Working capital management Recently you were appointed as finance manager of Superior Stationery Ltd, a company specialising in manufacturing high-end modern stationery. The management has signalled that the firm’s cash management practices needs improving.

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Working capital management Recently you were appointed as finance manager of Superior Stationery Ltd, a company specialising in manufacturing high-end modern stationery. The management has signalled that the firm’s cash management practices needs improving. After an initial evaluation you determine that the current operating and cash conversion cycles have a substantial impact on cash management. Further investigation reveals that the company is operating at production levels that do not take advantage of volume discounts, and that most suppliers do not offer cash discounts. A check on supplier’s invoices indicates that the company usually receive credit terms of net 30. An analysis of the company’s accounts payable showed that its average payment period is 39 days. You managed to get hold of industry data and found that the industry average payment period is 39 days. Next you studied the production cycle and inventory policies. The company’s policy is not to hold any more inventory than necessary in either raw materials or finished goods. The industry standard for average inventory age as reported in the trade association journal is 83 days, but for the company it is 110 days. The company sells to its customers on a net 60 basis, in line with the industry trend to grant such credit terms on stationery. By ageing the accounts receivable, you discovered that the average collection period for the firm was 75 days. Investigation of the trade association’s averages showed that the same collection period existed where net 60 credit terms were given. Where discounts were offered, the collection period was significantly reduced. If the company was to offer credit terms of 3/10 net 60, you believe that the average collection period could be reduced by 40%. The company was spending an estimated $26.5 million per year on operating cycle investments. You considered this expenditure level to be the minimum you would expect the firm to disburse during the year. Your concern was whether the firm’s cash management was as efficient as it could be. The company paid 15% for its cost of financing. For this reason you are concerned about the financing cost resulting from any inefficiencies in the management of the company’s cash conversion cycle. Required Based on the information given, answer the following questions. Note: You are to assume that the operating cycle investment per dollar of payables, inventory and receivables is the same, and work on the basis of a 365-day year. (a) Assuming a constant rate for purchases, production and sales throughout the year, calculate the company’s existing: (i) Operating cycle (OC). (ii) Cash conversion cycle (CCC). © The Open Polytechnic of New Zealand 3 603_71205 (iii) Resource investment needs. (4 marks) (b) If you can optimise the company’s operations according to industry standards, what would the company’s OC, CCC and resource investment needs be under these more efficient conditions? (4 marks) (c) In terms of resource investment requirements, what is the cost of the company’s operational inefficiency? (Hint: compare your answers to (a) and (b) and calculate the cost of financing.) (3 marks) (d) (i) If, in addition to achieving industry standards for payables and inventory, the firm can reduce the average collection period by offering 3/10 net 60 credit terms, what additional savings in financing costs would result from the shortened CCC, assuming that the level of sales remains constant? Hint: Repeat (b) and (c) above and recalculate industry OC, CCC and resource investment needed, which is also called the financing needed with the discount. (6 marks) (ii) If the firm’s sales (all on credit) are $40 million and 45% of the customers are expected to take the cash discount, how much will the firm’s annual revenues be reduced by as a result of the discount? (2 marks) (iii) If the firm’s variable cost of the $40 million in sales is 80%, determine the reduction in the average investment in accounts receivable and the annual savings resulting from this reduced investment assuming that sales remain constant. Hint: Refer to the example on page 640 of your textbook (Table 14.3). (6 marks) (iv) If the firm’s bad debt expenses decline from 2% of sales to 1.5% of sales (which is $40 million), what annual savings would result, assuming sales remain constant? (3 marks) (v) Using your findings in (b)–(d), calculate if any net profit or loss results from offering the cash discount. (2 marks) (e) On the basis of your analysis in (a)–(d), would you bring working capital measures in line with the industry and offer the proposed cash discount? Explain briefly. (2 marks) 4 © The Open Polytechnic of New Zealand 603_71205 (f) Other than accounts payable, what are the key sources of short-term financing that the company may consider in order to finance its resource investment need, as calculated in (b). List five unsecured sources and three secured sources. (8 marks) (g) Are secured short-term loans viewed as more risky than unsecured short-term loans? Why?/Why not? Explain, by giving two reasons. (2 marks) (h) In general, are interest rates and fees levied on secured short-term loans higher than the rates on unsecured short-term loans? Why?/Why not? Explain, by giving three reasons. (3 marks) [Total: 45 marks] Question 2: Better returns through cash management Sally Kano, head teacher at a local kindergarten, gets paid every 2 weeks by direct deposit into her cheque account. This account pays no interest and has no minimum balance requirement. Her monthly income (after deductions) is $4,200. Sally has a target cash balance of around $1,200. Whenever it exceeds that amount she transfers the excess into her savings account, which currently pays 2% annual interest. Her current savings balance is $15,000. Sally estimates she transfers about $500 per month from her cheque account into her savings account. Sally doesn’t waste any time in paying her bills and her monthly bills average about $2,000. Her monthly cash outlay for food, transport and other sundry items totals about $850. Reviewing her payment habits indicates that on average she pays her bills 9 days early. At present, most marketable securities (government bonds) are yielding about 4.75% annual interest. Required (a) What can Sally do regarding the handling of her current balances? Should Sally transfer her current savings account balances into marketable securities? Explain briefly. (2 marks) (b) Calculate the increase in annual interest earnings if Sally’s monthly surpluses are invested in marketable securities. (3 marks) (c) If Sally transfers $500 monthly from her cheque account into marketable securities, calculate the increase in earnings on a month’s transfer. (3 marks) © The Open Polytechnic of New Zealand 5 603_71205 (d) Rather than paying bills so quickly, Sally intended to pay bills on their due date. Calculate the annual savings from slowing down payments. Hint: You need to calculate total annual bills and daily purchases, and find the returns on marketable securities from additional funds invested. (4 marks) (e) Summarise and total all of Sally’s additional earnings from (b), (c) and (d) above. Can Sally increase her earnings by better managing her cash balances? Explain briefly. (3 marks) [Total: 15 marks] Question 3: Paying cash or by instalments Tim and Jill Cook recently bought a house and are looking for a lounge and dining set to furnish it. They visit Elegant Furniture Ltd. The furniture store offers financing arrangements for customers who can’t afford to pay cash. Tim and Jill have the cash to pay for the furniture, but it would deplete their savings, so they are looking at the financing option. The lounge and dining set costs $3,000. The store offers a financing plan that would allow them to either: put 10% down payment and finance the balance at 12% annual interest over 24 months, or pay cash – the couple will receive an immediate cash rebate of $200, thereby paying only $2,800 cash to buy the furniture. Required (a) Calculate the cash down payment for the loan. (1 mark) (b) If the couple chooses to pay by instalments, calculate the monthly payment on the available loan. Hint: Treat the current loan as an annuity and solve for the monthly payment. (3 marks) (c) Calculate the initial cash outlay under the cash purchase option. You need to take into account the cash down payment on loan. (3 marks) (d) Given that the couple can earn 3% on their savings, what opportunity cost will they give up over the 2 years if they opt to pay cash? (3 marks) 6 © The Open Polytechnic of New Zealand 603_71205 (e) What is the total cost of the cash purchase option at the end of 2 years? Hint: Add the opportunity cost to the initial cash outlay. (2 marks) (f) Should the couple choose to pay by instalments or the cash alternative? Explain, giving reasons. (3 marks) [Total: 15 marks] Question 4: Lease versus buy Jacky, a small manufacturer, wants to acquire a new machine costing $30,000. This can be accomplished in two ways – either lease or purchase the machine. The company has gathered the following information about the two alternatives. Lease: Jacky would obtain a 5-year lease requiring annual beginning-of-year lease payments of $10,000. The lessor would pay all maintenance costs and the lessee would be responsible for insurance and other costs. Jacky would be given the right to exercise an option to purchase the machine for $3,000 at the end of the lease term. Purchase: Jacky can finance the purchase of the machine with a 9% 5-year loan requiring annual end-of-year instalment payments. The machine has a useful life of 5 years, with no scrap value. Jacky would pay $1,200 per year for a service contract that covers all maintenance costs. The company’s tax rate is 28%. Required (a) Calculate the after-tax cash outflow from the lease alternative. (3 marks) (b) Calculate the annual loan repayment for the purchase alternative. Hint: Use the present value annuity formula. (3 marks) (c) Determine the interest and principal components of the loan payments. (5 marks) (d) Calculate the after-tax cash outflows associated with the purchase alternative. (6 marks) (e) Compare the cash outflows associated with both the leasing and purchasing alternatives. (6 marks) © The Open Polytechnic of New Zealand 7 603_71205 (f) Which alternative is preferable? Explain briefly. (2 marks) [Total: 25 marks]


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