Presentation

Group Topic Case

on (Session #)
1 Stock Valuation Nations Bank Session 7
2 Stock Valuation Reeby Sports (BM- Ch 4) Session 7
3 Capital Budgeting Vegetron’s CFO Calls Again (BM - Ch 5) Session 9
4 Capital Budgeting New Economy Transport (A) & (B) (BM - Ch 6) Session 9
5 Capital Budgeting Florida Power & Light Session 12
6 Capital Budgeting Southwest Airlines Session 12
7 Capital Budgeting Philip Morris Session 13
8 Project Analysis (Risk Analysis) Waldo County (BM - Ch 10) Session 13
9 Capital Budgeting Ecsy-Cola (BM - Ch 11) Session 15
10 Capital Budgeting - WACC Computerized Business Systems Session 15
11 Capital Structuring Claxton Drywall (BM - Ch 17) Session 17
12 Optimal Capital Structure McLeodUSA Session 17
13 Dividend Policy Lancaster Colony Session 19
14 Short-term Cash Management Pepsi Session 19
For BM Mini cases, refer the relevant chapters of the textbook
1. Nations Bank
Stock Valuation

Before Nations Bank was bought by Bank of America, Tina Brown was considering the
purchase of Nations Bank's common stock. Given Nations Bank's recent merger with
the Southeastern powerhouse, Bank South, and talks of penetration into the Florida
market via a takeover of Barnett Bank, Tina felt Nations Bank would be a solid "buy and
hold" as it continued to increase its market share through aggressive growth by
acquisition.
While Tina was convinced she wanted to own Nations Bank, with all the price volatility
surrounding the recent speculations, she was not sure if the price was above or below
the stock's intrinsic value. She decided to derive the price of Nations Bank's common
stock by using the Gordon Growth Model (Constant Growth Model).
To use the Gordon Growth Model, Tina had to first calculate Nations Bank's required
rate of return on their common stock. The risk free rate, as proxied by the yield on a
three month Treasury Bill, was 6%. The return on the market, as proxied by the return
on the Standard and Poor's 500 (S&P 500), was 10%. Nations Bank had a beta of 1.75.
Past dividend payments also had to be known. Tina was not sure how far back into the
future she should go to retrieve the dividend payment information, so she arbitrarily
stopped in 1987. Between 1987 and 1990, Nations Bank seemed to have very different
payout amounts. Not fully understanding the reasons behind these differences, Tina
decided to consider two periods for analysis: from 1987-1995 and from 1990-1995. The
dividend information that Tina recovered is shown below in Table 1.

Table 1
Year Dividends
1995 $2.00 ($1.00 through June 1995)
1994 $1.88
1993 $1.64
1992 $1.51
1991 $1.48
1990 $1.42
1989 $1.10
1988 $0.94
1987 $0.86

Questions

1. Using the Capital Asset Pricing Model (CAPM), what was Nations Bank's
required rate of return on common stock?
2. Consider the first time period from 1987-1995. Use the Gordon Growth Model to
determine the price of Nations Bank's common stock.
3. Consider the second time period from 1990-1995. Use the Gordon Growth Model
to determine the price of Nations Bank's common stock.
4. The answers for questions 2 and 3 are very different. What does this indicate, in
general, about the Gordon Growth Model? (Hint--The observed market price of
Nations Bank's common stock is $70.25.)
5. What effect does the stock's required rate of return have on the calculation of its
stock price when using the Gordon Growth Model?
6. If you felt that Nations Bank's last year dividend of $2.00 was going to be paid in
that constant amount throughout the remainder of the company's life (i.e. zero
growth), what would be the value of the stock today?
7. Based on your response to question 6, what is the relationship between the
present value of a dividend paid one year from now, a dividend paid ten years
from now and a dividend paid one hundred years from now?
Case 5: Florida Power & Light
Capital Budgeting: Renewal versus Replacement

Florida Power & Light (FP&L) is the primary subsidiary of Florida Power & Light Group,
representing 97% of their operating revenues. FP&L is a utility company that supplies
electric service throughout most of Florida's eastern seaboard. Their service area
contains 27,605 square miles which translates into approximately 3.4 million customers.
Of these 3.4 million customers, as a percentage of operating income, roughly 55%
comes from residential customers, 35% from commercial, 4% from industrial, and the
remaining 6% from other sources.
Paul Seiler, a senior contracts agent in the nuclear division at FP&L's Turkey Point Plant
in Florida City, Florida, is debating on whether to renew or replace the commercial
nuclear reactor's reactimeter. A reactimeter is a vital component of the nuclear power
generating process.
The core of a nuclear reactor must be maintained at a certain temperature and must
possess a particular chemical composition. Any deviation from this sensitive optimal mix
will result in the sub-optimization of the plant and a corresponding waste of energy. The
reactimeter is a computer with accompanying software that is used to monitor the
requisite characteristics of the Reactor Coolant System (RCS) and make minor
adjustments as needed.
Alternative 1:
In order to determine whether the reactimeter should be renewed or replaced, Paul had
to gather some financial information. If the current computer system is upgraded and
new software is purchased, the cost will be $80,000. An additional $5,000 will be
required to have the system installed and calibrated for accuracy. The renewed
computer system will have a useful life of just five years and will be depreciated in
compliance with the MACRS five year recovery system. Depreciation rates for years
one through five are .20, .32, .19, .12, and .12, respectively. Only the purchase cost of
$80,000 will be depreciable, not the installation cost.
At the end of the five year period, the renewed machine can be sold for $5,000 before
taxes. The renewed machine would also result in an increase in net working capital of
$20,000. Net profits resulting from an increase in operational efficiency for each year
will be as follows:
Table 1
Year Net increase in profits
1 $650,000
2 $425,000
3 $317,000
 4 $220,000
5 $129,000

Alternative 2:

The new system will also have a five year life and will be depreciated in compliance with
the MACRS five year recovery system. The fully depreciable cost of the new system will
be $100,000. Installation costs will be an additional $5,000. At the end of the five year
period, the renewed machine can be sold for $10,000 before taxes. Implementing the
new machine would result in an increase in net working capital of $15,000. If FP&L
decides to replace the old system with a new reactimeter, the resulting net profits will
be:

Table 2
Year Net increase in profits
1 $350,000
2 $350,000
3 $350,000
4 $350,000
5 $350,000

If a new system is purchased, the old system can be salvaged for $10,000. Finally,
FP&L has a 40% corporate tax rate.

Questions

1. What is the initial investment associated with both alternatives?

2. Calculate the net after-tax operating cash inflows associated with both
alternatives.
3. Calculate the year 5 cash flow associated with the sale of the computer for both
alternatives. That is, remember to consider that both computer systems can be
sold at the end of the fifth year.
4. Using a discount rate of 10%, calculate the present value of both alternatives.
Which alternative should Paul choose?
5. What are some of the qualitative factors to consider when making a decision
between the two alternatives?
6. Based on your answers from questions 4 and 5, has your decision changed
concerning which alternative is preferred?
Case 6: Southwest Airlines
Capital Budgeting: One Project - Accept/Reject Decision

The airline industry is extremely cyclical. That is, when the economy does well, so too
do airlines. In recent years, the airline industry has found itself with too many seats and
too few passengers. Some experts point to the past deregulation of the industry while
others argue that technological advances such as teleconferencing are responsible.
Several airlines such as Continental, America West, Eastern, and Trans World Airlines,
have filed for Chapter 11 Bankruptcy. Some have fully recovered, while others have
been forced to liquidate (Chapter 7). Narrowing profit margins have prompted airlines to
develop creative survival tactics.
Southwest Airlines has successfully found its niche in the industry by providing direct
flight service to less traveled routes such as those to and from smaller cities. Since
these routes do not generate nearly as much revenue as major city routes, Southwest
has found ways to reduce its costs. Costs are reduced by following a no frills policy that
the travelers refer to as "peanut flights." This means that instead of serving costly meals
(the quality of which passengers have historically complained about anyway),
Southwest serves just a bag of peanuts and a soft drink. With the recent success of
short, direct flights, Southwest is considering the purchase of one such additional route.
Before an airline applies to the federal government for a new route, a lengthy analysis is
performed to determine the feasibility of the route. Expenses to consider include airport
costs such as gate and landing fees and labor costs such as local baggage handlers
and maintenance workers. Many times the airline will provide its own employees to load
and unload luggage or to provide upkeep for their planes, but in the case of Southwest,
they have so many small cities to service that the outsourcing of these jobs is not
uncommon.
Table 1 provides a summary of the after-tax cash flows associated with the acquiring of
an additional small route. All costs and revenues are reflected by the following numbers.
Table 1
Projected Net Cash flows (in Millions of Dollars)
Year Net Cash flow
0 -$20.8
1 $4.5
2 $6.3
3 $5.2
4 $3.9
5 $2.1
6 $1.3
7 $0.5
Questions
1. What is the project's NPV assuming Southwest has a discount rate of 10%? How
do we interpret the NPV?
2. What is the project's IRR? How is this measure different from the NPV? What is
the interpretation of this number?
3. Calculate the project's Payback Period.
4. Assuming that Southwest has a required payback period of 5 years and a hurdle
rate of 10%, should Southwest accept the additional route? Based on the
project's NPV, should it be accepted? If conflicting conclusions occur, which
criteria would you follow?
5. When will conflicts likely occur among the three criteria?
6. Calculate the project's Modified Internal Rate of Return (MIRR). What critical
assumption does the MIRR make that differentiates it from the IRR?
7. Where does the value of MIRR fall relative to the discount rate and IRR?
Case 7: Philip Morris
Capital Budgeting: Projects with Dissimilar Risks

When most people hear the name Philip Morris, they think of tobacco, or more
specifically, Marlboro cigarettes. What most people do not realized is that the food
products Philip Morris markets generate more sales revenue for the firm. Recognizable
brand names include Kraft, Post, Maxwell House, and Entenmann's.
Philip Morris is considering the introduction of two new products. The first product is a
new breakfast cereal called Post Blueberry Morning. Post is an established name in the
cereal market with a market share of 16.7%. Getting shelf space is extremely difficult
and costly for most new products because grocery stores traditionally charge slotting
fees. Slotting fees are fixed amounts that companies must pay to gain ideal shelf
locations for their products. Post, however, feels less pressure from grocery stores
because of the consumer demand for their products. With the consumer preference for
Post brand cereal, Philip Morris feels that introducing Post Blueberry Morning will be a
low risk venture.
The second new product Philip Morris is considering the introduction of is a Gourmet
Hazel Nut coffee that will be sold under the Maxwell House family of products. Maxwell
House is also established in its market, but the coffee industry itself is more risky than
the high profit margin breakfast cereal market. Coffee profits are strongly affected by the
general swings in the commodity's price due to uncontrollable factors such as weather.
From month to month the price of coffee fluctuates making profits from coffee sales
fluctuate as well.
In performing a capital budgeting analysis, Philip Morris recognizes that these two
products should not be considered to be of equal risk. Therefore, traditional net present
value analysis should not be used to decide which product, if any, to produce. To help
the company decide how to handle the perspective investments, their finance
department forecasted the projects' expected net cash flows. Both projects have an
expected life of seven years. Table 1 shows the projected net cash flows associated
with both projects.
Table 1
Net cash flow Net cash flow
Year
Gourmet Hazel Nut Post Blueberry Morning
0 -$4,000,000 -$2,500,000
1 $1,000,000 $803,000
2 $1,200,000 $521,000
3 $750,000 $235,000
4 $950,000 $400,000
5 $880,000 $498,000
6 $500,000 $612,000
 7 $206,000 $519,000

Since the two projects have dissimilar risks, the finance department felt it would be
appropriate to indicate how certain they were about their estimates of the net cash flows
associated with each project. These certainty equivalents are shown in Table 2.

Table 2
C.E. Net cash flow
Year
Gourmet Hazel Nut Post Blueberry Morning
0 1.00 1.00
1 .80 .95
2 .70 .90
3 .60 .85
4 .50 .80
5 .40 .75
6 .30 .70
7 .20 .65

The appropriate discount rate for an average risk project for Philip Morris is 10%. They
feel that because the Gourmet Hazel Nut project is more risky than average, a risk-
adjusted discount rate of 12% should be used. Finally, the risk-free rate of return is
currently 5%.

Questions

1. If you assume the two projects are of equal risk, what is the net present value
(NPV) of each project? Because the projects are independent, which project(s)
would you accept?
2. Because the Gourmet Hazel Nut project is more risky, calculate its NPV using
the Risk-Adjusted Discount Rate (RADR).
3. Using the certainty equivalents method, calculate the projects' NPV. Does your
accept/reject decision change?
4. Explain the concept of certainty equivalents. Start with a definition and then
explain fully.
5. How do certainty equivalents adjust cash flows for risk and time. How does this
adjustment compare to the way RADRs treat risk and time?
Case 10: Computerized Business Systems
Capital Budgeting: Weighted Average Cost of Capital

Computerized Business Systems (CBS) transforms manual accounting and inventory

systems into computerized, more efficient, systems. Many of their customers describe
the transition as an overnight evolution from the dark ages to the 21st century. Manual
systems are far too cumbersome with respects to both time and inventory control.
CBS's computerized inventory systems, for example, allow every item in inventory, no
matter how small, to be tracked at all points throughout the production process.
Replenishing stock becomes an automatic process because the CBS system alerts the
manager when supplies reach a pre-programmed level.
Vicky Pagel has been a financial analyst with CBS for over five years. Although she
normally does not get involved with sales, her most recent assignment was to assist
Jack Ingram, a new sales representative. Jack is in the process of trying to sell a CBS
system to Corbin Mills, a firm that does not know how to determine accurately its
weighted average cost of capital (WACC). Corbin Mills, therefore, cannot determine
whether the net present value (NPV) of the CBS system is positive or negative.
To calculate Corbin Mills' WACC, Vicky first needed to gather information on the firm's
cost of raising funds from various sources. As she proceeded with the analysis, she
learned that Corbin Mills could issue 20-year corporate bonds at a coupon rate of 9%.
As a result of current interest rates, the bonds could be sold for $1,005 each. These
bonds have floatation costs of $35 per bond, pay interest semi-annually, and have a par
value of $1,000. A corporate tax rate of 40% applies.
Corbin Mills can raise additional funds through either retained earnings or new issues of
common stock. Their common stock is currently selling for $68.25 per share. The most
recent dividend paid was in the amount of $2.25. Corbin's dividends have previously
grown at a rate of 4%, but this growth rate is expected to jump to 10% the year after and
continue at this rate to infinity. If the firm wanted to sell new shares of common stock,
after underpricing and floatation costs, they could do so for $62.75 per share.
A final source from which funds could be raised is via preferred stock. $100-par
preferred stock can be issued at an 11% annual dividend rate. After floatation costs, the
preferred stock would sell for $95.50 per share.
The final set of information needed to calculate the WACC is the proportion of total
funds that each asset class represents. This information is given in Table 1. In
performing the NPV calculation, net after-tax cash flows must be known. These cash
flows are given in Table 2. All variables such as improvements in efficiency, employee
training costs, and salvage value are already incorporated in the cash flows.
Put yourself in Vicky Pagel's position, and develop the WACC calculation that will be
used in evaluating projects for Corbin Mills. Next, demonstrate whether the NPV for the
proposed CBS system is positive or negative. The following questions will lead you
step-by-step to complete the analysis.
To perform this type of analysis you are implicitly making several assumptions. Since
Jack will be the only one involved in communicating with Corbin Mills, he must
completely understand all of the assumptions and calculations that will be made
throughout the analysis. For this reason, the analysis must be clear as well as
technically correct.
Questions
Table 1 contains the market and book values of each asset class. Table 2 shows the
after-tax cash flows associated with the CBS system. Use these tables to answer the
questions which follow.
Table 1
Asset Class Book Value Market Value Target Ratio
Long-term Debt $35,000,000 $33,400,000 35%
Preferred Stock $5,000,000 $7,000,000 5%
Common Stock $40,000,000 $42,000,000 40%
Retained Earnings $10,000,000 $10,000,000 20%
Table 2
Year After-tax net cash flow
0 -$480,000
1-10 $80,000
11 $10,000

1. What is the firm's cost of preferred stock? Is this the same as the after-tax cost of
preferred stock?
2. What is the firm's cost of long-term debt? Is this the same as the after-tax cost of
long-term debt?
3. What is the firm's cost of retained earnings? Is this the same as the after-tax cost
of retained earnings?
4. What is the firm's cost of new common stock? Is this the same as the after-tax
cost of new common stock?
5. Using market values, what is Corbin Mill's WACC?
6. Using book values, what is Corbin Mill's WACC?
7. Using target ratios, what is Corbin Mill's WACC? Explain why the target ratio will
not always be maintained by a firm.
8. Which weights, market, book, or target, should be used in this analysis? Explain.
9. Would Corbin Mills be better off with the new CBS system (i.e. What is the NPV
of the proposed system?)? Does the answer to this question depend upon which
weight is used to calculate the WACC? Explain.
Case 12: McLeodUSA
Long-Term Investment Decision: Optimal Capital Structure

The recent growth of McLeodUSA prompted the firm once again to go into the financial
markets and file a registration statement for another $400 million in 10-year senior
notes. This move represents the fifth time in the last 27 months that McLeod has
borrowed in the private debt market raising over $1.125 billion.
The reason for the offering was given as a need to raise capital to fund continued
expansion in the area of intracity fiber optic networks. Acquisitions, joint ventures, and
other strategic alliances have been the source of capital usage in the past and McLeod
will certainly keep these types of options open in the future.
With such a great need for outside capital, McLeod has decided to fully investigate their
optimal capital structure. As such, they have decided to gather data to help analysts
with the necessary calculations. Table 1 provides expected levels of earnings per share
(EPS), standard deviation in EPS, and estimated required rates of return associated
with each capital structure scenario.
Table 1
Debt Expected Standard Deviation Estimated Required Rate
Ratio EPS of EPS of Return
0% $0.38 $0.21 10.3%
10% $0.43 $0.26 10.6%
20% $0.49 $0.33 11.4%
30% $0.55 $0.45 12.2%
40% $0.60 $0.62 13.4%
50% $0.52 $0.84 16.7%
60% $0.41 $1.08 20.6%

Questions

1. Calculate the coefficient of variation in EPS for each of the seven debt scenarios
using the data in Table 1.
2. Using the zero-growth valuation model, calculate the estimated stock price of
McLeod under each of the seven debt scenarios.
3. What are the two simplifying assumptions that the zero-growth valuation model
makes?
4. Based on the zero-growth valuation model, what is McLeod's optimal level of
debt?
5. Note from Table 1 that expected EPS are maximized at a debt level of 40%.
Does this optimum agree with the optimal capital structure derived from the zero-
growth valuation model? Which of the two should McLeod be more concerned
with maximizing? Explain.
Case 13: Lancaster Colony
Dividend Policy

Lancaster Colony, a diversified manufacturer and marketer, has increased its dividend
payment to stockholders each year for the past 38 years. This impressive track record
provides stockholders with a steady and predictable stream of income on which they
can rely.
Since sales and earnings have reached new highs for 10 consecutive years, and
because Lancaster sees several investment opportunities in their Specialty Foods
division, they are considering cutting their dividend next year and using the funds to
invest more heavily in the lucrative Specialty Foods Group. The Board of Directors feel
the rate of return Lancaster could earn by investing the funds internally is greater than
the rate of return their stockholders could get if they invested the dividend payments in
an equally risky venture outside the firm.
To the Board, it seemed silly to pay out a dividend when they had a good use for the
money internally. Still they recognized that cutting the dividend would stop their
impressive 38 year streak and more importantly surprise investors in a negative way.
Table 1 shows the earnings per share (EPS), dividends per share (DPS), and
corresponding dividend payout ratio for Lancaster over the past eight years.
Table 1
Year DPS EPS Dividend Payout Ratio
1994 $0.29 $1.32 22.3%
1995 $0.37 $1.57 23.4%
1996 $0.44 $1.71 25.7%
1997 $0.48 $2.01 23.8%
1998 $0.54 $2.22 24.3%
1999 $0.59 $2.28 25.9%
2000 $0.63 $2.51 25.1%
2001 $0.67 $2.37 28.3%

Questions

1. Define the Residual Theory of Dividends. Does Lancaster appear to be

employing this dividend policy alternative?
2. Define the Constant Payout Ratio policy. Does Lancaster appear to be employing
this dividend policy alternative?
3. Define the Fixed-Dollar or "Regular" dividend policy. Does Lancaster appear to
be employing this dividend policy alternative?
4. Define the Low-Regular-and-Extra Dividend policy. Does Lancaster appear to be
employing this dividend policy alternative?
5. How would stockholders likely react if Lancaster decided to cut their dividend
next year? (i.e. What would happen to the stock price and what would happen to
investor composition?)
6. What could Lancaster's Board of Directors do to mitigate the reaction of its
stockholders?
Case 14: Pepsi
Short-term Cash Management: Managing the Cash Conversion Cycle

Pepsi is a multinational company who operates within three primary industry segments:
beverages, snack foods, and restaurants. The primary products sold in the beverage
segment include Pepsi, Diet Pepsi, 7UP, and Mountain Dew. Frito-Lay represents the
domestic snack food business, while PepsiCo's restaurant segment consists primarily of
Taco Bell, Pizza Hut, and Kentucky Fried Chicken (KFC). Pepsi also engages in several
joint ventures around the world, each within one of the three industry segments.
Because Pepsi is such a large manufacturer and distributor, they spend millions of
dollars each year on salaries trying to keep track of orders, payments, and receipts for
each of their three lines of business.
Todd Rovelstad, a manager in Financial Services at Pepsi's Phoenix plant, has
discovered a way to reduce the time required to log orders, payments, and receipts. His
idea is simple, yet innovative. Todd uses bar codes to sort paperwork.
Just as bar codes are used in a grocery store to identify each item and its price, Todd
can use bar codes to identify where orders are sent to and from, the product that is
being referred to, and the amount of the product to be bought, sold, or shipped.
This idea has several positive attributes. First, the Pepsi employees will be able to do
their logging up to four times faster than they are able to under the current system.
Today, receipts for payment are left stacked until a processor can get to them. This also
allows employees to concentrate more on other ways in which the company can save
money. Second, the accuracy rate under the bar code system is 99.99%. While keying
in codes is relatively accurate also, Pepsi has been experiencing problems because
their workers are putting in too much over time and fatigue has increased the error rate.
Todd did not stop at bar codes for processing accounts receivables. He also saw the
usefulness of bar codes for mail. The post office now sorts mail electronically by bar
codes for those letters that have them. Pepsi can use coded envelopes to speed up the
return time when its customers pay for shipments. These funds can then be deposited
into PepsiCo's account much sooner than they currently can be. Even though interest is
earned on only one to two additional days, when considering the size of Pepsi, this will
translates into big savings.
Pepsi wants to determine just how much these new programs will save the company.
To determine the amount, they have disclosed the following information concerning the
operating cycle. Pepsi's average payment period is 29 days. Their average age of
inventory is 42 days. And the average collection period is 39 days.
Pepsi feels that with the new system in place, it can speed up the average collection
period by 12 days. This figure reflects the fact that the employees will not only receive
the payments earlier, but more importantly, they will be able to start processing the
receipts much sooner than they are currently able to do. The average age of the
inventory and average payment period are assumed to remain unchanged.

Pepsi currently spends $28,000,000 per year on its operating cycle investments. Funds
used for financing the operating cycle cost 12% per annum. Todd feels the additional
annual cost of $50,000 will be sufficient to pay for the added hardware necessary to use
bar codes. This expense does not take into consideration the additional salary
expenses that will be avoided due to a reduction in overtime costs.

Questions

1. Calculate Pepsi's current operating cycle, cash conversion cycle, and need for
short-term financing of the cash conversion cycle (i.e. What is Pepsi's negotiated
financing need?).
2. Calculate the operating cycle, cash conversion cycle, and need for short-term
financing of the cash conversion cycle if Pepsi decides to implement the use of
bar codes.
3. If the bar codes are used in the future, what will be the annual savings stemming
specifically from the cash conversion cycle financing reduction?
4. Considering the annual costs associated with implementing the bar code system,
should Pepsi change their logging systems?
5. Assume the cost of implementing the bar code system exceeds the savings in
reduction of short-term financing needs. Should Pepsi decide not to change
systems? Discuss.
6. Define the cash conversion cycle and explain why it is so important. Do you think
cash conversion cycles should be different for different industries (HINT -
consider a manufacturer versus a retailer).
7. What are the three ways to speed up the cash conversion cycle?
Case 15: Inn-Room Safe
Managing Accounts Receivable

Mass media news programs have made travelers aware, via hidden video cameras, of
how common it is for hotel employees and outsiders posing as hotel guests to gain
access to your room and steal your valuables right off the night stand. Of course, by the
time you find out something is missing there is no way to figure out who did it. And
housekeeping never seems to keep track of who cleaned your room. To combat this
problem, most hospitality establishments provide, at a nominal fee, an in-room safe that
can only be accessed by the guest and the top manager of the hotel.
Inn-Room Safe is a manufacturer and wholesaler of the most popular and secure in-
room safes on the market, the "Interchangeable Lock Block." Inn-Room specializes by
manufacturing and distributing only this one product which comes in four different sizes
to fit almost all hotel spaces.
Currently, Inn-Room provides shipping credit terms of net 30 days to top qualifying
customers and those paying by bank wire transfer. For other, less credit worthy
customers, net terms of 10 and 15 days are required. Inn-Room does not allow for a
discount for early accounts receivable collections. Recognizing that sales volume
should increase and that bad debt expenses should decrease, Inn-Room is considering
offering a 2% discount to those hotels who pay for shipments within 10 days.
Today, Inn-Room's average collection period is 23 days. With the proposed discount
offering, this number is expected to reduce to 14 days. Bad debt expense is expected to
decrease from 0.8% to 0.5%. Inn-Room now sells 1,700 safes on credit at an average
price of $234 and a variable cost of $157 per unit. After the discount, Inn-Room
forecasts that sales will increase by 7% and that 70% of all credit sales will be by hotels
that take the 2% discount. Finally, Inn-Room's required rate of return on a similar risk
investment is 12% under both account receivable options.
Questions

1. If Inn-Room decides to implement the newly proposed discount, what will be the
additional profit contribution from an increase in sales?
2. If Inn-Room decides to implement the newly proposed discount, what will be the
cost of the marginal investment in accounts receivable?
3. If Inn-Room decides to implement the newly proposed discount, what will be the
marginal benefit of reducing the bad debt expense?
4. If Inn-Room decides to implement the newly proposed discount, what will be the
marginal cost of paying the cash discount to early paying customers?
5. If Inn-Room decides to implement the newly proposed discount, what will be the
net profit from implementing the proposed plan?
6. What additional factors should Inn-Room consider when making such an
important decision?
Case 16 : Home Depot
Working Capital and Short-Term Management: The Cost of Taking a Cash
Discount on Accounts Payable

Home Depot, the largest home improvement retailer in the world, is on the cutting edge
of retail innovations. Much of their quick and steady rise to success is attributed to their
approach to creating new customers and cultivating future customers. Through an idea
called Home Depot University, adults take a four week comprehensive course in home
improvement techniques which, of course, illustrate how the products sold by Home
Depot can be used to enhance and modernize homes. The potential of kids as
customers has not slipped their attention either. A program, known as "Our Kids
Workshops," teaches children not only safety and creativity, but also plants a loyalty
seed for the future.
Another means by which Home Depot has differentiated themselves from their
competition is by marketing what are called proprietary brands. This simply means that
the product lines are only offered at Home Depot. Once customers adopt the product,
they cannot buy it elsewhere. This is a way for Home Depot to protect their customer
base from discount retailers who compete purely on price and drive down profit
margins. One of Home Depot's proprietary brands is RIDGID who produce everything
from power tools to wet/dry vacuums and air filtration systems.
When Home Depot buys products from RIDGID, they use credit and have 45 days to
make full payment on these accounts payable. However, if Home Depot wants to take
advantage of RIDGID's 2% cash discount offer, they must pay within 15 days. To
simplify record keeping, RIDGID uses the end-of-month (EOM) method when
determining the beginning of the credit period. This simply means that any sales made
throughout the month will have a starting credit period beginning on the first day of the
next month.
For example, Home Depot recently purchased a shipment of stationary bench-top
power tools from RIDGID on December 23. Since RIDGID follows the EOM method,
Home Depot's credit period does not start until January 1. If Home Depot wishes to take
the 2% cash discount offered, they must make full payment by January 15. If not, they
must pay the entire amount by February 14.
Questions

1. Calculate the exact cost of giving up the discount.

2. Home Depot's risk-free required rate of return is currently 7%. The firm's
Weighted Average Cost of Capital (WACC) is 13.4%. Finally, the rate at which
the company can borrow from a bank is 9.7%. Should Home Depot take the cash
discount or should they wait until the full credit period is up? On which of the
above three figures did you base your comparison? Explain.
3. Calculate the approximate cost of giving up the discount.
4. Perform a sensitivity analysis using both the actual and the approximation
formulas with cash discounts of 1%, 2%, and 3% and credit periods of 30 days,
45 days, and 60 days. What is the relationship between these two variables and
the error yielded by the approximation formula?