MANAGEMENT ADVISORY SERVICES EXERCISES Working Capital Policy 1 . Real Company has P8,000,000 in current assets, P3,500,000 of which are considered permanent current assets. In addition, the firm has P6,000,000 invested in fixed assets. Real Company wishes to finance all fixed assets and permanent current assets plus half of its temporary current assets with long-term financing costing 15 percent. Short-term financing currently costs 10 percent. Real Company's earnings before interest and taxes are P2,200,000. Income tax rate is 40 percent.
Working Capital Management A. What was Amore’s total debt in 2002? B. How much new, long-term debt financing will be needed in 2003? 4
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How much would Real Company's earnings after taxes under this financing plan? 2
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A firm that is in the process of preparing its financial plan for the upcoming year has estimated the following current assets (in P000,000) for the year. Month CA Month CA Month CA Jan 19.2 May 36.6 Sept 26.9 Feb 21.6 June 43.8 Oct 25.5 Mar 24.5 Jul 40.5 Nov 23.4 Apr 33.4 Aug 34.4 Dec 20.7
The KRAM Company had the following data for the current year, 2004: Sales, 2004 Sales, 2005 Items that vary directly with sales: Assets Liabilities Net profit margin Payout ratio
1. Compute the projected additional financing needed for 2005. 2. Compute the projected additional financing needed for 2005 under each assumption: A. Payout ratio is 55%
1. How much will the firm’s permanent level of assets be for the coming year?
C. Sales next year is P5,000,000 and the payout ratio is 40%.
3. Compute the maximum temporary financing requirement of the firm. External Financing Needed 3 . At year-end 2002, total assets for Amore Inc. were P1.2 million and accounts payable were P375,000. Sales, which in 2002 were P2.5 million, are expected to increase by 25% in 2003. Total assets and accounts payable are proportional to sales, and that relationship will be maintained. Amore typically uses no current liabilities other than accounts payable. Common stock amounted to P425,000 in 2002, and retained earnings were P295,000. Amore plans to sell new common stock in the amount of P75,000. The firm’s profit margin on sales is 6 percent, 60 percent of earnings will be retained. Exercises & Problems
45% 15% 15% 45%
Required:
The firm’s fixed assets should remain constant at P40 million. Owner’s equity is forecast to be P25 million. Working capital policy requires that 50% of maximum current assets be financed with permanent financing.
2. Compute the permanent financing requirement of the firm.
P4,000,000 5,500,000
B. Net profit margin is 10% and payout ratio is 30%
5
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The 2003 sales of Reign Co. amounted to P8 million. The dividend payout ratio is 30%. The percent of sales in each balance sheet item that varies directly with sales are expected to be as follows: Cash 8% Receivables 15% Inventories 16% Net fixed assets 30% Accounts payable 12% Accrued expenses 6% Net profit rate 9% Required: Page 1 of 9
MANAGEMENT ADVISORY SERVICES
Working Capital Management
A. Suppose that in 2004 sales increased by 25% over 2003 sales. How much additional (external) capital will be required?
C. Calculate the amount of negotiated financing required to support the firm’s cash conversion cycle.
B. What would happen to capital requirement if Reign can increase its sales by 40% and the payout ratio is increased to 40%?
D. How could management reduce the cash conversion cycle? 8
A firm that has an annual opportunity cost of 12% is contemplating installation of a lockbox system at an annual cost of P90,000. The system is expected to reduce mailing time by 2 days, reduce processing time by 1.5 days, and reduce check clearing time by 1 day. If the firm collects P300,000 per day, would you recommend the system?
9
Calma Company uses a continuous billing system that results in average daily receipts of P750,000. The company treasurer estimates that a proposed lock-box system could reduce its collection time by 2 days.
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Cash Management 6 . Samson Corporation, a leading producer of automobile batteries, turns out 1,500 batteries a day at a cost of P600 per battery for materials and labor. It takes the firm 22 days to convert raw materials into a battery. Samson allows its customers 40 days in which to pay for the batteries, and the firm generally pays suppliers in 30 days.
.
A. What is the length of Samson's cash conversion cycle? B. At a steady state in which Samson produces 1,500 batteries a day, what amount of working capital must it finance?
A. How much cash would the lock-box system free up for the company? B. What is the maximum amount that Calma would be willing to pay for the lock-box system if it can earn 6 percent on available short-term funds?
C. By what amount could Samson reduce its working capital financing needs if it was able to stretch its payables deferral period to 35 days? D. Samson's management is trying to analyze the effect of a proposed new production process on the working capital investment. The new production process would allow Samson to decrease it s inventory conversion period to 20 days and to increase its daily production to 1,800 batteries. However, the new process would cause the cost of materials and labor to increase to P700. Assuming the change does not affect the receivables collection period (40 days) or the payables deferral period (30 days), what will be the length of the cash conversion cycle and the working capital financing requirement if the now production process is implemented? 7
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Abbey Products is concerned about managing cash efficiently. On the average, inventories turns over 5 times, and accounts receivable are collected in 60 days. Accounts payable are paid approximately 30 days after they arise. The firms spends P30 million on operating cycle investments each year, at a constant rate. Assuming a 360-day year. A. Calculate the firm’s operating cycle B. Calculate the firm’s cash conversion cycle
Exercises & Problems
C. If the lock-box system could be arranged at an annual cost of P45,000, what would be the net gain from instituting the system? 10
. Syl Company projects that cash outlays of P45 million will occur uniformly throughout the year. Syl plans to meet its cash requirements by periodically selling marketable securities from its portfolio. The firm’s marketable securities are invested to earn 12 percent, and the cost per transaction of converting securities to cash P30. A. What is the optimal transaction size for transfer from marketable securities to cash? B. What will be Syl’s average cash balance? C. Compute the annual cost of cash based on optimal transaction size
Receivables Management 11 . McPan Company sells on terms of 3/10, net 30. Total sales for the years are P900,000. Forty percent of the customers pay on the 10th day and take discounts; the other 60 percent pay, on average, 40 days after their purchases. Assume 360 days per year. Page 2 of 9
MANAGEMENT ADVISORY SERVICES A. What is the days sales outstanding?
Working Capital Management 16
. The Electra Car Company purchases 20,000 units of a major component part each year. The firm's order costs are P200 per order and the carrying cost per unit is P2 per year.
B. What is the average amount of receivables? A. Compute the total inventory costs associated with placing orders of 20,000, 10,000, 5,000, 1,000.
C. What would happen to average receivables if McPan toughened up on its collection policy with the result that all no-discount customers paid on the 30th day?
B. Determine the EOQ for the component parts. 12
. S Mart has sales of P3 million. Its credit period and average collection periods are both 30 days, and 1.5% of its sales end as bad debts. The manager intends to extend the credit term to 45 days which will increase sales to P3.3 million. However, bad debt losses on the incremental sales would be 3%. Costs of products and related expenses amount to 40%, exclusive of the cost of carrying receivables of 15% and bad debt expenses. Assuming 360 days a year, what incremental cost of investment is required to support the change in policy?
17
. Ever Company is considering switching from level production to seasonal production in order to lower very high inventory costs. Average inventory levels would decline by P300,000 but production costs would rise about P40,000 because of additional startups and other inefficiencies. The firm's cost of financing inventory balances is 15%. A. Should the firm switch to seasonal production? (ignore income taxes)
13
. Dessa, Inc. currently has sales of P2.5 million. Its credit period and days sales outstanding (DSO) are both 30 days, and 1 percent of its sales end up as bad debts. The credit manager estimates that, if the firm extends its credit period to 45 days so that its days sales outstanding increases to 45 days, sales will increase by P250,000, but its bad debt losses on the incremental sales would be 2.5 percent. Variable costs are 60 percent, and the cost of carrying receivables, k, is 12.5 percent. Assume a tax rate of 40 percent and 360 days per year. A. Compute the incremental investment required to finance the increase in receivables if the change is effected. B. What would be the incremental cost of carrying receivables? C. What would be the effect of those changes in net income?
Inventory Management 14 . Wilbur Co. last year reported sales of P10,000,000 and an inventory turnover ratio of 2. The company is now adopting a just-in-time inventory system. If the new system is able to reduce the firm's inventory level and increase the firm's inventory turnover to 5, while maintaining the same level of sales, how much cash will be freed up?
B. At what interest rate would the cost of financing additional inventory under level production be equal to the added production costs of seasonal production?(ignore income taxes) C. Answer (A) and (B) if the applicable income tax rate is 40 percent. Trade Credit 18 . Cash discount Decisions. The credit terms for each of three suppliers are shown below: Supplier A Supplier B Supplier C Supplier D
2/10 n/55 3/10 n/55 2/15 n/45 2/10 n/30
A. Determine the annual approximate cost of giving up the cash discount from each supplier. B. Assuming that the firm needs short-term financing, recommend whether it would be better to give up the cash discount or take the discount and borrow from a bank at 20% annual interest. Evaluate each supplier separately using your findings in Question A.
15
. Tri Company's financial plan for next year- shows sales of P72 million and cost of sales of P45 million. It expects short-term interest rates to average 10% for the coming year. It aims to increase inventory turnover form the present 9 times to 12 times next year. How much is the incremental benefits in form of cost savings that can be achieved from the plan?
Exercises & Problems
C. Assuming that the entity continuously foregoes the cash discount, compute the annual effective cost of giving up the discount on each supplier. Page 3 of 9
MANAGEMENT ADVISORY SERVICES
Working Capital Management
Short-term Loan 19 . Divina Mendez, owner of DM Company is negotiating with Island City Bank for a P1M, 1-year loan. Island City Bank has offered DM Company the following alternatives. Calculate the effective annual interest rate for each alternative. Which alternative has the lowest effective annual interest rate?
60. Barangay Bank has agreed to lend the money at a 12% rate with a 15% compensating balance requirement. Townbank will lend at a 13% interest rate on a discounted loan from three months. A. What is the effective rate of interest charged by each bank?
A. A 12.5 percent annual rate on a simple interest loan, with no compensating balance required and interest due at the end of the year.
B. What is the cost of foregoing the discount? C. How much would Tyler have to borrow from each bank in order to take the discount?
B. A 9.25 percent annual rate on a simple interest loan, with a 20 percent compensating balance required and interest again due at the end of the year.
D. Suppose that Tyler normally banks with Barangay Bank and maintains deposit balance of P15,000, what amount would have to be borrowed and what would the effective interest rate be?
C. A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance. D. A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance and an existing cash balance of P150,000 E. A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance which earns 5% interest income. F. A 8.75 percent annual rate on a discount loan, with a 20 percent compensating balance and an existing cash balance of P150,000. The bank balance earns 5% interest income. Redo requirement (A) to (F) assuming the loan is for four (4) months. Short-term Financing Alternatives 20 . Lance Hardware can buy equivalent materials from two-distributors. Supplier A offers term 1/10, net 30 whereas Supplier B provides terms of 2/15, net 60.
22
. Dela Merced, owner of DM Company is negotiating with Island City Bank for a P500,000, 1year loan. Island City Bank has offered DM Company the following alternatives. Calculate the effective annual interest rate for each alternative. Which alternative has the lowest effective annual interest rate? A. A 12 percent annual rate on a simple interest loan, with no compensating balance required and interest due at the end of the year. B. A 9 percent annual rate on a simple interest loan, with a 20 percent compensating balance required and interest again due at the end of the year. C. An 8.75 percent annual rate on a discount loan, with a 15 percent compensating balance. D. Interest is figured as 8 percent of the P50,000 amount, payable at the end of the year, but the P50,000 is repayable in monthly installments during the year.
A. If Lance foregoes the discount, which of the two suppliers should it purchase from if supply prices are comparable. B. If Lance can borrow from Lending Bank at a 16%, should it forego the discount? C. If in (B) above the bank requires a 20% compensating balance for the loan, should the firm forego the discount? 21
. Tyler Company needs P100,000 to take advantage of a discount based on terms of 3/10, net
Exercises & Problems
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MANAGEMENT ADVISORY SERVICES
Working Capital Management
MULTIPLE CHOICE 1. May Co. has total fixed assets of P100,000 and no current liabilities. The table below displays its wide variation in current asset components. 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter Cash P 20,000 P 10,000 P 15,000 P 20,000 Accounts receivable 66,000 25,000 47,000 88,000 Inventory 20,000 65,000 59.000 10,000 Total P106,000 P100,000 P121,000 P118,000 If May's policy is to finance all fixed assets and half the permanent current assets with longterm financing and rest with short time-financing, what is the level of long-term financing? A. P68,000 C. P150,000 B. P100,000 D. P155,625 2. Silver Company has the following ratios: A*/S = 1.6; L*/S = 0.4: profit margin = 0.10; and dividend payout ratio = 0.45, or 45 percent. Sales last year were P100 million. Assuming that these ratios will remain constant and that all liabilities increase spontaneously with increases in sales, what is the maximum growth rate Silver Company can achieve without having to employ nonspontaneous external funds? *Spontaneous assets and liabilities A. 3.9 percent C. 7.8 percent B. 4.8 percent D. 9.6 percent 3. Color Paint Company has plants in 3 major cities. Sales for last year were P100 million, and the balance sheet at year-end is similar in percentage of sales to that of previous years (and this will continue in the future). All assets (including fixed assets) and current liabilities will vary directly with sales. Color Paint is already using assets at full capacity. Balance Sheet (In million pesos) Assets Current assets
P50
Fixed assets Total.
40 P90
Liability and Stockholders Equity Accounts payable and accruals Notes payable - long term Common stock Retained earnings Total
P25 30 15 20 P90
Color Paint has an after-tax profit margin of 5 percent and a dividend payout ratio of 30 Exercises & Problems
percent. If sales grow by 10 percent next year, the required new financing (RNF) to finance the expansion is A. P4,850,000 C. P2,650,000 B. P3,000,000 D. P5,000,000 4. The Gold Company has an inventory conversion period of 75 days, a receivables conversion period of 38 days, and a payable payment period of 30 days. What is the length of the firm's cash conversion cycle? A. 83 days C. 113 days B. 67 days D. 45 days 5. Texas Company turns out 200 calculators a day at a cost of P250 per calculator for materials and variable conversion cost. It takes the firm 18 days to convert raw materials into calculator. Texas usual credit terms to its customers is 30 days, and the firm generally pays its suppliers in 20 days. If the foregoing cycles are constant, what amount of working capital must Texas finance? A. P1,400,000 C. P2,400,000 B. P900,000 D. P1,800,000 6. Hep Inc., has a total annual cash requirement of P9,075,000 which are to be paid uniformly. Hep has the opportunity to invest the money at 24% per annum. The company spends, on the average, P40 for every cash conversion to marketable securities. What is the optimal cash conversion size? A. P60,000 C. P45,000 B. P55,000 D. P72,500 7. Collectrite Company sells on terms 3/10, net 30. Total sales for the year are P900,000. Forty percent of the customers pay on the tenth day and take discounts; the other 60 percent pay, on average, 45 days after their purchases. What is the average amount of receivables? A. P70,000 C. P77,200 B. P77,500 D. P67,500 8. Palma Company's budgeted sales for the coming year are P40,500,000 of which 80% are expected to be credit sales at terms of n/30. Palma estimates that a proposed relaxation of credit standards will increase credit sales by 20% and increase the average collection period from 30 days to 40 days. Based on a 360-day year, the proposed relaxation of credit to standards will result in an expected increase in the average accounts receivable balance of Page 5 of 9
MANAGEMENT ADVISORY SERVICES A. P540,000 B. P2,700,000
Working Capital Management C. P900,000 D. P1,620,000
9. The Tempo Company has an inventory conversion period of 60 days, a receivable conversion period of 30 days, and a payable payment period of 45 days. The Tempo's variable cost ratio is 60 percent and annual fixed costs of P600,000. The current cost of capital for Tempo is 12%. If Tempo's annual sales are P3,375,000 and all sales are on credit, what is the firm's carrying cost on accounts receivable, using 360 days year? A. P281,250 C. P20,250 B. P168,750 D. P56,250 10. Globe, Inc. is considering changing its credit terms from 2/15, net 30, to 3/10, net 30. In order to speed collections. At present, 40 percent of Globe's customers take the 2 percent discount. Under the new term, discount customers are expected to rise to 50 percent. Regardless of the credit terms, half of the customers who do not take the discount are expected to pay on time, whereas the remainder will pay 10 days late. The change does not involve a relaxation of credit standards; therefore bad debt losses are not expected to rise above their present 2 percent level. However, the more generous cash discount terms are expected to increase sales from P2 million to P2.6 million per year. Globe's variable cost ratio is 75 percent, the interest rate on funds invested in accounts receivable is 9 percent, and the firm's income tax rate is 40 percent What are the days sales outstanding (DSO) before- and after the- change of credit policy? A. 27 days and 22.5 days, respectively C. 22.5 days and 27 days, respectively B. 22.5 days and 21.5 days, respectively D. 21.5 days and 22.5 days respectively 11. If a firm purchases raw materials from its supplier on a 2/10, n/50 term, the equivalent annual effective interest (using 360-day year) of continuously giving up a cash discount and making payment on the 50th day is A. 14 percent C. 12.29 percent B. 19.94 percent D. 14.69 percent Questions 12 & 13 are based on the following information. A firm buys on terms of 2/10, net 30, but generally does not pay until 40 days after the invoice date. Its purchases total P1,080,000 per year.
12. How much "non-free" trade credit does the firm use on average each year? A. P120,000 C. P60,000 B. P90,000 D. P30,000 13. What is approximate cost of the "non-free" trade credit? A. 16 2% C. 21.9% B. 19.4% D. 24.5% 14. A company obtained a short-term bank loan of P500,000 at an annual interest rate of 8%. As a condition of the loan, the company is required to maintain a compensating balance of P100,000 in its checking account. The checking account earns interest at an annual rate of 3%. Ordinarily, the company maintains a balance of P50,000 in its account for transaction purposes. What is the effective interest rate of the loan? A. 7.77% C. 9.44% B. 8.50% D. 8.56% Questions 15 thru 18 are based on the following information. You plan to borrow P100,000 from your bank, which offers to lend you the money at a 15 percent nominal, or stated, rate on a 1-year loan. 15. What is the effective interest rate if the loan is discount loan? A. 17.65% C. 17.50% B. 13.00% D. 30.00% 16. What is the approximate effective interest rate if the loan is an add-on interest loan with 12 monthly payments? A. 17.65% C. 20.00% B. 15.00% D. 26.50% 17. What is the effective interest rate if the loan is a discount loan with a 10 percent compensating balance? A. 17.65% C. 17.50% B. 20.00% D. 26.50% 18. Under the terms of question no. 17, how much would you have to borrow to have the use of P100,000? A. P100,000 C. P120,000 B. P111,110 D. P133,333
Exercises & Problems
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MANAGEMENT ADVISORY SERVICES
Working Capital Management
19. Three suppliers of baseball equipment offer different credit terms to City Sports. X Co. offer terms of 1 ½ / 15, net 30. Y Enterprises offers terms of 1/10, net 30. Z Inc. offers terms of 2/10, net 60. City Sports would have to borrow from a bank at an annual rate of 10% in order to take any cash discounts. Which one of the following would be the most attractive for City Sports? A. Purchase from X and pay in 30 days B. Purchase from X, pays in 15 days, and borrows any money needed from the bank C. Purchase from Y and pay in 30 days D. Purchase from Z and pay in 60 days 20. Gees Pipeline, Inc., has developed plans for new pump that will allow more economical operation of the company’s oil pipelines. Management estimates that P2,400,000 will be required to put this new pump into operation. Funds can be obtained from a bank at 10 percent discount interest, or the company can finance the expansion by delaying to payment to its suppliers. Presently, Gees purchases under terms of 2/10, net 40, but management believes payment could be delayed 30 additional days without penalty; that is, payment could be made in 70 days. Which means of financing should Gees use? (Use the approximate cost of trade credit.) A. Trade credit, since the cost is about 12.24 percent. B. Trade credit, since the cost is about 3.13 percentage points less than the bank loan C. Bank loan, since the cost is about 1.13 percent points less than trade credit D. Bank loan, since the cost is about 3.13 percentage points less than trade credit SOLUTIONS
Exercises & Problems
Page 7 of 9
1
.
2
. 1. 2. Permanent financing = 61,900,000 3. Max. temporary financing = 21,900,000
3
. A. P480,000 (1,200,000 – 295,000 – 425,000) B. P18,750 (206,250 – 112,500) – 75,000
127,500 Permanent assets = 59,200,000 (40,000,000 + 19,200,000) (40,000,000 + 43,800,000 x 0.50) (43,800,000 x 0.5)
4
. 1 2a 2b 2c Inc in SNA450,000.450,000.450,000.300,000Inc in RE(453,750)(311,250)(385,000)(450,000)(3,750)78,75065,000(150,000) 5 . (a) (b) Inc in SNA1,020,0001,632,000Inc in RE(630,000)(604,800)390,0001,027,200 6 . A. Cash conversion cycle = 32 days (22 + 40 – 30) B. 28.8 million (1,500 x 600 x 32) C. 4.5 million (35 – 30) x 1,500 x 600 D. New CCC = 30 days (20 + 40 – 30) WC 37.8 million 1,800 x 700 x 30 7
. B. C. D.
8
.
9
. A. P1,500,000 (P750,000 x 2) B. P90,000 P1,500,000 x 6% C. P45,000 P90,000 – P45,000
10
. A. P150,000 B. P75,000 C. P18,000
11
. A. B. AR = 70,000 C. AR = 55,000
A. 132 days (72 + 60) 102 (132 – 30) 8.5 M (30 M x 102/360 reduce days AR (increase AR turnover), reduce days inventory(increase inventory turnover), increase days AP 72,000
(300,000 x 4.5 days x 12%) – 90,000
DSO = 28 days (10 x 40%) + (40 x 60%) (900,000/360 x 28) DSO = 22 days (10 x 40% +30 x 60%)
12
. OldNewChangeP&L EffectSales3,000,0003,300,000300,000x 60%180,000Bad debts %S1.5% 3%Bad debts45,0009,000(9,000)DSO3045AR250,000412,500162,500VC ratiox 40%Inc. in AR Inv’t65,000x 15%(9,750)Inc. Inc bef tax161,250
13
14
.
15
.
16
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OldNewChangeP&L EffectSales2,500,0002,750,000250,000x 0.4100,000Bad debtsx 2.5%(6,250)DSO3045AR208,333343,750135,417 x 0.6Inc. in AR Inv’t81,250.20x 12.5%(10,156.28)Inc. Inc bef tax83,593.720.6Inc’l Net Income50,156.23 3,000,000 OldNewDiffSales10 million10 millionInventory turnover25Inventory5,000,0002,000,0003,000,000 125,000 (1,250,000 x 10%) OldNewDiffCost of Sales45 million45,000,000Inventory turnover912Inventory5,000,0003,750,0001,250,000 A.
Order Size# of ordersOrder CostCarrying CostTotal20,0001 20020,00020,20010,0002 40010,00010,400 5,0004 800 5,000 5,800 1,000204,000 1,000 5,000 2(20,000)(200
B. 2,000 17
2
. A. B. 13.33% C. Answer is the same
Yes, cost savings of 5,000 (300,000 x 15%) – 40,000 (40/300)
18
. daysXNominalEffectiveSupplier A2/10 net 5545816.33%17.54%Supplier B3/10 net 5545824.74%27.59%Supplier C2/15 net 45301224.49%27.43%Supplier D2/10 net 30201836.73%43.86% 19 . One-year4-monthsA.12.5%12.5%B.11.5625% 9.25 8011.5625%C.12.28% 20)11.35%D.10.145%9.5%E.10.88%10.05%F.9.86%9.23%
8.75
20
. A. Supplier A = 18.18% Supplier B = 16.33% B. Borrow at 16%, pay supplier within discount period C. 20% (16/80), Yes, forego the discount.
21
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A. Barangay Bank = 14.12% Townbank = 13.44% (3.25/96.75) x 4 B. Trade discount = 22.27% C. Barangay Bank = 117,647 (100,000 0.85) Townbank = 103,359 (100,000 0.9675) D. Principal = 100,000, Effective interest rate = 12%
(12/85)
22
. A. B. 11.25%
1148% 8.75/(100 – 8.75 – 15) 8/50
9/80
12% C. D. 16%
(100 – 8.75 –
