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WC Review Examples

The document provides information to calculate key financial metrics like cash conversion cycle, incremental profit from extending credit terms, and optimal order quantity. It includes examples of companies analyzing inventory levels, accounts receivable, credit terms, sales, costs, and profits to optimize cash flow and reduce costs.

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97 views17 pages

WC Review Examples

The document provides information to calculate key financial metrics like cash conversion cycle, incremental profit from extending credit terms, and optimal order quantity. It includes examples of companies analyzing inventory levels, accounts receivable, credit terms, sales, costs, and profits to optimize cash flow and reduce costs.

Uploaded by

buse3ergin
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CORPORATE FINANCE

PROBLEMS & SOLUTIONS


A/R MANAGEMENT
• Jordan Air Inc. has average inventory of $1,000,000. Its estimated
annual sales are 15 million and the firm estimates its receivables
collection period to be twice as long as its average age of inventory.
The firm pays its trade credit on time; its terms are net 30. The firm
wants to decrease its cash conversion cycle by 10 days. It believes
that it can reduce its average inventory to $900,000. Assume a 360-
day year and that sales will not change. Cost of goods sold equal 80
percent of sales. By how much must the firm also reduce its accounts
receivable to meet its goal of a 10-day reduction?
• AAI = 360 days/ [($15 million 0.80)/$1 million)] = 30 days.
• ACP = 2.0 AAI = 60 days.
• Solve for accounts receivable:
• ACP = 60 = Receivable accounts/Sales per day
• = (A/R)/($15/360) = $2.5 million.
• Calculate new AAI, change in CCC, and new ACP required to meet goal:
• New AAI = 360/($12/0.9) = 360/13.333 = 27 days.
• Net change in AAI = -3 days.
• Total change in CCC required = 10 days.
• Reduction in ACP needed = 10 - 3 = 7 days.
• New ACP required = 60 - 7 = 53 days.
• Solve for new receivables level:
• ACP = 53 = [(A/R)/($15,000,000/360)]
• A/R = 53 $41,666.67 = $2,208,333.
• Old A/R = $2,500,000. New A/R = $2,208,333.
• Reduction required in A/R = $2,500,000 - $2,208,333 = $291,667.
1. You have recently been hired to improve the performance of Multiplex Corporation which
has been experiencing a severe cash shortage. As one part of your analysis, you want to
determine the firm's cash conversion cycle. Using the following information and a 360-day
year, what is your estimate of the firm's current cash conversion cycle?
Current inventory = $120,000
Annual sales = $600,000
Accounts receivable = $160,000
Accounts payable = $25,000
Total annual purchases = $360,000
Purchases credit terms: net 30 days
Receivables credit terms: net 50 days
Calculate each of the three main components of the cash conversion cycle:
Inventory conversion period (ICP):

Receivables collection period (RCP):

Payables deferral period (PDP):

Cash conversion cycle (CCC):


CCC = ICP + RCP - PDP = 120 + 96 - 25 = 191 days.
Bass Boats Inc. currently has sales of $1,000,000, and its days sales outstanding is 30 days. The
financial manager estimates that offering longer credit terms would (1) increase the days sales
outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt losses, which
were 2 percent on the old sales, would amount to 5 percent on the incremental sales only (bad
debts on the old sales would stay at 2 percent). Variable costs are 80 percent of sales, and Bass
has a 15 percent receivables financing cost. What would the annual incremental pre-tax profit be
if Bass extended its credit period?
DSO0 = 30 days; DSON = 50 days.
No discounts.
Calculate cost of carrying receivables at current and new sales levels:
Cost of carrying receivables = DSO(Sales/Day)(Variable cost ratio)(Cost of funds)
Sales at $1,000,000:
30($1,000,000/360)(0.8)(0.15) = $10,000.
Sales at $1,200,000:
50($1,200,000/360)(0.8)(0.15) = $20,000.
Analysis of policy change:
Current Effect of Credit New
Projections Policy Change Projections
Net sales $1,000,000 $200,000 $1,200,000
Production costs (800,000) (160,000) (960,000)
Profit before credit costs $ 200,000 $ 40,000 $ 240,000
Cost of carrying receivables (10,000) (10,000) (20,000)
Bad debt losses* (20,000) (10,000) (30,000)

Pre-tax profits $ 170,000 $ 20,000 $ 190,000


*
Bad debt losses old: $1,000,000(0.02) = $20,000.
Bad debt losses new: $1,000,000(0.02) + $200,000(0.05) = $30,000.
The annual incremental pre-tax profit with the change in policy is $20,000.
3. Aberwald Corporation expects to order 126,000 memory chips for inventory during the
coming year, and it will use this inventory at a constant rate. Fixed ordering costs are $200
per order; the purchase price per chip is $25; and the firm's inventory carrying cost is equal to
20 percent of the purchase price. (Assume a 360-day year.)
• If Aberwald holds a safety stock equal to a 30-day supply of chips, what is its average inventory
level?

Average inventory level =

= 1,587.50 + 10,500 = 12,087.50 12,088.

• How many orders should Aberwald place during the year?

Number of orders = = 39.69 40.


• If the lead time for placing an order is 5 days, and Aberwald holds a safety stock equal to a
30-day supply of chips, then at what inventory level should an order be placed?

• Reorder point = = 1,750 + 10,500 = 12,250.

• If Aberwald holds a safety stock equal to a 30-day supply of chips, what is Aberwald's
minimum cost of ordering and carrying inventory?

Average inventory is rounded to 12,088 = EOQ/2 + (126,000/360)(30).


Number of orders is rounded to 40 126,000/3,175.
Total cost = 40($200) + ($12,088)($25)(0.20) = $68,440.

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