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16-1 Primrose Corp has $15million of sales, $2 million of inventories, $3 million of

receivables and $1 million of payables. Its cost of goods sold is 80% of sales and it
finances working capital with bank loans at an 8% rate. What is Primrose's cash
conversion cycle (CCC)?

Inventory conversion period = $2,000,000/((0.8*$15,000,000)/365)=60.83 days


Average collection period = $3,000,000/($15,000,000/365)=73 days
Payables deferred period = $1,000,000/((0.8*$15,000,000)/365)=30.42 days
CCC = 60.83 + 73 - 30.42 = 103.41 days

If Primrose could lower its inventories and receivables by 10% each and increase its
payables by 10%, all without affecting either sales or cost of goods sold, what would the
new CCC be, how much cash would be freed up and how would that affect pre-tax
profits?

Inventory = $2,000,000 × 0.9 = $1,800,000


A/R = $3,000,000 × 0.9 = $2,700,000
A/P = $1,000,000 × 1.1 = $1,100,000

Inventory conversion period = $1,800,000/((0.8*$15,000,000)/365)=54.75 days


Average collection period = $2,700,000/($15,000,000/365)=65.70 days
Payables deferred period = $1,100,000/((0.8*$15,000,000)/365)=33.46 days
New CCC = 54.75 + 65.70 - 33.46 = 86.99 days

Cash freed up:


Inventory = (60.83 – 54.75)*((0.8*$15,000,000)/365) = $199,890.41
Receivables = (73 – 65.70)*($15,000,000/365) = $300,000
Payables = (33.46 – 30.42)*((0.8*$15,000,000)/365) = $99,945.21

Cash freed up = $199,890.41 + $300,000 – $99,945.21 = $399,945.20

$399,945.20 × 0.08 = $31,995.62 increase in pre-tax profit.

16-2
Lamar Lumber Company has sales of $10 million per year, all on credit terms calling for
payment within 30 days; and its accounts receivable are $2 million. What is Lamar’s
DSO, what would it be if all customers paid on time, and how much capital would be
released if Lamar could take action that led to on-time payments?

DSO = $2,000,000/($10,000,000/365) = 73 days

If all customers paid on time, then the firm’s DSO = 30 days. If customers paid on time,
the firm’s A/R = 30*($10,000,000/365) = $821,917.81
Cash freed up = $2,000,000 – $821,917.81 = $1,178,082.19

16-3
Lamar Lumber buys $8 million of materials (net of discounts) on terms of 3/5, net 60,
and it currently pays after 5 days and takes discounts. Lamar plans to expand, and this
will require additional financing. If Lamar decides to forego discounts, how much
additional credit could it get, and what would the nominal and effective cost of that credit
be? If it could get the funds from a bank at a rate of 10 percent, interest paid monthly,
based on a365-days year, what would be the effective cost of the bank loan,and should
Lamar use bank debt or additional trade credit?Explain

$8,000,000/365*55 days = $1,205,479.45


Nominal cost of trade credit = 3/97 * 365/55 = 3.09% * 6.6364 = 20.52%
Effective cost of trade credit = (1 + 3/97)365/55 – 1 = 1.2240 – 1 = 22.40%.
Bank loan: 10%, interest paid monthly
EAR = (1 +0.10/12)12 – 1 = 1.1047 – 1 = 10.47%.
The effective cost of the bank loan is more than half the effective cost of the trade credit.
Therefore, the bank loan should be used.

16-4
The Zocco Corporation has an inventory conversion period of 75days, an average
collection period of 38 days, and a payable deferral period of 30 days.
a. What is the length of the cash conversion cycle?
b. If Zocco’s annual sales are $3,421,875 and all sales are on credit, what is the
investment in accounts receivable?
c. How many times per year does Zocco turn over its inventory?

a. Cash conversion cycle = 75+38-30 = 83 days


b.Investment in accounts receivable = 3,421,875 * (38/365) = $ 356,250
c.Inventory turn over = 365/75 = 4.87 times/year

16-5
McDowell Industries sells on terms of 3/10, net 30. Total sales for the year are $912,500;
40 percent of the customers pay on the 10th day and take discounts, while the other 60
percent pay, on average, 40 days after their purchases.
a. What is the day’s sale outstanding?
b. What is the average amount of receivables?
c. What is the percentage cost of trade credit to customers who take the discount
and to those who do not take it?
d. What would happen to its accounts receivable if McDowell toughened up on its
collection policy with the result that all nondiscount customers paid on the 30th day?
a. 0.4(10) + 0.6(40) = 28 days
b. $912,500/365 = $2,500 sales per day
$2,500(28) = $70,000 = Average receivables
c. Customers who take discount: Free trade credit.
Customers who do not take the discount and pay on Day 30:
Nominal cost: 3/97 * 365/20 = 56.44%
Effective cost: (1 + 3/97)365/20 – 1 = 1.7435 – 1 = 74.35%
Customers who do not take the discount and pay on Day 40:
Nominal cost: 3/97 * 365/30 = 37.63%
Effective cost: (1 + 3/97)365/30 – 1 = 44.86%
d. 0.4(10) + 0.6(30) = 22 days
$912,500/365 = $2,500 sales per day
$2,500(22) = $55,000 = Average receivables
Sales may decline as a result of tightened credit. This would reduce receivables even
more so. Some customers may also take discounts further reducing receivables.

16-6
The Prestopino Corporation produces motorcycle batteries. Prestopino turns out 1,500
batteries a day at a cost of $6 per battery for materials and labor. It takes the firm 22
days to convert raw materials into a battery. Prestopino allows its customers 40 days in
which to pay for the batteries, and the firm generally pays its suppliers in 30 days.
a. What is the length of Prestopino’s cash conversion cycle?
b. At a steady state in which Prestopino produces 1,500 batteries a day, what amount
of working capital must it finance?
c. By what amount could Prestopino reduce its working capital financing needs if it
was able to stretch its payables deferrals period to 35 days?
d. Prestopino’s management is trying to analyze the effect of a proposed new
production process on its working capital investment. The new production process
would allow Prestopino to decrease its inventory conversion period to 20 days and to
increase its daily production to 1,800 batteries. However,the new process would cause
the cost of materials and labor to increase to $7. Assuming the change does not affect
the average collection period (40 days) or the payable deferral period (30days), what will
be the length of its cash conversion cycle and its working capital financing requirement if
the new production process is implemented?

a. Cash conversion cycle = 22 + 40 – 30 = 32 days


b. Working capital financing = 1,500 * 32 * $6 = $288,000
c. If the payables deferral period was increased by 5 days, then its cash conversion
cycle would decrease by 5 days, so its working capital financing needs would decrease
by: 1,500 * 5 * $6 = $45,000
d. Cash conversion cycle = 20 + 40 – 30 = 30 days
Working capital financing = 1,800 × 30 × $7 = $378,000
16-7
The Christie Corporation is trying to determine the effect of its inventory turnover ratio
and days sales outstanding (DSO) on its cash flow cycle. Christie’s 2005 sales (all on
credit)were $150,000, and it earned a net profit of 6 percent, or $9,000.It turned over its
inventory 6 times during the year, and its DSO was 36.5 days. The firm had fixed assets
totaling $35,000. Christie’s payable deferral period is 40 days.
a. Calculate Christie’s cash conversion cycle.
b. Assuming Christie holds negligible amounts of cash and marketable securities,
calculate its total assets turnover and ROA.
c. Suppose Christie’s managers believe that the inventory turnover can be raised to
7.3 times. What would Christie’s cash conversion cycle, total assets turnover, and ROA
have been if the inventory turnover had been 7.3 for 2005?

a. Inventory conversion period = 365/6 = 60.83 days


Receivables collection period = DSO = 36.5 days
Cash conversion cycle = 60.83 + 36.5 - 40 = 57.33 days
b. Total assets = $150,000/6 + (($150,000/365) * 36.5) + $35,000 = $75,000
Total assets turnover = $150,000/$75,000 = 2.0x
ROA = 6% * 2.0 = 12%
c. Inventory conversion period = 365/7.3 = 50 days
Cash conversion cycle = 50 + 36.5 - 40 = 46.5 days
Total assets = $150,000/7.3 + $15,000 + $35,000 = $70,548
Total assets turnover = $150,000/$70,548 = 2.13x
ROA = $9,000/$70,548 = 12.76%

16-8
Rentz Corporation is investigating the optimal level of current assets for the coming
year. Management expects sales to increase to approximately $2 million as a result of
an asset expansion presently being undertaken. Fixed assets total $1 million, and the
firm plans to maintain a 60% debt ratio. Rentz’s interest rate is currently 8% on both
short-term debt (which the firm uses in its level are under consideration: (1) a tight
police where current assets would be only 45% of projected sales, (2) a moderate policy
where current assets would be 50% of sales, and (3) a relaxed policy where current
assets would be 60% of sales. Earnings before interest and taxes should be 12% of total
sales, and the federal-plus-state tax rate is 40%
a. What is the expected return on equity under each current level?
b. In this problem, we assume that expected sales are independent of the current
asset policy. Is this a valid assumption? Why or why not?
c. How would the firm’s risk be affected by the different policies?
Tight Moderate Relaxed
Current assets $900,000.00 $1,000,000.0 $1,200,000.0
0 0
Fixed assets $1,000,000.0 $1,000,000.0 $1,000,000.0
0 0 0
Total assets

Debt $1,140,000.0 $1,200,000.0 $1,320,000.0


0 0 0
Equity $760,000.00 $800,000.00 $880,000.00
Total liability/equity

EBIT $240,000.00 $240,000.00 $240,000.00


Interest $91,200.00 $96,000.00 $105,600.00
Earnings before
taxes
Taxes $59,520.00 $57,600.00 $53,760.00
Net income
ROE 11.75% 10.80% 9.16%
b. This is not a valid assumption because a firm’s current asset polices may
significantly effect sales. It is difficult to determine an optimal current asset level and
may not even be possible.

c. The tighter the policy the higher the expected returns. As the current asset level
decreases it might seem that the difference is from accounts receivable. It could be
accomplished with higher discounts and a shorter collection period as well. Tighter
receivable polices could create additional costs but would most likely reduce bad debt
expenses. Lower inventories could cause a multitude of operational problems and could
mean lost sales.

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