Chapter 6 Solution - CF2 PDF

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1 Questions and ExercisesCHAPTER 6CREDIT AND INVENTORY MANAGEMENTBASIC1. Cash Discounts You place an order for 400 units of inventory at a unit price of $115. The supplier offers terms of 1/10, net 30. a. How long do you have to pay before the account is overdue? If you take the full period, how muc...

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Questions and Exercises

CHAPTER 6 CREDIT AND INVENTORY MANAGEMENT BASIC 1. Cash Discounts You place an order for 400 units of inventory at a unit price of $115. The supplier offers terms of 1/10, net 30. a. How long do you have to pay before the account is overdue? If you take the full period, how much should you remit? b. What is the discount being offered? How quickly must you pay to get the discount? If you do take the discount, how much should you remit? c. If you don’t take the discount, how much interest are you paying implicitly? How many days’ credit are you receiving? ANSWER: a. You have to pay within 30 days before the account is overdue. If you take the full period, you should remit : 400x $115= $46000 b. Discount offered = 1% You must pay within 10 days in order to avail discount. If you do take the discount, you should remit: : 400x $115x(1-1%)= 45540 c. If you don’t take the discount, then you are paying interest : $46000- $45540= $460 Credit Period = 30 days - 10 days= 20 days 2. Size of Accounts Receivable The Paden Corporation has annual sales of $29.5 million. The average collection period is 27 days. What is the average investment in accounts receivable as shown on the balance sheet? ANSWER: Accounts Receivable turnover = 365/Average collection period = 365/27= 13.52 Average receivables = Annual credit sales/Accounts Receivable turnover= $29.5/ 13.52= 2.145 mil 3. ACP and Accounts Receivable Kyoto Joe, Inc., sells earnings forecasts for Japanese securities. Its credit terms are 1/15, net 30. Based on experience, 70 percent of all customers will take the discount. a. What is the average collection period for the company? b. If the company sells 1,300 forecasts every month at a price of $1,550 each, what is its average balance sheet amount in accounts receivable? ANSWER: a. Average collection period = 0.7x 15 days+ 0.3x 30 days = 19.5 days

Corporate Finance 11th edition by Ross, Westerfield, Jaffe, and Jordan

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b. Accounts Receivable turnover = 365/Average collection period = 365/19.5= 18.72

Average balance = Annual credit sales/Accounts Receivable turnover= ($1300x1,550x12)/ 18.72= 2.145 mil 4. Terms of Sale A firm offers terms of 1/10, net 30. What effective annual interest rate does the firm earn when a customer does not take the discount? Without doing any calculations, explain what will happen to this effective rate if: a. The discount is changed to 2 percent. b. The credit period is increased to 60 days. c. The discount period is increased to 15 days ANSWER: Assumed value of order = $1000, credit term: 1/10, net 30 => The buyer can pay $1000x(1-1%)= 990 in 10 days or wait another 20 days and pay $1000 a. The discount is changed to 2 percent => Credit term is 2/10, net 30 Interest per period= (1000x2%)/(1000x(1-2%)= 2.04% Period in a year= 365/20=18.25 EAR= (1+ 2.04%)^18.25-1=20.13% b. The credit period is increased to 60 days=> Credit term is 1/10, net 60 Interest per period= (1000x1%)/(1000x(1-1%)= 1.01% Period in a year= 365/50=7.3 EAR= (1+ 1.01%)^7.3-1=7.61% c. The discount period is increased to 15 days=> Credit term is 1/15, net 30 Interest per period= (1000x1%)/(1000x(1-1%)= 1.01% Period in a year= 365/15=24.3 EAR= (1+ 1.01%)^24.3-1=27.66%

5. Evaluating Credit Policy Air Spares is a wholesaler that stocks engine components and test equipment for the commercial aircraft industry. A new customer has placed an order for eight highbypass turbine engines, which increase fuel economy. The variable cost is $2.6 million per unit, and the credit price is $2.815 million each. Credit is extended for one period, and based on historical experience, payment for about 1 out of every 200 such orders is never collected. The required return is 2.9 percent per period. a. Assuming that this is a one-time order, should it be filled? The customer will not buy if credit is not extended.

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Questions and Exercises

b. What is the break-even probability of default in part (a)? c. Suppose that customers who don’t default become repeat customers and place the same order every period forever. Further assume that repeat customers never default. Should the order be filled? What is the break-even probability of default? ANSWER: P= $2.815 million each V= $2.6 million per unit a. A one-time order: NPV= -v+ (1-)xP/(1+r)= -2.6+2.815x(1-1/200)/(1+2.9%)=0.122 mil > 0 b. the break-even probability is determined when NPV= 0 => the break-even probability= 1- 2.6x(1+2.9%)/2.815= 4.96% 4.96% is the maximum acceptable default probability for a new customer c. Repeat customers: NPV= -v+ (1-)x(P-v)/r= -2.6+(2.815-2.6)x(1-1/200)/2.9%= 4.78 mil > 0 The break-even probability is determined when NPV= 0 => the break-even probability = 1- 2.6x2.9%/(2.815-2.6)= 64.93% 64.93% is the maximum acceptable default probability for a new customer 6. EOQ Fhloston Manufacturing uses 1,860 switch assemblies per week and then reorders another 1,860. If the relevant carrying cost per switch assembly is $6.25, and the fixed order cost is $730, is the company’s inventory policy optimal? Why or why not?

INTERMEDIATE 7. Credit Policy Evaluation Happy Times currently has an all-cash credit policy. It is considering making a change in the credit policy by going to terms of net 30 days. Based on the following information, what do you recommend? The required return is .95 percent per month.

ANSWER: The cash flow from the old policy is: = (289 – 226)*1105 = $69615 And the cash flow from the new policy will be: = (296 – 229)*1125 = $75375 The incremental cash flow, which is perpetuity, is the difference between the old policy cash flows and the new policy cash flows,

Corporate Finance 11th edition by Ross, Westerfield, Jaffe, and Jordan

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so: Incremental cash flow = $75375 - $69615 = $5760 ( Benefits of changing policy) Cost of new policy = – [PQ + Q (v ′ – v) + v ′ (Q ′ – Q)] In this cost equation, we need to account for the increased variable cost for all units produced. This includes the units we already sell, plus the increased variable costs for the incremental units. So, the NPV of switching credit policies is: NPV = –[(289x1105 + 1105x($229 – 226) + $229(1125 – 1105)] + ($5760/0.95%) = $279075.8 8. Credit Policy The Silver Spokes Bicycle Shop has decided to offer credit to its customers during the spring selling season. Sales are expected to be 700 bicycles. The average cost to the shop of a bicycle is $650. The owner knows that only 96 percent of the customers will be able to make their payments. To identify the remaining 4 percent, the company is considering subscribing to a credit agency. The initial charge for this service is $950, with an additional charge of $15 per individual report. Should she subscribe to the agency? ANSWER: Cost of subscription= Initial charge + additional charge per individual report x Sales of bicycles = 950 + 15x700 =11450 Savings from not selling to bad credit risks= Avg cost x Sales of bycycles x 4% = 650x700x4%=18200 Company’s net savings = Savings from not selling to bad credit risks - Cost of subscription = 1820011450 = $6750 => Company should subcribe to the agency 9. EOQ The Trektronics store begins each week with 675 phasers in stock. This stock is depleted each week and reordered. If the carrying cost per phaser is $73 per year and the fixed order cost is $340, what is the total carrying cost? What is the restocking cost? Should the company increase or decrease its order size? Describe an optimal inventory policy for the company in terms of order size and order frequency. ANSWER: Total carrying cost = Q/2 x CC= 675/2 x 73 = $24637.5 Number order= weekly orders= 52 weeks in a year The restocking cost= Fx (T/Q) = 340 x 52= 17680 Annual demand= 675x52=35100

Company should order 572 phasers instead 675 phasers. Company should decrease its order size from 675 phasers to 572 phasers Number of order in a year under new policy = Annual Demand/ Q* = 52x675/572 = 61.36 => 61 orders

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Questions and Exercises

10. Credit Policy Evaluation The Harrington Corporation is considering a change in its cash-only policy. The new terms would be net one period. Based on the following information, determine if Harrington should proceed or not. The required return is 2.5 percent per period. What is the breakeven quantity for the new credit policy?

What is the break-even quantity for the new credit policy? ANSWER: Current policy : Fixed cost = sales - variable cost = (2,870 x 104) - (2,870 * 47) = $163,590 New policy: Assumed Y be the break even quantity Present value of sales = (108/(1+2.5%) x Y = 105.37Y Fixed cost = sales - variable costs $163,590= 105.37Y – 47Y Y = 2802.64 or 2803 Break even quantity for new credit policy is 2,803 units (approx). CHALLENGE 11. Safety Stocks and Order Points Saché, Inc., expects to sell 700 of its designer suits every week. The store is open seven days a week and expects to sell the same number of suits every day. The company has an EOQ of 500 suits and a safety stock of 100 suits. Once an order is placed, it takes three days for Saché to get the suits in. How many orders does the company place per year? Assume that it is Monday morning before the store opens, and a shipment of suits has just arrived. When will Saché place its next order? ANSWER: Number of suits sold per week= 700 Number weeks in the year = 52 Total number of suits sold per year = 52× 700= 36400 EOQ= 500

Corporate Finance 11th edition by Ross, Westerfield, Jaffe, and Jordan

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Number of order per year= total suits sold per year / EOQ = 3640/500= 72.8 or 73 orders Once a order placed it takes three days for Sache to get it's suits, Monday morning a shipment of suits has arrived before the store open which means Friday last order placed because of three days delay. So next order will be on Wednesday. Approximately 5 days between each order. Next order placed on =365 days / 72.8 = 5.014 days 12. Evaluating Credit Policy Solar Engines manufactures solar engines for tractortrailers. Given the fuel savings available, new orders for 125 units have been made by customers requesting credit. The variable cost is $11,400 per unit, and the credit price is $13,000 each. Credit is extended for one period. The required return is 1.9 percent per period. If Solar Engines extends credit, it expects that 30 percent of the customers will be repeat customers and place the same order every period forever, and the remaining customers will place one-time orders. Should credit be extended? ANSWER:

Cost= v x Q =$11,400 x 125 = $1,425,000 NPV = =$4,274,185.22 - $1,425,000 = 2849185.22 >0  Solar engine can grant credit....