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A B C D E F G H I J K L M N
1/13/2015
EVA = NOPAT – Capital costs
= EBIT(1 – T) – WACC (Total capital employed).
RR Industry
Current 1.75 2.25
Quick 0.92 1.16
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
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.
Chapter 21. Mini Case for Supply Chains and Working Capital Management
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COGS =0.90 × $660,000
COGS =$594,000
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Annual sales
$660,000
COGS/sales 90%
COGS =0.90 × Sales
=
Inventory / Daily COGS
c. Calculate the firm’s cash conversion cycle given annual sales are $660,000 and cost of goods sold are 90% of sales. Assume a
365-day year.
Need to determine the amount of inventory from the firm’s inventory turnover ratio. Then, one can calculate the inventory
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?
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?
A relaxed policy may be appropriate if it reduces risk more than profitability. However, RR is much less profitable than the average
Inventory conversion period
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Cash
Conversion
cycle (CCC)
=
Inventory
conversio
n period
+
Average
collection
period
–
Use lockboxes.
d. What might RR do to reduce its cash and securities without harming operations?
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Cash Balance as presented in the Mini Case Nov Dec Jan Feb Mar Apr
Sales Forecast
( 1 ) Sales (gross) $71,218 $68,212 $65,213 $52,475 $42,909 $30,524
Collections
( 2) During month of sale
Purchases
( 6 ) During month $44,603.75 $36,472.65 $25,945.40
(forecast sales in 2 months)x 0.85
Payments
Cash Surplus (or Loan Requirement)
( 15 ) Target cash balance 1,500.00 1,500.00
( 16 ) Cumulative surplus cash or loan needed
(Line 16 – Line 17) $15,357.64 $33,669.49
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 above. (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.
e. Should depreciation expense be explicitly included in the cash budget? Why or why not?
affect taxes, which do appear in the cash budget.
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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.)
No. Depreciation is a noncash charge. Only cash payments and receipts appear on the cash budget. However, depreciation does
affect taxes, which do appear in the cash budget.
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Cash budget indicates the company probably is holding too much cash.
If sales turn out to be considerably less than expected, RR could face a cash shortfall.
Long run: Company is likely to then take steps to reduce its cash holdings.
h. What reasons might RR have for maintaining a relatively high amount of cash?
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?
i. Is there any reason to think that RR may be holding too much inventory? If so, how would that affect EVA and ROE?
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?
j. If the company reduces its inventory without adversely affecting sales, what effect should this have on the company’s cash
position
RR’s days’ sales outstanding (DSO) of 45.63 days is well above the industry average (32 days). RR’s customers are paying less
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l. Does RR face any risks if it tightens its credit policy?
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Short run: If customers pay sooner, this increases cash holdings.
Terms: free credit period = 10
days.
“Official” credit period = 30
days.
n. Is it likely that RR could make significantly greater use of accruals?
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?
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?
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.
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Credit Breakdown
Total trade credit =
$21,918
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$16,438
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Nominal cost of costly trade credit:
r(nom) = $2,020
/ $16,438
r(nom) = 12.29%
But the $2,020 in lost discounts is paid all during the year, not just at year-end, so the EAR is higher.
Periodic rate =
1% /99%
Periodic rate =
1.01%
Aggressive: Uses short-term (temporary) capital to finance some permanent current operating assets.
Conservative: Uses long-term (permanent) capital to finance some temporary current operating assets.
Short-term debt is riskier than long-term debt for the borrower.
Short-term rates may rise.
r. Would it be feasible for RR to finance with commercial paper?
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.
q. What are the advantages and disadvantages of using short-term debt as a source of financing?
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Commercial paper (CP) are short term notes issued by large, strong companies. RR could not issue CP; the company is too small.
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