ACF 103 – Fundamentals of Finance

Tutorial 6 - Questions
Chapter 8
1. Lone Star Industries has current sales of $1 million and a net profit margin of
12%. It has fixed assets of $400,000 and current assets of $200,000. What
happens to the firm's asset turnover ratio and return on assets if it decides to
improve its liquidity by increasing current assets to $300,000? Assume that the
increase in current assets comes from new equity capital.

2. United Pickle Works needs to borrow $10 million for six years; no temporary
repayments are expected to occur during the period. One alternative is to issue
notes maturing in six years at a fixed annual interest rate of 10%. The other
alternative is to borrow the $10 million from its bank under an arrangement
requiring that the interest rate be adjusted annually. Management is willing to
accept a forecast that the six annual rates will be 8%, 9%, 10%, 12%, 12%,
and 12%. Based on the total amount of interest to be paid over the period,
which loan would require a smaller interest expense? Which financing method
is preferable?

3. The Clearwater Corporation has determined that the after-tax return on its
current assets is 6% while the after-tax return on fixed assets is 12%.
Clearwater's current balance sheet is as follows:

ASSETS LIABILITIES
Current Assets $300,000 Current Liabilities $200,000
Fixed Assets 700,000 Long-term Debt 300,000
Equity 500,000
Total Assets $1,000,000 Total Liab+Equity $1,000,000

Management wishes to increase its net profits by shifting $100,000 out of

current assets and investing it in fixed assets. Assess the impact of this strategy
on the firm's return on assets, as well as on its liquidity.

Chapter 9
1. Goodmonth Enterprises expects credit sales of $800 million next year. If the
firm can invest funds at the rate of 8% a year, what is the value of collecting
accounts payable two days earlier (use a 365-day year)?

2, Bull Run Brewery has a weekly payroll of $400,000 and paychecks are issued
every Friday. On the average, Bull Run's employees cash their checks
according to the following pattern:

Day Checks Clear Percent of

Payroll Account Checks Cleared
Friday 30
Monday 40
Tuesday 20
Wednesday 10
Assuming the company maintains a minimum balance in the account so as not
to break any banking laws, how would you manage the payroll account?

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3. Chou Dou Fu receives an average of $500,000 a day in payments from its
franchisees through the mail. The average time it takes to have funds available
at its bank is seven days from the postmark date. The firm has asked you to
evaluate the following three alternatives. Which offers the greatest financial
benefit to Chou Dou Fu? (Assume that the firm can earn 8% annually on its
marketable securities investments.)

a. Bank Shanghai offers concentration banking that will reduce the time
to have funds available from seven to five days. Bank Shanghai
charges a fee of $65,000 annually to set up and administer the system.
b. Kaifeng Bank offers a system that will reduce the time to available
funds to four days. Kaifeng Bank requires a $1,000,000 compensating
balance in order to administer the system.
c. Bank of Henan offers to set up an Electronic Funds Transfer system
that will reduce the time to available funds to two days. Bank of Henan
charges an annual fee of $300,000 for this service.

Chapter 10
Homework Problem
1. The ABC Company wishes to establish an EOQ for a particular item. The
annual usage is 12,000 units, order costs are $20, and the annual carrying cost
is $0.48 per unit. The EOQ equals ________.
A. 10 units
B. 100 units
C. 1,000 units
D. 10,000 units

2. Indo Processing Corp uses 20,000 gallons of solvent a year. The cost of
carrying the solvents is $1.62 a gallon per year, while the cost per order is
$200. What would the closest average inventory level be if Indo wished to
maintain a 400 gallon safety stock?
A. 1,511
B. 10,000
C. 812
D. 3,214

3. (Relaxation of credit standards) Lewis Enterprises is considering relaxing its

credit standards in order to increase its currently sagging sales. As a result of
the proposed relaxation, sales are expected to increase by 10% from 10,000 to
11,000 units during the coming year; the average collection period is expected
to increase from 45 days to 60 days; and bad debts are expected to increase
from 1% to 3% of sales. The sale price per unit is $40 and the variable cost per
unit is $31. If the firm’s required return on equal-risk investments is 25%,
evaluate the proposed relaxation and make a recommendation to the firm.

4. The Morgan Company sold 100,000 units of a product last year for $30 each.
Variable costs for each unit are $25. The sales manager believes that sales
would increase by 20%, with no increase in bad-debt losses, if the credit
period is extended from 30 to 60 days. The implementation of the new terms is
expected to increase the average collection period from 45 to 75 days. If the

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 firm's opportunity cost of funds is 20%, should it extend 60-day terms?
(Assume a 360-day year.)

5. Thermo Products, a manufacturer of solar heating panels, is currently selling

$6 million annually to dealers on 30-day credit terms. Management believes
that sales could be increased by changing its credit policy. The firm's present
collection period is 30 days and it is presently considering the following credit
policies:
Average Expected
Policy Collection Period Annual Sales
A 45 days $6.6 million
B 60 days 7.0 million
C 90 days 7.2 million

If the firm's variable costs average 75% and its opportunity cost of funds is
20%, which policy should be adopted? (Assume a 360-day year.)

6. The Bentley Corporation uses 100,000 units a year of a particular item. The
firm has determined that the economic order quantity is 2,000 units, based on
order costs of $100 per order and inventory carrying costs of $0.50 per unit.
Suppose that a quantity discount of $0.05 per unit is available for order sizes
of 10,000 units or more. Should Bentley take advantage of the quantity
discount?

7. Text book Ch 10, problem # 1 (p.275)

8. Text book Ch 10, problem # 2 (p.275)

9. Text book Ch 10, problem # 3 (p.276)

10. Text book Ch 10, problem # 8 (p.277)

Chapter 11
1. The trade terms "2/15, net 30" indicate that a ________ discount is offered if
payment is made within ________ days.
A. 2%; 15
B. 15%; 30
C. 2%;30
D. 30%; 15

2. In terms of an annual interest cost, would it be better for a firm to forego a

1/10, net 20 cash discount or a 2/10, net 30 discount (assume a 360 day year)?

3. Taylor Industries needs to raise funds on a short-term basis. One alternative is

to borrow from the bank at an 18% annual interest rate, while the second
involves foregoing cash discounts from a supplier whose trade credit terms are
2/10, net 60. Which alternative has the lower effective interest cost (assume a
360 day year)?

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4. Lots of Leather, a boutique specializing in high fashion women's leather items,
purchases a line of sandals from a single manufacturer. Its $20,000 annual
sandal shipment is usually received on the first of April under net 60-day
terms. Its supplier has offered a 5% discount if it will take shipment on the
first of March under net 30-day terms. If it costs the firm $200 a month to
store the sandals, and its cost of borrowing is 1% per month, should it accept
the supplier's offer?

5. Malaprop Systems, Inc. wants to borrow $200,000 in short-term funds. Bank

A is willing to lend at a 16% nominal interest rate, but will require
compensating balances equal to 30% of the loan amount. Bank B is charging a
nominal rate of 18%, but does not require any compensating balances. If
Malaprop normally keeps $50,000 in its checking account, which bank is
offering the better terms?

6. PDQ Co. has been using its receivables as collateral for a bank loan.
Receivables average $400,000 a month, and the bank is willing to lend up to
75% of the average amount at a 12% interest rate, while requiring a 1%
processing fee on the face amount of all receivables used as collateral. PDQ is
exploring an arrangement with a factor that is also willing to lend up to 75%
of the receivables factored, but at a rate of 15%. The factoring fee would be
2% of the face amount of all receivables factored. Under this arrangement,
PDQ would save the $3,000 per month its credit department costs, and it
would eliminate bad-debt losses equal to 1% of receivables. Should the firm
switch from the bank to the factor?

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 Gitman Ch 14/15 Tutorial Questions
Tutorial 6
1. 14–4 (Cash conversion cycle) Australian Products is concerned about managing
cash in an efficient manner. On average, inventories have an average age of 90
days and accounts receivable are collected in 60 days. Accounts payable are paid
approximately 30 days after they arise. The firm spends $30 million on
operating cycle (OC) investments each year, at a constant rate. Assuming a 365-
day year:
a. Calculate the firm’s OC.
b. Calculate the firm’s CCC.
c. Calculate the amount of financing required to support the firm’s CCC.
d. Discuss how management might be able to reduce the CCC.

2 14–5 (Changing the CCC) Camp Manufacturing turns over its inventory eight
times each year, has an APP of 35 days and an ACP of 60 days. The firm’s total
annual outlays for OC investments are $3.5 million. Assuming a 365-day year:
a. Calculate the firm’s OC and CCC.
b. Calculate the firm’s daily cash operating expenditure. How much
negotiated financing is required to support its CCC?
c. Assuming the firm pays 14% for its financing, by how much would it
increase its annual profits by favourably changing its current CCC by 20
days?

Homework Problem
3. 14–18 (EOQ, reorder point and safety stock) Alexis Limited uses 800 units of
a product per year on a continuous basis. The product has a fixed cost of $50 per
order and its carrying cost is $2 per unit per year. It takes five days to receive a
shipment after an order is placed, and the firm wishes to hold in inventory 10
days’ usage as a safety stock.
a. Calculate the EOQ.
b. Determine the average level of inventory.
c. Determine the reorder point.

4. 14–24 (Accounts receivable changes and bad debts) A firm is evaluating an

accounts receivable change that would increase bad debts from 2% to 4% of
sales. Sales are currently 50,000 units, the selling price is $20 per unit and the
variable cost per unit is $15. As a result of the proposed change, sales are
forecast to increase to 60,000 units.
a. What are bad debts in dollars at present and under the proposed change?
b. Calculate the cost of the marginal bad debts to the firm.
c. Ignoring the additional profit contribution from increased sales, if the
proposed change saves $3,500 and causes no change in the average
investment in accounts receivable, would you recommend it? Explain.
d. Considering all changes in costs and benefits, would you recommend the
proposed change? Explain.
e. Compare and discuss your answers in parts c and d.

5. 14–27 (Relaxation of credit standards) Lewis Enterprises is considering

relaxing its credit standards in order to increase its currently sagging sales. As a
result of the proposed relaxation, sales are expected to increase by 10% from

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 10,000 to 11,000 units during the coming year; the average collection period is
expected to increase from 45 days to 60 days; and bad debts are expected to
increase from 1% to 3% of sales. The sale price per unit is $40 and the variable
cost per unit is $31. If the firm’s required return on equal-risk investments is
25%, evaluate the proposed relaxation and make a recommendation to the firm.

6. 15–1 (Payment dates) Determine when a firm must make payment for
purchases made and invoices dated on 25 November under each of the following
credit terms.
a. net 30 date of invoice
b. net 30 EOM
c. net 45 date of invoice
d. net 60 EOM

7. 15–2 (Cost of forgoing cash discounts) Determine the cost of forgoing cash
discounts under each of the following terms of sale.
a. 2/10 net 30 e. 1/10 net 60
b. 1/10 net 30 f. 3/10 net 30
c. 2/10 net 45 g. 4/10 net 180
d. 3/10 net 45

8. 15–6 (Credit terms) Purchases made on credit are due in full by the end of the
billing period. Many firms extend a discount for payment made in the first part
of the billing period. The original invoice contains a type of ‘short-hand’
notation that explains the credit terms that apply. (Assume a 365-day year.)
a. Write the short-hand expression of credit terms for each of the following.
Beginning of
Cash discount Discount period Credit period credit period
1% 15 days 45 days date of invoice
2 10 30 end of month
2 7 28 date of invoice
1 10 60 end of month
b. For each of the sets of credit terms in part a, calculate the number of days
until the bill is due in full for invoices dated 12 March.
c. For each of the sets of terms, calculate the cost of giving up the cash
discount.
d. If the firm’s cost of short-term financing is 8%, what would you
recommend in regard to taking the discount or giving it up in each case?

9. 15–13 (Cost of bank loan) Data Back-up Systems has obtained a $10,000, 90-
day bank loan at an annual interest rate of 15%, payable at maturity.
a. How much interest (in dollars) will the firm pay on the 90-day loan?
b. Find the effective cost of the loan for the 90 days.
c. Annualise your finding in part b to find the effective annual rate of
interest for this loan, assuming it is rolled over each 90 days throughout
the year under the same terms and circumstances.

10 15–33 (Accounts receivable as collateral, cost of borrowing) Maximum Bank

has analysed the accounts receivable of Scientific Software Ltd. The bank has
chosen eight accounts totalling $134,000 that it will accept as collateral. The

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 bank’s terms include a lending rate set at prime + 3% and a 2% commission
charge. The prime rate is currently 8.5%.
a. The bank will adjust the accounts by 10% for returns and allowances. It
will then lend up to 85% of the adjusted acceptable collateral. What is
the maximum amount that the bank will lend to Scientific Software?
b. What is Scientific Software’s effective annual rate of interest if it
borrows $100,000:
i for 12 months,
ii for six months,
iii for three months?
(Assume that the prime rate remains at 8.5% during the life of the loan.)

11. 15–36 (Cost of factoring advance—single amount) Duff Industries wishes to

receive an advance from its factor on an account of $100,000 due in 30 days.
The factor holds a 10% factor’s reserve, charges on and deducts from the book
value of factored accounts a 2% factoring commission, and charges 16% annual
interest (paid in advance) on advances.
a. Calculate the maximum dollar amount of interest to be paid.
b. What amount will the firm actually receive?
c. What is the effective annual interest cost of this transaction?
d. What is the annual factoring cost (in per cent) for this transaction?

Homework Problem
12. 15–38 (Inventory financing) Raymond Manufacturing faces a liquidity crisis—
it needs a loan of $100,000 for 30 days. Having no source of additional
unsecured borrowing, the firm must find a secured short-term lender. The firm’s
accounts receivable are quite low, but its inventory is considered liquid and
reasonably good collateral. The book value of the inventory is $300,000, of
which $120,000 is finished goods.
(1) City-Wide Bank will make a $100,000 loan against the finished goods
inventory. The annual interest rate on the loan is 12% on the outstanding
loan balance plus a 0.25% administration fee levied against the $100,000
initial loan amount. Because it will be liquidated as inventory is sold, the
average amount owed over the month is expected to be $75,000.
(2) Sun State Bank is willing to lend $100,000 on the book value of
inventory for the 30-day period at an annual interest rate of 13%.
(3) Citizens’ Bank will loan $100,000 against the finished goods inventory
and charge 15% annual interest on the outstanding loan balance. A 0.5%
warehousing fee will be levied against the average amount borrowed.
Because the loan will be liquidated as inventory is sold, the average loan
balance is expected to be $60,000.
a. Calculate the dollar cost of each of the proposed plans for obtaining an
initial loan amount of $100,000.
b. Which plan do you recommend? Why?
c. If the firm had made a purchase of $100,000 for which it had been given
terms of 2/10 net 30, would it increase the firm’s profitability to forgo
the discount and not borrow as recommended in part b? Why or why
not?

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