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# TEXTBOOK: Erhardt & Brigham XXXXXXXXXXCorporate Finance (6th Edition). South-Western Textbook Readings: Chapter 4 - Time Value of Money Chapter 16 - Working Capital Management Chapter Problems 4 Mini...

### TEXTBOOK:

Erhardt & Brigham XXXXXXXXXXCorporate Finance (6th Edition). South-Western

Chapter 4 - Time Value of Money

Chapter 16 - Working Capital Management

 Chapter Problems 4 Mini Case Page XXXXXXXXXXPoints 16 Chapter 16 - Mini Case - 100
Answered Same Day Mar 29, 2020

## Solution

Shakeel answered on Apr 01 2020
a. Johnson plans to use the preceding ratios as the starting point for discussions with RRâ€™s operating team. She wants everyone to think about the pros and cons of changing each type of cu
ent asset and how changes would interact to affect profits and EVA. Based on the data, does RR seem to be following a relaxed, moderate, or restricted working capital policy?
There are few ratios like cu
ent ratio, quick ratio, inventory turnover ratio, DSO etc that reflect the firmâ€™s working capital policy. From the given such data, it is concluded that RR has large amounts of working capital relative to its level of sales. Thus, RR is following a relaxed policy.
. How can one distinguish between a relaxed but rational working capital policy and a situation in which a firm simply has excessive cu
ent assets because it is inefficient? Does RRâ€™s working capital policy seem appropriate?
A relaxed policy helps to reduce the risk inherited with the business operation rather than reducing its profitability. The profitability position of RR is poor than the Industryâ€™s average. Therefore the company probably has excessive working capital.
c. Calculate the firmâ€™s cash conversion cycle given annual sales are \$660,000 and cost of goods sold are 90% of sales. Assume a 365-day year.
Need to determine the amount of inventory from the firm's inventory turnover ratio. Then, one can calculate the inventory conversion period from the data given in the problem.
Annual sales =     \$660,000
COGS/sales =     90%
Inventory turnover =    Sales/Inventory
12.00    = \$660,000 / Inventory
Inventory = \$55,000
COGS    = 0.90    Ã— Sales
COGS    = 0.90    Ã— \$660,000
COGS    = \$594,000
Inventory conversion period     = Inventory / Daily COGS
= \$55,000 / \$1,627.40
= 33.8    days
Cash Conversion cycle (CCC) = Inventory conversion period + Average collection period    â€“                     Payables Defe
al Period
CCC    = 33.8    + 45.6    â€“ 30
CCC    = 49.4
d. Is there any reason to think that RR may be holding too much inventory?
RR's inventory turnover is 12 while that of Industry is 20. Therefore, Industry turnover of RR is much lower than Industry. The inventory ca
ying cost per dollar of sales for RR is much higher. So, on holding the excessive inventory, firmâ€™s operating costs are increasing that ultimately reduces its NOPAT. Holding too much inventory might be due to the reason of meeting the expected sales or against the speculation of higher inventory price in future.
e. If RR reduces its inventory without adversely affecting sales, what effect should this have on free cash flow: (1) in the short run and (2) in the long run?
Effect -
Short run: As the purchase of inventory declines, the cash will increase.
Long run: Company will hold less cash with better cash and inventory management plicy.
f. Johnson knows that RR sells on the same credit terms as other firms in its industry. Use the ratios presented earlier to explain whether RRâ€™s customers pay more or less promptly than those of its competitors. If there are differences, does that suggest RR...
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