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442 Brooks ◼ Financial Management: Core Concepts, 4e
© 2018 Pearson Education, Inc.
Average Receivable Turnover = 18.25 Days = Credit Sales / $42,000
Credit Sales = $42,000 × 18.25 = $766,500
Cash Sales = Total Sales – Credit Sales = $970,000 – $766,500
= $203,500
Chapter 13 ◼ Working Capital Management 443
7. Average accounts payable cycle. Calculate Rian Company’s average accounts payable cycle.
ANSWER
Average Accounts Payable = (Beginning of the year A/P + End of Year A/P) / 2
8. Average accounts payable cycle. Rian Company had a target of fifteen days for its payment
(accounts payable) cycle. What would the ending balance in the accounts payable account
need to be to reach this target (holding all other accounts the same)?
ANSWER
Working backward we have,
Chapter 13 ◼ Working Capital Management 445
© 2018 Pearson Education, Inc.
End of January Anticipated Cash Flow from Billings
= 5% of Oct + 20% of Nov + 30% of Dec + 60% of Jan
= 0.05 × $392,000 + 0.20 × $323,000 + 0.30 × $296,000 + 0.60 × $340,000
= $19,600 + $64,600 + $88,800 + $204,000 = $377,000
End of February Anticipated Cash Flow from Billings
= 5% of Nov + 20% of Dec + 25% of Jan + 60% of Feb
= 0.05 × $323,000 + 0.20 × $296,000 + 0.25 × $340,000 + 0.60 × $360,000
= $16,150 + $59,200 + $85,000 + $216,000 = $376,350
End of March Anticipated Cash Flows
= 5% of Dec + 10% of Jan + 25% of Feb + 60% of Mar
= 0.05 × $296,000 + 0.10 × $340,000 + 0.25 × $360,000 + 0.60 × $408,000
= $14,800 + $34,000 + $90,000 + $244,800 = $383,600
11. Credit screening. Tennindo, Inc. is starting up its new, cost-efficient gaming system console,
the yuu. Tennindo currently has 4,000 cash-paying customers and makes a profit of $60 per
unit. Tennindo wants to expand its customer base by allowing customers to buy on credit. It
estimates that credit sales will bring in an additional 1,200 customers per year, but that
there will also be a default rate on credit sales of 5%. It costs $260 to make a yuu, which
retails for $320. If all customers (old and new) buy on credit, what is the cost of bad debt
without credit screening? What is the most Tennindo would pay for credit screening that
accurately identifies bad-debt customers prior to the sale? What are the increased profits by
adding credit sales for customers with and without credit screening? Should Tennindo offer
credit sales if credit screening costs $10 per customer?
ANSWER
446 Brooks ◼ Financial Management: Core Concepts, 4e
© 2018 Pearson Education, Inc.
= $296,400 – $52,000 = $244,400
Tennindo should offer credit sales if credit screen costs $10 per customer
12. Credit screening. Screendoor, Inc. is a credit-screening consulting firm. Screendoor advises
Tennindo Inc. (from Problem 11) that it can offer a credit-screening device that is 90%
accurate and costs $5.00 per customer to apply. Using the data in Problem 11, determine
whether Tennindo should use Screendoor’s credit-screening system.
ANSWER
Profit with credit screening system:
448 Brooks ◼ Financial Management: Core Concepts, 4e
© 2018 Pearson Education, Inc.
Average inventory = (4,000,000 / 40) / 2 = 50,000
Annual Carrying Cost = 50,000 × $0.03 = $1,500
Annual Ordering Costs = 40 × $600 = $24,000
EOQ = [2 × 4,000,000 × $600 / 0.03]1/2 = 400,000
New Carrying Costs = 400,000 / 2 × $0.03 = $6,000
New Ordering Costs = 4,000,000 / 400,000 × $600 = $6,000
EOQ of 400,000 is optimal order quantity (carrying costs = ordering costs) and new TOTAL
Annual Inventory Cost = $6,000 + $6,000 = $12,000
16. Economic order quantity (EOQ). It turns out that the marketing manager in Problem 15 has
underestimated the zen-zen market. The zen-zens are a smash, and current estimates are
that the company will sell 8 million of them per year. Should the inventory manager simply
double the EOQ order quantity from Problem 15? Find the new EOQ, and verify that it is the
correct order quantity by finding the new carrying cost and new ordering cost.
ANSWER
17. Working capital and capital budgeting. Farbuck’s Tea Shops is thinking about opening
another tea shop. The incremental cash flow for the first five years is as follows:
Initial capital cost = $3,500,000
Operating cash flow for each year = $1,000,000
Recovery of capital assets after five years = $250,000
The hurdle rate for this project is 12%. If the initial cost of working capital is $500,000 for
teapots, teacups, saucers, and napkins, should Farbuck’s open this new shop if it will be in
business for only five years? What is the most it can invest in working capital and still have a
positive net present value?
ANSWER
Find the incremental cash flows by year
Chapter 13 ◼ Working Capital Management 449
© 2018 Pearson Education, Inc.
CF0 = $3,500,000 plus $500,000 outflow or –$4,000,000
CF1 through CF4 = $1,000,000
CF5 = $1,000,000 plus $500,000 plus $250,000 or $1,750,000
NPV at 12%
NPV = –$4,000,000 + $1,000,000 × (1 – 1/1.124) / 0.12 + $1,750,000 / 1.125
NPV = –$4,000,000 + $3,037,349 + $992,997 = $30,346
And the project is a go!
The most that Farbuck’s Tea Shops could spend on working capital is as follows:
For each additional dollar of current value they get $1/1.125 in return or a net present cash
outflow of $1 – $0.5674 = $0.4326. If the current NPV is $30,346 they could spend another
$30,346/0.4326 = $70,152 in working capital.
Proof:
NPV = –$4,070,152 + $1,000,000 × (1 – 1/1.124) / 0.12 + $1,820,152 / 1.125
NPV = –$4,070,152 + $3,037,349 + $1,032,803 = $0
Chapter 13 ◼ Working Capital Management 451
NPV = –$14,501,645 + $13,599,014 + $902,631 = $0
Solutions to Advanced Problems for Spreadsheet Application
1. Cash flow timing for accounts receivable.
Zenotech Incorporated
Actual Forecast
Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Sales in thousands of $
$ 3,866 $ 4,209 $ 3,113 $ 1,979 $ 1,543 $ 1,137 $ 1,010 $ 1,608 $ 1,974 $ 2,005 $ 2,608 $ 3,501 $ 4,070 $ 5,280 $ 3,547 $2,411 $1,604 $1,233
Collection Rates for Month:
Less than $2 million
Default 1.25%
Discount 48.00%
Net 60 39.00%
90 Days 7.50%
120 days 4.25%
100.00%
Between $2 and $5 million
Default 2.50%
Discount 41.00%
Net 60 42.00%
90 Days 9.00%
120 days 5.50%
100.00%
Over $5 million
Default 4.00%
Discount 37.00%
Net 60 41.50%
90 Days 11.00%
120 days 6.50%
100.00%
Discount rate 1.50%
Collected so Start with
Sept Sales:
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Anticipated Cash Flow 1,459$ 1,121$ 1,305$ 1,684$ 1,743$ 2,112$ 2,774$ 3,459$ 4,092$ 4,183$ 3,268$ 2,433$
Alternative Build the
Collections by Month:
Sep Oct Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov
Sales
$ 3,113 $ 1,979 $ 1,543 $ 1,137 $ 1,010 $ 1,608 $ 1,974 $ 2,005 $ 2,608 $ 3,501 $ 4,070 $ 5,280 $ 3,547 $ 2,411 $1,604
Collection Month TOTAL
January 1,459$ 171$ 148$ 602$ 538$
February 1,121$ 84$ 116$ 443$ 478$
March 1,305$ 66$ 85$ 394$ 760$
April 1,684$ 48$ 76$ 627$ 933$
May 1,743$ 43$ 121$ 770$ 810$
June 2,112$ 68$ 148$ 842$ 1,053$
Chapter 13 ◼ Working Capital Management 453
Solutions to Mini-Case
Cranston Dispensers, Inc.: Part 1
This case is designed to offer a comprehensive review of working capital management and
policy issues. Greatest emphasis is on the cash conversion cycle and associated computations,
but collections and credit policy are covered conceptually and a related EOQ problem is included
in the case questions.
1. Determine Cranston’s average production cycles for 2016 and 2017.
Inventory Turnover = COGS/ Avg Inventory
Production Cycle = 365/Inv Turnover
2. Determine Cranston’s average collection cycles for 2016 and 2017. Assume that all sales
are credit sales.
Receivable Turnover = Credit Sales/ Avg. Acc. Rec.
3,784/ ((722 + 642)/2) = 5.55
2016
$-
$5,000.00
$10,000.00
$15,000.00
$20,000.00
$25,000.00
$30,000.00
$35,000.00
214,758.00
239,758.00
264,758.00
289,758.00
314,758.00
339,758.00
364,758.00
389,758.00
414,758.00
439,758.00
464,758.00
489,758.00
514,758.00
539,758.00
564,758.00
589,758.00
614,758.00
639,758.00
664,758.00
689,758.00
714,758.00
Carrying Costs
Ordering Costs
TOTAL COSTS
© 2018 Pearson Education, Inc.
456 Brooks ◼ Financial Management: Core Concepts, 4e
c.) If this policy had been in effect during 2017, by how many days would Cranston have
shortened the cash conversion cycle?
458 Brooks ◼ Financial Management: Core Concepts, 4e
© 2018 Pearson Education, Inc.
A/R Turnover = Credit Sales/Avg. A/R ➔$600,000/$38,500 = 15.58
Inventory Turnover = Cost of Goods Sold/Avg. Inv ➔ $600,000/$15,500 = 38.71
A/P Turnover = Cost of Goods Sold/Avg. A/P ➔ $600,000/$5,500 = 109.09
Finally we calculate the collections cycle, the production cycle, and the payment cycle by
dividing each of the turnover rates into 365 days, respectively.
Collection cycle = 365/A/R Turnover➔ 365/15.58➔23.43 days
Production cycle = 365/Inv. Turnover➔365/38.71➔9.43 days
Payment cycle = 365/A/P Turnover➔365/109.09➔3.35 days
So the firm’s operation cycle = Collection cycle + Production cycle =23.43 + 9.43 = 32.86 days.
Cash conversion cycle = Operating cycle – payment cycle = 32.86 – 3.35 ➔29.51 days. So on
average, the firm has to finance its credit sales for about 30 days.
2. Credit screening cost-benefit analysis. Mid-West Marine Products currently sells its light-
weight boat lifts for $3,500 each. The unit cost of each lift is $2,600. On average, the firm
sells 2,000 lifts a year on a cash basis. Consumer Credit Check is offering Mid-West a credit
screening system at the rate of $25 per screen and assures them that the system will be at
least 99% accurate. Mid-West’s research indicates that if they offer credit terms, it will
boost their sales by 40% per year. They have also learned that the typical default rate in
their industry is around 3%.
a) Should Mid-West start offering credit terms?
b) If they do offer credit, should they do so with or without Consumer Credit Check’s credit
screening services? Please explain.
