Module 12 (Ch 12) Homework
Module 12 (Ch 12) Homework
Due Sunday by 11:59pm Points 10 Submitting a file upload
Available until Apr 19 at 11:59pm
Submit Assignment
Create an Excel spreadsheet to organize your answers to the following problem, and
submit your Excel file as an attachment by clicking on the appropriate button on this
page.
A company with annual sales of $22,000,000 is considering changing its payment terms from
net 40 to net 30 to encourage customers to pay more promptly. The company forecasts that
customers would respond by paying on day 32 rather than day 44 as at present (assume a 360
day year) but would decrease their purchases by $400,000 per year. The company also
forecasts that its idle cash balance would decrease by $80,000 and administrative costs would
e reduced by $30,000 per year. The company's variable costs average 62% of sales, it is in
the 35% marginal tax
acket, and it has an 8% cost of capital.
Part A: Calculate the incremental cash flows from accepting this proposal, and organize your
cash flows into a cash flow spreadsheet.
Part B: Calculate the proposal's NPV, IRR, and NAB.
Part C: Should the company shorten its payment terms?
Fin 310
Study Guide
Chapter 12
Investing in Permanent Working Capital
Summary of Key Concepts of the Chapte
The General Format. In this chapter we are talking about investing in working capital that is considered permanent under the assumption that we will continuously need this working capital in order to operate our business in the most profitable way possible. Because these investments are considered permanent, we can then eliminate the far right-hand column for future value that we had in our previous capital budgeting problems. This being the case, then, our cash flow worksheet will look something like this:
Time Zero
Years 1 – Infinity
Investments in W/C
Operating Cash Flows
Change in A/R
Administrative costs
Profit on change in collection period
Bad debts
Othe
Contribution margin on sales
Discounts
Tax on all of above
Total
Total
Before we look at the details of each of the line items in the worksheet, we need to realize that the items in the left column are proposed cash flows that will happen today and are not taxable, because spending or receiving money or other assets is never, by itself, a taxable event. But the items on the right are expected to happen each year, and they are taxable events because they represent increases or decreases in revenue or expenses. Also, it is important to note that not all of these items will pertain to all of the problems we will be working with. They are provided here only to remind us that we need to at least think about whether any of these apply for our particular situation. Now let us take a look at each of the line items specifically.
· Change in Accounts Receivable. Many of the working capital investments we will be concerned with propose to increase or decrease the investment in accounts receivable by changing credit terms or by offering discounts for early payment, or by changing collection policies and procedures. In this regard, please remember that we are dealing in this left-hand column of the worksheet with the effect that these changes in accounts receivable will have on cash. We are not, in the worksheet itself, dealing with changes in accounts receivable. This is, after all, a cash flow worksheet, and therefore only deals with changes in cash flows, not other assets. Accordingly any increase in accounts receivable would go into this column of the worksheet as a negative amount because it uses cash, and any decrease in accounts receivable would be entered as a positive number because such a change would increase the amount of cash coming into the company.
Because the calculations in this area are fraught with possibilities for e
ors, let's look at an example. Let's say that we decrease our average collection period from 40 days to 30 days in order to reduce our investment in accounts receivable, and this tightening in credit terms reduces our sales from $5 million to $4.9 million. And furthermore, let us assume that we have a variable cost percentage of 70%. Here is the calculation of the number that would go into the cash flow worksheet for the first item on the left-hand side.
Average Daily
Sales
Number of Days
Variable Cost %
A/R Level
Old sales level
5,000,000/360
40
70%
388,889
New sales level
4,900,000/360
30
70%
285,833
Net decrease in A/R
103,056
The $103,056 from the table above would then be entered into the cash flow worksheet as a positive cash flow at time zero.
· Profit on Change in Collection Period. The next line item on the cash flow worksheet is what I like to call the complement of the first line item. It is on this line that we put the profit portion (30% rather than the 70% cost figure used previously) of the change in accounts receivable that is
ought about by the action being proposed. Based on the numbers from the previous example above, this amount would be calculated as follows:
Average Daily
Sales
Number of Days
Variable Cost %
A/R Level
New sales level
4,900,000/360
40-30 = 10
30%
40,833
This $40,833 decrease in the accounts receivable balance will also be entered into the cash flow worksheet as a positive cash flow at time zero.
· Other. This third line item in the left-hand column of the worksheet is for any other increase or decrease in the balances of any other working capital accounts that occur as a result of the proposed change under consideration.
· Administrative Costs. Moving to the right-hand side of the cash flow worksheet we deal with the possibility of items that are changes in revenues or expenses, and are therefore taxable items. The first of these is an increase or decrease in administrative costs that is expected to result from the proposed action.
· Bad Debts. Next, we need to recognize the possibility that the change under consideration could affect the ability of our accounts receivable customers to pay their bills, so our bad debt expense may increase or decrease in accordance with these changes caused by the proposal under consideration. Continuing with our example from above, if our action under consideration is expected to increase bad debts from 2% to 2.2%, for example, we would calculate the change in bad debts as follows:
Sales
Bad Debt %
Bad Debts
Old policy
5,000,000
2.0%
100,000
New policy
4,900,000
2.2%
107,800
Net change in bad debts
7,800
· Contribution Margin on Sales. To the extent that our proposal is expected to increase or decrease our sales level, then we recognize this change on this line item in the worksheet. We basically multiply the increase or decrease in sales times the contribution margin percentage to get the amount needed for this line.
· Discounts. If the change under consideration entails a change in the discounts offered for prompt payment, then this will cause an increase or decrease in cash. If, for example, we offer a new 3% discount for paying within 10 days, and we estimate that 40% of our customers will choose to pay by the 10th day in order to get the discount, then we can calculate the cash flow from this change as follows:
4,900,000 X 0.40 X 0.03 = 58,800
· Tax on All Above Amounts. Since we have recorded all of the items (A, B, C, D) as gross numbers in the right-hand column of the worksheet, we will need to record the tax on the total of these amounts. This can be done by adding the numbers in A, B. C, and D, and then multiplying the total by the tax rate in order to show the tax effect on these items. The point here, of course, is that all the items on the right-hand side of the worksheet are taxable items, and the tax effect must therefore be recognized. If, of course, the items in A, B, C, and D were listed net of tax, then this final line item for taxes would not be necessary.
Please note that the example above constitutes what is called an “opposite project,” where the cash inflows come before the cash outflows. In a more usual investment situation, of course, the cash outflows come first, and then inflows come in the future. Also, please note that the working capital problems we deal with in this chapter are of both kinds. Recognizing this difference is especially important when we get around to calculating the internal rate of return for the project, as we will explain below.
The Three Methods. We will consider three common approaches to dealing with permanent working capital investments. All three of these methods take the time value of money into account, and they are all based on a process of comparing cash flows with the cost of capital that was so meticulously measured in the prior chapters, but the details of the calculations are different.
· Net Present Value. With this approach, we discount the future cash flows (in the right-hand column of the worksheet) back to the present at the required rate of return (the cost of capital) and then compare that number to the initial outlay of cash at time zero in the left-hand column of the worksheet. And the difference is what we call the net present value. If this number is positive, then we accept the project, and if it is negative, then we reject the project. Either the HP10BII calculator or Excel can be used in dealing with the math. Please note this the calculation itself should be fairly straightforward at this point since we have been doing these sorts of calculations throughout the semester. Please also note that the net cash flow in years 1 through infinity in the right-hand column of the worksheet is an annuity, so the PMT key on the calculator can be used.
· Internal Rate of Return. The internal rate of return is the rate of return that makes the NPV equal to zero. As with the NPV method above, the IRR can be found by using either the HP10BII calculator or Excel. The net cash flow in years 1 through infinity in the right-hand column of the worksheet is an annuity, so the PMT key on the calculator can be used. However, since the annual cash flows go on forever, a short-cut approach to finding the IRR would be to simply divide the