Chapter 1 The Scope of Corporate Finance



Chapter 23: Short-Term Financial Management

Answers to End of Chapter Questions

1. The key cause of differences in operating cycles is the nature of the firm’s business. Some firms have most of their sales in cash and therefore have minimal accounts receivable. Others might have a very long production process, and therefore need to pay for materials far sooner than collections from sales can be made. Each firm should minimize its operating cycle, within the limits of the business.

2. A firm wishes to convert raw material expense into cash as quickly as possible. As with the operating cycle, collecting sooner and paying later provide the company with the most cash available for investing. The firm should work to maximize its inventory turnover, minimize its average collection period, and maximize its average payment period.

3. If a firm aggressively minimized its cash conversion cycle, its inventory turnover will increase, average collection period will decrease and average payment period will increase. The key constraint concerning inventory is the need to prevent stockouts that might cause lost sales. Accounts receivable policies must ensure that too-tight credit policies cause customers to turn to competitors. Accounts payable policies must insure that good relations with vendors are maintained with longer payment periods.

4. There are costs associated with holding too much and too little of each current asset and liability. For example, if a firm has a liberal credit policy, it will attract more customers, resulting in higher sales. However, it will have the cost of supporting the higher level of accounts receivable and possibly more bad debts. If the firm has more restrictive credit policies, it may lose sales to competitors with more liberal terms. The firm wants to find the amount of each asset that minimizes these competing costs. Figure 23.2 provides a picture of the trade-off between competing costs, showing a picture of the lowest total cost, the optimal balance.

5. If a firm stretches its payments to vendors, it may anger its suppliers and potentially have difficulty getting shipments in the future. The firm might also be giving up discounts for early payment. The manager must look at the incentive for paying early vs. the cost of financing from other sources.

6. A firm might extend credit in order to obtain higher sales. The manager must balance the higher sales and profits against higher costs of holding more accounts receivable and higher bad debts. The main factor in determining credit terms is the industry practice. If a firm has credit terms that are too restrictive, relative to its competitors, it is more likely to lose sales.

7. The financial manager can address competing concerns by presenting a cost/benefit analysis, clearly showing the costs and benefits of each alternative. The firm should be interested in increasing shareholder wealth by choosing cost-minimizing strategies. The firm’s cash or treasury functions generally manage accounts receivable. Credit policies may, however, be a concern of the marketing department, which will favor policies that maximize sales.

8. Firms set credit standards by applying techniques for determining which customers should receive credit and how much credit should be granted. In analyzing credit requests and determining the level of credit to be offered, the company can gather information from both internal and external sources, weighing the costs of the information against the additional benefits. It is difficult to strictly quantify standards. The company hopes its customer acceptances will result in a reasonable (usually in line with the industry) default rate. Two common approaches to granting credit include the five Cs of credit and credit scoring.

9. The five Cs are more appropriate for high dollar clients because applying them requires an analyst experienced in reviewing and granting credit requests. A great deal of time and expense is involved in applying the five Cs. High volume, low dollar credit requests may not justify the expense of evaluating the five Cs.

10. Credit scoring applies statistically derived weights for key financial and credit characteristics to predict whether a potential customer will pay in a timely manner. The score measures the applicant’s overall credit strength. It is most commonly used by large credit card operations, such as those of banks, oil companies and department stores. Most useful factors might include credit references, home ownership, income range, payment history, year at address and years on the job.

11. When considering changing credit standards, the firm must look at what impact a change would have on sales, costs and overall cash flows. A restrictive credit policy could cost the firm lost sales, while relaxing standards could lead to an increase in bad debts. Relaxing credit standards generally increases sales and bad debt expense. Tightening credit standards lowers accounts receivable and bad debts but also lowers sales and profits. We use only variable costs because the model assumes an increase in sales will not cause fixed costs to increase.

12. The actual lost is the $16 cost of the sale, not the retail value of the sale. Bad debts are generally recognized at the cost of the sale for tax reasons. For tax reasons, the firm has lost the actual amount of the sale.

13. If a firm is considering increasing its cash discount, it must look at its own cost of financing. It is in essence providing financing to its customers. If it can obtain its own financing more cheaply, then it would make sense to offer increased financing to its customers. Here the focus is more on the cost of the company’s borrowing, rather than the impact of policies on sales and profits, as is the case with changing the firm’s credit standards.

14. Credit monitoring involves the ongoing review of a firm’s accounts receivable to determine if customers are paying according to the stated credit terms. If customers are not paying on time, credit monitoring will alert the firm to the problem. Average collection period allows the firm to determine if there is a general problem with accounts receivable. Aging of accounts receivable allows the firm to see what percentage of customers at any given time are falling behind on their payments. The payment pattern is the normal timing in which a firm’s customers pay their accounts, expressed as a percentage of monthly sales collected in each month following the sale. By tracking patterns over time, the company can determine its average pattern.

15. Payment pattern monitoring is helpful if the firm has very cyclical sales patterns. Payment patterns are not affected by changes in sales levels and should be constant over time. If the payment pattern changes, the firm should review its credit policies.

16. Float refers to funds that have been sent by the payer but are not yet usable funds to the payee. The four components of float are

• Mail float, the time delay between when payment is placed in the mail and when it is received.

• Processing float, the time between receipt of the payment and its deposit into the firm’s accounts

• Availability float, the time between deposit of the check and the availability of the funds to the firm.

• Clearing float, the time between the deposit of the check and the presentation of the check back to the bank on which it is drawn

From a collection and payment perspective, mail and processing float are generally the same. Availability and clearing float are concerns of the firm, not the payer of funds to the firm.

17. Cash position management involves looking at, on a daily basis, the collection, concentration and disbursement of funds for the company. The cash manager looks at the amount of funds to be collected, moves balances to appropriate accounts and funds projected disbursements. The cash position can be managed into the future when future cash flows can be properly forecasted. Smaller firms that do not engage in active cash position management may set a target cash balance for their checking accounts. Generally this is determined based on transactions requirements or a minimum balance set by the bank. The transactions requirement is determined by how much cash a firm needs for its day-to-day operations. A bank account analysis statement determines the value of the balances a firm leaves on deposit and matches that to the value of the services provided by the bank. Minimum balances somewhat offset the fees charged by the bank for its services.

18. The firm’s goal is to collect moneys as quickly as possible. In a field-banking system, most collections are made over the counter or at a collection office. These systems typically have many collection points, each of which may have a depository account at a local bank. In a mail-based system, the company typically has one or more collection points that process the incoming mail payments. In electronic collection systems, customers are sent bills in electronic format and then can pay their bills via electronic means. Most systems are web-based.

19. A lockbox system affects all three components of float. Customers mail payments to a post office box, which is emptied by the firm’s bank. The bank processes each payment and deposits the payments in the firm’s account. The bank sends deposit slips to the firm so they can be credited to the customers’ accounts. Because lockboxes are located near the firm’s customers, mail time is reduced and often clearing time. Processing time is reduced to almost zero because the bank deposits payments before the firm processes them. The firm assesses the economics of a lockbox system by performing a cost-benefit analysis based on the float value reduction in dollars, the firm’s cost of capital, the annual operating cost of the lockbox system and the firm’s tax rate.

20. A depository transfer check is an unsigned check drawn on one of the firm’s bank accounts and deposited in another of the firm’s bank accounts. An automated clearinghouse debit transfer is a preauthorized electronic withdrawal from the payer’s account and is generally known as an electronic depository transfer. A wire transfer is an electronic communication that removes funds from the payer’s bank and deposits the check in the payee’s bank on the same day, eliminating mail and clearing float and possibly reducing processing float. Wire transfers are generally used only for high dollar transfers because of their cost.

21. Accounts payable management is concerned with the time between the purchase of raw materials and the mailing of payment to the supplier. The A/P function examines all incoming invoices and determines the proper amount to be paid. The cash manager matches the invoice to the purchase order and assures that the goods were actually received. Companies may make full use of any credit period offered. Once payment has been authorized (vouchering), the cash manager generally manages the preparation and mailing or checks or initiates the electronic transfer of funds.

22. The difference between the payment amount with and without taking the cash discount is in effect the interest payment made by the firm to the supplier. The firm must compare the interest rate charged by its suppliers to the best rate charged by its short-term lenders. If the firm’s outside financing is more costly, then it should take the cash discount and pay its suppliers early.

23. A zero balance account always has an end-of-day balance of zero. This eliminates nonearning cash balances in corporate checking accounts. Controlled disbursement is a bank service that provides early notification of checks that will be presented against a company’s account on a given day. This allows the firm to determine its cash position and make any necessary investment/borrowing decisions in the morning. Controlled disbursement accounts can be set up as zero balance accounts for automatic funding through a company’s concentration account. Positive pay is a bank service used to combat check fraud. In positive pay, the company transmits a check-issued file to the bank. The bank matches the presented checks against this file and rejects any items that do not match. ZBA relates to a firm’s target cash balance, particularly if the bank requires a minimum balance to be maintained. If the firm were using ZBA, then it would have to amend this to the bank’s minimum balance requirement to be in compliance with the bank’s requirements.

24. Short-term investments must be liquid so the company can cash them in easily when needed. Preservation of principal is also important since the firm will want to know how much cash it will have available when needed. A short-term investment policy should look instruments that earn a competitive return. Guidelines should specify the purpose of the investment portfolio and provide recommendations and/or restrictions on acceptable investments and diversification. Money market mutual funds invest in a variety of short-term instruments. Rather than invest in a money market mutual fund, the firm manager could directly invest in U.S. Treasuries, short-term instruments issued by the U.S. government; federal agency issues, those issued by government-sponsored enterprises; bank financial instruments such as certificates of deposit, time deposits and banker’s acceptances. Corporate obligations include commercial paper and adjustable rate preferred stock.

25. The key base rates used in variable rate short-term borrowing are the prime rate, the rate of interest charged by the largest U.S. banks on short-term loans to their best business customers and LIBOR, (London Interbank Offered Rate), the rate that most creditworthy international banks that deal in Eurodollars charge on Interbank loans. Banks may charge the company prime plus a specified number of basis points, and the bank may charge fees that also impact the effective borrowing rate. Factors that affect the effective interest rate include the amount of interest and fees paid, usable amount of the loan and term of the loan.

Solutions to End of Chapter Problems

23-1.

a. The firm’s operating cycle is the sum of its inventory (AAI) and average collection period (ACP)

= 110 days + 50 days = 160 days

b. CCC = OC – APP = 160 – 40 = 120 days

c. Resources invested in the cash conversion cycle:

inventory = $36,000,000 × 75% × 110/365 = $8,136,986

+ accounts receivable = 36,000,000 × 50/365 = $4,931,507

– accounts payable = 36,000,000 × 75% × 70% × 40/365 = $2,071,233

= resources invested of $10,997,260

Management can work to reduce the amount of cash tied up in the cash conversion cycle by turning inventory more quickly, collecting accounts receivable more quickly, and paying payables more slowly.

23-2. Internet exercise

|23-3. |Plan |Inventory (I) |Collections (C) |Payments (P) |Change in CCC(I+C–P) |

| |A |+35 |+20 |+10 |+45 |

| |B |+20 |–15 |+10 |–5 |

| |C |–10 |+5 |0 |–5 |

| |D |–20 |+15 |+5 |–10 |

| |E |+15 |–15 |+20 |–20 |

Plan E will have the most beneficial impact on the collection cycle, with an increase in inventory and a decrease in the collection period canceling each other, leaving payments stretched by 20 days. This plan results in the biggest reduction (20 days) in the CCC.

23-4.

a. The firm’s AAI is 365/9.1 = 40 days in inventory on average

OC = AAI + ACP = 40 + 60 = 100 days

CCC = OC – APP = 100 – 35 = 65 days

b. Resources invested in the cash conversion cycle are:

Inventory = $72,000,000 × .5 × 40/365 = $3,945,205

+accounts receivable = $72,000,000 × 60/365 = $11,835,616

– accounts payable = $72,000,000 × .5 × .8 × 35/365 = $2,761,644

= resources invested of $13,019,177

c. If it reduces CCC by 20 days,

Resources invested in the cash conversion cycle are:

Inventory = $72,000,000 × .5 × 30/365 = $2,958,904

+ accounts receivable = $72,000,000 × 55/365 = $10,849,315

– accounts payable = $72,000,000 × .5 × .8 × 40/365 = $3,156,164

= resources invested of $10,652,055

Reduction in restructure investment=$43,019,177–$40,652,055=$2,367,122

The annual savings from the reduced investment = .14 × $2,367,122 = $331,397

d. If the change of 20 days could be accomplished in just one component, then it should be accomplished by reducing the firm’s collection period. This is most directly tied to sales and makes the biggest dollar contribution per day saved toward the reduction in resources invested.

23-5.

a. The firm’s AAI is 365/5 = 73 days in inventory on average

OC = AAI + ACP = 73 + 32 = 105 days

CCC = OC – APP = 105 – 25 = 80 days

b. Resources invested in the cash conversion cycle are:

Inventory = $3,600,000,000 × .8 × 73/365 = $576,000,000

+ accounts receivable = $3,600,000,000 × 32/365 = $315,616,438

– accounts payable = $3,600,000,000 × .8 × .5 × 25/365 = $98,630,137

= resources invested of $792,986,301

c. If it reduces CCC by 12 days solely by extending the average payment period by 12 days,

Resources invested in the cash conversion cycle are:

Inventory = $3,600,000,000 × .8 × 73/365 = $576,000,000

+ accounts receivable = $3,600,000,000 × 32/365 = $315,616,438

– accounts payable = $3,600,000,000 × .8 × .5 × 37/365 = $145,972,603

= resources invested of $745,643,835

Reduction in CCC investment = $792,986,301 – $745,643,835 = $47,342,466

Increase in annual profits from reduction in CCC = .18 × $47,342,466 = $8,521,644

d. A 12-day reduction in the average collection period would of have had a bigger impact, as would a 12-day reduction in the average age of inventory. In the calculation, accounts payable are reduced by both the percent of cost of goods sold and the percent of cost of goods sold that is represented by purchases. Because the accounts receivable investment is based on sales rather than cost of goods sold for inventory, a reduction in the average collection period would provide the largest reduction in resource investments and therefore the largest profit increase. The 12-day reduction in the average collection period is recommended.

23-6. Internet exercise

23-7. The inventory investment will decline by $2.05 million × .40 = $820,000. This decline will save the firm $820,000 × .14 = $114,800 per year. Subtracting the annual cost of $95,000 from the $114,800 annual savings results in net annual savings of $19,800. The firm should install the system.

23-8.

a. The average amounts of financing provided are:

|Pay Period |Payroll |Average Amount of Financing |

|Monthly |$4,000,000 |$4,000,000/2 = |$2,000,000 |

|Every 2 weeks |$1,800,000 |$1,800,000/2 = |$900,000 |

| |Additional Financing Provided |$1,100,000 |

b. Earnings on Additional Financing Invested = .15 × $1,100,000 = $165,000

– cost of New Health Plan 180,000

Net Loss from Proposal $–15,000

No, the firm should not change the pay period as proposed because the annual return on the additional financing of $165,000 is less than the $180,000 annual cost of the new health plan. A net loss of $15,000 would result from implementing the proposal.

23-9.

|a. | |Scores |Weighted scores |

| |Characteristic |X |Y |Z |X |Y |Z |

| |References (.25) |60 |90 |80 |15 |22.5 |20 |

| |Education (.10) |75 |80 |80 |7.5 |8 |8 |

| |Home (.10) |100 |90 |60 |10 |9 |6 |

| |Income (.15) |70 |70 |80 |10.5 |10.5 |12 |

| |History (.30) |60 |85 |70 |18 |25.5 |21 |

| |On job (.10) |50 |60 |90 |5 |6 |9 |

| |Score | | | |66 |81.5 |76 |

b. Applicant X should be rejected (7080), and Applicant Z accepted on a probationary basis (>70 ................
................

In order to avoid copyright disputes, this page is only a partial summary.

Google Online Preview   Download