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Answers and Solutions: 16 - 11
Equity 760,000 800,000 880,000
Total liability and equity $1,900,000 $2,000,000 $2,200,000
EBIT (12% $2 million) $ 240,000 $ 240,000 $ 240,000
Interest (8%) 91,200 96,000 105,600
Pre-tax earnings $ 148,800 $ 144,000 $ 134,400
sales. The exact nature of this function may be difficult to quantify, however, and
determining an “optimal” current asset level may not be possible in actuality.
c. As the answers to Part a indicate, the tighter policy leads to a higher expected return.
However, as the current asset level is decreased, presumably some of this reduction
comes from accounts receivable. This can be accomplished only through higher
insolvency and thus increase its chance of failing to meet fixed charges. Also, lower
inventories might mean lost sales and/or expensive production stoppages. Attempting
to attach numerical values to these potential losses and probabilities would be
extremely difficult.
website, in whole or in part.
December January February
Sales (Collections) $160,000 $40,000 $60,000
Purchases 40,000 40,000 40,000
Net cash flow (Coll – Pymts) 1,200 ($ 6,800) $13,200
effects of the changed credit policy on out into January and February, but here it
would probably be best to simply construct a new cash budget.
payable
accounts Average
days 365
000,650,3$
b. There is no cost of trade credit at this point. The firm is using “free” trade credit.
discount) of(net payables Average
365
Nominal cost = (2/98)(365/20) = 37.24%,
or $74,489.80/($300,000 – $100,000) = 37.24%.
536
2
website, in whole or in part.
16-17 a. Size of bank loan = (Purchases/Day)(Days late)
=
30
goutstandin
payables Days
goutstandin payables Days
Purchases
= ($600,000/60)(60 – 30) = $10,000(30) = $300,000.
Alternatively, one could simply recognize that accounts payable must be cut to half of
its existing level, because 30 days is half of 60 days.
c. (1) $300,000 × 0.075 = $22,500.
Loan amount = $300,000 + $22,500 = $322,500.
(2) Monthly installments = $322,500/12 = $26,875.
(3) Enter the following inputs into your calculator:
N = 12; PV = 300000; PMT = -26875; FV = 0; and solve for I/YR.
I/YR = 1.130552026%. Remember, this is a monthly rate, so APR is:
APR = 12 × 1.130552026% = 13.57%.
(4) EFF% = (1.01130552026)12 – 1 = 14.44%.
d. Given the limited information, the decision must be based on the rule-of-thumb
comparisons, such as the following:
1. Debt ratio = ($1,500,000 + $700,000)/$3,000,000 = 73%.
Raattama’s debt ratio is 73%, as compared to a typical debt ratio of 50%. The
firm appears to be undercapitalized.
2. Current ratio = $1,800,000/$1,500,000 = 1.20.
The current ratio appears to be low, but current assets could cover current
liabilities if all accounts receivable can be collected and if the inventory can be
liquidated at its book value.
Answers and Solutions: 16 - 15
3. Quick ratio = $400,000/$1,500,000 = 0.27.
The quick ratio indicates that current assets, excluding inventory, are only
sufficient to cover 27% of current liabilities, which is very bad.
The company appears to be carrying excess inventory and financing extensively with
debt. Bank borrowings are already high and the liquidity situation is poor. On the
basis of these observations, the loan should be denied, and the treasurer should be
advised to seek permanent capital, especially equity capital.
Answers and Solutions: 16 - 16
website, in whole or in part.
SPREADSHEET PROBLEM
16-18 The detailed solution for the spreadsheet problem, Ch16 P18 Build a Model
Solution.xlsx, is available on the textbook’s Web site.
Mini Case: 16 - 17
MINI CASE
Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is
rethinking her company’s working capital policy in light of a recent scare she faced when
RR’s corporate banker, citing a nationwide credit crunch, balked at renewing RR’s line of
credit. Had the line of credit not been renewed, RR would not have been able to make
payroll, potentially forcing the company out of business. Although the line of credit was
ultimately renewed, the scare has forced Johnson to examine carefully each component of
RR’s working capital to make sure it is needed, with the goal of determining whether the
line of credit can be eliminated entirely. In addition to (possibly) freeing RR from the need
for a line of credit, Johnson is well aware that reducing working capital will improve free
cash flow.
Historically, RR has done little to examine working capital, mainly because of poor
communication among business functions. In the past, the production manager resisted
Johnson’s efforts to question his holdings of raw materials, the marketing manager resisted
questions about finished goods, the sales staff resisted questions about credit policy (which
affects accounts receivable), and the treasurer did not want to talk about the cash and
securities balances. However, with the recent credit scare, this resistance became
unacceptable and Johnson has undertaken a company-wide examination of cash,
marketable securities, inventory, and accounts receivable levels.
Mini Case: 16 - 18
Johnson also knows that decisions about working capital cannot be made in a
vacuum. For example, if inventories could be lowered without adversely affecting
operations, then less capital would be required, and free cash flow would increase.
However, lower raw materials inventories might lead to production slowdowns and higher
costs, and lower finished goods inventories might lead to stock-outs and loss of sales. So,
before inventories are changed, it will be necessary to study operating as well as financial
effects. The situation is the same with regard to cash and receivables. Johnson has begun
her investigation by collecting the ratios shown below.
RR
Industry
Current
1.75
2.25
Quick
0.92
1.16
Total liabilities/assets
58.76%
50.00%
Turnover of cash and securities
16.67
22.22
Days sales outstanding (365-day basis)
45.63
32.00
Inventory turnover
10.80
20.00
Fixed assets turnover
7.75
13.22
Total assets turnover
2.60
3.00
Profit margin on sales
2.07%
3.50%
Return on equity (ROE)
10.45%
21.00%
Payables deferral period
30.00
33.00
a. Johnson plans to use the preceding ratios as the starting point for discussions
with RR’s operating team. Based on the data, does RR seem to be following a
relaxed, moderate, or restricted current asset usage policy?
Answer: A company with a relaxed current asset usage policy would carry relatively large
industry. Thus, RR is carrying a lot of inventory per dollar of sales, which would
meet the definition of a relaxed policy. Similarly, RR’s DSO is relatively high. Since
b. How can one distinguish between a relaxed but rational working capital policy
and a situation in which a firm simply has excessive current assets because it is
inefficient? Does RR’s working capital policy seem appropriate?
receivables to better serve customers, it should be able to offset the costs of carrying
c. Calculate the firm’s cash conversion cycle given annual sales are $660,000 and
cost of goods represent 80% of sales. Assume a 365-day year.
Answer: A firm’s cash conversion cycle is calculated as:
Inventory
Payables
Cash
calculated as:
RR’s average collection period is equal to its DSO. Its DSO is given as 45.6 days.
We are given that its payables deferral period is 30 days, so now we have all the
individual components to calculate RR’s cash conversion cycle.
