Problem: Working Capital Challenges
Hydrochem Ltd, a chemical sales company, is in urgent need of funds to secure an important contract. Although the product it sells is not of a high quality, the company is able to pass on the cost advantage to the customers. This enables the company to maintain its position in the market.
The company sells the product mainly on credit. It extends credit sales for long periods and keeps a large inventory of the product for resale. The company pays its creditors promptly before the credit period. As a result, it has a long working capital cycle.
Hydrochem Ltd has the opportunity to pursue a promising contract that would require a significant investment in a few months' time. The company's financial manager needed to make decisions about how to obtain adequate funds that would be needed to secure the contract.
An analysis of the current situation reveals the following:
The purchase cost of the product is R100 per unit. The holding cost is 10% of the unit cost. The cost of placing an order for the product is R30. The selling price is R140 per unit and the annual sales are 60 000 units, of which 90% is on credit. The credit terms are 2/10 net 60 days but it takes approximately 73 days to collect the debts from the credit customers. The discount applies to 30% of the credit sales. Bad debts usually account for 5% of the credit sales.
In view of the above, the financial manager proposed the following:
Proposal A
The company should take advantage of the quantity discount offered by its supplier who offers a discount of 6% for an order size of between 2 001 and 5 000 units and a discount of 7% for an order size of 5 001 units or more.
Proposal B
The credit terms should be changed to 5/10 net 60 days. This is expected to increase credit sales to 74 000 units, reduce the debtors collection period to 36.5 days, lower bad debts to 3% of credit sales and increase the percentage of the credit sales to which the discount applies to 60%.
Question I
Which working capital policy is Hydrochem Ltd following? Provide three reasons for your answer.
Question II
Calculate the EOQ if discounts are not available.
Question III
If Proposal A is implemented without considering Proposal B, what purchase quantity would you recommend? Motivate your answer with the relevant calculations.
Question IV
Would you recommend Proposal B, if the required rate of return on equal-risk investments is 15%? Ignore the carrying and ordering costs. Motivate your answer with the relevant calculations.