Problem 17-5 RECEIVABLES INVESTMENT

McDowell Industries sells on terms of 3/10, net 30. Total Sales for the year are $912,500;
40% of the customers pay on the 10th day and take discounts, while the other 60% pay,
on average, 40 days after their purchases.

a. What are the days sales outstanding?

Given:
Discount Period = 10 days
Customer taking the discount = 40%
Average payment days = 40 days
Customer not taking the discount = 60%

Solution:
Days sales outstanding = Discount Days x % of customer taking discount x
Average payment days x % of customer not taking the discount
Days sales outstanding = 10 days x 40% x 40 days x 60%
Days sales outstanding= 28 days

Thus, the days sales outstanding are 28-days.

b. What is the average amount of receivables?

Solution:
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑙𝑒𝑠
Sales per day = 365
$912,500
Sales per day =
365
Sales per day= $2,500

Average Receivables = Sales per day x Days sales outstanding

Average Receivables = $2,500 x 28 days
Average Receivables= $70,000

Thus, the average amount of receivables is $70,000

c. What is the percentage cost of trade credit to customers who take discounts?
Given:

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 Discount % = 3%
Days of credit outstanding = 30
Discount Period = 10 days

Solution:
Nominal Cost of trade credit:
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 % 365
Cost of trade credit = 100−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 % 𝑥 ( )
𝐷𝑎𝑦𝑠 𝑜𝑓 𝑐𝑟𝑒𝑑𝑖𝑡 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 − 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑑𝑎𝑦𝑠
3% 365
Cost of trade credit = 1−3% 𝑥 ( 30−10)
Cost of trade credit = 0.564432 or 56.44%

Effective Cost of trade credit:

365
𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
Cost of credit = (1 + ) 𝑑𝑎𝑦𝑠 𝑎𝑓𝑡𝑒𝑟 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 −1
1−𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
365
0.03
Cost of credit = (1 + ) 30−10 −1
1−0.03
Cost of credit = 0.7434755 or 74.35%

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

Given:
Discount % = 3%
Days of credit outstanding = 40
Discount Period = 10 days

Solution:
Nominal cost of trade credit
𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 % 365
Cost of trade credit = 100−𝐷𝑖𝑠𝑐𝑜𝑢𝑛𝑡 % 𝑥 ( )
𝐷𝑎𝑦𝑠 𝑜𝑓 𝑐𝑟𝑒𝑑𝑖𝑡 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑑𝑖𝑛𝑔 − 𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡 𝑑𝑎𝑦𝑠
3% 365
Cost of trade credit = 𝑥( )
100−3% 40−10
Cost of trade credit = 0.376288 or 37.63%

Effective Cost of trade credit:

365
𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
Cost of credit = (1 + ) 64−10 −1
1−𝑑𝑖𝑠𝑐𝑜𝑢𝑛𝑡
365
0.03
Cost of credit = (1 + ) 40−10 −1
1−0.03
Cost of credit = 0.448584 or 44.86%
e. What would happen to McDowell’s accounts receivable if it toughened up on its
collection policy with the result that all non-discount customers paid on the 30th day?

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 Given:
Discount Period = 10 days
Customer taking the discount = 40%
Credit Period = 30 days
Customer not taking the discount = 60%

Solution:
Days sales outstanding = (% of customer taking discounts x discount
period) + (% of customer not taking discounts x Credit period)
Days sales outstanding = (40% x 10) + (60% x 30)
Days sales outstanding = 4 + 18
Days sales outstanding = 22 days

Average accounts receivable = Sales each day x days sales outstanding

Average accounts receivable = $2,500 x 22
Average accounts receivable = $55,000

Thus, sales may decrease as a result of the tighter credit. It would

reduce receivables even further. Additionally, certain customers may now
accept discounts, significantly cutting accounts receivable.

Problem 17-6 WORKING CAPITAL INVESTMENT

Prestopino Corporationproducs 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 22 days
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?

Given:
Days Sales Outstanding (DSO) = 40 days
Days Inventory Outstanding (DIO) = 22 days
Days Payable Outstanding (DPO) = 30 days

Solution:
Cash Conversion Cycle = DSO + DIO - DPO
Cash Conversion Cycle = 40 days + 22 days - 30

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 Cash Conversion Cycle = 32 days

b. At a steady-state in which Prestopino produces 1,500 batteries a day, what amount of

working capital must it finance?

Given:
Days Output = 1,500 batteries
Cost per unit = $6
Cash conversion time = 32 days

Solution:
Working Capital Financing = Days Output x Cost per unit x Cash conversion
time
Working Capital Financing = 1,500 x $6 x 32
Working Capital Financing = $288,000

c. By what amount could Prestopino reduce its working capital financing needs if it was
able to stretch its payables deferral period to 35 days?

Given:
Days Output = 1,500 batteries
Cost per unit = $6
Increase in DPO days = 35-30 = 5 days

Solution:
Working Capital Reduction Amounts = Days output x Cost per unit x
Increase in DPO days
Working Capital Reduction Amounts = 1,500 x $6 x 5
Working Capital Reduction Amounts = $45,000

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 to 20 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 payables deferral period (30 days), what will be the
length of its cash conversion cycle and its working capital financing requirement if the
new production process is implemented?

Given:

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 Days Sales Outstanding (DSO) = 20 days
Days Inventory Outstanding (DIO) = 40 days
Days Payable Outstanding (DPO) = 30 days
Days Output = 1,800 batteries
Cost per unit = $7
Cash conversion time = 30 days

Solution:
Cash Conversion Cycle = DSO + DIO - DPO
Cash Conversion Cycle = 20 days + 40 days - 30
Cash Conversion Cycle = 30 days

Working Capital Financing = Days Output x Cost per unit x Cash conversion
time
Working Capital Financing = 1,800 x $7 x 30
Working Capital Financing = $378,000

Problem 17-7 CASH CONVERSION CYCLE

Christie Corporation is trying to determine the effect of its inventory turnover ratio and
days sales outstanding (DSO) on its cash conversion cycle. Christie's 2015 sales (all in
credit) were $150,000; its cost of goods sold is 80% of sales; and it earned a net profit of
6% or $9,000. It turned over its inventory 6 times during the year, and its DSO was 36.5
days. The firm had fixed assets totaling $35,000. Christie's payables deferral period is 40
days.

Given:
Credit Sales (2015) = $150,000
Cost of Goods Sold (80% of Sales) = $120,000
Net Profit = 6% or $9,000
Inventory Turnover = 6x
DSO = 36.5 days
Fixed Assets = $35,000
Payables Deferral Period = 40 days

a. Calculate Christie’s cash conversion cycle.

Solution:

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 Cash Conversion Cycle = 365/Inventory + Average - Payables
Turnover Collection Period Deferral Period
Cash Conversion Cycle = 365/ 6 + 36.5 days - 40 days
Cash Conversion Cycle = 60.83 days + 36.5 days - 40 day
Cash Conversion Cycle = 57.33 days

b. Assuming Christie holds negligible amounts of cash and marketable securities,

calculate its total assets turnover and ROA.

Solution:

Inventory = COGS/ Inventory Turnover

Inventory = $ 120,000/6
Inventory = $ 20,000

Accounts Receivable = (Sales/365) x DSO

Accounts Receivable = ($150,000/365) x 36.5
Accounts Receivable = $15,000

Total Assets = Inventory + Accounts Receivable + Fixed Assets

Total Assets = $20,000 + $15,000 + $35,000
Total Assets = $70,000

Total Assets Turnover = Sales/Total Assets

Total Assets Turnover = $150,000/$70,000
Total Assets Turnover = 2.14 times

ROA = Net Profit/Total Assets x 100

ROA = $9,000/$70,000 x 100
ROA = 12.86%

c. Suppose Christie's managers believe that the inventory turnover can be raised to 9.0
times. What would Christie's cash conversion cycle, total assets turnover, and ROA have
been if the inventory turnover had been 9.0 for 2015?

Solution:

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 Cash Conversion Cycle = 365/Inventory + Average - Payables
Turnover Collection Period Deferral Period
Cash Conversion Cycle = 365/ 9 + 36.5 days - 40 days
Cash Conversion Cycle = 40.56 days + 36.5 days - 40 day
Cash Conversion Cycle = 37.06 days

Inventory = COGS/ Inventory Turnover

Inventory = $ 120,000/9
Inventory = $ 13,333

Total Assets = Inventory + Accounts Receivable + Fixed Assets

Total Assets = $13,333 + $15,000 + $35,000
Total Assets = $63,333

Total Assets Turnover = Sales/Total Assets

Total Assets Turnover = $150,000/$63,333
Total Assets Turnover = 2.37 times

ROA = Net Profit/Total Assets x 100

ROA = $9,000/$63,333 x 100
ROA = 14.21%

Problem 17-8 CURRENT ASSETS INVESTMENT POLICY

Rentz Corporation is investigating the optimal level of current assets for the coming
year. Management expects sales to increase to approximately $2 million as a result of an
asset expansion presently being undertaken. Fixed assets total $1 million, and the firm
plans to maintain a 60% debt-to-assets ratio. Rentz's interest rate is currently 8% on both
short-term and long-term debt (which the firm uses in its permanent structure). Three
alternatives regarding the projected current assets level are under consideration: (1) a
restricted policy where current assets would be only 45% of projected sales, (2) a
moderate policy where current assets would be 50% of sales, and (3) a relaxed policy
where current assets would be 60% of sales. Earnings before interest and taxes should
be 12% of total sales, and the federal-plus-state tax rate is 40%.

a. What is the expected return on equity under each current assets level?

Given:
Sales= $2,000,000.00
Fixed Assets = $1,000,000.00

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 Debt= 60%
Equity= 40%
On both Short-term and Long-term Debt= 8%

Solution:
Alternative 1 Alternative 2 Alternative 3
(A restricted policy (A moderate policy where (A relaxed policy where
Particular where current assets current assets would be current assets would be
would be only 45% of 50% of sales, and) 60% of sales.)
projected sales)

Sales $2,000,000 $2,000,000 $2,000,000

Fixed Asset $1,000,000 $1,000,000 $1,000,000

Current Asset $900,000 $1,000,000 $1,200,000

($2,000,000 x 45%) ($2,000,000 x 50%) ($2,000,000 x 60%)

Total Asset $1,900,000 $2,000,000 $2,200,000

Equity $760,000 $800,000 $880,000

(40% equity-to-assets ratio) ($1,900,000 x 40%) ($2,000,000 x 40%) ($2,200,000 x 40%)

Debt $1,140,000 $1,200,000 $1,320,000

(60% debt-to-assets ratio) ($1,900,000 x 60%) ($2,000,000 x 60%) ($2,200,000 x 60%)

Total Equity and Debt $1,900,000 $2,000,000 $2,200,000

EBIT (12% on Sales) $240,000 $240,000 $240,000

($2,000,000 x 12%) ($2,000,000 x 12%) ($2,000,000 x 12%)
Less: Interest Rate of $91,200 $96,000 $105,600
8% ($1,140,000 x 8%) ($1,200,000 x 8%) ($1,320,000 x 8%)

EBT $148,800 $144,000 $134,400

($240,000- $91,200) ($240,000- $96,000) ($240,000- $105,600)
Less: Tax of 40% $59,520 $57,600 $53,760
($148,800 x 40%) ($144,000 x 40%) ($134,400 x 40%)

Net Profit $89,280 $86,400 $80,640

($148,800 - $59,520) ($144,000 - $57,600) ($134,400 - $53,760)

Return on Equity= 11.75% 10.80% 9.16%

Net Profit/ Equity ($89,280/$ 760,000) ($86,400/$ 800,000) ($80,640/$ 880,000)

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 Return of Equity: Alternative 1 Alternative 2 Alternative 3
11.75% 10.80% 9.16%

b. In this problem, we assume that expected sales are independent of the current assets
investment policy. Is this a valid assumption? Why or why not?

No, the assumption that the expected level of sales is independent of

current asset policy is not valid. The precise nature of this function may be difficult
to describe, and identifying a "ideal" current asset level may be impossible in
reality. The current asset policies of a company, particularly those pertaining to
accounts receivable, such as discounts, collection term, and collection procedure,
can have a substantial impact on sales.

c. How would the firm's risk be affected by the different policies?

Changing the level of debt while keeping the level of current assets (below,
equal, or above fixed assets) can influence the overall riskiness of any business.

Problem 17-10 CASH BUDGETING

Helen Bowers, owner of Helen's Fashion Designs, is planning to request a line of credit
from her bank. She has estimated the following sales forecasts for the firm for parts of
2015 and 2016:

May 2015 $180,000

June 180,000

July 360,000

August 540,000

September 720,000

October 360,000

November 360,000

December 90,000

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 January 2016 180,000

Estimates regarding payments obtained from the credit department are as follows:
collected within the month of sale, 10%; collected the month following the sale, 75%;
collected the second month following the sale, 15%. Payments for labor and raw materials
are made the month after these services were provided. Here are the estimated costs of
labor plus raw materials:

May 2015 $90,000

June 90,000

July 126,000

August 882,000

September 306,000

October 234,000

November 162,000

December 90,000

General and administrative salaries are approximately $27,000 a month. Lease

payments under long-term leases are $9,000 a month. Depreciation charges are $36,000
a month. Miscellaneous expenses are $2,700 a month. Income tax payments of $63,000
are due in September and December. A progress payment of $180,000 on a new design
studio must be paid in October. Cash on hand on July 1 will be $132,000, and a minimum
cash balance of $90,000 should be maintained throughout the cash budget period.

a. Prepare a monthly cash budget for the last 6 months of 2015.

Collection
and
Payment: 2015 2016
May June July August September October November December January

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Sales $ 180,000.00 $ 180,000.00 $ 360,000.00 $ 540,000.00 $ 720,000.00 $ 360,000.00 $360,000.00 $ 90,000.00 $ 180,000.00

Within
month of
sale 10% 18,000.00 18,000.00 36,000.00 54,000.00 72,000.00 36,000.00 36,000.00 9,000.00 18,000.00
During 1st
month of
sale 75% 135,000.00 135,000.00 270,000.00 405,000.00 540,000.00 270,000.00 270,000.00 67,500.00
During 2nd
month of
sale 15% 27,000.00 27,000.00 54,000.00 81,000.00 108,000.00 54,000.00 54,000.00
Total
Collections $ 18,000.00 $ 153,000.00 $ 198,000.00 $ 351,000.00 $ 531,000.00 $ 657,000.00 $414,000.00 $333,000.00 $ 139,500.00

May June July August September October November December

Labor and Raw
Materials $ 90,000.00 $ 90,000.00 $ 126,000.00 $ 882,000.00 $ 306,000.00 $ 234,000.00 $ 162,000.00 $ 90,000.00

Payment for
Labor and Raw
Materials $ 90,000.00 $ 90,000.00 $ 126,000.00 $ 882,000.00 $ 306,000.00 $ 234,000.00 $ 162,000.00

Gain or Loss for

the Month:
Cash Receipts: July August September October November December

Total Collections $ 198,000.00 $ 351,000.00 $ 531,000.00 $ 657,000.00 $ 414,000.00 $ 333,000.00

Cash
Disbursements:
Payment for Labor
and Raw Materials 90,000.00 126,000.00 882,000.00 306,000.00 234,000.00 162,000.00
General and
Administrative
salaries 27,000.00 27,000.00 27,000.00 27,000.00 27,000.00 27,000.00
Lease Payment 9,000.00 9,000.00 9,000.00 9,000.00 9,000.00 9,000.00
Miscellaneous
Expense 2,700.00 2,700.00 2,700.00 2,700.00 2,700.00 2,700.00
Income Tax
Payment 63,000.00 63,000.00
Progress Payment 180,000.00

Total Payments $ 128,700.00 $ 164,700.00 $ 983,700.00 $ 524,700.00 $ 272,700.00 $ 263,700.00

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 Total Collections $ 198,000.00 $ 351,000.00 $ 531,000.00 $ 657,000.00 $ 414,000.00 $ 333,000.00
Less: Total
Payments 128,700.00 164,700.00 983,700.00 524,700.00 272,700.00 263,700.00
Net Cash
Gain/Loss $ 69,300.00 $ 186,300.00 $ -452,700.00 $ 132,300.00 $ 141,300.00 $ 69,300.00

Cash Surplus or Loan

Requirement
July August September October November December

Cash on hand $ 132,000.00 $ 201,300.00 $ 387,600.00 $ -65,100.00 $ 67,200.00 $ 208,500.00

Net Cash Gain/Loss 69,300.00 186,300.00 -452,700.00 132,300.00 141,300.00 69,300.00
Cumulative cash 201,300.00 387,600.00 -65,100.00 67,200.00 208,500.00 277,800.00
Less: Target Cash Balance -90,000.00 -90,000.00 -90,000.00 -90,000.00 -90,000.00 -90,000.00
Cash surplus or loan needed $ 111,300.00 $ 297,600.00 $ -155,100.00 $ -22,800.00 $ 118,500.00 $ 187,800.00

October requires a loan since the balance is negative, indicating that the funds available
in the current month are insufficient, in which case Helen's Fashion Designs requires extra
financing or a loan of $22,800.00.

b. Prepare monthly estimates of the required financing or excess funds - that is, the
amount of money Bowers will need to borrow or will have available to invest.

July $111,300.00 excess funds

August $297,600.00 excess funds
September -$155,100.00 requires financing
October -$22,800.00 requires financing
November $118,500.00 excess funds
December $187,800.00 excess funds

For the months of July, August, November, and December, Helen Bowers
has excess cash available for investments. But for the month of September, the
company will need a loan of $155,100.00. The accrued cash surplus for the month
of October will reduce the company’s liability by a total amount of $22,800.00.

c. Now suppose receipts from sales come in uniformly during the month (that is, cash
receipts come in at the rate of 1/30 each day), but all outflows must be paid on the 5th.
Will this affect the cash budget? That is, will the cash budget you prepared be valid under
these assumptions? If not, what could be done to make a valid estimate of the peak

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 financing requirements? No calculations are required, although if you prefer, you can use
calculations to illustrate the effects.

July Cash Receipt $198,000.00

July Cash
Disbursements $128,700.00
July 10, July 14, July 20, July 30,
July 2, 2015 July 3, 2015 July 5, 2015 2015 2015 2016 2015

Opening Balance $132,000.00 $132,000.00 $132,000.00 $132,000.00 $132,000.00 $132,000.00 $132,000.00

Cumulative inflows
(Cash Receipt x 1/30 x
no. of days) 13,200.00 19,800.00 33,000.00 66,000.00 92,400.00 132,000.00 198,000.00
Cash Available 145,200.00 151,800.00 165,000.00 198,000.00 224,400.00 264,000.00 330,000.00
Less: Outflow 0 0 128,700.00 128,700.00 128,700.00 128,700.00 128,700.00
Less: Target Cash
Balance 90,000.00 90,000.00 90,000.00 90,000.00 90,000.00 90,000.00 90,000.00
Cash surplus or loan
needed $55,200.00 $61,800.00 -$53,700.00 -$20,700.00 $5,700.00 $45,300.00 $111,300.00

It may not be possible to use a cash budget that is centered on the end of
the month, since inflows and outflows are synchronized. Thus, the cash budget
should be set up that shows the cash balance of the company every 5th of each
month. Consequently, the company can show its maximum cash requirement and
use the figures to estimate the required credit.

Thus, as shown in the computation above, it will not affect the cash budget
that at the end of the month the company will have a surplus of $111,300 that
agrees with the excess of the monthly cash budget. Moreover, the selected date
of July shows the steady accumulation of inflow and how the company pays the
outflows. Moreover, on the 5th day of the month, the company requires additional
financing, and on the 14th the company’s inflow has exceeded the outflows.

d. Bowers’ sales are seasonal; and her company produces on a seasonal basis, just
ahead of sales. Without making any calculations, discuss how the company’s current and
debt ratios would vary during the year if all financial requirements were met with short-
term bank loans. Could changes in these ratios affect the firm’s ability to obtain bank
credit? Explain.

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 The peak sales in the preceding month will show a decreased current ratio
and an increased debt ratio due to additional financial requirements met with short-
term bank loans. As cash receipts are collected from sales, the current ratio would
increase and the debt ratio would decrease. But, changes in the ratio would affect
the firm’s ability to obtain bank credit. Since sales are seasonal and additional
funding is financed through short-term loans, debt ratios will be affected since it
takes into account short-term loans. Thus, when a company produces on a
seasonal basis while funded by short-term loans, the company would have more
debt than assets resulting in a higher debt ratio that consequently affects the
company’s ability to obtain future bank credit.

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