the interest rate associated with each of the loans. proposed relaxation of credit standards would not affect its 70-day average collec-
b. Which loan should John take? tion period but would increase bad debts to 7.5% of sales, which would increase to
300,000 units per year. Forrester requires a 12% return on investments. Show all
LG 6 P5–58 Number of years to equal future amount For each of the following cases, deter- necessary calculations required to evaluate Forrester’s proposed relaxation of credit
mine the number of years it will take for the initial deposit to grow to equal the standards.
future amount at the given interest rate.
LG 5 E15–5 Klein’s Tools is considering offering a cash discount to speed up the collection of
accounts receivable. Currently the firm has an average collection period of 65 days,
Case Initial deposit Future amount Interest rate annual sales are 35,000 units, the per-unit price is $40, and the per-unit variable cost
A $ 300 $ 1,000 7% is $29. A 2% cash discount is being considered. Klein’s Tools estimates that 80% of
B 12,000 15,000 5 its customers will take the 2% discount. If sales are expected to rise to 37,000 units
C 9,000 20,000 10 per year and the firm has a 15% required rate of return, what minimum average
D 100 500 9 collection period is required to approve the cash discount plan?
E 7,500 30,000 15

Personal Finance Problem

LG 6 P5–59 Time to accumulate a given sum Manuel Rios wishes to determine how long it will Problems All problems are available in .
take an initial deposit of $10,000 to double.
a. If Manuel earns 10% annual interest on the deposit, how long will it take for LG 2 P15–1 Cash conversion cycle American Products is concerned about managing cash effi-
him to double his money? ciently. On the average, inventories have an age of 90 days, and accounts receivable
b. How long will it take if he earns only 7% annual interest? are collected in 60 days. Accounts payable are paid approximately 30 days after they
c. How long will it take if he can earn 12% annual interest? arise. The firm has annual sales of about $30 million. Assume there is no difference
d. Reviewing your findings in parts a, b, and c, indicate what relationship exists in the investment per dollar of sales in inventory, receivables, and payables and that
between the interest rate and the amount of time it will take Manuel to double there is a 365-day year.
his money. a. Calculate the firm’s operating cycle.
b. Calculate the firm’s cash conversion cycle.
LG 6 P5–60 Number of years to provide a given return In each of the following cases, deter- c. Calculate the amount of resources needed to support the firm’s cash conversion
mine the number of years that the given annual end-of-year cash flow must continue cycle.
to provide the given rate of return on the given initial amount. d. Discuss how management might be able to reduce the cash conversion cycle.

LG 2 P15–2 Changing cash conversion cycle Camp Manufacturing turns over its inventory
Case Initial amount Annual cash flow Rate of return eight times each year, has an average payment period of 35 days, and has an average
A $ 1,000 $ 250 11% collection period of 60 days. The firm’s annual sales are $3.5 million. Assume there
B 150,000 30,000 15 is no difference in the investment per dollar of sales in inventory, receivables, and
C 80,000 10,000 10 payables and that there is a 365-day year.
D 600 275 9 a. Calculate the firm’s operating cycle and cash conversion cycle.
E 17,000 3,500 6 b. Calculate the firm’s daily cash operating expenditure. How much in resources
must be invested to support its cash conversion cycle?
c. If the firm pays 14% for these resources, by how much would it increase its
Personal Finance Problem annual profits by favorably changing its current cash conversion cycle by
LG 6 P5–61 Time to repay installment loan Mia Salto wishes to determine how long it will take 20 days?
to repay a loan with initial proceeds of $14,000 where annual end-of-year install-
ment payments of $2,450 are required. LG 2 P15–3 Multiple changes in cash conversion cycle Garrett Industries turns over its inven-
a. If Mia can borrow at a 12% annual rate of interest, how long will it take for her tory six times each year; it has an average collection period of 45 days and an
to repay the loan fully? average payment period of 30 days. The firm’s annual sales are $3 million. Assume
b. How long will it take if she can borrow at a 9% annual rate? there is no difference in the investment per dollar of sales in inventory, receivables,
c. How long will it take if she has to pay 15% annual interest? and payables; and assume a 365-day year.
d. Reviewing your answers in parts a, b, and c, describe the general relationship a. Calculate the firm’s cash conversion cycle, its daily cash operating expenditure,
between the interest rate and the amount of time it will take Mia to repay the and the amount of resources needed to support its cash conversion cycle.
loan fully.
 CHAPTER 15 Working Capital and Current Assets Management 635 636 PART 7 Short-Term Financial Decisions

b. Find the firm’s cash conversion cycle and resource investment requirement if it c. Determine the reorder point.
makes the following changes simultaneously. d. Indicate which of the following variables change if the firm does not hold the
(1) Shortens the average age of inventory by 5 days. safety stock: (1) order cost, (2) carrying cost, (3) total inventory cost, (4) reorder
(2) Speeds the collection of accounts receivable by an average of 10 days. point, (5) economic order quantity. Explain.
(3) Extends the average payment period by 10 days.
c. If the firm pays 13% for its resource investment, by how much, if anything, Personal Finance Problem
could it increase its annual profit as a result of the changes in part b? LG 3 P15–7 Marginal costs Jimmy Johnson is interested in buying a new Jeep SUV. There are
d. If the annual cost of achieving the profit in part c is $35,000, what action would two options available, a V-6 model and a V-8 model. Whichever model he chooses,
you recommend to the firm? Why? he plans to drive it for a period of 5 years and then sell it. Assume that the trade-in
value of the two vehicles at the end of the 5-year ownership period will be identical.
LG 2 P15–4 Aggressive versus conservative seasonal funding strategy Dynabase Tool has fore- There are definite differences between the two models, and Jimmy needs to
cast its total funds requirements for the coming year as shown in the following table. make a financial comparison. The manufacturer’s suggested retail price (MSRP) of
the V-6 and V-8 are $30,260 and $44,320, respectively. Jimmy believes the differ-
Month Amount Month Amount ence of $14,060 to be the marginal cost difference between the two vehicles.
However, there is much more data available, and you suggest to Jimmy that his
January $2,000,000 July $12,000,000 analysis may be too simple and will lead him to a poor financial decision. Assume
February 2,000,000 August 14,000,000 that the prevailing discount rate for both vehicles is 5.5% annually. Other pertinent
March 2,000,000 September 9,000,000 information on this purchase is shown in the following table:
April 4,000,000 October 5,000,000
May 6,000,000 November 4,000,000
June 9,000,000 December 3,000,000 V-6 V-8

MSRP $30,260 $44,320

a. Divide the firm’s monthly funds requirement into (1) a permanent component Engine (liters) 3.7 5.7
and (2) a seasonal component, and find the monthly average for each of these Cylinders 6 8
components. Depreciation over 5 years $17,337 $25,531
b. Describe the amount of long-term and short-term financing used to meet the Finance charges* over entire 5-year period $5,171 $7,573
total funds requirement under (1) an aggressive funding strategy and (2) a Insurance over 5 years $7,546 $8,081
conservative funding strategy. Assume that, under the aggressive strategy, long- Taxes and fees over 5 years $2,179 $2,937
term funds finance permanent needs and short-term funds are used to finance Maintenance/repairs over 5 years $5,600 $5,600
seasonal needs. Average miles per gallon 19 14
c. Assuming that short-term funds cost 12% annually and that the cost of long- Ownership period in years 5 5
term funds is 17% annually, use the averages found in part a to calculate the Miles driven per year over 5 years 15,000 15,000
total cost of each of the strategies described in part b. Cost per gallon of gas over 5-year ownership $3.15 $3.15
d. Discuss the profitability–risk trade-offs associated with the aggressive strategy *The finance charges are the difference between the total principal and interest paid over the
and those associated with the conservative strategy. entire 5-year period less the actual cost of the SUV. Assuming an annual 5.5% discount rate
over each of the 5 years and the respective present values of $30,260 for the V-6 and $44,320
for the V-8, the annual annuity payments are $7,086.20 and $10,379.70, respectively. [V-6:
LG 3 P15–5 EOQ analysis Tiger Corporation purchases 1,200,000 units per year of one com- (5 * $7,086.20) - $30,260 = $5,171, and V-8: (5 * $10,379.70) - $44,320 = $7,573]
ponent. The fixed cost per order is $25. The annual carrying cost of the item is 27%
of its $2 cost.
a. Determine the EOQ under each of the following conditions: (1) no changes, a. Calculate the total “true” cost for each vehicle over the 5-year ownership period.
(2) order cost of zero, and (3) carrying cost of zero. b. Calculate the total fuel cost for each vehicle over the 5-year ownership period.
b. What do your answers illustrate about the EOQ model? Explain. c. What is the marginal fuel cost from purchasing the larger V-8 SUV?
d. What is the marginal cost of purchasing the larger and more expensive V-8 SUV?
LG 3 P15–6 EOQ, reorder point, and safety stock Alexis Company uses 800 units of a product e. What is the total marginal cost associated with purchasing the V-8 SUV? How
per year on a continuous basis. The product has a fixed cost of $50 per order, and its does this figure compare with the $14,060 that Jimmy calculated?
carrying cost is $2 per unit per year. It takes 5 days to receive a shipment after an order
is placed, and the firm wishes to hold 10 days’ usage in inventory as a safety stock. LG 4 P15–8 Accounts receivable changes without bad debts Tara’s Textiles currently has credit
a. Calculate the EOQ. sales of $360 million per year and an average collection period of 60 days. Assume
b. Determine the average level of inventory. (Note: Use a 365-day year to calculate that the price of Tara’s products is $60 per unit and that the variable costs are $55
daily usage.) per unit. The firm is considering an accounts receivable change that will result in a
20% increase in sales and a 20% increase in the average collection period. No
 CHAPTER 15 Working Capital and Current Assets Management 637 638 PART 7 Short-Term Financial Decisions

change in bad debts is expected. The firm’s equal-risk opportunity cost on its invest- change in credit terms is expected to increase sales to $510,000. Bad-debt expenses
ment in accounts receivable is 14%. (Note: Use a 365-day year.) will increase from 1% to 1.5% of sales. The firm has a required rate of return on
a. Calculate the additional profit contribution from sales that the firm will realize if equal-risk investments of 20%. (Note: Assume a 365-day year.)
it makes the proposed change. a. What additional profit contribution from sales will be realized from the pro-
b. What marginal investment in accounts receivable will result? posed change?
c. Calculate the cost of the marginal investment in accounts receivable. b. What is the cost of the marginal investment in accounts receivable?
d. Should the firm implement the proposed change? What other information would c. What is the cost of the marginal bad debts?
be helpful in your analysis? d. Do you recommend this change in credit terms? Why or why not?

LG 4 P15–9 Accounts receivable changes with bad debts A firm is evaluating an accounts receiv- LG 6 P15–14 Float Simon Corporation has daily cash receipts of $65,000. A recent analysis of its
able change that would increase bad debts from 2% to 4% of sales. Sales are currently collections indicated that customers’ payments were in the mail an average of 2.5
50,000 units, the selling price is $20 per unit, and the variable cost per unit is $15. As days. Once received, the payments are processed in 1.5 days. After payments are
a result of the proposed change, sales are forecast to increase to 60,000 units. deposited, it takes an average of 3 days for these receipts to clear the banking system.
a. What are bad debts in dollars currently and under the proposed change? a. How much collection float (in days) does the firm currently have?
b. Calculate the cost of the marginal bad debts to the firm. b. If the firm’s opportunity cost is 11%, would it be economically advisable for the
c. Ignoring the additional profit contribution from increased sales, if the proposed firm to pay an annual fee of $16,500 to reduce collection float by 3 days?
change saves $3,500 and causes no change in the average investment in accounts Explain why or why not.
receivable, would you recommend it? Explain.
d. Considering all changes in costs and benefits, would you recommend the pro- LG 6 P15–15 Lockbox system Eagle Industries feels that a lockbox system can shorten its accounts
posed change? Explain. receivable collection period by 3 days. Credit sales are $3,240,000 per year, billed on a
e. Compare and discuss your answers in parts c and d. continuous basis. The firm has other equally risky investments that earn a return of
15%. The cost of the lockbox system is $9,000 per year. (Note: Assume a 365-day year.)
LG 4 P15–10 Relaxation of credit standards Lewis Enterprises is considering relaxing its credit a. What amount of cash will be made available for other uses under the lockbox
standards to increase its currently sagging sales. As a result of the proposed relax- system?
ation, sales are expected to increase by 10% from 10,000 to 11,000 units during the b. What net benefit (cost) will the firm realize if it adopts the lockbox system?
coming year; the average collection period is expected to increase from 45 to 60 Should it adopt the proposed lockbox system?
days; and bad debts are expected to increase from 1% to 3% of sales. The sale price
per unit is $40, and the variable cost per unit is $31. The firm’s required return on LG 6 P15–16 Zero-balance account Union Company is considering establishment of a zero-
equal-risk investments is 25%. Evaluate the proposed relaxation, and make a recom- balance account. The firm currently maintains an average balance of $420,000 in
mendation to the firm. (Note: Assume a 365-day year.) its disbursement account. As compensation to the bank for maintaining the zero-
balance account, the firm will have to pay a monthly fee of $1,000 and maintain a
LG 5 P15–11 Initiating a cash discount Gardner Company currently makes all sales on credit and $300,000 non–interest-earning deposit in the bank. The firm currently has no other
offers no cash discount. The firm is considering offering a 2% cash discount for pay- deposits in the bank. Evaluate the proposed zero-balance account, and make a rec-
ment within 15 days. The firm’s current average collection period is 60 days, sales are ommendation to the firm, assuming that it has a 12% opportunity cost.
40,000 units, selling price is $45 per unit, and variable cost per unit is $36. The firm
expects that the change in credit terms will result in an increase in sales to 42,000 units, Personal Finance Problem
that 70% of the sales will take the discount, and that the average collection period will LG 6 P15–17 Management of cash balance Alexis Morris, an assistant manager at a local
fall to 30 days. If the firm’s required rate of return on equal-risk investments is 25%, department store, gets paid every 2 weeks by direct deposit into her checking
should the proposed discount be offered? (Note: Assume a 365-day year.) account. This account pays no interest and has no minimum balance requirement.
Her monthly income is $4,200. Alexis has a “target” cash balance of around
LG 5 P15–12 Shortening the credit period A firm is contemplating shortening its credit period $1,200, and whenever it exceeds that amount she transfers the excess into her sav-
from 40 to 30 days and believes that, as a result of this change, its average collection ings account, which currently pays 2.0% annual interest. Her current savings bal-
period will decline from 45 to 36 days. Bad-debt expenses are expected to decrease ance is $15,000, and Alexis estimates she transfers about $500 per month from her
from 1.5% to 1% of sales. The firm is currently selling 12,000 units but believes checking account into her savings account. Alexis doesn’t waste any time in paying
that as a result of the proposed change, sales will decline to 10,000 units. The sale her bills, and her monthly bills average about $2,000. Her monthly cash outlay for
price per unit is $56, and the variable cost per unit is $45. The firm has a required food, gas, and other sundry items totals about $850. Reviewing her payment habits
return on equal-risk investments of 25%. Evaluate this decision, and make a recom- indicates that on average she pays her bills 9 days early. At this time, most mar-
mendation to the firm. (Note: Assume a 365-day year.) ketable securities are yielding about 4.75% annual interest.
Show how Alexis can better manage her cash balance.
LG 5 P15–13 Lengthening the credit period Parker Tool is considering lengthening its credit a. What can Alexis do regarding the handling of her current balances?
period from 30 to 60 days. All customers will continue to pay on the net date. The b. What do you suggest that she do with her monthly surpluses?
firm currently bills $450,000 for sales and has $345,000 in variable costs. The
 CHAPTER 15 Working Capital and Current Assets Management 639

c. What do you suggest Alexis do about the manner in which she pays her bills?
d. Can Alexis grow her earnings by better managing her cash balances? Show your
work.

LG 6 P15–18 ETHICS PROBLEM A group of angry shareholders has placed a corporate resolu-
tion before all shareholders at a company’s annual stockholders’ meeting. The reso-
lution demands that the company stretch its accounts payable, because these
shareholders have determined that all of the company’s competitors do so, and the
firm operates in a highly competitive industry. How could management at the
annual stockholders’ meeting defend the firm’s practice of paying suppliers on time?

Spreadsheet Exercise
The current balance in accounts receivable for Eboy Corporation is $443,000. This
level was achieved with annual (365 days) credit sales of $3,544,000. The firm offers
its customers credit terms of net 30. However, in an effort to help its cash flow posi-
tion and to follow the actions of its rivals, the firm is considering changing its credit
terms from net 30 to 2/10 net 30. The objective is to speed up the receivable collec-
tions and thereby improve the firm’s cash flows. Eboy would like to increase its
accounts receivable turnover to 12.0.
The firm works with a raw material whose current annual usage is 1,450 units.
Each finished product requires one unit of this raw material at a variable cost of
$2,600 per unit and sells for $4,200 on terms of net 30. It is estimated that 70% of
the firm’s customers will take the 2% cash discount and that, with the discount, sales
of the finished product will increase by 50 units per year. The firm’s opportunity cost
of funds invested in accounts receivable is 12.5%
In analyzing the investment in accounts receivable, use the variable cost of the
product sold instead of the sale price, because the variable cost is a better indicator of
the firm’s investment.

TO DO
Create a spreadsheet similar to Table 15.3 to analyze whether the firm should initiate
the proposed cash discount. What is your advice? Make sure you calculate the fol-
lowing:
a. Additional profit contribution from sales.
b. Average investment in accounts receivable at present (without cash discount).
c. Average investment in accounts receivable with the proposed cash discount.
d. Reduction in investment in accounts receivable.
e. Cost savings from reduced investment in accounts receivable.
f. Cost of the cash discount.
g. Net profit (loss) from initiation of proposed cash discount.

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