Chapter 7 Current Asset Management Discussion Questions 7-1. In the management of cash and marketable securities, why should the primary concern be for safety and liquidity rather than maximization of profit? 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. Explain the similarities and differences of lockbox systems and regional collection offices. 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. 7-3. Why would a financial manager want to slow down disbursements? 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. 7-4. Use The Wall Street Journal or some other financial publication to find the going interest rates for the list of marketable securities in Table 7-1 on page 200. Which security would you choose for a short-term investment? Why? 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. 7-5. Why are Treasury bills a favorite place for financial managers to invest excess cash? 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. 7-6. Explain why the bad debt percentage or any other similar credit-control percentage is not the ultimate measure of success in the management of accounts receivable. What is the key consideration? 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. 7-7. What are three quantitative measures that can be applied to the collection policy of the firm? The average collection period, the ratio of bad debts to credit sales, and the aging of accounts receivable. 7-8. What are the 5 Cs of credit that are sometimes used by bankers and others to determine whether a potential loan will be repaid? The 5 Cs of credit are character, capital, capacity, conditions, and collateral. 7-9. What does the EOQ formula tell us? What assumption is made about the usage rate for inventory? The EOQ or economic order point 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. 7-10. Why might a firm keep a safety stock? What effect is it likely to have on carrying cost of inventory? 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. 7-11. If a firm uses a just-in-time inventory system, what effect is that likely to have on the number and location of suppliers? 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. Chapter 7 Problems 1. Cost-benefit analysis of cash management (LO2) City Farm Insurance has collection centers across the country to speed up collections. The company also makes its disbursements from remote disbursement centers. The collection time has been reduced by two days and disbursement time increased by one day because of these policies. Excess funds are being invested in short-term instruments yielding 12 percent per annum. a. If City Farm has $5 million per day in collections and $3 million per day in disbursements, how many dollars has the cash management system freed up? b. How much can City Farm earn in dollars per year on short-term investments made possible by the freed-up cash? 7-1. Solution: City Farm Insurance a. $5,000,000 daily collections × 2.0 days speedup = $10,000,000 additional collections $3,000,000 daily disbursements × 1.0 days slowdown = $ 3,000,000 delayed disbursements $13,000,000 freed-up funds b. 2. Cost-benefit analysis of cash management (LO2) Neon Light Company of Kansas City ships lamps and lighting appliances throughout the country. Ms. Neon has determined that through the establishment of local collection centers around the country, she can speed up the collection of payments by three days. Furthermore, the cash management department of her bank has indicated to her that she can defer her payments on her accounts by one-half day without affecting suppliers. The bank has a remote disbursement center in Florida. a. If Neon Light Company has $2.25 million per day in collections and $1.05 million per day in disbursements, how many dollars will the cash management system free up? b. If Neon Light Company can earn 6 percent per annum on freed-up funds, how much will the income be? c. If the total cost of the new system is $400,000, should it be implemented? 7-2. Solution: Neon Light Company of Kansas City a. $2,250,000 daily collections × 3.0 days speedup = $6,750,000 additional collections $1,050,000 daily disbursements × 0.5 days slowdown = $525,000 delayed disbursements $7,275,000 freed-up funds b. $7,275,000 freed-up funds × 6% interest rate $ 436,500 interest on freed-up cash c. Yes. The income of $436,500 is $36,500 more than the cost of $400,000. 3. International cash management (LO2) Orbital Communications has operating plants in over 100 countries. It also keeps funds for transactions purposes in many foreign countries. Assume in 2010 it held 150,000 kronas in Norway worth $40,000. The funds drew 13 percent interest, and the krona increased 6 percent against the dollar. What is the value of the holdings, based on U.S. dollars, at year-end (Hint: multiply $40,000 times 1.13 and then multiply the resulting value by 106 percent.) 7-3. Solution: Orbital Communications $40,000 × 1.13 = $45,200 $45,200 × 106% = $47,912 4. International cash management (LO2) Postal Express has outlets throughout the world. It also keeps funds for transactions purposes in many foreign countries. Assume in 2010 it held 240,000 reals in Brazil worth 170,000 dollars. It drew 12 percent interest, but the Brazilian real declined 24 percent against the dollar. a. What is the value of its holdings, based on U.S. dollars, at year-end? (Hint: Multiply $170,000 times 1.12 and then multiply the resulting value by 76 percent.) b. What is the value of its holdings, based on U.S. dollars, at year-end if instead it drew 9 percent interest and the real went up by 13 percent against the dollar? 7-4. Solution: Postal Express a. $170,000 × 1.12 = $190,400 $190,400 × 76% = $114,704 dollar value of real holdings b. $170,000 × 1.09 = $185,300 $185,300 × 113% = $209,389 dollar value of real holdings 5. Average collection period (LO4) Thompson Wood Products has credit sales of $2,160,000 and accounts receivable of $288,000. Compute the value of the average collection period. 7-5. Solution: Thompson Wood Products 6. Average collection period (LO4) Oral Roberts Dental Supplies has annual sales of $5,200,000. Ninety percent are on credit. The firm has $559,000 in accounts receivable. Compute the value of the average collection period. 7-6. Solution: Oral Roberts Dental Supplies Credit Sales = 90% × $5,200,000 = $4,680,000 7. Accounts receivable balance (LO4) Knight Roundtable Co. has annual credit sales of $1,080,000 and an average collection period of 32 days in 2008. Assume a 360-day year. What is the company’s average accounts receivable balance? Accounts receivable are equal to the average daily credit sales times the average collection period. 7-7. Solution: Knight Roundtable Co. 8. Accounts receivable balance (LO4) Darla’s Cosmetics has annual credit sales of $1,440,000 and an average collection period of 45 days in 2008. Assume a 360-day year. What is the company’s average accounts receivable balance? Accounts receivable are equal to the average daily credit sales times the average collection period. 7-8. Solution: Darla’s Cosmetic Company $1,440,000 annual credit sales/360 = $4,000 per day credit sales $4,000 credit sales × 45 average collection period = $180,000 average accounts receivable balance 9. Credit policy (LO4) Barney’s Antique Shop has annual credit sales of $1,620,000 and an accounts receivable balance of $157,500. Calculate the average collection period (use 360 days in a year). 7-9. Solution: Barney’s Antique Shop (Continued) Since the firm has a shorter average collection period, it appears that the firm does not have a more lenient credit policy. 10. Determination of credit sales (LO4) Mervyn’s Fine Fashions has an average collection period of 50 days. The accounts receivable balance is $95,000. What is the value of its credit sales? 7-10. Solution: Mervyn’s Fine Fashion 11. Aging of accounts receivable (LO4) Route Canal Shipping Company has the following schedule for aging of accounts receivable: Age of Receivables April 30, 2013 (1) (2) (3) (4) Month of Sales Age of Account Amounts Percent of Amount Due April 0–30 $ 131,250 ____ March 31–60 93,750 ____ February 61–90 112,500 ____ January 91–120 37,500 ____ Total receivables $ 375,000 100% a. Fill in column (4) for each month. b. If the firm had $1,500,000 in credit sales over the four-month period, compute the average collection period. Average daily sales should be based on a 120-day period. c. If the firm likes to see its bills collected in 35 days, should it be satisfied with the average collection period? d. Disregarding your answer to part c and considering the aging schedule for accounts receivable, should the company be satisfied? e. What additional information does the aging schedule bring to the company that the average collection period may not show? 7-11. Solution: Route Canal Shipping Company Age of Receivables, April 30, 2013 a. (1) (2) (3) (4) Month of Sales Age of Account Amounts Percent of Amount Due April 0–30 $131,250 35% March 31–60 93,750 25% February 61–90 112,500 30% January 91–120 37,500 10% Total receivables $375,000 100% 7-11. (Continued) b. c. Yes, the average collection of 30 days is less than 35 days. d. No. The aging schedule provides additional insight that at least 40 percent of the accounts receivable are over 35 days old. e. It goes beyond showing how many days of credit sales accounts receivables represent to indicate the distribution of accounts receivable between various time frames. 12. Economic ordering quantity (LO5) Nowlin Pipe & Steel has projected sales of 72,000 pipes this year, an ordering cost of $6 per order, and carrying costs of $2.40 per pipe. a. What is the economic ordering quantity? b. How many orders will be placed during the year? c. What will the average inventory be? 7-12. Solution: Nowlin Pipe and Steel Company a. b. 72,000 units/600 units = 120 orders c. EOQ/2 = 600/2 = 300 units (average inventory) 13. Economic ordering quantity (LO5) Fisk Corporation is trying to improve its inventory control system and has installed an online computer at its retail stores. Fisk anticipates sales of 49,000 units per year, an ordering cost of $8 per order, and carrying costs of $1.60 per unit. a. What is the economic ordering quantity? b. How many orders will be placed during the year? c. What will the average inventory be? d. What is the total cost of ordering and carrying inventory? 7-13. Solution: Fisk Corp. a. b. 49,000 units/700 units = 70 orders c. EOQ/2 = 700/2 = 350 units (average inventory) d. 70 orders × $8 ordering cost = $ 560 350 units × $1.60 carrying cost per unit = 560 Total costs = $1,120 14. Economic ordering quantity (LO5) Fisk Corporation is trying to improve its inventory control system and has installed an online computer at its retail stores. Fisk anticipates sales of 49,000 units per year, an ordering cost of $2 per order, and carrying costs of $1.60 per unit. a. What is the economic ordering quantity? b. How many orders will be placed during the year? c. What will the average inventory be? d. What is the total cost of ordering and carrying inventory? 7-14. Solution: Fisk Corp. (Continued) a. b. 49,000 units/350 units = 140 orders c. EOQ/2 = 350/2 = 175 units (average inventory) d. 140 orders × $2 ordering cost = $280 175 units × $1.60 carrying cost per unit = 280 Total costs = $560 15. Economic ordering quantity with safety stock (LO5) Diagnostic Supplies has expected sales of 84,100 units per year, carrying costs of $5 per unit, and an ordering cost of $10 per order. a. What is the economic order quantity? b. What is the average inventory? What is the total carrying cost? c. Assume an additional 80 units of inventory will be required as safety stock. What will the new average inventory be? What will the new total carrying cost be? 7-15. Solution: Diagnostic Supplies a. b. EOQ/2 = 580/2 = 290 units (average inventory) 290 units × $5 carrying cost/unit = $1,450 total carrying cost c. 370 inventory × $5 carrying cost per year = $1,850 total carrying cost 16. Level versus seasonal production (LO5) Wisconsin Snowmobile Corp. is considering a switch to level production. Cost efficiencies would occur under level production, and after tax costs would decline by $36,000, but inventory would increase by $300,000. Wisconsin Snowmobile has to finance the extra inventory at a cost of 13.5 percent. a. Determine the extra cost or savings of switching over to level production. Should the company go ahead and switch to level production? b. How low would interest rates need to fall before level production would be feasible? 7-16. Solution: Wisconsin Snowmobile Corporation a. Inventory increases by $300,000 × Interest expense 13.5% Increased costs $ 40,500 Savings $36,000 Less: Increased costs ($40,500) Loss ($ 4,500) Don’t switch to level production. b. If interest rates fall to 12 percent or less, the switch would be feasible. However, the decision is more complicated because it depends on expectations for interest rates. If the extra inventory were considered permanent current assets and was financed by locking in long-term interest rates below 12 percent, then it would make sense to switch. However, given that short-term rates are volatile, this decision can’t be made on a dip in short-term interest rates below 12 percent. 17. Credit policy decision (LO4) Johnson Electronics is considering extending trade credit to some customers previously considered poor risks. Sales would increase by $150,000 if credit is extended to these new customers. Of the new accounts receivable generated, 5 percent will prove to be uncollectible. Additional collection costs will be 2 percent of sales, and production and selling costs will be 74 percent of sales. The firm is in the 35 percent tax bracket. a. Compute the incremental income after taxes. b. What will Johnson’s incremental return on sales be if these new credit customers are accepted? c. If the receivable turnover ratio is 3 to 1, and no other asset buildup is needed to serve the new customers, what will Johnson’s incremental return on new average investment be? 7-17. Solution: Johnson Electronics a. Additional sales $150,000 Accounts uncollectible (5% of new sales) – 7,500 Annual incremental revenue $ 142,500 Collection costs (2% of new sales) – 3,000 Production and selling costs (74% of new sales) – 111,000 Annual income before taxes $ 28,500 Taxes (35%) – 9,975 Incremental income after taxes $ 18,525 b. c. Receivable turnover = Sales/Receivable turnover = 3x Receivables = Sales/Receivable turnover = $150,000/3 = $50,000.00 Incremental return on new average investment = $18,525/$50,000.00 = 37.05% 18. Credit policy decision-receivables and inventory (LO4 and 5) Henderson Office Supply is considering a more liberal credit policy to increase sales, but expects that 9 percent of the new accounts will be uncollectible. Collection costs are 6 percent of new sales, production and selling costs are 74 percent, and accounts receivable turnover is four times. Assume income taxes of 20 percent and an increase in sales of $65,000. No other asset buildup will be required to service the new accounts. a. What is the level of accounts receivable to support this sales expansion? b. What would be Henderson’s incremental after tax return on investment? c. Should Henderson liberalize credit if a 16 percent after tax return on investment is required? Assume that Henderson also needs to increase its level of inventory to support new sales and that inventory turnover is two times. d. What would be the total incremental investment in accounts receivable and inventory to support a $65,000 increase in sales? e. Given the income determined in part b and the investment determined in part d, should Henderson extend more liberal credit terms? 7-18. Solution: Henderson Office Supply a. b. Added sales $ 65,000 Accounts uncollectible (9% of new sales) – 5,850 Annual incremental revenue $ 59,150 Collection costs (6% of new sales) – 3,900 Production and selling costs (74% of new sales) – 48,100 Annual income before taxes $ 7,150 Taxes (20%) – 1,430 Incremental income after taxes $ 5,720 7-18. (Continued) c. Yes! 35.20 percent exceeds the required return of 16 percent. d. Total incremental investment Inventory $32,500 Accounts receivable 16,250 Incremental investment $48,750 $5,720/$48,750 = 11.73% return on investment e. No! 11.73 percent is less than the required return of 16 percent. 19. Credit policy decision with changing variables (LO4) Fast Turnstiles Co. is evaluating the extension of credit to a new group of customers. Although these customers will provide $180,000 in additional credit sales, 12 percent are likely to be uncollectible. The company will also incur $16,200 in additional collection expense. Production and marketing costs represent 72 percent of sales. The firm is in a 34 percent tax bracket and has a receivables turnover of four times. No other asset buildup will be required to service the new customers. The firm has a 10 percent desired return. a. Calculate the incremental income after taxes and the return on incremental investment. Should Fast Turnstiles Co. extend credit to these customers? b. Calculate the incremental income after taxes and the return on incremental investment if 15 percent of the new sales prove to be uncollectible. Should credit be extended if 15 percent of the new sales prove uncollectible? c. Calculate the return on incremental investment if the receivables turnover drops to 1.6, and 12 percent of the accounts are uncollectible. Should credit be extended if the receivables turnover drops to 1.6, and 12 percent of the accounts are uncollectible (as in part a)? 7-19. Solution: Fast Turnstiles Co. a. Added sales $180,000 Accounts uncollectible (12% of new sales) 21,600 Annual incremental revenue 158,400 Collection costs 16,200 Production and selling costs (72% of new sales) 129,600 Annual income before taxes 12,600 Taxes (34%) 4,284 Incremental income after taxes $ 8,316 Yes, extend credit to these customers since the incremental return of 18.48 percent is greater than 10 percent. b. Added sales $180,000 Accounts uncollectible (15% of new sales) 27,000 Annual incremental revenue $153,000 Collection costs 16,200 Production and selling costs (72% of new sales) 129,600 Annual income before taxes 7,200 Taxes (34%) 2,448 Incremental income after taxes $ 4,752 Yes, extend credit. c. If receivable turnover drops to 1.6x, the investment in accounts receivable would equal $180,000/1.6 = $112,500. Credit should not be extended because 7.39 percent is less than the desired 10 percent. 20. Credit policy decision with changing variables (LO4) Slow Roll Drum Co. is evaluating the extension of credit to a new group of customers. Although these customers will provide $180,000 in additional credit sales, 12 percent are likely to be uncollectible. The company will also incur $16,200 in additional collection expense. Production and marketing costs represent 72 percent of sales. The firm is in a 34 percent tax bracket. No other asset buildup will be required to service the new customers. The firm has a 10 percent desired return. Assume the average collection period is 120 days. a. Compute the return on incremental investment b. Should credit be extended? 7-20. Solution: Slow Roll Drum Co. a. Added sales $180,000 Accounts uncollectible (12% of new sales) 21,600 Annual incremental revenue 158,400 Collection costs 16,200 Production and selling costs (72% of new sales) 129,600 Annual income before taxes 12,600 Taxes (34%) 4,284 Incremental income after taxes $ 8,316 First compute the accounts receivable balance. Accounts receivable = average collection × average daily period sales Then, compute return on incremental investment. Yes, extend credit. 13.86 percent is greater than 10 percent. 21. Credit policy and return on investment (LO4) Global Services is considering a promotional campaign that will increase annual credit sales by $450,000. The company will require investments in accounts receivable, inventory, and plant and equipment. The turnover for each is as follows: Accounts receivable 2x Inventory 6x Plant and equipment 1x All $450,000 of the sales will be collectible. However, collection costs will be 6 percent of sales, and production and selling costs will be 71 percent of sales. The cost to carry inventory will be 4 percent of inventory. Depreciation expense on plant and equipment will be 5 percent of plant and equipment. The tax rate is 30 percent. a. Compute the investments in accounts receivable, inventory, and plant and equipment based on the turnover ratios. Add the three together. b. Compute the accounts receivable collection costs and production and selling costs and then add the two figures together. c. Compute the costs of carrying inventory. d. Compute the depreciation expense on new plant and equipment. e. Add together all the costs in parts b, c, and d. f. Subtract the answer from part e from the sales figure of $450,000 to arrive at income before taxes. Subtract taxes at a rate of 30 percent to arrive at income after taxes. g. Divide the after tax return figure in part f by the total investment figure in part a. If the firm has a required return on investment of 8 percent, should it undertake the promotional campaign described throughout this problem. 7-21. Solution: Global Services a. Accounts receivable = Sales/Accounts receivable turnover Inventory = Sales/Inventory turnover Plant and equipment = Sales/(Plant and equipment turnover) $750,000 Total investment 7-21. (Continued) b. Collection cost = 6% × $450,000 $ 27,000 Production and selling costs = 71% × $450,000 = 319,500 Total costs related to accounts receivable $346,500 c. Cost of carrying inventory 4% × inventory 4% × $75,000 $3,000 d. Depreciation expense 5% × $450,000 $22,500 e. Total costs related to accounts receivable $346,500 Cost of carrying inventory 3,000 Depreciation expense 22,500 Total costs $372,000 f. Sales $450,000 – Total costs 372,000 Income before taxes 78,000 Taxes (30%) 23,400 Income after taxes $ 54,600 g. No, it should not undertake the campaign. The after tax return of 7.28 percent exceeds the required rate of return of 8 percent. (Problems 22–25 are a series and should be completed in order.) 22. Credit policy decision with changing variables (LO4) Dome Metals has credit sales of $180,000 yearly with credit terms of net 60 days, which is also the average collection period. Dome does not offer a discount for early payment, so its customers take the full 60 days to pay. What is the average receivables balance? Receivables turnover? 7-22. Solution: Dome Metals Sales/360 days = Average daily sales $180,000/360 = $500 Accounts receivable balance = $500 × 60 days = $30,000 Receivable turnover = or 360 days/60 = 6x 23. Dome Metals had credit sales of $180,000 yearly. Dome offered a 3 percent discount for payment in 18 days. What would the average receivables balance be? 7-23. Solution: Sales/360 days = Average daily sales $180,000/360 = $500 $500 × 18 days = $9,000 new receivable balance 24. Dome Metals had credit sales of $180,000 yearly with credit terms of net 60 days, which is also the average collection period. If Dome offered a 3 percent discount for payment in 18 days and every customer took advantage of the new terms and reduced its bank loans, which cost 12 percent, by the cash generated from its reduced receivables, what will be the net gain or loss to the firm? Should it offer the discount? 7-24. Solution: Sales / 360 days = Average daily sales $180,000 / 360 = $500 Old receivable balance = $500 × 60 days = $30,000 New receivable balance= $500 × 18 days = $9,000 Old receivables – New receivables = Funds freed by with discount discount $30,000 – $9,000 = $21,000 discount Savings on loan = 12% × $21,000 = $ 2,520 Discount on sales = 3% × $180,000 = (5,400) Net change in income from discount $(2,880) No! Don’t offer the discount since the income from reduced bank loans does not offset the loss on the discount. 25. Dome Metals has credit sales of $180,000 yearly with credit terms of net 60 days, which is also the average collection period. Dome offered a 3 percent discount for payment in 18 days, and Dome reduced its bank loans, which cost 12 percent. Assume that the new trade terms of 3/18, net 60 will increase sales by 15 percent because the discount makes the Dome’s price competitive. If Dome earns 20 percent on sales before discounts, what will be the net change in income? Should it offer the discount? 7-25. Solution: New sales = $180,000 × 1.15 = $207,000 Change in sales = $207,000 – $180,000 = $ 27,000 Sales per day = $207,000/360 = $575 Average receivables balance = $575 × 18 = $ 10,350 Increase profit on new sales = 20% × $27,000 = $ 4,320 Reduced profit because = 3% × $207,000 = (6,210) of discount Savings in interest cost ($30,000 – $10,350) × 12% = 2,358 Net change in income $ 1,548 Yes, offer the discount because total profit increases. COMPREHENSIVE PROBLEM Logan Distributing Company (receivables and inventory policy) (LO4 and 5) Logan Distributing Company of Atlanta sells fans and heaters to retail outlets throughout the Southeast. Joe Logan, the president of the company, is thinking about changing the firm’s credit policy to attract customers away from competitors. The present policy calls for a 1/10, net 30 cash discount. The new policy would call for a 3/10, net 50 cash discount. Currently, 30 percent of Logan customers are taking the discount, and it is anticipated that this number would go up to 50 percent with the new discount policy. It is further anticipated that annual sales would increase from a level of $400,000 to $600,000 as a result of the change in the cash discount policy. The increased sales would also affect the inventory level. The average inventory carried by Logan is based on a determination of an EOQ. Assume sales of fans and heaters increase from 15,000 to 22,500 units. The ordering cost for each order is $200 and the carrying cost per unit is $1.50 (these values will not change with the discount). The average inventory is based on EOQ/2. Each unit in inventory has an average cost of $12. Cost of goods sold is equal to 65 percent of net sales; general and administrative expenses are 15 percent of net sales, and interest payments of 14 percent will only be necessary for the increase in the accounts receivable and inventory balances. Taxes will be 40 percent of before-tax income. a. Compute the accounts receivable balance before and after the change in the cash discount policy. Use the net sales (total sales minus cash discounts) to determine the average daily sales. b. Determine EOQ before and after the change in the cash discount policy. Translate this into average inventory (in units and dollars) before and after the change in the cash discount policy. c. Complete the following income statement. Before Policy Change After Policy Change Net sales (Sales – Cash discounts) Cost of goods sold Gross profit General and administrative expense Operating profit Interest on increase in accounts receivable and inventory (14%) Income before taxes Taxes Income after taxes d. Should the new cash discount policy be utilized? Briefly comment. CP 7-1. Solution: Logan Distributing Company a. Accounts receivable = Average collection × Average daily period sales Before Average collection period .30 × 10 days = 3 .70 × 30 days = 21 24 days (Avg. acc. receivables) Average daily sales Accounts receivable = 24 days × $1,107.78 = $26,586.72 before policy change After Average collection period .50 × 10 days = 5 .50 × 50 days = 25 30 days (Avg. acc. receivables) CP 7-1. (Continued) Average daily sales Accounts receivable = 30 days × $1,641.67 = $49,250.10 after policy change b. Before After Average inventory Before CP 7-1. (Continued) After c. Before Policy Change After Policy Change Net sales (Sales – Cash discount) $398,800 $591,000 Cost of goods sold (65%) 259,220 384,150 Gross profit 139,580 206,850 General and admin. expense (15%) 59,820 88,650 Operating profit 79,760 118,200 *Interest on increase in accounts receivable and inventory (14%) 3,550.45 Income before taxes 79,760 114,649.55 Taxes (40%) 31,904 45,859.82 Income after taxes $ 47,856 $ 68,789.73 d. The new cash discount policy should be utilized. The interest cost on the increased accounts receivable and inventory is small in comparison to the increased operating profit from the policy change. Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley R. Danielsen 9780077861612, 9781260013917, 9781259277160
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