Set-8-solutions - tute solutions PDF

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BFC2140 CORPORATE FINANCE I TUTORIAL SET 8 - SOLUTIONS WORKING CAPITAL MANAGEMENT Warm up 8-1. Define net working capital, and discuss the importance of working capital management. Net working capital is the difference between current assets and current liabilities. Working capital management refers...

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BF BFC2140 CORPORATE FINANCE I TUTORIAL SET 8 - SOLUTIONS WORKING CAPITAL MANAGEMENT Warm up 8-1.

Define net working capital, and discuss the importance of working capital management. Net 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. The goal of working capital management is to ensure that the company can continue its day-to-day operations and pay its short-term debt obligations.

8-2.

What are some of the trade-offs required 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.

Question 1: Given the aggregate balance sheet and income statement for Sifty Sasha's Burbon Exporters, calculate the cash conversion cycle. Income Statement Sales COGS

3,635 Inventory 3,257 A/R A/P

Balance Sheet Start 2015 390 403 249

End 2015 420 432 272

Average daily sales = sales/365 days = 3,635/365 = 9.96 Average daily COGS = COGS/365 days = 3,257/365 = 8.92 Inventory days = inventory / (average daily COGs) = 420/8.92 = 47.09 Accounts receivable days = accounts receivable / average daily sales = 432/9.96 = 43.37 Accounts payable days = accounts payable / average daily COGS = 272/8.92 = 30.49 CCC = Inventory days + accounts receivable days – accounts payable days = 47.09 + 43.37 – 30.49 = 59.97

Question 2: Listed below are three different transactions that Sifty Sasha Burbon exporters might make. Indicate how each transaction would affect each of the following (a) Cash (b) Working Capital Your responses should be: Increase, Decrease or No change. Transaction Cash Net Working Capital (i) Your company makes a sale of inventory for cash at cost. (ii) Your company takes delivery of $1,000 worth of inventory on 30 days credit. (iii) Your company arranges for $1,000,000 worth of short term debt to be refinanced with debt of 4 years maturity. (iv) Your Company donates $40,000 to charity. Net working capital = current assets – current liabilities Transaction (i) Your company makes a sale of inventory for cash at cost. (ii) Your company takes delivery of $1,000 worth of inventory on 30 days credit. (iii) Your company arranges for $1,000,000 worth of short term debt to be refinanced with debt of 4 years maturity. (iv) Your Company donates $40,000 to charity.

Cash Increase

no change no impact on cash

no change no impact on cash

Decrease

Net Working Capital No Change Cash (CA) will increase and inventory (CA) will decrease. No Change inventory will increase (CA) and A/C Payable will increase (CL) NWC = CA – CL = no change Increase ST debt (CL) will decrease and LT debt will increase. Hence, NWC = CA – CL = increase Decrease CA decrease

Question 3: The credit terms for each of three suppliers are shown in the following table. Supplier A B C

Credit terms 1/10 net 55 2/10 net 30 2/20 net 60

Required A) Determine the approximate cost of giving up the cash discount from each supplier. Assume a 360 day year. B) Assuming your firm needs short-term financing, recommend whether it would be better to give up the cash discount or take the discount and borrow from a bank at 15% annual interest. Evaluate each supplier separately using your findings in a. C) What impact, if any, would the fact that your firm could stretch its accounts payable (net period only) by 20 days from supplier C have on your answer in (b) relative to this supplier? a) Assuming a $100 purchase For Supplier A, the credit term of 1/10 net 55 means that you get a 1% discount if you pay within 10 days or you can pay the full amount within 55 days. One percent of $100 is a $1 discount, so you can either pay $99 in 10 days or $100 in 55 days. The difference is 45 days, so you need to compute the interest rate over the 45 days and then compute the effective annual rate associated with that 45 day interest rate. $1/$99 = 0.0101 or 1.01% interest for 45 days. There are 360/45 = 8 periods of 45 days in a year. Thus, your effective annual rate is (1.0101) 8 – 1 = 0.083723 or 8.37%

Similarly for Supplier B, the term 2/10 net 30 means that you get 2% discount if you pay within 10 days or full amount if paying in 30 days. The interest is 2/98 = 0.020408 or 2.0408% for 20 days. Thus, the effective annual rate is (1+0.020408)(360/20) -1 = 0.43857 or 43.86% For Supplier C, the term 2/20 net 60 means that you get 2% discount if you pay within 20 days or full amount if paying in 60 days. The interest is 2/98 = 0.020408 or 2.0408% for 40 days. Thus, the effective annual rate is (1.020408)(360/40) -1 = 0.1994 or 19.94% b) For Suppliers B and C, if you could find a bank that would lend you at 15% annual interest, you would be better off borrowing from the bank and take advantage of the discount. This is because the cost of forgoing the discount for these two suppliers is higher than the cost of borrowing from the bank. For Supplier A, the cost of forgoing the discount is smaller than the cost of borrowing from the bank, so you are better off borrowing from the Supplier A. c) If you could stretch your accounts payable by 20 days from Supplier C, you the term is now essentially 2/20 net 80. Repeat the analysis above with the new term, the effective annual rate is (1.020408)(360/60) -1 = 0.12887 or 12.89% Now, the cost of borrowing from Supplier C is lower than from the bank (15%), thus you would forgo the discount. The risk (cost) of doing stretching is, however, that Supplier C may discontinue business with your firm, leaving your firm to find another source, which may be more expensive or

of lower quality. A poor credit rating might also result, making it difficult for your firm to obtain good credit terms with other suppliers. Question 4: What effect will the following events have on the cash conversion cycle? A) Higher financing rates induce the firm to reduce its level of inventory. B) The firm obtains a new line of credit that enables it to avoid stretching payables to its suppliers. C) The firm factors its accounts receivable. D) A recession occurs, and the firm’s customers increasingly stretch their payables a) Higher finance rates induce the firm to reduce its level of inventory. Thus, the cash conversion cycle will be lower. b) The firm obtains a new line of credit that enables it to avoid stretching payables to its suppliers. The cash conversion cycle could be higher since account payables days is lower. c) The firm factors its accounts receivable. Since accounts receivable is lower, CCC will also be lower. d) A recession occurs, and the firm’s customers increasingly stretch their payables. As the firm’s accounts receivable days increase, CCC is higher....