Chapter 7
Discussion Questions
7-1.
Cash and marketable securities are generally used to meet the transaction needs of the
firm and for contingency purposes. Because the funds must be available when needed,
the primary concern should be with safety and liquidity rather than the maximum profits.
7-2.
Liquidity is the quality of converting an asset to cash quickly and at fair market value.
7-3.
The treasury manager is most concerned with daily cash flows of a corporation as it is the
manager’s responsibility to invest temporary funds into money market instruments and to
provide for temporary cash needs through borrowing. Income based on accrual
accounting methods will not capture daily cash surpluses and deficits.
7-4.
A firm could operate with a negative balance on the corporate books, as indicated in
Table 7-2, knowing float will carry them through at the bank. Cheques written on the
corporate books may not clear until many days later at the bank. For this reason, a
negative account balance on the corporate books of $100,000 may still represent a
positive balance at the bank.
7-5.
Both lockbox systems and regional collection offices allow for the rapid processing of
checks that originate at distant points. The difference is that a regional collection center
requires the commitment of corporate resources and personnel to staff an office, while a
lockbox system requires only the use of a post office box and the assistance of a local
bank. Clearly, the lockbox system is less expensive.
7-6.
By slowing down disbursements or the processing of checks against the corporate
account, the firm is able to increase float and also to provide a source of short-term
financing.
7-7.
The answer to this question may well depend upon the phase of the business cycle at the
time the question is considered. In normal times, small CDs and savings accounts may
prove adequate. However, in a tight money period, wide differentials may be established
between the various instruments and maximum returns may be found in Treasury bills,
large CDs, commercial paper, and money market funds.
7-8.
Treasury bills are popular because of the large and active market in which they trade.
Because of this, the investor may literally pinpoint the maturity desired -- choosing
anywhere from one day to a year. The ‘T-bill’ market provides maximum liquidity and
can absorb almost any dollar amount of business.
7-9.
U.S. money market rates until the mid 90s had been lower than Canadian rates on similar
risk instruments, due to the underlying inflationary rate being lower in the United States
and due to the monetary policy of the U.S. central bank being somewhat less restrictive.
These factors reversed by the 90s allowing Canadian rates to dip significantly below U.S.
rates.
7-10. The money market is a communications network where trades in short-term financial
obligations occur. Canada’s money market is centered in Toronto. The Eurobond market
is for financial obligations with longer maturities and exists where the currency of the
bond is not in its home jurisdiction. Although centered in London the Euromarkets are
around the globe. Canada has tried to establish Euro-centres in Vancouver and Montreal.
7-11. An investment in accounts receivable requires a commitment of funds as is true of any
other investment. The key question is: Will the dollar returns from the resource
commitment provide a sufficient rate of return to justify the investment? There is no such
thing as too many or too few bad debts, only too low a return on capital.
7-12. The EOQ or economic order quantity tells us at what size order point we will minimize
the overall inventory costs to the firm, with specific attention to inventory ordering costs
and inventory carrying costs. It does not directly tell us the average size of inventory on
hand and we must determine this as a separate calculation. It is generally assumed,
however, that inventory will be used up at a constant rate over time, going from the order
size to zero and then back again. Thus, average inventory is half the order size.
7-13. A safety stock protects against the risk of losing sales to competitors due to being out of
an item. A safety stock will guard against late deliveries due to weather, production
delays, equipment breakdowns and many other things that can go wrong between the
placement of an order and its delivery. With more inventory on hand, the carrying cost of
inventory will go up.
7-14. A just-in-time inventory system usually means there will be fewer suppliers, and they
will be more closely located to the manufacturer they supply.
Internet Resources and Questions
1. www.bankofcanada.ca/rates/daily-digest/
www.federalreserve.gov/releases/h15/update
2. www.bloomberg.com/markets/rates/index.html
3. www.bmo.com/home/commercial?nav=top
4. www.bankofcanada.ca/rates/daily-digest/
www.boj.or.jp/en/index.htm
Problems
7-1.
7-2.
Cats Copier, Inc.
Bank Books
Initial amount
$20,000
Deposits
+ 85,000
Cheques
– 18,000
Balance
$87,000
Float
$12,000 *
*Based on the balance on the corporate books minus the balance
on the bank’s books.
Sheila’s Society Clothing Manufacturer
a. $4,000,000 daily collections
× 2.5 days speed up =
$10,000,000 additional collections
$3,000,000 daily disbursements
× 1.5 days slow down =
4,500,000 delayed disbursement
$14,500,000 freed-up funds
b. $14,500,000
×
6%
$ 870,000
freed-up funds
interest rate
interest on freed-up cash
7-3.
Aurora Electrical Company
a. $1,500,000 daily collections
× 2 days speed up =
$800,000 daily disbursements
× 1 day slow down =
$3,000,000 additional collections
800,000 delayed disbursement
$3,800,000 freed-up funds
b. $3,800,000
×
4%
$ 152,000
freed-up funds
interest rate
interest on freed-up cash
c. $152,000
125,000
$ 27,000
Benefit
Cost
Net benefit
7-4.
Proceed!
Megahurtz International Car Rentals
a. Canadian investment =
Interest earned @ 12%
Total investment yearend
Less real depreciation @ 20% =
Net investment value
$42,000
5,040
47,040
9,408
$37,632
b. Canadian investment =
Interest earned @ 9%
Total investment yearend
Plus real appreciation @ 10% =
Net investment value
$42,000
3,780
45,780
4,578
$50,358
7-5.
Bow Island Implement Dealers
$350,000 daily receipts × 3 days speed up =
$1,050,000
Opportunity cost of funds at
8%
Annual benefit
84,000
Annual new bank fee
75,000
Annual savings from new bank collection system
$ 9,000
Accept the offer!
7-6.
Byron Bank
Average daily receipts $40,000,000/ 365 =
$109,589
$109,589 daily receipts × 2 days speed up =
Short term money market rates at
Annual benefit
Annual new bank fee
Annual cost of cash management system
Reject the offer!
$219,178
9%
19,726
26,000
$ 6,274
7-7.
Your Banker
$255,000 daily receipts × 3 days speed up =
$765,000
Less compensating balance requirement
60,000
Net funds freed up
$705,000
Opportunity benefit (cost) of funds at
12%
Annual benefit
84,600
Annual new bank fee
50,000
Annual savings from concentration banking system $ 34,600
Accept the package!
7-8.
Oscar’s Checkbook
a. $62 + $40 + $32 + $70 + $44 = $248
b.
Probability cheque
Amount
has cleared
$62
×
75%
40
×
75%
32
×
40%
70
×
40%
44
×
40%
Expected
value
$ 46.50
30.00
12.80
28.00
17.60
$134.90
c. (a – b) = $248.00 – $134.90 = $113.10 float
7-9.
Lett
a. r =
100 − 97.29 365
×
= 0.0847 = 8.47%
97.29
120
b. rEFF
100 − 97.29 120
= 1 +
− 1 = 0.0872 = 8.72%
97.29
365
7-10.
a. r =
Crossborder Inc.
100 − 98.82 365
×
= 0.0726 = 7.26%
98.82
60
365
100 − 98.82 60
b. rEFF = 1 +
− 1 = 0.0749 = 7.49%
98
.
82
7-11.
Treasury Bill
100 − P 365
×
= 0.0535 = 5.35%
P
91
P = 98.68372139
Discounted price on $1,000,000 = $986,837.21
a. r =
365
100 − P 91
b. rEFF = 1 +
− 1 = 0.0535 = 5.35%
P
P = 98.70902635
Discounted price on $1,000,000 = $987,090.26
7-12.
Sanders’ Prime Time Lighting Co.
Average collection period =
=
7-13.
Accounts receivable
Average daily credit sales
$195,205
$195,205
=
= 38 days
$1,875,000 / 365 $5,136.99
Barney’s Antique Shop
$1,080,400 annual credit sales
= $2,960 credit sales a day
365 days
$2,960 average daily credit sales × 40 average collection period
= $ 118,400 average accounts receivable balance
7-14.
Barney’s (Continued)
Average collection period =
=
Accounts receivable
Average daily credit sales
$138,800
= 35 days
$1,447,500 / 365
Since the firm has a shorter average collection period, it appears that the
firm does not have a more lenient credit policy.
7-15.
Mervyn’s Fine Fashion
Accounts receivable
Average collection period =
Average daily credit sales
$86,302
Credit sales/ 365
$86,302
Credit sales =
× 365
42 days
= $750,005
42 days
7-16.
=
Bugle Boy Company
Average accounts receivable
= Annual sales × Average days outstanding/ 365
Average accounts receivable (new) = $5,820,000 × 45/365
= $717,534
Average accounts receivable (old) = $3,960,000 × 45/365
= $488,219
Increased investment in accounts receivable
= $717,534 – $488,219
= $229,315
Opportunity cost of funds tied up in accounts receivable at 10%
= $22,932 ($229, 315 × 0.10)
7-17.
Y.B.U. Ltd.
Average accounts receivable
= Annual sales × Average days outstanding/ 365
Average accounts receivable (new) = $5,100,000 × 45/365
= $628,767
Average accounts receivable
= $4,500,000 × 30/365
= $369,863
Increased investment in accounts receivable
= $628,767 – 369,863
= $258,904
Annual financing cost of funds tied up in accounts receivable at 9%
= $23,301 ($258,904 × 0.09)
7-18.
Johnson Electronics
a. Additional sales
Accounts uncollectible (10% of new sales)
Annual incremental revenue
Collection costs (3% of new sales)
Production and selling costs (79% of new sales)
Incremental income before taxes
b. Incremental return on sales =
$100,000
– 10,000
90,000
– 3,000
– 79,000
$ 8,000
Incremental income
Incremental sales
= $8,000/$100,000 = 8.0%
c. Receivable turnover
Receivables
= Sales/Accounts receivable = 6×
= Sales/Receivable turnover
= $100,000/6
= $16,666.67
Incremental return on new average investment = $8,000/$16,666.67 = 48%
Note:
7-19.
This incremental return on the new investment would be
compared to the before tax opportunity cost of funds.
Henderson Office Supply
a. Investment in accounts receivable =
$60,000
= $12,000
5
b. Added sales
$ 60,000
Accounts uncollectible (8% of new sales)
– 4,800
Annual incremental revenue
55,200
Collection costs (5% of new sales)
– 3,000
Production and selling costs (78% of new sales) – 46,800
Annual income before taxes
$ 5,400
Return on incremental investment =
$5,400
= 0.45 = 45%
$12,000
c. Yes! 45% exceeds the required return of 25%.
d. Investment in inventory =
$60,000(.78)
= $11,700
4
Total incremental investment
Inventory
Accounts receivable
Incremental investment
$11,700
12,000
$23,700
Return on incremental investment =
$5,400
= 0.2278 = 22.78%
$23,700
e. No! 22.78% is less than the required return of 25%.
7-20.
Comiskey Fence Co.
a. Added sales.........................................................
Accounts uncollectible (12% of new sales)........
Annual incremental revenue...............................
Collection costs...................................................
Production and selling costs (70% of new sales)
Annual income before taxes................................
Investment in accounts receivable =
$180,000
21,600
158,400
15,700
126,000
$ 16,700
Sales
$180,000
=
= $36,000
Turnover
5×
Return on incremental investment =
$16,700
= 0.464 = 46.4%
$36,000
Yes, extend credit to these customers as 46.4% incremental return is greater than 15%.
b. Same as above except accounts uncollectible are 15% of $180,000 or
$27,000. This is $5,400 more than the value in part a. The value can also be
computed as:
Added sales..........................................................
Accounts uncollectible (15% of new sales)........
Annual incremental revenue...............................
$180,000
27,000
153,000
Collection costs...................................................
Production and selling costs (70% of new sales)
Annual income before taxes...............................
Return on incremental investment =
15,700
126,000
$ 11,300
$11,300
= 0.314 = 31.4%
$36,000
Yes, extend credit. (31.4%>15%)
c. If receivable turnover drops to 1.5 ×, the investment in accounts receivable
would equal $180,000/ 1.5 = $120,000. The return on this investment, with a
12% uncollectible rate, is 13.92%.
Return on incremental investment =
$16,700
= 0.1392 = 13.92%
$120,000
The credit should not be extended. 13.92% is less than the desired 15%.
7-21.
Comiskey Fence Co. (Continued)
First compute the new accounts receivable balance.
Accounts receivable = Average collection period × average daily sales
= 120 days ×
$180,000
= 120 × $493
365
= $59,178
OR:
365
Average collection period
365 days
=
= 3.0417 ×
120 days
Accounts receivable turnover =
Sales
accounts receivable turnover
$180,000
=
= $59,178
3.0417
Accounts receivable =
Then compute return on incremental investment.
Return on incremental investment =
$16,700
= 0.2822 = 28.22%
$59,178
Yes, extend credit. 28.22% is greater than 15%.
7-22.
Apollo Data Systems
a. Accounts receivable:
Inventory:
$600,000/ 5 × =
$600,000/ 8 × =
$120,000
$75,000
($600,000 × .77)/ 8 × =
$57,750
$600,000/ 2 × =
=
$300,000
$495,000
b. Collection costs:
.03 × $600,000 =
Production & selling costs: .77 × $600,000 =
Total
$18,000
$462,000
$480,000
Or
Plant and equipment:
Total investment
c. Inventory carrying costs:
.06 × $75,000 =
$4,500
d. Amortization expense:
.07 ×$300,000 =
$21,000
e. $480,000 + $4,500 + $21,000 = $505,500
f. $600,000 - $505,500 =
Taxes: .30 × $94,500 =
Net income =
$94,500
$28,350
$66,150
g.
Since this exceeds the required rate of return of 12% proceed
7-23.
Apollo Data Systems (Continued)
a. Inventory:
$600,000/ 4 × = $150,000
b. Total investment now
= $120,000 + $150,000 + $300,000
= $570,000
a.
Not acceptable!
7-24.
Dome Resources
a. Sales/365 days = average daily sales
$144,000/365 = $394.52
Accounts receivable balance = $394.52 × 30 days = $11,836
365
Accounts receivable turnover =
Average collection period
365 days
=
= 12.17 ×
30 days
OR:
Turnover =
Sales
$144,000
=
Accounts receivable $11,836
= 12.17 ×
b. $394.52 × 10 days = $3,945 new receivable balance
c. Old receivables – new receivables = Funds freed by discount
$11,836 – $3,945
= $ 7,891
Savings on loan = 10% × $7,891 =
Discount on sales = 2% × $144,000 =
$ 789
(2,880)
Net change in income from discount
$(2,091)
No! Don't offer the discount since the income from the reduced bank loans,
does not offset the loss on the discount.
d. New sales = $144,000 × 1.15 =
Change in sales = $165,600 – $144,000 =
Sales per day = $165,600/365 =
Average receivables = $453.70 × 10 =
Increase profit on new sales = 20% × $21,600 =
Discount cost = 2% × $165,600 =
Interest savings ($11,836 – $4,537) × 10% =
Net change in income
$165,600
$21,600
$453.70
$4,537
$4,320
(3,312)
730
$1,738
Yes, offer the discount because total profit increases.
7-25.
Trench Town Tire
a. Sales/365 days = average daily sales
$1,025,000/365 = $2,808.22
Accounts receivable balance = $2,808.22 × 38 days = $106,712
365
Accounts receivable turnover =
Average collection period
365 days
=
= 9.61 ×
38 days
OR:
Turnover =
Sales
$1,025,000
=
Accounts receivable $106,712
= 9.61 ×
b. $2,808.22 × 10 days = $28,082 new receivable balance
c. Old receivables – new receivables = Funds freed by discount
$106,712 – $28,082
= $ 78,630
Savings on loan = 6% × $78,630 =
Discount on sales = 2% × $1,025,000 =
Net change in income from discount
$ 4,718
(20,500)
$(15,782)
No! Don't offer the discount since the income from the reduced bank loans,
does not offset the loss on the discount.
d. New sales = $1,025,000 × 1.20 =
Change in sales = $1,230,000 – $1,025,000 =
Sales per day = $1,230,000/365 =
Average receivables = $3,369.86 × 10 =
Increase profit (new sales) = 18% × $205,000 =
Discount cost = 2% × $1,230,000 =
Interest savings ($106,712 – $33,699) × 6% =
Net change in income
$1,230,000
$205,000
$3,369.86
$33,699
$36,900
(24,600)
4,381
$16,681
Yes, offer the discount because total profit increases.
7-26.
Manning Alternatives
Δ Sales ($3,500,000 – $2,600,000)
$900,000
Δ Contribution margin @
5%
Δ Discount expense
Present policy 2% (85%) $2,600,000
44,200
New policy 3% (65%) $3,500,000
68,250
(24,050)
Δ Investment in accounts receivable
Present policy $2,600,000 × 14/365
99,726
New policy $3,500,000 × 31/365
297,260
$197,534
Δ Opportunity cost on investment
in accounts receivable at 11%
Total incremental change
No! Manning should not initiate the change.
$45,000
(24,050)
(21,729)
$ (779)
7-27.
Sundre Canoes
Δ Sales
Present policy 200,000 × $25 =
New policy $5,000,000 × 115%
$ 5,000,000
5,750,000
$ 750,000
Δ Contribution margin ($25 – $20)/ $25 = 20%
Δ Discount expense
Present policy 2% (70%) $5,000,000
New policy 2% (25%) $5,750,000
$150,000
70,000
28,750
41,250
41,250
Δ Bad debt expense
Present policy 1.5% (90%) $5,000,000 67,500
New policy 2.5% (90%) $5,750,000 129,375
(61,875)
(61,875)
Δ Investment in accounts receivable
Present policy
60% $5,000,000 × 10/365
30% $5,000,000 × 40/365
New policy
15% $5,750,000 × 10/365
75% $5,750,000 × 70/365
Δ Opportunity cost on investment in
accounts receivable at 11%
Total incremental change
Yes! Sundre should initiate the change.
$ 82,192
164,384
$246,576
$
23,630
827,055
850,685
$ 604,109
(66,452)
$ 62,923
7-28.
a. Δ Sales
Present policy
New policy
Double Play, Inc.
(Monthly analysis)
Δ Contribution margin (1 – .80) =
Δ Discount expense
Present policy 3% (30%) $ 500,000
New policy no discount
Δ Bad debt expense
Present policy 2% ($500,000)
New policy 1.75% ($465,000)
$ 500,000
465,000
$ (35,000)
20%
$ (7,000)
$ 4,500
0
$ 4,500
4,500
$ 10,000
8,138
$ 1,862
1,862
Δ Investment in accounts receivable
Present policy, average collection period
70% × 60 days
42 days
30% × 10days
3 days
45 days
$500,000 × 12 × 45/365 =
$739,726
New policy
$465,000 × 12 × 30/365 =
458,630
$281,096
Δ Opportunity benefit on investment in
accounts receivable at
Total incremental change
9%/12
Yes! Double Play Inc. should tighten its credit policy.
2,108
$ 1,470
b. Since this problem is calculated on a monthly basis it is important
to note the average balance of accounts receivable under both
policies.
Present policy
New policy
$739,726
$458,630
c. The discount rate or opportunity cost of funds that is chosen is the
rate charged by the bank. The bank is likely extending credit on the
strength of the accounts receivable position and has chosen its
interest rate accordingly. We are matching the risk of the asset
(accounts receivable) with the expected rate of return for this
investment.
7-29.
Tothe Nines Ltd.
Δ Sales
Present policy (all cash *)
New policy
Δ Contribution margin (1 – .65) =
Δ Discount expense
Present policy no discount (all cash *)
New policy 2% (70%) $4,600,000
Δ Bad debt expense
Present policy (all cash *)
New policy 1% ($4,600,000)
Δ Marketing expense
Present policy 9% ($3,800,000)
New policy 9% ($4,600,000)
$3,800,000
4,600,000
$800,000
35%
$280,000
$
0
64,400
$64,400
(64,400)
$
0
46,000
$46,000
(46,000)
$342,000
414,000
$(72,000)
(72,000)
Δ Administrative expense (related to credit department)
Present policy
$
0
New policy $25,000 + 2 ($30,000)
$ 85,000
$(85,000)
Δ Investment in accounts receivable
Present policy (all cash *)
$
0
New policy
$4,600,000 (70%) × 10/365
$ 88,219
$4,600,000 (30%) × 30/365
113,425
$201,644
Δ Opportunity benefit on investment in A/R
11%
Δ Investment in inventory
Present policy (65%) $3,800,000 / 9
$274,444
New policy (65%) $4,600,000 / 9
332,222
$ 57,778
Δ Opportunity benefit on inv. investment
11%
Total incremental change
(85,000)
$ (22,181)
(6,356)
$(15,937)
No! Tothe Nines should not adopt the proposed policy and the new credit
department.
7-30.
Trust Mechanics Inc.
a.
Δ Sales
Present policy $6,300,000
Policy one
7,000,000
$ 700,000
Policy two
Policy #1
Policy #2
$ 49,000
$ 70,000
Δ Bad debt expense (on incremental sales only)
Policy one 2% ($700,000)
(14,000)
New policy 2.25% ($1,000,000)
(22,500)
$7,300,000
$1,000,000
Δ Contribution margin (1 – .93)= 7%
Δ Investment in accounts receivable (incremental sales only)
Policy one
$700,000 × 52/365 =
Policy two
$1,000,000 x 67/365 =
$99,726
$183,562
Δ Opportunity benefit on investment in
accounts receivable at 16%
Policy one: $99,726 × 16% =
Policy two: $183,562 × 16% =
(15,956)
(29,370)
Total incremental change
$ 19,044
$ 18,130
Both policies are viable. Policy one is the best choice if a choice
must be made.
b. Would the existing customers maintain an average collection
period of 43 days, when new customers are allowed 52 days under
policy one and 67 days under policy two?
Notice the impact if existing customers stretch their payment
patterns to correspond with the new customers.
Δ Investment in accounts receivable (existing customers)
Present policy
$6,300,000 × 43/365 =
Policy one
$6,300,000 × 52/365 =
Policy two
$6,300,000 × 67/365
$ 742,192
$ 897,534
$1,156,438
Δ policy one ($897,534 – $742,192) =
Δ policy two ($1,156,438 – $742,192) =
$155,342
$414,246
Δ Opportunity cost of investment in accounts receivable at 16%
Δ policy one $155,342 × 16% =
Δ policy two $414,246 × 16% =
$24,855
$66,279
This would render both policies unacceptable.
c. The analysis presented assumes a perpetuity for the cash flow
changes. It ignores any impacts on machinery usage and
accelerated wear and tear due to increased sales. This would bring
forward in time capital investments. The analysis may also ignore
competitive responses.
7-31.
a.
Marv’s Women’s Wear
Age of Receivables April 30, 2006
(1)
(2)
(3)
Age of
Month of sale
account
Amounts
April
0-30
$88,000
March
31-60
44,000
February
61-90
33,000
January
91-120
55,000
Total receivables
$220,000
(4)
Percent of
amount due
40%
20%
15%
25%
100%
b.
Accounts receivable
Average daily credit sales
$220,000
$220,000
=
=
$960,000 / 120
$8,000
= 27.5 days
Average collection period =
c. Yes, the average collection period of 27.5 days is less than 30
days.
d. No. The aging schedule provides additional insight that 60% of the
accounts receivable are over 30 days old.
e. It goes beyond showing how many days of credit sales accounts
receivable represent, to indicating the distribution of accounts.
7-32.
Midwest Pipes
a. EOQ =
2 SO
=
C
2 × 12,000 × $6
= 90,000 = 300 pipes
$1.60
b. 12,000 pipes/ 300 pipes = 40 orders
c. EOQ/ 2 = 300 pipes/ 2 = 150 pipes (average inventory)
d.
SO CQ
TC =
+
Q
2
12,000 × $6 $1.60 × 300
=
+
= 40 × $6 + $1.60 × 150
300
2
= $240 + $240
= $480
7-33.
a. EOQ =
Retro Disk Services
2SO
=
C
2 × 105,125 × $100
= 8,410,000 = 2,900 disks
$2.50
b. 105,125 disks/ 2,900 disks = 36.25 orders
c. EOQ/ 2 = 2,900/ 2 = 1,450 disks (average inventory)
d. 36.25 orders × $100 ordering cost =
1,450 inventory × $2.50 carrying cost per unit =
Total costs =
7-34.
$3,625
3,625
$7,250
Fisk Corporation
a. EOQ =
2SO
=
C
2 × 75,000 × $8
= 1,000,000 = 1,000 units
$1.20
b. 75,000 units/ 1,000 units = 75 orders
c. EOQ/ 2 = 1,000 units/ 2 = 500 units (average inventory)
d. 75 orders × $8 ordering cost =
500 inventory × $1.20 carrying cost per unit =
Total costs =
7-35.
$ 600
600
$1,200
Fisk Corp. (Continued)
a. EOQ =
2SO
=
C
2 × 75,000 × $2
= 250,000 = 500 units
$1.20
75,000 units/ 500 units = 150 orders
EOQ/ 2 = 500 units/ 2 = 250 units (average inventory)
150 orders × $2 ordering cost =
250 inventory × $1.20 carrying cost per unit =
Total costs =
$300
300
$600
b. The number of units ordered declines 50%, while the number of orders
doubles. The average inventory and total costs both decline by one-half.
Notice that the total cost did not decline in equal percentage to the decline in
ordering costs. This is because the change in EOQ and other variables (½) is
proportional to the square root of the change in ordering costs (¼).
7-36.
Diagnostic Supplies
a. EOQ =
2 SO
=
C
2 × 135,000 × $4
= 360,000 = 600 units
$3
b. EOQ/2 = 600 units/2 = 300 units (average inventory)
300 units × $3 carrying cost/unit = $900 total carrying cost
SO CQ
+
Q
2
135,000 × $4 $3 × 600
=
+
= 225 × $4 + $3 × 300
600
2
= $900 + $900
= $1,800
TC =
c.
EOQ
+ Safety stock
2
600
=
+ 80
d.
2
= 380
380 inventory × $3 carrying cost per year
= $1,140 total carrying cost
Average inventory =
7-37.
North Pole Snowmobile
a. Inventory increases by
× interest expense
Increased costs
Less: Savings
Loss
$250,000
13.5%
33,750
30,000
($ 3,750)
Don't switch to level production. Cost of increased investment in
inventory greater than cost efficiencies.
b. If interest rates fall to 12% or less, the switch would be feasible.
$30,000 savings
= 12%
$250,000 increased inventory
7-38.
Janitorial Services Ltd.
The current situation:
EOQ =
2 SO
=
C
2 × 54,000 × $87.75
= 7,290,000 = 2,700 packages
$1.30
54,000 packages per year /2,700 EOQ =
20 orders per year
Average inventory at EOQ= 2,700/2 =
1,350
Annual cost at EOQ
= (20 orders x $87.75)
+ (1,350 average inventory × $1.30)
+ (54,000 packages × $7.00)
= $1,755 + $1,755 + $378,000
= $381,510
The proposed annual ordering:
Each order
Average inventory
= 54,000
= 54,000/ 2 = 27,000
Annual cost (with discount)
= (1 orders × $87.75)
+ (27,000 average inventory × $1.30)
+ (54,000 packages × $7.00 × 94%)
= $87.75 + $35,100 + $355,320
= $390,507.75
No! Do not change the present ordering policy.
7-39.
Downey Disks
Number of annual units = $200,000/ $5 = 40,000
At EOQ:
EOQ =
TC =
2SO
=
C
2 × 40,000 × $125
= 4,000,000 = 2,000 units
$2.50
SO CQ 40,000 × $125 $2.50 × 2,000
+
=
+
= $2,500 + $2,500 = $5,000
2
2,000
2
Q
However currently:
At 4×/ year orders = 40,000/4 = 10,000
TC =
SO CQ 40,000 × $125 $2.50 × 10,000
+
=
+
= $500 + $12,500 = $13,000
Q
2
10,000
2
Opportunity cost of not ordering at EOQ = $13,000 ̶ $5,000 = $8,000
7-40.
Coverall Basics Ltd.
Existing inventory investment = $4,000,000/5 =
New system inventory investment = $4,000,000/8 =
Reduced inventory investment =
Opportunity benefit (cost) of
reduced investment in inventory at 11% =
Cost of new control system =
Benefit =
$800,000
500,000
$300,000
$33,000
35,000
($ 2,000)
No! The new system is not worth it.
Comprehensive Problem
7-41.
Bailey Distributing Company
Receivables and Inventory Policy
a. Accounts receivable = Average collection period × average daily sales
Before:
Average collection period
.40 × 10 =
4
18
.60 × 30 =
22 days
Average daily sales
Credit sales – discount
365 days
= $200,000 – (.01) (.40) ($200,000)
365 days
= $200,000 – $800
365 days
Accounts receivable
After:
= $199,200
365 days
= 22 days × $545.75
= $12,007
= $545.75
Average collection period
.50 × 10 =
5
25
.50 × 50 =
30 days
Average daily sales
Credit sales – discount
365 days
Accounts receivable
= $250,000 – (.03) (.50) ($250,000)
365 days
= $250,000 – $3,750
365 days
= $246,250
= $674.66
365 days
= 30 days × $674.66
= $20,240
b. EOQ
Before
EOQ =
2SO
=
C
2 × 20,000 × $100
= 4,000,000 = 2,000 appliances
$1.00
2 SO
=
C
2 × 25,000 × $100
= 5,000,000 = 2,236 appliances
$1.00
After
EOQ =
Average inventory:
Before: 2,000/ 2 = 1,000 units
1,000 × $6.50 = $6,500
After:
1,118 × $6.50 = $7,267
2,236/ 2 = 1,118 units
c.
Net sales (sales - cash discount)
Before Policy
Change
After Policy
Change
$199,200
$246,250
Cost of goods sold (65%)
Gross Profit
General and admin. expense (10%)
Operating profit
*Interest on increase in accounts
receivable and inventory (12%)
Income before taxes
Taxes (25%)
Income after taxes
* 12% × AR
12% × INV
129,480
69,720
19,920
49,800
160,063
86,187
24,625
61,562
49,800
12,450
$37,350
1,080
60,482
15,121
$45,361
= 12% × ($20,240 – $12,007)
= 12% × $8,233 =
= 12% × ($7,267 – $6,500)
= 12% × $767 =
$988
$ 92
$1,080
d. Utilize new cash discount policy. Interest cost on the increased
accounts receivable and inventory is small in comparison to the
increased operating profit from the policy change.
There would be a slight increase in ordering costs to 11.18 orders
(25,000/ 2,236) from 10 orders per year (20,000/2,000). This will
cost an additional $100 (1 × $100). To the extent that carrying
costs do not include the opportunity cost of funds tied up in
inventory, carrying costs will increase up to $118 ($1 × $118).
