P15-1
P15–1 Cash conversion cycle American Products is concerned about managing cash efficiently. On average, inventories have an age of 80 days, and accounts receivable are collected in 40 days. Accounts payable are paid approximately 30 days after they arise. The firm has annual sales of about $30 million. Goods sold total $20 million, and purchases are $15 million.
a. Calculate the firm’s operating cycle. a XXXXXXXXXXPARTICULARS XXXXXXXXXXAMOUNT
Average inventories 90
Add: Average Account recievable 60
Firm 's operating cycle( days) 150
b. Calculate the firm’s cash conversion cycle. b XXXXXXXXXXPARTICULARS XXXXXXXXXXAMOUNT
Average inventories 90
Add: Average Account recievable 60
Firm 's operating cycle 150
Less:Average Accounts payable 30
Firm's cash conversion cycle 120
c. Calculate the amount of resources needed to support the firm’s cash conversion cycle. c XXXXXXXXXXPARTICULARS XXXXXXXXXXAMOUNT
Inventory 7,307,260.27
XXXXXXXXXX= (30,000,000 x 90/365)
Add: Accounts Recievable 4,931,506.85
4,931,506.85= (30,000,000 x 60/365)
Less: Accounts payable 2,465,753.42
2,465,753.42=(30,000,000 x 30/365)
Resources needed to support the firm CCC's 9,773,013.70
d. Discuss how management might be able to reduce the cash conversion cycle. d The cash conversion can be reduced by increasing the payable time and decreasing the recievable time or by the combination of both
P15-4
P15–4 Aggressive versus conservative seasonal funding strategy Dynabase Tool has forecast its total funds requirements for the coming year as shown in the following table.
Month Amount Month Amount
January $2,000,000 July $12,000,000
Fe
uary 2,000,000 August 14,000,000
March 2,000,000 September 9,000,000
April 4,000,000 October 5,000,000
May 6,000,000 November 4,000,000
June 9,000,000 December 3,000,000
a. Divide the firm’s monthly funds requirement into (1) a permanent component and (2) a seasonal component, and find the monthly average for each of these components.
a Average permanent requirement = $24,000,000 / 12 = $2,000,000 $2,000,000.00
Average seasonal requirement = $48,000,000 / 12 = $4,000,000 $4,000,000.00
b. Describe the amount of long-term and short-term financing used to meet the total funds requirement under (1) an aggressive funding strategy and (2) a conservative funding strategy. Assume that, under the aggressive strategy, long-term funds finance permanent needs and short-term funds are used to finance seasonal needs.
b Aggressive funding strategy :
It will finance seasonal needs with short-term funding, so amount will be $4,000,000 as calculated in part a. And the permanent needs will be financed with long term funds and the amount will be $2,000,000
Conservative funding strategy :
It will finance the highest requirement level i.e. $14,000,000 with long-term debt.
c. Assuming that short-term funds cost 5% annually and that the cost of long-term funds is 10% annually, use the averages found in part a to calculate the total cost of each of the strategies described in part b. Assume that the firm can earn 3% on any excess cash balances.
c Aggressive = 2,000,000 * 10% + 4,000,000 * 5%
Aggressive Strategy $400,000.00
Conservative Strategy = Peak Level * 10% = $14,000,000 * 10%
Conservative Strategy $1,400,000.00
d. Discuss the profitability–risk tradeoffs associated with the aggressive strategy and those associated with the conservative strategy.
d In the given case, there is a huge difference in cost associated with aggressive strategy and conservative strategy. The conservative strategy is almost three times more expensive as compared to aggressive strategy, which makes aggressive strategy more attractive. Thus, aggressive strategy is more profitable and also more risky because the firm may face shortage of funds in future if the requirement suddenly increases and in such case it may not be able to gather the required funds.
The firm has to pay interest on idle funds (net 7%) in case of conservative strategy which makes it more expensive. But it is also safer, because it would have ample funds to meet any kind of contingency.
P15-15
P15–15 Lockbox system Eagle Industries believes that a lockbox system can shorten its accounts receivable collection period by 3 days. Credit sales are $3,240,000 per year, billed on a 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.)
a. What amount of cash will be made available for other uses under the lockbox system?
a amount of cash=annual credit sales *3/365
3,240,000* 3/365
XXXXXXXXXX
b. What net benefit (cost) will the firm realize if it adopts the lockbox system? Should it adopt the proposed lockbox system?
net benefit( cost)=available cash x rate of return-cost of lock box
XXXXXXXXXX
Thus, the net cost of the lock box os $5, XXXXXXXXXXThe proposed plan is not beneficial , thus, it should not be adopted
P16-2
P16–2 Cost of giving up early payment discounts Determine the cost of giving up the discount under each of the following terms of sale. (Note: Assume a 365-day year.)
a. 2/10 net 30. a. 2/10 means 2% discount for payment made within 10 days, otherwise payable in full by days 30
so discount % = 2%
discount days = 10
payment days = 30
cost of giving up discount = 2%/(1-2%)*365/(30-10)
37.24%
b 1/10 net 30.
b. 1/10 net 30. cost of giving up discount = 1%/(1-1%)*365/(30-10)
18.43%
c. 1/10 net 45. c. 1/10 net 45.
cost of giving up discount = 1%/(1-1%)*365/(45-10)
10.53%
d. 3/10 net 90. d. 3/10 net 90
cost of giving up discount = 3%/(1-3%)*365/(90-10)
14.11%
e. 1/10 net 60. e. 1/10 net 60.
cost of giving up discount = 1%/(1-1%)*365/(60-10)
7.37%
f. 3/10 net 30. f. 3/10 net 30.
cost of giving up discount = 3%/(1-3%)*365/(30-10)
56.44%
g. 4/10 net 180. g. 4/10 net 180.
cost of giving up discount = 4%/(1-4%)*365/(180-10)
8.95%
Kanton Company
KANTON COMPANY
Morton Mercado, the CFO of Kanton Company, carefully developed the estimates of the firm's total funds requirements for the coming year. These are shown in the following table:
Month Total Funds Month Total Funds
January $1,000,000 July $6,000,000
Fe
uary $1,000,000 August $5,000,000
March $2,000,000 September $5,000,000
April $3,000,000 October $4,000,000
May $5,000,000 November $2,000,000
June $7,000,000 December $1,000,000
In addition, Morton expects short-term financing costs of about 10% and long-term financing costs of about 14% during that period. He developed the three possible financing strategies that follow:
Strategy 1 - Aggressive: Finance seasonal needs with short-term finds and permanent needs with long-term funds.
Strategy 2 - Conservative: Finance an amount equal to the peak need with long-term funds and use short-term funds only in an emergency.
Strategy 3 - Tradeoff: Finance $3,000,000 with long-term funds and finance the remaining funds requirements with short-term funds.
Using data on the firm's total funds requirements, Morton estimated the average annual short-term and long-term financing requirements for each strategy in the coming year, as shown in the following table.
AVERAGE ANNUAL FINANCING
Type of Financing Strategy 1 Aggressive Strategy 2 Conservative Strategy 3 Tradeoff
Short-term $2,500,000 $0 $1,666,667
Long-term $1,000,000 $7,000,000 $3,000,000
To ensure that, along with spontaneous financing from accounts payable and accruals, adequate short-term financing will be available, Morton plans to establish an unsecured short-term bo
owing a
angement with its local bank, Third National. The bank has offered either a line-of-credit agreement or a revolving credit agreement. Third National's terms for a line of credit are an interest rate of 2.50% above the prime rate, and the bo
owing must be reduced to zero for a 30-day period during the year. On an equivalent revolving credit agreement, the interest rate would be 3% above prime with a commitment fee of 0.50% on the average unused balance.
Under both loans, a compensating balance equal to 20% of the amount bo
owed would be required. The prime rate is cu
ently 7%. Both the line-of-credit agreement and the revolving credit agreement would have bo
owing limits of $1,000,000. For purposes of his analysis, Morton estimates that Kanton will bo
ow $600,000 on the average during the year, regardless of which financing strategy and loan a
angement it chooses. (Note: assume a 365-day year.)
Case Study Questions:
a. Determine the total annual cost of each of the three possible financing strategies.
b. Assuming that the firm expects its cu
ent assets to total $4 million throughout the year, determine the average amount of net working capital under each financing strategy. (Hint: Cu
ent liabilities equal average short-term financing.)
c. Using the net working capital found in part b as a measure of risk, discuss the profitability-risk trade-off associated with each financing strategy. Which strategy would you recommend to Morton Mercado for Kanton Company? Why?
d. Find the effective annual rate under: 1) the line-of-credit agreement and 2) the revolving credit agreement. (Hint: Find the ratio of the dollars that the firm will pay in interest and commitment fees to the dollars that the firm will effectively have use of.)
e. If the firm expects to bo
ow an average of $600,000, which bo
owing a
angement would you recommend to Kanton? Why?
Answers
a Total annual cost under each financing strategies:
Particulars Type of Financing Total Annual Cost
Short Term Long Term
Finance Cost 10% 14%
Average Funds used under following strategies
Strategy 1 Aggressive $2,500,000.00 $1,000,000.00
Strategy 2 Conservative $0.00 $7,000,000.00
Strategy 3 Tradeoff $1,666,667.00 $3,000,000.00
Total Annual Cost Average funds used * Finance Rate Average funds used * Finance Rate
Strategy 1 Aggressive $250,000.00 $140,000.00 $390,000.00
Strategy 2 Conservative $0.00 $980,000.00 $980,000.00
Strategy 3 Tradeoff $166,666.70 $420,000.00 $586,666.70
b. Net working capital
Particulars Strategy 1 Aggressive Strategy 2 Conservative Strategy 3 Tradeoff
Cu
ent Asset $4,000,000.00 $4,000,000.00 $4,000,000.00
Short Term Bo
owings i.e. Cu
ent Liabilities $2,500,000.00 $0.00 $1,666,667.00
Net Working Capital = Cu
ent Assets - Cu
ent Liabilities $1,500,000.00 $4,000,000.00 $2,333,333.00
c Profitability-risk trade-off associated with each financing strategy.
Strategy Profitability-risk and Strategy to select
Strategy 1 Aggressive Average Working Capital is on 1,500,000 under the Strategy 1 Aggressive. This working capital is not sufficient as Only Short term bo
owing is adjusted. Company might have other liabilities too. Thus Company may not be able to pay off them. Thus, I would not recommend this strategy to the Company
Strategy 2 Conservative Average Working Capital is on 4,000,000 under the Strategy 2 Conservative. Under this strategy, company will have the highest working capital amongst the all 3. This is also not ideal as the working capital is in excess and risk is associated with that too. Thus, I would not recommend this strategy