Solutions Manual

CHAPTER 19

ACCOUNTS RECEIVABLE
AND INVENTORY MANAGEMENT

SUGGESTED ANSWERS TO THE REVIEW QUESTIONS AND PROBLEMS

I. Questions

1. Cash and marketable securities are generally used to meet the transaction
needs of the firm and for contingency purposes. Because the funds must
be available when needed, the primary concern should be with safety and
liquidity rather than the maximum profits.

2. Float exists because of the delay time in check processing. Electronic

funds transfer, or the electronic movement of funds between computer
terminals, would eliminate the need for checks and thus eliminate float.

3. A firm could operate with a negative balance on the corporate books

knowing float will carry them through at the bank. Checks written on the
corporate books may not clear until many days later at the bank. For this
reason, a negative account balance on the corporate books of 100,000
may still represent a positive balance at the bank.

4. By slowing down disbursements or the processing of checks against the

corporate account, the firm is able to increase float and also to provide a
source of short-term financing.

5. The average collection period, the ratio of bad debts to credit sales and
the aging of accounts receivable.

6. Trade credit is usually granted on open account. The invoice is the credit
instrument.

7. Credit costs: cost of debt, probability of default, and the cash discount.
No-credit costs: lost sales. The sum of these is the carrying costs.

8. 1. Character:determines if a customer is willing to pay his or her

debts.

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2. Capacity: determines if a customer is able to pay debts out of

operating cash flow.
3. Capital: determines the customers financial reserves in case
problems occur with operating cash flow.
4. Collateral: assets that can be liquidated to pay off the loan in case of
default.
5. Conditions: customers ability to weather an economic downturn and
whether such a downturn is likely.

9. 1. Perishability and collateral value

2. Consumer demand
3. Cost, profitability, and standardization
4. Credit risk
5. The size of the account
6. Competition
7. Customer type

Ifthecreditperiodexceedsacustomersoperatingcycle,thenthefirmis
financingthereceivablesandotheraspectsofthecustomersbusiness
thatgobeyondthepurchaseofthesellingfirmsmerchandise.

10. a. B: A is likely to sell for cash only, unless the product really works. If
it does, then they might grant longer credit periods to entice buyers.
b. A: Landlords have significantly greater collateral, and that collateral
is not mobile.
c. A: Since As customers turn over inventory less frequently, they have
a longer inventory period, and thus, will most likely have a longer
credit period as well.
d. B: Since As merchandise is perishable and Bs is not, B will
probably have a longer credit period.
e. A: Rugs are fairly standardized and they are transportable, while
carpets are custom fit and are not particularly transportable.

11. The three main categories of inventory are: raw material (initial inputs to
the firms production process), work-in-progress (partially completed
products), and finished goods (products ready for sale). From the firms
perspective, the demand for finished goods is independent from the
demand for the other types of inventory. The demand for raw material
and work-in-progress is derived from, or dependent on, the firms needs

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for these inventory types in order to achieve the desired levels of finished
goods.
12. JIT systems reduce inventory amounts. Assuming no adverse effects on
sales, inventory turnover will increase. Since assets will decrease, total
asset turnover will also increase. Recalling the DuPont equation, an
increase in total asset turnover, all else being equal, has a positive effect
on ROE.

13. Carrying costs should be equal to order costs. Since the carrying costs
are low relative to the order costs, the firm should increase the inventory
level.

14. Since the price of components can decline quickly, Apple does not have
inventory which is purchased and then declines quickly in value before it
is sold. If this happens, the inventory may be sold at a loss. While this
approach is valuable, it is difficult to implement. For example, Apple
manufacturing plants will often have areas set aside that are for the
suppliers. When parts are needed, it is a matter of going across the floor
to get new parts. In fact, m0st computer manufacturers are trying to
implement similar inventory systems.

II. Multiple Choice Questions

1. D 4. A 7. D 10. D 13. D
2. B 5. D 8. C 11. D
3. D 6. C 9. B 12. D

III. Problems

Problem 1

The firms average daily sales are its annual (credit) sales divided by 365
days.

Average daily sales = 912,500/365 days = 2,500

The average collection period is the credit period plus the average days past
the due date.

Average collection period = 45 + 15 = 60 days

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The average investment in accounts receivable is determined by multiplying

the average daily sales by the average collection period.

Investment in accounts receivable = 2,500 x 60 = 150,000

Problem 2

a. The accounts receivable turnover is calculated by dividing 365 days by

the average collection period of 25 days.

Accounts receivable turnover = 365/25 = 15 times

b. The average investment in accounts receivable is calculated by dividing

credit sales by the accounts receivable turnover.

Average investment in accounts receivable = 600,000/15 = 40,000

This method uses the total sales value of the accounts receivable. The
cost (variable or total) is sometimes used as the relevant measure of the
amount of funds tied up in accounts receivable. Using only variable cost
as the relevant measure, the investment in accounts receivable would be
32,000 (40,000 x 0.80).

Problem 3

a. The marginal pretax profits for each risk class are shown below:

Risk Class
A B C
1. Marginal profits on additional sales
= Additional sales x CM
= Additional sales x 0.15 7,500 6,000 3,000

2. Marginal increase in bad debt losses

= Additional sales x Bad debt loss
ratio 2,500 3,200 2,400

3. Marginal investment in A/R

= (Additional sales/365) x 90
A = 12,330, B = 9,900, C = 4,950

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Opportunity cost of marginal

investment in AR
= Marginal investment in A/R x
Opportunity cost 2,466 2,376 6,485

4. Net change in pretax profits

= Marginal profits Marginal costs 2,534 424 (885)

* The contribution margin of 0.15 is calculated by subtracting the variable

cost percentage from 1.00 or (1.00 0.85 = 0.15)

Problem 4

Jazz Auto Supply should not adopt the change in the discount rate because
the change results in a net disadvantage of 211.

1. Marginal profits on additional sales

= Additional sales x Contribution margin
= 0 x 0.25 0

2. Current bad debt losses

= Current sales x Current bad debt loss ratio
= 400,000 x 0.03 = 12,000

New bad debt losses

= New sales x New bad debt loss ratio
= 400,000 x 0.025 = 10,000

Reduction in bad debt losses

= Current bad debt losses New bad debt losses
= 12,000 10,000 2,000

3. Current average A/R balance

= Current average daily sales x Current average collection period
= (400,000/365) x 42 = 46,032

New average A/R balance

= New average daily sales x New average collection period
= (400,000/365) x 38 = 41,648

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Reduction in A/R investment

= Current average A/R balance New average A/R balance
= 46,032 - 41,648 = 4,384

Earnings on funds released by reduction in A/R investment

= Reduction in A/R x Required pretax rate of return
= 4,384 x 0.18 789

4. Cost of current cash discount

= Current sales x Current percentage taking discount
x Current percentage discount
= 400,000 x 0.45 x 0.01 = 1,800

Cost of new discount

= New sales x New percentage taking discount
x New percentage discount
= 400,000 x 0.60 x 0.02 = 4,800

Cost of increase in cash discount

= Cost of new cash discount Cost of current cash discount
= 4,800 1,800 3,000

5. Net advantage/disadvantage of changing credit terms

= Marginal returns Marginal costs
= (0 + 2,000 + 789) 3,000 (211)

Problem 5

a. S = 12,000; O = 50; C = 0.10

Q* = (2) (12,000) (50) = 3,464 gallons

0.10

b. The average inventory is determined by dividing the economic order

quantity, Q* by 2, as follows:

Average inventory = 3,464/2 = 1,732 gallons

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c. C = 0.10; Q* = 3,464; S = 12,000 ; O = 50

Total inventory costs = CQ/2 + SO/Q

TIC = [(0.10) (3,464) / 2] + [(12,000) (50) / 3,464) = 346 per month

d. Q* = 3,464; Average daily demand = 12,000/30days

T* = Q*/Average daily demand

T* = 3,464 / (12,000/30 days) = 9 days

e. S = 12,000; Q* = 3,464

N* = S/Q*
N* = 12,000 / 3,464 = 3 orders per month or

Time period = 30; T = 9

N* = Time period/T*
N* = 30 / 9 = 3 orders per month

Problem 6

a. S = 36,000; O = 100; C = 5

Q* = (2) (36,000) (100) = 1,200 fruit cakes

5

b. Q* = 1,200 ; SS = 3,000

Average inventory (Qa) = [(Q*/2) + SS]

Qa = [(1,200 / 2) + 3,000] = 3,600 fruit cakes

c. S = 36,000; Q* = 1,200

N* = S/Q*
N* = 36,000 / 1,200 = 30 orders per year

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d. Fruitcake Specialists total inventory cost is found by multiplying the

average inventory, 3,600 fruit cakes, by the carrying cost per unit, 5,
and then adding the product of the orders per year, 30, multiplied by the
ordering costs per order, 100.

Total inventory costs = (3,600) (5) + (30) (100) = 21,000

e. SS = 3,000; S = 36,000; Time period = 365 ; n = 5

Qr = SS + (S/Time period) (n)

Qr = 3,000 + (36,000 / 365) (5) = 3,495 fruitcakes

Problem 7

The costs per period are the same whether or not credit is offered; so we can
ignore the production costs. The firm currently has sales of, and collects
110 x 2,000 = 220,000 per period. If credit is offered, sales will rise to
120 x 2,000 = 240,000.

Defaults will be 4 percent of sales, so the cash inflow under the new policy
will be .96 x 240,000 = 230,400. This amounts to an extra 10,400 every
period. At 2 percent per period, the PV is 10,400/.02 = 520,000. If the
switch is made, Dama de Noche will give up this months revenues of
220,000; so the NPV of the switch is 300,000. If only half of the
customers take the credit, then the NPV is half as large: 150,000. So,
regardless of what percentage of customers takes the credit, the NPV is
positive. Thus, the change is a good idea.

Problem 8

The cash flow from the old policy is the quantity sold times the price, so:

Cash flow from old policy = 40,000(510) = 20,400,000

The cash flow from the new policy is the quantity sold times the new price,
all times one minus the default rate, so:

Cash flow from new policy = 40,000(537) (1 .03) = 20,835,600

The incremental cash flow is the difference in the two cash flows, so:

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Incremental cash flow = 20,835,600 20,400,000 = 435,600

The cash flows from the new policy are a perpetuity. The cost is the old cash
flow, so the NPV of the decision to switch is:

NPV = 20,400,000 + 435,600/.025 = 2,976,000

Problem 9

a. The old price as a percentage of the new price is: 90/91.84 = .98

So the discount is: Discount = 1 .98 = .02 or 2%

The credit terms will be: Credit terms: 2/15, net 30

b. We are unable to determine for certain since no information is given

concerning the percentage of customers who will take the discount.
However, the maximum receivables would occur if all customers took
the credit, so:

Receivables = 3,300(90) = 297,000 (at a maximum)

c. Since the quantity sold does not change, variable cost is the same
under either plan.

d. No, because: d = .02 .11 = .09 or 9%

Therefore the NPV will be negative. The NPV is:

NPV = 3,300(90) + (3,300) (91.84) (.02 .11)/(.01) = 3,023,592

The breakeven credit price is:

P (1 + r) / (1 ) = 90 (1.01)/ (.89) = 102.13

This implies that the breakeven discount is:

Breakeven discount = 1 (90/102.13) = .1188 or 11.88%

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The NPV at this discount rate is:

NPV = 3,300(90) + (3,300) (102.13) (.1188 .11)/(.01)

NPV 0

Problem 10

a. The cost of the credit policy switch is the quantity sold times the
variable cost. The cash inflow is the price times the quantity sold,
times one minus the default rate. This is a one-time, lump sum, so we
need to discount this value one period. Doing so, we find the NPV is:

NPV = 15(760) + (1 .2) (15) (1,140)/1.02 = 2,011.76

The order should be taken since the NPV is positive.

b. To find the breakeven default rate, , we just need to set the NPV equal
to zero and solve for the breakeven default rate. Doing so, we get:

NPV = 0 = 15(760) + (1 ) (12) (1,140)/1.02

= .3200 or 32.00%

c. Effectively, the cash discount is:

Cash discount = (1,140 1,090) /1,140 = .0439 or 4.39%

Since the discount rate is less than the default rate, credit should not be
granted. The firm would be better off taking the 1,090 up-front than
taking an 80% chance of making 1,140.

Problem 11

a. The cash discount is:

Cash discount = (75 71) /75 = .0533 or 5.33%

The default probability is one minus the probability of payment, or:

Default probability = 1 .90 = .10

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Since the default probability is greater than the cash discount, credit
should not be granted; the NPV of doing so is negative.

b. Due to the increase in both quantity sold and credit price when credit is
granted, an additional incremental cost is incurred of:

Additional cost = (6,200) (33 32) + (6,900 6,200) (33)

Additional cost = 29,300

The breakeven price under these assumptions is:

NPV = 0 = 29,300 (6,200) (71) + {6,900 [(1 .10) P 33]

6,200(71 32)} / (1.00753 1)

NPV = 34,100 440,200 + 273,940.31P 10,044,478.08

10,666,468.16

21,185,246.24 = 273,940.31P
P = 77.34

c. The credit report is an additional cost, so we have to include it in our

analysis. The NPV when using the credit reports is:

NPV = 6,200 (32) .90 (6,900) 33 6,200 (71) 6,900 (1.50) +

{6,900 [0.90 (75 33) 1.50] 6,200 (71 32)} / (1.00753 1)

NPV = 198,400 204,930 440,200 10,350 + 384,457.73

NPV = 72,622.27

The reports should not be purchased and credit should not be granted.

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