Practice Questions Week 14

Q1. Cash conversion cycle

Everdeen Inc. has a 90-day operating cycle. If its average age of inventory is 35 days, how long is
its average collection period? If its average payment period is 30 days, what is its cash conversion
cycle?
Solution:
Operating cycle = Average age of inventory + Average collection period
Average collection period = Operating cycle – Average age of inventory = 90 – 35 = 55 days
The collection period is 55 days (because the operating cycle is 90 days, and it is the sum of the
age of inventory and the collection period). The cash conversion cycle is the difference between
the operating cycle and the average payment period, so in this case the cash conversion cycle is 90
– 30 = 60 days.

Q2. Cash conversion cycle

Metal Supplies is concerned about its cash management. On average, the day’s sales in inventory
(duration of inventory on shelf) is 90 days. Accounts receivable are collected in 90 days, while
accounts payable are paid in 60 days. Metal Supplies has annual sales of $14 million; cost of goods
sold total $9.5 million, and purchases are $5 million. (Note: Use a 365-day year.)
a. Calculate Metal Supplies’ operating cycle.
b. What is Metal Supplies’ cash conversion cycle?
c. Calculate the amount of resources needed to support Metal Supplies’ cash conversion
cycle.
d. Discuss how Metal Supplies might be able to reduce its cash conversion cycle.

Solution:
a.OC = Average age of inventories + Average collection period
= 90 days + 90 days
= 180 days
b. CCC = Operating cycle − Average payment period
= 180 days − 60 days
= 120 days
c. To calculate the amount of resources needed, you must calculate the amount of inventory,
receivables, and accounts payable.
For the inventory balance: $9,500,000 × (90 ÷ 365) = $2,342,466
For the receivables balance: $14,000,000 × (90 ÷ 365) = $3,452,055
For the payables balance: $5,000,000 × (60 ÷ 365) = $821,918
So, the total resource requirement is $2,342,466 + $3,452,055 − $821,918 = $4,972,603

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 d. Turn inventory around as quickly as possible without stockouts that result in lost sales;
collect accounts receivable as quickly as possible without losing sales from high-pressure
collection techniques; manage mail, processing, and clearing time to reduce them when
collecting from customers and to increase them when paying suppliers; and pay accounts
payable as slowly as possible without damaging the firm’s credit rating or its relationships
with suppliers.

Q3. Changing cash conversion cycle

The Furniture Corporation turns over its inventory seven times a year, has an average collection
period of 45 days, and has an average payment period of 30 days. It has annual sales of $5
million and cost of goods sold of $1.8 million.
a. What is the firm’s operating cycle and cash conversion cycle?
b. Calculate the dollar value of inventory held by the firm.
c. Suppose the firm could reduce the average age of its inventory from 73 days to 63 days.
By how much would it reduce its dollar investment in working capital?
Solution:
a.OC = AAI + ACP
= 52 days + 45 days
= 97 days
CCC = OC −APP
= 97 days − 30 days = 67 days
b. The inventory balance equals cost of goods sold divided by inventory turnover:
Inventory = $1,800,000 ÷ 7 = $257,143
c. The investment in inventory will reduce from approximately $257,143 to $180,000, implying
that additional funds will be available for other purposes than inventory.
So the net working capital is reduced by $77,100 (i.e., $257,143 ‒ $180,000).

Q4. Funding requirements

Rajasthani Umbrella is a seasonal business that sells umbrellas. At the peak of its rainy selling
season, the firm has INR 2,500,000 in cash, INR 3,600,000 in inventory, INR 400,000 in accounts
receivable, and INR 350,000 in accounts payable. During the slow dry season, the firm holds INR
800,000 in cash, INR 1,000,000 in inventory, INR 200,000 in accounts receivable, and INR
150,000 in accounts payable. Calculate Rajasthani Umbrella’s minimum and peak funding
requirements.
Solution:
Maximum and minimum seasonal funding requirements
Funding requirement = cash + inventory + accounts receivable – accounts payable
Maximum funding requirement = INR 2,500,000 + INR 3,600,000+ INR 400,000 − IN350,000
= INR 6,150,000
Minimum funding requirement = INR 800,000+ INR 1,000,000+ INR 200,000 − INR 150,000
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 = INR 1,450,000

Q5. Aggressive versus conservative seasonal funding strategy

Dynabase Tool has forecast its total funds requirements for the coming year as shown in the
following table.

a. Divide the firm’s monthly funds requirement into (1) a permanent component and (2) a
seasonal component, and find the monthly average for each of these components.
b. Describe the amount of long-term and short-term financing used to meet the total funds
requirement under (1) an aggressive funding strategy and (2) a conservative funding
strategy. Assume that, under the aggressive strategy, long-term funds finance permanent
needs and short-term funds are used to finance seasonal needs.
c. Assuming that short-term funds cost 5% annually and that the cost of long-term funds is
10% annually, use the averages found in part a to calculate the total cost of each of the
strategies described in part b. Assume that the firm can earn 3% on any excess cash
balances.
d. Discuss the profitability–risk tradeoffs associated with the aggressive strategy and those
associated with the conservative strategy.

Solution:
a.
Total Funds Permanent Seasonal
Month Requirements Requirements Requirements
January $2,000,000 $2,000,000 $ 0
February 2,000,000 2,000,000 0
March 2,000,000 2,000,000 0
April 4,000,000 2,000,000 2,000,000
May 6,000,000 2,000,000 4,000,000
June 9,000,000 2,000,000 7,000,000
July 12,000,000 2,000,000 10,000,000
August 14,000,000 2,000,000 12,000,000

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 September 9,000,000 2,000,000 7,000,000
October 5,000,000 2,000,000 3,000,000
November 4,000,000 2,000,000 2,000,000
December 3,000,000 2,000,000 1,000,000

Average permanent requirement = $2,000,000

Average seasonal requirement = $48,000,000  12
= $4,000,000
b. (1) Under an aggressive strategy, the firm would borrow from $1,000,000 to $12,000,000
according to the seasonal requirement schedule shown in part a at the prevailing short-
term rate. The firm would borrow $2,000,000, or the permanent portion of its
requirements, at the prevailing long-term rate.
(2) Under a conservative strategy, the firm would borrow at the peak need level of
$14,000,000 at the prevailing long-term rate.
c. Aggressive  ($2,000,000  0.10) + ($4,000,000  0.05) = $200,000 + $200,000
= $400,000
Note that under the aggressive approach, there are no surplus balances.
Conservative Under the conservative approach, the firm borrows $14,000,000 because that
is required to cover its peak need during the year. During much of the year, the firm will
have excess cash to invest. The average amount of excess cash is the average difference
between the peak need, $14 million, and the sum of the permanent need and the average
seasonal need, $6 million. So the average surplus cash is $8,000,000.
Total interest paid = $14,000,000 × 0.10 = $1,400,000
Total interest received = $8,000,000 × 0.03 = $240,000
Total cost of conservative approach = $1,400,000 – $240,000 = $1,160,000
d. The aggressive approach is less costly for two reasons. First, some of the money that the firm
borrows costs 5% rather than 10%, whereas in the conservative approach the firm pays 10%
on all of its debt. Second, under the aggressive approach, the firm borrows less in total over
the year.
However, the conservative approach guarantees that the firm will have the money it needs
throughout the year, whereas the aggressive approach assumes that the firm can borrow at
5% whenever it wants to. The aggressive approach exposes the firm to refinancing risk, so
managers will have to make a judgment about whether eliminating that risk is worth the
added cost of the conservative approach.

Q6. Economic order quantity

Cohen Industrial Products uses 2,100 switch assemblies per month and then reorders another
2,100. The carrying cost per switch assembly is $20 per year, and the fixed order cost is $300. The
plant operates 250 days in a year and maintains a minimum inventory level of two days’ worth of
switch assemblies. Assuming that the lead time to receive orders is three days, calculate the
economic order quantity (EOQ) and the reorder point.

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Solution:
S = 25,200 (2,100 × 12)
O = $300
C = $20
EOQ = √ [(2 × S × O) ÷ C] = √ (2 × 25,200 × $300 / $20) = 869.482 or 870 Units
Reorder point = Days of lead time × Daily usage + Safety stock
= 3 days × (25,200 switches / 250 days) + [2 days]
= 102.8 or 103 units

Q7. EOQ analysis

Enviro Exhaust Company purchases 1,200,000 units per year of a component with a purchase
price of $50. The fixed cost is $15 per order, and the carrying cost is 30% of the purchase price.
a. Calculate the EOQ based on the data given.
b. Calculate the EOQ if the order cost is zero. What is the implication to the firm if there is a
decrease in the order cost?
Solution:
(2×𝑆×𝑂) (2×1,200,000×$15)
a. (1) EOQ = √ =√ = 1,549 units
𝐶 0.3×50
b. If the order cost is 0, EOQ = 0. EOQ decreases as ordering cost decreases. It will be more
cost effective for the firm to place more orders and keep less in stock (reducing carrying
cost) provided that no stockouts occur.
Q8. EOQ, reorder point, and safety stock
Outdoor Living Manufacturers uses 1,000 units of a product per year. Its fixed cost is $28 per
order, while the carrying cost is $5 per unit per year. The lead time is five days and, therefore,
the firm keeps seven days’ usage in inventory as safety stock. (Note: Use a 365-day year where
required.)
a. Calculate the EOQ and the average inventory.
b. How many orders will Outdoor Living Manufacturers place during one year?
c. When should Outdoor Living Manufacturers place its orders?
d. Suppose Outdoor Living Manufacturers does not keep safety stock. Explain the changes,
if any, which will occur in (1) order cost, (2) carrying cost, (3) total inventory cost, (4)
reorder point, and (5) EOQ.
Solution:
(2×𝑆×𝑂) (2×1,000×$28)
a. EOQ = √ 𝐶
=√ 5
= 106 units
Average level of inventory = EOQ ÷ 2 = 53 units
b. Number of orders = 1,000 ÷106 = 9.43 units

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 Outdoor Living Manufacturers will have to place 10 orders during one financial year
provided that all costs remain unchanged.
5×1,000 7×1,000
c. Reorder point= 365
+ 365 = 32.88 units
d. Order cost: The order cost is fixed and will not change.
Carrying cost: Remains unchanged.
Total inventory cost: May increase
if stock outs occur.
Reorder point: The reorder point will decrease from 33 units to 14 units.

Q9. Accounts receivable changes

Tara’s Textiles currently has credit sales of $30 million per month, an average collection period of
60 days, and bad debts equal to 3% of sales. Assume that the price of Tara’s products is $60 per
unit and that the variable costs are $55 per unit. The firm is considering tightening up their credit
policy, allowing customers 30 days rather than 60 to pay their bills. With a stricter credit policy in
place, sales will fall by 10%, but the average collection period will drop to 30 days and the bad
debts percentage will fall to 1%. Determine whether the company should make this change if their
cost of capital is 1% per month.
Solution:
Answering this question is essentially a capital budgeting problem that requires a comparison between the
cash flow stream that Tara’s Textiles generates under its current policy and the cash flows it would
generate under the new policy. The better policy is the one that provides the higher NPV.
Step 1: Calculate the NPV of the cash flow stream from Tara’s current credit policy:
Monthly units of manufacturing = $30,000,000 ÷ $60 per unit = 500,000
Monthly variable cost of manufacturing (MVCM) = 500,000 units × $55 = $27,500,000
Collection on credit sales in 60 days = 500,000 units × $60 × (1 – 0.03) = $29,100,000
Monthly net cash flow (MNCF) starting in 60 days = $29,100,000 – $27,500,000 =
$1,600,000
NPVCurrent = MVCM0 – PV0 of MVCM1 + PV0 of MNCF starting in 60 days
NPVCurrent = –$27,500,000 – $27,500,000/(1 + 0.01) + ($1,600,000 ÷ 0.01)/(1 + 0.01) =
$103,688,119
Step 2: Calculate the NPV of the cash flow stream from Tara’s proposed credit policy:
Monthly units of manufacturing = $27,000,000 ÷ $60 per unit = 450,000
Monthly variable cost of manufacturing (MVCM) = 450,000 units × $55 = $24,750,000
Collection on credit sales in 30 days = 450,000 units × $60 × (1 – 0.01) = $26,730,000
Monthly net cash flow (MNCF) starting in 30 days = $26,730,000 – $24,750,000 =
$1,980,000
NPVProposed = MVCM0 + PV0 of MNCF starting in 30 days

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 NPVProposed = –$24,750,000 + ($1,980,000 ÷ 0.01) = $173,250,000
Step 3: Compare the current and proposed credit standards:
NPVCurrent = $103,688,119 < NPVProposed = $173,250,000
Based on this analysis, Tara’s should adopt the proposed credit standards.

Q10. Accounts receivable changes with bad debts

A firm is evaluating an accounts receivable change that would increase bad debts from 2% to 4%
of sales. Sales are currently 50,000 units per month, the selling price is $20 per unit, and the
variable cost per unit is $15. As a result of the proposed change, sales are forecast to increase to
60,000 units. If the cost of capital is 0.75% per month, should the firm change its credit policy?
Solution:

Profit from sales

Proposed plan [60,000  ($20 − $15)] $300,000
Current plan (50,000  ($20 − $15)] 250,000
Benefit of marginal profit increase $50,000

Bad debts
Proposed plan (60,000  $20  0.04) $48,000
Current plan (50,000  $20  0.02) 20,000
Cost of marginal bad debts $28,000

Net benefit from implementing proposed plan $22,000

This policy change is recommended because the increase in profits from sales exceeds the
increase in bad debt expense.