Mini Case: 16 – 20
d. Is there any reason to think that RR may be holding too much inventory?
e. If RR reduces its inventory without adversely affecting sales, what effect should
this have on free cash flow: (1) in the short run and (2) in the long run?
industry. Use the ratios presented earlier to explain whether RR’s customers pay
more or less promptly than those of its competitors. If there are differences, does
that suggest RR should tighten or loosen its credit policy? What four variables
make up a firm’s credit policy, and in what direction should each be changed by
RR?
period, (2) credit period, (3) credit standards, and (4) collection policy. Cash
discounts generally produce two benefits: (1) they attract new customers who view
discounts as a price reduction, thus sales would increase, and (2) they cause a
reduction in the days sales outstanding (DSO) since some established customers will
pay more promptly to take advantage of the discount, thus the level of receivables
their purchases. The shorter a firm’s credit period, the shorter the firm’s days sales
outstanding, and the lower the level of receivables held. A shorter credit period might
Mini Case: 16 – 21
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website, in whole or in part.
also tend to decrease sales, especially when a competitor’s credit period is longer
than the firm’s own credit period. The effect of the credit period on bad debt expense
is indeterminate.
In order 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, a firm may impose differing credit limits
depending on the customer’s financial strength. Tight credit standards would tend to
decrease sales (fewer customers would qualify for credit), decrease the level of
receivables held, and would cause a decrease in the amount of bad debt expenses.
account over to a collection agency. A tight collection policy would decrease the
level of receivables held, as customers would decrease the length of time they took to
g. Does RR face any risks if it tightens its credit policy?
h. If the company reduces its DSO without seriously affecting sales, what effect
would this have on its free cash flow (1) in the short run and (2) in the long run?
Mini Case: 16 – 22
i. What is the impact of higher levels of accruals, such as accrued wages or
accrued taxes? Is it likely that RR could make changes to accruals?
Answer: Higher levels of accruals increase free cash flow. No, RR could not make greater use
firm’s profitability, as well as by industry conventions regarding when wage
payments are made and IRS regulations regarding tax payments. (Increasingly,
j. Assume that RR purchases $200,000 (net of discounts) of materials on terms of
1/10, net 30, but that it can get away with paying on the 40th day if it chooses not
to take discounts. How much free trade credit can the company get from its
equipment supplier, how much costly trade credit can it get, and what is the
percentage cost of the costly credit? Should RR take discounts?
Answer: If RR’s net purchases are $200,000 annually, then, with a 1% discount, its gross
in a steady state, RR will on average have 10 days’ worth of purchases in payables,
Trade credit if discounts are not taken: $21,918 = total trade credit
Trade credit if discounts are taken: -5,479 = free trade credit
Difference: $16,439 = costly trade credit
To obtain $16,439 of costly trade credit, RR must give up 0.01($202,020) = $2,020 in
439,16$
Here is a formula that can be used to find the nominal annual interest rate of costly
trade credit:
cost Nominal
Days536
% iscountD
website, in whole or in part.
%.912.2 = 290.12 = 1667.12 0.0101 =
10 – 40
536
99
1
Note (1) that the formula gives the same nominal annual interest rate as was
calculated earlier, (2) that the first term is the periodic cost of the credit (RR spends
$1 to get the use of $99), and (3) that the second term is the number of “savings
periods” per year (RR delays payment for 40 – 10 = 30 days), and there are 365/30 =
12.1667 30-day periods in a year. Therefore, we could calculate the exact effective
annual interest rate as: effective rate = (1.0101)12.1667 – 1 = 13.01%.
If RR can obtain financing from its bank (or from other sources) at an interest rate
of less than 13.01%, it should borrow the funds and take discounts.
k. Cash doesn’t earn interest, so why would a company have a positive target cash
balance?
l. What might RR do to reduce its target cash balance without harming
operations?
m. RR tries to match the maturity of its assets and liabilities. Describe how RR
could adopt either a more aggressive or more conservative financing policy.
finances all of its fixed assets with long-term capital, but part of its permanent
current operating assets with short-term, nonspontaneous credit. There are degrees of
aggressiveness, in fact, a firm could choose to finance all of its permanent current
operating assets and part of its fixed assets with short-term credit; this would be a
highly aggressive position, and one that would subject the firm to the dangers of
Mini Case: 16 – 26
n. What are the advantages and disadvantages of using short-term debt as a source
of financing?
Answer: Although using short-term credit is generally riskier than using long-term credit,
flotation costs are generally high for long-term debt but trivial for short-term debt.
(2) Prepayment penalties with long-term debt can be expensive; short-term debt
this are: (1) if a firm uses long-term debt, its interest costs will be relatively stable
o. Would it be feasible for RR to finance with commercial paper?
Answer: It would not be feasible for RR to finance with commercial paper. Commercial paper
very active, liquid market for commercial paper, and, since there is virtually no
default risk, commercial paper rates are generally less than the stated prime rate, and
not much more than the T-bill rate. Note, though, that issuers of commercial paper
Mini Case: 16 – 27
p. In an attempt to better understand RR’s cash position, Johnson developed a
cash budget. Data for the first 2 months of the year are shown below. (Note that
Johnson’s preliminary cash budget does not account for interest income or
interest expense.) She has the figures for the other months, but they are not
shown. After looking at the cash budget, answer the following questions.
Collections:
(2) During Month Of Sale
(0.2)(0.98)(Month’s Sales) 12,781.75 10,285.10
(3) During First Month After Sale
(6) 0.85(Forecasted Sales
2 Months From Now) $44,603.75 $36,472.65 $25,945.40
Payments
(7) Payments For Purchases 44,603.75 36,472.65
(12) Cash At Beginning Of Forecast $ 3,000.00
Cash Surplus (or Loan Requirement)
e. 1. What does the cash budget show regarding the target cash level?
website, in whole or in part.
e. 2. Should depreciation expense be explicitly included in the cash budget? Why or
why not?
e. 3. What are some other potential cash inflows besides collections?
e. 4. How can interest earned or paid on short-term securities or loans be
incorporated in the cash budget?
e. 5. In her preliminary cash budget, Johnson has assumed that all sales are collected
and thus that RR has no bad debts. Is this realistic? If not, how would bad debts
be dealt with in a cash budgeting sense? (Hint: Bad debts will affect collections
but not purchases.)