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Chapter 15 Principles of Finance 6e
Besley/Brigham
15-16
h. Marketable securities can be held as a substitute for cash balances and as a temporary
i. When selecting marketable securities for a portfolio one must consider default risk, interest rate
15-30 Integrative Problem
a. The four variables that make up a firm’s credit policy are (1) credit standards, (2) credit terms,
(3) collection policy, and (4) monitoring function.
To qualify for credit in the first place, customers must meet the firm’s credit standards. These
dictate the minimum acceptable financial position required of customers to receive credit. Also,
Collection policy refers to the procedures that the firm follows to collect past-due accounts.
These can range from a simple letter or phone call to turning the account over to a collection
Principles of Finance 6e Chapter 15
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b. Average collection period (ACP) and days sales outstanding (DSO) both mean the average
length of time the firm must wait after making a sale before receiving payment. DSO is the
more preferred business nomenclature. Under the current credit policy, the DSO is
approximately 19.15 days:
c. Of the $3,600,000 in current sales 62.5 percent are affected by the discount. So,
d. Analysis of the change:
Existing Policy Proposed Policy
Annual Amounts
Total annual sales $3,600,000.0 $4,000,000.0
Daily Amounts = (Annual amounts)/360
Current sales collected on Day10 $6,125.0
Existing sales collected on Day 30 3,200.0
Cash flow time line – Existing Policy (Daily sales)
0 0.0278% 10 30 60 days
(7,500.0) 6,125.0 3,200.0 550.0
Chapter 15 Principles of Finance 6e
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( ) ( ) ( )
Existing 10 30 60
$6,125.0 $3,200.0 $550.0
NPV $(7,500.0)
1.00027778 1.00027778 1.00027778
$(7,500.0) $6,108.0 $3,173.4 $540.9 $2,322.4
= + + +
= + + + =
Cash flow time line – Proposed Policy (daily sales)
0 0.0278% 20 45 90 days
(8,333.3) 7,813.9 1,111.1 1,944.4
e. If sales remain at $3,600,000 after the change is made, then the following situation would exist:
Existing Policy Proposed Policy
Annual Amounts
Total annual sales $3,600,000.0 $3,600,000.0
Current sales collected on Day10 = 62.5% 2,205,000.0
Cash flow time line – Existing Policy (Daily sales)
…
Principles of Finance 6e Chapter 15
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(7,500.0) 6,125.0 3,200.0 550.0
$(7,500.0) $6,108.0 $3,173.4 $540.9 $2,322.4
= + + + =
Cash flow time line – Proposed Policy (daily sales)
0 0.0278% 20 45 90 days
(7,500.0) 7,032.5 1,000.0 1,750.0
f. (1) To monitor a firm’s accounts receivable means to analyze the effectiveness of the firm’s
credit policy in an aggregate sense.
(2) A firm would want to monitor its receivables because the optimal credit policy, and hence
(3) The DSO and aging schedule can be used to monitor a firm’s accounts receivable. If the
firm’s DSO is higher than the industry average it means that the firm might have an
…
15-20
15-31 Integrative Problem
a. The EOQ model is written:
PP C
T O 2
= EOQ
b. Under the assumptions listed above, total inventory costs (TIC) can be expressed as follows:
Q
T
O +
2
Q
PP) (C =
costs
orderingI
Total
+
costs
carrying
Total
= TIC =
Costs
Inventory
Total
Here Q = number of units in each order (production run), and the other variables are as
defined in part (a).
Note that if no safety stock is carried, Q/2 is the average number of units carried in inventory
during the year, and T/Q is the number of orders placed (production runs) each year.
The optimal order quantity is that quantity that minimizes total inventory costs, which is found
using the EOQ model.
c. The EOq and total inventory costs for the fly rods is
PP C
T O 2
= EOQ
Principles of Finance 6e Chapter 15
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When 100 fly rods are ordered each time inventory is needed, total inventory costs equal:
d. 500 Rods:
TIC = [(C x PP) x (Q/2)] + O(T/Q)
= (0.1 x $320) x (500/2) + $64(2,500/500)
e. If SSP orders the EOQ amount of 100 rods, it will order 25 times = 2,500/100 during the year.
f. There are two ways to view the impact of safety stocks on total inventory costs. SSP’s total cost
of carrying the operating inventory is $3,200[see part (c)]. Now the cost of carrying an
g. The EOQ model can still be used if there are seasonal variations in usage, but it must be
Chapter 15 Principles of Finance 6e
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h. (1) Just-in-time (JIT) procedures are designed specifically to reduce inventories. If a JIT
system were put in place, it probably would obviate the need for using the EOQ model. The
15-32 Integrative Problem
a. Short-term credit is any liability originally scheduled for payment within one year. The major
b. Accruals increase automatically as a firm’s operations expand. They consist of accrued wages
and accrued taxes. Accruals are “free” in the sense that no explicit interest is paid on funds
(2) If the discount is taken, then SSP must pay this supplier on Day 11 for purchases made on
Day 1, on Day 12 for purchases made on Day 2, and so on. Thus, in a steady state, SSP
will on average have 10 days’ worth of purchases in payables, so,
Principles of Finance 6e Chapter 15
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(3) To obtain $5,444.40 of costly trade credit SSP must give up 0.02 ($50,000) = $1,000 in lost
discounts annually. Because the forgone discounts pay for $5,444.40 of credit, the
approximate cost rate is 18.37 percent:
$5,444.40
There is a formula that can be used to find the approximate cost rate of costly trade credit:
period
Discount
-
period credit
of Length
Discount - 1
Discount a
In this situation,
18.4% 0.1837 =
10 - 50
360
0.02 - 1
0.02
=
Discount a
Forgoing of Cost
Note (1) that the formula gives the same cost rate as was calculated earlier, (2) that the
first term is the periodic cost of the credit (SSP spends $2 to get the use of $98), and (3)
that the second term is the number of “savings periods” per year (SSP delays payment for
50 ─ 10 = 40 days, and there are 360/40 = 9 40-day periods in a year.)
19.94%. = 0.1994 = 1 -
0.98
0.02
+ 1 = 1 -
Discount - 1
Discount
+ 1 = EAR
9m
The effective annual rate is 19.94%:
d. (1) With a simple interest loan, SSP gets the full use of the $800,000 for a year, and then pays
0.09($800,000) = $72,000 in interest at the end of the term, along with the $800,000
principal repayment. For a 1-year simple interest loan, the simple rate, 9 percent, is also
the effective annual rate.
(2) On a discount interest loan, the bank deducts the interest from the face amount of the loan
Chapter 15 Principles of Finance 6e
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$728,000
(3) The effective annual rate on the loan is:
11.25% = 0.1125 =
$640,000
$72,000
.2)$800,000(0 - $800,000
.09)$800,000(0
funds usable of Amount
Interest
rate Effective
=
=
e. A secured loan is one backed by collateral, often using inventories or receivables. Inventories
f. When receivables are pledged, the lender not only has a claim against the receivables but also
has recourse to the borrower. If the firm that bought the goods does not pay, the selling firm
must take the loss. Therefore, the risk of default on the pledged accounts receivable remains
g. The three forms of inventory financing discussed in the text are blanket liens, trust receipts, and
warehouse receipts. An inventory blanket lien gives the lending institution a lien against all of
Principles of Finance 6e Chapter 15
15-25
15-33 Computer-Related Problem
a. INPUT DATA:
Old New
Annual Data:
Sales $3,000,000.00 $2,800,000.00
Variable cost ratio 70.0% 70.0%
Daily Data (360 days):
Sales $8,333.33 $7,777.78
KEY OUTPUT:
Net present value $2,348.64 $2,250.61
MODEL GENERATED DATA:
Cash Flows of Existing Policy:
Outflow on Day 0 ($5,833.33)
Chapter 15 Principles of Finance 6e
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b. INPUT DATA:
Old New
Annual Data:
Sales $3,000,000.00 $3,300,000.00
Variable cost ratio 70.0% 70.0%
Daily Data (360 days):
Sales $8,333.33 $9,166.67
Collection--discount cust. $0.00 $0.00
KEY OUTPUT:
Net present value $2,348.64 $2,611.04
MODEL GENERATED DATA:
Cash Flows of Existing Policy:
c. If the credit policy is not changed and sales increase to $3.4 million, compared to the
policy given in part (b), which tightens the terms to 45 days, we have
INPUT DATA:
Old New
Annual Data:
Sales $3,400,000.00 $3,300,000.00
Variable cost ratio 70.0% 70.0%
Principles of Finance 6e Chapter 15
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Variable cost $2,380,000.00 $2,310,000.00
Daily Data (360 days):
Sales $9,444.44 $9,166.67
KEY OUTPUT:
Net present value $2,661.79 $2,611.04
MODEL GENERATED DATA:
Cash Flows of Existing Policy:
Outflow on Day 0 ($6,611.11)
Chapter 15 Principles of Finance 6e
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ETHICAL DILEMMA
Money Back Guarantee, No Questions Asked
Ethical dilemma:
This is an interesting situation. TradeSmart, Inc. has a very liberal return policy, allowing customers to
return for almost any reason the electronic products purchased from the company. The returned products
then are passed on to the manufacturers as defective, even though there often is nothing wrong with them.
TradeSmart responds to the manufacturers complaints by reminding them that the company has neither a
service department nor any qualified service personnel--they only sell the products. The problem is that
TradeSmart returns products even when it is suspected that either the manufacturer's warranty has been
voided or there was no intent by the customer to keep the product when it originally was purchased. Is this
return policy fair to the manufacturers?
Discussion questions:
• What is the ethical dilemma?
In this case, the ethical dilemma appears to be whether TradeSmart's return policy is designed to take
• Do you agree with TradeSmart's return policy?
To answer this question, other questions should be asked. Do you believe that TradeSmart returns
• Should TradeSmart change its return policy to satisfy the manufacturers of the products it sells?
If TradeSmart modifies its return policy, there is a chance its reputation will be tarnished to some degree
and that it will lose customers and thus profits. A change in policy will certainly increase the costs
Principles of Finance 6e Chapter 15
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• What would you do if you were one of TradeSmart's suppliers?
References:
Excessive and unjustified product returns have been a problem for retailers and manufacturers for many,
many years, especially in the electronics industry. With the advent of the electronic supermarkets, the
problem has intensified because these stores have implemented rather liberal return policies. Excessive
returns have forced manufacturers to absorb additional costs of repackaging and reshipping products that
were used slightly if at all, but no longer can be sold as brand new.
Manufacturers blame the problem on the "no questions asked" money-back guarantee policies offered by
stores such as Kmart and Wal-Mart. Such liberal return policies have created a customer behavior dubbed
the "Super Bowl Problem," which occurs when a product is bought to be used for a specific one-time event
and then it is returned immediately after the event. Examples include the purchase of a large-screen
television to have a Super Bowl party for the neighborhood or the purchase of a camcorder for a relative's
wedding, baptism, or other special event--as soon as the event is over, the product is returned to, and for
the most part, gladly accepted by the store from which it was purchased. One manufacturer estimated that
the "Super Bowl Problem" was so bad that only 15 percent of the products returned actually were defective.
In recent years, many retailers have tightened their return policies by limiting the amount of time customers
have to return certain types of purchases. Even so, an example of the cost of returns is provided by the
Consumer Electronics Manufacturers Association, which estimated that returns in the electronics industry
cost $10 billion in 1997. More astounding is that defective products accounted for only 2 percent of all
returns. Clearly, then, the problem of unfounded returns is still a very significant problem.
The problems faced by manufacturers and suppliers resulting from liberal return policies, as well as some of
the recent solutions to these problems, are described in the following articles:
"Enterprise: Unjustified Returns Plague Electronics Makers," The Wall Street Journal, September 26, 1994,
p. B1+.
"Fewer Unhappy Returns: Electronics Vendors Grapple With Costs of Fickle Customers," Los Angeles
Times, November 11, 1998, p. C-1.
"You Buy It, You Keep It, More Stores Are Saying," The New York Times, May 30, 1999, p. 1.
