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Fixed
assets are $600,00, and the firm plans to maintain a 50 percent dept-to-assets ration.
Calgary has no operating current liabilities. The interest rate is 10% on all dept. three
alternative current asset policies are under consideration: 40, 50, and 60% of projected
sales. The company expects to earn 15% before interest and taxes on sales of $3
million. Calgary effective federal-plus-state tax rate is 40%. What is the expected
return on equity under each alternative?
ST-1 the Calgary company alternative balance sheets
(ST-2) vanderheiden press Inc. and the herrenhouse Publishing Company had the
following balance sheets as of December 31,2004 (thousands of dollars):
earning before interest and taxes for both firm are $30 million, and the affective
federal-plus-state tax rate is 40%.
a. what is the return on equity for each firm of the interest rate on current
liabilities is 10% and the rate on long term dept is 13%?
b. Assume that the short-term rate rises to 20%. While the rate on new long-term
dept rises to 16%, the rate on existing long-term dept remains unchanged.
What would be the return on equity for vanderheiden press and herrenhouse
Publishing under these condition?
c. Which company is in a riskier position? Why?
ST-2 a. and b.
Income statement for year ended December 31,2004 (thousands of dollars)
vanderheiden press herrenhouse Publishing
a b a b
EBIT $30,000 $30,000 $30,000 $30,000
Interest 12,400 14,400 10,600 18,600
Taxable income $17,600 $15,600 $19,400 $11,400
Taxes (40%) 7,040 6,240 7,760 4,560
Net income $10,560 $9,360 $11,640 $6,840
Equity $100,000 $100,000 $100,000 $100,000
Return on equity 10.56% 9.36% 11.64% 6.84%
The vanderheiden press has a higher ROE when short-term interest rates are high whereas
herrenhouse Publishing does better when rates are lower.
c. herrenhouse position is riskier. First, its profit and return on equity are much more volatile than
vanderheiden second, herrenhouse must renew its large short-term loan every year, and if the
renewal comes up at a time when money is very tight, when its business is depressed, or both, then
herrenhouse could be denied credit, which could put it out of business.
(22-1) William and sons last year reported sales of $10 million and an inventory
turnover ratio of 2. the company is now adopting a new inventory system. If the new
system is able to reduce the firm inventory level and increase the firms inventory
turnover ratio to 5, while maintaining the same level of sales, how much cash will be
freed up?
22-1 Sales = $10,000,000; S/I = 2.
Inventory = S/2
$10,000,000
= = $5,000,000.
2
Inventory = S/5
$10,000,000
= = $2,000,000.
5
A/R
DSO =
S/365
A/R
17 = $3,500
A/R = 17 $3,500 = $59,500.
(22-3) what is the nominal and effective cost of trade credit under the credit terms
of 3/15, net 30?
3 365
22-3 Nominal cost of trade credit =
97 30 - 15
= 0.0309 24.33 = 0.7526 = 75.26%.
(22-4) a large trailer obtains merchandise under the credit terms of 1/15, net 45,
but routinely takes 60 days to pay its bills. Given that the retrailer is an important
customer, suppliers allow the firm to stretch its credit term. What is the trailer
effective cost of trade credit?
22-4 Effective cost of trade credit = (1 + 1/99)8.11 - 1.0
= 0.0849 = 8.49%.
$500,000 15 = $7,500,000.
(22-6) 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, the other
60% pay, on average, 40 days after their purchases.
a. what is the days sales outstanding?
b. what is the average amount of receivable?
c. what would happen on average receivable if McDowell toughened up on its
collection policy with the result that all nondiscount customers paid on the 30th day?
22-6 a. 0.4(10) + 0.6(40) = 28 days.
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.
(22-7) calculate the nominal annual cost of nonfree trade credits under each of the
following terms. Assume payment is made either on the due date or on the discount
date.
a. 1/15, net 20.
b.2/10, net 60.
c. 3/10, net 45.
d. 2/10, net 45.
e. 2/15, net 40.
1 365
22-7 a. = 73.74%.
99 5
2 365
b. = 14.90%.
98 50
3 365
c. = 32.25%.
97 35
2 365
d. = 21.28%.
98 35
2 365
e. = 29.80%.
98 25
(22-8) a. if a firm buys under terms of 3/15, net 45, but actually pays on the 20th day
and still takes the discount, what is the nominal cost of its nonfree trade credit?
b. does it receive more or less credit than it would if it paid within 15 days? 22-8 a.
3 365
= 45.15%.
97 45 - 20
Because the firm still takes the discount on Day 20, 20 is used as the
discount period in calculating the cost of nonfree trade credit.