FIN 302-Tutorial 2

1. GOLD BULL Pty Ltd is struggling to compute its Cash Conversion Circle (CCC) and have
retained you to come to their rescue. You are told that the company expects its cost of sales,
which is 80% of sales to be P480, 000 this year. You discover that the company turns over its
inventory, receivables and accounts payables 24; 15 and 40 times respectively per year (360
days). Determine the CCC for the company as well as the average balances in accounts
receivables, accounts payables and inventory.

CCC = ICP + DSO – PDP

ICP = 360/Inventory turnover = 360/24 = 15 days
DSO = 360/Receivables turnover = 360/15 = 24 days
PDP = 360/payables turnover = 360/40 = 9 days

CCC = 15 + 24 – 9 = 30 Days

ICP = Inventory/daily COGS

15 = Inv/(48000/360) therefore Inv = P20000
ACP = Receivables/daily Sales
24= Recev/((48000/0.8)/360) therefore Receivables = P40000
PDP = Payables/daily COGS
9 = Payables/ (600000/360) Therefore payables = P15000

2. Mzathi incorporation has P45 000 debtors, Inventory of P25 000, payable deferral period
of 12 days and cash conversion cycle of 30 days. Assume 360 days in a year.

Use the above information to calculate:

i. Annual sales of this company

CCC = ICP + ARP – PDP
30 = (45000 + 25000)/ (sales/360) – 12
Sales = P600, 000
ii. The number of days it takes to covert credit sales into cash
ARP = Debtors/ daily sales
= 45000/(600,000/360) = 27 Days
iii. The Operating circle
OC = ICP + ARP
ICP = Inventory/daily sales = 25,000/ (600,000/360) = 15 days
OC = 27 + 15 = 42 Days

3. The Baumol Model of cash management is a model that tries to minimize the total cost of
managing cash using a model that was derived from a total cost function.
 i. Present the total cost function that the Baumol model tries to minimize.

Total cost = k(C/2) + F(T/C)

ii. Derive the Baumol model from the total cost function you presented above.

TC = (½).C.K +C-1FT

D(TC)/DC = K/2 – TF/C2 = 0

K/2 =FT/C2
C2 = 2FT/k

C = √2FT/k

4. Assume a company that has a savings account as its only bank account. This account
unlike many savings accounts can be drawn up to zero Pula. The company trade in a market
where short-term securities attract 5% returns per year and it costs the company P50 each
time it buys or sells securities. The daily standard deviation of cash flows is P31.623.
Assume 1 year is 360 days.

Calculate the optimal cash level for this company using the cash management model
that incorporates uncertainty in making estimates. Interpret your results with regards
to buying and selling securities for this company.

The Miller-Orr Model is the right model to use under this circumstance.
First calculate the spread = 3[(3xTxV)/ (4xr)] 1/3
3[(3x50x 31.6232)/ (4x (0.05/360))]1/3
= 1,938.99
Second calculate the upper limit = Lower limit + Spread
= 0 + 1,938.99
= 1,938.99
Lastly calculate the return point (Optimal cash) = Lower limit + (Spread/3)
= 0 + (1,938.99/3)
= 646.33
Decision rule: If cash balance increases to 1,938.99 the company should invest
1,293.66 (1,938-646.33) and if cash balance decreases to zero the company should
liquidates is marketable securities to the value of P646.33 (643.66-0) to replenish
cash.

5. Total transactions per annum for Gets smooth Pty Ltd amounts to P45 000. The company
has a target cash balance of P9 000. It faces an opportunity cost of 7% for holding cash. Get
Smooth’s total assets are worth P630 000. Receivables and inventory are 15% and 20% of
total assets respectively. The company has a cash conversion cycle of 85 days. It is a
company credit policy to delay payments to suppliers by 40 days.
Base on the above information;

Determine the cost per transaction faced by the company.

C*=√(2cT/k)
9000=√ (2 x c x45,000/0.07)
9000^2=90000c/0.07
0.07x81,000,000=90000c
5,670,000=90,000c
C=P63.00

6. List the four assumptions that that make the Baumol Model to work

Assumption of the Baumol Model

i. The firm is able to project its cash requirements with certainty & receive a
specific amount at regular intervals.
ii. The firm’s cash payments occur uniformly over a period of time i.e. A steady
rate of cash flows
iii. Opportunity cost of holding cash is known & does not change over time
iv. The firm will incur the same transaction cost whenever it converts securities to
cash & each transaction incurs both a fixed & a variable cost

7. What is the alternative model to the Baumol model and how is it different to the Baumol
model of cash management.

The Miller-Orr model it is different from the Baumol model in that it relaxes the
assumption of certainty associated with the latter and assumes conditions of
uncertainty in management of cash.

MULTIPLE CHOICE

Payables deferral period Answer: e EASY

i. Plummer Products purchases P3,750,000 of materials each year, and it has an average accounts payable
balance of P350,000. Assuming there are 365 days per year, what is Plummer’s payables deferral period?

a. 25.91 days
b. 27.83 days
c. 30.38 days
d. 32.52 days
e. 34.07 days

Average collection period (or DSO) Answer: a MEDIUM

ii. Carroll Construction has annual sales of P730,000, and it has P100,000 of accounts receivable. Based on a
365-day year, what is Carroll's average collection period (or DSO)?

a. 50 days
b. 52 days
c. 54 days
d. 56 days
e. 58 days

Cash conversion cycle Answer: d MEDIUM

iii. Ashwell Corp has P1,600,000 of sales, P200,000 of inventories, P150,000 of receivables, and P100,000 of
payables. Its cost of goods sold is 70% of sales. What is Ashwell’s cash conversion cycle (CCC)?

a. 60.77 days
b. 62.55 days
c. 64.63 days
d. 66.81 days
e. 68.22 days

Accounts receivable increase Answer: b

iv. Cannon Company has enjoyed a rapid increase in sales in recent years, following a decision
to sell on credit. However, the firm has noticed an increase in its collection period. Last
year, total sales were P1 million, and P250,000 of these sales were on credit. During the
year, the accounts receivable account averaged P41,096. It is expected that sales will
increase in the forthcoming year by 50%, and, while credit sales should continue to be the
same proportion of total sales, it is expected that the days sales outstanding will also
increase by 50%. If the resulting increase in accounts receivable must be financed
externally, how much external funding will Cannon need?
a. P 41,096
b. P 51,370
c. P 47,359
d. P106,471
e. P 92,466

Cash Management Answer: d EASY

v. Which of the following statements is CORRECT?
a. The Miller-Orr Model of cash management assumes a world with certainty
b. The Baumol model of cash management assumes a world with uncertainty.
c. Under the Baumol model the lower control limit is set by management

d. when using the Miller-Orr model the upper limit is set by adding the lower limit to
the spread
e. It is difficult to set lower limit and upper limit whether using the Baumol model or
the Miller-Orr model..

Effect of lowering the DSO on net income Answer: d MEDIUM

vi Kirby Industries has sales of P110,000 and accounts receivable of P12,500, and it gives
its customers 30 days to pay. The industry average DSO is 25.5 days, based on a 365-day year.
If the company changes its credit and collection policy sufficient to cause its DSO to fall to the
industry average, and if it earns 9.5% on any cash freed-up by this change, how would that affect
the firm's net income, assuming other things are held constant?
a. P422.12
b. P435.43
c. P447.86
d. P457.43
e. P469.93

Days sales outstanding (DSO) Answer: a MEDIUM

vii. Rangala Corp sells on terms that allow customers 30 days to pay for merchandise. Its
sales last year were P450,000, and its year-end receivables were P45,000. If its DSO is
less than the 30-day credit period, then customers are paying on time. Otherwise, they are
paying late. By how much are customers paying early or late? Base your answer on this
equation: DSO - Credit Period = days early or late, and use a 365-day year when
calculating the DSO. A positive answer indicates late payments.
a. 6.50
b. 6.75
c. 7.00
d. 7.25
e. 7.50

viii. Which one of the following is not a source of float?

a. Post delay.
b. Payment delay.
c. clearing delay.
d. availability delay.
e. Processing delay.

Forecasting financial requirements Answer: c MEDIUM/HARD

ix. Which of the following statements is CORRECT?
a. When we use the AFN formula, we assume that the ratios of assets and liabilities to
sales (A*/S0 and L*/S0) vary from year to year in a stable, predictable manner, and
the formula recognizes that they do not remain constant over time.
b. When fixed assets are added in large, discrete units as a company grows, the
assumption of constant ratios is more appropriate than if assets are relatively small
and can be added in small increments as sales grow.
c. Firms whose fixed assets are “lumpy” frequently have excess capacity, and this
should be built into the financial forecasting process.
d. For a firm that uses lumpy assets, it is impossible to have small increases in sales
without expanding fixed assets.
e. A graph showing the relationship between assets and sales is always linear if
economies of scale exist.

Forecasting inventories - regression analysis Answer: d MEDIUM

x. Last year Dallas Designs had P500,000 of sales, and it expects sales to increase by 20% during the coming
year. Dallas’ CFO uses a simple linear regression to forecast the company’s required inventory for a given
level of projected sales, and based on the firm's recent history, this equation was developed: Inventories =
P22,000 + 0.125(Sales). Based on this equation and the forecasted sales, what is the required level of
inventories for the coming year?
a. P 88,000
b. P 91,000
c. P 94,000
d. P 97,000
e. P100,000
i. Payables deferral period Answer: e EASY

Accounts payable $350,000

Annual purchases $3,750,000
Purchases per day $10,274
Inventory conversion period (in days) 34.07

ii. Average collection period (or DSO) Answer: a MEDIUM

Annual sales $730,000

Accounts receivable $100,000
Sales per day $2,000
ACP (or DSO) = Accts receivable / sales per day 50.00

iii. Cash conversion cycle Answer: d MEDIUM

Sales $1,600,000
Inventories $200,000
Receivables $150,000
Payables $100,000
Cost of goods sold (% of sales) 70%
Inventory conversion period 65.18
Average collection period 34.22
Payables deferral period 32.59
Cash conversion period 66.81

iv. Accounts receivable increase Answer: b

DSO = P41,096/(P250,000/365) = 60 days.

New A/R = [(P250,000)(1.5)/(365)](60)(1.5) = P92,466.
Hence, increase in receivables = P92,466 - P41,096 = P51,370.

v. Cash Management Answer: d EASY

vi

. Effect of lowering the DSO on net income Answer: d MEDIUM

 Rate of return on cash generated 9.5%
Sales $110,000
A/R $12,500
Days in Year 365
Sales/day $301.37
Company DSO 41.5
Industry DSO 25.5
Excess DSO 16.0
Cash flow from reducing the DSO $4,815.07
Alternative Calculation:
A/R at industry DSO $7,684.93
Change in A/R $4,815.07
Additional Net Income $457.43
vii

. Days sales outstanding (DSO) Answer: a MEDIUM

Credit period 30
Sales $450,000
Sales/Day $1,233
Receivables $45,000
DSO 36.5
Credit period - DSO 6.50

viii. Monitoring receivables Answer: b MEDIUM

ix. Forecasting financial requirements Answer: c MEDIUM/HARD

x. Forecasting inventories - regression analysis Answer: d MEDIUM