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Working Capital Management: © 2019 Pearson Education LTD
Working Capital Management: © 2019 Pearson Education LTD
Note: All problems in this chapter are available in MyFinanceLab. An asterisk (*) indicates problems
with a higher level of difficulty.
Evaluate: Homer Boats turns over (i.e., sells) its inventory in 50 days and collects the cash
from the sale in 30 days. So, it takes Homer Boats 80 days to sell a boat and collect the cash
from the sale.
Execute: Cash Conversion Cycle inventory days receivable days – payables days 80
60 – 120 20 days
Evaluate: FastChips turns over (i.e., sells) its inventory in 80 days and collects the cash from
the sale in 60 days. So, it takes Fastchips 140 days to sell a computer chip and collect the cash
from the sale. But FastChips has to pay its own supplier in 120 days for the computer chip.
Hence at day 120, FastChipw has to come up with the cash to pay its supplier for the computer
chip and then wait 20 additional days (to day 140) before its customer pays it for the computer
chip.
3. Plan: Calculate the components (Inventory days, Receivable days, and Payable days) of the
Cash Conversion Cycle, and then calculate the cash conversion cycle.
Execute:
Inventory balance
Inventory days
Cost of goods sold/365
15,000
80,000/365
68.44 days
Accounts receivable balance
Receivable days
Sales/365
30,000
100,000/365
109.5 days
Evaluate: Cash Conversion Cycle inventory days receivable days – payables days 68.44
109.5 – 182.5 4.56 days
Westerly collects cash from its customers 4.56 days before it has to pay its suppliers.
4. Ignoring revenues and other expenses associated with the new plant, the NPV of the $2.11
million investment in net working capital is simply the present value of the $2.11 million that
the firm will recoup at the end of ten years minus the initial $2.11 million investment.
$2,110,000
NPV $2,110,000 $1,043,589.17.
(1.064)11
5. Plan: Calculate the Present Value of the working capital investment under a 3% and a 5% growth
rate assumption. Then compute the difference in Present Value.
Execute: The cost of the working capital is the present value of the future changes in the
working capital from year to year.
111(1.05) 111(1.05)
PV 178.39285
0.12 0.05 (0.12 0.05) 1.12
111(1.03) 111(1.03)
PV 136.10714
0.12 0.03 (0.12 0.03) 1.12
Evaluate: The change from 5% to 3% growth in working capital reduces the present value of
the cost of investing in the working capital from $178,392.85 to $136,107.14, resulting in an
increase in firm value of $42,285.71.
6. a. Net working capital is current assets minus current liabilities. Using this definition, The
Greek Connection’s net working capital is $7,782 – $3,520 = $4,262. Some analysts
calculate the net operating working capital instead, which is the non-interest earning current
assets minus the non-interest bearing current liabilities. In this case, the notes payable would
not be included in the calculation since they are assumed to be interest bearing. Net
operating working capital for The Greek Connection is $7,782 – ($1,300 + $1,220) =
$5,262.
b. The cash conversion cycle (CCC) is equal to the inventory days plus the accounts receivable
days minus the accounts payable days. The Greek Connection’s cash conversion cycle for
2004 was 41.4 days.
c. If The Greek Connection accounts receivable days had been 30 days, its cash conversion
cycle would have been only
CCC = 40.32 + 30 – 37.07 = 33.25 days
7. Plan: Calculate the cost of the trade credit if your firm does not take the discount and pays on
day 60.
Execute: In this instance, the customer will have the use of $96 for an additional 45 days (60
15) if he chooses not to take the discount. It will cost him $4 to do so because he must pay $100
for the goods if he pays after the fifteen-day discount period. Thus, the interest rate per period
is:
$4
0.4166 4.167%
$96
The number of 45-day periods in a year is 365/45 8.1 periods. So, the effective annual cost of
the trade credit is:
EAR (1.04167)8.1 1
39.19%
Evaluate: As we have calculated, the annual cost of not taking the trade discount is 39.19%. If
the firm has other means of financing, such as a bank line of credit at 10% annually, it should
take the trade discount, avoid the 39.19% cost, and borrow from the bank.
Execute: If you were to pay within the 20-day discount period, you would pay $97 for $100
worth of goods. If you wait until day 30, you will owe $100. Thus, you are paying $3 in interest
for a 10-day (30 20) loan. The interest rate per period is:
$3
3.09%
$97
The number of 10-day periods in a year is 365/10 36.5 periods. So, the effective annual cost
of the trade credit is:
EAR (1.0309)36.5 1
203.97%
Evaluate: As in Problem 18.7, the firm should look to its other sources of financing and only
pay 203.97% if it is the lowest rate financing available.
*9. Plan: Calculate the costs and benefits of outsourcing the billing and collection functions.
Outsource if benefits outweigh costs.
Execute: The benefit of outsourcing the billing and collection to the other firm is equal to what
Fast Reader can earn on the funds that are freed up. Because average daily collections are
$10,200 and float will be reduced by 17 days, Fast Reader will have an additional $173,400
($10,200 17). (Think about this as follows. Immediately after hiring the billing firm, its
collection float drops by 17 days, so all collections due within the next 17 days are immediately
available.) The billing firm charges $500 per month. At a 7.4% annual rate, the monthly
discount rate is 1.0741/12 – 1 0.596 5.96%, so the present value of these charges in perpetuity
is 500/0.00596 $83,795.64 8,389.26.
If additional cash is invested at the same rate in perpetuity, PV = 173,400 / 7.04% =
2,343,243.24
Evaluate: Thus, the costs ($83,795.64) are much lower than the benefits ($2,343,243.24), and
Fast Reader should employ the billing firm.
Another solution could be to simply compare for on a monthly basis:
*10. Plan: Calculate the costs and benefits of switching banks. Shift to the new bank if benefits
outweigh costs.
Execute: The electronic funds transfer system will free up $51,000 ( 5 $10,200). (Think about
this as follows. Immediately after switching banks, its collections due within the next five days
are immediately available.) On the other hand, Saban will have to pay a cost because it has to
hold $25,000 in a noninterest-earning account, which means it has essentially given up these
funds.
Evaluate: Because the benefits ($51,000) are larger than the costs ($25,000), it should switch
banks.
Execute: If we assume all the sales were made on credit, the average length of time it takes
Manana to collect on its sales is 37.64 days:
Accounts receivable
Accounts receivable days
Average daily sales
$5,600,000
$54,300,000
365
37.64 days
Evaluate: It takes Manana 37.64 days on average to collect its accounts receivable.
Percent of Accounts
Days Outstanding Amount Owed Receivable
0–15 $ 68,000 19.3%
16–30 $ 75,000 21.2%
31–45 $ 92,000 26.1%
46–60 $ 82,000 23.2%
more than 60 $ 36,000 10.2%
$353,000 100.0%
Evaluate: $36,000 of accounts receivable are more than 60 days outstanding. If credit terms are
net 30 days, management should investigate.
13. Plan: Calculate the benefit of taking the discount. If it is more than the 10.8% cost of the loan,
then borrow from the bank and take the discount.
Execute: If Simple Simon’s takes the discount, it must pay $98.3 in 10 days for every $100 of
purchases. If it elects not to take the discount, it will owe the full $100 in 25 days. The interest
rate on the loan is:
$1.7
1.73%
$98.3
The loan period is 15 days ( 25 10). The effective annual cost of the trade credit is:
EAR (1.0173)365/15 – 1
51.79%
Evaluate: Because the bank loan is only 10.8%, Simple Simon’s should borrow the funds from
the bank in order to take advantage of the discount.
14. a. Your firm is paying $1.7 to borrow $98.3 for 20 days (= 35 – 15).
The interest rate per period is 1.7 / 98.3 = 1.73%.
The effective annual rate is (1.0173)365/20 – 1 = 36.74%.
b. In this case, your firm is stretching its accounts payable. You are still paying $3 to borrow
$97, so the interest rate per period is 3.09%. However, the loan period is now 30 days (= 45
– 15). The effective annual rate is reduced to 23.2% because your firm has use of the money
for a longer period of time:
EAR = (1.0173)365/30 – 1 = 23.2%.
*15. Plan: Calculate the firm’s cash conversion cycle over two different years. Evaluate how well
the firm is managing it payables.
Evaluate:
a. The cash conversion cycle (CCC) is equal to the inventory days plus the accounts receivable
days minus the accounts payable days. IMC’s cash conversion cycle for 2015 was 35.2
days, and for 2016, it was 45.6 days.
Execute:
b. If IMC’s suppliers are offering terms of net 30 days, IMC should consider waiting longer
to pay for its purchases. In 2012, it paid nearly five days earlier than necessary, and in 2013,
it paid 2.5 days earlier. IMC could, therefore, have kept the money working for it longer
because there was no discount offered for early payment. The early payment may give IMC a
preferred position with its suppliers, however, which may have benefits that are not
presented here. IMC’s decision on whether to extend its accounts payable days would have
to take these benefits into consideration.
Execute:
Average inventory balance
Average days of inventory
Cost of goods sold/365
1,200,000
7,000,000/365
62.57 days
17. Plan: Calculate inventory in days. Also, evaluate how much the firm would have to reduce its
inventory to get it inventory days to match the industry average.
Execute:
a. The inventory days ratio is equal to the inventory divided by average daily cost of goods
sold. This was 148.2 days for Happy Valley Homecare Suppliers in 2015:
$1,770,000
Inventory days 148.2 days
$4,360,000
365
Evaluate:
b. To reduce its inventory days to 73 days, HVHS must decrease its investment in inventory
turnover to $872,000:
Inventory
73 days Inventory $872,000
$4,360,000
365
This means HVHS could reduce its investment in inventory by $898,000 ( $1,770,000
$872,000).