Chapter 15, Problem 12IC

a.

Summary Introduction

To determine: The investment policy followed by Company S.

Introduction:

Economic Value Added:

The economic value added is a tool to measure the financial performance of a company. This value estimates the economic profit of a company. The economic value added is determined by deducting the cost of capital from the operating profit.

Explanation of Solution

Given information:

The current ratio is 1.75.

The quick ratio is 0.83.

The turnover of cash and securities is 16.67.

The policy followed by the company is relaxed working capital policy. This is clear from the following points:

• The working capital policy is analyzed through the firm’s short-term liquidity ratios like current ratio, quick ratio, turnover of cash, and securities and days of outstanding sales.
• These ratios indicate that the company has a large amount of working capital as compared to the level of sales.
• So, the company is following a relaxed working capital policy.

• The working capital policies are of three types relaxed, restricted, and moderate policy.
• When the working capital is high than the sales level, this means that the company is following the relaxed policy.
• When the working capital is less then the sales level, this means that the policy followed by the company is the restricted policy.
• The policy, which is in between of these two extreme policies is the moderate policy.

Conclusion

Thus, the working capital policy followed by the company is the relaxed working capital policy.

b.

Summary Introduction

To explain: The way to distinguish between the relaxed current assets investment policy and a situation of a firm having a largeamount of current assets due to inefficiency and whether the current assets investment policy is appropriate or not.

Explanation of Solution

There is the difference between rational but relaxed current assets investment policy and the situation of having a largeamount of current assets due to inefficiency. This is explained as:

• A relaxed net operating working capital is the policy under which the comparatively large amount of cash, securities, and inventories are carried and sales are stirred by a liberal strategy.
• This policy results in higher level of receivables, so the company is not able to take benefits of the credit offered by the accounts payable and accruals.
• The situation where a firm had a largeamount of current assets due to inefficiency is another situation. This means that the firm is not able to convert the assets into cash fast.
• The type of policy which is adopted is suitable if it minimizes risk more than increasing the profitability.

• The relaxed but rational net operating working capital refers to the policy in which the working capital is higher than the level of the sales.
• This kind of policy is effective in reducing risk.
• If a company is having a large amount of current assets, this means that the company is not in a profitable situation.

Conclusion

Thus, there is difference between the current assets investment policy and a situation of having a largeamount of current assets due to inefficiency and the current assets investment policy which is adopted is appropriate.

c.

Summary Introduction

To explain: The way in which the Company can adopt a more aggressive or traditional financial policy.

Explanation of Solution

The company wants to match the maturity of its assets and liabilities. The company can adopt a moderate policy to match it. However, the way in which company can adopt a more aggressive or conservative policy is as follows:

• In this case, the company should follow the moderate policy, as it is also called as the maturity method.
• It falls between the aggressive policy and the conservative policy and it is best to be chosen when the firm has to match the maturity.
• If the company wants to adopt a more aggressive policy, the greatest amount of short-term debt will be used.
• If the company wants to adopt a conservative policy, the least amount of short-term debt will be used.

There are three kinds of policies, which are the alternative current asset financing policies. These are as follows:

• Aggressive short-term financing policy: This is a policy in which the company agrees to finance a fraction of the permanent working capital by temporary sources. This policy looks to reduce the liquidity while meeting the short-term necessities. The organization accepts a higher risk of liquidation to save the rate of long-term financing and to obtain a higher return.
• Moderate short-term financing policy: This is also called as a maturity method policy. In this policy, the life period of current assets is matched to the maturity period of the sources of funds. This is the reason the fixed assets are financed by long-term sources and the short-term funds are financed by the short-term sources.
• Conservative short-term financing policy: In this policy the management does not take the risk. This is why the working capital needs are financed by the long-term sources. The short-term sources are restricted to the unexpected and emergency situation only.

Conclusion

Thus, the moderate financing policy should be used if the company wants to match the maturity of assets and liabilities. To adopt a more aggressive or conservative policy, the company should do as mentioned above.

d.

Summary Introduction

To determine: The cash conversion cycle.

Introduction:

Cash Conversion Cycle:

The cash conversion cycle refers to the time period, which starts from the production and ends when the receipt of sale is produced for a product. This cycle measures the effectiveness of the management of a company.

Explanation of Solution

Given information:

The payment deferral period is 30 days.

The inventory conversion period is 365/Inventory turnover.

The inventory turnover is 4.82.

The day's sales outstanding is 45.6 or 46 days.

Calculation of the cash conversion cycle:

The formula to calculate the cash conversion cycle is,

$\text{Cash}\text{conversion}\text{cycle}=\left(\begin{array}{l}\text{Inventory}\text{conversion}\text{period}\\ +\text{Receivables}\text{collection}\text{period}\\ -\text{Payables}\text{deferral}\text{period}\end{array}\right)$

Substitute 76 days for the inventory conversion period (refer working note), 46 days for receivables collection period and 30 days for the payables deferral period in the above formula.

$\begin{array}{c}\text{Cash}\text{conversion}\text{cycle}=\left(76+46-30\right)\\ =92\text{days}\end{array}$

The cash conversion cycle is 92 days.

Working note:

Calculation of the inventory conversion period:

$\begin{array}{c}\text{Inventory}\text{conversion}\text{period}=\frac{\text{Number}\text{of}\text{days}\text{in}\text{a}\text{year}}{\text{Inventory}\text{turnover}}\\ =\frac{365}{4.82}\\ =76\text{days}\end{array}$

Conclusion

Thus, the cash conversion cycle is of 92 days.

e.

Summary Introduction

To explain: The action of the company to reduce the cash and securities with harming operations.

Explanation of Solution

The company can take following actions to reduce the cash and securities without harming operations:

• Use of lockbox system: In this system, the customers can make the payments to the lockboxes, which are provided in the post office near to them.
• Concentration banking: Under this system, the collection centers should be opened near to the debtors.
• Controlling outflow: The firm should try to slow down the payments to some extent. However, this should not affect the goodwill and credit rating of the firm.

• The cash and securities are those financial assets, which are used for balancing the effective needs of a company.
• The company wants to reduce the cash and securities but without harming the operations.
• For this, those ways are used where the company can collect the cash in some other manner from the customers.
• The company needs to manage the inflows and outflows for this purpose.

Conclusion

Thus, the company should do the above-mentioned actions to reduce the cash and marketable securities without harming the operations.

f.

Summary Introduction

To explain: The assumption of no bad debts is realistic or not and the way in which bad debts be dealt in a cash budgeting sense.

Explanation of Solution

Following points explain the given situation:

• It is not a realistic approach to assume that there is no bad debt.
• Bad debts are expected when credit is given.
• In a cash budgeting sense, the collections would lower down by the percentage of bad debts.
• The payments would remain unchanged and because of which the loan balances would increase.
• The cash surplus balance would be reduced because of the difference in the amount of collection.

• The bad debts are those amounts owed to the creditor which the creditor is not willing to return.
• In cash budgeting sense, to assume that there are no bad debts is not a real approach.
• When the company gives credit, the chances of having bad debts are always there.

Conclusion

The assumption of nil bad debts is not a realistic approach and the bad debts will be dealt with the manner stated above.

g.

Summary Introduction

To determine: The target cash balance is appropriate or not, the actions taken by the company to improve the cash management policies and effect on the economic value added.

Explanation of Solution

The target cash balance is appropriate as the company is holding too much cash.

The actions taken by the company to improve the cash management policies and effect on the economic value added is as follows:

• The company can improve its economic value added either by investing cash in other useful assets or returning to the shareholders.
• If the company utilizes the cash for profitable investments, the costs will remain similar, but the operating income will increase, which results in an increase of the economic value added.
• If the firm decides to return the capital to the holders, by raising the dividend or reburying the common stock shares, the revenue of the firm will remain the same but the on the whole cost of capital would fall which increases the economic value added.

• The economic value added is a value that is calculated by deducting the cost of capital from the operating profit of the company.
• This value shows the financial performance of the company.
• The company needs to improve the cash management policies if the company sees that the cash budget is not effective.

Conclusion

The target cash balance is appropriate and the ways to improve the cash management policies are as mentioned above.

h.

Summary Introduction

To explain: The reason, if the company is holding too much inventory and its effect on the Economic value added and return on equity.

Explanation of Solution

The reason for the holding of too much inventory by the company and the effect of it is as follows:

• The inventory turnover of the company is equal to 4.42, which is comparatively lower than the firm’s turnover, which is 7.
• This shows that the firm is holding a high amount of inventory per dollar of sales.
• This reduces the return on equity, as by holding more inventory, the company is increasing the costs.
• The working capital must be financed, so the economic value added will be decreased.

• The return on equity is a financial tool to measure the profitability of a company.
• The return on equity determines that portion of the equity that is distributed to the shareholders.
• The increased inventory in the company shows that the company is not able to sell the goods and thus it is not a profit-making company.

Conclusion

Thus, the reason for the company is holding too much inventory is the lowestinventory turnover ratio and the effect of it on the return on equity and economic value added are that both get reduced.

i.

Summary Introduction

To explain: The effect on the company’s cash position (1) in the shorter run and (2) the longer run.

Explanation of Solution

The effect on the company’s cash position is as follows:

• If the firm minimizes the inventory amount it holds, the carrying expenses will be reduced.
• The ordering costs of inventory increases, as the company will set up the production runs more often.
• If the company reduces the inventory investment, the chances of running short in cash increases and this would result in a loss of sale and the goodwill of customers.
• The company’s cash position will not be affected in the short run.
• The cash position will be affected in the long run.

The inventory costs are of three types and the effect of it is as follows:

• Carrying cost: The cost, which is incurred in keeping or maintaining the raw material inventory or work in progress or finished goods is the carrying cost.
• Ordering cost: This includes the cost of acquisition of inventory. This is calculated by multiplying the cost per order by the number of orders placed in a year.
• Cost of stock outs: This refers to the costs of the stock which are out in the sense when the firm has faced a situation of loss in sales and back orders. This is also known as hidden costs.

Conclusion

Thus, the company’s cash position will be effected (1) upto some extent in short run and (2) a lot in the long run.

j.

Summary Introduction

To explain: Whether the customers of the company should pay less or more than those of its competition and the suggestion that company should restrict or relax its policy, the four variables that make the credit policy and the direction in which it should be changed by the company.

Explanation of Solution

• The company’s days of sales outstanding are 45.63 days and the average days of sales outstanding in the industry are 32 days. This means that the customers of this company are paying less than the competitors.
• As the days of sales outstanding are greater than the average of the industry, the firm should tighten the credit policy.

The credit policy is the policy, which is made so that the company can control the level of total investment in the receivables. The decision is made regarding receivables and credit to be extended is determined. The four elements in the credit policy are as follows:

• Credit period: The credit period refers to the length of time over which the customers are allowed to delay the payment.
• Cash discounts: The discounts are offered for a different period. The discounts are offered mostly to induce customers to make prompt payments.
• Credit standards: The firm takes a risk about the paying capacity of a company when the firm sells anything on credit. So, the company sets a credit standard that is applied in selecting the customers for credit sales.
• Collection policy: The firm should also have the policy to deal with the slow paying customers. The slow paying customers increase the interest cost and more cash is tied up in receivables. The overall collection policy should neither be too strict nor be too loose.

• The days of sales outstanding refers to the days in which the company is able to sell the inventories.
• The credit policy is a kind of rule, which is made to decide the amount of credit that should be extended to the customers.
• The parameters and the principles, which govern the extension of credit to the customers are defined or are set by the credit policy.
• The credit policy has four important elements and those are the credit period, cash discounts, credit standards and the collection policy.

Conclusion

Thus, the customers are paying lesser than the competitors, the firm should tighten the credit policy and the elements of the credit policy are credit period, cash discounts, credit standards and the collection policies.

k.

Summary Introduction

To explain: The risks company faces if it restricts the credit policy.

Explanation of Solution

The risks company has to face if it restricts its credit policy are as follows:

• The tightening of the credit policy by the company decreases the sales of the company.
• The customers will not stay with the company, if they have the pressure to pay their bills sooner.
• The strict credit policy can affect the goodwill and hence it will damage the growth prospects of sales for the company.

• The credit policy is a kind of parameter, which is set by a company to decide the amount of credit to be extended to the customers.
• If the company restricts the policy, this means the company would set more limits for providing the credit.
• In that case, the company has risks and these risks will make an adverse consequence on the sales of the company and the customers.

Conclusion

Thus, the firm has the above-mentioned risks in tightening the credit policy.

l.

Summary Introduction

To determine: The effect of the days of sales outstanding on the sales and effect on the cash position in the (1) short run and (2) long run, the effect on this on economic value added in the longer run.

Explanation of Solution

The effect of the days of sales outstanding on the sales and effect on the cash position is as follows:

• (1) In the short run: The effect of the days of sales outstanding in the short run is that it will increase the cash balance of the company as the customers will pay before the no discounted period.
• (2) In the long run: The effect of the days of sales outstanding in the long run is that the target cash balance needed decreases with time and so the amount of financing also decreases. This would reduce the economic value added in the long run.

• The days of sales outstanding refers to those days in which the company will be able to sell its inventories.
• If the days of sales outstanding reduce, the company is able to sell the inventories fast and so the cash balance with the company increases fast.
• The company with time, will use this cash in more productive assets or pay this cash to the shareholders.
• This in turn, will increase the economic value added of the company.

Conclusion

Thus, the days of sales outstanding will (1) increase the cash balance and reduce the economic value added and (2) decreases the target cash balance for the long run and decreases the economic value added.

m.

Summary Introduction

To determine: The amount of trade credit the company can get, the cost of trade credit and the percentage cost of costly credit, should the company can get discounts and the reason for getting it.

Explanation of Solution

Given information:

The terms are of 1/30, net 30.

The company is paying on the 40^th day.

The amount of purchase is $3 million.

Calculation of the amount of trade credit the company should get if it takes the discount:

The formula to calculate the total trade credit is,

$\text{Total}\text{trade}\text{credit}=\left(\begin{array}{l}\text{Credit}\text{purchases}\text{of}\text{each}\text{day}\\ \times \text{Credit}\text{period}\end{array}\right)$

Substitute $8,219 for the credit purchases each day and 10 days for the credit period (working note) in the above formula.

$\begin{array}{c}\text{Total}\text{trade}\text{credit}=\left(\$8,219\times 10\right)\\ =\$82,190\end{array}$

The total trade credit if the company takes a discount is $82,190.

Calculation of the trade credit if the discount is not taken:

The formula to calculate the trade credit is,

$\text{Total}\text{trade}\text{credit}=\left(\begin{array}{l}\text{Credit}\text{purchases}\text{of}\text{each}\text{day}\\ \times \text{Credit}\text{period}\end{array}\right)$

Substitute $8,219 for the credit purchases of each day and 40 days for the credit period (working note) in the above formula.

$\begin{array}{c}\text{Total}\text{trade}\text{credit}=\left(\$8,219\times 40\right)\\ =\$328,760\end{array}$

The trade credit if the company does not takes a discount is $328,760.

Calculation of the costly trade credit:

The formula to calculate the costly trade credit is,

$\text{Costly}\text{trade}\text{credit}=\left[\begin{array}{l}\text{Trade}\text{credit}\text{if}\text{discounts}\text{are}\text{not}\text{taken}\\ -\text{Trade}\text{credit}\text{if}\text{discounts}\text{are}\text{taken}\end{array}\right]$

Substitute $328,760 for trade credit if discounts are not taken and $82,190 if discounts are taken in the above formula.

$\begin{array}{c}\text{Costly}\text{trade}\text{credit}=\left[\$328,760-\$82,190\right]\\ =\$246,570\end{array}$

The costly trade credit is $246,570.

Calculation of the percentage of the costly trade credit:

The formula to calculate the percentage of the costly trade credit is,

$\left(\begin{array}{l}\text{Percentage}\text{of}\text{costly}\\ \text{trade}\text{credit}\end{array}\right)=\text{Period}\text{rate}\times \text{Period/Year}$

Substitute 0.0101 for period rate and 12.167 for period/year (working note) in the above formula.

$\begin{array}{c}\left(\begin{array}{l}\text{Percentage}\text{of}\text{costly}\\ \text{trade}\text{credit}\end{array}\right)=0.0101\times 12.167\\ =0.1228\text{or}12.28\%\end{array}$

The percentage of costly trade credit or the nominal cost of trade credit is 12.28%.

Calculation of effective annual cost of trade credit:

The formula to calculate the effective annual cost of trade credit is,

$\text{Effective}\text{annual}\text{cost}\text{of}\text{trade}\text{credit}={\left(1+\text{Periodic}\text{rate}\right)}^{\text{Period/Year}}-1$

Substitute 0.0101 for periodic rate and 12.167 for the period/year (working note) in the above formula.

$\begin{array}{c}\text{Effective}\text{annual}\text{cost}\text{of}\text{trade}\text{credit}={\left(1+0.0101\right)}^{12.167}-1\\ ={\left(1.0101\right)}^{12.167}-1.0\\ =0.1301\text{or}13.01\%\end{array}$

The effective annual cost of trade credit is 13.01%.

As the effective annual cost of trade credit is more than the nominal cost of trade credit, the company should take the discounts.

Working note:

Calculation of the credit purchases if the firm takes discount,

$\begin{array}{c}\text{Credit}\text{purchases}\text{each}\text{day}=\frac{\text{Amount}\text{of}\text{purchases}}{\text{Number}\text{of}\text{days}\text{in}\text{a}\text{year}}\\ =\frac{\$3,000,000}{365}\\ =\$8,219\end{array}$

The credit purchase for each day is $8,219.

Calculation of the credit period if the discount is taken:

Given terms are 1/30, net 30 which means that the firm gives a discount of 1% if the customers pay within 10 days of the invoice date.

This means the credit period is of 10 days.

Calculation of the credit period if the discount is not taken:

Given terms are 1/10, net 30 which means that the firm gives a discount of 1% if the customers pay within 30 days of the invoice date.

This means the credit period is of 40 days.

Calculation of the periodic rate,

$\begin{array}{c}\text{Periodic}\text{rate}=\frac{\text{Discount}\text{percentage}}{100-\text{Discount}\text{percentage}}\\ =\frac{1}{100-1}\\ =\frac{1}{99}\\ =0.0101\end{array}$

The periodic rate is 0.0101.

Calculation of the period/year,

$\begin{array}{c}\text{Period/Year}=\frac{365}{\text{Days}\text{credit}\text{outstanding}-\text{Discount}\text{period}}\\ =\frac{365}{40-10}\\ =\frac{365}{30}\\ =12.167\end{array}$

The period/year is 12.167.

Conclusion

The amount of trade credit the company can get is$82,190 if it takes a discount, $328,760 if it does not takes a discount, the costly trade credit is $246,570, the percentage cost of costly credit is 12.28% and the company should take discounts.

n.

Summary Introduction

To determine: The effective annual cost rate.

Explanation of Solution

Given information:

The additional amount to be raised is $100,000.

This is as a 1-year loan from the bank.

The rate for this loan is 8%.

Assume the simple interest and add-on interest on a 12-month installment loan.

Calculation of the effective annual cost rate:

The formula to calculate the effective annual cost rate is,

$\text{Effective}\text{annual}\text{cost}\text{rate}={\left(1+\text{Monthly}\text{rate}\right)}^{\text{Number}\text{of}\text{months}}-1$

Substitute 0.012043 for the monthly rate (refer working note) and 12 for the number of months in the above formula.

$\begin{array}{c}\text{Effective}\text{annual}\text{cost}\text{rate}={\left(1+0.012043\right)}^{12}-1\\ =1.1545-1\\ =0.1545\text{or}15.45\%\end{array}$

Working note:

Calculation of the total amount to be repaid,

$\begin{array}{c}\text{Total}\text{amount}\text{to}\text{be}\text{repaid}=\text{Present}\text{value}\times \left(1+\text{Rate}\right)\\ =\$100,000\times 1.08\\ =\$108,000\end{array}$

The total amount to be repaid is $108,000.

Calculation of the monthly payments,

$\begin{array}{c}\text{Monthly}\text{payments}=\frac{\text{Total}\text{amount}\text{to}\text{be}\text{repaid}}{\text{Number}\text{of}\text{months}}\\ =\frac{\$108,000}{12}\\ =\$9,000\end{array}$

The monthly payments are $9,000.

Calculation of the monthly rate,

By the help of a financial calculator, the monthly rate is 1.2043%.

Conclusion

Hence, the effective annual cost rate is 15.45%.