ANSWERS AND SOLUTIONS
98. Compensating balances Answer: c Diff: M
99. Receivables management Answer: b Diff: M
100. DSO and aging schedule Answer: c Diff: M
101. Days sales outstanding (DSO) Answer: c Diff: M
102. Working capital policy Answer: d Diff: M
Statements a, b, c, and e are all true statements. Statement d is false, and thus the appropriate choice. Holding minimal levels of inventory may result in lost sales.
103. Miscellaneous concepts Answer: e Diff: M
104. Working capital financing policy Answer: c Diff: M 105. Working capital financing policy Answer: b Diff: M 106. Working capital financing policy Answer: c Diff: M
Statement b illustrates an aggressive financing policy, not a conser-vative one.
107. Short-term financing Answer: a Diff: M
Statement a is true. Under normal conditions the yield curve is upward sloping, thus, short-term interest rates are lower than long-term interest rates. Consequently, a firm financing with short-term debt will pay less interest than a firm financing with long-term debt--increasing its ROE.
However, a firm increases its risk by financing with short-term debt because such debt must be “rolled over” frequently, and the firm is exposed to the volatility of short-term interest rates. The other statements are false.
108
. Short-term versus long-term financing Answer: d Diff: M
109. Cash management Answer: e Diff: M
110. Float Answer: a Diff: M
111. Sales collections Answer: d Diff: E
receiptsMarch = (0.20)($38,000) + (0.40)($33,000) + (0.40)($30,000) = $32,800.
112
. Accounts receivable balance Answer: a Diff: E
Accounts receivables = DSO Sales per day = 35($2,027,773/365) = $194,444.
Step 1: Determine the inventory conversion period:
Inventory conversion period = Inventory/Daily sales
= $5,000,000/$100,000
= 50 days.
Step 2: Determine the receivables collection period:
Receivables collection period = Receivables/Daily sales
= $2,000,000/$100,000
= 20 days.
Step 3: Given data and information calculated above, determine the firm’s cash conversion cycle:
Cash conversion cycle = 50 + 20 - 30
= 40 days.
114. Cash conversion cycle Answer: a Diff: E
cycle
115. Maturity matching Answer: e Diff: E
A maturity matching policy implies that fixed assets and permanent current assets are financed with long-term sources. Thus, since the minimum balance that total assets approach is $320,000, and $260,000 of that balance is fixed assets, permanent current assets equal $60,000. The likely level of long-term financing is $320,000.
Long-term debt financing = Permanent cash assets + Fixed assets.
Permanent cash assets = Low end of total assets - Fixed assets = $320,000 - $260,000 = $60,000.
Long-term debt financing = $60,000 + $260,000 = $320,000.
116
Daily purchases =
120. Revolving credit agreement cost Answer: b Diff: E Interest rate on borrowed funds = 0.09 + 0.015 = 10.5%.
Cost of unused portion: $4,000,000 0.005 = $ 20,000 Cost of used portion: $6,000,000 0.105 = 630,000 Total cost of loan agreement $650,000
121. Inventory and NPV Answer: d Diff: E
We are given the up-front cost. The new software system’s cash flows are the annual cash amounts freed up by not having to invest in inventory.
0 1 2 3 4 5 Years | | | | | |
-75,000,000 +200,000,000 +200,000,000 +200,000,000 +300,000,000 +300,000,000 10%
NPV = -$75,000,000 + $181,818,000 + $165,289,000 + $150,263,000 + $204,904,000 + $186,276,000
NPV = $813,550,000.
122. Inventory turnover ratio and DSO Answer: a Diff: E Step 1: Determine sales level using the DSO equation.
DSO =
Step 2: Calculate inventory turnover ratio.
Inv. turnover =
Net float = $75,000 - $51,000 = $24,000.
124. Cash budget Answer: c Diff: M
Construct a simplified cash budget:
125. ROE and working capital policy Answer: c Diff: M Construct simplified comparative balance sheets and income statements for the restricted and relaxed policies (In thousands of dollars):
15% of Sales 25% of Sales
126. Inventory conversion period Answer: d Diff: M
Inventory conversion period (ICP) =
Inventory /
Sales
days
365 .
Annual sales = 12 $2 million = $24 million.
Inventory = 0.5 $2 million = $1 million.
ICP =
127. Cash conversion cycle Answer: d Diff: M
Old With Change 80
$
365 365 $80
365 365
DSO =
Net change is –27 days (CCC is 27 days shorter).
128. Cash conversion cycle Answer: e Diff: M
Calculate each of the three main components of the cash conversion cycle:
Inventory Conversion period (ICP):
129. Cash conversion cycle Answer: b Diff: M
cycle
For this problem we are only interested in the change in the CCC. We may therefore ignore the Payables Deferral Period since it is assumed to remain unchanged.
Old CCC (ignore payables) = $12,000,000/$100,000 + $8,000,000/$100,000 = 120 + 80 = 200 days.
First, calculate Sales/Day = $50,735,000/365 = $139,000.
Then, calculate the old inventory conversion period:
Inventory/Sales per day = $15,012,000/$139,000 = 108 days.
Then, find the new inventory conversion period:
$13,066,000/$139,000 = 94 days.
We have cut the inventory conversion period by 108 – 94 = 14 days.
Then, calculate the old DSO:
Accts. Rec./Sales per day = $10,008,000/$139,000 = 72 days.
Then, find the new DSO = $8,062,000/$139,000 = 58 days.
We have cut the DSO by 72 – 58 = 14 days.
Finally, find the total net change = -14 + (-14) – 10 = -38 days.
131. Accounts payable balance Answer: e Diff: M
Approximate percentage cost =
Calculate the nominal percentage, which is the nominal annual cost:
Nominal cost =
Calculate the effective annual rate (EAR):
Numerical solution:
The company pays every 50 days or 365/50 = 7.3 times per year. Thus, the average accounts payable are $4,562,500/7.3 = $625,000. The effective cost of trade credit can be found as follows:
EAR = (1 + 2/98)365/35 - 1 = 1.2345 - 1 = 0.2345 = 23.45%.
134. EAR cost of trade credit Answer: d Diff: M
Number of compounding periods = 365/50 = 7.30.
Use periodic rate and compounding periods to determine the annual nominal rate 2.04% 7.3 = 14.90%.
Calculate EAR
EAR = (1 + 2/98)365/50 – 1 = (1.0204)7.3 – 1 = 1.1589 – 1 = 0.1589 = 15.89%.
135. Costly trade credit Answer: a Diff: M
Phranklin’s net purchases are $819,388 (1 - 0.02) = $803,000. Purchases per day are $803,000/365 = $2,200.00. Total trade credit is 40 $2,200 =
$88,000. Free trade credit is 15 $2,200 = $33,000. Thus, costly trade credit, assuming discounts are taken, is $88,000 - $33,000 = $55,000. If discounts are not taken, then the maximum amount of costly trade credit is
$88,000.
136. Stretching accounts payable Answer: e Diff: M Accounts payable: (1/99)(365/(40 - 10)) = 12.29%. However, this is a nominal rate. EAR is calculated as follows:
EAR = (1 + 1/99)12.1667 - 1 = 13.01%.
137
.
Changes in working capital and free cash flow Answer: b Diff: M FCF = EBIT(1 – T) + DEP – CapExp - NOWC$180,000,000 = $850,000,000(0.6) + $120,000,000 - $360,000,000 - NOWC
$180,000,000 = $510,000,000 + $120,000,000 - $360,000,000 - NOWC
$180,000,000 = $270,000,000 - NOWC -$90,000,000 = -NOWC
NOWC = $90,000,000.
Net operating working capital needs to increase by $90 million, so we need to find the response that shows working capital increasing by that amount.
Statement a is false because NOWC = $470,000,000 + $230,000,000 - $790,000,000
= -$90,000,000. Statement b is true because NOWC = $470,000,000 +
$230,000,000 - $610,000,000 = +$90,000,000. Statement c is false because NOWC
= -$500,000,000 + $480,000,000 – (-$80,000,000) = +$60,000,000. Statement d is false because NOWC = -$400,000,000 + $480,000,000 - $80,000,000 = $0.
Statement e is false because NOWC = $500,000,000 + $100,000,000 –
(-$480,000,000) = $1,080,000,000.
138. Aging Schedule Answer: b Diff: M
Alternative solution using dollar amounts of receivables:
Calculate the net reduction in A/R:
Current A/R = $2,500,000. New A/R with 20% reduction:
$2,500,000 - 0.20($2,500,000) = $2,000,000.
Net reduction in A/R = $500,000.
Calculate the interest savings and net savings:
Interest savings = $500,000(0.11) = $55,000.
Net savings = Interest savings - Annual lockbox cost = $55,000 - $15,000 = $40,000.
140. Cash conversion cycle Answer: c Diff: T
ICP = 365 days/($10 million/$1 million) = 36.5 days.
DSO = 2.0 ICP = 73 days.
Solve for accounts receivable:
DSO = 73 = Accounts receivable/Sales per day = (A/R)/($10/365) = $2 million.
Calculate new ICP, change in CCC, and new DSO required to meet goal:
New ICP = 365/($10/$0.863) = 365/11.5875 = 31.5 days.
Net change in ICP = -5 days.
Total reduction in CCC required = 10 days.
Reduction in DSO needed = 10 – 5 = 5 days.
A/PNo discount = $11,760 30 days = $352,800.
A/PDiscount = $11,760 10 days = $117,600.
Calculate financing amount in notes payable and interest cost. The firm will need to borrow the difference in notes payable.
$352,800 - $117,600 = $235,200.
The additional interest cost is $235,200 0.10 = $23,520.
Calculate total purchases and discounts lost:
Total purchases = 365 days 12,000 gross purchases = $4,380,000.
Discounts lost = $4,380,000 0.02 = $87,600.
Construct comparative financial statements:
*Any EBIT can be used, since the difference in EBIT from the two policies is zero.
142
. Accounts payable balance Answer: d Diff: T
Step 1: Calculate the nominal annual cost of trade credit.
Nominal annual cost =
Step 2: Using the nominal annual cost from Step 1 determine the amount of free trade credit.
Step 3: Determine gross and net sales.
Step 4: Since accounts payable are shown net of discounts, determine daily sales based on net sales figure. Then multiply this amount by 30 days.
Accounts payable balance = $18,747.53 30 = $562,426.03 $562,426.
143. Working capital investment policy Answer: c Diff: M Step 1: Calculate net fixed assets, which will be the same under either
Restricted: Total assets turnover = TA
Step 3: Develop balance sheets for each policy to determine the debt level.
Restricted Relaxed Current assets $ 540,000 $ 736,364 Fixed assets 900,000 900,000
Total liabilities & equity $1,440,000 $1,636,364 Step 4: Determine interest under each policy:
Restricted: $720,000 0.10 = $72,000.
Relaxed: $818,182 0.10 = $81,818.
Step 5: Calculate the difference in interest expense (the savings) between the 2 policies:
$81,818 - $72,000 = $9,818.
144
. Working capital investment policy and ROE Answer: b Diff: M Step 1: From the previous problem we can now set up an income statement for
each policy.
Step 2: Calculate ROE using common equity as calculated in the prior problem for each policy.
Step 3: Calculate the difference in ROEs.
ROE = 6.5% - 5.0% = 1.5%.
145. Working capital investment policy and ROE Answer: a Diff: M From the prior two problems, we know that the ROE for the relaxed policy is 5%. Now, we need to calculate the new ROE under the restricted policy.
Step 1: Calculate the new sales and EBIT levels.
New sales = $3,600,000 0.85 = $3,060,000.
New EBIT = $150,000 0.90 = $135,000.
Equity 612,000 Total liabilities & equity $1,224,000
Step 4: Develop the firm’s income statement under the restricted policy.
EBIT $135,000 Interest (10%) 61,200 EBT $ 73,800 Taxes (40%) 29,520 Net income $ 44,280
Step 5: Calculate the firm’s ROE under the restricted policy.
ROE = NI/E = $44,280/$612,000 ROE = 7.24%.
Step 6: Calculate the difference in ROEs between the 2 policies.
ROE = 7.24% - 5% = 2.24%.
146. Permanent working capital financing Answer: c Diff: M Time lines: Note that the cash flows viewed from the firm’s perspective involve inflows at time 0, and repayment of coupon and/or maturity value in the future.
2-year note:
0 i = ? 1 2 Years
| | |
+100,000 FV = -118,810
2-year bond:
0 i = ? 1 2 Years
| | |
+973.97 -85 -85
FV = -1,000
Note: Inputs: N = 2; PV = 100,000; PMT = 0; FV = -118,810.
Output: I = 9.0%.
Bond: Inputs: N = 2; PV = 973.97; PMT = -85; FV = -1,000.
Output: I = 10.0%.
The difference is 10.0% - 9.0% = 1.0%.
147. DSO and the cost of trade credit Answer: e Diff: T Determine the number of days the firm would wait to pay its suppliers so that the cost of the trade credit equals the cost of the bank loan:
I/YR = 10.1349; PV = -99; PMT = 0; FV = 100; and then solve for N = 0.1041.
Multiply 0.1041 by 365 to convert it to the number of days per year:
0.1041(365) = 38 days.
To get the final answer we must add back the initial 10 days of “free”
financing. This gives 38 + 10 = 48 days.