CH-7 Current Asset Management – Foundations of Financial Management : Book Guide

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). Solution Manual for Foundations of Financial Management Stanley B. Block, Geoffrey A. Hirt, Bartley Danielsen, Doug Short, Michael Perretta 9780071320566, 9781259268892, 9781259261015