Lahore School of Economics

Financial Management II
Working Capital Management – 4
Assignment 14 Solution

Problems for Assignment

Q1) a. Days sales outstanding = 0.4(10) + 0.6(40) = 28 days.

b. $912,500/365 = $2,500 sales per day.

Average receivables = $2,500(28) = $70,000

c. Customers who take discount: Free trade credit.

d. Customers who do not take the discount and pay on Day 40:
1. Nominal cost: 3/97  365/(40 – 10) = 37.63%.

2. Effective cost: (1 + 3/97)365/30 – 1 = 0.4486 = 44.86%.

e. 0.4(10) + 0.6(30) = 22 days.

$912,500/365 = $2,500 sales per day.

Average receivables = $2,500(22) = $55,000

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.

Q2) Interest = 0.1($500,000)(30/365) = $4,109.59

EAR = (1+ 0.1/12)12 – 1 = 10.47%

Q3) Interest = 0.1($500,000) = $50,000

Face amount = $500,000 + $50,000 = $550,000
Monthly payment = $550,000/12 = $45,833.33

To find the exact effective rate, recognize that the firm receives $500,000 and must make monthly payments of
$45,833.33 (like an annuity).
 PV = $500,000, PMT = -$45,833.33, N = 12, I = 1.497% per month => 1.497(12) = 17.96% per year.

EAR = (1+ 0.1796/12)12 – 1 = 19.52%

Examples

Q1) Additional credit = $8,000,000/365  55 days = $1,205,479.45.

3 36 5
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Nominal cost of trade credit = 97 55 = 3.09%  6.6364 = 20.52%.
Effective cost of trade credit = (1 + 3/97)365/55 – 1 = 1.2240 – 1 = 22.40%.

Bank loan: 10%, interest paid monthly

EAR = (1 + 0.10/12)12 – 1 = 1.1047 – 1 = 10.47%.

Because the effective cost of the bank loan is less than half the effective cost of the trade credit, the bank loan
should be used and Lamar should pay within the discount period.