Exercises in Working Capital Management A. Cash Management 1. Breela Breeland nd Industr Industries ies has daily daily cash receipts receipts of $65,000. $65,000. A recen recentt analy analysis sis of its collec collectio tions ns indicat indicated ed that customer’s payments payments were in the mail an averae of !.5 days. days. "nce received, the payments payments are processed in 1.5 days. After payments payments are deposited, it ta#es an averae of days for these receipts to clear the %an#in system. a.& 'ow much much collection collection float float ( in days days & does the firm current currently ly have ) %.& If the firm’s opportunity cost is 11 percent, would it %e economically advisa%le for the firm to pay an annual fee of $16,500 in order to reduce collection float %y days ) *+plain.
!. "rient "rient "il feels a loc#%o+ loc#%o+ system system can shorten shorten its its accounts accounts receiva%l receiva%lee collection collection period period %y days. days. redit redit sales are ,!-0,000 per year, %illed on a continuous %asis. %asis. he firm has other e/ually ris#y investments with with a return of 15 . he cost of the loc#%o+ loc#%o+ system is ,000 per per year. a.& 2hat amount amount of of cash will will %e made made availa%le availa%le for for other other uses under under the loc#% loc#%o+ o+ system) system) %.& 2hat net %enefit (cost& will the firm receive if it adopts the loc#%o+ system) 3hould it adopt the proposed loc#%o+ system ) . 4orca Industr Industries ies of 3an ieo, ieo, alifornia alifornia,, ust received received a chec# in the amount amount of 700,000 700,000 from a customer customer in Banor, Banor, 8aine. 8aine. If the firm processes processes the chec# in the normal normal manner, manner, the funds will %ecome %ecome availa%le availa%le in 6 days. o speed up this process, the firm could send send an employee to the %an# in Banor on which the chec# is drawn to present it for payment. payment. 3uch action will will cause the funds funds to %ecome availa%le availa%le after ! days. days. If the cost of the direct send is 650 and the firm can earn 11 percent on these funds, what recommendation would you ma#e) *+plain. -. A lare lare 8idwes 8idwester tern n firm has annual annual cash cash dis%ur dis%ursem sement entss of 60 million million made continu continuous ously ly over the year. year. Althouh annual service and administrative costs would increase %y 100,000, the firm is considerin writin all dis%ursement chec#s on a small %an# in Idaho. he firm estimates this will allow an additional additional 19 days of cash usae. usae. If the firm earns a return on other e/ually e/ually ris#y investme investments nts of 1! percent, should should it chane to the distant %an#) 2hy, or why not) 5. ollfree ollfree *nterprises *nterprises routinely routinely finds its chec#in chec#in account to cover all chec#s when written. written. A thorouh analysis of its chec#in account discloses that the firm could maintain an averae account %alance !5 %elow the current level and ade/uately ade/uately cover all all chec#s presented. presented. he averae account account %alance is currently currently 00,000. If the firm can earn 10 percent on short:term investments, what, if any, annual savins would result from maintainin the lower averae account %alance) B. Accounts Receivable Management 1. 2ic#low 2ic#low ;roduct ;roductss currently currently has an averae averae collection collection period period of -5 days and annual annual credit sales sales of $1 million. million. Assume a 60:day year. a.& 2hat is the firm’ firm’ss averae averae accounts accounts receiva%le receiva%le %alance %alance)) %.& If the e/ual:ris# opportunity cost of the investment in accounts receiva%le is 1! percent, what is the total opportunity cost of the investment in accounts receiva%le)
!. heryl’s 8enswear feels its credit costs costs are too hih. hih. By tihtenin tihtenin its its credit standards, %ad %ad de%ts will fall fall from 5 of sales to !. 'owever, 'owever, the the firm estimates estimates that sales sales will fall from 100,000 100,000 to 0,000 0,000 per year. year. he varia%le cost per unit is 50 of the sales price, and the averae investment in receiva%les is e+pected to remain unchaned. a.& 2hat cost will the firm face in a reduced contri%ution contri%ution to to profits from sales) %.& 3hould the firm tihten tihten its credit standards) standards) *+plain your answer. answer. . Adair Industries Industries is is considerin considerin rela+in rela+in its credit standards standards in order to increase its its currently sain sales. As a result of the proposed rela+ation, sales are e+pected to increase %y 10 percent from 10,000 to 11,000 units durin the comin year. he averae collection period is e+pected to increase from -5 to 60 days, and %ad de%ts are e+pected to increase from 1 percent to percent of sales. he sale price per unit is -0 and the varia%le cost per unit is 1. If the firm’s re/uired return on e/ual:ris# investments is !5, evaluate the proposed rela+ation and ma#e a recommendation to the firm. -. ;ritchard ;ritchard ;roducts ;roducts current currently ly ma#es all all sales on credit credit and and offers offers no cash discoun discount. t. he firm firm is considerin considerin a! percent cash discount for payment within 15 days. he firm’s current averae collection period is 60 days, sales are -0,000 units, the firm e+pects that the chane in credit terms will result in an increase in sales to -!,000 units, that <0 percent of the sales will ta#e the discount and that the averae collection period will fall to 0 days. If the firm’s re/uired re/uired rate of return on e/ual:ris# e/ual:ris# investme investments nts is !5 percent, percent, should the proposed proposed discount %e offered)
5. 3pectradyne, Inc. is contemplatin shortenin its credit period from -0 to 0 days and %elieves that as a result of this chane its averae collection period will decline from -5 to 6 days. Bad de%t e+penses are e+pected to decrease from 1.5 to 1 percent of sales. he firm is currently sellin 1!,000 units %ut %elieves that as a result of the proposed chane, sales will decline to 10,000 units. he sale price per unit is 56 and the varia%le cost per unit is -5. he firm has a re/uired rate of return on e/ual:ris# investments of !5. *valuate this decision and ma#e a recommendation to the firm. 6. avid has ust accepted a o% as the financial manaer of 3" 3ales, Inc. In the course of his review of company operatin policies, he collected the followin information reardin 3"’s receiva%les policy, and would li#e to use them in evaluatin a variety of alternatives surroundin this issue= 3ellin ;rice $-0.00 >aria%le 8f. ost ? @nit !-.00 >aria%le 3A ost ? @nit 6.00 Ci+ed ost? @nit 5.00 3ales level ( in units & -00,000 Cull apacity <50,000 Averae collection period 6 days redit terms !?15, n?-5 Bad e%t *+penses ! of sales "pportunity ost of funds !0 per annum Annual collection e+penses $50,000.00 All of the company’s sales are on credit. 0 of al sales are paid within the discount period. *valuate the followin alternatives consecutively= that is, decisions on one issue will %e carried over in arrivin at decisions for succeedin issues. A. hanin the company’s credit terms to ?15, n?-5 should reduce their averae collection period to days. It is estimated that -0 of all sales would not %e made within the discount period. 3hould 3" chane its discount level) B. Dela+in credit terms so that the discount period is now !0 days with n?60 should increase sales volume %y an additional !0,000 units. Eo chane is anticipated in the percentae of customers who are ta#in advantae of the discount. Averae collection period will %e stretched to -7 days. 3hould the company rela+ its credit terms) . Dela+in its credit standards should enerate an additional sales volume of 60,000 units. Averae collection period on the incremental sales will %e <5 daysF none of these payments will %e made within the discount period. Bad de%ts on these additional sales will %e 10. 3hould the company try to attract these additional customers %y lowerin its credit standards) C. Inventory Management 1. 4yons *lectronics purchases 1,!000,000 units per year of one component. Ci+ed cost per order is !5. Annual carryin cost of the item is !< percent of its $! cost. etermine the *"G under the followin conditions= 1.& no chanes !.& order cost of Hero .& carryin cost of Hero
!. icho as and *lectric is re/uired to carry a minimum of !0 days’ averae coal usae, which is 100 tons of coal. It ta#es10 days %etween order and delivery. At what level of coal would * reorder ) . 3a%ra o. uses 700 units of a product per year on a continuous %asis. he product has a fi+ed cost $50 per order, and its carryin cost is $! per unit per year. It ta#es 5 days to receive a shipment after an order is placed. a.& alculate the *"G. %.& etermine the reorder point. -. he 'ede orporation manufactures only one product= plan#s. he sinle raw material used in ma#in plan#s is the dint. Cor each plan# manufactured, 1! dints are re/uired. Assume that the company manufactures 150,000 plan#s per year, that it costs $!00 each time dints are ordered, and that carryin costs are $7 per dint per year. a.& etermine the economic order /uantity of dints. %.& 2hat are total inventory costs for 'ede) c.& 'ow many times per year would inventory %e ordered)
5. A collee %oo#store is attemptin to determine the optimal order /uantity for a popular %oo# on psycholoy. he store sells 5000 copies of this %oo# a year at a retail price of $1!.50 althouh the pu%lisher allows the store a !0 discount on this price. he store fiures that it costs $1 per year to carry a %oo# in inventory and $100 to prepare an order for new %oo#s. a.& etermine the total costs associated with orderin 1, !, 5, 10 and !0 times a year. %.& etermine the economic order /uantity. 6. Cavorite Coods, Inc. %uys 50,000 %o+es of ice cream cones every two months to service steady demand for the product. "rder costs are $100 per order, and carryin costs are $.-0 per %o+. a.& etermine the optimal order /uantity. %.& he vendor now offers Cavorite Coods a /uantity discount of $0.0! per %o+ if it %uys cones in order siHes of 10,000 %o+es. 3hould Cavorite Coods avail itself of the /uantity discount) <. o reduce production start:up costs, Bodden ruc# ompany may manufacture loner runs of the same truc#. *stimated savins from the increase in efficiency are $!60,000 per year. 'owever, inventory turnover will decrease from 7 times to 6 times a year. osts of oods sold are $-7 million on an annual %asis. If the re/uired rate of return on investments in inventories is 15, should the company instiate the new production plan) D. ources o! "inancing ## Management o! Current $iabilities 1. 4' Industries has a line of credit at Cirst Ban# that re/uires to pay 11 percent interest on its %orrowin and maintain a compensatin %alance e/ual to 15 percent of the amount %orrowed. he firm has %orrowed $700,000 durin the year under the areement. alculate the effective interest rate on the firm’s %orrowin in each of the followin circumstances. a.& he firm normally maintains no deposit %alances at Cirst Ban#. %.& he firm normally maintains <0,000 in deposit %alances at Cirst Ban#. c.& he firm normally maintains 150,000 in deposit %alances at Cirst Ban#.
!. ommercial paper is usually sold at a discount. ;@4; has ust sold an issue of 0:day commercial paper with a face value of $1 million. he firm has received <7,000. a.& 2hat is the effective annual interest rate will the firm pay for financin with commercial paper) %.& If a %ro#erae fee of $,61! was paid from the initial proceeds to an investment %an#er for sellin the issue, what effective annual interest rate will the firm pay) . Bor# orporation wishes to %orrow $100,000 for one year. It must choose one of the followin alternatives= A.& An 7 loan on a discount %asis with !0 compensatin %alances re/uired. B.& A loan on a discount %asis with 10 compensatin %alances re/uired. .& A 10.5 loan on a collect %asis with no compensatin %alance re/uirement. 2hich alternative should Bor# orp. choose if it is concerned with the effective interest rate) -. he 3el%y amin 8anfacturin ompany has e+perienced a severe cash s/ueeHe and must raise !00,000 over the ne+t ninety days. he company has already pleded its receiva%les in support of a loan. 3till, it has 5<0,000 in unencum%ered inventories. etermine which of the followin financin alternatives is %etter= A.& he ody Eational Ban# of Deno will lend aainst finished oods, provided they are placed in a pu%lic warehouse under its control. As the finished oods are released for sale, the loan is reduced %y the proceeds of the sale. he company currently has 00,000 in finished oods inventories and would e+pect to replace finished oods that are sold out of the warehouse with the new finished oods, so that it could %orrow the full !00,000 for 0 days. he interest rate is 10, and the company will pay warehouse costs of ,000. Cinally it will e+perience a reduction in efficiency as a result of this arranement. 8anaement estimates that the lower efficiency will reduce %efore:ta+ profits %y 5,000. B.& he arlotti Cinance ompany will lend the company the money under a floatin lien on all of its inventories. he rate is !, %ut no additional e+penses will %e incurred. 5. he JedHie ordae ompany needs to finance a seasonal %ule in inventories of -00,000. he funds are needed for si+ months. he company is considerin the followin possi%ilities= A.& 2arehouse receipt loan from a finance company. erms are 1! with an 70 advance aainst the value of the inventory. he warehousin costs are <,000 for the si+ month period. he residual financin re/uirement, which is -00,000 less the amount advanced, will need to %e financed %y foroin cash discount on its paya%les. 3tandard terms are !?10, net 0F however, the company feels it can postpone payment until the fortieth day without adverse effect. B.& A floatin lien arranement from the supplier of the inventory at an effective interest rate of !0. he supplier will advance the full value of the inventory. .& A field warehouse loan from another finance company at an interest rate of 10. he advance is <0, and field warehousin cost of 10,000 for the si+ month period. he residual financin re/uirement will need to %e financed %y foroin cash discounts on paya%les as in the first alternative. 2hich is the least costly method of financin the inventory needs of the firm)
6. 3phin+ 3upply ompany needs to increase its wor#in capital %y 100,000. It has decided that there are three alternatives of financin availa%le. A.& Coro cash discounts, ranted on a %asis of ?10, net 0. B.& Borrow from the %an#, at 15 interest. his alternative would necessitate maintainin a !5 compensatin %alance. .& Issue commercial paper at 1-. he cost of placin the issue would %e 1000 each si+ months. Assumin the firm would prefer the fle+i%ility of %an# financin, provided the additional cost of this fle+i%ility is no more than !, which alternative would 3phin+ select) <. he Bone ompany has %een factorin its accounts receiva%le for the past five years. he factor chares a fee of ! and will lend up to 70 of the volume of receiva%les purchased for an additional 1.5 per month. he firm typically has sales of 500,000 per month, <0 of which are on credit. By usin the factor, two savins are affected= 1.& !000 per month that would %e re/uired to support a credit department !.& a %ad de%t e+pense of 1 percent on credit sales he firm’s %an# has recently offered to lend the firm up to 70 of the face value of the receiva%les. he %an# would chare 15 per annum interest plus a ! processin chare per dollar of receiva%les lendin. he firm e+tends terms of net 0, and all customers who pay their %ills do so %y the thirtieth of the month. 3hould the firm discontinue its factorin arranement in favor of the %an#’s offer if the firm %orrows, on the averae, 100,000 per month on its receiva%les) 7. he ud ompany purchases raw materials on terms of !?10, net 0. A review of the company’r records %y the owner, 8r. ud, revealed that payments are usually made 15 days after purchases are received. 2hen as#ed why the firm did not ta#e advantae of its discounts, the %oo##eeper, 8r. rind, replied that it cost only ! for these funds, whereas a %an# loan would cost the firm 1!. a.& 2hat mista#e is 8r. rind ma#in ) %.& 2hat is the real cost of not ta#in advantae of the discount )
Additional *+ercises=
1. Kordan Air has averae inventory of $1m. Its estimated annual sales are $15m and the firm estimates its receiva%les collection period to %e twice as lon as its inventory conversion period. he firm pays its trade credit on timeF its terms are net 0. he firm wants to decrease its cash conversion cycle %y 10 days. It %elieves that it can reduce its averae inventory to $00,000. Assume a 60:day year and that sales will not chane. ost of oods sold e/uals 70 of sales. By how much must the firm reduce its accounts receiva%le to meet its oal of a 10:day reduction) !. he 2iley *lectrical 8anufacturin orp. annually calculates a num%er of turnover ratios involvin several of its wor#in capital accounts. "peratin activity is level throuhout the year. Based on a 60:day year, the firm calculates the averae turnover of three of its accounts to %e the followin= A?D L +F inventory L 6+F A?; L 1!+. alculate the time it ta#es 2iley *lectrical to complete its averae short term operatin cycle. 'ow would the cash cycle turnover for 2iley’s cash position %e affected if the A?; and A?D turnover ratios were reversed) . ross ollecti%les currently fills mail orders from all over the @.3. and receipts come in to head/uarters in 4ittle Doc#, Ar#ansas. he firm’s averae accounts receiva%le (A?D& is considerin a reional loc#%o+ system to speed up collections which it %elieves will reduce A?D %y !0. he annual cost of the system is $15,000. 2hat is the estimated net annual savins to the firm from implementin the loc#%o+ system) -. opple ea 'ouses, Inc. operates seven restaurants in the state of ;ennsylvania. he manaer of each restaurant transfers funds daily from the local %an# to the company’s principal %an# in 'arris%ur. here are appro+imately !50 %usiness days durin a year in which transfers occur. 3everal methods of transfer are availa%le. A wire transfer results in immediate availa%ility of funds, %ut the local %an#s chare $5 per wire transfer. A transfer throuh an automatic clearinhouse involves ne+t:day settlement, or a 1:day delay, and costs $.00 per transfer. Cinally, a depository transfer chec# arranement costs $0.0 per transfer, and mailin times result in a :day delay on averae for the transfer to occur. (his e+perience is the same for each restaurant.& he company presently uses depository transfer chec#s for all transfers. he restaurants have the followin daily averae remittances= D*3A@DAE 1 ! $,000 $-,600
$!,<00
$5,!00
5 $-,100
6 $,500
< $,700
a& If the opportunity cost of funds is 10, which transfer procedure should %e used for each of the restaurants) %& If the opportunity cost of funds were 5, what would %e the optimal stratey) 5. he 4ist ompany, which can earn < on money mar#et instruments, currently has a loc#%o+ arranement with a Eew "rleans %an# for its sourthern customers. he %an# handles $m a day in return for a compensatin %alance of $!m. a& he 4ist ompany has discovered that it could divide the southern reion into a southwestern reion (with $1m a day in collections, which could %e handled %y a allas %an# for a $1m compensatin %alance& and a southeastern reion (with $!m a day in colections, which could %e handled %y an Atlanta %an# for a $!m compensatin %alance&. In each case, collections would %e one:half day /uic#er than with the Eew "rleans arranement. 2hat would %e the annual savins (or cost& of dividin the southern reion) %& In an effort to retain the %usiness, the Eew "rleans %an# has offered to handle collections strictly on a fee %asis (no compensatin %alance&. 2hat would %e the ma+imum fee the Eew "rleans %an# could chare and still retain 4ist’s %usiness) 6. Mou have ust %een hired %y 2orldwide oys as their cash manaer. "n your first day on the o%, you find that the cash manaement system is in disarray. onse/uently, it must first %e overhauled, and in the process you must educate your employees and the firm’s manaement. wo alternatives to the present cash flow system have %een presented to you. 2hat decisions should %e made in each case) Lockbox. Averae collection float is presently 6. days. By adoptin a loc#%o+ system, the float will %e reduced to !.7 days. he daily collections are ;1,500,000F e+cess funds can %e invested at a rate of 7, and there are !,500 chec#s per day. he %an# will chare ;!00 per day plus !0 cents per chec# processed. (Assume a 65:day year throuhout and calculate the daily %enefits and costs.& Wire Transfer. 2orldwide currently employs electronic ’s to move funds %etween various %an#s and its concentration %an#. By switchin to wire transfers, it would reduce float %y one day. he electronic ’s cost ;1.<7 per transfer while wire transfers cost ;-.-5 per transfer. he num%er of transfers per day is 0 while the averae siHe is ;!,000. he interest rate is 7. <. he ow%oy Bottlin ompany will enerate $1!m in credit sales ne+t year. ollections of these credit sales will occur evenly over this period. he firm’s employees wor# !<0 days a year. urrently, the firm’s processin system ties up four days’ worth of remittance chec#s. A recent report from a financial consultant indicated procedure that will ena%le ow%oy Bottlin to reduce processin float %y two full days. If ow%oy invests the released funds to earn 6, what will %e the annual savins) 7. Alpine 3ystems is a distri%utor of refrierated storae units to the meat products industry. All its sales are on a credit %asis, net 0 days. 3ales are evenly distri%uted over its 10 sales reions throuhout the @nited 3tates. elin/uent accounts are no pro%lem. he company has recently underta#en an analysis aimed at improvin its cash manaement procedures. Alpine determined that it ta#es an averae of .! days for customers’ payments to reach the head office in ;itts%urh from the time they are mailed. It ta#es another full day in processin time prior to depositin the chec#s with a local %an#. Annual sales averae $5,000,000 for each reional office. Deasona%le investment opportunities can %e found yieldin 7 per year. o alleviate the float pro%lem confrontin the firm, the use of a loc# %o+ system in each of the 10 reions is %ein considered. his would reduce mail float %y one day. "ne day in processin float would also %e eliminated, plus a full day in transit float. he loc# %o+ arranement would cost each reion $!!5 per month. a& 2hat is the opportunity cost to Alpine 3ystems of the funds tied up in mailin and processin) @se a 65 day year. %& 2hat would the net cost or savins %e from use of the proposed cash acceleration techni/ue) 3hould Alpine adopt the system) . o reduce production start:up costs, Bodden ruc# ompany may manufacture loner runs of the same truc#. *stimated savins from the increase in efficiency are ;!60,000 a year. 'owever, inventory turnover will decrease from 7+ to 6+ a year. ost of sales are ;-7m on an annual %asis. If the re/uired rate of return on inventories is at 15, should the company instiate the new production plan) 10. urham:CeltH orporation presently ives terms of net 0 days. It has $60m in sales, and its averae collection period is -5 days. o stimulate demand, the company may ive terms of net 60 days. If it does instiate these terms, sales are e+pected to increase %y 15. After the chane, the averae collection period is e+pected to %e <5 days. 2ith no difference in payment ha%its %etween old and new customers. >aria%le costs are $0.70 for every $1.00 of sales, and the company’s re/uired rate of return on investment in receiva%les is !0. 3hould the company e+tend its credit period) Assume a 60:day year.
11. o increase sales from their present annual $!-million, Kefferson Jnu 8onroe ompany, a wholesaler, may try more li%eral credit standards. urrently, the firm has an averae collection period of 0 days. It %elieves that with increasinly li%eral credit standards, the followin will result= D*I ;"4IM Increase in sales from previous sales level (in millions& Averae collection period for incremental sales (days&
A $!.7 -5
B 1.7 60
1.! 0
.6 1--
he prices of its products averae $!0 per unit, and varia%le costs averae $17 per unit. Eo %ad de%t losses are e+pected. If the company has an opportunity cost of funds of 0, which credit policy should %e pursued) (Assume a 60:day year.& 1!. Cavorite Coods, Inc. %uys 50,000 %o+es of ice cream cones every two months to service steady demand for the product. "rder costs are $100 per order, and carryin costs are $0.-0 per unit. a. etermine the optimal order /uantity. %. he vendor now offers Cavorite Coods a /uantity discount of $0.0! per %o+ if it %uys cones in order siHes of 10,000 %o+es. 3hould Cavorite Coods avail of the /uantity discount) 1. Mou are purchasin furniture on terms of ?10, n?0. Mou will %e una%le to pay %y the tenth day %ut could pay the $!5,000 invoice price at the end of 60 days. Alternately, you could %orrow the necessary funds throuh a 0:day %an# loan at an 17 annual interest rate. a& alculate the effective interest rate or cost of payin for the furniture at the end of 60 days. 2ould you consider such a payment plan to %e superior to payment on the final due date) %& alculate the dollar costs associated with payin for the furniture at the end of 0 days versus %orrowin from the %an# in order to ta#e advantae of the cash discount offer. "n what %asis should you purchase the furniture) 1-. etermine the annual percentae interest cost for each of the followin terms of sale, assumin the firm does not ta#e the cash discount %ut pays on the final day of the net period (60:day year&= a& %& c& d&
1?!0, net 0 (500 invoice& !?0, net 60 ($1,000 invoice& !?5, net 10 ($100& ?10, net 0 ($!50&
15. 2hat is the cost of foreoin a ?15, n?50 cash discount if payment is made on the !0 th day) "n the -0th day) "n the 50 th day) 'ow many days should he pay his de%t from the time of the completion of the contract so that he will only effectively have a 10 opportunity cost) 16. Guic#%ow ompany currently uses ma+imum trade credit %y not ta#in discounts on its purchases. Guic#%ow is considerin %orrowin from its %an#, usin notes paya%le, in order to ta#e trade discounts. he firm wants to determine the effect of this policy chane on its net income. he standard industry credit terms offered %y all its suppliers are !?10, net 0 days, and Guic#%ow pays in 0 days. Its net purchases are $11,<60 per day, usin a 60:day year. he rate on the notes paya%le is 10 and the firm’s ta+ rate is -0. If the firm implements the plan, what is the e+pected chane in Guic#%ow’s net income) 1<. he Co+ ompany is a%le to sell $1m of commercial paper every months at a rate of 10 and a placement cost of $,000 per issue. he dealers re/uire Co+ to maintain %an# lines of credit demandin $100,000 in %an# %alances, which otherwise would not %e held. Co+ has a -0 ta+ rate. 2hat do the funds from commercial paper cost Co+ after ta+es) 17. ommercial paper has no stipulated interest rate. It is sold on a discount %asis, and the amount of the discount determines the interest cost to the issuer. "n the %asis of the followin information, determine the percentae interest cost on an annual %asis for each of the followin issues. (Assume a 60:day year.& I33@* a % c d e
CA* >A4@* $ !5,000 100,000 50,000 <5,000 100,000
;DI* $!-,500 5,500 -7,700 <1,00 ,100
*E"D 60 days 170 0 !<0 0
1. he 8arc and 8ona 8anufacturin o. provides specialty steel products to the oil industry. Althouh the firm’s %usiness is hihly correlated with the cyclical swins in oil e+ploration activity, it also e+periences some sinificant seasonality. It is this seasonality in its need for funds that the firm is currently concerned a%out. he firm needs ;500,000 for the !:month Kuly:Auust period each year, and as a result, the company’s >; for finance is currently considerin the followin three sources of financin= a. *sta%lish a line of credit with ominic evelopment Ban#. he %an# has areed to provide 8arch and 8ona with the needed ;500,000, carryin an interest rate of 1- with interest discounted and a compensatin %alance of !0 of the loan %alance. 8arc and 8ona does not have a %an# account with ominic and would have to esta%lish one to satisfy the compensatin %alance re/uirement. %. 8arc and 8ona can foro its trade discounts over the two months of Kuly and Auust when the fundin will %e needed. he firm’s discount terms are ?15, net 0, and the firm averaes ;500,000 in trade credit purchases in Kuly and Auust. c. Cinally, 8arc and 8ona could enter into a pledin arranement with a local finance company. he finance company has areed to e+tend 8arc and 8ona the needed ;500,000 if it pledes ;<50,000 in receiva%les. he finance company has offered to advance the ;500,000 with 1! annual interest paya%le at the end of the two:month loan term. In addition, the finance company will chare a 9 of 1 fee %ased on pleded receiva%les to cover the cost of processin the company’s accounts. (his fee is paid at the end of the loan period.& AnalyHe the cost of each alternative and select the %est one. !0. he 3econd Eational Ban# offers you a 0:day note for $15,000 discounted at per annum. Also availa%le is a $15,000, 0 day note from the hird Eational Ban# which re/uires repayment of principal plus interest at .5 annual rate when the note is due. a& 2hat are the proceeds that each %an# would credit to your account) %& 2hat is the effective rate of interest %ein chared %y each %an#) c& Instead of a 0:day note, assume that you can %orrow for a 60:day period. 'ow would your answer to ;arts (a& and (%& %e affected) !1. ;or# orporation wishes to %orrow $100,000 for one year. It must choose one of the followin alternatives= a& An 7 loan on a discount %asis with !0 compensatin %alances re/uired. %& A loan on a discount %asis with 10 compensatin %alances re/uired. c& A 10.5 loan on a collect %asis with no compensatin %alance re/uirement. 2hich alternative should ;or# orporation choose if it is concerned with the effective interest rate) !!. 2ater ;ar# Inc. (2;I& estimates that as a result of the seasonal nature of its %usiness, it will re/uire an additional ;50,000 of cash for the month of Kuly. 2;I has the followin four alternatives availa%le for raisin the needed funds= a& *sta%lish a 1 year line of credit of ;50,000 with a commercial %an#. he commitment fee would %e 0.5 percent per year on the unused portion, and the interest chare on the used funds will %e 1! per year. Assume that the funds are needed only in Kuly, and there are 0 days in Kuly and 60 days in the year. %& Coreo the trade discount of ?10, net -0 on ;50,000 of purchases durin Kuly. c& Issue ;50,000 of 0:day commercial paper at an 11.- annual interest rate. he total transactions fee, includin the cost of a %ac#up credit line, on usin the commercial paper, is 0.5 of the amount of issue. d& Issue ;50,000 of 60:day commercial paper at an 11.0 annual interest rate, plus a transactions fee of 0.-. 3ince the funds are re/uired only for 0 days, the e+cess funds ;50,000& can %e invested in mar#eta%le securities for the month of Auust, earnin 10.7 annually. he total transactions cost of purchasin and sellin the mar#eta%le securities is 0.- of the amount of the issue. De/uired= 1. 2hat is the cost of each of the financin arranement) 3how computations. !. Is the source with the lowest e+pected cost necessarily the one to select) 2hy or why not) !. "tis Ba#er, manaer of %an#in relationships at Baldwin an, wishes to esta%lish a prearraned unsecured short term %orrowin arranement with the firm’s local %an#. he %an# has offered either a line of credit or a revolvin credit areement. he %an#Ns terms for a line of credit are an interest rate of . a%ove the prime rate, and the %orrowin must %e reduced to Hero for a 0:day period durin the year. "n an e/uivalent revolvin credit arranement, the interest rate would %e !.7 a%ove prime with a commitment fee of 0.50 on the averae unused %alance. @nder %oth loans, a compensatin %alance e/ual to !0 of the amount %orrowed would %e re/uired. he prime rate is currently 7. Both the line of credit and the revolvin credit areement would have %orrowin limits of ;1m. "tis e+pects Baldwin an on averae to %orrow ;500,000 durin the year reardless of which loan areement it chooses. Cind the effective annual rate of interest under %oth arranements. 2hich arranement would you recommend)
!-. . harles 3mith was recently hired as president of ellvoe "ffice */uipment Inc., a small manufacturer of metal office e/uipment. As his assistant, you have %een as#ed to review the company’s short:term financin policies and to prepare a report for 3mith and the %oard of directors. o help you et started, 3mith has prepared some /uestions which, when answered, will ive him a %etter idea of the company’s short:term financin policies. ellvoe had e+pected a really stron mar#et for office e/uipment for the year ust ended, and in anticipation of stron sales, the firm increased its inventory purchases. 'owever, sales for the last /uarter of the year did not meet e+pectations, and now ellvoe finds itself short on cash. he firm e+pects that its cash shortae will %e temporary, lastin only months. (he inventory has %een paid for and cannot %e returned to suppliers. In the office e/uipment mar#et, the desins chane nearly every two years, and ellvoe’s inventory reflects the new desin chanes, so its inventory is not o%solete.& ellvoe has decided to use inventory financin to meet its short:term cash needs. It estimates that it will re/uire $700,000 for inventory financin durin this :month period. ellvoe has neotiated with the %an# for a :month, 1,000,000 line of credit with terms of 10 annual interest on the used portion, a 1 commitment fee on the unused portion, and a $1!5,000 compensatin %alance at all times. *+pected inventory levels to %e financed are as follows= Month Amount Kanuary 16 $700,000 Ce%ruary 500,000 8arch 00,000 alculate the cost of funds from this source, includin interest chares and commitment fees. ('int= *ach month’s %orrowins will %e $1!5,000 reater than the inventory level to %e financed %ecause of the compensatin %alance re/uirement.& !5. A factor has areed to lend the K> orp. wor#in capital on the followin terms. K>’s receiva%les averae $100,000 per month and have a 0:day averae collection period. (note that K>’s credit terms call for payment in 0 days and accounts receiva%le averae $00,000 %ecause of the 0:day averae collection period.0 he factor will chare 1! interest on any advance (O per month paid in advance&, will chare a ! processin fee (also paid in advance& on all receiva%les factored, and will maintain a !0 reserve. If K> underta#es the loan it will reduce its own credit department e+penses %y $!,000 per month. 2hat is the annual effective rate of interest to K> on the factorin arranement) Assume that the ma+imum advance is ta#en. !6. anlewood Doofin 3upply, Inc. has areed to %orrow wor#in capital from a factor on the followin terms= anlewood’s credit sales averae $150,000 per month and have a 0 day averae collection period (note that the firm offers 0 day credit terms and its accounts receiva%le averae $-50,000 %ecause of the 0 day collection period.& he factor will chare 1 interest on any advances, will chare a ! processin fee on all receiva%les factored, and will advance only a ma+imum of 75 of the value of the receiva%les. If anlewood underta#es the loan it will reduce its own credit department e+penses %y $1,500 per month. 2hat is the annual effective rate of interest to anlewood on the factorin areement) Assume that the ma+imum advance is ta#en. !<. Assume that 3unshine ;roducts Inc. has an areement with 3hady Cinance ompany to factor its receiva%les. 3hady chares a flat commission of ! of the receiva%les factored, plus 6 a year interest on the outstandin %alance. It also deducts a reserve of 10 for returned and damaed materials. Interest and commission are paid in advance. Eo interest is chared on the reserve or the commission. If the averae level of outstandin receiva%les is $<00,000, and if they are turned over - times a year (hence the commission is paid - times a year&, then what is the effective /uarterly interest rate chared %y 3hady for this arranement) !7. he Koe istri%utin o. offers a ! percent discount on cash purchases and a one percent discount for payment within !0 days. If you ta#e neither discount, payment must %e made within 60 days. 2hat is the cost of foreoin that cash discount and payin in 60 days instead) 2hat is the cost of foreoin the !0:day discount and payin in 60 days instead) 2hat is the cost of foreoin the cash discount and payin in !0 days instead)
!. eweles *lectric ompany sells 500,000 standard wall switches a year. *ach switch costs the company ;!.00. he percentae cost of carryin the switch inventory is !0 percent of inventory value. he company can order these switches from either of two competin manufacturers. 8anufacturer A delivers in days and re/uires a fi+ed orderin cost of ;100 per order. 8anufacturer B, which would re/uire a fi+ed orderin cost of ;<5 per order, ta#es 5 days to deliver. Assume that no safety stoc# is %ein carried. Re%uire&' 1. alculate eweles’ *"G for wall switches for %oth suppliers. !. 'ow many orders a year must %e places with each supplier (assumin that only one supplier is used)& . 2hat is the reorder point levels for orderin from each supplier) -. onsiderin only inventory costs, should the firm order its wall switches from 8anufacturer A or 8anufacturer B) 5. Assumin a safety stoc# of 1,500 wall switches, how much would the total inventory costs %e for each supplier) 6. Defer to the oriinal data. Assume that the firm chose 8anufacturer B as its wall switch supplier. eweles has %een offered a 1 percent discount if it orders !0,000 units or more at a time. 3hould the firm increase the orderin /uantity to !0,000 units and ta#e the discount)
0. 8iel#e ;roducts, a Eew Kersey:%ased firm, manufactures and distri%utes leal and financial services and products directly to consumers. he firm has rown rapidly, causin a need for short:term financin. ;art of their sales are for cash, %ut a maority are for credit. he credit sales are financed %y short:term %orrowins. As the *" you have decided the whole short:term financin stratey needs to %e reevaluated. 2hat is the effective interest rate for %oth) 3hould either of these %e employed instead of the %an# loan and?or line of credit)
A. ;resently 8iel#e has two %an# loans. he first is a si+:month loan for $1,000,000 %ased on discount interest that carries an interest rate of 16 percent. he loan has a compensatin %alance re/uirement of $100,000F typically 8iel#e would have only $15,000 in the %an#. he second is a 170:day $!,500,000 line of credit that has an annual commitment fee of ! percent on the unused portion of the line. "ver the last 170 days the interest rates and usae have %een as follows=
Interest rate otal %orrowin
First 75 Days 1-.5 $1,!50,000
Second 75 Days 15.<5 $1,000,000
Last 30 Days 16 $1,00,000
2hat is the effective interest on %oth loans) B. Instead of the %an# loans, 8iel#e is investiatin pledin and?or factorin its receiva%les. wo alternatives are as follows= Pledging receivables. 4oan is for 6 months. otal receiva%les are $,000,000, of which the loan is for <0 percent. he processin fee is 1 percent of the receiva%les pleded every 6 months. he interest rate is 15 percent. Factoring receivables. he areement is for 6 months. he loan is for <0 percent of the receiva%les, which are $,000,000. he factorin commission is 0.70 of 1 percent of the total receiva%les per every 6 months. he interest rate is 16 percent.
