Chapter 17 - Working Capital Management

Problem 1. Guardian, Inc., is trying to develop an asset-financing plan. The firm has $400,000 in
temporary current assets and $300,000 in permanent current assets. Guardian also has $500,000
in fixed assets. Assume a tax rate of 40 percent.

a. Construct two alternative financing plans for Guardian. One of the plans should be
conservative, with 75 percent of assets financed by long-term sources, and the other
should be aggressive, with only 56.25 percent of assets financed by long-term sources.
The current interest rate is 15 percent on long-term funds and 10 percent on short-term
financing.
b. Given that Guardian’s earnings before interest and taxes are $200,000, calculate
earnings after taxes for each of your alternatives.
c. What would happen if the short-and long-term rates were reversed?

Solution:
Guardian, Inc.
a. Temporary current assets $ 400,000
Permanent current assets 300,000
Fixed assets 500,000
Total assets $1,200,000

Conservative
% of Interest Interest
Amount Total Rate Expense
$1,200,000 × .75 = $900,000 ×.15 = $135,000 Long-term
$1,200,000 × .25 = $300,000 ×.10 = 30,000 Short-term
Total interest charge $165,000
Aggressive
$1,200,000 × .5625 = $675,000 × .15 = $101,250 Long-term
$1,200,000 × .4375 = $525,000 × .10 = 52,500 Short-term
Total interest charge $153,750
(Continued)
b. Conservative Aggressive
EBIT $200,000 $200,000
–Int 165,000 153,750
EBT 35,000 46,250
Tax 40% 14,000 18,500
EAT $ 21,000 $ 27,750

c. Reversed:
Conservative
$1,200,000 × .75 = $900,000 ×.10 = $ 90,000 Long-term
$1,200,000 × .25 = $300,000 ×.15 = 45,000 Short-term
Total interest charge $135,000
Aggressive
$1,200,000 × .5625 = $675,000 ×.10 =$67,500 Long-term
$1,200,000 × .4375 = $525,000 ×.15 = 78,750 Short-term
Total interest charge $146,250
Reversed Conservative Aggressive
EBIT $200,000 $200,000
–Int 135,000 146,250
EBT 65,000 53,750
Tax 40% 26,000 21,500
EAT $ 39,000 $ 32,250
Problem 2. Higgins Athletic Wear has expected sales of 22,500 units a year, carrying costs of $1.50
per unit, and an ordering cost of $3 per order.
a. What is the economic order quantity?

b. What will be the average inventory? The total carrying cost?

c. Assume an additional 30 units of inventory will be required as safety stock. What will the
new average inventory be? What will the new total carrying cost be?

Solution:
Higgins Athletic Wear

a.

b. EOQ/2 = 300/2 = 150 units (average inventory)

150 units × $1.50 carrying cost/unit = $225 total carrying cost

c.

180 inventory × $1.50 carrying cost per year

= $270 total carrying cost
 d. Ordering Cost = Annual Sales/ EOQ x Ordering Cost per order

= 22,500/ 300 x 3 = $225

Problem 3 Marv’s Women’s Wear has the following schedule for aging of accounts receivable.

Age of Receivables, April 30, 2024

(1) (2) (3) (4)
Percent of
Month of Sales Age of Account Amounts Amount Due
April.................................. 0–30 $ 88,000 ____
March................................ 31–60 44,000 ____
February............................ 61–90 33,000 ____
January.............................. 91–120 55,000 ____
Total receivables............ $220,000 100%

a. Fill in column (4) for each month.

b. If the firm had $960,000 in credit sales over the four-month period, compute the average
collection period. Average daily sales should be based on a 120-day period.

c. If the firm likes to see its bills collected in 30 days, should it be satisfied with the average
collection period?

d. Disregarding your answer to part c and considering the aging schedule for accounts
receivable, should the company be satisfied?

e. What additional information does the aging schedule bring to the company that the average
collection period may not show?

. Solution:
Marv’s Women’s Wear
Age of Receivables, April 30, 2024
a.
(1) (2) (3) (4)
Month of Age of Percent of
Sales Account Amounts Amount Due
April 0-30 $ 88,000 40%
March 31-60 44,000 20%
February 61-90 33,000 15%
January 91-120 55,000 25%
 Total receivables $220,000 100%

b.

c. Yes, the average collection of 27.5 days is less than 30 days.

d. No. The aging schedule provides additional insight that 60
percent of the accounts receivable are over 30 days old.
e. It goes beyond showing how many days of credit sales
accounts receivables represent, to indicate the distribution of
accounts receivable between various time frames.

Problem 4. Johnson Electronics is considering extending trade credit to some customers previously
considered poor risks. Sales will increase by $100,000 if credit is extended to these new customers.
Of the new accounts receivable generated, 10 percent will prove to be uncollectible. Additional
collection costs will be 3 percent of sales, and production and selling costs will be 79 percent of
sales. The firm is in the 40 percent tax bracket.
a. Compute the incremental income after taxes.

b. What will Johnson’s incremental return on sales be if these new credit customers are
accepted?

c. If the receivable turnover ratio is 6 to 1, and no other asset buildup is needed to serve the
new customers, what will Johnson’s incremental return on new average investment be?
Solution:
Johnson Electronics

a. Additional sales.................................................... $100,000

Accounts uncollectible (10% of new sales).......... – 10,000
Annual incremental revenue................................. $ 90,000
Collection costs (3% of new sales)....................... – 3,000
Production and selling costs (79% of new sales).. – 79,000
Annual income before taxes................................. $ 8,000
Taxes (40%).......................................................... – 3,200
Incremental income after taxes............................. $ 4,800

b.

c. Receivable turnover = Sales/Receivable turnover = 6x

Receivables = Sales/Receivable turnover
= $100,000/6
= $16,666.67
Incremental return on new average investment =
$4,800/$16,666.67 = 28.80%
Cash Receipts, & Cash Budget Preparations

Problem 5. GSM Merchandising expects its revenues and payments for the first part of the year to be:

Seventy percent of the firm's sales are on credit. Past experience shows that 40 percent of accounts
receivable are collected in the month after sale, and the remainder is collected in the second month
after sale. Prepare a schedule of cash receipts for March, April and May. GSM's pays its payments in the
following month. GSM's had a cash balance of $2,000 on March 1, which is also its minimum required
cash balance. There is an outstanding loan of $2,000 on March 1. Prepare a cash budget for March, April,
and May.
Brigham

17-3 Lancaster Lumber buys $8 million of materials (net of discounts) on terms 3/5, net 55 and it
currently pays on the 5th day and takes discounts. Lancaster plans to expand, which will require
additional financing. If Lancaster decides to forego discounts, how much additional credit could it obtain,
and what would be the nominal and effective cost of the credit? If the company could get funds from the
bank at a rate of 9%, interest paid monthly, based on a 365-day year, what would be the effective cost of
the bank loan? Should Lancaster use bank debt or additional trade credit?

Purchases = $8,000,000; terms = 3/5 net 55; currently pays on Day 5 and takes discounts.

Forgoes discounts; additional credit = ?

$8,000,000/365  55 days = $1,205,479.45.

3 36 5
¿ ¿
Nominal cost of trade credit = 97 55 = 3.09%  6.6364 = 20.52%.

Effective cost of trade credit = (1 + 3/97)365/55 – 1 = 1.2240 – 1 = 22.40%.

Bank loan: 9%, interest paid monthly

EAR = (1 + 0.09/12)12 – 1 = 1.0938 – 1 = 9.38%.

Because the effective cost of the bank loan is less than half the effective cost of the trade credit,
the bank loan should be used.