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Assignment No. 1

The document contains 5 problems related to cash management and credit analysis for various companies. Problem 1 involves calculating operating and cash conversion cycles for a company. Problem 2 evaluates relaxing credit standards for a boat company. Problem 3 analyzes cash discounts from 3 suppliers. Problem 4 recommends whether a company should accept a cash management proposal. Problem 5 calculates expected customer defaults.

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180 views

Assignment No. 1

The document contains 5 problems related to cash management and credit analysis for various companies. Problem 1 involves calculating operating and cash conversion cycles for a company. Problem 2 evaluates relaxing credit standards for a boat company. Problem 3 analyzes cash discounts from 3 suppliers. Problem 4 recommends whether a company should accept a cash management proposal. Problem 5 calculates expected customer defaults.

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I. Problems.

1. Lunar Calendar Company is analyzing the performance of its cash management department. The firm
has inventory that turns 7.2 times per year, an average payment period of 40 days, and an average
collection period of 60 days. The firm’s total annual outlays are $2,500,000. (Assume a 365-day year.)

a. Calculate the firm’s operating and cash conversion cycles.

Computation:

AAI = 365 / 7.2 times inventory = 51 days


OC = 51 days + 60 days = 111 days
CCC = 11 days – 40 = 71 days

Answer: OC = 111 days


CCC = 71 days

b. Calculate the amount of resources needed to support the firm’s cash conversion cycle.

Resources needed = ($2, 500, 000 / 365) x 71 days


= $486, 301. 37

c. The firm is considering speeding the collection of accounts receivable by using lockboxes. The lockboxes
would reduce the average collection period by 4 days and cost $2,000 in fees. If the firm can earn 9% on its
short-term investments, what recommendation would you make to the firm regarding the lockbox system?

Solution:

Savings in short-term investments from the lockbox system


($2, 500, 000/365 = 6,849.32 per day x 4 days x 0.09 = $2, 465. 76
6, 849.32 x 4 days = $27, 397. 28 x 9% = 2,465.76
Fees 2,000.00
465.76

Answer: The firm should use the lockbox system since it produces savings of $2, 465.76.

2. Jonah’s Boats, Inc. is considering relaxing its credit standards in order to meet a competitor’s change in
credit policy. As a result of the proposed change, sales during the coming year are expected to increase
15%, from 5,000 boats to 5,750 boats, the average collection period is expected to increase from 35 days
to 45 days, and bad debts are expected to increase from 2% to 3%. The average sale price per unit is
$1,000 and the variable cost per unit is $850. The firm’s required return on investment is 10%.

Evaluate the proposed change in credit standards and make a recommendation to the firm.
Solution:

Additional profit contribution from sales


(750 additional boats x ($1,000-$850) $112, 500
Cost of marginal investment in AR:
Average investment, proposed plan = 5, 750 boats x $850 $39,643,055.56
45/365
Average investment, present plan = 5, 000 boats x $850 $44,321,428.57
35/365
Marginal investment in AR $84,076,984.13
Required return on investment x 0.10
Cost of marginal investment in AR $ 8,407,698.413
Cost of marginal bad debts:
Bad debts, proposed plan (0.03 x $1, 000 x 5, 750 boats) $172, 500
Bad debts, present plan (0.02 x $1, 000 x 5, 000 boats) $100, 000
Cost of marginal bad debts (72, 500)
Net profit from implementing proposed plan $8,335,198

3. MernoMate, a manufacturer of phone answering machines, is analyzing the credit terms of three of its
suppliers, shown below. Its cost of borrowing from its bank is 14%.

Supplier Credit Terms


1 1/10 net 45
2 2/15 net 30
3 2/10 net 35

From which, if any, of the suppliers should the cash discount be taken, and why?

Answer:
 Supplier 2 = 48. 67% cost of giving up discount > 14% borrowing cost; therefore, take discount and
borrow from the bank. In this case, the recommended strategy is to take the discount since the cost
of giving discount is greater than the borrowing cost.

 Supplier 3 = 29.20% cost of giving up discount > 14% borrowing cost; therefore, take discount and
borrow from the bank. In this case, the recommended strategy is to take the discount since the cost
of giving discount is greater than the borrowing cost.

Solution:

Supplier Cost of Giving up the Cash Discount Cost of borrowing from its bank
1 1% x [365/(45-10)] = 10.43% 14%
2 2% x [365/(30-15)] = 48.67% 14%
3 2% x [365/(35-10)] = 29.20% 14%

 Supplier 1 = 10. 43% cost of giving up discount is lesser than 14% borrowing cost; therefore, give
up discount.
4. Don's Sons Company has been offered by its bank to manage its cash at a cost of $35,000 per year.
Under the proposed cash management, the firm can reduce the cash required on hand by $180,000. Since
the bank is also doing a lot of record keeping, the firm's administrative cost would decrease by $2,000 per
month. What recommendation would you give the firm with respect to the proposed cash management
assuming the firm's opportunity cost is 12 percent?

Answer: The firm should accept the proposed cash management. The benefits of $45, 600 are greater than
costs of $35, 000.

Solution:

Additional benefit from reduced required cash


($180, 000 x 0.12) $21, 600
Reduction in administrative costs
($2, 000 x 12) 24, 000
Total Benefit 45, 600
Less: Cost (Bank’s fee) 35, 000
Additional benefit $10, 600

5. Flesher, Inc.'s credit manager studied the bill-paying habits of its customers and found that 90% of them
were prompt. She also discovered that 22% of the slow payers and 5% of the prompt ones subsequently
defaulted. The company has 3,000 accounts on its books, none of which has yet defaulted.

Calculate the total number of expected defaults, assuming no repeat business is on the horizon.

Solution:

Prompt payment (3, 000 x 90%) = 2, 700 x 5% 135


Slow Payment (3, 000 x 10%) = 300 x 22% 66
Total Expected Defaults 201

Answer: 201

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