21-17 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.
c. (1) $300,000 × 0.075 = $22,500.
Loan amount = $300,000 + $22,500 = $322,500.
(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:
2. Current ratio = $1,800,000/$1,500,000 = 1.20.
Answers and Solutions: 21 – 16
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.
SPREADSHEET PROBLEM
21-18 The detailed solution for the spreadsheet problem, Ch21 P18 Build a Model Solution.xls,
is available on the textbook’s Web site.
Answers and Solutions: 21 – 18
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
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
Mini Case: 21 – 19
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
RR
Industry
Current
1.75
2.25
Quick
0.92
1.16
Total liabilities/assets
58.76%
50.00%
16.67
22.22
45.63
32.00
10.80
20.00
7.75
13.22
2.60
3.00
2.07%
3.50%
10.45%
21.00%
30.00
33.00
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: 21 – 20
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
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:
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.
Mini Case: 21 – 21
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:
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
Mini Case: 21 – 22
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
Mini Case: 21 – 23
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: 21 – 24
The four variables that make up a firm’s credit policy are (1) discount amount and
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
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?
Mini Case: 21 – 25
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
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: 21 – 26
Answer: If RR’s net purchases are $200,000 annually, then, with a 1% discount, its gross
If the discount is not taken, then RR will wait 40 days before paying, so
Therefore:
Trade credit if discounts are not taken: $21,918 = total trade credit
Here is a formula that can be used to find the nominal annual interest rate of costly
trade credit:
Mini Case: 21 – 27
In this situation,
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
Mini Case: 21 – 28
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
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
Mini Case: 21 – 29