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
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, which are also called cash discounts, are price reductions that
suppliers offer customers for early payment of bills.
i. Credit policy is defines the policies and procedures for 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
period is lengthened, sales will generally increase, as will accounts receivable. This
will increase the financing needs and possibly increase bad debt losses. A shortening
of the credit period will have the opposite effect.
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
firm’s customers to pay off their credit purchases.
An aging schedule breaks down accounts receivable according to how long they
have been outstanding. This gives the firm a more complete breakdown of their
accounts receivable than that provided by days sales outstanding.
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.
n. Commercial paper is unsecured, short-term promissory notes of large firms, usually
issued in denominations of $100,000 or more and having an interest rate somewhat
below the prime rate. A secured loan is backed by collateral, often inventories or
receivables.
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.
16-3 False. Both accounts will record the same transaction amount.
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 debt. If
the lender will not extend the loan, the firm could be forced into bankruptcy.
A firm might borrow short-term if it thought that interest rates were going to fall and,
therefore, that the long-term rate would go even lower. A firm might also borrow short–
term if it were only going to need the money for a short while and the higher interest would
be offset by lower administration costs and no prepayment penalty. Thus, firms do
consider factors other than interest rates when deciding on the maturity of their debt.
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.
costly.
16-9 Commercial paper refers to promissory notes of large, strong corporations. These notes
have maturities that generally vary from one day to 9 months, and the return is usually 1½
to 3½ percentage points below the stated prime rate, and up to ½ of a percentage point
above the T-bill rate. Most commercial paper outstanding is issued by financial
institutions.
SOLUTIONS TO END–OF-CHAPTER PROBLEMS
16-1 COGS = $10,000,000; Inventory turnover = COGS/Inventory = 2.
Inventory = COGS/(Inventory turnover)
=
2
000,000,10$
= $5,000,000.
5
000,000,10$
16-2 DSO = 17; Sales/Day = $3,500; A/R = ?
DSO =
S/365
A/R
17 =
A/R
$3,500
A/R = DSO(Sales per day) = 17 $3,500 = $59,500.
16-5 Net purchase price of inventory = $500,000/day.
Credit terms = 2/15, net 40.
$500,000 15 = $7,500,000.
16-6 a. 0.3(10) + 0.7(50) = 38 days.
b. $1,500,000/365 = $4,109.59 sales per day.
$4,109.59(38) = $156,164 = Average receivables.
16-7 a.
1 365
99 5
= 73.74%.
b.
2 365
98 50
= 14.90%.
2 365
2 365
16-8 a. Nominal cost of trade credit = Cost per period 𝗑 (Number of periods per year)
Nominal cost of trade credit = (Disc. Pct.
16-9 Sales per day =
365
500,562,4$
= $12,500.
Discount sales per day = 0.5($12,500) = $6,250.
A/R attributable to discount customers = $6,250(10) = $62,500.
A/R attributable to nondiscount customers:
Alternatively,
DSO = $437,500/$12,500 = 35 days.
35 = 0.5(10) + 0.5(DSONondiscount)
DSONondiscount = 30/0.5 = 60 days.
16-10 Accounts payable:
Nominal cost =
80
536
97
3
= (0.03093)(4.5625) = 14.11%.
EAR cost = (1.03093)4.5625 – 1.0 = 14.91%.
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.
16-12 a. First, express inventory turnover in terms of COGS and inventory.
Inventory turnover = COGS/Inventory. This implies:
Inventory = COGS/(Inventory turnover)
= $1,800,000/6
= $300,000.
b. Inventory = $300,000 (as calculated in part a).
DSO = Receivables/(Daily sales)
Receivables = DSO(Daily sales) = 41($3,250,000/365) = $365,068.49
Total assets = Inventory + Receivables + Fixed assets
= $300,000 + $365,068.49 + $535,000
= $300,000 + $365,068.49 + $535,000 = $1,200,068.49
Total assets turnover = Sales/Total assets
= $3,250,000/$1,200,068.49 = 2.7082.
Inventory conversion period = Inventory/(Daily COGS)
/365$1,800,000
000,200$
= $200,000/($1,800,000/365)
= 40.56 days.
Cash conversion cycle = 40.6 + 41 – 45 = 36.6 days.
Note: The receivables balance was calculated in part b and does not change; the
inventory was calculated in part c.
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:
Restricted
Moderate
Relaxed
Current assets
(% of sales x 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)
$760,000
$800,000
$880,000
Total liability and equity
$1,900,000
$2,000,000
$2,200,000
EBIT (12% of sales)
$240,000
$240,000
$240,000
Interest (8%)
Pre-tax earnings
$179,200
$176,000
$169,600
Taxes (25%)
Net income
$134,400
$132,000
$127,200
Return on equity
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.
c. As the answers to Part a indicate, the restricted policy leads to a higher expected return.
However, as the current asset level is decreased, presumably some of this reduction
16-14 a. Collections and Purchases:
December January February
Sales (Collections) $160,000 $40,000 $60,000
Purchases 40,000 40,000 40,000
*November purchases = $140,000.
b. If the company began selling on credit on December 1, then it would have zero receipts
during December, down from $160,000. Thus, it would have to borrow an additional
$160,000, so its loans outstanding by December 31 would be $164,400. The loan
16-15 a.
payable
accounts Average
=
days 365
000,650,3$
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.
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.
Nominal cost =
period
Discount
goutstandin is
credit Days
365
percent
Discount
100
percentDiscount
−
−
b. Simple interest rate per day = Nominal rate/Days in year
= 0.08/360 = 0.000222222.
Interest charge for month = Rate per day × Loan amount × Days in month
= 0.000222222 × $300,000 × 30
= $2,000.
c. (1) $300,000 × 0.075 = $22,500.
Loan amount = $300,000 + $22,500 = $322,500.
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.