Chapter 16

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CHAPTER 16

THE MANAGEMENT OF WORKING CAPITAL

FOCUS
Day to day business runs on working capital. We can't do without it, but we'd like to use as
little as possible. Our focus is on understanding what's involved in running the routine aspects of a
business effectively without wasting resources. That means understanding the implications of decisions
about each of the working capital accounts and about how working capital is financed.
PEDAGOGY
Our approach is especially practical in this area. We stay away from optimization models and
concentrate on trade-offs that are generally analyzed with a little math and a lot of intuition. We provide
a special insight into internal relations and company politics in the area of receivables.
TEACHING OBJECTIVES
In this chapter students should gain an insight into the short term operating nature of working
capital and its importance in running any company. In particular they should understand that working
capital requires financing and appreciate the short term sources of funds available to support operating
needs. Further they should have a detailed understanding of the issues and problems associated with
managing each of the three major working capital assets: cash, receivables and inventories.
OUTLINE
I.

WORKING CAPITAL BASICS

The short term nature of the assets and liabilities that arise from routine operations.
A. Working Capital, Funding Requirements, and the Current Accounts
The conceptual relationship between working capital and the current accounts. The need to
fund net working capital. Spontaneous financing.
B. The Objective of Working Capital Management
Running the firm effectively with as little as possible tied up in W/C.
C. Operations - The Cash Conversion Cycle
Two graphic portrayals of how cash flows in and out of a company and through the working
capital accounts.
D. Permanent and Temporary Working Capital
The variation in W/C with business activity.
E. Financing Net Working Capital
W/C lends itself to short term financing.
Financing policies with respect to permanent and temporary W/C.
F. Working Capital Policy
The elements of W/C policy defined.

II. SOURCES OF SHORT TERM FINANCING

A. Spontaneous Financing
The nature of accruals and payables. Credit terms, prompt payment discounts
B. Unsecured Bank Loans
Notes, lines, revolvers, compensating balances.
C. Commercial Paper
The nature of commercial paper and its issuers.

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D. Short-Term Credit Secured by Current Assets
Pledging and factoring receivables. Inventory financing, liens and warehousing.

III. CASH MANAGEMENT

A. Definitions and Objectives
The motives for holding cash and the objective of achieving adequate liquidity while tying up
minimum resources.
B. Marketable Securities
Near cash liquidity with a modest return.
C. Check Disbursement and Collection Procedures
The check collection/clearing system and how it works.
D. Accelerating Cash Receipts
Lock boxes, concentration banking, wire transfers.
E. Managing Cash Outflow
Central vs. local cash management, remote disbursing.
F. Evaluating the Cost of Cash Management Services
Cost benefit analyses to determine if cash management systems are worthwhile.
IV. MANAGING ACCOUNTS RECEIVABLE
A. Objectives and Policy
The balance between more revenue with easy customer relations and potential bad debt losses.
A shared responsibility with sales.
B. Determinants of the Receivables Balance
Credit policy, terms of sale, collection policy, and the conflict with sales.
C. Summary and Conclusion- A Practical Management Warning
The politics of uncollected receivables can be a career pitfall for the CFO.
V. INVENTORY MANAGEMENT
Finance generally has an oversight responsibility for inventory management.
A. Who Is Responsible for Inventory
The primary responsibility is generally in manufacturing or operations. Finance has an
oversight function.
B. The Benefits and Costs of Carrying Inventory
Business runs smoother with more inventory but the costs include interest, storage, insurance,
and taxes along with exposure to shrinkage and obsolescence.
C. Inventory Control and Management
Balancing the costs and benefits of inventory.
D. The Economic Order Quantity (EOQ) Model
The popular model to balance ordering and carrying costs.
E. Safety Stocks, Reorder Points, and Lead Times
The concepts incorporated with the EOQ model.
F. Tracking Inventories - the ABC System
The effort expended in control should be related to the cost and importance of the inventory.
G. Just In Time (JIT) Inventory Systems
The objective of JIT and the practical limitations on its use.
QUESTIONS
1.
Explain the different circumstances under which firms should use short-term or long-term
financing.

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ANSWER: Whether financing should be long or short term depends on the longevity of the things it's
used to support. Long-term money is used to acquire things that remain with the firm for substantial
periods such as fixed assets or extended projects. These things are generally funded with money that
doesn't have to be paid back for similarly long periods like equity and long term loans. Short-term items
like inventory and receivables come and go quickly. They "turn over" constantly (there's always
inventory, but the items within it change). These assets are generally funded by trade credit or by short
term borrowing that has to be repaid in a relatively brief period.
The idea of short or long term financing is related to the maturity matching principle. Money should
be repayable when whatever it finances generates cash.
2.
Because companies always have inventory and accounts receivable, most banks are happy to
make long term loans to support those assets. Either refute or support that statement.
ANSWER: The statement isn't true. Although firms always have inventory and receivables, the
underlying assets in which the value resides turn over constantly. Therefore banks are willing to make
short-term loans based on those items.
3.
Describe the maturity matching principle. What are the risks of not matching maturities? How
would you characterize a firm that ignores the principle? Can you think of situations in which it would
be advisable for an otherwise prudent firm to deviate from the principle?
ANSWER: The maturity matching principle says that financing to support assets (and projects) should
be repayable at the time those items generate enough cash to make the repayments.
Financing long-term items with short-term money tends to reduce interest costs (short rates are
generally lower), but exposes one to the risk that refinancing will be either expensive or unavailable
sometime during the item's life. A firm that does that exposes itself to additional financial risk. This
can occur if management is imprudent or ignorant, or is forced into the situation because long-term
money isn't available.
Financing short-term needs with long-term money ignores the maturity matching principle, but is
conservative rather than risky. Such a policy implies funds will always be available for short-term
needs, but they may be more expensive than if acquired short term. Some very risk-averse managers
feel this is the right thing to do.
4.
Working capital spontaneously finances itself because it's being turned over all the time. Is this
statement true, false, or a little of both? Exactly what is meant by spontaneous financing? Does
working capital require funding? Why?
ANSWER: The statement is partially true. Spontaneous financing refers to the fact that some
resources, mainly inventory and labor, don't have to be paid for immediately. These unpaid liabilities
are reflected in the payables and accruals accounts. They remain on the balance sheet because new
inventory and labor are being acquired and used all the time. Typically, however, spontaneous financing
supports only a fraction of working capital requirements. Hence net working capital, the difference
between gross working capital (current assets) and spontaneous financing (current liabilities), requires
funding.
5.
Working capital is generally defined as the difference between current assets and current
liabilities. Is this definition precisely correct? Why?
ANSWER: No. The working capital concept involves the assets and liabilities that arise from the
normal day to day activities of a business. These are only roughly equivalent to the current accounts in
most companies. Things like prepaid expenses and the current portion of long term debt are included in
the current accounts but conceptually aren't working capital items.

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6.

Support or challenge each of the following statements individually:

a. Because accounts receivables aren't purchased like inventory or fixed assets, they don't require
financing.
b. Cash represents a pool of available money, so it actually reduces financing needs.
ANSWER: a. A receivable is generated when product is shipped reflecting the fact that a sale has been
made. Building the product, however, requires cash that isn't recovered until the receivable is collected.
Therefore, receivables require funding.
b. Cash is money in the bank available to pay bills and transact business. That money has to be
deposited and therefore represents an asset just like a machine or an inventory item. In effect, the firm
"buys" an account balance at the bank. Therefore cash requires financing. It certainly doesn't reduce
the need for financing.
7.

How does a firm's operating cycle differ from its cash conversion cycle? Explain fully.

ANSWER: A business's operating cycle begins with the purchase of inventory that in time is turned
into product and sold. The sale results in a receivable that becomes cash when collected. The cash is
used to purchase more inventory starting the cycle again. The term operating cycle refers to both the
sequence of events and the time required to go through it once. The cash conversion cycle is the
operating cycle in days less the payables deferral period, which is the time between receiving and
paying for inventory.
8.
You work in the finance department of a manufacturing company. Over lunch, a friend in the
engineering department said she'd heard that the firm used a lot of temporary working capital. Because
temporary equipment is usually of lower quality than permanent material, she wonders why the
company, which is quite prosperous, doesn't buy the best and store it when it isn't needed.
What misconceptions does your friend have? Write a brief explanation for someone who knows
nothing about finance to straighten out her understanding.
ANSWER: Your friend probably thinks working capital is an asset that's purchased like a machine or
building. In this misconception she's confusing working capital with capital equipment.
Working capital refers to the assets and liabilities that arise from the everyday running of the
business including cash, receivables, and inventory, less payables and accruals. These things depend on
the level of business being done at a point in time, and can vary over the year if volume is seasonal.
Permanent working capital refers to the minimum level required during an annual cycle. Temporary
working capital is the increase over the minimum level required when seasonal increases occur. There
isn't a quality issue in the distinction.
9.

Why does it make sense to finance net working capital separately from fixed assets?

ANSWER: The assets making up working capital turn over regularly in short periods. They also tend
to generate cash shortly after they're held. This situation lends itself to short term financing. Fixed
assets, on the other hand, require commitments of funds for long periods. It makes sense to finance
these items separately, because of their different terms.
10.
You work in the finance department of HiTech Inc. The firm's owner and CEO, Charlie Dollars,
is very profit oriented. He understands that short-term interest rates are quite low at the moment, and
has suggested that the firm finance all of its working capital needs with short term loans. The CFO has
asked you to prepare a memo for his signature outlining why this may not be the best strategy. In your
memo, outline the working capital financing options available to most firms and discuss the trade-offs
involved in using long term versus short term financing

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ANSWER: Working capital can be financed by either short- or long-term funds. Short-term money is
always borrowed while long-term funds can be either debt or equity. Short-term financing is usually
cheaper (lower interest) but has to be renewed periodically as loans become due for repayment. This
means a strategy of supporting working capital with short-term borrowing requires a continuous series
of new loans.
This creates a risk, because short rates do sometimes exceed long rates. Worse, situations
occasionally occur in which refinancing isn't available at any rate. That can put a company out of
business, because it suddenly has no way to sustain its working capital requirements.
Therefore, in order not to risk ruin, most companies limit their short term financing, and use some
long-term debt and/or equity to support working capital.
11.
What are the advantages and disadvantages of stretching payables? If you owned your own
business, would you do it? Why or why not?
ANSWER: Slowing cash payments to vendors is known as stretching payables or leaning on the trade.
It generally means paying in a longer period than specified by the terms of sale. The practice conserves
the payer's cash reducing the need for working capital financing which saves interest expense. The
disadvantage is that it offends suppliers who want to be paid on time making them reluctant to do
business with the slow payer. In extreme cases suppliers refuse to make further credit sales to slow
paying customers demanding cash in advance. This can cause disruptions in the slow payers production
and administrative processes.
Stretching payables also affects a firm's credit rating. Vendors report slow payers to credit bureaus,
which include the information in their reports. Being labeled a slow payer makes it more difficult to get
credit of any kind. In other words, paying vendors slowly today can keep you from getting a bank loan
or credit from a new vendor tomorrow.
The firm that stretches payables walks a fine line. Most vendors will tolerate a little tardiness, the
trick is not to overdo it. Whether you would do it or not is a matter of personal preference.
12.
What's the difference between a promissory note, a line of credit, and a revolving credit
agreement? Are they mutually exclusive? That is, might one be part of the other?
ANSWER: A promissory note is a contractual document associated with a specific loan. A line of
credit and a revolving credit agreement are agreements between a company and a bank as to the
maximum amount the firm can borrow during a specified period. The line is informal meaning the
unused portion can be revoked by the bank at any time. The revolver is a commitment to have funds
available and requires a commitment fee on unused balances. Individual loans made under either a line
or a revolver may have separate promissory notes.
13.
Explain the difference between pledging and factoring receivables. Which is likely to be more a
more expensive source of financing? Is factoring the same kind of financing as pledging?
ANSWER: Pledging involves borrowing money based on the collateral value of receivables. The
accounts continue to belong to the borrowing company, which is responsible for their administration and
collection. Factoring means actually selling the receivable to the factor, who then takes care of
collection. Factoring is more expensive because the financial institution does more work.
14.

Factoring may involve interest even though it isn't a loan. How can this come about?

ANSWER: If the factor pays its customer (the firm selling the receivable) before money is collected
from the customer, it is out funds until collection is actually made. In such cases the factor's charges
have to include interest for that interim period.

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15.
What is the biggest problem associated with financing secured by inventory? How is it
addressed in practice?
ANSWER: The biggest administrative difficulty associated with inventory financing is keeping track
of the secured material and making sure it's available to the lender in the event of default. The difficulty
arises because the borrower needs to continue to use the inventory during the financing period. This
makes continuous monitoring necessary for complete security. Third party warehousing companies are
able to do that, but their services are expensive.
16.
Outline the reasons for holding cash and the big cost associated with it. How do these lead to
the objective of cash management? How do marketable securities help or hinder achievement of the
objective?
ANSWER: Cash is held to conduct normal business activities (transactions demand), to provide the
capability of handling emergencies (precautionary demand), and to take advantage of unexpected
opportunities (speculative demand). It may also be necessary to hold cash to satisfy compensating
balance requirements. Having enough cash is known as having adequate liquidity
The problem associated with holding cash is that it earn a very small return if any at all. Therefore it
isn't wise to tie up any more money than necessary in cash balances. The objective of cash management
is to balance the need for liquidity with cost of holding extra cash. Marketable securities help in
achieving the objective because they provide nearly the liquidity of cash, but also offer a modest return.
17.
The Medco Supply Co. operates out of Waco, Texas, and has a number of customers around
Portland, Maine. It seems to take a particularly long time for the Portland customers' payment checks to
reach Medco. What can the company do to speed things up? Explain how your solution would work.
ANSWER: Medco's mail float from Maine can be reduced by installing a lockbox in Portland that is
operated by a local bank. Customers in that area would mail payment checks to the Portland lockbox
which would be deposited in the check clearing system by the bank immediately. This avoids the delay
of mailing all the way to Texas.
18.
Sally Johnson lives in Baltimore, and does business with a large, national brokerage firm.
When she sends the broker a check, she mails it to a local address in Baltimore. However, when she
receives a check, from the broker, it comes from San Francisco. Her sister Joan lives in Los Angeles
and uses the same firm. She mails payments to an office a few blocks from her home, but receives
checks from an office in Miami. What's going on? Should the Johnson sisters be upset?
ANSWER: The brokerage firm is playing the mail float to its advantage at the expense of clients.
Receipts travel a short distance so the firm gets its money quickly. Disbursements, on the other hand,
travel cross-country keeping customers' funds in the firm's account a few days longer where it earns
interest.
The Johnson sisters have a right to be upset. This kind of dealing is a violation of the trust inherent
in the broker-client relationship (called a fiduciary relationship).
19.
You're the cash manager for Huge Inc., which has factories and stores all over the country.
Each operation has several bank accounts to receive deposits and pay vendors, so the company's cash is
spread all over the country under the control of divisional CFO's. It's essential that those divisional
executives have control of their cash to run their operations effectively. However, the rather substantial
cash total isn't earning anything because it's too dispersed to be invested in marketable securities.
Suggest a way to fix this problem and explain how it will work.

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ANSWER: Huge should consider concentration banking in which a single bank monitors the amounts
in remote locations daily, and sweeps excess amounts into a central account. The central balance is
likely to be large enough to be invested effectively.
20.
Every company should take full advantage of the sophisticated cash management services
offered by today's banking industry. Right or wrong? Explain.
ANSWER: Wrong. Cash management systems should only be used if they save money. The benefit of
sophisticated systems is that they reduce cash balances, which reduces the amount of working capital
financing needed, which in turn saves on interest expense. The cost generally involves a fixed annual
fee for setup and maintenance and a variable charge related to volume. For the system to be cost
effective, the interest savings it generates have to exceed its total cost.
In small firms the cash volume affected by a system may not be large enough to generate interest
savings sufficient to cover its cost. In such cases sophisticated techniques shouldn't be used.
21.
Outline the costs and benefits involved in the trade-off between a tighter versus a looser
receivables policy.
ANSWER: A tighter receivables policy means credit is granted only to higher quality customers and
overdue receivables are pursued more aggressively. This reduces bad debt losses but also tends to
offend customers and lower sales.
22.
Inventory management is a shared responsibility between finance and manufacturing just as
receivables management involves both sales and finance. Right or wrong? Explain.
ANSWER: Wrong. Finance rarely has a direct responsibility for inventory. Manufacturing or
operations executives usually determine what and how much to carry. Finance has an overview
responsibility to ensure inventory is usable and current and that the firm isn't carrying more than it
needs.
23.
Because of the advances in computer technology, inventory management is a precise science,
and there's no excuse for not having the optimal quantity on hand at all times. Is that statement true or
false? Explain.
ANSWER: False. Inventory management is far from an exact science. Cost effective inventories are
achieved through frequent reviews of what is needed and what is on hand, attention to detail, and a
combination of manual and automated tracking systems.
24.
Does the EOQ model properly applied prevent stockouts? Does it address stockouts at all? Do
you think the EOQ model solves very many of management's inventory problems?
ANSWER: The EOQ model itself doesn't address stockouts. The safety stock concept does. Hence
when EOQ is combined with a safety stock the overall model does help to manage stockouts. EOQ
itself just balances the cost of ordering against the cost of holding inventory. These issues are a small
part of overall inventory management. EOQ is presented in most text because it is concise and easy to
understand. However, it may give the impression that there's less to inventory management than there
really is, and that the subject is more precise than it actually is.
25.
The Philipps Lighting Company manufactures decorative light fixtures. Its revenues are about
$100 million a year. It purchases inputs from approximately 20 suppliers most of which are much larger
companies located in various parts of the country. Sam Spade, the vice president of manufacturing is a

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sophisticated executive who has always been very impressed by the latest innovative techniques in
management.
Last week Sam came into a meeting of the executive team with a proposal to cut inventory costs to
almost nothing. Just in time (JIT) is the wave of the future, he said, and proposed that Philipps enter
into negotiations with of all its suppliers to implement the concept immediately.
You're the CFO and tend to be more skeptical about new methods. Prepare a memo to the team,
tactfully outlining the problems and risks involved in Sam's proposal.
ANSWER: Staff: JIT is a great idea in theory, but it has two important practical problems. The firm
using JIT is essentially pushing the task of carrying its inventory back onto its suppliers. That means the
suppliers have to be willing to work very hard to maintain the inventory and to ensure precisely timed
shipments arrive "just in time" for production. Suppliers are generally willing to do that only if the
customer using JIT is very important to them. For example, suppose a company makes piston rings, and
sells 90% of its output to General Motors. That firm will go to any lengths to keep GM's business,
including orchestrating timely JIT deliveries. If the piston ring manufacturer sold its output to 20 or 30
different customers, it wouldn't be particularly motivated to do JIT for any of them.
Since Philipps doesn't buy a large portion of the output of any of our suppliers, it's hard to imagine
that they would be willing to go to the trouble of managing JIT shipments for us.
Distance is another complicating factor. If suppliers are located far away, a trucking company is
between them and the JIT company. That means the trucker also has to commit to precisely timed
deliveries to make the JIT idea work. That can be almost impossible if large distances are involved.
This would be a big problem in our case, since our suppliers are from several hundred to thousands of
miles away.
Further, the risks of JIT are substantial. If we're not carrying inventory and a promised shipment
fails to arrive, everything stops. That can obviously be very costly.
In summary, although JIT has some benefits for very large and powerful companies, I doubt that
it will be feasible for us.
BUSINESS ANALYSIS
1.
You're a supervisor in the treasury department of Big Corp. Recently there's been increasing
concern about the firm's rising interest costs. Fred Eyeshade is an analyst in your group who transferred
from the accounting department a short time ago. He has suggested that senior management mandate a
50% across the board cut in cash, inventory, and receivables along with a doubling of payables to reduce
the firm's financing needs for net working capital. Explain why this might not be a good idea with
respect to each of the elements of net working capital (four accounts).
ANSWER: Reducing current assets and increasing current liabilities reduces the money tied up in
working capital. That reduces related borrowing and saves interest expense. However these actions can
be overdone. Collecting receivables too aggressively offends customers and can reduce sales. Too little
inventory in production can cause expensive idle time and missed schedules. A lack of inventory can
also cause stockouts at the point of sale, which delay customer orders and can result in lost business.
Similarly, too little cash can make it impossible to pay bills on time and conduct business efficiently.
Stretching payables offends vendors and can lead to higher prices for input and delays in resupply.
Unless working capital is being managed very poorly, Fred's suggestion is probably too drastic and
might hurt more than it helps.
2.
Things tend to run more smoothly and efficiently with more working capital. With respect to
receivables and inventory, explain why this statement isn't absolutely true. In other words, why might a
very large inventory or receivables balance not do much good at all?

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ANSWER: Large balances in receivables may indicate the presence of uncollectible items that should
be written off. A big inventory account can imply material that's useless because it's damaged or
obsolete. In both cases the items are "inactive," and lie under the things that are turning over. They
don't help in running the company because they aren't used for anything.
3.
You and your friend Harry have started a business. Harry is a technical whiz, but doesn't know
much about business or finance. After several months you've been approved for a $100,000 bank loan
at what seems to be a rather high interest rate, 12%. Harry is especially bothered by the rate. He thinks
banks shouldn't get any more than 4% or 5%, but doesn't really know why he feels that way. When you
both were about to sign the loan papers the banker mentioned that a minimum balance of $20,000 would
have to remain in the bank. Hearing this, Harry pulled out his calculator and made a calculation at
which he became outraged. He then stormed out of the meeting.
Why is Harry so upset? What calculation did he make? Write a short memo explaining banking
practices to calm Harry down. Is there a kind of minimum balance requirement that might make Harry's
calculation invalid?
ANSWER: Harry's calculation probably figured the effective interest rate on the loan with a 20%
minimum compensating balance. This would have been 12% / .8 = 15%, a rate that does seem
excessively high. It seems that the bank is being devious by quoting 12% when it's actually charging
15%. However, minimum balances are a standard practice designed to "compensate" banks for their
services.
Further, Harry probably doesn't understand two things about the loan business, the bank's cost and
its risk.
The bank lends businesses money it "borrows" from depositors, and operates on the "spread"
between the interest it pays out and the rate it charges on loans. When interest rates are up, both of these
rates are high, but the bank doesn't get to keep any more money that it does when rates are lower.
Spreads are generally between five and ten percent. Out of that the bank has to pay all of its operating
costs, cover loans that default, and make a profit. Harry's anger should be directed at generally high
rates, which usually reflect inflation, rather than at the bank.
The other thing Harry should keep in mind is risk from the bank's viewpoint. To the loan committee
your business is a high-risk venture with a good chance of failure which implies a default on their loan.
The bank has to be compensated with interest for bearing that risk. Admittedly, it's hard for
entrepreneurs to identify with that view of themselves.
Things may not be as bad as they seem if the requirement is for an average minimum balance. In
that case all of the loaned money can be used at times as long as an average balance of at least 20% is
maintained. You might have done that anyway.
4.
You're the CFO of the Wachusett Window Company, which sells windows to residential
builders. The firm's customers tend to be small, thinly capitalized construction companies that are
frequently short of cash. Over the past year, there's been a slump in the housing industry and
Wachusett's sales have slowed. Several months ago the marketing department initiated a program to
attract new customers to counteract the downward sales trend. The VP of Marketing and the president
agreed that the firm would have to deal with even smaller, newer builders if it was going to keep sales
up. At the time the president overruled your concerns about the credit quality of such customers. He
personally approved a number of accounts brought in by the sales department that ordinarily wouldn't
have qualified for credit.
More recently receivables have gone up substantially, and collection efforts have been less
successful than usual. Collectors have asked for help from sales representatives in chasing down
delinquent customers, but the VP of marketing says they don't have time because "reps have to be out on
the street selling."
The president has suddenly become concerned about the receivables increase, and has demanded to
know why Finance has let it happen. Prepare a memo explaining the processes behind the creation and

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management of receivables and explain what's behind the increase. Tactfully explain why the blame
should not be placed solely on the finance department. Can you argue that finance is completely
without fault in this matter?
ANSWER: Receivables are ordinarily considered the responsibility of the finance department.
However, the appropriate management of problem accounts calls for consideration of how they arise in
the first place.
In the normal course of events receivables come from credit sales proposed by the sales/marketing
department and approved by the credit and collections department. The approval by the credit
department is key to the idea that finance is responsible for collection. It signifies a judgment by
specialists that the debt is likely to be collectible. Rejection signifies a high probability that the
account will not be collected and will result in a loss.
The sales department, on the other hand, is responsible for delivering customers. Salespeople
don't generally worry too much about credit worthiness, because under normal conditions the credit
department takes care of that.
In our current situation, we made the decision to extend credit despite concern about several
customers' ability to pay. This has created a delinquency situation that we have to work together to
resolve.
When a receivable isn't paid, the credit department starts calling and writing the customer. Those
contacts, however, tend to be with lower level administrative personnel. In collecting from cash poor
companies, the trick is to get the debtor to prioritize our bill over those of other vendors. People in the
customer's payables department don't have the authority or motivation to do that. Getting paid by
troubled companies generally takes an executive decision, and it's relatively hard for collectors to get to
the customer's executives.
The sales force, on the other hand, tends to have an ongoing relationship with people higher up in
the customer organization who can prioritize bill payments. In problem situations, that relationship can
be crucial to successful collection of the account. The sales rep is in the best position to present the
customer with the reality that unless the old bill is paid, we can't supply any more product. In small
cash poor companies, that pitch generally has to be made to the president, and the salesperson has much
better access to that office than the bill collector.
It's therefore imperative that the collections department get some help from sales to work the
overdue receivables. Without that we're unlikely to collect much. This needs to happen quickly,
because the older receivables get, the less likely they are to be collected.
In this case, because of the nature of the customers involved, we should probably get ready for some
loss whatever we do.
(Notice the wording of the first four paragraphs. The problem is the fault of the president and the
VP of marketing, because they made the decision to lower credit standards over the CFO's objection.
However, it would rarely be wise to come right out and say that. Saying, "I told you so," to your boss
isn't likely to get you anything but grief. The idea is to gently remind the president of how the situation
came about without accusing anyone of fault, and then to quickly focus on the team effort required to
fix the problem. Particularly notice the wording in the fourth paragraph "we" made the decision..., not
"you" made the decision...
Also notice the last paragraph. It would be unwise to give the impression that everything will be ok
if you get some help from sales. There's very likely to be a write-off required, and its better not to
surprise the president with that later.
Unfortunately, it's possible that the CFO is going to be the scapegoat in this situation regardless of
what he or she does. Many top executives don't like to admit that they were wrong, and routinely lay
the blame for mistakes elsewhere.)
5.
In the situation at Wachusett Window outlined in the last question, do you think a higher prompt
payment discount alongside the new sales program would have kept receivables down? Why?

The Management of Working Capital

132

ANSWER: No. The problem customers aren't likely to have the cash to pay their bills promptly
regardless of the incentive offered. An additional discount would probably hurt because it would be
taken by customers who are already paying on time.
6.
Speculate on the nature of the relationship between the credit and collections department and
the sales department at Wachusett Window in the last two questions.
ANSWER: It probably isn't too good. Credit and collections is likely to be resentful of the override of
their rejections and to be really upset that the accounts are now proving to be problems. The fact that
sales is unwilling to help in the collection effort is probably rubbing salt in the wound.
7.
Wildebrant Inc runs out of inventory all the time both in the factory and at the point of sale.
However, the company is profitable, and no one worries about it much. Is this ok? What's probably
going on that management doesn't see? Why don't they see it? What would you suggest to fix the
problem? How would it work?
ANSWER: The problem is that the cost of running out of inventory isn't identified on financial
statements. Shortages result in lower sales when they prevent filling orders and higher costs when they
disrupt production, but those effects are buried in the financial results and aren't explicitly identified as
being the result of inventory problems. When a company is profitable, such inefficiencies tend to be
overlooked. They frequently aren't identified until times get tough and people start to look for ways to
increase sales and lower cost. This, of course, is a mistake, because the firm could be doing even better
in good times if it controlled inventory more effectively.
The problem can be addressed by a tracking system that creates a report whenever a stockout occurs.
An estimate can then be made of the financial consequences of each stockout. Compiling a list of all
stockouts every month for management review will go a long way to motivate some attention to
watching inventory levels more closely.

PROBLEMS
Definitions: (pages 665 667)
1.

Scherbert Industries has the following balance sheet accounts as of 12/31/x3 (not a complete
balance sheet):
Accounts Payable
Accounts Receivable
Accruals
Cash
Common Stock
Fixed Assets (net)
Inventory
Long Term Debt

$650,000
845,000
257,500
137,200
1,200,000
8,250,000
655,000
3,500,000

Calculate gross and net working capital.

SOLUTION:
Gross Working Capital = Cash + A/R + Inventory
= $137,200 + $845,000 + $655,000
= $1,637,200
Working Capital
= Gross Working Capital A/P Accruals

133

Chapter 16
= $1,637,200 - $650,000 - $257,500
= $729,700

Cash Conversion Cycle: Figure 16-2 (page 669)

2.
Southport Inc. has an inventory turnover of 10X, an ACP of 45 days, and turns over its payables
once a month. How long are Southport's operating and cash conversion cycles? (Use a 360-day year.)
SOLUTION:
Inventory Conversion Period
Operating Cycle

= 360/10 = 36 days
= Inventory Conversion Period + ACP
= 36 + 45 = 81 days

Cash conversion Cycle

= Operating Cycle Payables Deferral Period
= 81 30 = 51 days

Working Capital Financing Policies: Example 16-1 (page 673)

3.
The Langley Corporation is in a seasonal business. It requires a permanent base of net working
capital of $10 million all year long, but that requirement temporarily increases to $20 million during a
four-month period each year. Langley has three financing options for net working capital.
a. Finance the peak level year-round with equity which costs 20%, and invest temporarily unused
funds in marketable securities which earn 6%.
b. Finance permanent net working capital with equity and temporary net working capital with a
short-term loan at 12%.
c. Finance all net working capital needs with short-term debt at 12.5%.
Calculate the cost of each option. Which would you choose? Why?
SOLUTION: Net W/C levels: $10M for 8 months
$20M for 4 months
a. $20M .20
= $4,000,000
$10M .06 (8/12) = 400,000
$3,600,000
b. $10M .20
=
$2,000,000
+$10M .12 (4/12) =
400,000
$2,400,000
c. $10M .125
=
$1,250,000
+$10M .125(4/12) =
416,667
$1,666,667
The decision is subjective depending on the firm's profitability and the likely prospects for future
increases in short term rates.

Prompt Payment Discount (page 675)

4.

Calculate the effective interest rate implied by the following terms of sale, using a 365-day year.
2/10, net 30

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134

1/5, net 15
.5/10, net 30
2.5/10, net 25
1/5, net 20
SOLUTION:
(365/20) 2 = 36.5%
(365/10) 1 = 36.5%
(365/20) 1/2 = 9.125%
(365/15) 2.5 = 60.833%
(365 /15) 1 = 24.333%
5.
Rocky Inc. can buy its inventory from any of four suppliers all of which offer essentially the
same pricing and quality. Their credit terms, however, vary considerably as follows:
A
2/10, net 30
B
3/5, net 20
C
1/20, net 45
D
3/5, net 90
a. Calculate the implied interest rate associated with each policy.
b. If Rocky buys some material from each vendor, which discounts should it take and which
should it forego if it pays 18% for working capital financing? Why?
SOLUTION:
a.

A
B
C
D

(365 / 20) x .02 = 36.5%

(365 / 15) x .03 = 73.0%
(365 / 25) x .01 = 14.6%
(365 / 85) x .03 = 12.9%

b. Rocky is effectively borrowing at the rates calculated in part a if does not take the discounts offered.
Hence Rocky should pay promptly and take the discounts from suppliers A and B, because those rates
are much higher than the 18% it pays for working capital financing. I.e., it should avoid borrowing
from suppliers A and B. On the other hand, Rocky should forego the discounts, pay on the net date, and
effectively borrow from suppliers C and D, because those rates are lower than the 18% it pays for
working capital financing.

Revolving Credit Agreements: Example 16-2 (page 678)

6.
Thompson Inc. has a $10M revolving credit agreement with its bank. It pays interest on
borrowing at 2% over prime and a % commitment fee on available but unused funds. Last month
Thompson had borrowings of $5M for the first half of the month and $10M for the second half.
Calculate its interest charges for the month. The banks prime rate is 6%.
SOLUTION:
The interest rate on borrowing is 6% + 2% = 8%
Monthly rate is 8%/12 = .6667% (multiply by .006667)
Interest charges:
First half of the month:
$ 5M .006667 = $16,667.50
Second half of the month:
$10M .006667 = $33,335.00
The monthly commitment fee rate on unused funds is
.25%/12 = .02083% (multiply by .0002083)
First half of month: $5M .0002083 =
$ 520.50

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Chapter 16
Second half of month: none

$
0.00
$50,523.25

7.
The Conejo Corp. borrows from its bank under an $8 million revolving credit arrangement. It
pays a base rate of 9% on its outstanding loan plus a % commitment fee on the unused balance. The
firm had borrowed $2 million going into April and borrowed an additional $4 million on April 11. No
further borrowing or repayment was made during the month. Calculate Canejos interest charges for
April.
SOLUTION:
Interest monthly rate: 9%/12 = .75% (multiply by .0075)
$2,000,000 was outstanding for the first ten days of the month
$2M .0075 (10/30) = $5,000
$6,000,000 was outstanding for the last twenty days of the month
$6M .0075 (20/30) = $30,000
Commitment fee monthly rate: .25%/12=.02083% (multiply by .0002083)
The unused balance was $6,000,000 for the first 10 days
$6,000,000 .0002083 10/30 = $417
The unused balance was $2,000,000 for the last 20 days
$2,000,000 .0002083 20/30 = $277 $278
Total financing charges are the sum of these
$30,000 + $5,000 + $417 + $278 = $35,695
8.

The Grass Ridge Company has the following current asset accounts
Cash
Accounts Receivable
Inventory

$1,900,000
$4,600,000
$5,500,000

Its current ratio is 2.5:1. The bank is willing to lend the company enough to finance its working capital
needs under a $10 million revolving credit arrangement at a base rate of 12% with a 3/8% commitment
fee on the unused balance. If the current accounts stay relatively constant throughout the year, what will
Grass Ridge pay the bank for working capital financing?
SOLUTION:
C/L = $12M/$2.5 = $4.8M
Net W/C = $12M $4.8M = $7.2M = Average amount borrowed
Unused commitment = $10M $7.2M = $2.8M
Interest = $7.2M .12
Commitment fee = $2.8M .00375
Total W/C financing charges

= $864,000
=
10,500
$874,500

9.
Bridgeport Inc has a $30 million revolving credit agreement with its bank at prime plus 3.2%
based on a calendar year. Prior to the month of April, it had taken down $15 million that was
outstanding for the entire month. On April 10, it took down another $5M. Prime is 8.2%, and the

The Management of Working Capital

136

bank's commitment fee is .25% annually. Calculate the charges associated with Bridgeport's revolving
credit agreement for the month of April.
SOLUTION:
k = 8.2% + 3.2% = 11.4% => .95% monthly
commitment fee = .25% => .0208% monthly
Outstanding in April:

$15M for the whole month

$ 5M for 2/3 month

Unused balance:

$30M $15M
$30M $15M $5M

= $15M for 1/3 month

= $10M for 2/3 month

Interest:
[$15M + (2/3)$5M](.0095) = $174,167
Commitment fee:
[(1/3)$15M + (2/3)$10M](.000208) =
2,427
$176,594

Compensating Balances: Example 16-3 (page 679)

10.
What is the effective interest rate on a $750,000 loan at 8% for 120 days if a 20% minimum
compensating balance is required?
SOLUTION: 8%/(1 .20) = 10%
11.
Calculate the effective interest rate on loans with the following minimum
compensating balance requirements:
Loan Rate
Compensating Balance
a.
6.5%
20%
b.
12.0%
10%
c.
10.5%
15%
d.
14.0%
25%
e.
8.5%
30%
SOLUTION:
a.
b.
c.
d.
e.

6.5/.8 = 8.125%
12.0/.9 = 13.333%
10.5/.85 = 12.353%
14/.75 = 18.667%
8.5/.7 = 12.143%

Pledging Accounts Receivable: Example 16-4 (page 681)

12.
Jenkins Appliances has cash flow problems and needs to borrow between $50,000 and $60,000
for approximately sixty (60) days. Because the business is small and relatively new, unsecured loans are
very hard to get and are expensive when they are available. The bank has offered such a loan at 25%.
Climax Inc., A finance company, has offered an alternative loan if receivables are pledged as collateral.
Climax will lend 70% of the average receivables balance for 14% plus an administrative fee of $1,200.

137

Chapter 16

Jenkins average receivables balance is $80,000. Which alternative should Jenkins choose? Calculate
using a 360-day year. Assume the bank is willing to lend the same amount as Climax.
SOLUTION:
Assume that the loan will be $80,000 x 70% = $56,000
Cost of 25% loan for 60 days: $56,000 x .25 x 60/360 = $2,333.33
Cost of pledging: $56,000 x .14 x 60/360 + $1,200 = $2,506.67
Hence the bank loan is cheaper.
13.
DeSquam Inc. pledges receivables of $250M per year to the Sharkskin Finance Company which
advances cash equal to 80% of the face value of the accounts pledged. DeSquams receivables are
usually collected in about 36 days, so 10% of the annual amount advanced is generally outstanding at
any time. (36 days is one tenth of a year, so receivables turn over ten times a year.) Sharkskin
charges 14% interest plus an administrative fee of 1.6% of the amount pledged. What is DeSquams
cost of receivables financing? State the result in dollar terms and as a rate.

SOLUTION:

Amount advanced per year = $250M .8 = $200M

Average amount outstanding @ 10% = $200M .10 = $20M
Interest on loan = $20M .14 = $2.8M
Administrative fee = $250M .016 = $4M
Total financing charges = $4.0M + $2.8M = $6.8M
Charges as a % of avg loan balance = $6.8 / $20M = 34%

14.
The York Company has an average receivables balance of $55,000, which turns over once every
30 days. It offers all of its receivables to its bank as collateral for short-term borrowing (pledging). The
bank generally accepts 60% of the accounts offered and advances cash equal to 85% of those. Interest
is 3% over prime and the bank charges a 1% administrative fee on the gross value of all accounts
offered. The prime rate is currently 9.5%. What effective rate is York paying for its receivables
financing?
SOLUTION:
Gross amount offered = $55,000 12 = $660,000
Administrative charge rate:
.01
Administrative fee
$ 6,600
Average loan balance = $55,000 .60 .85 = $28,050
Interest rate = 9.5% + 3% = 12.5%:
.125
$ 3,506
Total financing charges

$10,106

Effective interest:
Total Financing Charges
$10,106

36.0%
Average Loan Balance
$28,050

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138

Factoring Receivables: Example 16-5 (page 683)

15.
Southern Fabrics Inc factors all of its receivables. The firm does $150 million in business each
year, and would have an ACP of 36.5 days if it collected its own receivables. The firm's gross margin is
35%. The factor operates without recourse and pays immediately upon taking over the accounts. It
discounts by 10% the gross amount factored and pays Southern immediately. Because the factor doesn't
collect from customers until they pay, it charges interest at 10% in the interim.
a. Calculate the gross cost of factoring to Southern Fabrics if all receivables are collectible.
b. What interest rate is implied by the arrangement?
c. Suppose Southern is considering giving up the factoring arrangement and handling its own
collections. Should the firm do it if bad debt losses are expected to average 3% of gross sales and
running a collections department will cost about $1.5 million per year? Assume the interest cost of
carrying the receivable balance is also 10%.
d. What is the implied interest rate in the factoring arrangement if the costs in part c are taken into
account?
SOLUTION:
a.
Factor's Discount = $150M .10 = $15M
Interest = (36.5 / 365) .10 $150M = 1% $150M = $1.5M
Total charges = $16.5M
b.
Ordinary A/R balance = $150M (36.5/365) = $15M
Implied interest = Total financial charges/loan balance
= $16.5M/$15M = 110%
c.
The cost of doing the collections job includes the cost of product lost on the bad debts (not the
entire amount of the lost revenue since the gross margin on those sales isn't an actual loss) and the cost
of running a collections department.
Bad debt losses = $150M 3% .65
Collection department expense
Interest on A/R balance @ 10%

= $2.9M
= $1.5M
= $1.5M
$5.9M
Southern is better off to do the job itself, since the cost is considerably less than the $16.5M the firm is
paying to the factor.
d.
($16.5M $5.9M)/$15M = 70.67%

Inventory Financing: Example 16-6 (page 684)

16.
Central City Bank will lend Williams Inc. 60% of the value of its inventory at 12% if Williams
will pledge the inventory as collateral for the loan. The bank also insists that Williams employ a
warehousing company to monitor and control the inventoried material. Blyth Warehousing will do the
job for an annual fee of $150,000 plus 2% of the value of all the inventory it handles. Williams moves
inventory valued at about $15M through its plant each year at a turnover rate of 5 times. What will the
cost of financing be under this proposal? State the result in both dollar and percentage (of amount
borrowed) terms.

SOLUTION:
Average inventory balance = $15,000,000 / 5 = $3,000,000
Average loan @ 60% of inventory = $3,000,000 .6 = $1,800,000
Interest on average loan balance = $1,800,000 .12 = $216,000
Handling fee = $150,000 + ($15,000,000 .02)

139

Chapter 16
= $150,000 + $300,000 = $450,000
Total charges = interest + handling = $216,000 + $450,000 = $666,000
Financing cost as a % of average loan = $666,000 / $1,800,000 = 37%

17.
The Shamrock Company has a raw materials inventory of $20M, which is completely replaced
approximately 10 times a year. The Bridgewater Bank is willing to advance financing of 75% of the
value of Shamrock's inventory at an interest rate of 12%. However, it requires a warehousing system to
secure its interests. A warehousing company will install and operate the system for $800,000 a year plus
.5% of the value of materials entering the system. What is the effective cost of this financing to
Shamrock?
SOLUTION:
Entering inventory charge:
$20M 10 .005 = $200M .005
= $1.0M
Base charge:
.8M
Total warehousing charges
$1.8M
Average loan amount advanced: $20M .75 = $15M
Warehousing as a percent of loan = $1.8M/$15M
Plus traditional interest
Total effective financing charges

= 12%
= 12%
= 24%

Evaluating Lock Box Systems Example 16-7 (page 692)

18.
Tambourines Inc. collects $12M per year from customers in a remote location. The average
remittance check is $1,200. A lock box system would shorten the overall float on these receipts from 8
days to 7 days, but would cost $2,500 per year plus $.20 per check. The relevant interest rate is 9%.
Should Tambourines install the system? Use a 360-day year.

SOLUTION:
Interest savings on the available funds are:
Current amount in float $12M (8/360) = $266,667
Proposed amount in float $12 (7/360) = $233,333
Float reduction
$ 33,334
Interest saved on float reduction at 9%
$ 3,000
Cost of lock box system
Number of checks per year $12M / $1,200 = 10,000
Per check charges: $.20 10,000
= $2,000
Annual base fee:
= $2,500
Total cost
$4,500
Hence the cost exceeds the savings by $1,500 per year so the system should not be installed.
19.
The Hadley Motor Company is located in Florida but has a number of customers in the Pacific
Northwest. Sales to those customers are $30 million a year paid in checks that average about $1,500.
The checks take an average of nine days to clear into Hadley's Florida bank. A bank in Oregon will
operate a lock box system for Hadley for $8,000 a year plus $.50 per check. The system can be
expected to reduce the clearing time to six days.
a. Is the lock box system worthwhile if Hadley borrows at 13.5%?

The Management of Working Capital

140

b. What is the minimum number of days of float time the system has to save (to the nearest tenth of a
day) to make it worthwhile?

SOLUTION:
a.

Float reduction:

$30 M

9 6 days
$246,575
365 days

Interest savings = $246,575 .135 = $33,288

Costs:
# of checks = $30M/$1,500 = 20,000
Variable cost = 20,000 $.50 = $10,000
Fixed cost
= 8,000
$18,000
The lock box is a good idea since the interest savings exceeds the cost.
b. Interest saving per day of float saved:
($30M/365) .135 = $11,096
Minimum # of days to make system pay:
$18,000/$11,096 = 1.62 days
20.
Colburn Inc. is considering a lock box system. The firm has analyzed its credit receipts and
determined the following:
Average time checks are in mail 3 days
Average internal check processing time 3 days
Average to clear the banking system 2 days
Total credit sales - $180 million
Average check - $10,000
Colburn funds its accounts receivable with short-term debt at 8%. First Bank has indicated their lock
box system will reduce mail float by an average of one day and eliminate internal processing time. The
cost of the system is $0.50 for each check processed, plus 0.05% of the gross revenues processed.
Should Colburn implement the lock box system? If the charge based on gross revenue remains
constant, at what per check charge would Colburn be indifferent to lock box arrangement?
SOLUTION:
Number of checks: $180 million/$10,000 = 18,000 checks
Reduction in A/R: $180 million x 4/360 = $2 million
Savings in interest expense: $2 million x .08 = $160,000
Cost of new system: $180 million x .0005 + $.50 x 18,000 = $99,000
Implementing would save $160,000 - $99,000 = $61,000
If C = per check charge Colburn would be indifferent if the cost of the system was equal to the
interest saved or
$160,000 = $90,000 + 18,000C
$70,000 = 18,000C

141

Chapter 16
C = $3.89

21.
Bozarth Business Machines (BBM) has analyzed the value of implementing a lock box system.
The firm anticipates revenues of $630 million with an average invoice of $1,500. BBM borrows at 12%
and has made an arrangement with Old Second Bank to manage a lock box for $.24 per check and .06%
of total receipts. BBM has estimated that the lock box will save $200,000 annually. How many days
does BBM expect the system save in the collection process?
SOLUTION:
Number of invoices: $630 million/$1,500 = 420,000 invoices
cost of the system + net annual benefit = interest savings
$630 million x .0006 + (.24 x 420,000) + $200,000 = (Days/360) x $630 million x .12
$378,000 + $100,800 + $200,000 = $210,000 (Days)
Days = $678,800/$210,000 = 3.23 Days

Credit and Collections Policy: Example 16-8 (page 696)

22.
The Bailey Machine Tool Company thinks it can increase sales by $10M by loosening its credit
standards somewhat. The firm normally experiences bad debts of about 2% of sales, but marketing
estimates that the incremental business would be from financially weaker customers who would not pay
about 17% of the time. The firms gross margin is 18% (production related costs are 82% of revenue).
a. Should Bailey lower its credit standards to get the new business?
b. Would your answer change if taking on the new business also involved incremental collection
expenses of $150,000 per year.

SOLUTION:
a. The contribution to profit from new customers that pay is
$10,000,000 .83 .18 = $1, 494,000
The loss on bad debts associated with new customers that dont pay is
$10,000,000 .17 .82 = $1,394,000
(Note that the loss on an uncollected debt is just the cost of the product sold, not the entire
revenue amount that includes the profit that would have been made on the sale.)
Hence the loosening of credit standards looks marginally profitable by $100,000 per year. Thats
probably not enough to make implementing the plan advisable because of the inaccuracies inherent in
making estimates like these.
b. Another $150,000 in cost makes the project marginally unacceptable (by $50,000), which would
make the argument against doing it even stronger.
23.
Over the past few years, the marketing department at Goldston & Co has convinced the finance
department to permit credit sales to increasingly marginal customers. Revenue has risen as a result, but
bad debts are now at 6% of sales. Finance has suggested that credit policy be tightened to reduce bad
debt losses. Their proposal calls for a more restrictive policy under which sales would fall by 8% but
bad debt losses would drop to 2.6% of revenue. Under the current policy Golstons revenue forecast is
$400 million with a contribution margin of 38%. Implementing the new credit policy wouldnt have an
effect on contribution margin but would require an additional $500,000 in annual fixed costs.
a. Should Goldston implement finances new credit policy?
b. What non-financial considerations should be evaluated.
c. Should the new policy be implemented if bad debts only are only expected to drop to 4% of
revenues?

The Management of Working Capital

142

SOLUTION: ($000)
a.

Original
With New Plan
Cash from sales
400,000 x .94 = 376,000
400,000 x .92 x .974 = 358,432
Variable Costs
400,000 x .62 = 248,000
400,000 x .92 x .62 = 228,160
Contribution Margin
128,000
130,272
Relevant Fixed Costs
0
500
Operating Income
128,000
129,772
Operating income is $1,772,000 higher with the new plan so it should be implemented.

b.

Will the tighter policy offend existing customers who may pay slowly but who Golston
nevertheless wants to keep?
With New Plan
Cash from sales
400,000 x .92 x .96 = 353,280
Variable Costs
400,000 x .92 x .62 = 228,160
Contribution margin
125,120
Relevant fixed costs
500
Operating Income
124,620
Operating income is $3,380,000 lower with the new plan so it shouldnt be implemented.

c.

24.
The Kranberry Kids Klothing Kompany is in the volatile garment business. The firm has
annual revenues of $250 million and operates with a 30% gross margin on sales. Bad debt losses
average 3% of revenues. Kranberry is contemplating an easing of its credit policy in an attempt to
increase sales. The loosening would involve accepting a lower quality customer for credit sales. It is
estimated that sales could be increased by $20 million a year in this manner. However, the collections
department estimates that bad debt losses on the new business would run four times the normal level,
and that internal collection efforts would cost an additional $1 million a year.
a. Is the policy change a good idea?
b. Is it likely that coupling an increased prompt payment discount with the looser guidelines would
reduce the bad debt losses?
c. Is it possible that the idea in part b could have a net negative impact? How?
SOLUTION:
a.
Bad debt loss rate = 3% 4 = 12%
Margin on added revenue actually collected = $20M .88 .30 = $5.3M
Bad debt losses on new business = $20M .12 = $2.4M
Cost of bad debt losses = $2.4M .7 = $1.7M
Collection effort = $1.0M
Total loss/cost = $2.7M
The policy change looks like a good idea, since the added margin on new sales exceeds the expected
losses and costs.
b.

No, because the new customers are likely to be so cash poor that they won't take the discount.

c.
An increased discount might hurt because it would be taken by customers who are already
paying on time, but not by those who create collection problems.

Economic Order Quantity Model (EOQ): Example 16-9 (page 704)

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Chapter 16

25.
Sharons Sweater Shop orders 5,000 sweaters per year from a supplier at a wholesale cost of
$65 each. Carrying costs are 22% of cost, and it costs $52 to place and receive an order. How many
orders should Sharon place with the supplier each year and how large should each be.

SOLUTION:
The Economic Order Quantity is
EOQ = [2FD/C]1/2
Where:
The carrying cost per unit is
C = $65 x .22 = $14.30
The fixed cost per order is.
F = $52
and the products annual demand is
D = 5,000
Substituting we have
EOQ = [2FD/C]1/2
EOQ = [2($52)(5,000)/$14.30]1/2
= [36,363.64]1/2
= 190.69
Hence Sharon should order approximately 191 sweaters at a time. At that quantity shell order
approximately (5,000 / 191 = 26.18) 26 times a year.
26.
Smithson Hydraulics Inc. carries an inventory of valves that cost $25 each. The firm's
inventory carrying cost is approximately 18% of the value of the inventory. It costs $38 to place,
process, and receive an order. The firm uses 20,000 valves a year.
a. What ordering quantity minimizes the inventory costs associated with the valves? (Round to the
nearest unit.)
b. How many orders will be placed each year if the EOQ is used?
c. What are the valves' carrying and ordering costs if the EOQ is used?
SOLUTION:
a.
EOQ = [2FD/C]1/2
where:
C = .18 $25 = $4.50, F = $38, and D = 20,000
Hence
EOQ = [2($38)(20,000)/$4.50]1/2
= 581
b.

20,000/581 = 34.4

c.

Ordering cost = 34.4 $38 = $1,307

Carrying cost = (581/2) $25 .18 = $1,307

27.
Emmons Motors is a distributor of electric motors. The firm projects product demand next year
of 25,000 units. It costs $320 to place an order with suppliers. Management has determined that the
EOQ is 1,000 units. How much per year does it cost Emmons to carry a unit of inventory?

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144

SOLUTION:
EOQ = [2FD/C]1/2
1,000 = [(2 x 320 x 25,000)/C]1/2
C1/2 = [(16,000,000)1/2]/1000 = 4
C = $16

Just In Time (JIT) Inventory Systems: Example 16-10 (page 707)

28.
EverFit Inc. manufactures commercial grade fitness equipment used in spas and health clubs.
The firm produces complex resistance exercise machines designed to strengthen specific muscles.
EverFits engineering department designs the equipment and then contracts with metal working shops to
produce parts to their specifications. The parts are inventoried at EverFits factory and assembled for
shipment to customers. The $250,000 parts inventory is financed with short-term debt at 6% interest.
Shrinkage and obsolescence cost about 1%, while taxes and insurance run about $10,000 per year.
EverFit has discussed a just in time (JIT) system with its suppliers all of which are located
within fifty miles. The suppliers are small firms that depend on EverFits business, and are willing to
try to deliver parts in accordance with its production schedule.
However, EverFits CFO is concerned that although their intentions are good, the suppliers
wont be able to manage their operations precisely enough to consistently meet customer JIT
requirements. Further, he thinks that when a JIT delivery is missed, it will generally be a day and a half
before it is finally received. During that time the assembly staff of 25 people will be idle. Each
assembly worker earns about $30 per hour and must be paid for eight hours a day whether working or
not.
a. If the measure of the system is saving money, how many JIT failures
can the system tolerate and still break even?
b. Comment on the advisability of the JIT idea based on your answer to
part a.
c. What qualitative factors might also be concerns?
d. Suggest a way to test the system before making a final decision.
SOLUTION:
a. Operating perfectly annual JIT savings will be
Interest
Shrink and Obsolescence .
Taxes and Insurance
Total

$250,000 x .06 = $15,000

$250,000 x .01 = 2,500
10,000
$27,500

The cost of a delivery failure is:

25 people x $30 per hour x 8 hrs per day x 1.5 days = $9,000
Break even number of failures = $27,500 / $9,000 = 3.1
b. It seems unlikely that small, presumably unsophisticated suppliers located as far as 50 miles away
will be able to make JIT deliveries missing only three times each year. Hence the idea seems unlikely to
be cost effective.
c. An extended delivery failure lasting several days or weeks could be a financial disaster. It could also
have negative consequences on EverFits relations with its own customers who may be anxious to
receive product on time.
d. Run the JIT system for a few months without getting rid of the existing inventory. When a delivery is
missed, use parts out of inventory If there are a lot of missed deliveries, scrap the system. If not, slowly
work down the existing inventory.

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Chapter 16