CHAPTER 22 WORKING CAPITAL MANAGEMENT (Difficulty: E = Easy, M = Medium, and T = Tough) True-False Easy: Net working capital Answer: b Diff: E Net working capital may be defined as current assets minus current liabilities This also defines the current ratio a True b False Net working capital Answer: b Diff: E Net working capital is defined as current assets divided by current liabilities a True b False Working capital An increase in a current asset account must corresponding increase in a liability account Answer: b be Diff: E accompanied by a a True b False Working capital policy Answer: a Diff: E Determination of a firm's investment in net operating working capital and how that investment is financed are elements of working capital policy a True b False Goal of cash management Answer: a Diff: E Cash is often referred to as a "non-earning" asset Thus, one goal of cash management is to minimize the amount of cash necessary to conduct business a True b False Chapter 22 - Page Motives for holding cash Answer: a Diff: E Firms hold cash balances in order to complete transactions that are necessary in business operations and as compensation to banks for providing loans and services a True b False Cash budget Answer: a Diff: E A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on uniform cash receipts and disbursements, but actual receipts are concentrated at the beginning of each month a True b False Cash budget Answer: a Diff: E Shorter-term cash budgets, in general, are used for actual cash control while longer-term budgets are used primarily for planning purposes a True b False Float Answer: a Diff: E For a firm that makes heavy use of float, being able to forecast its collections and disbursement check clearings is essential a True b False Lockbox 10 Answer: a Diff: E Lockbox arrangements are one way for a firm to speed up its collection of payments from customers a True b False Receivables balance 11 Answer: b Diff: E Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio will also have a high payables-to-sales ratio a True b False Chapter 22 - Page Receivables balance 12 Answer: a Diff: E The average accounts receivables balance is determined jointly by the volume of credit sales and the days sales outstanding a True b False Receivables aging 13 Answer: b Diff: E If a firm has a large percentage of accounts over 30 days old, it is a sign that the firm's receivables management needs to be reviewed and improved a True b False Monitoring receivables 14 Answer: a Diff: E The aging schedule is a commonly used method of monitoring receivables a True b False Credit policy 15 Answer: a Diff: E The four major elements in a firm's credit policy are (1) credit standards, (2) discounts offered, (3) credit period, and (4) collection policy a True b False Cash discounts 16 Answer: b Diff: E If you receive some goods on April with the following terms; 3/20, net 30, June dating, it means that you will receive a percent discount if the bill is paid on or before June 20 and that the full amount must be paid 30 days after receipt of the goods a True b False Trade discounts 17 Answer: b Diff: E Offering trade credit discounts is costly to a firm and as a result, firms that offer trade discounts are usually those that are performing poorly and need cash quickly a True b False Chapter 22 - Page Change in credit policy 18 Answer: a Diff: E A firm changes its credit policy from 2/10, net 30, to 3/10, net 30 The change is meant to meet competition, so no increase in sales is expected Average accounts receivable will probably decline as a result of this change a True b False Goal of inventory management 19 Answer: b Diff: E The central goal of inventory management is to provide sufficient incentives to ensure that the firm never suffers a stock-out (i.e., runs out of an inventory item) a True b False Goal of inventory management 20 Answer: a Diff: E The principal goal of most inventory management systems is to balance the costs of ordering, shipping, and receiving goods with the cost of carrying those goods, while simultaneously meeting the firm's policy with respect to avoiding running short of stock and disrupting production schedules a True b False Inventory management interaction 21 Answer: b Diff: E Inventory management is largely self-contained, that is, only minimum coordination among other departments such as sales, purchasing, and production is required for successful inventory management a True b False Working capital financing 22 Answer: a Diff: E Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive working capital financing strategy because of the inherent risks of using short-term financing a True b False Chapter 22 - Page Permanent working capital 23 Answer: a Diff: E Permanent net operating working capital reflects the fact that net operating working capital does not shrink to zero even when business is at a seasonal or cyclical low Thus, permanent net operating working capital represents a minimum level of net operating working capital the firm must finance a True b False Conservative financing approach 24 Answer: a Diff: E A conservative financing approach to working capital will result in all permanent net operating working capital being financed using long-term securities a True b False Accruals 25 Answer: a Diff: E Accruals are "free" financing in the sense that no explicit interest is paid on accruals a True b False Accruals Answer: a Diff: E 26 Accruals are “spontaneous,” but, unfortunately, due to law and economic forces, firms have little control over the level of these accounts a True b False Accruals 27 Answer: b Diff: E The fact that no explicit interest cost is paid on accruals, and that the firm can exercise considerable control over their level, makes accruals an attractive source of additional funding a True b False Trade credit 28 Answer: b Diff: E If a firm is offered credit terms of 2/10, net 30, it is in the firm's financial interest to pay as early as possible during the discount period a True b False Chapter 22 - Page Trade credit 29 Answer: b Diff: E Trade credit can be separated into two components: free trade credit, which involves credit received after the discount period ends, and costly trade credit, which is the cost of discounts not taken a True b False Trade credit 30 Answer: a Diff: E As a rule, managers should try to always use the free component of trade credit but should use the costly component only after comparing its costs to the costs of similar credit from other sources a True b False Trade credit 31 Answer: a Diff: E Trade credit is an inexpensive source of short-term financing if no discounts are offered a True b False Trade credit 32 Answer: a Diff: E When deciding whether or not to take a trade discount, the cost of borrowing funds should be compared to the cost of trade credit to determine if the cash discount should be taken a True b False Cost of trade credit 33 Answer: a Diff: E The calculated cost of trade credit is reduced by paying late a True b False Cost of trade credit 34 Answer: a Diff: E The calculated cost of trade credit for a firm that buys on terms of 2/10, net 30, is lower (other things held constant) if the firm pays in 40 days than if it pays in 30 days a True b False Chapter 22 - Page Cost of trade credit 35 Answer: a Diff: E One of the disadvantages of not taking trade credit discounts when offered is that the firm's investment in accounts payable rises a True b False Net trade credit 36 Answer: b Diff: E A firm is said to be extending net trade credit when its accounts receivable are less than its accounts payable a True b False Net trade credit 37 Answer: a Diff: E When a firm has accounts payable that are greater than the level of its receivables, the firm is actually receiving net trade credit a True b False Stretching accounts payable 38 "Stretching" accounts financing technique Answer: b payable is a widely accepted and Diff: E costless a True b False Short-term financing 39 Answer: a Diff: E Short-term financing may be riskier than long-term financing since, during periods of tight credit, the firm may not be able to rollover (renew) its debt a True b False Short-term financing 40 Answer: a Diff: E One of the advantages of short-term debt financing is that firms can expand or contract their short-term credit more easily than their longterm credit a True b False Chapter 22 - Page Short-term financing 41 Answer: a Diff: E Short-term loans generally are obtained faster than long-term loans because when lenders consider long-term loans they insist on a more thorough evaluation of the borrower's financial health and because the loan agreement is more complex a True b False Bank loans 42 Answer: b Diff: E A line of credit and a revolving credit agreement are similar except that a line of credit creates a legal obligation for the bank a True b False Bank loans 43 Answer: a Diff: E The maturity of most bank loans is short-term Bank to business loans are frequently 90-day notes which are often rolled over, or renewed, at the end of their maturity a True b False Promissory note 44 Answer: b Diff: E A promissory note is the document signed when a bank loan is executed and it specifies financial aspects of the loan The separate indenture note will specify items such as collateral and other terms and conditions a True b False Line of credit 45 Answer: a Diff: E A line of credit can be either a formal or informal agreement between borrower and bank regarding the maximum amount of credit the bank will extend to the borrower subject to certain conditions a True b False Revolving credit and risk 46 Answer: a Diff: E Under a revolving credit agreement the risk to the firm of being unable to obtain funds when needed is lower than with a line of credit a True b False Chapter 22 - Page Medium: Cash and capital budgets 47 Answer: b Diff: M The cash budget and the capital budget are planned separately, and although they are both important to the firm, they are independent of each other a True b False Cash budget and depreciation 48 Answer: b Diff: M Since depreciation is a non-cash charge it does not appear nor have an effect on the cash budget a True b False Seasonal patterns and cash 49 Answer: b Diff: M The target cash balance is set optimally such that it need not be adjusted for seasonal patterns and unanticipated fluctuations although it is changed to reflect long-term changes in the firm's operations a True b False Synchronization of cash flows 50 Answer: a Diff: M Synchronization of cash flows is an important cash management technique and effective synchronization can actually increase a firm's profitability a True b False Float 51 Answer: b Diff: M Collections float offsets disbursement float If a firm's collections float is greater than its disbursement float then a firm is said to operate with positive net float a True b False Float 52 Answer: b Diff: M A lockbox plan is one method of speeding up the check-clearing process for customer payments and decreasing the firm's net float position a True b False Chapter 22 - Page Lockbox 53 Answer: b Diff: M A firm has a daily average collection of checks equal to $250,000 It takes the firm approximately days to convert the funds into usable cash Assume (1) a lockbox system could be employed which would reduce the cash conversion procedure to ½ days and (2) the firm could invest any additional cash received at percent after taxes The lockbox system would be a good buy if it costs only $23,000 annually a True b False Receivables and growth 54 Answer: b Diff: M A firm which makes 90 percent of its sales on credit and 10 percent for cash is currently growing at a rate of 10 percent annually If the firm maintains stable growth it will also be able to maintain its accounts receivable at its current level, since the 10 percent cash sales can be used to manage the 10 percent growth rate a True b False Receivables and growth 55 Answer: a Diff: M In managing a firm's accounts receivable it is possible to increase credit sales per day yet still keep accounts receivable fairly steady if the firm can shorten the length of its collection period a True b False Collection policy 56 Answer: b Diff: M A firm's collection policy and the procedures it follows to collect accounts receivable play an important role in keeping its deferrables period short, although too strict a collection policy can result in outright losses due to non-payment a True b False Collection policy 57 Answer: a Diff: M Changes in a firm's collection policy can affect sales, working capital and even additional funds needed a True b False Chapter 22 - Page 10 30 Trade credit Answer: a Diff: E 31 Trade credit Answer: a Diff: E 32 Trade credit Answer: a Diff: E 33 Cost of trade credit Answer: a Diff: E 34 Cost of trade credit Answer: a Diff: E 35 Cost of trade credit Answer: a Diff: E 36 Net trade credit Answer: b Diff: E 37 Net trade credit Answer: a Diff: E 38 Stretching accounts payable Answer: b Diff: E 39 Short-term financing Answer: a Diff: E 40 Short-term financing Answer: a Diff: E 41 Short-term financing Answer: a Diff: E 42 Bank loans Answer: b Diff: E 43 Bank loans Answer: a Diff: E 44 Promissory note Answer: b Diff: E 45 Line of credit Answer: a Diff: E 46 Revolving credit and risk Answer: a Diff: E 47 Cash and capital budgets Answer: b Diff: M 48 Cash budget and depreciation Answer: b Diff: M 49 Seasonal patterns and cash Answer: b Diff: M 50 Synchronization of cash flows Answer: a Diff: M 51 Float Answer: b Diff: M 52 Float Answer: b Diff: M 53 Lockbox Answer: b Diff: M Interest earned = $250,000(1.5)(0.06) = $22,500 Thus, the cost ($23,000) exceeds the benefit ($22,500) 54 Receivables and growth Answer: b Diff: M 55 Receivables and growth Answer: a Diff: M 56 Collection policy Answer: b Diff: M 57 Collection policy Answer: a Diff: M 58 Cash versus credit sales Answer: b Diff: M 59 Days sales outstanding Answer: a Diff: M 60 Extending the credit period Answer: a Diff: M 61 DSO and past due accounts Answer: b Diff: M 62 Aging schedule and credit policy Answer: b Diff: M 63 Maturity matching Answer: a Diff: M 64 Maturity matching Answer: b Diff: M 65 Aggressive financing approach Answer: a Diff: M 66 Aggressive financing approach Answer: b Diff: M 67 Risk and short-term financing Answer: a Diff: M 68 Short-term financing Answer: b Diff: M 69 Short-term financing Answer: a Diff: M 70 Trade credit Answer: b Diff: M 71 Stretching accounts payable Answer: a Diff: M 72 Stretching accounts payable Answer: b Diff: M 73 Stretching accounts payable Answer: b Diff: M 74 Prime rate Answer: b Diff: M 75 Revolving credit agreement Answer: a Diff: M 76 Working capital Answer: c Diff: E 77 Cash conversion cycle Answer: b Diff: E Statement a is false If inventory increases, and sales not, more cash is being “tied up” in inventory so the cash conversion cycle is increased, not reduced Statement b is true If the company reduces its DSO, it is collecting its accounts receivables more efficiently, so it reduces the cash conversion cycle Statement c is false If the company pays its bills sooner, it uses its cash to pay off accounts payable, and this increases its cash conversion cycle 78 Cash budget Answer: e Diff: E 79 Cash budget Answer: a Diff: E 80 Cash budget Answer: d Diff: E Statement a is false because depreciation is not a cash item (Although depreciation will affect taxes, depreciation itself will not be explicitly included in the cash budget The question asks “explicitly.”) Statement b is true because this is a cash transaction, so it should be included in the cash budget Statement c is true because this is a cash transaction and should be included in the cash budget is the correct choice Since statements b and c are true, statement d 81 Marketable securities Answer: a Diff: E 82 Monitoring receivables Answer: b Diff: E 83 Credit policy Answer: e Diff: E 84 Credit policy Answer: d Diff: E 85 Inventory management Answer: e Diff: E 86 Working capital financing policy Answer: a Diff: E 87 Commercial paper Answer: d Diff: E 88 Working capital financing Answer: e Diff: E 89 Working capital financing Answer: a Diff: E Statement a is false, and therefore the appropriate answer Commercial paper is a type of unsecured promissory note issued by large, strong firms Statements b, c, d, and e are all accurate statements 90 Cash management Answer: a Diff: E Net float = Disbursements float - Collections float; therefore the larger the disbursements float and the lower the collections float the better the cash management system A lockbox is used to speed cash collections If a firm's outflows come due early in the month rather than uniformly this will necessitate a large line of credit 91 Cash management Answer: e Diff: E A very efficient cash management system could allow a firm to operate with positive net float where the firm has a negative checkbook balance at most times but still does not bounce its checks The other statements are false A good cash management system maximizes disbursement float and minimizes collections float A well-designed lockbox system minimizes collections float which would increase a firm's net float Increases in interest rates raise the opportunity cost of idle cash A firm prefers to write checks, maximizing its disbursement float and increasing its net float 92 Lockbox Answer: d Diff: E 93 Cash conversion cycle Answer: d Diff: M 94 Cash conversion cycle Answer: d Diff: M Statements a and b are true; therefore, statement d is the appropriate choice Delaying payments to suppliers increases the length of the cash conversion cycle 95 Cash balances Answer: c Diff: M 96 Cash budget Answer: e Diff: M 97 Marketable securities portfolio Answer: d Diff: M 98 Compensating balances Answer: c Diff: M 99 Receivables management Answer: b Diff: M 100 DSO and aging schedule Answer: c Diff: M 101 Days sales outstanding (DSO) Answer: c Diff: M 102 Working capital policy Answer: d Diff: M Statements a, b, c, and e are all true statements Statement d is false, and thus the appropriate choice Holding minimal levels of inventory may result in lost sales 103 Miscellaneous concepts Answer: e Diff: M 104 Working capital financing policy Answer: c Diff: M 105 Working capital financing policy Answer: b Diff: M 106 Working capital financing policy Answer: c Diff: M Statement b illustrates an aggressive financing policy, not a conser-vative one 107 108 Short-term financing Answer: a Diff: M Statement a is true Under normal conditions the yield curve is upward sloping, thus, short-term interest rates are lower than long-term interest rates Consequently, a firm financing with short-term debt will pay less interest than a firm financing with long-term debt increasing its ROE However, a firm increases its risk by financing with short-term debt because such debt must be “rolled over” frequently, and the firm is exposed to the volatility of short-term interest rates The other statements are false Short-term versus long-term financing Answer: d Diff: M 109 Cash management Answer: e Diff: M 110 Float Answer: a Diff: M 111 Sales collections Answer: d Diff: E March receipts = (0.20)($38,000) + (0.40)($33,000) + (0.40)($30,000) = $32,800 112 113 Accounts receivable balance Answer: a Diff: E Accounts receivables = DSO  Sales per day = 35($2,027,773/365) = $194,444 Cash conversion cycle Answer: d Diff: E Facts given: Payables deferral period = 30 days; Inv = $5,000,000; Rec = $2,000,000; ADS = $100,000 Cash conversion Inv conversion Rec collection Pay deferral = + – cycle period period period 114 Step 1: Determine the inventory conversion period: Inventory conversion period = Inventory/Daily sales = $5,000,000/$100,000 = 50 days Step 2: Determine the receivables collection period: Receivables collection period = Receivables/Daily sales = $2,000,000/$100,000 = 20 days Step 3: Given data and information calculated above, determine the firm’s cash conversion cycle: Cash conversion cycle = 50 + 20 - 30 = 40 days Cash conversion cycle Cash conversion cycle = Answer: a Diff: E Inv conversion Rec collection Pay deferral + – period period period = 72 + 60 - 45 = 87 days 115 Maturity matching Answer: e Diff: E A maturity matching policy implies that fixed assets and permanent current assets are financed with long-term sources Thus, since the minimum balance that total assets approach is $320,000, and $260,000 of that balance is fixed assets, permanent current assets equal $60,000 The likely level of long-term financing is $320,000 Long-term debt financing = Permanent cash assets + Fixed assets Permanent cash assets = Low end of total assets - Fixed assets = $320,000 - $260,000 = $60,000 116 Long-term debt financing = $60,000 + $260,000 = $320,000 Cost of trade credit Answer: a Diff: E Answer: d Diff: E Answer: b Diff: E 365  = 21.71% 97 52 Nominal percentage cost = 117 Cost of trade credit 365  = 37.24% 98 35 - 15 Nominal percentage cost = 118 Cost of trade credit    365      96    Nominal percentage cost =  119 Free trade credit = 3.042 = 304.2% Answer: a Diff: E $730,000 = $2,000 365 Free trade credit = $2,000  15 = $30,000 Daily purchases = 120 Revolving credit agreement cost Answer: b Diff: E Interest rate on borrowed funds = 0.09 + 0.015 = 10.5% Cost of unused portion: $4,000,000  0.005 = $ 20,000 Cost of used portion: $6,000,000  0.105 = 630,000 Total cost of loan agreement $650,000 121 Inventory and NPV Answer: d Diff: E We are given the up-front cost The new software system’s cash flows are the annual cash amounts freed up by not having to invest in inventory Years 10% | | | | | | -75,000,000 +200,000,000 +200,000,000 +200,000,000 +300,000,000 +300,000,000 $200,000,000 $200,000,000 $200,000,000 + + (1.1) (1.1) (1.1)3 $300,000,000 $300,000,000 + + (1.1) (1.1)5 NPV = -$75,000,000 + $181,818,000 + $165,289,000 + $150,263,000 + $204,904,000 + $186,276,000 NPV = $813,550,000 NPV = -$75,000,000 + 122 Inventory turnover ratio and DSO Step 1: Diff: E Determine sales level using the DSO equation DSO = 50 = $100,000,000 = $36,500,000,000 = $730,000,000 = Step 2: Answer: a Receivables Sales/365 $100,000,000 Sales/365 50(Sales) 365 50(Sales) Sales Calculate inventory turnover ratio Sales Inv $730,000,000 Inv turnover = $125,000,000 Inv turnover = 5.84 Inv turnover = 123 Float Positive disbursement float = $15,000(5) = $75,000 Negative collections float = $17,000(3) = $51,000 Answer: d Diff: E Net float = $75,000 - $51,000 = $24,000 124 Cash budget Answer: c Construct a simplified cash budget: Sales Collections (same month’s sales) Collections (last month’s sales) Total collections Purchases payments Other payments Total payments Net cash gain (loss) 125 $3,000 1,176 1,800 2,976 1,500 700 2,200 $ 776 Diff: M (0.98  0.40  $3,000) (1.00  0.60  $3,000) ROE and working capital policy Answer: c Diff: M Construct simplified comparative balance sheets and income statements for the restricted and relaxed policies (In thousands of dollars): 15% of Sales Restricted $ 60.0 100.0 $160.0 25% of Sales Relaxed $100.0 100.0 $200.0 Debt Equity Total liabilities and equity $ 80.0 80.0 $160.0 $100.0 100.0 $200.0 Income statement: EBIT Interest (10%) EBT Taxes (40%) Net income $ 36.0 (8.0) $ 28.0 (11.2) $ 16.8 $ 36.0 (10.0) $ 26.0 (10.4) $ 15.6 Balance sheet: Current assets Fixed assets Total assets ROE = NI/Equity $16.8/$80 = 0.21 Difference in ROEs = 0.21 - 0.156 = 0.054 = 5.4% 126 $15.6/$100 = 0.156 Inventory conversion period Answer: d Diff: M Answer: d Diff: M 365 days Sales/Inventory Annual sales = 12  $2 million = $24 million Inventory = 0.5  $2 million = $1 million 365 ICP = = 15.2 days $24/$1 Inventory conversion period (ICP) = 127 Cash conversion cycle Old 365 365 ICP = $80 = = $20 With Change 91.25 + 365 365 $80 = = 73.000 $16 + $16 DSO = $80 = 365 DP = 35 days CCC = 73.00 -35.00 129.25 days $14 $80 = 365 DP 63.875 New CCC = -35.000 101.875 days Change in CCC = 101.875 – 129.25 = -27.375 days  -27 days Net change is –27 days (CCC is 27 days shorter) 128 Cash conversion cycle Answer: e Diff: M Calculate each of the three main components of the cash conversion cycle: Inventory Conversion period (ICP): $120,000 $120,000 ICP = = = 73 days $600,000/365 $1,643.8356 Days sales outstanding (DSO): $157,808 $157,808 DSO = = = 96 days $600,000/365 $1,643.8356 Payables deferral period (PDP): $25,000 $25,000 PDP = = = 25 days $365,000/365 $1,000 Cash conversion cycle (CCC): CCC = ICP + DSO – PDP = 73 + 96 – 25 = 144 days 129 Cash conversion cycle Answer: b Diff: M Cash conversion Inv conversion Rec collection Pay deferral = + – cycle period period period For this problem we are only interested in the change in the CCC We may therefore ignore the Payables Deferral Period since it is assumed to remain unchanged Old CCC (ignore payables) = $12,000,000/$100,000 + $8,000,000/$100,000 = 120 + 80 = 200 days New CCC = $9,600,000/$90,000 + $6,400,000/$90,000 = 106.67 + 71.11 = 177.78 days Change in CCC = New CCC – Old CCC = 177.78 – 200 = -22.22 days Round to 22 days shorter 130 Cash conversion cycle Answer: e Diff: M First, calculate Sales/Day = $50,735,000/365 = $139,000 Then, calculate the old inventory conversion period: Inventory/Sales per day = $15,012,000/$139,000 = 108 days Then, find the new inventory conversion period: $13,066,000/$139,000 = 94 days We have cut the inventory conversion period by 108 – 94 = 14 days Then, calculate the old DSO: Accts Rec./Sales per day = $10,008,000/$139,000 = 72 days Then, find the new DSO = $8,062,000/$139,000 = 58 days We have cut the DSO by 72 – 58 = 14 days Finally, find the total net change = -14 + (-14) – 10 = -38 days 131 Accounts payable balance Approximate percentage cost = Accounts payable = Answer: e Diff: M Answer: e Diff: M 365  = 0.212828 98 35 $159,621 = $750,000 0.212828 132 EAR cost of trade credit Calculate the nominal percentage, which is the nominal annual cost: Nominal cost = 365 days  = 0.0204  36.5 = 0.7449  74.5% 100  20  10 Calculate the effective annual rate (EAR): Numerical solution: EAR = (1.0204)36.5 - 1.0 = 2.0905 - 1.0 = 109.05%  109% 133 Financial calculator solution: (EAR) Inputs: P/YR = 36.5; NOM% = 74.49 Output: EAR cost of trade credit EFF% = 109% Answer: e Diff: M The company pays every 50 days or 365/50 = 7.3 times per year Thus, the average accounts payable are $4,562,500/7.3 = $625,000 The effective cost of trade credit can be found as follows: EAR = (1 + 2/98)365/35 - = 1.2345 - = 0.2345 = 23.45% 134 EAR cost of trade credit Calculate the interest rate per period Periodic rate = 2/98 = 2.04% Calculate the number of compounding periods Answer: d Diff: M Number of compounding periods = 365/50 = 7.30 Use periodic rate and compounding periods to determine the annual nominal rate 2.04%  7.3 = 14.90% Calculate EAR EAR = (1 + 2/98)365/50 – = (1.0204)7.3 – = 1.1589 – = 0.1589 = 15.89% 135 Costly trade credit Answer: a Diff: M Phranklin’s net purchases are $819,388  (1 - 0.02) = $803,000 Purchases per day are $803,000/365 = $2,200.00 Total trade credit is 40  $2,200 = $88,000 Free trade credit is 15  $2,200 = $33,000 Thus, costly trade credit, assuming discounts are taken, is $88,000 - $33,000 = $55,000 If discounts are not taken, then the maximum amount of costly trade credit is $88,000 136 Stretching accounts payable Answer: e Accounts payable: (1/99)(365/(40 - 10)) = 12.29% nominal rate EAR is calculated as follows: EAR = (1 + 1/99)12.1667 - = 13.01% 137 Changes in working capital and free cash flow FCF $180,000,000 $180,000,000 $180,000,000 -$90,000,000 NOWC = = = = = = Diff: M However, this is a Answer: b Diff: M EBIT(1 – T) + DEP – CapExp - NOWC $850,000,000(0.6) + $120,000,000 - $360,000,000 - NOWC $510,000,000 + $120,000,000 - $360,000,000 - NOWC $270,000,000 - NOWC -NOWC $90,000,000 Net operating working capital needs to increase by $90 million, so we need to find the response that shows working capital increasing by that amount Statement a is false because NOWC = $470,000,000 + $230,000,000 - $790,000,000 = -$90,000,000 Statement b is true because NOWC = $470,000,000 + $230,000,000 - $610,000,000 = +$90,000,000 Statement c is false because NOWC = -$500,000,000 + $480,000,000 – (-$80,000,000) = +$60,000,000 Statement d is false because NOWC = -$400,000,000 + $480,000,000 - $80,000,000 = $0 Statement e is false because NOWC = $500,000,000 + $100,000,000 – ($480,000,000) = $1,080,000,000 138 Aging Schedule Answer: b Diff: M Short’s credit policy is 2/10, net 30 days, so customers’ receivables are overdue after 30 days The percentage of accounts overdue (after 30 days) is 15% + 3% + 2% = 20% Fryman’s credit policy is 2/10, net 45 days, so customers’ receivables are overdue after 45 days The percentage of accounts overdue (after 45 days) is 7% + 3% = 10% Thus, Short has the greatest percentage of overdue accounts at 20% (Note that you could also use the dollar amounts to develop the total percentage of overdue accounts, but you would arrive at the same answer.) Alternative solution using dollar amounts of receivables: ($14,700  $2,940  $1,960) = 20% $98,000 ($10,290  $4,410) Fryman: = 10% $147,000 Short: 139 Lockbox Answer: e Diff: M Calculate the net reduction in A/R: Current A/R = $2,500,000 New A/R with 20% reduction: $2,500,000 - 0.20($2,500,000) = $2,000,000 Net reduction in A/R = $500,000 Calculate the interest savings and net savings: Interest savings = $500,000(0.11) = $55,000 Net savings = Interest savings - Annual lockbox cost = $55,000 - $15,000 = $40,000 140 Cash conversion cycle Answer: c Diff: T ICP = 365 days/($10 million/$1 million) = 36.5 days DSO = 2.0  ICP = 73 days Solve for accounts receivable: DSO = 73 = Accounts receivable/Sales per day = (A/R)/($10/365) = $2 million Calculate new ICP, change in CCC, and new DSO required to meet goal: New ICP = 365/($10/$0.863) = 365/11.5875 = 31.5 days Net change in ICP = -5 days Total reduction in CCC required = 10 days Reduction in DSO needed = 10 – = days New DSO required = 73 – = 68 days Solve for new receivables level: DSO = 68 = [(A/R)/($10,000,000/365)] A/R = 68  $27,397.26 = $1,863,014 Old A/R = $2,000,000 New A/R = $1,863,014 Reduction required in A/R = $2,000,000 - $1,863,014 = $136,986 141 Financial statements and trade credit Calculate A/P with and without taking discounts: Answer: d Diff: T A/PNo discount = $11,760  30 days = $352,800 A/PDiscount = $11,760  10 days = $117,600 Calculate financing amount in notes payable and interest cost need to borrow the difference in notes payable $352,800 - $117,600 = $235,200 The additional interest cost is $235,200  0.10 = $23,520 The firm will Calculate total purchases and discounts lost: Total purchases = 365 days  12,000 gross purchases = $4,380,000 Discounts lost = $4,380,000  0.02 = $87,600 Construct comparative financial statements: I Partial balance sheet: Take Discounts Don’t Take Discounts (Borrow N/P) (Use Max Trade Cdt) Difference Accounts payable $117,600 $352,800 -$235,200 Notes payable (10%) 235,200 +235,200 Total current liab $352,800 $352,800 $ II Partial income statement: EBIT* $140,000 $140,000 $ Less: Interest 23,520 +23,520 Discounts lost 87,600 -87,600 EBT $116,480 $ 52,400 +$ 64,080 Less: Taxes (at 40%) 46,592 20,960 +25,632 Net income $ 69,888 $ 31,440 +$ 38,448 *Any EBIT can be used, since the difference in EBIT from the two policies is zero 142 Accounts payable balance Step 1: Answer: d Diff: T Calculate the nominal annual cost of trade credit 365  98 30  10 = 0.0204  18.25 = 37.24% Nominal annual cost = Step 2: Using the nominal annual cost from Step determine the amount of free trade credit Free trade credit 37.24% = Costly trade credit Free trade credit 37.24% = $375,000 Free trade credit = $139,650 Step 3: Determine gross and net sales $139,650 = Discount, which represents 2% of sales .02Sales = $139,650 Sales = $6,982,500 Net sales = 0.98Sales = 0.98($6,982,500) = $6,842,850 Step 4: Since accounts payable are shown net of discounts, determine daily sales based on net sales figure Then multiply this amount by 30 days $6,842,850 365 = $18,747.53 Daily net sales = Accounts payable balance = $18,747.53  30 = $562,426.03  $562,426 143 Working capital investment policy Step 1: Answer: c Diff: M Calculate net fixed assets, which will be the same under either policy S NFA $3,600,000 4.0 = NFA FA turnover = NFA = $900,000 Step 2: Determine total assets under each policy, given the total assets turnover ratio for each one S TA $3,600,000 2.5 = TA Restricted: Total assets turnover = TA = $1,440,000 Relaxed: 2.2 = $3,600,000 TA TA = $1,636,364 Step 3: Develop balance sheets for each policy to determine the debt level Restricted Relaxed Current assets $ 540,000 $ 736,364 Fixed assets 900,000 900,000 Total assets $1,440,000 $1,636,364 Debt Equity $ 720,000 720,000 $ 818,182 818,182 Total liabilities & equity $1,440,000 $1,636,364 Step 4: Determine interest under each policy: Restricted: $720,000  0.10 = $72,000 Relaxed: $818,182  0.10 = $81,818 Step 5: Calculate the difference in interest expense (the savings) between the policies: $81,818 - $72,000 = $9,818 144 145 Working capital investment policy and ROE Answer: b Diff: M Step 1: From the previous problem we can now set up an income statement for each policy Restricted Relaxed EBIT $150,000 $150,000 Interest (10%) 72,000 81,818 EBT $ 78,000 $ 68,182 Taxes 31,200 27,273 Net income $ 46,800 $ 40,909 Step 2: Calculate ROE using common equity as calculated in the prior problem for each policy $46,800 $40,909 Restricted: ROE = Relaxed: ROE = $720,000 $818,182 = 6.5% = 5.0% Step 3: Calculate the difference in ROEs ROE = 6.5% - 5.0% = 1.5% Working capital investment policy and ROE Answer: a Diff: M From the prior two problems, we know that the ROE for the relaxed policy is 5% Now, we need to calculate the new ROE under the restricted policy Step 1: Calculate the new sales and EBIT levels New sales = $3,600,000  0.85 = $3,060,000 New EBIT = $150,000  0.90 = $135,000 Step 2: Calculate the new level of assets under the restricted policy S/TA = 2.5 $3,060,000/2.5 = $1,224,000 Step 3: Develop the firm’s balance sheet under the restricted policy Total assets $1,224,000 Debt $ 612,000 Equity Total liabilities & equity Step 4: Develop the firm’s income statement under the restricted policy EBIT Interest (10%) EBT Taxes (40%) Net income 146 612,000 $1,224,000 $135,000 61,200 $ 73,800 29,520 $ 44,280 Step 5: Calculate the firm’s ROE under the restricted policy ROE = NI/E = $44,280/$612,000 ROE = 7.24% Step 6: Calculate the difference in ROEs between the policies ROE = 7.24% - 5% = 2.24% Permanent working capital financing Answer: c Diff: M Time lines: Note that the cash flows viewed from the firm’s perspective involve inflows at time 0, and repayment of coupon and/or maturity value in the future 2-year note: i = ? | +100,000 2-year bond: i = ? | +973.97 | Years | FV = -118,810 | -85 Years | -85 FV = -1,000 Note: Inputs: Output: N = 2; PV = 100,000; PMT = 0; FV = -118,810 I = 9.0% Bond: Inputs: Output: N = 2; PV = 973.97; PMT = -85; FV = -1,000 I = 10.0% The difference is 10.0% - 9.0% = 1.0% 147 DSO and the cost of trade credit Answer: e Diff: T Determine the number of days the firm would wait to pay its suppliers so that the cost of the trade credit equals the cost of the bank loan: I/YR = 10.1349; PV = -99; PMT = 0; FV = 100; and then solve for N = 0.1041 Multiply 0.1041 by 365 0.1041(365) = 38 days to convert it to the number of days per year: To get the final answer we must add back the initial 10 days of “free” financing This gives 38 + 10 = 48 days ... the bank loan? a b c d e 30 36 40 46 48 days days days days days Chapter 22 - Page 39 CHAPTER 22 ANSWERS AND SOLUTIONS Chapter 22 - Page 40 Net working capital Answer: b Diff: E Net working capital. .. management Answer: b Diff: E 20 Goal of inventory management Answer: a Diff: E 21 Inventory management interaction Answer: b Diff: E 22 Working capital policy Answer: a Diff: E 23 Permanent working. .. Inventory management Answer: e Diff: E 86 Working capital financing policy Answer: a Diff: E 87 Commercial paper Answer: d Diff: E 88 Working capital financing Answer: e Diff: E 89 Working capital