Chapter 6 Working Capital and the Financing Decision Discussion Questions 6-1. Explain how rapidly expanding sales can drain the cash resources of a firm. Rapidly expanding sales will require a buildup in assets to support the growth. In particular, more and more of the increase in current assets will be permanent in nature. A non-liquidating aggregate stock of current assets will be necessary to allow for floor displays, multiple items for selection, and other purposes. All of these “asset” investments can drain the cash resources of the firm. 6-2. Discuss the relative volatility of short- and long-term interest rates. Figure 6-10 shows the long-run view of short- and long-term interest rates. Normally, short-term rates are much more volatile than long-term rates. 6-3. What is the significance to working capital management of matching sales and production? If sales and production can be matched, the level of inventory and the amount of current assets needed can be kept to a minimum; therefore, lower financing costs will be incurred. Matching sales and production has the advantage of maintaining smaller amounts of current assets than level production, and therefore less financing costs are incurred. However, if sales are seasonal or cyclical, workers will be laid off in a declining sales climate and machinery (fixed assets) will be idle. Here lies the trade-off between level and seasonal production: Full utilization of fixed assets with skilled workers and more financing of current assets versus unused capacity, training and retraining workers, with lower financing for current assets. 6-4. How is a cash budget used to help manage current assets? A cash budget helps minimize current assets by providing a forecast of inflows and outflows of cash. It also encourages the development of a schedule as to when inventory is produced and maintained for sales (production schedule), and accounts receivables are collected. The cash budget allows us to forecast the level of each current asset and the timing of the buildup and reduction of each. 6-5. “The most appropriate financing pattern would be one in which asset buildup and length of financing terms is perfectly matched.” Discuss the difficulty involved in achieving this financing pattern. Only a financial manager with unusual insight and timing could design a plan in which asset buildup and the length of financing terms are perfectly matched. One would need to know exactly what current assets are temporary and which ones are permanent. Furthermore, one is never quite sure how much short-term or long-term financing is available at all times. Even if this were known, it would be difficult to change the financing mix on a continual basis. 6-6. By using long-term financing to finance part of temporary current assets, a firm may have less risk but lower returns than a firm with a normal financing plan. Explain the significance of this statement. By establishing a long-term financing arrangement for temporary current assets, a firm is assured of having necessary funding in good times as well as bad, thus we say there is low risk. However, long-term financing is generally more expensive than short-term financing and profits may be lower than those which could be achieved with a synchronized or normal financing arrangement for temporary current assets. 6-7. A firm that uses short-term financing methods for a portion of permanent current assets is assuming more risk but expects higher returns than a firm with a normal financing plan. Explain. By financing a portion of permanent current assets on a short-term basis, we run the risk of inadequate financing in tight money periods. However, since short-term financing is less expensive than long-term funds, a firm tends to increase its profitability over the long run (assuming it survives). In answer to the preceding question, we stressed less risk and less return. Here the emphasis is on risk and high return. 6-8. What does the term structure of interest rates indicate? The term structure of interest rates shows the relative level of short-term and long-term interest rates at a point in time on U.S. treasury securities. It is often referred to as a yield curve. 6-9. What are three theories for describing the shape of the term structure of interest rates (the yield curve)? Briefly describe each theory. Liquidity premium theory, the market segmentation theory, and the expectations theory. The liquidity premium theory indicates that long-term rates should be higher than short-term rates. This premium of long-term rates over short-term rates exists because short-term securities have greater liquidity, and therefore higher rates have to be offered to potential long-term bond buyers to entice them to hold these less liquid and more price-sensitive securities. The market segmentation theory states that Treasury securities are divided into market segments by the various financial institutions investing in the market. The changing needs, desires, and strategies of these investors tend to strongly influence the nature and relationship of short- and long-term rates. The expectations hypothesis maintains that the yields on long-term securities are a function of short-term rates. The result of the hypothesis is that when long-term rates are much higher than short-term rates, the market is saying that it expects short-term rates to rise. Conversely, when long-term rates are lower than short-term rates, the market is expecting short-term rates to fall. 6-10. Since the mid-1960s, corporate liquidity has been declining. What reasons can you give for this trend? The decrease in liquidity can be traced in part to more efficient inventory management such as just-in-time inventory and point of sales terminals that provide better inventory control. The decline in working capital can also be attributed to electronic cash flow transfer systems, and the ability to sell accounts receivables through securitization of assets (this is more fully explained in the next chapter). It might also be that management is simply willing to take more liquidity risk as interest rates declined. Chapter 6 Problems 1. Expected value (LO6) Gary’s Pipe and Steel company expects sales next year to be $800,000 if the economy is strong, $500,000 if the economy is steady, and $350,000 if the economy is weak. Gary believes there is a 20 percent probability the economy will be strong, a 50 percent probability of a steady economy, and a 30 percent probability of a weak economy. What is the expected level of sales for next year? 6-1. Solution: Gary’s Pipe and Steel Company State of Economy Sales Probability Expected Outcome Strong $800,000 .20 $160,000 Steady 500,000 .50 250,000 Weak 350,000 .30 105,000 Expected level of sales = $515,000 2. Expected value (LO6) Sharpe Knife Company expects sales next year to be $1,550,000 if the economy is strong, $825,000 if the economy is steady, and $550,000 if the economy is weak. Mr. Sharpe believes there is a 30 percent probability the economy will be strong, a 40 percent probability of a steady economy, and a 30 percent probability of a weak economy. What is the expected level of sales for the next year? 6-2. Solution: Sharpe Knife Company State of Economy Sales Probability Expected Outcome Strong $1,550,000 .30 $465,000 Steady 825,000 .40 330,000 Weak 550,000 .30 165,000 Expected level of sales = $960,000 3. External financing (LO1) Tobin Supplies Company expects sales next year to be $500,000. Inventory and accounts receivable will increase $90,000 to accommodate this sales level. The company has a steady profit margin of 12 percent with a 40 percent dividend payout. How much external financing will Tobin Supplies Company have to seek? Assume there is no increase in liabilities other than that which will occur with the external financing. 6-3. Solution: Tobin Supplies Company $500,000 Sales .12 Profit margin 60,000 Net income – 24,000 Dividends (40%) $ 36,000 Increase in retained earnings $ 90,000 Increase in assets – 36,000 Increase in retained earnings $ 54,000 External funds needed 4. External financing (LO1) Antivirus Inc. expects its sales next year to be $2,500,000. Inventory and accounts receivable will increase $480,000 to accommodate this sales level. The company has a steady profit margin of 15 percent with a 35 percent dividend payout. How much external financing will the firm have to seek? Assume there is no increase in liabilities other than that which will occur with the external financing. 6-4. Solution: Antivirus Inc. $2,500,000 Sales .15 Profit margin 375,000 Net income – 131,250 Dividends (35%) $ 243,750 Increase in retained earnings $ 480,000 Increase in assets – 243,750 Increase in retained earnings $236,250 External funds needed 5. Level versus seasonal production (LO1) Antonio Banderos & Scarves makes headwear that is very popular in the fall/winter season. Units sold are anticipated as: October 1,250 November 2,250 December 4,500 January 3,500 11,500 units If seasonal production is used, it is assumed that inventory will directly match sales for each month and there will be no inventory buildup. However, Antonio decides to go with level production to avoid being out of merchandise. He will produce the 11,500 items over four months at a level of 2,875 per month. a. What is the ending inventory at the end of each month? Compare the units sales to the units produced and keep a running total. b. If the inventory costs $8 per unit and will be financed at the bank at a cost of 12 percent, what is the monthly financing cost and the total for the four months? (Use 1 percent or the monthly rate.) 6-5. Solution: Antonio Banderos and Scarves a. Units Sold Units Produced Change in Inventory Ending Inventory October 1,250 2,875 +1,625 1,625 November 2,250 2,875 + 625 2,250 December 4,500 2,875 –1,625 625 January 3,500 2,875 – 625 0 b. Ending Inventory Total Cost per Unit ($8 per unit) Inventory Financing Cost (at 1% per month) October 1,625 13,000 130 November 2,250 18,000 180 December 625 5,000 50 January 0 0 0 Total Financing Cost = $360 6. Level versus seasonal production (LO1) Bambino Sporting Goods makes baseball gloves that are very popular in the spring and early summer season. Units sold are anticipated as follows: March 3,250 April 7,250 May 11,500 June 9,500 31,500 If seasonal production is used, it is assumed that inventory will directly match sales for each month and there will be no inventory buildup. The production manager thinks the preceding assumption is too optimistic and decides to go with level production to avoid being out of merchandise. He will produce the 31,500 units over 4 months at a level of 7,875 per month. a. What is the ending inventory at the end of each month? Compare the unit sales to the units produced and keep a running total. b. If the inventory costs $12 per unit and will be financed at the bank at a cost of 12 percent, what is the monthly financing cost and the total for the four months? (Use .01% as the monthly rate.) 6-6. Solution: Bambino Sporting Goods a. Units Sold Units Produced Change in Inventory Ending Inventory March 3,250 7,875 +4,625 4,625 April 7,250 7,875 + 625 5,250 May 11,500 7,875 –3,625 1,625 June 9,500 7,875 –1,625 0 6-6. (Continued) b. Ending Inventory Total Cost ($12 per unit) Inventory Financing Cost (at 1% per month) March 4,625 55,500 $ 555 April 5,250 63,000 630 May 1,625 19,500 195 June 0 0 0 Total Financing Cost = $1,380 7. Short-term versus longer-term borrowing (LO3) Boatler Used Cadillac Co. requires $850,000 in financing over the next two years. The firm can borrow the funds for two years at 12 percent interest per year. Mr. Boatler decides to do forecasting and predicts that if he utilizes short-term financing instead, he will pay 7.75 percent interest in the first year and 13.55 percent interest in the second year. Determine the total two-year interest cost under each plan. Which plan is less costly? 6-7. Solution: Boatler Used Cadillac Co. Cost of Two-Year Fixed Cost Financing $850,000 borrowed @ 12% per annum × 2 years = $204,000 interest cost Cost of Two-Year Variable Short-Term Financing 1st year $850,000 × 7.75% per annum = $ 65,875 interest cost 2nd year $850,000 × 13.55% per annum = $115,175 interest cost 181,050 total interest cost The short-term plan is less costly. 8. Short-term versus longer-term borrowing (LO3) Biochemical Corp. requires $550,000 in financing over the next three years. The firm can borrow the funds for three years at 10.60 percent interest per year. The CEO decides to do a forecast and predicts that if she utilizes short-term financing instead, she will pay 8.75 percent interest in the first year, 13.25 percent interest in the second year, and 10.15 percent interest in the third year. Determine the total interest cost under each plan. Which plan is less costly? 6-8. Solution: Biochemical Corp. Cost of Three-Year Fixed Cost Financing $550,000 borrowed × 10.60% per annum × 3 years = $174,900 Cost of Three-Year Variable Short-Term Financing 1st year $550,000 × 8.75% per annum = $ 48,125 Interest cost 2nd year $550,000 × 13.25% per annum = 72,875 Interest cost 3rd year $550,000 × 10.15% per annum = 55,825 Interest cost $176,825 3-year total The fixed cost plan is less costly. 9. Short-term versus longer-term borrowing (LO3) Sauer Food Company has decided to buy a new computer system with an expected life of three years. The cost is $150,000. The company can borrow $150,000 for three years at 10 percent annual interest or for one year at 8 percent annual interest. How much would Sauer Food Company save in interest over the three-year life of the computer system if the one-year loan is utilized and the loan is rolled over (reborrowed) each year at the same 8 percent rate? Compare this to the 10 percent three-year loan. What if interest rates on the 8 percent loan go up to 13 percent in year 2 and 18 percent in year 3? What would be the total interest cost compared to the 10 percent, three-year loan? 6-9. Solution: Sauer Food Company If Rates Are Constant $150,000 borrowed × 8% per annum × 3 years = $36,000 interest cost $150,000 borrowed × 10% per annum × 3 years = $45,000 interest cost $45,000 – $36,000 = $9,000 interest savings borrowing short-term If Short-Term Rates Change 1st year $150,000 × .08 = $12,000 2nd year $150,000 × .13 = $19,500 3rd year $15,000 × .18 = $27,000 Total = $58,500 $58,500 – $45,000 = $13,500 extra interest costs borrowing short-term. 10. Optimal policy mix (LO5) Assume that Hogan Surgical Instruments Co. has $2,500,000 in assets. If it goes with a low-liquidity plan for the assets, it can earn a return of 18 percent, but with a high-liquidity plan, the return will be 14 percent. If the firm goes with a short-term financing plan, the financing costs on the $2,500,000 will be 10 percent, and with a long-term financing plan, the financing costs on the $2,500,000 will be 12 percent. (Review Table 6-11 for parts a, b, and c of this problem.) a. Compute the anticipated return after financing costs with the most aggressive asset-financing mix. b. Compute the anticipated return after financing costs with the most conservative asset-financing mix. c. Compute the anticipated return after financing costs with the two moderate approaches to the asset-financing mix. d. Would you necessarily accept the plan with the highest return after financing costs? Briefly explain. 6-10. Solution: Hogan Surgical Instruments Company a. Most aggressive Low liquidity $2,500,000 × 18% = $450,000 Short-term financing 2,500,000 × 10% = –250,000 Anticipated return $200,000 b. Most conservative High liquidity $2,500,000 × 14% = $350,000 Long-term financing 2,500,000 × 12% = –300,000 Anticipated return $ 50,000 c. Moderate approach Low liquidity $2,500,000 × 18% = $450,000 Long-term financing 2,500,000 × 12% = –300,000 $150,000 OR High liquidity $2,500,000 × 14% = $350,000 Short-term financing 2,500,000 × 10% = –250,000 $ 100,000 6-10. (Continued) d. You may not necessarily select the plan with the highest return. You must also consider the risk inherent in the plan. Of course, some firms are better able to take risks than others. The ultimate concern must be for maximizing the overall valuation of the firm through a judicious consideration of risk-return options. 11. Optimal policy mix (LO5) Assume that Atlas Sporting Goods Inc. has $840,000 in assets. If it goes with a low-liquidity plan for the assets, it can earn a return of 15 percent, but with a high-liquidity plan the return will be 12 percent. If the firm goes with a short-term financing plan, the financing costs on the $840,000 will be 9 percent, and with a long-term financing plan, the financing costs on the $840,000 will be 11 percent. (Review Table 6-11 for parts a, b, and c of this problem.) a. Compute the anticipated return after financing costs with the most aggressive asset-financing mix. b. Compute the anticipated return after financing costs with the most conservative asset-financing mix. c. Compute the anticipated return after financing costs with the two moderate approaches to the asset-financing mix. d. If the firm used the most aggressive asset-financing mix described in part a and had the anticipated return you computed for part a, what would earnings per share be if the tax rate on the anticipated return was 30 percent and there were 20,000 shares outstanding? e. Now assume the most conservative asset-financing mix described in part b will be utilized. The tax rate will be 30 percent. Also assume there will only be 5,000 shares outstanding. What will earnings per share be? Would it be higher or lower than the earnings per share computed for the most aggressive plan computed in part d? 6-11. Solution: Atlas Sporting Goods Inc. a. Most aggressive Low liquidity $840,000 × 15% = $126,000 Short-term financing 840,000 × 9% = –75,600 Anticipated return $ 50,400 b. Most conservative High liquidity $840,000 × 12% = $ 100,800 Long-term financing 840,000 × 11% = –92,400 Anticipated return $ 8,400 6-11. (Continued) c. Moderate approach Low liquidity $840,000 × 15% = $126,000 Long-term financing 840,000 × 11% = –92,400 Anticipated return $ 33,600 OR High liquidity $840,000 × 12% = $ 100,800 Short-term financing 840,000 × 9% = –75,600 Anticipated return $ 25,200 d. Anticipated return $ 50,400 – Taxes (30%) 15,120 Earnings after taxes 35,280 Shares 20,000 Earnings per share $1.76 e. Anticipated return $ 8,400 – Taxes (30%) 2,520 Earnings after taxes 5,880 Shares 5,000 Earnings per share $1.18 It is higher ($1.18 vs. $1.76) 12. Matching asset mix and financing plans (LO3) Colter Steel has $4,200,000 in assets. Temporary current assets $1,000,000 Permanent current assets 2,000,000 Fixed assets 1,200,000 Total assets $4,200,000 Short-term rates are 8 percent. Long-term rates are 13 percent. Earnings before interest and taxes are $996,000. The tax rate is 40 percent. If long-term financing is perfectly matched (synchronized) with long-term asset needs, and the same is true of short-term financing, what will earnings after taxes be? For a graphical example of perfectly matched plans, see Figure 6-5. 6-12. Solution: Colter Steel Long-term financing equals: Permanent current assets $2,000,000 Fixed assets 1,200,000 $3,200,000 Short-term financing equals: Temporary current assets $1,000,000 Long-term interest expense = 13% × $3,200,000 = $ 416,000 Short-term interest expense = 8% × 1,000,000 = 80,000 Total interest expense $ 496,000 Earnings before interest and taxes $ 996,000 Interest expense 496,000 Earnings before taxes $ 500,000 Taxes (40%) 200,000 Earnings after taxes $ 300,000 13. Impact of term structure of interest rates on financing plans (LO4) In Problem 12, assume the term structure of interest rates becomes inverted, with short-term rates going to 11 percent and long-term rates 5 percentage points lower than short-term rates. If all other factors in the problem remain unchanged, what will earnings after taxes be? 6-13. Solution: Colter Steel (Continued) Long-term interest expense = 6% × $3,200,000 = $192,000 Short-term interest expense = 11% × 1,000,000 = 110,000 Total interest expense $302,000 Earnings before interest and taxes $996,000 Interest expense 302,000 Earnings before taxes $694,000 Taxes (40%) 277,600 Earnings after taxes $416,400 14. Conservative versus aggressive financing (LO5) Guardian Inc. is trying to develop an asset-financing plan. The firm has $400,000 in temporary current assets and $300,000 in permanent current assets. Guardian also has $500,000 in fixed assets. Assume a tax rate of 40 percent. a. Construct two alternative financing plans for Guardian. One of the plans should be conservative, with 75 percent of assets financed by long-term sources, and the other should be aggressive, with only 56.25 percent of assets financed by long-term sources. The current interest rate is 15 percent on long-term funds and 10 percent on short-term financing. b. Given that Guardian’s earnings before interest and taxes are $200,000, calculate earnings after taxes for each of your alternatives. c. What would happen if the short- and long-term rates were reversed? 6-14. Solution: Guardian Inc. a. Temporary current assets $ 400,000 Permanent current assets 300,000 Fixed assets 500,000 Total assets $1,200,000 Conservative % of Interest Interest Amount Total Rate Expense $1,200,000 × .75 = $900,000 × .15 = $135,000 Long-term $1,200,000 × .25 = $300,000 × .10 = 30,000 Short-term Total interest charge $165,000 Aggressive $1,200,000 × .5625 = $675,000 × .15 = $101,250 Long-term $1,200,000 × .4375 = $525,000 × .10 = 52,500 Short-term Total interest charge $153,750 6-14. (Continued) b. Conservative Aggressive EBIT $200,000 $200,000 – Int 165,000 153,750 EBT 35,000 46,250 Tax 40% 14,000 18,500 EAT $ 21,000 $ 27,750 c. Reversed: Conservative $1,200,000 × .75 = $900,000 × .10 = $ 90,000 Long-term $1,200,000 × .25 = $300,000 × .15 = 45,000 Short-term Total interest charge $135,000 Aggressive $1,200,000 × .5625 = $675,000 × .10 = $67,500 Long-term $1,200,000 × .4375 = $525,000 × .15 = 78,750 Short-term Total interest charge $146,250 Reversed Conservative Aggressive EBIT $200,000 $200,000 – Int 135,000 146,250 EBT 65,000 53,750 Tax 40% 26,000 21,500 EAT $ 39,000 $ 32,250 15. Alternative financing plans (LO5) Lear Inc. has $840,000 in current assets, $370,000 of which are considered permanent current assets. In addition, the firm has $640,000 invested in fixed assets. a. Lear wishes to finance all fixed assets and half of its permanent current assets with long-term financing costing 8 percent. The balance will be financed with short-term financing, which currently costs 7 percent. Lear’s earnings before interest and taxes are $240,000. Determine Lear’s earnings after taxes under this financing plan. The tax rate is 30 percent. b. As an alternative, Lear might wish to finance all fixed assets and permanent current assets plus half of its temporary current assets with long-term financing and the balance with short-term financing. The same interest rates apply as in part a. Earnings before interest and taxes will be $240,000. What will be Lear’s earnings after taxes? The tax rate is 30 percent. c. What are some of the risks and cost considerations associated with each of these alternative financing strategies? 6-15. Solution: Lear Inc. a. Current assets – Permanent current assets = Temporary current assets $840,000 – $370,000 = $470,000 Long-term interest expense = 8% [$640,000 + ½($370,000)] = 8% ($825,000) = $66,000 Short-term interest expense = 7% [$470,000 + ½($370,000)] = 7% × ($655,000) = $45,850 Total interest expense = $66,000 + $45,850 = $111,850 Earnings before interest and taxes $240,000 Interest expense 111,850 Earnings before taxes $128,150 Taxes (30%) 38,445 Earnings after taxes $ 89,705 6-15. (Continued) b. Alternative financing plan Long-term interest expense = 8% [$640,000 + $370,000 + ½($470,000)] = 8% ($1,245,000) = $99,600 Short-term interest expense = 7% [½($470,000)] = 7% (235,000) = $16,450 Total interest expense =$99,600 + $16,450 =$116,050 Earnings before interest and taxes $240,000 Interest 116,050 Earnings before taxes $123,950 Taxes (30%) 37,185 Earnings after taxes $ 86,765 c. The alternative financing plan, which calls for more financing by high-cost debt, is more expensive and reduces after tax income by $2,940. However, we must not automatically reject this plan because of its higher cost since it has less risk. The alternative provides the firm with long-term capital which at times will be in excess of its needs and invested in marketable securities. It will not be forced to pay higher short-term rates on a large portion of its debt when short-term rates rise and will not be faced with the possibility of no short-term financing for a portion of its permanent current assets when it is time to renew the short-term loan. 16. Expectations hypothesis and interest rates (LO4) Using the expectations hypothesis theory for the term structure of interest rates, determine the expected return for securities with maturities of two, three, and four years based on the following data. Do an analysis similar to that in Table 6-6. 1-year T-bill at beginning of year 1 6% 1-year T-bill at beginning of year 2 7% 1-year T-bill at beginning of year 3 9% 1-year T-bill at beginning of year 4 11% 6-16. Solution: 2-year security (6% + 7%)/2 = 6.5% 3-year security (6% + 7% + 9%)/3 = 7.33% 4-year security (6% + 7% + 9% + 11%)/4 = 8.25% 17. Expectations hypothesis and interest rates (LO4) Using the expectations hypothesis theory for the term structure of interest rates, determine the expected return for securities with maturities of two, three, and four years based on the following data. Do an analysis similar to that in the right-hand portion of Table 6-6. 1-year T-bill at beginning of year 1…… 5% 1-year T-bill at beginning of year 2…… 8% 1-year T-bill at beginning of year 3…… 7% 1-year T-bill at beginning of year 4…… 10% 6-17. Solution: 2 year security (5% + 8%)/2 = 6.50% 3 year security (5% + 8% + 7%)/3 = 6.67% 4 year security (5% + 8% + 7% + 10%)/4 = 7.50% 18. Interest costs under alternative plans (LO3) Carmen’s Beauty Salon has estimated monthly financing requirements for the next six months as follows: January $8,500 April $8,500 February 2,500 May 9,500 March 3,500 June 4,500 Short-term financing will be utilized for the next six months. Projected annual interest rates are: January 9.0% April 16.0% February 10.0% May 12.0% March 13.0% June 12.0% a. Compute total dollar interest payments for the six months. To convert an annual rate to a monthly rate, divide by 12. Then, multiply this value times the monthly balance. To get your answer, sum up the monthly interest payments. b. If long-term financing at 12 percent had been utilized throughout the six months, would the total-dollar interest payments be larger or smaller? Compute the interest owed over the six months and compare your answer to that in part a. 6-18. Solution: Carmen’s Beauty Salon a. Short-term financing Month Rate On Monthly Basis Amount Actual Interest January 9% .75% $8,500 $ 63.75 February 10% .83% $2,500 $ 20.75 March 13% 1.08% $3,500 $ 37.80 April 16% 1.33% $8,500 $113.05 May 12% 1.00% $9,500 $ 95.00 June 12% 1.00% $4,500 $ 45.00 $375.35 6-18. (Continued) b. Long-term financing Month Rate On Monthly Basis Amount Actual Interest January 12% 1% $8,500 $ 85.00 February 12% 1% $2,500 $ 25.00 March 12% 1% $3,500 $ 35.00 April 12% 1% $8,500 $ 85.00 May 12% 1% $9,500 $ 95.00 June 12% 1% $4,500 $ 45.00 $370.00 Total dollar interest payments would be larger under the short-term financing plan as described in part b. 19. Break-even point in interest rates (LO3) In Problem 18, what long-term interest rate would represent a break-even point between using short-term financing as described in part a and long-term financing? (Hint: Divide the interest payments in 18a by the amount of total funds provided for the six months and multiply by 12.) 6-19. Solution: Carmen’s Beauty Salon (Continued) Divide the total interest payments in part (a) of $375.35 by the total amount of funds extended $37,000 ($8,500 + 2,500 + 3,500 + 8,500 + 9,500 + 4,500) and multiply by 12. 20. Cash receipts schedule (LO1) Eastern Auto Parts Inc. has 15 percent of its sales paid for in cash and 85 percent on credit. All credit accounts are collected in the following month. Assume the following sales: January $65,000 February 55,000 March 100,000 April 45,000 Sales in December of the prior year were $75,000. Prepare a cash receipts schedule for January through April. 6-20. Solution: Eastern Auto Parts Jan Feb Mar Apr Sales $65,000 $55,000 $100,000 $45,000 15% Cash sales 9,750 8,250 15,000 6,750 85% Prior month’s sales* 63,750 55,250 46,750 85,000 Total cash receipts $73,500 $63,500 $61,750 $91,750 *Based on December sales of $75,000 21. Level production and related financing effects (LO3) Bombs Away Video Games Corporation has forecasted the following monthly sales: January $100,000 July $ 45,000 February 93,000 August 45,000 March 25,000 September 55,000 April 25,000 October 85,000 May 20,000 November 105,000 June 35,000 December 123,000 Total annual sales = $756,000 Bombs Away Video Games sells the popular Strafe and Capture video game. It sells for $5 per unit and costs $2 per unit to produce. A level production policy is followed. Each month’s production is equal to annual sales (in units) divided by 12. Of each month’s sales, 30 percent are for cash and 70 percent are on account. All accounts receivable are collected in the month after the sale is made. a. Construct a monthly production and inventory schedule in units. Beginning inventory in January is 25,000 units. (Note: To do part a, you should work in terms of units of production and units of sales.) b. Prepare a monthly schedule of cash receipts. Sales in the December before the planning year are $100,000. Work part b using dollars. c. Determine a cash payments schedule for January through December. The production costs of $2 per unit are paid for in the month in which they occur. Other cash payments, besides those for production costs, are $45,000 per month. d. Prepare a monthly cash budget for January through December using the cash receipts schedule from part b and the cash payments schedule from part c. The beginning cash balance is $5,000, which is also the minimum desired. 6-21. Solution: Bombs Away Video Games Corporation a. Production and inventory schedule in units Beginning Inventory + Production1 – Sales2 = Ending Inventory Jan. 25,000 + 12,600 – 20,000 = 17,600 Feb. 17,600 + 12,600 – 18,600 = 11,600 Mar. 11,600 + 12,600 – 5,000 = 19,200 Apr. 19,200 + 12,600 – 5,000 = 26,800 May 26,800 + 12,600 – 4,000 = 35,400 June 35,400 + 12,600 – 7,000 = 41,000 July 41,000 + 12,600 – 9,000 = 44,600 Aug. 44,600 + 12,600 – 9,000 = 48,200 Sept. 48,200 + 12,600 – 11,000 = 49,800 Oct. 49,800 + 12,600 – 17,000 = 45,400 Nov. 45,400 + 12,600 – 21,000 = 37,000 Dec. 37,000 + 12,600 – 24,600 = 25,000 1 Total annual sales = $756,000 $756,000/$5 per unit = 151,200 units 151,200 units/12 months = 12,600 per month 2 Monthly dollar sales/$5 price = unit sales 6-21. (Continued) 6-21. (Continued) 6-21. (Continued) 22. Level production and related financing effects (LO3) Esquire Products Inc. expects the following monthly sales: January $28,000 May $8,000 September $29,000 February 19,000 June 6,000 October 34,000 March 12,000 July 22,000 November 42,000 April 14,000 August 26,000 December 24,000 Total sales = $264,000 Cash sales are 40 percent in a given month, with the remainder going into accounts receivable. All receivables are collected in the month following the sale. Esquire sells all of its goods for $2 each and produces them for $1 each. Esquire uses level production, and average monthly production is equal to annual production divided by 12. a. Generate a monthly production and inventory schedule in units. Beginning inventory in January is 12,000 units. (Note: To do part a, you should work in terms of units of production and units of sales.) b. Determine a cash receipts schedule for January through December. Assume that dollar sales in the prior December were $20,000. Work part b using dollars. c. Determine a cash payments schedule for January through December. The production costs ($1 per unit produced) are paid for in the month in which they occur. Other cash payments (besides those for production costs) are $7,400 per month. d. Construct a cash budget for January through December using the cash receipts schedule from part b and the cash payments schedule from part c. The beginning cash balance is $3,000, which is also the minimum desired. e. Determine total current assets for each month. Include cash, accounts receivable, and inventory. Accounts receivable equal sales minus 40 percent of sales for a given month. Inventory is equal to ending inventory (part a) times the cost of $1 per unit. 6-22. Solution: Esquire Products Inc. a. Production and inventory schedule in units Beginning Inventory + Production1 – Sales2 = Ending Inventory Jan. 12,000 + 11,000 – 14,000 = 9,000 Feb. 9,000 + 11,000 – 9,500 = 10,500 Mar. 10,500 + 11,000 – 6,000 = 15,500 Apr. 15,500 + 11,000 – 7,000 = 19,500 May 19,500 + 11,000 – 4,000 = 26,500 June 26,500 + 11,000 – 3,000 = 34,500 July 34,500 + 11,000 – 11,000 = 34,500 Aug. 34,500 + 11,000 – 13,000 = 32,500 Sept. 32,500 + 11,000 – 14,500 = 29,000 Oct. 29,000 + 11,000 – 17,000 = 23,000 Nov. 23,000 + 11,000 – 21,000 = 13,000 Dec. 13,000 + 11,000 – 12,000 = 12,000 1 $264,000 sales/$2 price = 132,000 units 132,000 units/12 months = 11,000 units per month 2 Monthly dollar sales/$2 = number of units 6-22. (Continued) 6-22. (Continued) 6-22. (Continued) e. Esquire Products Inc. Assets Cash Accounts Receivable Inventory Total Current Jan. $7,800 $16,800 $9,000 $33,600 Feb. 13,800 11,400 10,500 35,700 Mar. 11,600 7,200 15,500 34,300 Apr. 6,000 8,400 19,500 33,900 May 3,000 4,800 26,500 34,300 June 3,000 3,600 34,500 41,100 July 3,000 13,200 34,500 50,700 Aug. 3,000 15,600 32,500 51,100 Sept. 3,000 17,400 29,000 49,400 Oct. 8,600 20,400 23,000 52,000 Nov. 27,400 25,200 13,000 65,600 Dec. 43,800 14,400 12,000 70,200 The instructor may wish to point out how current assets are at relatively high levels and illiquid during June through October. In November and particularly December, the asset levels remain high, but they become increasingly more liquid as inventory diminishes relative to cash. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160
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