18-1A. Liquidity and working capital policy.

Which firm follows the most aggressive working capital policy and why? The financial statements for both firms are found below: Firm A Cash Accounts Receivable Inventories Net Fixed Assets Total Firm B Cash Accounts Receivable Inventories Net Fixed Assets Total $ 150,000 50,000 300,000 1,500,000 2,000,000 Accounts Payable Notes Payable Current Liabilities Bonds Common Equity Total $ $ 400,000 200,000 600,000 400,000 1,000,000 2,000,000 $ 100,000 100,000 300,000 1,500,000 2,000,000 Accounts Payable Notes Payable Current Liabilities Bonds Common Equity Total $ $ 200,000 200,000 400,000 600,000 1,000,000 2,000,000

Financial measures of firm liquidity Firm A 500,000 400,000 100,000 1.25 0.50 100,000 Firm B 500,000 600,000 (100,000) 0.83 0.33 150,000

Working Capital (Current Assets) Current Liabilities Net Working Capital Current Ratio Acid Test Ratio Cash

$ $ $

$ $ $

Firm B is obviously the more aggressive of the two firms. Note the fact that it has negative net working capital (current liabilities exceed current assets) and both its current ratio and acid test ratio are lower. Notice that the higher level of cash for Firm B is more than offset by it more aggressive use of current liabilities.

18-3A. Estimating the cost of bank credit

Paymaster Enterprises arranged to finance its seasonable working capital needs with a short-term bank loan.

Given: Interest rate Minimum demand deposit Principal Term

12% per annum 10% of the loan balance throughout the loan term $100,000 3 months

First we calculate the interest expense for the three month loan as follows: Interest = .12 x $100,000 x 3/12 = $ 3,000 Assuming that Paymaster has to leave 10% of the loan idle in a compensating balance the effective cost of credit can be calculated as follows: APR = [$3,000/($100,000 - 10,000 - 3,000)] x (12/3) = 13.79%

If the company already has sufficient funds in the bank to satisfy the compensating balance requirement then the cost of credit drops to 12.37%. (i.e. no need for minimum demand deposit) APR = [$3,000/($100,000 - 3,000)] x (12/3) = 12.37%

18-5A Cost of trade credit Calculate effective cost of the ff. trade credit terms where payment is made on the net due date, using the APR formula.

a) 2/10, net 30 b) 3/15, net 30 c) 3/15, net 45 d) 2/15, net 60

(0.02/0.98) x (1/(20/360)) = (0.03/0.97) x (1/(15/360)) = (0.03/0.97) x (1/(30/360)) = (0.02/0.98) x (1/(45/360)) =

36.73% 74.23% 37.11% 16.33%

18-6A Annual percentage yield (APY)

Compute cost of the trade credit temrs using compounding formula, or annual percentage yield

Note: This problem can be easily solved using the exponent function (yx) on a hand calculator. Simply let y = (1+r/m) and x = m, then solve for yx. Finally subtract "1" to obtain the effective cost of credit with compounding of interest.
APY = (1 + i/m) - 1 i = Nominal interest rate m = # of compounding periods in a year a) 2/10, net 30 APY = (1 + (0.3673/18))^18 - 1 = 1.4385 -1 = 43.85% APY = (1 + (0.7423/24))^24 - 1 = 2.0773 -1 = 107.73% APY = (1 + (0.3711/12))^12 - 1 = 1.4412 -1 = 44.12% APY = (1 + (0.1633/8))^8 - 1 = 1.1755 -1 = 17.55%
m

b) 3/15, net 30

c) 3/15, net 45

d) 2/15, net 60

18-8A. Cost of short-term bank loan Southwest Forging Corp. recently arranged for a ling of credit with First National Bank of Dallas.

Maximum loan = $ 100,000 Interest = 1% over prime rate Compensating balance = 20% in demand deposit account throughout the year Prime rate = 12% .13x $100,000 = $ 13,000 Monthly interest = $ 1,083 Compensating balance = = $ .20 x $100,000 20,000 Interest =

a) If Southwest normally maintains balance of $20,000-$30,000 in checking account what is effective cost of credit through the line-of-credit agreement where the maximum loan amount is used for a full year APR = ($13,000/$100,000) x (1/(360/360)) = 13% b) Recompute effective cost of credit if firm will have to borrow the compensating balance and it borrows the maximum possible under the loan agreement APR = ($13,000/($100,000 - $20,000)) x (1/(360/360)) = 16.25% Interest expense for the loan is $13,000; however, the firm gets the use of only .8 x $100,000 = $80,000.

18-9A. Cost of commercial paper

Tri-State Enterprises plans to issue commercial paper for the first time in the firm's 35-year history. Issue notes = $ 500,000 Maturity = 180 days Carrying rate = 10-1/4 % = 10.25% Cost of issue = $ 12,000 paid in advance a) Cost of credit Interest = .1025 x $500,000 x 180/360 = $ 25,625 APR = interest principal x 1 time

APR = (($25,625 + $12,000)/($500,000 - $12,000 - $25,625)) x (1/(180/360)) = 16.27%

1 8 0 1 / 3 6 0

b) What other factors should the company consider in analysing the use of commercial paper? The risk involved with the issue of commercial paper should be considered. This risk relates to the fact that the commercial paper market is highly impersonal and denies even the most credit-worthy borrower any flexibility in terms of when repayment is made. In addition, commercial paper is a viable source of credit to only the most credit-worthy borrowers. Thus, it may simply not be available to the firm.

18-11A. Cost of factoring

MDM, Inc. considering factoring its receivables. Credit sales = $ 400,000 per month Ave receivable balance = $ 800,000 Credit terms = 60 days Offer: Credit = 90% of receivables factored less interest on the loan Rate = 1-1/2 % per month 10% difference in the advance and face value of all receivables factored = Factoring fee = 1% Reserve = 9% (which the factor maintains) If MDM decides to factor its receivables, it will sell them all. Cost reduction in credit department = $ 1,500 per month a) Estimate cost of borrowing the maximum amount of credit available to MDM through the factoring agreement. Face Value of Receivables (2 months credit sales) Less: Factoring Fee 1% Reserve 9% Interest 3% Computed (1 1/2% per month for 60 days)* Loan Advance (less discount interest)

$ 800,000 (8,000) (72,000) $ 720,000 (21,600) $ 698,400

*Note: Interest is calculated on the 90 percent of the factored accounts that can be borrowed, (.90 x $800,000 x .015 x 2 months) = $21,600 or ($800,000 - 8,000 - 72,000) x .015 x 2 months = $21,600. Thus, the effective cost of credit to MDM is calculated as follows: APR = (($21,600 + $8,000 - $3,000)/$698,400) x (1/(60/360)) = 22.85% **Credit department savings for 60 days = 2 x $1500= $3,000 Calculated on an annual basis, the cost of credit would be:
3 6 1 0 / 3 6 0

First compute for: Interest Factoring Fee Credit Dept Savings .015 x $720,000 x 12 .01 x $400,000 x 12 12 x $1500 = = = $ $ $ 129,600 48,000 18,000

APR = (($129,600 + $48,000 - $18,000)/$698,400) x (1/(360/360)) = 0.228522337 b) What other considerations than cost should be accounted for by MDM in determining whether to enter the factoring agreement Of particular concern here is the presence of any "stigma" associated with factoring. In some industries, factoring simply is not used unless the firm's financial condition is critical. This would appear to be the case here, given the relatively high effective rate of interest on borrowing.

18-12A. Cost of secured short-term credit

Sean-Janeow Import Co. Needs = $ 500,000 Period = 3-months Explore 2 possible sources of credit:
a) Pledged Receivables (A/R):

Loan = $ 500,000 secured by A/R Advance 80% of the value of its pledged receivables Rate = 11% Fee = 1% based on receivables pledged Average receivables = $ 1,000,000 throughout the year Compute for A/R 0.80 A/R A/R = $500,000 loan = $500,000/.80 = $ 625,000 receivables pledged = (0.01) x ($625,000) = $6,250 = $ 6,250 (0.11) x ($500,000) x 90/360 = $13,750 = $ 13,750 (($13,750 + $6,250)/$500,000) x (1/(90/360)) = 16.0%

Fee

Interest Cost =

Effective Rate =

b) Field warehouse agreement with insurance company Loan = $ 500,000 secured by S-J's inventory of salad oil Rate = 9% Warehouse cost = $ 2,000 per month Warehousing cost = $2,000 x 3 months = $ 6,000 0.09 x $500,000 x 90/360 $ 11,250 (($6,000 + $11,250)/$500,000) x (1/(90/360)) 13.8%

Interest cost =

Effective Rate = =

The inventory loan would be preferred since its cost is lower under the conditions presented to S-J.

18-13A.

Cost of short-term financing Borrow = Rate = $ 20,000 for a gift shop 10% p.a. for 6-months

a) Calculate effective rate of interest on the loan Interest = $20,000 x .10 x 180/360 = $ 1,000

APR = (($1,000)/$20,000) x (1/(180/360)) = 10.0% b) In addition, bank requires you to maintain a 15% compensating balance No demand deposit account to meet compensating balance requirement. You will have to put up 15% of the loan amount from your own personal money and keep in a checking account Net proceeds from the loan $20,000 - (.15 x $20,000) = $17,000. Effective cost of credit is APR = (($1,000)/$17,000) x (1/(180/360)) = 11.76% We would have gotten the same answer by assuming that you borrow the necessary compensating balance. In that case the amount borrowed (B) is found as follows: B - .15B .85B B = Interest = = 20000 = 20000 = $20,000/.85 $ 23,529.41

.10 x 180/360 x $23,529.41 = $ 1,176.47

APR = (($1,176.47)/$20,000) x (1/(180/360)) = 11.76% c) In addition, interest will be discounted We assess the impact of discounted interest and the 15%compensating balance.

As in part (b) the discounted interest serves to reduce the loan proceeds:
APR = (($1,000)/($20,000 - $3,000 - $1,000)) x (1/(180/360)) = 12.5% If you borrowed enough to cover both the compensating balance requirement and discounted interest, then you would borrow (B) such that B - .15B - (.10 x 6/12)B .8B B Interest = = = = 20000 20000 25000

.10 x 6/12 x $25,000 = $ 1,250 .15 x $25,000 = $ 3,750

Compensating Balance =

APR = (($1,250)/($25,000 - $1,250 - $3,750)) x (1/(180/360)) = 12.5% The cost of the bank loan rises once again in part (c) due to the reduction in funds available to you from the loan as a result (this time) of discounted interest.

18-15A. Cash conversion cycle

Mega PC Inc. striving to improve management of working capital for the last 5 years 1999 2,873 411 283 220 365 2000 3,475 538 447 293 2001 5,296 726 466 429 2002 7,753 903 1,040 251 2003 12,327 1,486 1,643 233

Sales - Net Receivables- Total Accounts Payable Inventories- Total Days in a year

a) Calculate DSO and DSI for the 5 years

Days of Sales Outstanding (DSO) =

Accounts Receivable Sales / 365 Inventories Sales / 365

Days of Sales in Inventory (DSI) =

DSO DSI
b) Calculate CCC

1999 52.2 27.9

2000 56.5 30.8

2001 50.0 29.6

2002 42.5 11.8

2003 44.0 6.9

Days of Payables Outstanding (DPO) =

Accounts Payable Sales / 365

Cash Conversion Cycle (CCC) = DSO + DSI - DPO 1999 36.0 44.2 2000 47.0 40.3 2001 32.1 47.5 2002 49.0 5.4 2003 48.6 2.3

DPO CCC

Generally, DSO and DSI are decreasing and DPO is increasing. This signifies that Mega PC is collecting receivables faster, turning inventory more rapidly, and paying suppliers slower. Mega PC has achieved significant improvement in its working capital management practices.