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    CHAPTER 14

    Working Capital Management

    Learning Objectives

    1 !e"ine net #orking capital$ %isc&ss t'e importance o" #orking capital management$

    an% be able to comp&te a "irm(s net #orking capital

    ) !e"ine t'e operating an% cas' c*cles$ e+plain 'o# t'e* are &se%$ an% be able to

    comp&te t'eir val&es "or a "irm

    , !isc&ss t'e relative a%vantages an% %isa%vantages o" p&rs&ing -1. "le+ible an% -).

    restrictive c&rrent asset investment strategies

    4 E+plain 'o# acco&nts receivable are create% an% manage%$ an% be able to comp&te

    t'e cost o" tra%e cre%it

    / E+plain t'e tra%e0o"" bet#een carr*ing costs an% reor%er costs$ an% be able to

    comp&te t'e economic or%er &antit* "or a "irm(s inventor* or%ers

    2 !e"ine cas' collection time$ %isc&ss 'o# a "irm can minimi3e t'is time$ an% be able

    to comp&te t'e cas' collection costs an% bene"its o" a lockbo+

    5%enti"* t'ree c&rrent asset "inancing strategies an% %isc&ss t'e main so&rces o"

    s'ort0term "inancing

    5 C'apter O&tline

    141 Working Capital 6asics

    Working capital management involves two key issues.

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    What is the appropriate amount and mix of current assets for the firm to

    hold?

    How should these current assets be financed?

    Let us review some basic definitions related to working capital.

    C&rrent assets are cash and other assets that the firm expects to convert

    into cash in a year or less.

    C&rrent liabilities (or short-term liabilities are obligations that the firm

    expects to pay off in a year or less.

    Working capital! also calledgrossworking capital!is the funds invested

    in a company"s cash account! account receivables! inventory! and other

    current assets.

    7et #orking capital -7WC.refers to the difference between current

    assets and current liabilities.

    o #W$ is important because it is a measure of li%uidity and

    represents the net short-term investment the firm keeps in the

    business.

    Working capital management involves making decisions regarding the

    use and sources of current assets

    Working capital e""icienc* refers to the length of time between when a

    working capital asset is ac%uired and when it is converted into cash.

    Li&i%it* is the ability of a company to convert assets&real or financial

    &into cash %uickly without suffering a financial loss.

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    A. Working Capital Accounts and Trade-Offs

    'he various working capital accounts are

    Cas'8 'his account includes cash and marketable securities like

    'reasury securities.

    o 'he higher the cash balance! the better the ability of the

    firm to meet its short-term financial obligations.

    Receivables 'hese represent the amount owed by customers who

    have taken advantage of the firm"s trade credit policy.

    5nventor* )irms maintain inventory of raw materials and work in

    process and finished goods.

    Pa*ables 'he payables balance represents the amount owed to the

    firm"s vendors and suppliers on materials purchased on credit.

    o 'he accrual accounts are liabilities incurred but not yet

    paid! such as accrued wages or taxes.

    14) T'e Operating an% Cas' Conversion C*cles

    'he cash conversion cycle begins when the firm invests cash to purchase the raw

    materials that would be used to produce the goods that the firm manufactures and ends

    not with the finished goods being sold to customers and the cash collected on the sales*

    but when you take into account the time taken by the firm to pay for its purchases.

    +ee ,xhibit ./ for a graphical representation of the cash conversion cycle.

    When managing working capital accounts! financial managers want to do the following

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    0elay paying accounts payable as long as possible without suffering any

    penalties.

    1aintain minimal raw material inventories without causing manufacturing

    delays.

    2se as little labor as possible to manufacture the product while producing

    a %uality product.

    1aintain minimal finished goods inventories without losing sales.

    3ffer customers the most attractive credit terms possible on trade credit to

    maximi4e sales while minimi4ing the risk of nonpayment.

    $ollect cash payments on accounts receivable as fast as possible to close

    the loop.

    With the financial manager"s goal being to maximi4e the value of the firm! each of the

    decisions above is intended to shorten the cash conversion cycle and improve the firm"s

    li%uidity.

    'wo tools to measure the working capital management efficiency are the operating cycle

    and the cash conversion cycle.

    A. Operating Cycle

    'he operating c*clebegins when the firm receives the raw materials it purchased

    and ends when the firm collects cash payments on its credit sales.

    'wo measures&days" sales outstanding and days" sales in inventory&help

    determine the operating cycle.

    !a*s( sales in inventor* -!95.shows how long the firm keeps its

    inventory before selling it.

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    o 5t is the ratio of the inventory balance to the daily cost of goods

    sold.

    o 'he %uicker a firm can move out its raw materials as finished

    goods! the shorter the duration when the firm holds it inventory!

    and the more efficient it is in managing its inventory.

    !a*s( sales o&tstan%ing -!9O.estimates how long it takes on average

    for the firm to collect its outstanding accounts receivable balance.

    o 'his ratio is also called the average collection perio% -ACP..

    o 6n efficient firm with good working capital management should

    have a low average collection period compared to its industry.

    'he operating cycle is calculated by summing the days" sales outstanding and the

    days" sales in inventory.

    Operating Cycle DSO DSI= + -141.

    B. Cash Conversion Cycle

    'hecas' conversion c*cle is related to the operating cycle! but it does not start

    until the firm actually pays for its inventory.

    'he cash conversion cycle is the length of time between the cash

    outflow for materials and the cash inflow from sales.

    'o measure the cash conversion cycle! we need another measure called the day"s

    payables outstanding.

    !a*s( pa*able o&tstan%ing -!PO.shows how long a firm takes to pay off its

    suppliers for the cost of inventory.

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    'he cash conversion cycle is then calculated by summing the days" sales

    outstanding and the days" sales in inventory and subtracting the days" payables

    outstanding.

    'he formula is shown in ,%uation ./

    CashConversionCycle DSO DSI DPO= +

    14, Working Capital 5nvestment 9trategies

    )inancial managers use two types of strategies for current assets investmentsflexibleand

    restrictive.

    A. Flexible Current Asset nvest!ent "trategy

    'he flexible strategy has a highpercent of current assets to sales! whereas a

    restrictive policy has a lowpercent of current assets to sales.

    'he "le+ible strateg*calls for management to invest large amounts in cash!

    marketable securities! and inventory.

    'he strategy also promotes a liberal trade credit policy for customers! which

    results in high levels of accounts receivable.

    'he flexible strategy is perceived be a low risk and low return course of action for

    management to follow.

    'he advantage of this policy is the large working capital balances the firm holds.

    'he strategy"s downside is the high inventor*0carr*ing cost associated with

    owning a high level of inventory and providing liberal credit terms for its

    customers.

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    'he higher carrying costs result for two reasons

    'he investment in the low return current assets deprives the higher returns

    that management could earn on longer term assets like plant and

    e%uipment.

    Higher amounts of inventory results in higher warehousing and storage

    costs.

    B. #estrictive Current Asset nvest!ent "trategy

    $urrent assets are kept to a minimum in therestrictive strateg*

    'he firm barely invests in cash and inventory! and has tight terms of sale intended

    to curb credit sales and accounts receivable.

    'he restrictive strategy is a high-risk! high-return alternative to the flexible

    strategy.

    'he high risk comes in the form of s'ortage coststhat can be either

    financial or operating.

    Financialshortagecosts arise mainly from the illi%uidity shortage of cash

    and a lack of marketable securities to sell for cash.

    o 5f unpaid bills are due! the firm will be forced to use expensive

    external emergency borrowing.

    o 5f funding cannot be secured! default occurs on some current

    liability and the firm runs the risk of being forced into bankruptcy

    by creditors.

    Operatingshortagecosts result from lost production and sales.

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    o 5f the firm does not hold enough raw materials in inventory! time

    may be wasted by a halt in production.

    o 5f the firm runs out of finished goods! sales may also be lost! and

    customer dissatisfaction may arise.

    o 7estrictive sale policies such as allowing no credit sales will also

    result in lost sales.

    o 3verall! operating shortage costs can be substantial! especially if

    the product markets are competitive.

    C. The Working Capital Trade-off

    'he optimal current asset investment strategy will depend on the relative

    magnitudes of carrying costs versus shortage costs. 'his conflict is often referred

    to as the working capital trade-off.

    )inancial managers need to balance shortage costs against carrying costs

    to find an optimal strategy.

    5f carrying costs are larger than shortage costs! then the firm will

    maximi4e value by adopting a more restrictive strategy.

    3n the other hand! if shortage costs dominate carrying costs! the firm will

    need to move toward a more flexible policy.

    3verall! management will try to find the level of current assets that

    minimi4es the sum of the carrying costs and shortage costs.

    144 Acco&nts Receivables

    A. Ter!s of "ale

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    Whenever a firm sells a product! the seller spells out the terms and conditions of

    the sale in a document called the terms of sale.

    'he agreement specifies when the cash payment is due and the amount of any

    discount if early payment is made.

    'rade credit! which is short-term financing! is typically made with a discount for

    early payment rather an explicit interest charge.

    6n offer of 89:;! net ;< means that the selling firm offers a 9 percent

    discount if the buyer pays the full amount of the purchase in cash within

    ; days of the invoice date.

    o 3therwise! the buyer has ; days to pay the balance in full from

    the date of delivery.

    'o calculate the cost! we need to determine the interest rate the buyer is paying

    and convert it to an e%uivalent annual rate.

    'he formula for calculating the ,67 for a problem like this is shown below! in

    ,%uation .!

    ,ffective annual rate =

    9>?:dayscredit

    0iscount-@ -

    0iscountedprice

    'rade credit is a loan from the supplier and it can be a very costly form of credit.

    B. Aging Accounts #eceivables

    6 common tool that credit managers use is called an aging schedule.

    'he aging schedule shows the breakdown of the firm"s accounts receivable by

    their date of sale&how long has the account not been paid in days.

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    5ts purpose is to identify and then track delin%uent accounts and to see that they

    are paid.

    6ging schedules are also an important financial tool for analy4ing the %uality of a

    company"s receivables.

    'he aging schedule reveals patterns of delin%uency and shows where

    collection efforts should be concentrated.

    ,xhibit .> shows aging schedules for three different firms.

    14/ 5nventor* Management

    5nventory management is largely a function of operations management! not financial

    management.

    1anufacturing companies generally carry three types of inventory raw materials! work

    in process! and finished goods.

    A. $cono!ic Order %uantity

    'he economic order %uantity (,3A mathematically determines the minimum

    total inventory cost! taking into account reorder costsand inventory-carrying

    costs.

    'he optimal order si4e strikes the balance between these two costs.

    ,%uation . shows how to calculate ,3A.

    B. &ust-in-Ti!e nventory 'anage!ent

    5n this system the exact day-by-day! or even hour-by-hour! raw material needs

    are delivered by the suppliers! who deliver the goods 8Bust in time< for them to

    be used on the production line.

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    6 big advantage of this system is that there are essentially no raw inventory

    costs and no chance of obsolescence or loss to theft.

    3n the other hand! if the supplier fails to make the needed deliveries! then

    production shuts down.

    5f the system works for a firm! it cuts down their investment in working capital

    dramatically.

    142 Cas' Management an% 6&%geting

    A. #easons for (olding Cash

    'wo reasons exist for holding a cash balance. )irst! it facilitates transactions

    with suppliers! customers and employees.

    'he second reason is simply that most banks re%uire firms to hold minimum cash

    balances! or compensating balances$in exchange for the services they provide.

    B. Cash Collection

    $ollection time! or "loat$is the time between when a customer makes a payment

    and when the cash becomes available to the firm.

    $ollection time can be broken down into three components.

    )irst is delivery time! or mailing time.

    o When a customer mails payment! it may take several days before

    that payment arrives.

    +econd is processing delay.

    o 3nce the payment is received! it must be opened! examined!

    accounted for! and deposited at the firm"s bank.

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    )inally! there is a delay between the time of the deposit and the time when

    the cash is available for withdrawal.

    Cayments in cash at the point of sale reduce the collection time to 4ero.

    o Cayment by check or credit card at the point of sale eliminates the

    mail time but not the processing time.

    6 lockboxsystem allows geographically dispersed customers to send their

    payments to a post office box close to them.

    With a concentration account! a post office box is replaced by a local branch!

    which receives the mailings! processes the payments! and makes the deposits.

    ,ither approach will reduce the collection time to an extent! but there is a cost

    associated with it.

    6nother increasingly popular means of reducing cash collection time is through

    the use of electronic funds transfers! which reduces cash collection times in

    every phase.

    )irst! mailing time is eliminated.

    +econd! processing time is reduced or eliminated since no data entry is

    necessary.

    )inally! electronic funds transfers typically have little or no delay in funds

    availability.

    14 :inancing Working Capital

    A. "trategies for Financing Working Capital

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    ,xhibit .D shows the three basic strategies that a firm can follow to finance its

    working capital and fixed assets.

    ,ach of the three panels show ( the total long-term financing needed!

    which consists of long-term debt and e%uity! and (/ the seasonal needs for

    working capital that fluctuates with the level of sales.

    'he mat&rit* matc'ing strateg*is shown in )igure 6 of ,xhibit .D.

    6ll working capital is funded with short-term borrowing! and! as the level of

    sales varies seasonally! short-term borrowing fluctuates between some

    minimum and maximum level.

    6ll fixed assets are funded with long-term financing.

    'he 8matching of maturities< is one of the most basic techni%ues used by

    financial managers to reduce risk when financing assets.

    'he long0term "&n%ing strateg*is shown in )igure E in ,xhibit .D.

    'his strategy relies on long-term debt to finance bothcapital assets and

    working capital.

    'his strategy reduces the risk of funding current assets because there is no

    need to worry about refinancing assets since all funding is long term.

    )igure $ in ,xhibit .D shows the s'ort0term "&n%ing strateg*whereby all

    working capital and a portion of fixed assets are funded with short-term debt.

    While this lowers the cost under some interest rate scenarios! it forces the

    firm to continually refinance the funding of the long-term assets in a changing

    interest rate environment.

    B. Financing Working Capital in )ractice

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    1any financial managers try to match the maturities of assets and liabilities when

    funding the firm.

    'hat is! short-term assets are funded with short-term financing! and long-

    term assets are funded with long-term financing.

    1ost financial managers like to fund some of their currents assets with long-term

    debt as shown in )igure 6 of ,xhibit .D! so-called permanent #orking capital

    5n recent years! a number of large! well-known firms of the highest credit

    standing have been funding some of their long-term fixed assets with short-term

    debt sold in the commercial paper market.

    C. "ources of "hort-Ter! Financing

    6ccounts payable (trade credit! bank loans! and commercial paper are common

    sources of short-term financing.

    Eetween FF; and /;;9! acco&nts pa*ableconstituted 9D percent of total current

    liabilities for all publicly traded manufacturing firms.

    'he buyer needs to figure out whether it makes financial sense to pay early

    and take advantage of the discount or to wait and pay in full when the account

    is due.

    Eetween FF; and /;;9! s'ort0term bank loans accounted for F percent of total

    current liabilities for all publicly traded manufacturing firms.

    6n in"ormal line o" cre%itis a verbal agreement between the firm and the

    bank! allowing the firm to borrow up to an agreed-upon upper limit.

    5n exchange for providing the line of credit! a bank may re%uire that the

    firm holds a compensating balancewith them.

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    6 "ormal line o" cre%itis also known as 8revolving credit!< whereby the

    bank has a legal obligation to lend to the firm an amount of money up to a

    preset limit.

    o 'he firm pays a yearly fee! in addition to the interest expense on the

    amount they borrow.

    5f the firm backs the loan with an asset! the loan is defined as secured*

    otherwise! the loan is unsecured.

    +ecured loans allow the borrower to borrow at a lower interest rate! all

    else being e%ual.

    Commercial paperis a promissory note issued by large financially secure firms!

    which have high credit ratings.

    $ommercial paper is not 8secured!< which means that the issuer is not

    pledging any assets to the lender in the event of default.

    However! most commercial paper is backed by a credit line from a

    commercial bank.

    'herefore! the default rate on commercial paper is very low! resulting in

    an interest rate that is usually lower than what a bank would charge on a

    direct loan.

    )or medium-si4e and small businesses! acco&nts receivable "inancingis an

    important source of funds.

    6 company can secure a bank loan by pledging the firm"s accounts

    receivable as security.

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    6 second way for a business to finance itself with accounts receivables is

    tosellthe receivables to a factor at a discount.

    'he firm that sold the receivables has no further legal obligation to the

    factor.

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    55 9&ggeste% an% Alternative Approac'es to t'e Material

    'his chapter focuses on short-term financial decisions that involve cash inflows and outflows

    that will occur within a year or less. ,xamples include the purchase of raw materials! payment

    for the purchases of raw materials! sale of finished inventory! and the collection of cash for sales

    made on credit. 'his chapter focuses on these types of decisions! which are called working

    capital management.

    'he chapter begins by reviewing some basic definitions and concepts that are necessary

    to further our study of working capital management. #ext! the authors examine the individual

    working capital accounts and then learn how to construct and analy4e the operating and cash

    conversion cycles. 'hen they examine how the different working capital accounts are managed

    the cash account! accounts receivables! and inventory. )inally! the different financing options

    that financial managers consider! and the risks involved! are discussed.

    5nstructors may choose to cover this chapter at any point in the semester. 'he material is

    sufficiently independent of previous material to allow that. 5t is important to recogni4e that many

    undergraduates are more likely to deal with working capital management issues on their first Bob

    than with issues like capital budgeting decisions or capital structure decisions.

    #one of the %uantitative material is likely to be overwhelming! and as in previous

    chapters! the end-of-chapter problems emphasi4e repetition to allow instructors to work some

    problems in class and assign others for the students to work on their own.

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    555 9&mmar* o" Learning Objectives

    . !e"ine net #orking capital$ %isc&ss t'e importance o" #orking capital

    management$ an% be able comp&te a "irm(s net #orking capital

    #et working capital is the difference between current assets and current liabilities. Working

    capital management refers to the decisions made regarding the use of current assets and how

    they are financed. 'he goal of working capital management is to ensure that the firm can

    continue its day-to-day operations and pay its short-term debt obligations. 'he computation

    of net working capital for 0ell $omputer is illustrated in +ection .

    /. !isc&ss t'e operating an% cas' c*cles$ e+plain 'o# are t'e* &se%$ an% be able

    to comp&te t'eir val&es "or a "irm

    'he operating cycle can be defined as the period starting with the receipt of raw materials

    and ending with the receipt of cash for finished goods made from those raw materials. 5t can

    be broken into two components ( days" sales in inventory! which shows how long a firm

    keeps its inventory before selling it! and (/ days" sales outstanding! which indicates how

    long it takes on average for the firm to collect its outstanding accounts receivable. 7elated to

    the operating cycle is the cash conversion cycle! which is the length of time between the cash

    outflow for materials and the cash inflow from sales. 6n additional measure! that of days"

    payables outstanding! is re%uired to calculate the cash conversion cycle. Eoth cycles are

    simple tools to help the financial manager measure working capital efficiency and control

    li%uidity. 'he computations are illustrated in +ection ./.

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    9. !isc&ss t'e relative a%vantages an% %isa%vantages o" p&rs&ing -1. "le+ible an% -).

    restrictive c&rrent asset investment strategies

    6 flexible strategy involves maintaining relatively high levels of cash! marketable securities!

    and inventory! while a restrictive strategy keeps the levels of current assets relatively low. 5n

    general! a flexible strategy is thought to be low risk and low return* its downsides include

    low returns on current assets! potentially high inventory-carrying costs! and the cost of the

    money necessary to provide liberal credit terms. 'he restrictive strategy involves higher risk

    and return! with higher potential financial and operating shortage costs as its maBor

    drawbacks.

    . E+plain 'o# acco&nts receivable are create% an% manage%$ an% be able to

    comp&te t'e cost o" tra%e cre%it

    6ccounts receivable are promises of future payment from customers that buy goods or

    services on credit. 'he details are defined in the terms of sale! which include the due date! the

    interest rate charge! and any discounts for early payment. 'he terms of sale are affected by

    the practice in the industry and the creditworthiness of the customer. 'o manage accounts

    receivable! the financial manager should keep close track of both days" sales outstanding and

    the aging schedule.

    . E+plain t'e terms inventory-carrying costsan% reorder costs*an% be able to

    comp&te t'e economic or%er &antit* "or a "irm(s inventor* or%ers

    'he trade-off between carrying costs and reorder costs exists because as the si4e of a firm"s

    orders for materials increases! the number of orders and total reorder costs decline. 6t the

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    5; 9&mmar* o" ?:dayscredit

    0iscount-@ -

    0iscountedprice

    14/,conomic order %uantity (,3A ,3A =

    / 7eorder costs +ales per period

    $arrying costs

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    ; 6e"ore =o& >o On ?&estions an% Ans#ers

    9ection 141

    . How do you calculate net working capital! and why is it important?

    #et working capital is calculated as the difference between the current assets and current

    liabilities. 5t is important for a firm to keep a positive net working capital balance! as

    these funds are used to cover the day-to-day expenses and short-term liabilities as they

    come due.

    /. What are some of the trade-offs re%uired in the management of working capital accounts?

    When managing working capital accounts! a financial manager is looking to delay paying

    accounts payable as long as possible without suffering any penalties! maintain minimal

    finished goods inventories without losing sales! and collect cash payments on accounts

    receivable as fast as possible to close the loop! among other things.

    9ection 14)

    . What is the operating cycle! and how is it related to the cash conversion cycle?

    'he operating c*clestarts with the receipt of raw materials and ends with the collection

    of cash from customers for the sale of finished goods. 'he operating cycle can be

    described in terms of two components days" sales in inventory and days" sales

    outstanding. 'he cash conversion cycle is the length of time between the actual cash

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    outflow for materials and the actual cash inflow from sales. 'o calculate it! we need all of

    the information used to calculate the operating cycle plus one additional measure days"

    payables outstanding.

    9ection 14,

    . What are the two general current asset investment strategies discussed in this section! and

    how do they differ?

    'ypically! the two main current asset investment strategies are flexible and restrictive

    strategies. 'he flexible strategy prompts management to keep large balances of cash!

    marketable securities! and inventory. 'his strategy is perceived to be a relatively low-risk

    and low-return course of action for management to follow. 'he restrictive strategy!on the

    other hand! prompts management to keep the usage of current assets to a minimum and is

    perceived to be high risk and high return.

    /. What are the types of costs associated with each of these strategies?

    'he flexible strategy is associated with a high level of carrying costs because of a firm"s

    high levels of inventory and providing liberal credit for customers. 'he restrictive

    strategy is associated with shortage costs! which can be either financial or operating in

    nature.

    9ection 144

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    . What does 8:! net 9;< mean?

    5f a company declares a 8:! net 9;< means of sale! it signifies that it will grant the

    customer a percent discount if the customer pays the full amount within days of the

    invoice date. 3therwise the customer has 9; days to pay the balance in full from the date

    of the delivery.

    /. What is an aging schedule! and what is its purpose?

    'he aging schedule for a firm lists the accounts receivable broken down by the number of

    days until they are due or past due. )irms use aging schedules to keep track of their

    accounts receivables and to assess how effective they are collecting on these accounts.

    9ection 14/

    . What is the economic order %uantity model?

    'he economic order %uantity model is an inventory management tool that mathematically

    determines the minimum total inventory cost! taking into account reorder costs and

    inventory-carrying costs. 'he main obBective of the model is to find the trade-off between

    the two costs.

    /. Why is an investment in inventory considered to be costly?

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    5nvestment in inventory is considered costly! because inventory must be stored! which

    results in rental and maintenance costs. )urthermore! inventory on hand is subBect to loss

    and theft! and faces the possibility of becoming obsolete. )inally! investment in inventory

    provides no return unlike an investment in financial or real assets would.

    9ection 142

    . What is float?

    'he collection time! which is the time between when a customer makes a payment and

    the time the cash becomes available is to the firm! is also referred to as float.

    /. ,xplain how lockboxes are used.

    Lockboxes are post office boxes set up by the firm for its customers to deliver their

    payments to these boxes instead of the firm"s business address. 'he post office then

    collects these payments and delivers them to the bank. 'he main purpose of lockboxes is

    to minimi4e collection time for firms through cutting down on postal time and through

    processing the payments directly at the bank.

    9ection 14

    . List and briefly describe the three main short-term financing strategies.

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    'he three main short-term financing strategies are ( self-li%uidating strategy! in which

    the maturity of the liabilities is matched with that of assets* (/ conservative strategy!

    which relies more heavily on long-term financing* and (9 restrictive strategy! which

    relies primarily on short-term financing.

    /. What are the advantages and disadvantages of short-term financing?

    +hort-term financing offers companies greater flexibility and usually a lower cost of

    capital. 3n the other hand! short-term financing often comes with some illi%uidity

    problems as well as uncertainty due to increased exposure to interest rate fluctuations.

    9. Iive examples of sources of short-term financing.

    ,xamples of short-term financing include accounts payable! short-term bank loans!

    informal lines of credit! formal lines of credit! or commercial paper. 'he two main

    current asset investment strategies are ( flexible strategy! which encourages

    management to keep large balances of current assets! and (/ restrictive strategy! which

    keeps the usage of current assets to a minimum.

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    ;5 9el" 9t&%* Problems

    141 Jou are provided the following working capital information for the Elue 7idge

    $ompany

    Acco&nt 6eginning 6alance En%ing 6alance

    5nventory K /!>;; K/!F;6ccounts receivable 9!/// /!;;6ccounts payable /!;; /!>D;

    #et sales /!F$ost of goods sold F!>9;

    5f all sales are on credit! what are the firm"s operating and cash conversion cycles?

    9ol&tion8

    We calculate the operating and cash conversion cycles for Elue 7idge as follows

    5nventory = K/!F;

    6ccounts receivable = K/!;;

    6ccounts payable = K/!>D;

    #et sales = K/!F

    $ost of goods sold = KF!>9;

    6ccounts receivable K/!L;;0+3 = = = -.> days

    $redit sales 9>? K/! ?LF 9>?

    daysD.?99>?>9;!-FK

    LF;!/K

    9>?$3I+

    5nventory0+5 ===

    6ccounts payable K/! >D;0C3 = = = F.> days

    $3I+ 9>? K-F!>9; 9>?

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    %a*s@/,=+=+=

    D.?9>.-

    0+50+3cycle3perating

    %a*s4/=+=+=

    >.FD.?9>.-

    0C30+50+3cycleconversion$ash

    14) 1errifield $osmetics calculates that its operating cycle for last year was D> days. 'he

    company had K/9;!;;; in its accounts receivable account and had sales of K.F/ million.

    What can you say about 1errifield"s inventory management?

    9ol&tion8

    'he following information describes 1errifield"s inventory management

    3perating cycle = D> days

    6ccounts receivables = K/9;!;;;

    #et sales = K!F/;!;;;

    daysD.99>?;;;!F/;!-K

    ;;;!/9;K

    9>?sales$redit

    sreceivable6ccounts0+3 ===

    %a*s,),=+=+=

    0+5

    0+5D.9D>

    0+50+3cycle3perating

    1errifield $osmetics takes 9/.9 days to move the inventory through as finished products.

    14, Eelow is a partial aging of accounts receivable for Eitar 7oofing +ervices. )ill in the rest

    of the information and determine its days" sales outstanding. How does it compare to the

    industry average of ; days?

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    Age o" Acco&nts -in %a*s. ;al&e o" Acco&nt -. B o" Total Acco&nt

    ;-; K/!;;;-9; /;!9>;9- ;9!//;>->; D/!;;

    3ver >; /9!D;Total K9!/;

    9ol&tion8

    'he missing information for Eitar 7oofing is as follows

    Age o" Acco&nts -in %a*s. ;al&e o" Acco&nt -. B o" Total Acco&nt

    ;-; K/!;;; 9F.DM-9; /;!9>; //.D

    9- ;9!//; F.>->; D/!;; 9.D3ver >; /9!D; .

    'otal K9!/; ;;M

    %a*s44)=++++=

    ++++=9.->//.LD9.LL-.>FD.9

    9>?(;.;?>;(;.-9D?(;.-F9;(;.//D-;(;.9FD0+3,ffective

    Eitar takes about days more than the industry average of ; to collect on its receivables.

    'he firm should focus collection efforts on all credit sales that take >; days or more to

    collect.

    144 Ey obtaining a lockbox! #i4am"s 1anufacturing was able to reduce its total cash

    collection time by two days. 'he firm has annual sales of KD;!;;; and can earn .D

    percent annual interest. 6ssuming that the lockbox costs K; per year! calculate the

    savings that can be attributed to the lockbox.

    9ol&tion8

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    'he following information applies to #i4am"s lockbox

    6nnual sales = KD;!;;;

    6nnual interest rate = .DM

    6nnual cost of lockbox = K;

    $ollection time saved = / days

    A@C,2==

    ==

    ?;K/;D?.;>.?>-!-K

    >.?>-!-K9>?

    K?D;!;;;salesdaily

    Savings

    verage

    'he firm can save KF.9> each year by using the lockbox.

    14/ 7ockville $orporation is looking to borrow K/;!;;; at a stated . percent 6C7 from

    its bank! which re%uires its customers to maintain a ; percent compensating balance.

    What is the effective interest rate on this loan for 7ockville $orporation?

    9ol&tion8

    7ockville $orporation"s loan information is as follows

    6mount to be borrowed = K/;!;;;

    +tated annual interest rate = .M

    $ompensating balance = ;M

    6mount deposited as compensating balance = K/;!;;; x ;.; = K/!;;;

    ,ffective borrowing amount e%ual to K/;!;;; G K/!;;; = K//!;;;

    5nterest expense = K/;!;;; x ;.; = K/!/;

    B@ .K//?!;;;

    K/-!/?;

    amountborrowing,ffective

    expense5nterestrateinterest,ffective ===

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    Ey setting aside a compensating balance of ; percent or K/!;;; on the loan! the firm

    increases its interest rate effectively to F. percent.

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    ;55 Critical T'inking ?&estions

    141 What factors must a financial manager consider when making decisions about account

    receivables?

    When dealing with accounts receivables! important decisions for the financial manager

    include the amount of credit offered to various customers and the term of the credit. 'he

    financial manager should keep close track of both the aging schedule and the effective

    0+3. 5f either or both show consistent deterioration! it may be time to reconsider the

    firm"s credit policy or the characteristics of its customers. 5n addition! in some industries!

    sales vary by season. 6 firm must be aware of seasonal patterns and make the necessary

    adBustments before drawing any conclusions about its accounts receivable.

    14) List some of the working capital management characteristics you would expect a

    computer manufacturing company following Bust-in-time delivery system! such as 0ell.

    )irms like 0ell are likely to do an exceptional Bob of managing their inventory and

    collecting on their receivables. 0ell employs a strategy similar to Bust-in-time

    management where they maintain Bust sufficient inventory to meet the needs for a very

    short time. 'his saves the firm a huge investment in inventory. 'hus their days sales in

    inventory (0+5 will be very low compared to other industries. +imilar to 0ell! firms will

    have a short collection period! and their operating cycle will be much lower than firms in

    other industries. 5f other computer manufacturing firms follow the 0ell operating

    philosophy! they will extend their days payables (0C3 to the point that tier cash

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    conversion cycle is negative. 5n other words! instead of having to invest in its working

    capital! these firms will end up taking more time to pay their suppliers than the time taken

    to produce! sell! and collect on the receivables.

    14, What costs would a firm following a flexible current asset investment strategy worry

    about! and why?

    'he strategy"s downside is the high carrying costassociated with owning a high level of

    inventory and providing liberal credit terms for customers. Ey investing in current assets!

    management foregoes the higher rate of return it could have earned by investing in long-

    term assets. 'herefore! there is an opportunity cost involved when investing in current

    assets. +econd! large investments in some types of inventory can re%uire significant

    warehousing and storage costs! which can be expensive.

    144 How are customers and suppliers affected by a firm"s working capital management

    decisions?

    $ustomers like firms to maintain large finished goods inventories because when they go

    to make a purchase! the item they want will likely be in stock. 5n general! large inventory

    helps stimulate sales and increase customer satisfaction! but they can be a costly item on

    a firm"s balance sheet. 1anagement"s decisions on the firm"s receivables policy is driven

    by the industry type. $ompanies selling perishable products! such as food companies!

    might ask for payment in full in less than ; days. 3n the other hand! if the firm is selling

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    durable goods! the terms of credit are likely to be more generous. 'he terms of sale are

    also affected by the creditworthiness of the customer. 5f the firm is confident that it will

    be paid! it is far more likely to extend credit than if there was some doubt about payment.

    5f the customer is a particularly large firm or if there is a likelihood of repeat business!

    then extending credit may be part of the marketing effect to secure the order. 'hus! when

    the financial manager makes a decision to increase working capital! good things are likely

    to happen to the firm&sales should increase! relationships with vendors and suppliers

    should improve! and work or manufacturing stoppages should be less likely.

    14/ 6 beverage bottling company in Nermont has days" sales outstanding of /9.D days. 5s this

    good? ,xplain.

    5n general! a lower 0+3 reflects the fact that the firm is managing its receivables very

    well. However! it is not possible to decide whether a 0+3 of /9.D days is good or bad

    unless you have a basis for comparison. 'hat basis of comparison could be a peer group!

    historical data for the firm itself! or targets set by the management.

    142 How do the following circumstances affect the cash conversion cycle (a favorable credit

    terms allow the firm to pay its accounts payable more slowly! (b inventory turnover

    increases! and (c accounts receivable turnover decreases?

    (a )avorable credit terms from suppliers allow the firm to use the suppliers" funds to

    finance their working capital. 5t also reduces the firm"s cash conversion cycle.

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    (b 6n increase in the inventory turnover! that is! the 0+5 decreases! reduces both the

    firm"s operating cycle and the cash conversion cycle.

    (c 6s the accounts receivables turnover (0+3 decreases! the firm improves its

    receivables management and reduces its operating cycle and hence! its cash

    conversion cycle.

    14 What are some industries in which the use of lockboxes would especially benefit

    companies? ,xplain.

    Lockboxes are a useful tool to speed up collection of receivables when the customer base

    is dispersed across a large geographical area. #ormally! this would mean customer

    payments would have to be mailed in! consolidated! and then deposited at the firm"s

    bank. 'he alternative of setting up a lockbox system allows the firm to redirect customer

    payments to regional locations for %uicker consolidation and cashing of payments. 'his is

    typical in the retail industry where each store of a chain is located in a different city or

    state.

    14 +uppose you are a financial manager at a big firm and you expect the interest rates to

    decline in the near future. What current asset investment strategy would you recommend

    the company pursue?

    6t a large firm! management would have access to the commercial paper market! which

    can provide cheaper funding than short-term bank financing. 'o borrow in the

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    commercial paper market! a firm has to be financially strong. 5f interest rates are expected

    to decline! such firms can plan on raising working capital by issuing commercial paper.

    'hus! all or a portion of the working capital needs can be funded through short-term

    funds that can be rolled over as long as interest rates are declining.

    14@ Why is commercial paper only available to the most creditworthy customers?

    $ommercial paper is available only to firms that are financially strong for two reasons.

    )irst! there is no secondary market for investors to li%uidate prior to maturity.

    $onse%uently! investors must hold it to maturity and have the confidence that the issuer

    would pay them back at that time. +econd! this type of debt is not secured by any real

    assets of the issuing firm. 'hus! firms that are the most creditworthy are able to raise

    funds in this market at costs that are lower than bank loans.

    141D ,xplain what a negative cash conversion cycle means.

    7ecogni4e the cash conversion cycle is a function of a firm"s receivables turnover!

    inventory turnover! and payables turnover. )irms that are highly efficient in managing

    their inventory and receivables will have a short operating cycle and not need a large

    investment in working capital. 6 large payables turnover implies that the firm is making

    use of their suppliers" funds to fund their working capital needs. 'he difference between

    the operating cycle and the payables turnover is the cash conversion cycle. 6 negative

    cash conversion cycle means that the time taken by the firm to meet its payables exceeds

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    its operating cycle. 5n other words! the amount of time to manage their inventory and the

    time taken to collect its receivables is less than the time taken to pay its suppliers.

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    ;555 ?&estions an% Problems

    6A95C

    141 Cas' conversion c*cle8Wolfgang"s 1asonry estimates that it takes the company /D

    days on average to pay off its suppliers. 5t also knows that it has days" sales in inventory

    of > days and days sales" outstanding of 9/ days. How does Wolfgang"s cash conversion

    cycle compare to that of an industry average of D days?

    9ol&tion8

    0C3 = /D days

    0+5 = > days

    0+3 = 9/ days

    5ndustry average for cash conversion cycle = D days.

    Wolfgang"s cash conversion cycle =

    %a*s2@=+=

    +=/D>9/

    0C30+50+3cycleconversion$ash

    +ince the firm"s cycle is less than the industry average of D days! the firm is more

    efficient than other firms in the industry in managing its working capital.

    14) Cas' conversion c*cle8#orthern 1anufacturing $ompany found that during the last

    year! they took D days to pay off its suppliers! while they took >9 days to collect their

    receivables. 'he company"s days" sales in inventory was F days. What is #orthern"s

    cash conversion cycle?

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    9ol&tion8

    0C3 = D days

    0+5 = F days

    0+3 = >9 days

    #orthern"s cash conversion cycle =

    %a*s2/=+=

    +=DF>9

    0C30+50+3cycleconversion$ash

    14, Cas' conversion c*cle80evon 6utomotive estimates that it takes the company about >/

    days to collect cash from customers on finished goods from the day it receives raw

    materials and about > days to pay its suppliers. What is the company"s cash conversion

    cycle? 5nterpret your answer.

    9ol&tion8

    0C3 = > days

    3perating cycle = >/ days

    0evon"s cash conversion cycle =

    $ash conversion cycle = 3perating cycle 0C3

    = >/ O >

    = -9 days

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    'his firm has a negative cash conversion cycle. 'he amount of time to manage its

    inventory and the time taken to collect its receivables is less than the time taken to pay its

    suppliers.

    144 Operating c*cle8Lilly Eakery distributes its products to more than D restaurants and

    delis. 'he company"s collection period is /D days! and it keeps its inventory for four

    days. What is Lilly"s operating cycle?

    9ol&tion8

    0+5 = days

    0+3 = /D days

    Lilly"s operating cycle =

    %a*s,-

    /D

    0+50+3cycle3perating

    =+=

    +=

    14/ Operating c*cle8#et+peed 'echnologies is a telecom component manufacturer. 'he

    firm typically has a collection period of days and days" sales in inventory of /F days.

    What is the operating cycle for #et+peed?

    9ol&tion8

    0+5 = /F days

    0+3 = days

    #et+peed"s operating cycle =

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    %a*s,=+=

    +=/F

    0+50+3cycle3perating

    142 Cost o" tra%e cre%it +ybex $orp. sells its goods with terms of /:; ,31! net 9;. What

    is the implicit cost of the trade credit?

    9ol&tion8

    $redit terms = /:; ,31! net 9;

    ,ffective annual rate = -price0iscounted

    0iscount-

    creditdays:9>?

    +

    = ( @ /:F9>:/;O

    = (.;/;./;;O

    = .F O

    = ;.F! or 44/@ percent

    14 Cost o" tra%e cre%it Puggs! 5nc.! sells its goods with terms of :; ,31! net >;. What is

    the implicit cost of the trade credit?

    9ol&tion8

    ,ffective annual rate = -price0iscounted

    0iscount-

    creditdays:9>?

    +

    = ( @ :F>9>:;O

    = (.;DD.9O

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    = .9D/ O

    = ;.9D/! or ,4)B

    14 Lockbo+87osenthal 0esign has daily sales of KF!;;;. 'he financial management team

    determined that a lockbox would reduce the collection time by .> days. 6ssuming the

    company can earn ./ percent interest per year! what are the savings from the lockbox?

    9ol&tion8

    6ll sales are assumed to be credit sales.

    6nnual interest rate = ./M

    $ollection time saved = .> days

    A4$@DCCD===

    >.-;?/.;;;;!?FK+avings

    ;;;!?FKsalesdaily6verage

    'he firm can save K!F;.; due to the use of lockbox.

    14@ Lockbo+8Cacific 'raders has annual sales of K!F!;;;. 'he firm"s financial manager

    has determined that using a lockbox will reduce collection time by /.9 days. 5f the firm"s

    opportunity cost on savings is ./ percent! what are the savings from using the lockbox?

    9ol&tion8

    6nnual sales = K!F!;;;

    6nnual interest rate = ./M

    $ollection time saved = /.9 days

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    A2)2@1==

    ==

    9./;?/?.;DL.-F-!?K+avings

    DL.-F-!?K9>?

    K-!LF?!;;;salesdaily6verage

    'he firm can save K>/>.F due to the use of lockbox.

    141D E""ective interest rate8'he Qellog Eank re%uires borrowers to keep an percent

    compensating balance. Iorman Pewels borrows K9;!;;; at a D percent stated 6C7.

    What is the effective interest rate on the loan?

    9ol&tion8

    6mount to be borrowed = K9;!;;;

    +tated annual interest rate = D.;M

    $ompensating balance = M

    6mount deposited as compensating balance = K9;!;;; ;.; = K/D!/;;

    ,ffective borrowing amount = K9;!;;; G K/D!/;; = K9/!;;

    5nterest expense = K9;!;;; ;.;D = K/9!;;

    21B===K9-/!L;;

    K/9!L;;

    amountborrowing,ffective

    expense5nterestrateinterest,ffective

    Ey setting aside a compensating balance of percent or K/D!/;; on the loan! the firm

    increases its interest rate effectively to D.> percent.

    1411 E""ective interest rate81organ $ontractors borrowed K.D million at an 6C7 of ;./

    percent. 'he loan called for a compensating balance of / percent. What is the effective

    interest rate on the loan?

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    9ol&tion8

    6mount to be borrowed = K!D;!;;;

    +tated annual interest rate = ;./M

    $ompensating balance = /M

    6mount deposited as compensating balance = K!D;!;;; ;.;/ = K/;!;;;

    ,ffective borrowing amount e%ual to K!D;!;;; G K/;!;;; = K!;!;;;

    5nterest expense = K!D;!;;; x ;.;./ = KD!;;

    112B===K-!?;!;;;

    K-DL!?;;

    amountborrowing,ffective

    expense5nterestrateinterest,ffective

    Ey setting aside a compensating balance of / percent or K/;!;;; on the loan! the firm

    increases its interest rate effectively to .> percent.

    141) :ormal line o" cre%it8Winegartner $osmetics is setting up a line of credit at its bank for

    K million for up to two years. 'he loan rate is .D percent and also calls for an annual

    fee of ; basis points on any unused balance for the year. 5f the firm borrows K/ million

    on the day the loan agreement was signed! what is the firm"s effective rate?

    9ol&tion8

    Line of credit limit = K!;;;!;;;

    Loan rate = .DM

    6nnual fee on used balance = ;.M

    6mount borrowed = K/!;;;!;;;

    2nused balance = K9!;;;!;;;

    6nnual fee = K9!;;;!;;; x ;.;; = K/!;;;

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    5nterest expense = K/!;;;!;;; x ;.;D = KD!;;

    24CB=

    +

    =

    +=

    K/!;;;!;;;

    K-/!;;;(K--D!?;;

    amountEorrowed

    fee6nnualexpense5nterestrateinterest,ffective

    'he effective borrowing rate for the firm is >.M with the annual fee of ; basis points.

    57TERME!5ATE

    141, Cas' conversion c*cle8Jour boss asks you to compute the company"s cash conversion

    cycle. Looking at the financial statements! you see that the average inventory for the year

    was K/>!9;;! accounts receivable were KD!F;;! and accounts payable were at K!;;.

    Jou also see that the company had sales of K!;;; and that cost of goods sold was

    K//!;;;. 5nterpret your firm"s cash conversion cycle.

    9ol&tion8

    6ll sales are assumed to be credit sales.

    6ccounts receivables = KD!F;;

    6ccounts payables = K!;;

    +ales = K!;;;

    5nventory = K/>!9;;

    $ost of goods sold = K//!;;;

    6ccounts receivable K-D!F;;0+3 = = = /. days

    $redit sales 9>? K-?! ;;; 9>?

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    daysD.DL9>?;;;!-//K

    9;;!/>K

    9>?$3I+

    5nventory0+5 ===

    6ccounts payable K-?!-;;0C3 = = = ?./ days

    $3I+ 9>? K-//!;;; 9>?

    %a*s/@=+=+=

    /.?D.DL./

    0C30+50+3cycleconversion$ash

    'he firm takes nearly D> days from the time it pays for its raw materials to the time it

    reali4es cash from its credit sales. Ey taking a couple of more days to pay it suppliers

    relative to the time it takes to collect on its receivables! it reduces the cash conversion

    cycle.

    1414 Cas' conversion c*cle8Elackwell 6utomotive! 5nc.! reported the following information

    for the last fiscal year.

    6lack#ell A&tomotive$ 5nc

    Assets As o" ,,1)DD Liabilities an% E&it*

    $ash and marketable sec. K /9!; 6ccounts payable and accruals K>6ccounts receivable !/ #otes payable /5nventories //!3ther current assets !//9

    'otal current assets K9D!F; 'otal current liabilities K

    #et sales F/!99/$ost of goods sold D!;;

    $alculate the firm"s cash conversion cycle and operating cycles.

    9ol&tion8

    6ccounts receivables = K!/

    6ccounts payables = K>9!/D

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    #et sales = KF/!99/

    5nventory = K//!

    $ost of goods sold = KD!;;

    6ccounts receivable K--!/?L0+3 = = = ?>.? days

    $redit sales 9>? KF-/! 99/ 9>?

    daysD.--9>?;;!?DK

    !/-/K

    9>?$3I+

    5nventory0+5 ===

    6ccounts payable K->9!/?D0C3 = = = -;L.F days

    $3I+ 9>? K?D!;; 9>?

    %a*s1@C)=+=+=

    D.--?.?>0+50+3cycle3perating

    $ash conversion cycle = 0+3 @ 0+5 O 0C3

    = >. @ .D O ;.F

    = @, %a*s

    141/ Cas' conversion c*cle8,lsee! 5nc.! has net sales of K9 million with D percent of it

    being credit sales. 5ts cost of goods sold is > percent of annual sales. 'he firm"s cash

    conversion cycle is .9 days. 'he inventory for the firm is K!D!9! while its

    accounts payable is K/!D!>F;. What is the firm"s accounts receivable balance?

    9ol&tion8

    #et sales = K9!;;;!;;;

    $redit sales = (;.D K9!;;;!;;; = KF!D;!;;;

    6ccounts payable = K/!D!>F;

    5nventory = K!D!9

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    $ost of goods sold = (;.> +ales = (;.> K9!;;;!;;; = K!;!;;;

    $ash conversion cycle = .9 days

    6ccounts payable K/!-D-!>F;0C3 = = = F9.L days

    $3I+ 9>? KL!?;!;;; 9>?

    5nventory K-!L-D!90+5 = = = DL.? days

    $3I+ 9>? KL!?;!;;; 9>?

    %a*s/22=+=+=

    0+3

    L.F9?.DL0+39.-

    0C30+50+3cycleconversion$ash

    2sing the 0+3 e%uation! we can solve for the accounts receivable.

    6ccounts receivables?> > days

    $redit sales 9>? F D?; ;;; 9>?

    6ccounts receivables ?>.> K/>!D-/.99

    A#+"O .

    , * *= = =

    = =A1$/11$@1C1

    'he firm has accounts receivables of 1$/11$@1.

    1412 Cas' conversion c*cle8Poanna Handicrafts! 5nc.! has net sales of K./9 million with ;

    percent of it being credit sales. 5ts cost of goods sold is K/. million. 'he firm"s cash

    conversion cycle is D.F days. 'he firm"s operating cycle is >.9 days. What is the firm"s

    accounts payable?

    9ol&tion8

    #et sales = K!/9;!;;;

    $redit sales = (;. x K!/9;!;;; = K/!!;;;

    $ash conversion cycle = D.F days

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    3perating cycle = >.9 days

    $ost of goods sold = K/!;!;;;

    %a*s,C4==

    +=

    0C30C39.L>F.D

    0C30+50+3(cycleconversion$ash

    6ccounts payable 6ccounts payable0C3 = = = 9L. days

    $3I+ 9>? K/!?;!;;; 9>?

    6ccounts payable = 9L.HK>!F?L.F; = A)2$ ))1@)

    'he firm has accounts payable of )2$))).

    141 Operating c*cle86viva 'echnology"s operating cycle is days. 5ts inventory level was

    at K9!;;; last year! and the company had a K. million cost of goods sold. How long

    does it take 6viva to collect on its receivables?

    9ol&tion8

    3perating cycle = days

    5nventory = K9!;;;

    $ost of goods sold = K!;;!;;;

    days?.9>?;;;!-;;!-K

    ;;;!-9K

    9>?$3I+

    5nventory0+5 ===

    %a*s,2/=+=+=

    0+3

    ?.0+3L-0+50+3cycle3perating

    5t takes 6viva 9>. days to collect on its receivable.

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    141 Operating c*cle8Cremier $orp. has sales of K/!9! and its cost of goods sold is D;

    percent of sales. 6ssume all sales are credit sales. 5f the firm"s accounts receivable total

    K9!F;/ and its operating cycle is .> days! how much inventory does the firm have?

    9ol&tion8

    $redit sales = K/!9

    3perating cycle = .> days

    $ost of goods sold = (;.D x K/!9 = K>!>

    6ccounts receivable = K9!F;/

    6ccounts receivable K--9!F;/0+3 = = = ?-./ days

    $redit sales 9>? KL-/! 9 9>?

    %a*s,D4=+=+=

    0+5

    0+5/.?->.L-

    0+50+3cycle3perating

    A4$,2DC=

    ===

    5nventory

    days.9;

    9>?>-!?>LK

    5nventory

    9>?$3I+

    5nventory0+5

    'he firm has inventory of 4$,21.

    141@ Economic or%er &antit*8Longhorn 'raders is one of the largest 7N dealers in 6ustin

    and sells about /!;; recreational vehicles a year. 'he cost of placing an order with their

    supplier is K;;! and the inventory-carrying costs are K; for each 7N. 'he company

    likes to maintain safety stock of / 7Ns. 1ost of their sales are either in spring or the fall

    of each year. How many orders will the firm need to place this year?

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    9ol&tion8

    6nnual sales = /!;; units

    $ost of placing an order = K;;

    5nventory-carrying cost per 7N = K;

    +afety stock = / 7Ns

    .D/;K

    ;;!/;;K/

    tscos$arrying

    periodper+alescosts7eorder/,3A

    =

    =

    =

    ,conomic order %uantity = D9 7Ns

    #o. of orders the firm needs to place = /!;; : D9 = 12

    14)D E""ective interest rate8'he $larkson 0esigner $ompany is looking for a loan of

    KD;!;;;.'he bank will provide the loan at an 6C7 of >.D. +ince the loan calls for a

    compensating balance! the effective interest rate on the loan increased to F./ percent.

    What is the compensating balance on this loan?

    9ol&tion8

    6mount to be borrowed = KD;!;;;

    +tated annual interest rate = >.DM

    $ompensating balance = ?

    ,ffective interest rate = F./M

    5nterest expense = KD;!;;; x ;.;>D = K!>/.;

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    9.9/!??DK;F/?.;

    ?;.?>/!?-Kamountborrowing,ffective

    amountborrowing,ffective

    K?-!?>/.?;F./?M

    amountborrowing,ffective

    expense5nterestrateinterest,ffective

    ==

    =

    =

    ,ffective borrowing amount = KD;!;;; G K$E = KD!9/.9

    $ompensating balance deposit = KD;!;;; - KD!9/.9 = KF/!>D.D

    $ompensating balance = KF/!>D.D : KD;!;;; = )/2B

    Ey setting aside a compensating balance of /.>M on the loan! the firm increases its

    interest rate effectively from >.D to F./ percent.

    14)1 E""ective interest rate8'he $olonial Window 'reatments $ompany is borrowing

    K!;;!;;;. 'he loan re%uires a ; percent compensating balance! and the effective

    interest rate on the loan is F.D percent. What is the stated 6C7 on this loan?

    9ol&tion8

    6mount to be borrowed = K!;;!;;;

    +tated annual interest rate = ?

    $ompensating balance = ;M

    ,ffective interest rate = F.DM

    $ompensating balance = (;.; x K!;;!;;; = K;!;;;

    ,ffective borrowing amount = K!;;!;;; G K;!;;; = K!9;!;;;

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    >/?!-9-K;;;!9?;!-K;FD?.;expensenterest5

    amountborrowing,ffective

    expense5nterestF.D?M

    amountborrowing,ffective

    expense5nterestrateinterest,ffective

    ==

    =

    =

    +tated interest rate = K9!>/ : K!;;!;;; = /B

    14)) :ormal line o" cre%it8Iruppa! 5nc.! has Bust set up a formal line of credit of K; million

    with )irst $ommunity $ommercial Eank. 'he line of credit is good for up to five years.

    'he bank will be charging them an interest rate of >./ percent on the loan! and in

    addition the firm will pay an annual fee of >; basis points on the unused balance. 'he

    firm borrowed KD. million on the first day the credit line became available. What is the

    firm"s effective interest rate on this line of credit?

    9ol&tion8

    Line of credit limit = K;!;;;!;;;

    Loan rate = >./M

    6nnual fee on used balance = ;.>M

    6mount borrowed = KD!;;!;;;

    2nused balance = K9!;;;!;;;

    6nnual fee = K/!;;!;;; x ;.;;> = K!;;;

    5nterest expense = KD!;;!;;; x ;.;>/ = K>!D;

    24/B=+=

    +=

    KD!?;;!;;;

    K-?!;;;(K>L!D?;

    amountEorrowed

    fee6nnualexpense5nterestrateinterest,ffective

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    14), :ormal line o" cre%it8Lansdowne ,lectronics has a formal line of credit of K million

    up to three years with H#0 Eank. 'he interest rate on the loan is .9 percent! and under

    the agreement! Lansdowne has to pay ; basis points on the unused amount as the annual

    fee. +uppose the firm borrows K>D!;;; the first day of the agreement. What is the fee

    the company must pay? What is the effective interest rate?

    9ol&tion8

    Line of credit limit = K!;;;!;;;

    Loan rate = .9M

    6nnual fee on used balance = ;.M

    6mount borrowed = K>D!;;;

    2nused balance = K9/!;;;

    6nnual fee = K9/!;;; x ;.;; = 1$2)/

    5nterest expense = K>D!;;; x ;.;9 = K9!DD

    //4B=+

    =

    +=

    K>D?!;;;

    K-!>/?(K9?!DD?

    amountEorrowed

    fee6nnualexpense5nterestrateinterest,ffective

    14)4 Lockbo+8Pennifer ,lectricals is evaluating whether a lockbox they are currently using is

    worth keeping. 1anagement estimates that the lockbox reduces the mail float by . days

    and the processing by half a day. 'he remittances average K;!;;; a day for Pennifer

    ,lectricals! with the average check K;;. 'he bank charges K;.9 per processed check.

    6ssume that there are /D; business days in a year and the firm"s opportunity cost of those

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    funds is > percent. What will the firm"s savings be from using the lockbox?

    9ol&tion8

    6verage daily sales = K;!;;;

    #o. of business days = /D;

    3pportunity cost of funds = >M

    6verage check amount = K;;

    #o. of checks processed per day = K;!;;; : K;; = ;;

    $ollection time saved = . days

    Crocessing time saved = ;. days

    Cer-check processing fee = K;.9

    'he cost of a lockbox = ;; checks K;.9 per check /D; days = KF!;

    +avings from mail float = . days K;!;;; = KF;!;;;

    +avings from processing float = ;. days K;!;;; = K/!;;;

    'otal savings = (+avings from mail float @ +avings from processing float

    = KF;!;;; @ K/!;;; = K!;;;

    +avings from lockbox = K!;;; ;.;>= 2$@DD

    +ince the savings from the lockbox is less than the cost of the lockbox! it is not worth

    keeping the lockbox for Pennifer ,lectricals.

    14)/ Lockbo+8Ha4el $orp. has Bust signed up for a lockbox. 1anagement expects the

    lockbox to reduce the mail float by /. days. Ha4el $orp."s remittances average K9D!;;;

    a day for Ha4el! with the average check being K/. 'he bank charges K;.9D per

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    processed check. 6ssume that there are /D; business days in a year. What will the firm"s

    savings be from using the lockbox if the opportunity cost of those funds is / percent?

    9ol&tion8

    6verage daily sales = K9D!;;;

    #o. of business days = /D;

    6verage check amount = K/

    #o. of checks processed per day = K9D!;;; : K/ = /F>

    $ollection time saved = /. days

    Cer check processing fee = K;.9D

    'he cost of a lockbox = /F> checks K;.9D per check /D; days = K/F!D;.;

    +avings from mail float = /. days K9D!;;; = KDD!D;;

    3pportunity cost of funds = /M

    +avings from lockbox = KDD!D;; ;./= @$,)4

    +ince the savings from the lockbox is less than the cost of the lockbox! it is not worth

    keeping the lockbox for Ha4el $orp.

    14)2 Aging sc'e%&le8Iinseng $ompany collects ; percent of its receivables in ; days or

    fewer! 9 percent in to 9; days! D percent in 9 to days! D percent in > to >; days!

    and percent in more than >; days. 'he company has K!/9!;;; in accounts receivable.

    Crepare an aging schedule for Iinseng $ompany.

    9ol&tion8

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    6ccounts receivables = K!/9!;;;

    Age o" Acco&nts -in %a*s. ;al&e o" Acco&nt -. B o" Total Acco&nt

    ;-; K >;>!;; ;.;M-9; 9D>!;9; 9.;

    9- !F; D.;>->; !F; D.;3ver >; >;!>; .;Total K!/9!;;; ;;.;M

    14) Aging sc'e%&le86 partial aging of accounts receivable for Lincoln $leaning +ervices is

    given in the following table. What percent of receivables are in the -day range?

    0etermine the firm"s effective days" sales outstanding. How does it compare to the

    industry average of 9 days?

    Age o" Acco&nts

    -in %a*s. ;al&e o" Acco&nt -. B o" Total Acco&nt

    ; K/D!;;;9; !//;

    >; 9!F;D 9!/Total KF!/ ;;.;M

    9ol&tion8

    6ccounts receivables = KF!/

    Age o" Acco&nts

    -in %a*s. ;al&e o" Acco&nt -. B o" Total Acco&nt

    ; K/D!;;; >.;M9; !//; /.> $, 14@>; 9!F; F./D 9!/ .9

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    Total KF!/ ;;.;M

    ,ffective 0+3= 6ge of the account category Cercent of 67 for the account category

    = (; x ;.> @ 9; x ;./> @ x ;.F @ >; x ;.;F/ @ D x ;.;9

    = /./ days

    'he firm is more efficient than other firms in the industry as its effective 0+3 is lower.

    14) Aging sc'e%&le8Qeswick )encing $ompany collects percent of its receivables in ;

    days or fewer! 9 percent in ; to 9; days! / percent in 9 to days! percent in > to

    >; days! and percent in more than >; days. 'he company has KF9D!;;; in its accounts

    receivable account. Crepare an aging schedule for Qeswick )encing.

    9ol&tion8

    6ccounts receivables = KF9D!;;;

    Age o" Acco&nts

    -in %a*s. ;al&e o" Acco&nt -. B o" Total Acco&nt

    ;-; K/!>; .;M-9; 9!; 9.;9- /!; /.;>->; >!; .;

    3ver >; 9D!; .;Total KF9D!;;; ;;.;M

    14)@ :actoring Renex! 5nc.! sells K/;!;;; of its accounts receivable to factors at 9 percent

    discount. 'he firm"s average collection period is F; days. What is the dollar cost of the

    factoring service? What is the simple annual interest cost of the factors loan?

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    9ol&tion8

    6ccounts receivables sold = K/;!;;;

    )actor discount = 9M

    6verage collection period = F; days

    0ollar cost of factoring per month = K/;!;;; x ;.;9 = $/DD

    0ollar cost over F; days = KD!;; x 9 = K//!;;

    +imple monthly interest cost of factoring = 9:FD = ;.;9;F9

    +imple interest cost of factoring = ;.;9;F9 x / = ,1B

    14,D :actoring 6 firm sells K;;!;;; of its accounts receivable to factors at / percent

    discount. 'he firm"s average collection period is one month. What is the dollar cost of the

    factoring service?

    9ol&tion8

    6ccounts receivables sold = K;;!;;;

    )actor discount = /M

    6verage collection period = 9; days

    0ollar cost of factoring per month = K;;!;;; x ;.;/ = )$DDD

    A!;A7CE!

    14,1 What impact would the following actions have on the operating and cash conversion

    cycles? Would the cycles increase! decrease! or remain the unchanged?

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    a 1ore raw material than usual is purchased.

    b 'he company enters into an off season! and inventory builds up.

    c Eetter terms of payment are negotiated with suppliers.

    % 'he cash discounts offered to customers are decreased.

    e 6ll else remaining the same! an improvement in manufacturing techni%ue decreases

    the cost of goods sold.

    9ol&tion8

    9it&ation Operating c*cle Cas' conversion

    c*cle

    a. 1ore raw material than usual is

    purchased.ncrease ncrease

    b. 'he company enters into an off

    season! and inventory builds up.ncrease ncrease

    c. Eetter terms of payment are

    negotiated with suppliers.

    o change +ecrease

    d. 'he cash discounts offered to

    customers are decreased.ncrease ncrease

    e. 6ll else remaining the same! an

    improvement in manufacturing

    techni%ue decreases the cost of goods

    sold.

    ncrease nchanged

    14,) What impact would the following actions have on the operating and cash conversion

    cycles? Would the cycles increase! decrease! or remain the unchanged?

    a Less raw material than usual is purchased.

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    b 'he company encounters unseasonable demand! and inventory declines rapidly.

    c 'ighter terms of payment are demanded by suppliers.

    % 'he cash discounts offered to customers are increased.

    e 6ll else remaining the same! due to labor turnover and poor efficiency! the cost of

    goods sold increases.

    9ol&tion8

    9it&ation Operating c*cle

    Cas' conversion

    c*clea. Less raw material than usual is

    purchased.+ecrease +ecrease

    b. 'he company encounters unseasonable

    demand! and inventory declines rapidly.+ecrease +ecrease

    c. 'ighter terms of payment are demanded

    by suppliers.o change ncrease

    d. 'he cash discounts offered to customers

    are increased. +ecrease +ecrease

    e. 6ll else remaining the same! due to

    labor turnover and poor efficiency! the

    cost of goods sold increases.+ecrease nchanged

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    14,, 1organ +ports $ompany Bust reported the following financial figures.

    Morgan 9ports E&ipment Compan*

    Assets Liabilities an% E&it*

    $ash and marketable sec. K >DD!/9 6ccounts payable K!D/

    6ccounts receivable !!9 #otes payable /!5nventories !9/!D

    'otal current assets K9!9!; 'otal current liabilities K9!9

    #et sales F!F/!/9/$ost of goods sold !FD!9FF

    a $alculate the firm"s days" sales outstanding.

    b What is the firm"s days" sales in inventory?

    c What is the firm"s days" payable outstanding?

    % What is the firm"s operating cycle? How does it compare to the industry average

    of D/ days?

    e What is the firm"s cash conversion cycle? How does it compare to the industry

    average of / days?

    9ol&tion8

    a6ccounts receivable K-!L?!--9

    0+3 = = = >$redit sales 9>? KF!F-/!99/ 9>?

    @ %a*s

    b. %a*sCD2===9>?9FF!FD!?K

    DL!9-/!-K

    9>?$3I+

    5nventory0+5

    c.6ccounts Cayable K-!D/-!>>F

    0C3 = =$3I+ 9>? K?!FD!9FF 9>? = 1D/ %a*s

    d.

    %a*s14C/=+=+=

    >.L;F.>D

    0+50+3cycle3perating

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    'he firm is very inefficient in managing its receivable and inventory as its

    operating cycle exceeds the industry average of D/ days by about DD days.

    e.%a*s4)C=

    +=

    +=

    D.-;?>.L;F.>D(

    0C30+50+3cycleconversion$ash

    'he firm"s cash conversion cycle is on a par with the industry average of / days

    thanks to its suppliers" very generous credit policy.

    14,4 Packson ,lectricals is one of the largest dealers of generators in Choenix and sells about

    /!;;; of them a year. 'he cost of placing an order with their supplier is KD;!! and the

    inventory-carrying costs are KD; for each generator. 'hey like to maintain safety stock

    of at all times.

    a What is the firm"s ,3A?

    b. How many orders will the firm need to place this year?

    c What is the average inventory for the season?

    9ol&tion8

    6nnual sales = /!;;; units

    $ost of placing an order = KD;

    5nventory-carrying cost per generator = KD;

    +afety stock = generators

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    a.

    L.-9/-D;K

    ;;;!/D?;K/

    tscos$arrying

    periodper+alescosts7eorder/,3A

    ==

    =

    ,conomic order %uantity = 1,, generators

    b. #o. of orders the firm needs to place = /!;;; : 99 = 1/ or%ers

    c. 6verage inventory = ((99 O ;:/ @ = ) generators

    14,/ 'an4ani%e! 5nc.! sells K/;;!;;; of its accounts receivable to factors at percent discount.

    'he firm"s average collection period is F; days.

    a What is the dollar cost of the factoring service?

    b What is the simple annual interest cost of the factors loan?

    c What is the effective annual interest cost of the loan?

    9ol&tion8

    6ccounts receivables sold = K/;;!;;;

    )actor discount = M

    6verage collection period = F; days

    a. 0ollar cost of factoring per month = K/;;!;;; x ;.; = 1D$DDD

    0ollar cost over F; days = K;!;;; x 9 = K9;!;;;

    b. +imple monthly interest cost of factoring = :F = ;.;/>

    +imple interest cost of factoring = ;.;/> x / = 2,)B

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    c

    /D2B==+=

    +=

    ;>.;

    ;/>.;(

    rateAuoted

    ,67

    /

    m

    m

    CFA )roble!s

    .9>. 6 company increasing its credit terms for customers from :;! net 9; to :;! net >; willlikely experience

    6. an increase in cash on hand.E. an increase in the average collection period.$. higher net income.

    0. a higher level of uncollectible accounts.

    9ol&tion8

    E is correct.

    .9D. +uppose a company uses trade credit with the terms of /:;! net ;. 5f the company paystheir account on the ;th day! the effective borrowing cost of skipping the discount onday ; is closest to

    6. .>ME. .FM

    $. .;M0. /;./M

    9ol&tion8

    0 is correct.9>?:;

    ;.;/$ost = -@ - /;./ percent

    ;.FL

    =

    .9. Which of the companies has the lowest accounts receivable turnover in the year /;S/?

    6. $ompany 6E. $ompany E$. $ompany $0. $ompany 0

    9ol&tion8

    E is correct.

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    $ompany 6 K>.; million:K./ million = .;;$ompany E K.; million:K. million = /.>D$ompany $ K9.; million:K.; million = 9.;;$ompany 0 K;.> million:K;./ million = 9.;;

    .9F. 'he industry average receivables collection period6. increased from /;S to /;S/E. decreased from /;S to /;S/$. did not change from /;S to /;S/0. increased along with the increase in the industry accounts receivable turnover.

    9ol&tion8

    E is correct./;S D9 days

    /;S/ D;.9F9#ote 5f the number of days decreased from /;S to /;S/! the receivableturnover increased.

    .;. Which of the companies reduced the average time it took to collect on accountsreceivable from /;S to /;S/?

    6. $ompany 6E. $ompany E$. $ompany $0. $ompany 0

    9ol&tion8

    E is correct.$ompany E increased its accounts receivable (6:7 turnover and reducedits number of days of receivables between /;S and /;S/.

    /;S /;S/$ompany 6:7 #umber 67 #umber

    turnover of days of turnover of days of receivables receivables

    6 .;;; D9.;;; .;;; D9.;;;E /.;; >.;;; /.>>D 9>.D$ 9./ >.;; 9.;;; /.>>D0 .;;; D9.;;; 9.;;; /.>>D

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    9ample Test Problems

    141 5f your firm"s 0+3 is D.9 days and the days" sales in inventory is 9F.> days! what is the

    firm"s operating cycle?

    9ol&tion8

    %a*sC2@=+=+=

    >.9F9.D

    0+50+3cycle3perating

    14) 5f $halet $orp. has an operating cycle of F9. days and days" payables outstanding of

    ./ days! what is the firm"s cash conversion cycle?

    9ol&tion8

    %a*s4/)==

    +=/.L.F9

    0C30+50+3cycleconversion$ash

    14, 7anger $leaning $ompany has borrowed KF;!;;; at a stated 6C7 of . percent. 'he

    loan calls for a compensating balance of percent. What is the effective interest rate for

    this company?

    9ol&tion8

    6mount to be borrowed = KF;!;;;

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    +tated annual interest rate = .M

    $ompensating balance = M

    6mount deposited as compensating balance = KF;!;;; x ;.; = KD!/;;

    ,ffective borrowing amount = KF;!;;; G KD!/;; = K/!;;

    5nterest expense = KF;!;;; x ;.; = KD!>;

    @)4B===KL/!L;;

    KD!>?;

    amountborrowing,ffective

    expense5nterestrateinterest,ffective

    144 7osemary $orp. has daily sales of K9F!;;;. 'he financial manager determined that a

    lockbox would reduce the collection time by /./ days. 6ssuming the company can earn

    . percent interest per year! what are the savings from the lockbox?

    9ol&tion8

    6verage daily sales = K9F!;;;

    $ollection time saved = /./ days

    +avings from mail float = /./ days K9F!;;; = K9;!;;

    +avings if invested = K9;!;; x (;.; = 12$1@

    14/ $hoi ,xports is setting up a line of credit at its bank for KD. million for up to three years.

    'he loan rate is D.D percent and also calls for an annual fee of ; basis points on any

    unused balance for the year. 5f the firm borrows K million on the day the loan agreement

    was signed! what is the firm"s effective rate?

  • 8/12/2019 chapter 14 for bfc2140 for monash

    69/69

    9ol&tion8

    Line of credit limit = KD!;;!;;;

    Loan rate = D.DM

    6nnual fee on used balance = ;.M

    6mount borrowed = K!;;;!;;;

    2nused balance = K/!;;!;;;

    6nnual fee = K/!;;!;;; x ;.;; = 1)$/DD

    5nterest expense = K!;;;!;;; x ;.;DD = K9F9!D;

    CD4B=+=

    +=

    KD!?;;!;;;

    K-/!?;;(K?F;!>/?

    amountEorrowedfee6nnualexpense5nterestrateinterest,ffective


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