8/6/2019 2010036

1/10

WorkingCapitalManagement

WeekendAssignment: 3

Ankit Khandelwal2010036PGDM (FT)

8/6/2019 2010036

2/10

Chapter 22Working Capital Management

22-1 Sales = $10,000,000; S/I = 2 .

Inventory = S/2

=2

000,000,10$= $5,000,000.

If S/I = 5 , how much cash is freed up?

Inventory = S/5

=5

000,000,10$= $2,000,000.

Cash Freed = $5,000,000 - $2,000,000 = $3,000,000.

22-2 DSO = 17; Credit Sales/Day = $3,500; A/R = ?

DSO =S/365

A/R

17 =$3,500

A/R

A/R = 17 $3,500 = $59,500.

22-3 Nominal cost of trade credit =

1-3 0

53 6

9 7

3

= 0.0309 24.33 = 0.7526 = 75.26%.

Effective cost of trade credit = (1.0309)24.33 - 1.0 = 1.0984 = 109.84%.

22-4 Effective cost of trade credit = (1 + 1/99)8.11 - 1.0= 0.0849 = 8.49%.

22-5 Net purchase price of inventory = $500,000/day.

Credit terms = 2/15, net 40.

$500,000 15 = $7,500,000.

8/6/2019 2010036

3/10

22-6 a. 0.4(10) + 0.6(40) = 28 days.

b. $912,500/365 = $2,500 sales per day.

$2,500(28) = $70,000 = Average receivables.

c. 0.4(10) + 0.6(30) = 22 days. $912,500/365 = $2,500 sales per day.

$2,500(22) = $55,000 = Average receivables.

Sales may also decline as a result of the tighter credit. This wouldfurther reduce receivables. Also, some customers may now takediscounts further reducing receivables.

22-7 a.5

53 6

9 9

1

= 73.74%.

b.50

536

98

2 = 14.90%.

c.35

536

97

3 = 32.25%.

d.35

536

98

2 = 21.28%.

e.25

536

98

2 = 29.80%.

22-8 a.20-45

536

97

3 = 45.15%.

Because the firm still takes the discount on Day 20, 20 is used asthe discount period in calculating the cost of nonfree trade credit.

b. Paying after the discount period, but still taking the discount gives

the firm more credit than it would receive if it paid within 15 days.

8/6/2019 2010036

4/10

22-9 Sales per day =365

500,562,4$= $12,500.

Discount sales = 0.5($12,500) = $6,250.

A/R attributable to discount customers = $6,250(10) = $62,500.

A/R attributable to nondiscount customers:

Total A/R $437,500Discount customers A/R 62,500Nondiscount customers A/R $375,000

days.60250,6$

000,375$

dayperSales

A/R

customerstnondiscoun

goutstandinsalesDays===

Alternatively,

DSO = $437,500/$12,500 = 35 days.

35 = 0.5(10) + 0.5(DSONondiscount)DSONondiscount = 30/0.5 = 60 days.

Thus, although nondiscount customers are supposed to pay within 40days, they are actually paying, on average, in 60 days.

Cost of trade credit to nondiscount customers equals the rate ofreturn to the firm:

Nominal rate =10-60

536

98

2 = 0.0204(7.3) = 14.90%.

Effective cost = (1 + 2/98)365/50 - 1 = 15.89%.

22-10Accounts payable:

Nominal cost =80

536

97

3

= (0.03093)(4.5625) = 14.11%.

EAR cost = (1.03093)4.5625 - 1.0 = 14.91%.

22-11a.cycle

conversion

Cash

=period

deferral

Payables

period

collection

sReceivable

period

conversion

Inventory

+

8/6/2019 2010036

5/10

= 75 + 38 - 30 = 83 days.

b. Average sales per day = $3,421,875/365 = $9,375.Investment in receivables = $9,375 38 = $356,250.

c. Inventory turnover = 365/75 = 4.87 .

22-12a. Inventory conversion period = 365/Inventory turnover ratio= 365/5 = 73 days.

Receivables collection period = DSO = 36.5 days.

cycle

conversion

Cash

=period

deferral

Payables

period

collection

sReceivable

period

conversion

Inventory

+

= 73 + 36.5 - 40 = 69.5 days.

b. Total assets = Inventory + Receivables + Fixed assets= $150,000/5 + [($150,000/365) 36.5] + $35,000= $30,000 + $15,000 + $35,000 = $80,000.

Total assets turnover = Sales/Total assets= $150,000/$80,000 = 1.875 .

ROA = Profit margin Total assets turnover= 0.06 1.875 = 0.1125 = 11.25%.

c. Inventory conversion period = 365/7.3 = 50 days.

Cash conversion cycle = 50 + 36.5 - 40 = 46.5 days.

Total assets = Inventory + Receivables + Fixed assets= $150,000/7.3 + $15,000 + $35,000= $20,548 + $15,000 + $35,000 = $70,548.

Total assets turnover = $150,000/$70,548 = 2.1262 .

ROA = $9,000/$70,548 = 12.76%.

8/6/2019 2010036

6/10

22-13a. Return on equity may be computed as follows:

Tight Moderate RelaxedCurrent assets (% of sales Sales) $ 900,000 $1,000,000

$1,200,000

Fixed assets 1,000,000 1,000,0001,000,000 Total assets $1,900,000 $2,000

$2,200,000

Debt (60% of assets) $1,140,000 $1,200,000$1,320,000

Equity 760,000 800,000880,000

Total liab./equity $1,900,000 $2,000,$2,200,000

EBIT (12% $2 million) $ 240,000 $ 240,000 $240,000Interest (8%) 91,200 96,000

105,600Earnings before taxes $ 148,800 $ 144,000 $

134,400 Taxes (40%) 59,520

53,760Net income $ 89,280 $ 86,400 $

80,640Return on equity 11.75% 10.80%

9.16%

b. No, this assumption would probably not be valid in a real worldsituation. A firms current asset policies, particularly with regard toaccounts receivable, such as discounts, collection period, andcollection policy, may have a significant effect on sales. The exactnature of this function may be difficult to quantify, however, anddetermining an optimal current asset level may not be possible inactuality.

8/6/2019 2010036

7/10

c. As the answers to Part a indicate, the tighter policy leads to a higherexpected return. However, as the current asset level is decreased,presumably some of this reduction comes from accounts receivable.This can be accomplished only through higher discounts, a shortercollection period, and/or tougher collection policies. As outlinedabove, this would in turn have some effect on sales, possibly

lowering profits. More restrictive receivable policies might involvesome additional costs (collection, and so forth) but would alsoprobably reduce bad debt expenses. Lower current assets wouldalso imply lower liquid assets; thus, the firms ability to handlecontingencies would be impaired. Higher risk of inadequateliquidity would increase the firms risk of insolvency and thusincrease its chance of failing to meet fixed charges. Also, lowerinventories might mean lost sales and/or expensive productionstoppages. Attempting to attach numerical values to thesepotential losses and probabilities would be extremely difficult.

8/6/2019 2010036

8/10

22-14a. I. Collections and Purchases: December January FebruarySales $160,000 $40,000

$60,000Purchases 40,000 40,000

40,000Payments 140,000* 40,000

40,000*November purchases = $140,000.

II. Gain or Loss for Month:Receipts from sales $160,000 $40,000

$60,000Payments for:Purchases 140,000 40,000

40,000Salaries 4,800 4,800

4,800

Rent 2,000 2,0002,000

Taxes 12,000 ------

Total payments $158,800 $46,$46,800

Net cash gain (loss) $ 1,200 ($ 6,800)$13,200

III. Cash Surplus or Loan Requirements:Cash at start of month 400 1,600

(5,200)Cumulative cash $ 1,600 ($ 5,200) $

8,000Target cash balance 6,000 6,000

6,000Cumulative surplus cash ortotal loans to maintain$6,000 target cash balance ($ 4,400) ($11,200) $

2,000

b. If the company began selling on credit on December 1, then itwould have zero receipts during December, down from $160,000.Thus, it would have to borrow an additional $160,000, so its loansoutstanding by December 31 would be $164,400. The loanrequirements would build gradually during the month. We couldtrace the effects of the changed credit policy on out into Januaryand February, but here it would probably be best to simplyconstruct a new cash budget.

8/6/2019 2010036

9/10

22-15a.payable

accountsAverage=

days365

000,650,3$ 10 days = $10,000 10 =

$100,000.

b. There is no cost of trade credit at this point. The firm is using freetrade credit.

c.discount)of(net

payablesAverage=

365

000,650,3$ 30 = $10,000 30 = $300,000.

Nominal cost = (2/98)(365/20) = 37.24%,

or $74,490/($300,000 - $100,000) = 37.25%.

Effective cost = (1 + 2/98)365/20 - 1 = 0.4459 = 44.59%.

d. Nominal rate = %.8324.=10-40

536

98

2

Effective cost = (1 + 2/98)365/30 - 1 = 0.2786 = 27.86%.

22-16Trade Credit

Terms: 2/10, net 30. But the firm plans delaying payments 35additional days, which is the equivalent of 2/10, net 65.

Nominal cost =period

Discount

goutstandinis

creditDays

365

percent

Discount-100

percentDiscount

= %5413.=)6364(6.0.0204=55

536

98

2=

10-65

536

2-100

2 .

Effective cost = (1 + 2/98)365/55 - 1 = 14.35%.

8/6/2019 2010036

10/10

22-17a. Size of bank loan = (Purchases/Day)(Days late)

=

30goutstandin

payablesDays

goutstandin

payablesDays

Purchases

= ($600,000/60)(60 - 30) = $10,000(30) = $300,000.

Alternatively, one could simply recognize that accounts payablemust be cut to half of its existing level, because 30 days is half of60 days.

b. Given the limited information, the decision must be based on therule-of-thumb comparisons, such as the following:

1. Debt ratio = ($1,500,000 + $700,000)/$3,000,000 = 73%.Raattamas debt ratio is 73 percent, as compared to a typicaldebt ratio of 50 percent. The firm appears to beundercapitalized.

2. Current ratio = $1,800,000/$1,500,000 = 1.20.

The current ratio appears to be low, but current assets couldcover current liabilities if all accounts receivable can be collectedand if the inventory can be liquidated at its book value.

3. Quick ratio = $400,000/$1,500,000 = 0.27.

The quick ratio indicates that current assets, excludinginventory, are only sufficient to cover 27 percent of currentliabilities, which is very bad.

The company appears to be carrying excess inventory and financingextensively with debt. Bank borrowings are already high, and theliquidity situation is poor. On the basis of these observations, theloan should be denied, and the treasurer should be advised to seekpermanent capital, especially equity capital.