Discussion Questions
1. Explain how rapidly expanding sales can drain the cash resources of a firm.
2. Discuss the relative volatility of short- and long-term interest rates.
3. What is the significance to working capital management of matching sales and production?
4. How is a cash budget used to help manage current assets?
5. "The most appropriate financing pattern would be one in which asset buildup and length of financing terms is perfectly matched." Discuss the difficulty involved in achieving this financing pattern.
6. By using long-term financing to finance part of temporary current assts, a firm may have less risk but lower returns than a firm with a normal financing plan. Explain the significance of this statement.
7. A firm that uses short-term financing methods for a portion of permanent current assets is assuming more risk but expects higher returns than a firm with a normal financing plan. Explain.
8. What does the term structure of interest rates indicate?
9. What are three theories for describing the shape of the term structure of interest rates (the yield curve)? Briefly describe each theory.
10. Since the middle 1960s, corporate liquidity has been declining. What reasons can you give for this trend?
Problems
1. Gary's Pipe and Steel company expects sales next year to be $800,000 if the economy is strong, $500,000 if the economy is steady, and $350,000 if the economy is weak. Gary believes there is a 20 percent probability the economy will be strong, a 50 percent probability of a steady economy, and a 30 percent probability of a weak economy.
What is the expected level of sales for next year?
2. Nile Riverboat Co., a major boat building company highly sensitive to the economy, expects profits next year to be $2,000,000 if the economy is strong, $1,200,000 if the economy is steady, and minus $400,000 if the economy is weak. Mr. Nile believes there is a 30 percent probability of a strong economy, a 40 percent probability of a steady economy, and a 30 percent probability of a weak economy. What is the expected value of profits for next year?
3. Nile Riverboat Co., a major boat building company highly sensitive to the economy, expects profits next year to be $2,000,000 if the economy is strong, $1,200,000 if the economy is steady, and minus $400,000 if the economy is weak. Mr. Nile believes there is a 30 percent probability of a strong economy, a 40 percent probability of a steady economy, and a 30 percent probability of a weak economy. What is the expected value of profits for next year?
4. Shamrock Diamonds expects sales next year to be $3,000,000. Inventory and accounts receivable will increase $420,000 to accommodate this sales level. The company has a steady profit margin of 10 percent with a 25 percent dividend payout. How much external financing will the firm have to seek?
5. Electric Chair and Table Co. expects sales next year to be $10,000,000. Inventory and accounts receivable will increase by $1,400,000 and accounts payable will increase by $300,000. The company has a profit margin of 9 percent and pays out 30 percent of profits in dividends. How much external financing will be necessary?
Assume there is no increase in liabilities other than that which will occur with the external financing.
6. Fashion's Clothiers sells scarves that are very popular in the fall-winter season. Units sold are anticipated as:
October..................................................... 2,000
November................................................. 4,000
December ................................................. 8,000
January ..................................................... 6,000
20,000 units
If seasonal production is used, it is assumed that inventory buildup will directly match sales for each month and there will be no inventory buildup.
The production manager thinks the above assumption is too optimistic and decides to go with level production to avoid being out of merchandise. He will produce the 20,000 units over 4 months at a level of 5,000 per month.
a. What is the ending inventory at the end of each month? Compare the units produced to the units sold and keep a running total.
b. If the inventory costs $7 per unit and will be financed at the bank at a cost of 8 percent, what is the monthly financing cost and the total for the four months?
7. Procter Micro-Computers, Inc., requires $1,200,000 in financing over the next two years. The firm can borrow the funds for two years at 9.5 percent interest per year. Mr. Procter decides to do economic forecasting and determines that if he utilizes short-term financing instead, he will pay 6.55 percent interest in the first year and 10.95 percent interest in the second year. Determine the total two-year interest cost under each plan. Which plan is less costly?
8. Sauer Food Company has decided to buy a new computer system with an expected life of three years. The cost is $150,000. The company can borrow $150,000 for three years at 10 percent annual interest or for one year at 8 percent annual interest.
How much would Sauer Food Company save in interest over the three-year life of the computer system if the one-year loan is utilized and the loan is rolled over (reborrowed) each year at the same 8 percent rate? Compare this to the 10 percent three-year loan. What if interest rates on the 8 percent loan go up to 13 percent in year 2 and 18 percent in year 3? What would be the total interest cost compared to the 10 percent, three-year loan?
9. Assume Stratton Health Clubs, Inc., has $3,000,000 in assets. If it goes with a low liquidity plan for the assets, it can earn a return of 20 percent, but with a high liquidity plan, the return will be 13 percent. If the firm goes with a short-term financing plan, the financing costs on the $3,000,000 will be 10 percent, and with a long-term financing plan, the financing costs on the $3,000,000 will be 12 percent. (Review Table 6-11 for parts a, b, and c of this problem.)
a. Compute the anticipated return after financing costs with the most aggressive asset- financing mix.
b. Compute the anticipated return after financing costs with the most conservative asset- financing mix.
c. Compute the anticipated return after financing costs with the two moderate approaches to the asset-financing mix.
d. Would you necessarily accept the plan with the highest return after financing costs? Briefly explain.
10. Assume that Atlas Sporting Goods, Inc., has $800,000 in assets. If it goes with a low- liquidity plan for the assets, it can earn a return of 15 percent, but with a high-liquidity plan the return will be 12 percent. If the firm goes with a short-term financing plan, the financing costs on the $800,000 will be 8 percent, and with a long-term financing plan, the financing costs on the $800,000 will be 10 percent. (Review Table 6-11 for parts a, b, and c of this problem.)
a. Compute the anticipated return after financing costs with the most aggressive asset- financing mix.
b. Compute the anticipated return after financing costs with the most conservative asset- financing mix.
c. Compute the anticipated return after financing costs with the two moderate approaches to the asset-financing mix.
d. If the firm used the most aggressive asset-financing mix described in part a and had the anticipated return you computed for part a, what would earnings per share be if the tax rate on the anticipated return was 30 percent and there were 20,000 shares outstanding?
e. Now assume the most conservative asset-financing mix described in part b will be utilized. The tax rate will be 30 percent. Also assume there will only be 5,000 shares outstanding. What will earnings per share be? Would it be higher or lower than the earnings per share computed for the most aggressive plan computed in part d?
11. Colter Steel has $4,200,000 in assets.
Temporary current assets ......................... $1,000,000
Permanent current assets.......................... 2,000,000
Fixed assets .............................................. 1,200,000
Total assets......................................... $4,200,000
Short-term rates are 8 percent. Long-term rates are 13 percent. Earnings before interest and taxes are $996,000. The tax rate is 40 percent.
If long-term financing is perfectly matched (synchronized) with long-term asset needs, and the same is true of short-term financing, what will earnings after taxes be? For a graphical example of perfectly matched plans, see Figure 6-5.
12. In problem 11, assume the term structure of interest rates becomes inverted, with short- term rates going to 11 percent and long-term rates 4 percentage points lower than short- term rates.
If all other factors in the problem remain unchanged, what will earnings after taxes be?
13. Guardian, Inc., is trying to develop an asset-financing plan. The firm has $400,000 in temporary current assets and $300,000 in permanent current assets. Guardian also has $500,000 in fixed assets. Assume a tax rate of 40 percent.
a. Construct two alternative financing plans for Guardian. One of the plans should be conservative, with 75 percent of assets financed by long-term sources, and the other should be aggressive, with only 56.25 percent of assets financed by long-term sources. The current interest rate is 15 percent on long-term funds and 10 percent on short-term financing.
b. Given that Guardian's earnings before interest and taxes are $200,000, calculate earnings after taxes for each of your alternatives.
c. What would happen if the short-and long-term rates were reversed?
14. Lear, Inc., has $800,000 in current assets, $350,000 of which are considered permanent current assets. In addition, the firm has $600,000 invested in fixed assets.
a. Lear wishes to finance all fixed assets and half of its permanent current assets with long-term financing costing 10 percent. Short-term financing currently costs 5 percent. Lear's earnings before interest and taxes are $200,000. Determine Lear's earnings after taxes under this financing plan. The tax rate is 30 percent.
b. As an alternative, Lear might wish to finance all fixed assets and permanent current assets plus half of its temporary current assets with long-term financing. The same interest rates apply as in part a. Earnings before interest and taxes will be $200,000. What will be Lear's earnings after taxes? The tax rate is 30 percent.
c. What are some of the risks and cost considerations associated with each of these alternative financing strategies?
15. Using the expectations hypothesis theory for the term structure of interest rates, determine the expected return for securities with maturities of two, three, and four years based on the following data. Do an analysis similar to that in Table 6-6.
1-year T-bill at beginning of year 1 6%
1-year T-bill at beginning of year 2 7%
1-year T-bill at beginning of year 3 9%
1-year T-bill at beginning of year 4 11%
16. Modern Tombstones has estimated monthly financing requirements for the next six months as follows:
January ................. $20,000 April .................. $10,000
February ............... 6,000 May ................... 22,000
March ................... 8,000 June ................... 12,000
Short-term financing will be utilized for the next six months. Projected annual interest rates are:
January ................. 9.0% April .................. 15.0%
February ............... 8.0% May ................... 12.0%
March ................... 12.0% June ................... 9.0%
a. Compute total dollar interest payments for the six months. To convert an annual rate to a monthly rate, divide by 12.
b. If long-term financing at 12 percent had been utilized throughout the six months, would the total dollar interest payments be larger or smaller?
17. In problem 16, what long-term interest rate would represent a break-even point between using short-term financing as described in part a and long-term financing? Hint: Divide the interest payments in 16a by the amount of total funds provided for the six months and multiply by 12.
18. Sherwin Paperboard Company expects to sell 600 units in January, 700 units in February, and 1,200 units in March. January's ending inventory is 800 units. Expected sales for the whole year are 12,000 units. Sherwin has decided on a level production schedule of 1,000 units (12,000 units/12 months = 1,000 units per month). What is the expected end-of-month inventory for January, February, and March? Show the beginning inventory, production, and sales for each month to arrive at ending inventory.
Beginning inventory + Production (level) - Sales = Ending inventory
19. Sharpe Computer Graphics Corporation has forecasted the following monthly sales:
|
January ..............
|
$80,000
|
July..............
|
$ 30,000
|
|
February ............
|
70,000
|
August .........
|
31,000
|
|
March ................
|
10,000
|
September ...
|
40,000
|
|
April ..................
|
10,000
|
October........
|
70,000
|
|
May ...................
|
15,000
|
November....
|
90,000
|
|
June ...................
|
20,000
|
December ....
|
110,000
|
Total annual sales = $576,000
The firm sells its graphic forms for $5 per unit, and the cost to produce the forms is $2 per unit. A level production policy is followed. Each month's production is equal to annual sales (in units) divided by 12.
Of each month's sales, 30 percent are for cash and 70 percent are on account. All accounts receivable are collected in the month after the sale is made.
a. Construct a monthly production and inventory schedule in units. Beginning inventory in January is 15,000 units. (Note: To do part a, you should work in terms of units of production and units of sales.)
b. Prepare a monthly schedule of cash receipts. Sales in the December before the planning year are $90,000. Work part b using dollars.
c. Determine a cash payments schedule for January through December. The production costs of $2 per unit are paid for in the month in which they occur. Other cash payments, besides those for production costs, are $30,000 per month.
d. Prepare a monthly cash budget for January through December. The beginning cash balance is $5,000 and that is also the minimum desired.
20. Seasonal Products Corporation expects the following monthly sales:
|
January ..............
|
$20,000
|
May .............
|
$1,000
|
September .........
|
$20,000
|
|
February ............
|
15,000
|
June .............
|
3,000
|
October..............
|
25,000
|
|
March ................
|
5,000
|
July..............
|
10,000
|
November..........
|
30,000
|
|
April ..................
|
3,000
|
August .........
|
14,000
|
December ..........
|
22,000
|
Total annual sales = $168,000
Sales are 20 percent for cash in a given month, with the remainder going into accounts receivable. All 80 percent of the credit sales are collected in the month following the sale. Seasonal Products sells all of its goods for $2 each and produces them for $1 each.
Seasonal Products uses level production, and average monthly production is equal to annual production divided by 12.
a. Generate a monthly production and inventory schedule in units. Beginning inventory in January is 5,000 units. (Note: To do part a, you should work in terms of units of production and units of sales.)
b. Determine a cash receipts schedule for January through December. Assume that dollar sales in the prior December were $15,000. Work part b using dollars.
c. Determine a cash payments schedule for January through December. The production costs ($1 per unit produced) are paid for in the month in which they occur. Other cash payments, besides those for production costs, are $6,000 per month.
d. Construct a cash budget for January through December. The beginning cash balance is
$1,000, and that is also the required minimum.
e. Determine total current assets for each month. (Note: Accounts receivable equal sales minus 20 percent of sales for a given month.)