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17-2

Lamar Lumber Company has sales of $10 million per year, all on credit terms calling for payment within 30
days; and its accounts receivable are $2 million. What is Lamar’sD SO, what would it be if all customers paid
on time, and how much capital would be released if Lamar could take action that led to on-time payments? 

Solution:

DSO = $2,000,000/($10,000,000/365) = 73 days 

If all customers paid on time, then the firm’s DSO = 30 days.

If customers paid on time,the firm’s A/R = 30*($10,000,000/365) = $821,917.81

Cash freed up = 2,000,000 – 821,917.81 = 1,178,082.19

117-3 COST OF TRADE CREDIT AND BANK LOAN

Lamar lumber buys $8 million of materials (net of discounts) on terms of 3/5, net 60; and it currently pays

after 5 days and takes discounts. Lamar plans to expand, which will require additional financing. If Lamar

decides to forgo discounts, how much additional credit could it obtain and what would be the nominal and

effective cost of that credit? If the company could get the funds from a bank at a rate of 10%, interest paid

monthly, based on a 365-day year, what would be the effective cost of the bank loan? Should lamar use bank

debt or additional trade credit? Explain.

Purchases = $8,000,000;
terms = 3/5 net 60;
currently pays on Day 5 and takes discounts.
Forgoes discounts; additional credit = X
 
$8,000,000/365*55 days = $1,205,479.45.
Nominal cost oftrade credit =3 x 365 = 3.09% * 6.6364 = 20.52%.
 
Effective costof trade credit = (1 + 3/97)365/55 - 1 = 1.2240- 1 = 22.40%.
Bank loan: 10%, interest paid monthly
EAR = (1 +0.10/12)12 - 1 = 1.1047 - 1 = 10.47%.
 
The effective cost of the bank loan is more than half the effective cost of the trade credit. Therefore , the bank
loan should be used.

17-4 CASH CONVERSION CYCLE

Zocco Corporation has an inventory conversion period of 75 days, an average collection period of 38 days, and
a payables deferral period of 30 days. A-What is the length of the cash conversion cycle? B- If Zocco’s annual
sales are $3,421,875 and all sales are on credit, what is the investment in accounts receivable? C- How many
times per year does Zocco turn over its inventory?
Solution:

Cash Inventory Receivables Payables

conversion conversion + collection − deferral
a. cycle = period period period
= 75 + 38 – 30 = 83 days.

b. Average sales per day = $3,421,875/365 = $9,375.

Investment in receivables = $9,375  38 = $356,250.

c. Inventory turnover = 365/75 = 4.87.

17-5 RECEIVABLE INVESTMENT

Solution:
A. What is the days sales outstanding?
The days sales outstanding would be the weighted average of the number of days taken to repay. 40% pay in
10 days and 60% pay in 40 days
DSO = 0.4X10 + 0.6X40 = 28 days
B. What is the average amount of receivables?
Average Sales = Total Sales / Days in a year
Average Sales = $912,500 / 365
Average Sales = $2,500 sales per day

Average amount of receivables = Per day sales X Average Sales

Average Receivables = $2,500 * 28 days

= 70,000

c. What is the percentage cost of trade credit to customers who take the discount?

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total-sales-for-the-year-are-1-397-500-40-of-the-customers-pay-on-the-10th-day-and-take-discounts-while-the-
other-60-pay.html

d. What is the percentage cost of trade credit to customers who do not take the discount and pay in 40 days.

Nominal annual cost

of trade credit = (Discount % / (100 – Discount %)) x (365 / (Days credit is outstanding -Discount period)
= (3% / (100 – 3%)) x (365 / (40 – 10) = 37.63%

e. What would happen to McDowell’s account receivable if it toughened up on its collection policy with the
result that all nondiscount customers paid on the 30th day?

0.4(10) + 0.6(30) = 22 days.

$912,500/365 = $2,500 sales per day.
$2,500(22) = $55,000 = Average receivables.
Sales may also decline as a result of the tighter credit. This would further reduce receivables. Also, some
customers may now take discounts further reducing receivables
17-6 WORKING CAPITAL INVESTMENT

The Prestopino Corporation produces motorcycle batteries. Prestopino turns out 1,500 batteries a day at a cost
of $6 per battery for materials and labor. It takes the firm 22days to convert raw materials into a battery.
Prestopino allows its customers 40 days in which to pay for the batteries, and the firm generally pays its
suppliers in 30 days.
a. What is the length of Prestopino’s cash conversion cycle? 
b. At a steady state in which Prestopino produces 1,500 batteries a day, what amount of working capital must it
finance?
c. By what amount could Prestopino reduce its working capital financing needs ifit was able to stretch its
payables deferrals period to 35 days?
d. Prestopino’s management is trying to analyze the effect of a proposed new production process on its
working capital investment. The new production process would allow Prestopino to decrease its inventory
conversion period to20 days and to increase its daily production to 1,800 batteries. However , the new process
would cause the cost of materials and labor to increase to $7. Assuming the change does not affect the
average collection period (40 days) or the payable deferral period (30days), what will be the length of its cash
conversion cycle and its working capital financing requirement if the new production process is implemented?

Answer
a. Cash conversion cycle = 22 + 40 – 30 = 32 days.

b. Working capital financing = 1,500  32  $6 = $288,000.

c. If the payables deferral period was increased by 5 days, then its cash conversion cycle would decrease
by 5 days, so its working capital financing needs would decrease by
Decrease in working capital financing = 1,500  5  $6 = $45,000.

d. Cash conversion cycle = 20 + 40 – 30 = 30 days.

Working capital financing = 1,800  30  $7 = $378,000.

17-7 CASH CONVERSION CYCLE

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17-8

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