Discussion Questions
1. In the management of cash and marketable securities, why should the primary concern be for safety and liquidity rather than maximization of profit?
2. Explain the similarities and differences of lockbox systems and regional collection offices.
3. Why would a financial manager want to slow down disbursements?
4. Use The Wall Street Journal or some other financial publication to find the going interest rates for the list of marketable securities in Table 7-1.
Which security would you choose for a short-term investment? Why?
5. Why are Treasury bills a favorite place for financial managers to invest excess cash?
6. Explain why the bad debt percentage or any other similar credit-control percentage is not the ultimate measure of success in the management of accounts receivable. What is the key consideration?
7. What are three quantitative measures that can be applied to the collection policy of the firm?
8. What are the 5 Cs of credit that are sometimes used by bankers and others to determine whether a potential loan will be repaid?
9. What does the EOQ formula tell us? What assumption is made about the usage rate for inventory?
10. Why might a firm keep a safety stock? What effect is it likely to have on carrying cost of inventory?
11. Why might a firm keep a safety stock? What effect is it likely to have on carrying cost of inventory?
Problems
1. City Farm Insurance has collection centers across the country to speed up collections. The company also makes its disbursements from remote disbursement centers. The collection time has been reduced by two days and disbursement time increased by one day because of these policies. Excess funds are being invested in short-term instruments yielding 12 percent per annum.
a. If City Farm has $5 million per day in collections and $3 million per day in disbursements, how many dollars has the cash management system freed up?
b. How much can City Farm earn in dollars per year on short-term investments made possible by the freed-up cash?
2. Nicholas Birdcage Company of Hollywood ships cages throughout the country. Nicholas has determined that through the establishment of local collection centers around the country, he can speed up the collection of payments by one and one-half days. Furthermore, the cash management department of his bank has indicated to him that he can defer his payments on his accounts by one-half day without affecting suppliers. The bank has a remote disbursement center in Florida.
a. If the company has $4 million per day in collections and $2 million per day in disbursements, how many dollars will the cash management system free up?
b. If the company can earn 9 percent per annum on freed-up funds, how much will the income be?
c. If the annual cost of the new system is $700,000, should it be implemented?
3. Megahurtz International Car Rentals has rent-a-car outlets throughout the world. It also keeps funds for transactions purposes in many foreign countries. Assume in 2003, it held 100,000 reals in Brazil worth 35,000 dollars. It drew 12 percent interest, but the Brazilian real declined 20 percent against the dollar.
a. What is the value of its holdings, based on U.S. dollars, at year-end (Hint: multiply $35,000 times 1.12 and then multiply the resulting value by 80 percent.)
b. What is the value of its holdings, based on U.S. dollars, at year-end if it drew 9 percent interest and the real went up by 10 percent against the dollar?
4. Thompson Wood Products has credit sales of $2,160,000 and accounts receivable of $288,000. Compute the value of the average collection period.
5. Lone Star Petroleum Co. has annual credit sales of $2,880,000 and accounts receivable of $272,000. Compute the value of the average collection period.
6. Knight Roundtable Co. has annual credit sales of $1,080,000 and an average collection period of 32 days in 2008. Assume a 360-day year. What is the company's average accounts receivable balance? Accounts receivable are equal to the average daily credit sales times the average collection period.
7. Darla's Cosmetics has annual credit sales of $1,440,000 and an average collection period of 45 days in 2008. Assume a 360-day year.
What is the company's average accounts receivable balance? Accounts receivable are equal to the average daily credit sales times the average collection period.
8. In Problem 7, if accounts receivable change to $200,000 in the year 2009, while credit sales are $1,800,000, should we assume the firm has a more or a less lenient credit policy?
9. Hubbell Electronic Wiring Company has an average collection period of 35 days. The accounts receivable balance is $105,000. What is the value of its credit sales?
10. Marv's Women's Wear has the following schedule for aging of accounts receivable.
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Age of Receivables, April 30, 2004
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(1)
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(2)
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(3)
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(4)
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Month of Sales
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Age of Account
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Amounts
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Percent of Amount Due
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April .................................
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0-30
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$ 88,000
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March ...............................
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31-60
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44,000
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February ...........................
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61-90
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33,000
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January .............................
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91-120
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55,000
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Total receivables ...........
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$220,000
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100%
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a. Fill in column (4) for each month.
b. If the firm had $960,000 in credit sales over the four-month period, compute the average collection period. Average daily sales should be based on a 120-day period.
c. If the firm likes to see its bills collected in 30 days, should it be satisfied with the average collection period?
d. Disregarding your answer to part c and considering the aging schedule for accounts receivable, should the company be satisfied?
e. What additional information does the aging schedule bring to the company that the average collection period may not show?
11. Nowlin Pipe & Steel has projected sales of 72,000 pipes this year, an ordering cost of
$6 per order, and carrying costs of $2.40 per pipe.
a. What is the economic ordering quantity?
b. How many orders will be placed during the year?
c. What will the average inventory be?
12. Howe Corporation is trying to improve its inventory control system and has installed an online computer at its retail stores. Howe anticipates sales of 126,000 units per year, an ordering cost of $4 per order, and carrying costs of $1.008 per unit.
a. What is the economic ordering quantity?
b. How many orders will be placed during the year?
c. What will the average inventory be?
d. What is the total cost of inventory expected to be?
13. (See Problem 12 for basic data.) In the second year, Howe Corporation finds it can reduce ordering costs to $1 per order but that carrying costs will stay the same at $1.008 per unit.
a. Recompute a, b, c, and d in Problem 12 for the second year.
b. Now compare years one and two and explain what happened.
14. Higgins Athletic Wear has expected sales of 22,500 units a year, carrying costs of $1.50 per unit, and an ordering cost of $3 per order.
a. What is the economic order quantity?
b. What will be the average inventory? The total carrying cost?
c. Assume an additional 30 units of inventory will be required as safety stock. What will the new average inventory be? What will the new total carrying cost be?
15. Dimaggio Sports Equipment, Inc., is considering a switch to level production. Cost efficiencies would occur under level production, and aftertax costs would decline by
$35,000, but inventory would increase by $400,000. Dimaggio would have to finance the extra inventory at a cost of 10.5 percent.
a. Should the company go ahead and switch to level production?
b. How low would interest rates need to fall before level production would be feasible?
16. Johnson Electronics is considering extending trade credit to some customers previously considered poor risks. Sales will increase by $100,000 if credit is extended to these new customers. Of the new accounts receivable generated, 10 percent will prove to be uncollectible. Additional collection costs will be 3 percent of sales, and production and selling costs will be 79 percent of sales. The firm is in the 40 percent tax bracket.
a. Compute the incremental income after taxes.
b. What will Johnson's incremental return on sales be if these new credit customers are accepted?
c. If the receivable turnover ratio is 6 to 1, and no other asset buildup is needed to serve the new customers, what will Johnson's incremental return on new average investment be?
17. Collins Office Supplies is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible. Collection costs are 5 percent of new sales, production and selling costs are 78 percent, and accounts receivable turnover is five times. Assume income taxes of 30 percent and an increase in sales of $80,000. No other asset buildup will be required to service the new accounts.
a. What is the level of accounts receivable to support this sales expansion?
b. What would be Collins's incremental aftertax return on investment?
c. Should Collins liberalize credit if a 15 percent aftertax return on investment is required?
Assume Collins also needs to increase its level of inventory to support new sales and that inventory turnover is four times.
d. What would be the total incremental investment in accounts receivable and inventory to support a $80,000 increase in sales?
e. Given the income determined in part b and the investment determined in part d, should Collins extend more liberal credit terms?
18. Curtis Toy Manufacturing Company is evaluating the extension of credit to a new group of customers. Although these customers will provide $240,000 in additional credit sales, 12 percent are likely to be uncollectible. The company will also incur $21,000 in additional collection expense. Production and marketing costs represent 72 percent of sales. The company is in a 30 percent tax bracket and has a receivables turnover of six times. No other asset buildup will be required to service the new customers. The firm has a 10 percent desired return on investment.
a. Should Curtis extend credit to these customers?
b. Should credit be extended if 14 percent of the new sales prove uncollectible?
c. Should credit be extended if the receivables turnover drops to 1.5 and 12 percent of the accounts are uncollectible (as was the case in part a).
19. Reconsider problem 18. Assume the average collection period is 120 days. All other factors are the same (including 12 percent uncollectibles). Should credit be extended?
20. Apollo Data Systems is considering a promotional campaign that will increase annual credit sales by $600,000. The company will require investments in accounts receivable, inventory, and plant and equipment. The turnover for each is as follows:
Accounts receivable .................................... 5x
Inventory ..................................................... 8x
Plant and equipment.................................... 2x
All $600,000 of the sales will be collectible. However, collection costs will be 3 percent of sales, and production and selling costs will be 77 percent of sales. The cost to carry inventory will be 6 percent of inventory. Depreciation expense on plant and equipment will be 7 percent of plant and equipment. The tax rate is 30 percent.
a. Compute the investments in accounts receivable, inventory, and plant and equipment based on the turnover ratios. Add the three together.
b. Compute the accounts receivable collection costs and production and selling costs and add the two figures together.
c. Compute the costs of carrying inventory.
d. Compute the depreciation expense on new plant and equipment.
e. Add together all the costs in parts b, c, and d.
f. Subtract the answer from part e from the sales figure of $600,000 to arrive at income before taxes. Subtract taxes at a rate of 30 percent to arrive at income after taxes.
g. Divide the aftertax return figure in part f by the total investment figure in part a. If the firm has a required return on investment of 12 percent, should it undertake the promotional campaign described throughout this problem.
21. In Problem 20, if inventory turnover had only been 4 times:
a. What would be the new value for inventory investment?
b. What would be the return on investment? You need to recompute the total investment and the total costs of the campaign to work toward computing income after taxes. Should the campaign be undertaken?
22. Maddox Resources has credit sales of $180,000 yearly with credit terms of net 30 days, which is also the average collection period. Maddox does not offer a discount for early payment, so its customers take the full 30 days to pay.
What is the average receivables balance? What is the receivables turnover?
23. If Maddox were to offer a 2 percent discount for payment in 10 days and every customer took advantage of the new terms, what would the new average receivables balance be? Use the full sales of $180,000 for your calculation of receivables.
24. If Maddox reduces its bank loans, which cost 12 percent, by the cash generated from its reduced receivables, what will be the net gain or loss to the firm?
25. Assume that the new trade terms of 2/10, net 30 will increase sales by 20 percent because the discount makes the Maddox price competitive. If Maddox earns 16 percent on sales before discounts, should it offer the discount? (Consider the same variables as you did for problems 22 through 24.)
COMPREHENSIVE PROBLEM
Bailey Distributing Company sells small appliances to hardware stores in the southern California area. Michael Bailey, the president of the company, is thinking about changing the credit policies offered by the firm to attract customers away from competitors. The current policy calls for a 1/10, net 30, and the new policy would call for a 3/10, net 50. Currently 40 percent of Bailey customers are taking the discount, and it is anticipated that this number would go up to 50 percent with the new discount policy. It is further anticipated that annual sales would increase from a level of $200,000 to $250,000 as a result of the change in the cash discount policy.
The increased sales would also affect the inventory level. The average inventory carried by Bailey is based on a determination of an EOQ. Assume unit sales of small appliances will increase from 20,000 to 25,000 units. The ordering cost for each order is $100 and the carrying cost per unit is $1 (these values will not change with the discount). The average inventory is based on EOQ/2. Each unit in inventory has an average cost of $6.50.
Cost of goods sold is equal to 65 percent of net sales; general and administrative expenses are 10 percent of net sales; and interest payments of 12 percent will be necessary only for the increase in the accounts receivable and inventory balances. Taxes will equal 25 percent of before-tax income.
a. Compute the accounts receivable balance before and after the change in the cash discount policy. Use the net sales (Total sales - Cash discounts) to determine the average daily sales and the accounts receivable balances.
b. Determine EOQ before and after the change in the cash discount policy. Translate this into average inventory (in units and dollars) before and after the change in the cash discount policy.
c. Complete the income statement.
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Before Policy Change
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After Policy Change
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Net sales (Sales - Cash discounts)
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Cost of goods sold
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Gross profit
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General and administrative expense
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Operating profit
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Interest on increase in accounts receivable and inventory (12%)
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Income before taxes
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Taxes
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Income after taxes
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d. Should the new cash discount policy be utilized? Briefly comment.