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Answers and Solutions: 16 - 1
Chapter 16
Supply Chains and Working Capital Management
ANSWERS TO END-OF-CHAPTER QUESTIONS
16-1 a. Working capital is a firm’s investment in short-term assets—cash, marketable
securities, inventory, and accounts receivable. Net working capital is current assets
minus current liabilities. Net operating working capital is operating current assets
minus operating current liabilities.
c. Permanent current operating assets are the current operating assets needed even at the
low point of the business cycle. For a growing firm in a growing economy,
permanent current assets tend to increase over time. Temporary current operating
assets are the current operating assets required above the permanent level when the
economy is strong and/or seasonal sales are high.
e. The inventory conversion period is the average length of time it takes to convert
materials into finished goods and then to sell them. It is calculated by dividing total
inventory by daily cost of goods sold. The average collection period is the average
length of time required to convert a firm’s receivables into cash. It is calculated by
dividing accounts receivable by sales per day. The cash conversion cycle is the
Answers and Solutions: 16 - 2
calculated by dividing accounts payable by credit purchases per day (COGS/365).
f. A cash budget is a schedule showing cash flows (receipts, disbursements, and cash
balances) for a firm over a specified period. The target cash balance is the desired
cash balance that a firm plans to maintain in order to conduct business.
h. Trade discounts are price reductions that suppliers offer customers for early payment
of bills.
i. Credit policy is nothing more than the firm’s policy on granting and collecting credit.
There are four elements of credit policy, or credit policy variables. These are credit
period, credit standards, collection policy, and discounts.
The credit period is the length of time for which credit is extended. If the credit
by effectively lowering prices. Credit terms are usually stated in the following form:
2/10, net 30. This means a 2% discount will apply if the account is paid within 10
days, otherwise the account must be paid within 30 days.
j. An account receivable is created when a good is shipped or a service is performed,
and payment for that good is not made on a cash basis, but on a credit basis.
Days sales outstanding (DSO) is a measure of the average length of time it takes a
Answers and Solutions: 16 - 3
k. Accruals are continually recurring short-term liabilities, especially accrued wages and
accrued taxes. Trade credit is debt arising from credit sales and recorded as an
account receivable by the seller and as an account payable by the buyer.
l. Stretching accounts payable is the practice of deliberately paying accounts payable
late. Free trade credit is credit received during the discount period. Credit taken in
excess of free trade credit, whose cost is equal to the discount lost is termed costly
trade credit.
16-2 The two principal reasons for holding cash are for transactions and compensating
balances. The target cash balance is not equal to the sum of the holdings for each reason
because the same money can often partially satisfy both motives.
16-4 The four elements in a firm’s credit policy are (1) credit standards, (2) credit period,
(3) discount policy, and (4) collection policy. The firm is not required to accept the credit
16-5 If an asset’s life and returns can be positively determined, the maturity of the asset can be
matched to the maturity of the liability incurred to finance the asset. This matching will
ensure that funds are borrowed only for the time they are required to finance the asset and
that adequate funds will have been generated from the asset by the time the financing
Answers and Solutions: 16 - 4
16-6 From the standpoint of the borrower, short-term credit is riskier because short-term
interest rates fluctuate more than long-term rates, and the firm may be unable to repay the
16-7 This statement is false. A firm cannot ordinarily control its accruals since payrolls and
the timing of wage payments are set by economic forces and by industry custom, while
tax payment dates are established by law.
16-8 Yes. If a firm is able to buy on credit at all, if the credit terms include a discount for
SOLUTIONS TO END-OF-CHAPTER PROBLEMS
16-1 Sales = $10,000,000; S/I = 2.
Inventory = S/2
=
2
000,000,10$
= $5,000,000.
If S/I = 5, how much cash is freed up?
16-2 DSO = 17; Credit Sales/Day = $3,500; A/R = ?
DSO =
S/365
A/R
17 =
$3,500
A/R
A/R = 17 $3,500 = $59,500.
16-4 Effective cost of trade credit = (1 + 1/99)8.11 – 1.0
= 0.0849 = 8.49%.
16-5 Net purchase price of inventory = $500,000/day.
Answers and Solutions: 16 - 6
16-6 a. 0.3(10) + 0.7(50) = 38 days.
b. $1,500,000/365 = $4,109.59 sales per day.
16-7 a.
5
536
99
1
= 73.74%.
b.
50
536
98
2
= 14.90%.
Answers and Solutions: 16 - 7
16-8 a.
20 45
536
97
3
−
= 45.15%.
Because the firm still takes the discount on Day 20, 20 is used as the discount period
in calculating the cost of nonfree trade credit.
16-9 Sales per day =
365
500,562,4$
= $12,500.
Discount sales = 0.5($12,500) = $6,250.
A/R attributable to discount customers = $6,250(10) = $62,500.
DSO = $437,500/$12,500 = 35 days.
35 = 0.5(10) + 0.5(DSONondiscount)
DSONondiscount = 30/0.5 = 60 days.
Thus, although nondiscount customers are supposed to pay within 40 days, they are
actually paying, on average, in 60 days.
Answers and Solutions: 16 - 8
16-11 a.
cycle
conversion
Cash
=
period
deferral
Payables
-
period
collection
Average
+
period
conversion
Inventory
= 50 + 35 – 25 = 60 days.
c. COGS = 0.80 × Sales
= 0.80 × $4,380,000
= $3,504,000.
Answers and Solutions: 16 - 9
16-12 a. Inventory turnover = COGS/Inventory
6.0= $$1,800,000/Inventory
Inventory = $300,000.
Average collection period = DSO = 41.0 days.
cycle
conversion
Cash
=
period
deferral
Payables
period
- collection
Average
+
period
conversion
Inventory
= 60.8 + 41 – 45 = 56.8 days.
Answers and Solutions: 16 - 10
c. Sales/Inv. = 9
$1,800,000/Inv. = 9
Inv. = $200,000
ROA = $227,500/$100,068 = 20.68%.
16-13 a.
Current year sales are expected to be $1,600,000x(1.25) = $2,000,000.
Return on equity may be computed as follows:
Tight Moderate Relaxed
Current assets
(% of sales Sales) $ 900,000 $1,000,000 $1,200,000
Fixed assets 1,000,000 1,000,000 1,000,000
Total assets $1,900,000 $2,000,000 $2,200,000
Debt (60% of assets) $1,140,000 $1,200,000 $1,320,000
b. No, this assumption would probably not be valid in a real world situation. A firm’s
current asset policies, particularly with regard to accounts receivable, such as
discounts, collection period, and collection policy, may have a significant effect on
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.
16-14 a. I. Collections and Purchases:
December January February
Sales (Collections) $160,000 $40,000 $60,000
Purchases 40,000 40,000 40,000
Payments for purchases 140,000* 40,000 40,000
Answers and Solutions: 16 - 12
16-15 a.
payable
accounts Average
=
days 365
000,650,3$
10 days = $10,000 10 = $100,000.
b. There is no cost of trade credit at this point. The firm is using “free” trade credit.
d. Nominal rate =
%.8324. =
10 40
536
98
2
−
Effective cost = (1 + 2/98)365/30 – 1 = 0.2786 = 27.86%.
16-16 Trade Credit
Terms: 2/10, net 30. But the firm plans delaying payments 35 additional days, which is
the equivalent of 2/10, net 65.
Answers and Solutions: 16 - 13
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%.
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.
Answers and Solutions: 16 - 15
SPREADSHEET PROBLEM
Mini Case: 16 - 16
MINI CASE
Karen Johnson, CFO for Raucous Roasters (RR), a specialty coffee manufacturer, is
(NOPAT) and then subtracting the dollar cost of all the capital the firm uses:
EVA = EBIT(1 – T) – Capital costs
= EBIT(1 – T) – WACC(Capital employed).
If EVA is positive then the firm’s management is creating value. On the other hand,
if EVA is negative, then the firm is not covering its cost of capital and stockholders’ value is
being eroded. If RR could generate its current level of sales with fewer assets, it would need
less capital. This would, other things held constant, lower capital costs and increase its
EVA.
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 - 17
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, the dollar cost of capital would decline, and
EVA would increase. However, lower raw materials inventories might lead to production
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
a. Johnson plans to use the preceding ratios as the starting point for discussions
with RR’s operating team. She wants everyone to think about the pros and cons
of changing each type of current asset and how changes would interact to affect
profits and EVA. Based on the data, does RR seem to be following a relaxed,
moderate, or restricted working capital policy?
Answer: A company with a relaxed working capital policy would carry relatively large
amounts of current assets relative to sales. It would be guarding against running out
Mini Case: 16 - 18
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?
Answer: RR may choose to hold large amounts of inventory to avoid the costs of “running
short,” and to cater to customers who expect to receive their coffee immediately. RR
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:
period
conversion
Inventory
+ Average
collection
period –
period
deferral
Payables
=
cycle
conversion
Cash
Mini Case: 16 - 19
d. What might RR do to reduce its cash without harming operations?
Answer: To the extent that “cash and securities” consist of low-yielding securities, they could
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.
RR’S CASH BUDGET FOR JANUARY AND FEBRUARY
November December January February March April
Sales
(1) Sales (Gross) $71,218 $68,212.00 $65,213.00 $52,475.00 $42,909 $30,524
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
0.7(Previous Month’s Sales) 47,748.40 4 5,649.10
(4) During Second Month After Sale
0.1(Sales 2 Months Ago) 7,121.80 6,821.20
(5) Total Collections (Lines 2 + 3 + 4) $67,651.95 $62,755.40
Purchases:
(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
(8) Wages And Salaries 6,690.56 5,470.90
(9) Rent 2,500.00 2,500.00
(10) Taxes
(11) Total Payments $53,794.31 $44,443.55
Net Cash Flows
(12) Cash At Beginning Of Forecast $ 3,000.00
(13) Net Cash Flow: Collections – Payments $13,857.64 $18,311.85
(14) Cumulative NCF (Prior mos. + this mos. NCF) 16,857.64 35,169.49
Cash Surplus (or Loan Requirement)
(15) Target Cash Balance 1,500.00 1,500.00
(16) Surplus Cash Or Loan Needed $15,357.64 $33,669.49
Mini Case: 16 - 20
e. Should depreciation expense be explicitly included in the cash budget? Why or
why not?
Answer: No, depreciation expense is a noncash charge and should not appear explicitly in the
f. 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.)
Answer: It is not realistic to assume zero bad debts. When credit is granted, bad debts should
g. Johnson’s cash budget for the entire year, although not given here, is based
heavily on her forecast for monthly sales. Sales are expected to be extremely low
between May and September but then to increase dramatically in the fall and
winter. November is typically the firm’s best month, when RR ships its holiday
blend of coffee. Johnson’s forecasted cash budget indicates that the company’s
cash holdings will exceed the targeted cash balance every month except for
October and November, when shipments will be high but collections will not be
coming in until later. Based on the ratios shown earlier, does it appear that RR’s
target cash balance is appropriate? In addition to possibly lowering the target
cash balance, what actions might RR take to better improve its cash
management policies, and how might that affect its EVA?
Answer: The company’s turnover of cash and its projected cash budget suggest that the
company is holding too much cash. RR could improve its EVA by either investing
Mini Case: 16 - 21
h. What reasons might RR have for maintaining a relatively high amount of cash?
Answer: If sales turn out to be considerably less than expected, the company could face a cash
i. Is there any reason to think that RR may be holding too much inventory? If so,
how would that affect EVA and ROE?
Answer: As pointed out in part a, RR’s inventory turnover (10.8) is considerably lower than
j. If the company reduces its inventory without adversely affecting sales, what
effect should this have on the company’s cash position (1) in the short run and
(2) in the long run? Explain in terms of the cash budget and the balance sheet.
Answer: Reducing inventory purchases will increase the company’s cash holdings in the short
k. Johnson knows that RR sells on the same credit terms as other firms in its
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?
Answer: RR’s DSO is 45.63 days as compared with 32 days for the average firm in its
Mini Case: 16 - 22
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.
The level of receivables held would decrease due to the lower level of sales and also
the probability that customers now qualifying for credit would take less time to pay.
Bad debt expenses should decrease due to raising customers’ minimum acceptable
financial positions.
l. Does RR face any risks if it tightens its credit policy?
Answer: A tighter credit policy may discourage sales. Some customers may choose to go
Mini Case: 16 - 23
m. If the company reduces its DSO without seriously affecting sales, what effect
would this have on its cash position (1) in the short run and (2) in the long run?
Answer in terms of the cash budget and the balance sheet. What effect should
this have on EVA in the long run?
Answer: If customers pay their bills sooner, this will increase the company’s cash position in
n. In addition to improving the management of its current assets, RR is also
reviewing the ways in which it finances its current assets. With this concern in
mind, Johnson is also trying to answer the following questions. Is it likely that
RR could make significantly greater use of accruals?
Answer: No, RR could not make greater use of its accruals. Accruals arise because (1)
workers are paid after they have actually provided their services, and (2) taxes are
accounts.
o. 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?
Mini Case: 16 - 24
Answer: If RR’s net purchases are $200,000 annually, then, with a 1% discount, its gross
purchases are $200,000/0.99 = $202,020. Net daily purchases from this supplier are
$200,000/365 = $547.94.
Therefore:
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
Mini Case: 16 - 25
In this situation,
%.912.2 = 290.12 = 1667.12 0.0101 =
10 - 40
536
99
1
p. 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.
Answer: There are three alternative current asset financing policies: aggressive, moderate, and
relaxed. A moderate financing policy matches asset and liability maturities. (Of
course exact maturity matching is not possible because of (1) the uncertainty of asset
Mini Case: 16 - 26
q. 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,
short-term credit does have some significant advantages. A short-term loan can be
obtained much faster than long-term credit. Lenders insist on a more thorough
financial examination before extending long-term credit. If a firm’s needs for funds
r. 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
is unsecured, short-term debt issued by large, financially strong firms and sold
primarily to other business firms, to insurance companies, to pension funds, to money
