Exercises chapter 14: Administration of working capital and current assets

P14.2 Changing the cash conversion cycle Camp Manufacturing completes its inventory
turnover 8 times a year, has an average payment period of 35 days and an average
collection period of 60 days. The company's annual sales amount to $3.5 million. Assume
that there is no difference in the investment per dollar of sales in inventory, accounts
receivable, and accounts payable, and that the year has 365 days.
c) If the company pays 14% for these resources, how much would its annual profits
increase by favorably changing its current cash conversion cycle to 20 days?
Data
Inventory turnover = 8 times
PPP = 35 days
PPC = 60 days
Annual sales = $3.5 million
Investment in resources = 14%

a)Calculate the company's operating cycle and cash conversion cycle.

EPI = Days of the year / Inventory Rotation =365 / 8 = 46 days

Operating cycle CO = EPI + PPC

CO = 46 Days + 60 days = 106 days
Cash Conversion Cycle CCE = EPI + PPC – PPP
CCE = 46 Days + 60 Days – 35 days = 71 Days
b) Determine the company's daily operating cash expenses. How much should you
invest in resources to sustain your cash conversion cycle?

Daily operating expenses = Total expense / 365

Daily operating expenses = $3,500,000 / 365
Daily operating expenses = $9589.04
Resource Need = Daily operating expenses x CCE
Resource Need = $9589.04 X 71 = $680, 821.92

Inventory = $3,500,000 x (46/ 365) = $441,095.89

Accounts receivable= $3,500,000 x (60/ 365)= + $575,342.47
Accounts payable = $3,500,000 x (35/365)=-$335,616.44
Resource Need = $680, 821.92

The company's daily operating expenses are $9,589.04 and it must invest in
resources to maintain its cash conversion cycle $680,821.92

b)If the company pays 14% for these resources, how much would its annual profits
increase by favorably changing its current cash conversion cycle to 20 days?

14% in CCE resources = 20 Days

Annual Profits = (Daily Expense x Cash Cycle Reduction)
Annual profits = (9589 * 20 days) (14%) = = $26,849.00
Your annual profits would increase by $26,849.20

P14.4 Aggressive Seasonal Funding Strategy Versus Conservative Strategy Dynabase

Tool forecast its total funding needs for the next year, which are shown in the table below.

a) Divide the funds required monthly by the company by 1. a permanent component

and 2. a seasonal component, and calculate the monthly average of each of these
components.
1) Permanent component 2) Temporary component

Month Amount
January $2,000,000
February 2,000,000
March 2,000,000
April 4,000,000
October 5,000,000
November 4,000,000
December 3,000,000
Month Amount
May $6,000,000
June 9,000,000
July 12,000,000
August 14,000,000
September 9,000,000
Average = $3,142,857 Average = $10,000,000
b) Describe the amount of long-term and short-term financing to satisfy the total need
for funds with: 1. an aggressive financing strategy and 2. a conservative financing
strategy. Assume that with the aggressive strategy, long-term funds finance
permanent needs and short-term funds are used to finance seasonal needs.
1)
Short-term Financing Cost = 10,000,000
Long-term Financing Cost = +22,000,000
Profit from excess balances = 0
Total cost of aggressive strategy = 32,000,000
2)
Short-term Financing Cost = 0
Long-term financing cost = 72,000,000
Profit from excess balances = -18,000,000
Total cost of conservative strategy = 54,000,000

c) If we assume that short-term funds cost 12% annually and that the cost of long-
term funds is 17% annually, use the averages obtained in part a) to calculate the total
cost of each of the strategies described in section b).
1)
Short-term Financing Cost = 0.1200 x 10,000,000 $ 1,200,000
Long-term Financing Cost = 0.1700 x 22,000,000 +3,740,000
Profit from excess balances = 0
Total cost of aggressive strategy = $4,940,000
2)
Short-term Financing Cost = 0
Long-term Financing Cost = 0.1200 x 72,000,000 $ 8,640,000
Profit from excess balances = 0.1700 x 18,000,000 -3,060,000
Total cost of conservative strategy = 5,580,000
d) Comment on the balances between profitability and risk related to the aggressive
strategy and those related to the conservative strategy.
Answer:
Short-term financing in the aggressive strategy makes the company riskier than the
conservative strategy due to sudden changes in interest rates and the difficulties of
obtaining short-term financing if resources are urgently required. The conservative strategy
avoids risks since the interest rate is guaranteed, however long-term financing is more
expensive.
P14.6 CEP, replenishment point and safety inventory Alexis Company uses 800 units of
a product annually, continuously. The product has a fixed cost of $50 per order, and its cost
to keep it in stock is $2 per unit per year. The company requires 5 days to receive a
shipment after placing an order and wants to hold it for 10 days as safety stock.
A)Calculate the CEP
CEP= √2x800x50 =200
2
b) Determine the average inventory level. (Note: Consider a 365-day year to calculate
daily usage.)
($2 x 800 units = $1,600.00)
Inventory Turnover 365/10 =36.5 ; 365/5 =73
($1,600.00/36.5 =43.84) the average 10-day inventory is 43.84 ($1,600.00/73 =21.92) the
average 5-day inventory is 21.92
c) Determine the replacement point.

d) Indicate which of the following variables changes if the company does not maintain
safety inventory: 1. order cost, 2. stock holding cost, 3. Total inventory cost, 4. replacement
point, 5. economic order quantity. Explain your answer.

P14.9 Changes in Accounts Receivable with Bad Debts A company evaluates a change
in its accounts receivable that would increase bad debts to 2 to 4% of sales. Currently, sales
are 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 is the dollar amount of bad debts currently and with the proposed change?
Currently the delinquencies equal to 50,000 * $20 * 2% = $1,000,000 * 2% = $20,000

Bad debts proposed equal to 60,000 * $20 * 4% = $1,200,000 * 4% = $48,000

b) Calculate the cost of the company's marginal bad debts.

The cost of marginal bad debt would be equal to $48,000 - $20,000 = $28,000
c) If we ignore the additional contribution of increased sales to profits, and the proposed
change saves $3,500 without producing any change in the average investment in
accounts receivable, would you recommend its implementation? Explain.
No, the change would not be recommended because it increases the debt by $28,000 for a
savings of $3,500 dollars and the proposed change is not worth it.
d) Considering all the changes in costs and benefits, would you recommend the proposed
change? Explain your answer.
Yes, because the additional contribution from sales is equal to 10,000.00 units per ($20-
$15) = $50,000 cost of marginal investment less $28,000.00 Cost of marginal debt equal to
The net benefit from applying the plan = $22,000
e) Compare and analyze the answers you gave in parts c) and d).
If we take into account the net benefit of the application of the proposed plan, it would be
advisable. To accurately evaluate the profitability of a proposal you must look at the
additional sales and subtract the marginal bad debt. Failure to account for additional sales,
as in part c, is not an appropriate way to analyze a proposal.

P14.13 Extension of the credit period Parker Tool is considering extending its credit
period from 30 to 60 days. All customers will continue to pay within the payment period.
Currently, the company invoices $450,000 in sales and has $345,000 in variable costs. The
change in credit conditions is expected to increase sales to $510,000. Bad debt expenses
will increase to 1 to 1.5% of sales. The company has a required rate of return on
investments of similar risk of 20%. (Note: Consider a year of 365 days).
a) What additional contribution of sales to profits will be obtained with the proposed
change?
b) What is the cost of the marginal investment in accounts receivable?
c) What is the cost of marginal bad debt?
d) Would you recommend this change in credit conditions? Because?