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16 Current CHAPTER Asset Management CHAPTER ORIENTATION This chapter initiates our study of liquidity management. Here, we focus on the cash flow process and the reasons why a firm holds cash balances. The objectives of a sound cash management system are identified. The concept of float is defined. Several techniques that firms can use to favorably affect their cash receipts and disbursement patterns are examined. Finally, the composition of the firm's marketable securities portfolio is discussed. Additionally, the risk-return tradeoff associated with the firm's investment in accounts receivable is discussed. For accounts receivable, this tradeoff occurs as less creditworthy customers with a higher probability of bad debts are taken on to increase sales. The analysis is similar for sound inventory management. Here a larger investment in inventory leads to more efficient production and speedier delivery; this should result in increased sales. However, additional financing costs to support the increase in inventory and increased handling and carrying costs are required. CHAPTER OUTLINE I. Why a company holds cash A. The firm's cash balance is constantly affected by a variety of influences. Sound cash management techniques are based on a thorough understanding of the cash flow process. 1. 2. On an irregular basis, cash holdings are increased from several external sources, such as from the sale of securities. In a similar fashion, irregular cash outflows reduce the firm's cash balance. Typical examples include cash dividend payments and the interest requirements on debt agreements. Other major sources of cash arising from internal operations occur on a rather regular basis. Accounts receivable collections are an example. 3. 234 B. Three motives for holding cash balances have been identified by Keynes. 1. 1 The transactions motive is the need for cash to meet payments that arise in the ordinary course of doing business. Holding cash to meet a payroll or to acquire raw materials characterizes this motive. The precautionary motive describes the investment in liquid assets that are used to satisfy possible, but as yet indefinite, needs for cash. Precautionary balances are a buffer against all kinds of things that might happen to drain the firm's cash resources. The speculative motive describes holding cash to take advantage of hoped-for, profit-making situations. 2. 3. II. Variations in liquid asset holdings A. Considerable variation is present in the liquid asset holdings of major industry groups and individual firms. 1. This is because (l) not all of the factors noted above affect every firm and (2) the executives in different firms who are ultimately responsible for cash management tasks have different risk-bearing preferences. Some industries invest very heavily in liquid assets. For example, the total-liquid-assets-to-total-assets ratio of the contract construction industry greatly exceeds that of the utility industry. 2. B. Because assets are acquired, used, and sold every day, the management of liquid assets must be viewed as a dynamic process. The cash flow process is complex. In order to cut through this complexity, it is necessary that the firm's cash management system operates within clearly defined objectives. A properly designed cash management program forces the financial manager to come to grips with a risk-return tradeoff. 1. 2. 3. He or she must strike an acceptable balance between holding too much cash and holding too little cash. A large cash investment minimizes the chances of insolvency, but it penalizes company profitability. A small cash investment frees excess (cash) balances for investment in longer-lived and more profitable assets, which increases the firm's profitability. III. Cash management objectives and decisions A. B. The firm's cash management system should strive to achieve two prime objectives: 1. Enough cash must be on hand to dispense effectively with the disbursal needs that arise in the course of doing business. John Maynard Keynes, The General Theory of Employment Interest and Money (New York: Harcourt Brace Jovanovich, Inc., 1936). 1 235 2. C. The firm's investment in idle cash balances must be reduced to a minimum. In the attempt to meet the two objectives noted above, certain decisions dominate the cash management process. These decision areas can be reduced to the three following questions: 1. What can be done to speed up cash collections and slow down or better control cash outflows? 2. What should be the composition of the marketable securities portfolio? 3. How should the investment in liquid assets be split between actual cash holdings and marketable securities? Cash acceleration and deceleration techniques revolve around the concept of float. Float can be broken down into four elements: 1. Mail float refers to funds that are tied up as a result of the time that elapses from the moment a customer mails his or her remittance check until the firm begins to process the check. Processing float refers to funds that are tied up as a result of the firm's recording and processing remittance checks prior to their deposit in the bank. Transit float refers to funds that are tied up as a result of the time needed for a deposited check to clear through the commercial banking system and become "usable" funds to the firm. Disbursing float refers to funds that are technically usable to the firm until its payment check has cleared through the banking system and has been charged against its deposit account. IV. Collection and disbursement procedures A. 2. 3. 4. B. Float reduction can result in considerable benefits in terms of (l) usable funds that are released for company use and (2) in the returns produced on these freed-up balances. A study problem at the end of this chapter illustrates the calculation of such savings. In October of 2003, President Bush signed into law the Check Clearing for the 21st Century Act. The law took effect on October 28, 2004. This new law is now commonly referred to as "Check 21." Prior to this new regulation ordinary paper checks were physically transported by land carrier or air carrier from the depositing location to the financial institution that would eventually pay the check drawn against the firm's or individual's bank account. Check 21 allows financial institutions the option of clearing a check image instead of the original check. Such digital substitutes can then be quickly processed within the banking clearing system in the same way that you use the internet on your personal computer. These digital substitutes are being referred to as substitute checks or image replacement documents. The impetus for this new law was threefold: (1) bank regulators, like those at the Federal Reserve System, feel that Check 21 will accelerate check collection 236 at the ultimate or payee bank, (2) it is forecast that out-of-pocket transportation costs to the banking system will be reduced, this increasing individual bank profitability, and (3) the high degree of physical risk exposure associated with airline service can be minimalized. From the viewpoint of the firm's cash management system, "managing the float" will eventually be directly impacted. What is called "disbursing float" above could be dramatically reduced towards a few hours instead of a day or two. But, Check 21 did not require banks to alter their "hold" time on specific checks or substitute checks posted to the firm's account within the bank (these are ultimately cash inflows that become "good" funds). So while the check may have cleared within the bank clearing mechanism, (i.e., from bank to bank), the firm may not have use of "good" funds until banks are forced by a yet-to-be-defined regulatory change to reduce their "hold" time on checks that have actually cleared. Thus, the effects of Check 21 on "transit float" (the third type of float mentioned above) will occur gradually as pressure is put on individual financial institutions to reduce hold times and make the funds available for disbursement by the receiving firm. The upshot for the firm, and its cash management system, is that the greatest profitability opportunities are still associated with reducing mail float and processing float. C. Several techniques are available to improve the management of the firm's cash inflows. These techniques may also provide for a reduction in float. 1. The lock-box arrangement is a widely used commercial banking service for expediting cash gathering. a. The objective is to reduce both mail and processing float. b. The procedure behind a lock-box system is very simple. The firm rents a local post office box and authorizes a local bank in which a deposit account is maintained to pick up remittances from the box. (l) Customers are instructed to mail their payments to the numbered post office box. (2) A deposit form is prepared by the bank for each batch of processed checks. (3) The bank may notify the firm daily as to the amount of funds deposited on the firm's behalf. (4) The firm that receives checks from all over the country establishes several lock boxes. c. A lock-box arrangement provides for (l) increased working cash, (2) elimination of clerical functions, and (3) early knowledge of dishonored checks. The firm must carefully evaluate whether this or any cash management service is worth the added costs. Usually, the bank 237 d. levies a charge for each check processed through the system. The marginal income generated from released funds must exceed the added costs of the system to make it economically beneficial. A study problem at the end of this chapter illustrates this kind of calculation. D. Techniques used by firms that hope to improve the management of their cash outflows include: (l) zero balance accounts, (2) payable-through drafts, and (3) remote disbursing. 1. Zero balance accounts (ZBAs) permit centralized control (i.e., at the head office) over cash disbursements, but, at the same time, they allow the firm to maintain disbursing authority at the local or divisional level. a. The major objective of a ZBA system is to achieve better control over cash payments. A secondary benefit of this technique might be an increase in disbursement float. Under a ZBA system, each profit center (division) has a disbursing account located in the same concentration bank. (l) (2) The firm's authorized employees write payment checks in the usual manner. These checks then clear through the banking system and are presented to the firm's concentration bank for payment. The checks are paid by the bank and negative balances build up in the appropriate disbursing accounts. Daily, the negative balances are restored to a zero level by means of credits to the various ZBAs and a corresponding reduction in the firm's master demand deposit account in the concentration bank. b. (3) (4) c. For the firm that has several operating units, the benefits from using a ZBA system include: (1) (2) (3) (4) Centralized control over disbursements. Reduction of time spent on superficial cash management activities. Reduction of excess cash balances held in outlying accounts. An increase in disbursement float. 238 2. Payable-through drafts (PTDs) have the physical appearance of ordinary checks but they are drawn on and paid by the issuing firm instead of the bank. The bank serves as a collection point for the documents and passes the documents on to the firm for inspection and authorization for payment. a. The objective of a payable-through draft system is to provide for effective control of field authorized payments. An example would be a claim settlement authorized by an insurance agent. Stop payment orders can be initiated by the firm's headquarters on any drafts considered inappropriate. Legal payment of individual drafts takes place after review and approval of the drafts by the company. Disbursing float, however, is usually not increased by the use of drafts. For purposes of measuring usable funds to the firm, drafts presented daily for payment are charged in total against the corporate master demand deposit account. b. c. 3. Electronic funds transfer methods are serving to reduce transit, mail, and processing float. a. If Firm A owes money to Firm B, this situation ought to be immediately reflected on both the books and bank accounts of these companies. This ideal within the U.S. financial system has not been reached; the trend toward it is readily observable. Business firms, for example, are using systems like terminal-based wire transfers to move funds within their cash management systems. The heart of electronic funds transfer (EFT) is the elimination of the check as a method of transferring funds. The process of EFT should provide for a more efficient economy, since funds (cash) will be released for more productive purposes. b. c. V. Evaluating the costs of cash management services A. Whether a particular cash management system will provide an economic benefit to the firm can be evaluated by use of this relationship: added costs = added benefits B. Clearly, if the benefits exceed the costs of using the system, then the system is economically feasible. 239 C. On a per unit-basis, this relationship can be expressed as follows: P = (D) (S) (i) where P D S i = increase in per-check processing cost, if the new system is adopted, = days saved in the collection process, i.e., float reduction, = average check size in dollars, = the daily, before-tax opportunity cost (rate of return) of carrying cash. D. VI. The sum of (D) (S) (i) must exceed P for the system to be beneficial to the firm. A study problem at the end of this chapter provides an example of this logic. When selecting a proper marketable securities mix, five factors should be considered. 1. Financial risk is the uncertainty of expected returns from a security due to unforeseeable changes in the financial capacity of the security issuer to make future payments to the security owner. Interest rate risk is the uncertainty in expected returns caused by possible changes in interest rates. This is particularly important for securities that have long, as opposed to short, terms of maturity. (See study problem 5 for an illustration of this point.) Liquidity is the ability to transform a security into cash. Consideration should be given to (l) the time needed to sell the security and (2) the likelihood that the security can be sold at or near its prevailing market price. The taxability of interest income and capital gains is seriously considered by some corporate treasurers. a. The interest income from municipal obligations is tax-exempt. Composition of the marketable securities portfolio A. 2. 3. 4. 240 b. The following equation may be used to determine an equivalent before-tax yield on a taxable security. (1) Notation: r = equivalent before-tax yield. r* = after-tax yield on tax-exempt security. T = firm's marginal income tax rate. (2) Computation r (3) = r* (1 - T) Example: Suppose a firm has a choice between investing in a 1-year tax-free debt issue yielding 6% on a $1,000 outlay or a 1-year taxable issue that yields 7% on a $1,000 outlay. The firm pays federal taxes at the rate of 34%. Which security is more beneficial to the firm? = r (4) 5. 0.06 = 9.09% (1 - 0.34) Clearly, this firm should choose the tax-exempt security. The yield criterion involves a weighing of the risks and benefits inherent in the four previously mentioned factors. The higher the risks associated with a particular security, the higher the expected yield (risk-return tradeoff). A Treasury bill is a direct obligation of the U.S. government sold on a regular basis by the U.S. Treasury. a. b. c. d. These bills may now be purchased in denominations as small as $1,000. The bills are currently offered with maturities of 91, 182, and 365 days. Since Treasury bills are sold on a discount basis, the investor does not receive an actual interest payment. Since Treasury bills are backed by the U.S. government, they are considered risk-free and consequently sell at lower yields than those obtainable on other marketable securities. The income from Treasury bills is subject only to federal income taxes and is always taxed as an ordinary gain. B. Marketable security alternatives 1. e. 241 2. Federal agency securities represent debt obligations of federal government agencies and were created to carry out lending programs of the U.S. government. a. b. c. The Federal National Mortgage Association (FNMA) renders supplementary assistance to the secondary market for mortgages. The Federal Home Loan Banks (FHLB) function as a credit reserve system for member banks. The Federal Land Banks grant loans to members of Federal Land Bank Associations who are engaged in agriculture, provide agricultural services, or own rural homes. The Federal Intermediate Credit Banks grant loans to and purchase notes originating from loans made to farmers by other financial institutions. The Banks for Cooperatives make loans to cooperative associations which are owned and controlled by individuals involved in general farm business. Securities of these "big five" federally sponsored agencies are not directly backed by the U.S. government. The maturities available range from 30 days to 15 years, with most (80%) maturing in 5 years or less. The yields available always exceed those of Treasury bills of comparable maturity and are taxable at the federal, state, and local level. d. e. f. g. h. 3. Bankers' acceptances are largely concentrated in the financing of foreign transactions; this acceptance is a draft (order to pay) drawn on a specific bank by an exporter in order to obtain payment for goods shipped to a customer who maintains an account with that bank. a. b. c. d. The maturities run mostly from 30 to 180 days, with the most common period being 90 days. Like Treasury bills, the acceptances are sold on a discount basis. Income generated from acceptances is fully taxable at all governmental levels. Acceptances provide investors with a higher yield than do Treasury bills and agency obligations of comparable maturity. 4. A negotiable certificate of deposit (CD), is a marketable receipt for funds that have been deposited in a bank for a fixed time period at a fixed interest rate. a. CDs are offered in denominations ranging from $25,000 to $10,000,000, with popular sizes of $100,000, $500,000 and $1,000,000. 242 b. c. d. 5. Original maturities on CDs range from 1 to 18 months. Yields on CDs are higher than yields on Treasury bills, and, in recent years, they have exceeded those available on acceptances. The income received from CDs is taxed at all governmental levels. Commercial paper refers to short-term, unsecured promissory notes sold by large businesses in order to raise cash. a. b. c. d. Paper is usually sold in relatively large denominations, typically in excess of $25,000, and ranging up to $1,000,000. The notes are sold on a discount basis with maturities ranging from 3 to 270 days. It is the only investment instrument discussed here that has no active trading in a secondary market. The return on commercial paper is fully taxable at all governmental levels. 6. Repurchase agreements are legal contracts that involve the actual sale of securities by a borrower to the lender, with a commitment on the part of the borrower to repurchase the securities at the contract price plus a stated interest charge. a. b. c. These agreements are usually executed in sizes of $500,000 or more. The maturity is either for a specified time period (tailored to the needs of the investor) or there is no fixed maturity date. The yields are generally less than those of Treasury bill rates of comparable maturities and are taxable at all governmental levels. 7. Money market mutual funds usually invest in a diversified portfolio of short-term, high-grade debt instruments like those described in this section. a. b. c. d. These funds sell their shares to a large number of small investors in order to raise cash. The funds offer the investing firm a high degree of liquidity and investment expertise. The returns earned from owning shares in a money market fund are taxable at all governmental levels. Table 16.1 summarizes the salient features of the major money market instruments important to businesses. 243 Table 16.1 Features of Selected Money Market Instruments Denominations Maturities $1,000 and increments 91 days of $1,000 182 days 365 days 9-month not presently issued Wide variation from 5 days* to more than 10 $1,000 to $1,000,000 years (*Farm Credit consolidated systemwide discount notes) No set size; typically range from $25,000 to $1,000,000 $15,000 to $10,000,000 Predominantly from 30 to 180 days 1 to 18 months Basis Discount Liquidity Excellent secondary market Good for issues of "Big Five" agencies Taxability Exempt from state and local income; do not qualify for favorable capital gains rate Generally exempt at local level; FNMA issues are not Instrument U.S. Treasury Bills: Direct obligations of the U.S. government Federal Agency Securities: Obligations of corporations and agencies created to affect the federal government's lending programs. Bankers Acceptances: Drafts accepted for future payment by commercial banks Negotiable Certificates of Deposit: Marketable receipts for funds deposited in a bank for a fixed time period. Commercial Paper: Short-term, unsecured promissory notes. Repurchase Agreements: Legal contracts between a borrower (security seller) and lender (security buyer.) The borrower will repurchase at the contract price plus an interest charge Money Market Mutual Funds: Hold a diversified portfolio of short-term, high-grade debt instruments Discount or coupon; usually on coupon Discount Good for acceptances of large "money market" banks Fair to good Taxed at all levels of government Taxed at all levels of government Accrued interest 500 $5,000 to $5,000,000; $1,000 and $5,000 multiples above the initial offering size are sometimes available Typical sizes are $500,000 or more 3 to 270 days Discount Poor; no active, secondary market in usual sense Fixed by the agreement, i.e., borrower will repurchase Taxed at all levels of government According to terms of contract Not applicable Taxed at all levels of government Some require an initial investment as small as $1,000 Shares can be sold at any Net asset value time Good; provided by the fund itself Taxed at all levels of government 8. Money market deposit accounts became available to the public on December 14, 1982, on authorization of the Depository Institutions Deregulatory Committee. a. These accounts are offered by commercial banks and thrift institutions. The intent is to compete with money market mutual funds, but they do differ in significant ways from the funds. b. One characteristic of the money market deposit accounts (MMDAs) that makes them inappropriate for most businesses is that the number of transactions per month on each account is limited. Firms generally do not want to be restricted on the number of times per month that they can tap their liquid asset reserves. That runs counter to the very logic of holding a buffer stock of liquidity. c. Alternatively, the MMDAs have become very popular with individual investors. VII. Accounts receivable A. Typically, accounts receivable represent just over 25% of a firm's assets. B. The size of the investment in accounts receivable varies from industry to industry and is affected by several factors including the percentage of credit sales to total sales, the level of sales, and the credit and collection policies--more specifically the terms of sale, the quality of customer, and collection efforts. C. Although all these factors affect the size of the investment, only the credit and collection policies are decision variables under the control of the financial manager. D. The terms of sale are generally stated in the form a/b net c, indicating that the customer can deduct a percentage if the account is paid within b days; otherwise, the account must be paid within c days. E. If the customer decides to forgo the discount and not pay until the final payment date, the annualized opportunity cost of passing up this a% discount and withholding payment until the cth day is determined as follows: annualized opportunity a 360 cost of foregoing the = x discount 1- a c-b Example: Given the trade credit terms of 3/20 net 60, what is the annualized opportunity cost of passing up the 3% discount and withholding payment until the 60th day? Substituting in the values from the example, we get Solution: 27.8% = 0.03 360 x 1 - 0.03 60 - 20 245 F. A second decision variable in determining the size of the investment in accounts receivable in addition to the trade credit terms is the type of customer. 1. The costs associated with extending credit to lower-quality customers include: a. Increased costs of credit investigation b. Increased probability of customer default c. Increased collection costs Analyzing the credit application is a major part of accounts receivable management. 1. Several avenues are open to the firm in considering the credit rating of an applicant. Among these are financial statements, independent credit ratings and reports, bank checking, information from other companies, and past experiences. 2. One commonly used method for credit evaluation is called credit scoring and involves the numerical evaluation of each applicant in which an applicant receives a score based upon the answers to a simple set of questions. The score is then evaluated relative to a predetermined standard, its level relative to that standard determining whether or not credit scoring should be extended to the applicant. The major advantage of credit scoring is that it is inexpensive and easy to perform. 3. Once the decision to extend credit has been made and if the decision is yes, a maximum credit line is established as a ceiling on the amount of credit to be extended. The third and final decision variable in determining the size of the investment in accounts receivable is the firm's collection policies. 1. Collection policy is a combination of letter sending, telephone calls, personal visits, and legal actions. 2. The greater the amount spent on collecting, the lower the volume of bad debts. a. The relationship is not linear, however, and, beyond a point, is not helpful. b. If sales are independent of collection efforts, then methods of collection should be evaluated with respect to the reduction in bad debts against the cost of lowering those bad debts. Credit should be extended to the point that marginal profitability on additional sales equals the required rate of return on the additional investment in receivables necessary to generate those sales. G. H. I. 246 J. Credit policy changes involve direct tradeoffs between costs and benefits. Determining whether the increased sales contribute more toward profits than the increased costs take away from them is the job of marginal or incremental analysis. Marginal analysis is performed as follows: 1. Estimate the change in profits from the new policy. This is equal to the increased sales times the profit contribution less any additional bad debts incurred. 2. Estimate the cost of the additional investment in accounts receivable and inventory. 3. Estimate the change in the cost of the cash discount (if a change in the cash discount is enacted). 4. Compare the incremental revenues with the incremental costs. VIII. Inventory A. Typically, inventory accounts for about 4.88% of a firm's assets. B. The purpose of carrying inventories is to uncouple the operations of the firm. (i.e., to make each function of the business independent of each other function.) C. As such, the decision with respect to the size of the investment in inventory involves a basic tradeoff between risk and return. D. The risk comes from the possibility of running out of inventory if too little inventory is held, while the return aspect of this tradeoff results because increased inventory investment costs money. E. There are several general types of inventory. 1. Raw materials inventory consists of the basic materials that have been purchased from other firms to be used in the firm's productions operations. This type of inventory uncouples the production function from the purchasing function. 2. Work in process inventory consists of partially finished goods that require additional work before they become finished goods. This type of inventory uncouples the various production operations. 3. Finished goods inventory consists of goods on which the production has been completed but the goods are not yet sold. This type of inventory uncouples the production and sales function. 4. Stock of cash inventory serves to make the payment of bills independent of the collection of accounts due. F. In order to manage the investment in inventory effectively, two problems must be dealt with: the order quantity problem and the order point problem. The order quantity problem involves the determination of the optimal order size for an inventory item given its expected usage, carrying, and ordering costs. G. 247 H. The economic order quantity (EOQ) model attempts to determine the order size that will minimize total inventory costs. The EOQ is given as: Q* = 2SO C I. J. K. L. M. N. O. where C = carrying costs per unit O = ordering costs per order S = total demand in units over the planning period Q* = the optimal order quantity in units The order point problem attempts to answer the following question: How low should inventory be depleted before it is reordered? In answering this question, two factors become important: 1. What is the usual procurement or delivery time, and how much stock is needed to accommodate this time period? 2. How much safety stock does the management desire? Modification for safety stocks is necessary, since the usage rate of inventory is seldom stable over a given timetable. This safety stock is used to safeguard the firm against changes in order time and receipt of shipped goods. The greater the uncertainty associated with forecasted demand or order time, the larger the safety stock. 1. The costs associated with running out of inventory will also determine the safety stock levels. 2. A point is reached where it is too costly to carry a larger safety stock given the associated risk. Inflation can also have an impact on the level of inventory carried. 1. Goods may be purchased in large quantities in anticipation of price rises. 2. The cost of carrying goods may increase, causing a decline in Q*, the optional order quantity. The just-in-time inventory control system is more than just an inventory control system; it is a production and management system. 1. Under this system, inventory is cut down to a minimum, and the time and physical distance between the various production operations are also minimized. 2. Actually, the just-in-time inventory control system is just a new approach to the EOQ model which tries to produce the lowest average level of inventory possible. 3. Average inventory is reduced by locating inventory supplies in convenient locations and setting up restocking strategies that cut time and thereby reduce the needed level of safety stock. 248 ANSWERS TO END-OF-CHAPTER QUESTIONS 16-1. The procedure by which funds generated from company activity are accommodated (directed) through the firm from the time of their initial receipt until their ultimate disposition. Over the long run, accounts receivable collections account for the largest regular source of cash in the typical manufacturing company. Payment of accounts payable, payroll expenses, and the distribution of income to the owners (cash dividends) are the major forms of cash disbursal. Other sources of cash for a company may include receipts from the sale of assets, assumption of additional debt, issuance of new stock, or gains realized from investments. While these are important sources of cash to a company, the proceeds are not available on a regular basis. Major capital expenditure programs, new company acquisitions, and inventory stockpiling are examples of irregular disbursals of cash outside the normal course of everyday business. 16-2. The three classical motives for holding cash and near-cash balances are: (1) the transactions motive; (2) the precautionary motive; (3) the speculative motive. Transactions balances allow the firm to make payments that arise in the ordinary course of doing business. Precautionary balances provide a buffer stock of liquid assets that can be drawn down if unexpected demands for cash arise. Speculative balances permit the economic unit to take advantage of future profit-making situations. 16-3. The firm must: (1) maintain adequate cash balances that will permit it to meet the disbursal needs that occur in the course of doing business; (2) reduce idle cash balances to a minimum. 16-4. a. Choosing among various methods available for speeding up cash receipts, slowing down cash payments, and providing for more effective control over cash outflows. Splitting the firm's liquid asset holdings among cash and marketable securities. Choosing the appropriate marketable securities mix. Mail float: this represents funds which are not usable to the firm because of the time necessary for a customer's remittance check to travel through the mail to a company collection center. Processing float: this represents funds tied up due to the time needed for the company to process the remittance checks and get them ready for deposit in a demand deposit account. Transit float: this represents funds tied up because of the time necessary for a deposited check to clear through the commercial banking system and become "good" funds to the firm. b. c. 16-5. a. b. c. 249 d. Disbursing float: this refers to funds available in the firm's demand deposit account due to the time needed for a payment check to clear through the banking system. 16-6. In the context of cash management, financial risk is the uncertainty of future returns from a security caused by possible changes in the financial capability of the security-issuer to make future payments to the security-owner. This is sometimes called default risk. On the other hand, the uncertainty related to the expected returns from a financial asset caused by changes in interest rates is called interest rate risk. 16-7. The size of the investment in accounts receivable is determined primarily by these factors: a. The percentage of credit sales to total sales. While this factor plays a major role in determining the investment in accounts receivable, it is generally not within the control of the financial manager. In essence, the nature of the business tends to determine the blend between credit sales and cash sales. The level of sales. As sales increase, so will accounts receivable. Again, this is not an effective decision tool. Credit and collection policies. Specifically the terms of sale, the quality of customer, and collection efforts are determinants of the level of investment in receivables that are under the control of the financial manager. b. c. 16-8. If a credit manager experienced no bad debt losses over the past year, then credit was probably not extended to enough customers. Ideally, credit should be extended to the point where marginal revenue from added sales due to increased credit is equal to the marginal costs associated with increased bad debts, costs of investigation, costs of collection, and increased required rate of return. Obviously, the credit manager was nowhere near this level if no bad debts were incurred. 16-9. The returns associated with a more liberal credit policy come from the fact that extending credit to weaker customers or liberalizing the trade credit terms will probably increase sales, resulting in a larger profit level. The risks involved largely result from the increased possibility of extending credit that will eventually become bad debts. 16-10. The purpose of carrying inventories is to uncouple the operations of the firm (i.e., to make each function of the business independent of each other's function.) By uncoupling the various operations of the firm, delays or shutdowns in one area no longer affect the production and sale of the final product. Raw materials inventory, for example, uncouples the production function from the purchasing function. Goods in process inventory uncouples the various production operations in the firm's production and sales functions. 250 16-11. The major assumptions of the EOQ model include: (1) Constant or uniform demand. (2) Constant unit price regardless of amount ordered. (3) Constant carrying costs per unit. (4) Constant ordering costs per order regardless of the size of the order. (5) Instantaneous delivery. SOLUTIONS TO END-OF-CHAPTER PROBLEMS 16-1. a. 1. 2. 3. 4. 5. b. $1,500,000 (0.0825) (1/12) $1,500,000 (0.0825)(2/12) $1,500,000 (0.0825)(3/12) $1,500,000 (0.0825)(6/12) $1,500,000 (0.0825)(12/12) = = = = = $10,312.50 $20,625.00 $30,937.50 $61,875.00 $123,750.00 < < > > > Recommendation $30,000 No $30,000 No $30,000 Yes $30,000 Yes $30,000 Yes Let (%) be the required yield. With $1,500,000 to invest for three months and a three-month holding period, we have: $1,500,000 (%) (3/12) $1,500,000 (%) (%) = = $ 30,000 $ 120,000 $120,000 / $1,500,000 = 8% The break-even yield, therefore, is 8%. 16.2 a. First, it is necessary to compute Portobello's average remittance check size and the daily opportunity cost of carrying cash. The average check size is: $24,000,000 10,000 = $2,400 per check The daily opportunity cost of carrying cash is: 0.08 365 = 0.00021692 per day Second, the days saved in the collection process can be evaluated according to the general format of: Added Costs = Added Benefits 251 or P = (D) (S) (i) 0.25 = (D) ($2,400) (0.0002192) 0.4752 days D Therefore, Portobello Scuba Diving will experience a financial gain if it adopts the lock-box system and by doing so, will speed up its collections by more than 0.4752 days. b. In this situation, the daily opportunity cost of carrying cash is: 0.04 365 = 0.0001096 per day For Portobello to break even should it choose to install the lock-box system, the cash collections must be accelerated by 0.9504 days as follows: $0.25 = (D) ($2,400) (0.0001096) 0.9504 days = D c. The break-even cash acceleration period of 0.9504 days is greater than the 0.4752 days found in part a. This is due to the lower yield available on near cash assets (or 4% annually versus 8%). Since the alternative rate of return on the freed-up balances is lower on the second situation, more funds must be invested to cover the costs of operating the lock-box system. The greater cash acceleration period generates this increased level of required funds. 16.3 Annual revenues $438 million = = $1,200,000 Days in year 365 Four days' float reduction (i.e., 3 days' mail float plus 1 day processing float) will free up $4,800,000 (4 days x $1,200,000) which can be used to lower the outstanding balance drawn against the line of credit. The resulting annual saving in interest costs will equal: (cash freed-up) ($4,800,000) x x (interest rate on debt) (.08) = $384,000 252 The cost of the old centralized billing system is the sum of the interest costs being incurred (see above) plus the processing costs of $66,000. Thus, we have: Opportunity cost of current system (Total cost of new system) Net annual gain (loss) $450,000 (200,000) $250,000 Byron Sporting Goods should switch to be concentration banking system. By so doing, the company will save $250,000 annually. 16-4. Annual revenues $362 million = = $991,781 Days in year 365 Four days' float reduction (i.e., 3 days' mail float plus 1 day processing float) will free up $3,967,124 which can be used to lower the outstanding balance drawn against the line of credit. The resulting annual saving in interest costs will equal $277,699 as follows: $3,967,124 (.07) = $277,699 The cost of the old centralized billing system is the sum of the interest costs being incurred (see above) plus the costs processing of $57,500. Thus, we have: Cost of centralized system: Less: Flat Fee from bank Net annual gain $335,199 $175,000 $160,199 16-5. a. Freemont Shops should switch to the concentration banking system. By so doing, the company will save $160,199 annually. Recommendation 1. $800,000 (.105) (1/12) = $7,000 < $20,000 No 2. $800,000 (.105) (2/12) = $14,000 < $20,000 No 3. $800,000 (.105) (3/12) = $21,000 > $20,000 Yes 4. $800,000 (.105) (6/12) = $42,000 > $20,000 Yes 5. $800,000 (.105) (12/12) = $84,000 > $20,000 Yes Let (%) be the required yield. With $800,000 to invest for two months and a two-month holding period, we have: $800,000 (%) (2/12) $800,000 (%) (%) = = = $ 20,000 $120,000 $120,000/$800,000 = 15% b. The break-even yield, therefore, is 15%. 253 16-6. a. First, it is necessary to compute Mustang's average remittance check size and the daily opportunity cost of carrying cash. The average check size is: $12,000,000 = $2,000 per check. 6,000 The daily opportunity cost of carrying cash is: 0.07 = 0.0001918 per day 365 Second, the days saved in the collection process can be evaluated according to the general format of Added Costs = Added Benefits or P = (D) (S) (i) 0.20 = (D) ($2,000) (0.0001918) 0.5214 days = D. Therefore, Mustang Ski-Wear will experience a financial gain if it adopts the lock-box system and by doing so, will speed up its collections by more than 0.5214 days. b. In this situation, the daily opportunity cost of carrying cash is: 0.045 = 0.0001233 per day 365 For Mustang to break even should it choose to install the lock-box system, the cash collections must be accelerated by 0.8110 days as follows: $0.20 = (D) ($2,000) (0.0001233) 0.8110 days = D. c. The break-even cash acceleration period of 0.8110 days is greater than the 0.5214 days found in part a. This is due to the lower yield available on near-cash assets (or 4.5% annually versus 7.0%). Since the alternative rate of return on the freed-up balances is lower in the second situation, more funds must be invested to cover the costs of operating the lock-box system. The greater cash acceleration period generates this increased level of required funds. Annual collections = ($4,800,000) x (10) = $48,000,000 Daily collections = $48,000,000/365 = $131,507 The opportunity cost of the mail and processing float is: ($131,507) x (4.2 days) x (0.07) = $38,663 16-7. a. 254 b. Use of the suggested cash acceleration system will result in a float reduction of 3.2 days (i.e., 1.2 days mail float, 1 day processing float, and 1 day transit float). The gross annual savings from the system, then, can be calculated as: ($131,507) x (3.2) x (.07) = $29,458 The cost of operation of the lock-box system is: ($250 per month) x (10 regions) x (12 months) = $30,000 Therefore, the net annual savings (costs) are: ($29,458) - ($30,000) = -$542 The firm should not adopt the system, as the net gain is negative and equal to -$542. 16-8. a. Reduction in mail float: (2 days) x ($1,000,000) = Reduction in processing float: (2 days) x ($1,000,000) = Total float reduction = $ 2,000,000 $ 2,000,000 $ 4,000,000 $ 240,000 b. c. (0.06) x ($4,000,000) = The average number of checks to be processed each day through the lockbox arrangement is: ($1,000,000) = 500 checks per day $2,000 Thus, the cost of the lock-box system on an annual basis is: (500) x ($0.18) x (270 days) = $24,300 Next, we have to calculate the cost of the ADTC system. The First Pennsylvania Bank will not contribute to the cost of the ADTC arrangement because it is the lead concentration bank and thereby receives the transferred data. This means Pierce Designs will be charged for six ADTCs each business day. The ADTC system, then, costs ($15) x (6) x (270) = $24,300. Note that only by mere coincidence does the cost of the ADTC system equal that of the lock-box arrangement. Finally, we have the total cost of the proposed system: Lock-box cost ADTC cost Total cost $ 24,300 24,300 $ 48,600 255 d. The information just developed strongly indicates that Pierce Designs should install the proposed cash receipts acceleration system. The net annual gain associated with this recommendation is $191,400 as follows: Projected return on freed balances Less cost of new system Net annual gain $240,000 (48,600) $191,400 16-9. a. The average accrued wages under the monthly payment system are: 4 x ($500,000) = $1,000,000 2 This means that the firm has, on the average, $750,000 (i.e., $1,000,000 $250,000) more to invest. This provides an annual return of ($750,000) x (0.07) = $52,500. Therefore, Daniel Shoe should move to the monthly payment system since it will generate $52,500 - $35,000 = $17,500 in net annual savings. Let r = the break-even rate of return on the near-cash portfolio: $750,000 x (r) = $35,000 r = 0.0467 or 4.67% A reasonable margin of safety favoring adoption of the monthly payment proposal is present. b. 16-10. The value of one day of processing float is: $12,000,000 = $44,444 270 The annual savings at 6% for two days are: ($44,444) x (2) x (0.06) = $5,333 16-11. This exercise attempts to illustrate that a change in the firm's accounts payable policy can properly be viewed as a part of the overall problem of cash management. Before evaluating the 45-day and 60-day payment alternatives, it is necessary to calculate the amount of purchases that are actually discounted and the value of the annual purchase discount earned by Bradford Construction. These amounts are calculated below: Purchases discounted ($37,500,000 annual purchases) x (0.25) = $9,375,000 Purchase discounts earned ($9,375,000) x (0.03) = $281,250 with $281,250 in purchase discounts earned. Bradford actually pays: ($9,375,000) - ($281,250) = $9,093,750, 10 days after purchase. 256 The annual amount not discounted is ($37,500,000) - ($9,375,000) = $28,125,000. We are now in a position to evaluate first the 45-day proposal and, second, the 60day proposal. 45-day alternative: (1) (2) x (3) Principal amount $ 28,125,000 $138,699 9,093,750 104,640 $243,339 - $281,250 + 243,339 - $ 37,911 60-day alternative: (1) Principal amount $28,125,000 9,093,750 (2) Extra time available 30 days 50 days (3) (4) = (1) x (2) x (3) Interest Interest rate earned 0.12 365 = $277,397 0.12 365 = 149,486 Total added return $426,883 Lost discounts earned Total added return Loss to Bradford by stretching payables to 45 days. Extra time available 15 days 35 days Interest rate 0.12 365 0.12 365 Total added return Interest earned = = (2) (3) (4) = (1) x - $281,250 Lost discounts earned + $426,883 Total added return $145,633 Gained by Bradford by stretching payables to 60 days Finally, we can evaluate the effect of the projected price increase to Bradford that is associated with the 60-day alternative. Price Increase: $37,500,000 Purchases .005 $ 187,500 Price increase $187,500 Price increase - 145,633 Net added return $ 41,867 Loss to Bradford 257 Ultimately, none of the proposed courses of action would benefit the firm. 258 16-12. a. P = t =1 18 $80 (1.09) t + $1,000 (1.09)18 = $912.44 The bond can be sold for $912.44. This was developed as follows: $80 x (8.7556) + $1,000 x (.21199) = $912.44 b. c. $1,000 - $912.44 = $87.56 loss First, we find the price of the 4-year bond, which now has 2 years remaining to maturity: P = t =1 2 $80 (1.09) t + $1,000 (1.09) 2 = $982.41 Then, we can determine the expected capital loss on the shorter-term bond as follows: $1,000 - $982.41 = $17.59 The capital loss on the shorter-term bond is much less than that suffered on the longer-term instrument. d. 16-13. a. Interest rate risk, which leads to a maturity premium, as discussed in Chapter 2. The after-tax yield to Aggieland Fireworks on the BBB-rated bond is (0.09) x (1-0.46) = .0486 = 4.86%. Since the yield on the tax-exempt issue is already stated on an after-tax basis, we can conclude the 5% return on the municipal is preferable. r = r = b. r* (1 - T) 0.055 0.055 = = 0.10185 or 10.185% (1 - 0.46) 0.54 259 16-14. a. a 360 x 1- a c - b where a b c = amount of the discount = the discount period = the net period = 0.3636 or 36.36% = 0.3673 or 36.73% = 0.5567 or 55.67% = 0.2227 or 22.27% = 0.1392 or 13.92% = 0.3789 or 37.89% 0.01 360 x 1 - 0.01 20 - 10 b. c. d. e. f. 0.02 360 x 1 - 0.02 30 - 10 0.03 360 x 1 - 0.03 30 - 10 0.03 360 x 1 - 0.03 60 - 10 0.03 360 x 1 - 0.03 90 - 10 0.05 360 x 1 - 0.05 60 - 10 16-15.Applicant #1 Z = 3.3(0.2) + 1.0(0.2) + 0.6(1.2) + 1.4(0.3) + 1.2(0.5) Z = 0.66 + 0.2 + 0.72 + 0.42 + 0.6 Z = 2.6 < 2.7 thus, reject Applicant #2 Z = 3.3(0.2) + 1.0(0.8) + 0.6(1.0) + 1.4(0.3) + 1.2(0.8) Z = 0.66 + 0.8 + 0.6 + 0.42 + 0.96 Z = 3.44 > 2.7 thus, accept Applicant #3 Z = 3.3(0.2) + 1.0(0.7) + 0.6(0.6) + 1.4(0.3) + 1.2(0.4) Z = 0.66 + 0.7 + 0.36 + 0.42 + 0.48 Z = 2.62 < 2.7 thus, reject Applicant #4 Z = 3.3(0.1) + 1.0(0.4) + 0.6(1.2) + 1.4(0.4) + 1.2(0.4) Z = 0.33 + 0.4 + 0.72 + 0.56 + 0.48 Z = 2.49 < 2.7 thus, reject 260 Applicant #5 Z = 3.3(0.3) + 1.0(0.7) + 0.6(0.5) + 1.4(0.4) + 1.2(0.7) Z = 0.99 + 0.7 + 0.30 + 0.56 + 0.84 Z = 3.39 > 2.7 thus, accept Applicant #6 Z = 3.3(0.2) + 1.0(0.5) + 0.6(0.5) + 1.4(0.4) + 1.2(0.4) Z = 0.66 + 0.5 + 0.30 + 0.56 + 0.48 Z = 2.5 < 2.7 thus, reject 16-16. a. Sales - cost of goods sold Sales = Gross Profit Margin $600,000 - cost of goods sold = 0.10 $600,000 Cost of goods sold = $540,000 = Inventory turnover ratio = 6 = $90,000 = Cost of goods sold Average inventory $540,000 Average inventory Average inventory b. Inventory turnover ratio Inventory turnover = 360 Average Collection Period 360 40 = 9 times Inventory turnover ratio Cost of goods sold Average inventory $480,000 Average inventory Average inventory = = = 9 times 9 times $53,333 261 c. Cost of goods sold Average inventory $1,150,000 Average inventory Average inventory = = 5 Inventory turnover ratio = $230,000 = $21,500,000 cost of goods (0.86)($25,000,000) d. (1 - Gross profit margin) (Sales) Inventory turnover ratio = 360 45 = 8 times $21,500,000 Average inventory Average inventory 16-17. a. Q* = = 8 times = $ 2,687,500 2SO C = = = b. 2( 3000 )10 0.10 600,000 775 units = Total costs S Q C + O Q 2 3000 3000 $.10 + $10 2 3000 $150 + $10 $160 Order one time: = = = 262 Order four times: = = = 750 3000 $10 $.10 + 2 750 $37.50 + $40 $77.50 Order five times: = = = Order ten times: = = = Order 15 times: = = = c. (1) (2) (3) (4) (5) (6) EOQ 600 3000 $.10 + $10 2 600 $30.00 + $50.00 $80 300 3000 $10 $0.10 + 2 300 $15.00 + $100 $115 200 3000 $0.10 + $10 2 200 $10 + $150 $160 constant or uniform demand constant unit price constant carrying costs constant ordering costs instantaneous delivery independent orders = 16-18. a. 2SO C = = 2(250,000)100 1 7,071 units or 7,100 units 263 b. c. 250,000 7,100 = 35.2 orders per year Inventory order point = Delivery time stock + safety stock = = = 1 x 250,000 + 5,000 50 5,000 + 5,000 10,000 units = d. Average inventory EOQ + Safety stock 2 7,100 + 5,000 2 = = 8,550 units e. EOQ = = 2(500,000)100 1 10,000 units Elasticity of %EOQ EOQ with = respect to a %Sales double in sales = EOQ Sale EOQ Sales = 10,000 - 7,100 500,000 - 250,000 / 7,100 250,000 .4085 = .4085 or 40.85% 1.0 = 264 f. EOQ = = 2(250,000)100 2 5,000 Elasticity of EOQ with respect to a = double in carrying costs = %EOQ %Carrying Costs 5,000 - 7,100 2 -1 7,100 1 = -0.2958 or -29.58% g. EOQ = = 2(250,000)200 1 10,000 Elasticity of EOQ with respect to a = double in ordering costs = (h) %EOQ %Ordering Costs 10,000 - 7,100 200 - 100 = 40.85% 7,100 100 The selling price of the item does not enter the EOQ equation and does not affect the level of EOQ (although the carrying cost which is 10% of the selling price does). The EOQ equation attempts to minimize costs and, as such, the selling price does not enter into its calculation; thus, the elasticity of EOQ with respect to the selling price is 0. 265 SOLUTION TO COMPREHENSIVE PROBLEM a. The amount of cash balances that will be freed if New Wave Surfing Stuff, Inc. adopts the system proposed by the Bank of the U.S.: Cash balances freed due to the reduction in mail float = (# of days eliminated) x (Average daily cash remittances) 2.5 x $150,000 = $375,000 Cash balances freed due to the reduction in processing float = (# of days eliminated) x (Average daily cash remittances) 3 x $150,000 = $450,000 $825,000 Total float reduction b. Opportunity cost of maintaining the current banking arrangement: Opportunity Cost--Interest = (Forecast yield on marketable securities portfolio) x (Total float reduction) .05 x 825,000 = = $41,250 55,000 $96,250 Opportunity Cost--Interest Opportunity Cost--Clerical Expense Total Opportunity Cost c. Projected annual cost of operating the proposed system: Average number of checks to be processed each day through the lock-box arrangement: Daily remittance Average Check Size = $150,000 $750 = 200 checks 266 Resulting cost of lock-box system on an annual basis: Cost = [(Average # of checks) x (Processing cost per check) x (# of business days per year)] 200 Cost = $16,200 x $0.30 x 270 = Next, the estimated cost of the automated deposit transfer center (ADTC) must be calculated. The Bank of the U.S. will not contribute to the cost of the ADTC because it is the lead concentration bank and thereby receives the transferred data. As a result, New Wave will be charged for six ADTCs (three locations @ two checks each) each business day. The ADTC system, therefore, costs: Cost year)] Cost Cost = [(# of daily transfers) x (cost per transfer) x (# of business days per = 6 = $567 x $ .35 x 270 Accordingly, the total cost of the proposed system is: Lock-box cost ADTC cost Total Cost d. $16,200 567 $16,767 The net annual gain associated with adopting the proposed system is: Opportunity cost of current system (Total cost of new system) Net annual gain (loss) [STEP B] [STEP C] $96,250 (16,767) $79,483 As a result, the analysis suggests the company should adopt the proposed cash receipts acceleration system. 267 ALTERNATIVE PROBLEMS AND SOLUTIONS ALTERNATIVE PROBLEMS 16-1A. (Lock-Box System) Regency Components is located in Nashville, Tennessee. The firm manufactures components used in a variety of electrical devices. All the firm's finished goods are shipped to five regional warehouses across the United States. Tennessee State Bank of Nashville is Regency Components' lead bank. Tennessee State recently completed a study of Regency's cash-collection system. Tennessee State estimates that it can reduce Regency's total float by 3.0 days with the installation of a lock-box arrangement in each of the firm's five regions. The lock-box arrangement would cost each region $600 per month. Any funds freed up would be added to the firm's marketable securities portfolio and would yield 11% on an annual basis. Annual sales average $10,000,000 for each regional office. The firm and the bank use a 365-day year in their analyses. Should Regency Components' management approve the use of the proposed system? 16-2A. (Buying and Selling Marketable Securities) Universal Concrete Company has generated $700,000 in excess cash that it could invest in marketable securities. In order to buy and sell the securities, the firm will pay total transactions fees of $25,000. a. Would you recommend purchasing the securities if they yield 11.5% annually and are held for 1. 2. 3. 4. 5. b. One month? Two months? Three months? Six months? One year? What minimum required yield would the securities have to return for the firm to hold them for two months (what is the break-even yield for a twomonth holding period)? 16-3A. (Costs of Services) Colorado Communications is investigating the possibility of adopting a lock-box system as a cash receipts acceleration device. In a typical year, this firm receives remittances totaling $10 million by check. The firm will record and process 7,000 checks over this same time period. The Colorado Springs Second National Bank has informed the management of Colorado Comm that it will expedite checks and associated documents through the lock-box system for a unit cost of $.30 per check. Colorado Comm's financial manager has projected that cash freed by adoption of the system can be invested in a portfolio 268 of near-cash assets that yield an annual before-tax return of 7%. Colorado Comm's financial analysts use a 365-day year in their procedures. a. b. c. What reduction in check collection time is necessary for Colorado Comm to be neither better nor worse off for having adopted the proposed system? How would your solution to a be affected if Colorado Comm could invest the freed balances only at an expected annual return of 4.5%? What is the logical explanation for the differences in your answers to a and b? 16-4A. (Lock-Box System) Alpine Systems is a distributor of refrigerated storage units to the meat products industry. All its sales are on a credit basis, net 30 days. Sales are evenly distributed over its 10 sales regions throughout the United States. Delinquent accounts are no problem. The company has recently undertaken an analysis aimed at improving its cash-management procedures. Alpine determined that it takes an average of 3.2 days for customers' payments to reach the head office in Pittsburgh from the time they are mailed. It takes another full day in processing time prior to depositing the checks with a local bank. Annual sales average $5,000,000 for each regional office. Reasonable investment opportunities can be found yielding 8% per year. To alleviate the float problem confronting the firm, the use of a lock-box system in each of the 10 regions is being considered. This would reduce mail float by 1.0 days. One day in processing float would also be eliminated, plus a full day in transit float. The lock-box arrangement would cost each region $225 per month. a. b. What is the opportunity cost to Alpine Systems of the funds tied up in mailing and processing? Use a 365-day year. What would the net cost or savings be from use of the proposed cashacceleration technique? Should Alpine adopt the system? 16-5A. (Cash Receipts Acceleration System) Carter's Bicycles, Inc. is a vertically integrated, national manufacturer and retailer of racing bicycles. Currently, the firm has no coordinated cash-management system. A proposal, however, from the First Pennsylvania Bank aimed at speeding up cash collections is being examined by several of Carter's corporate executives. The firm currently uses a centralized billing procedure, which requires that all checks be mailed to the Philadelphia head office for processing and eventual deposit. Under this arrangement, all the customers' remittance checks take an average of 4 business days to reach the head office. Once in Philadelphia another 1.5 days are required to process the checks for ultimate deposit at the First Pennsylvania Bank. The firm's daily remittances average $1 million. The average check size is $2,000. Carter's currently earns 7% annually on its marketable securities portfolio. 269 The cash-acceleration plan proposed by officers of First Pennsylvania involves both a lock-box system and concentration bank. First Pennsylvania would be the firm's only concentration bank. Lock boxes would be established in (1) San Francisco, (2) Dallas, (3) Chicago, and (4) Philadelphia. This would reduce funds tied up by mail float to three days, and processing float will be eliminated. Funds would then by transferred twice each business day by means of automated depository transfer checks from local banks in San Francisco, Dallas, and Chicago to the First Pennsylvania Bank. Each ADTC costs $16. These transfers will occur all 270 business days of the year. Each check processed through the lock-box system will cost $.22. a. b. c. d. What amount of cash balances will be freed if Carter's Bicycles adopts the system suggested by First Pennsylvania? What is the opportunity of maintaining the current banking setup? What is the projected annual cost of operating the proposed system? Should Carter's adopt the new system? Compute the net annual gain or loss associated with adopting the system. 16-6A. (Marketable Securities Portfolio) Katz Jewelers currently pays its employees on a weekly basis. The weekly wage bill is $500,000. This means that on the average the firm has accrued wages payable of ($500,000)/2 = $250,000. Harry Katz works as the firm's senior financial analyst and reports directly to his father, who owns all of the firm's common stock. Harry Katz wants to move to a monthly wage payment system. Employees would be paid at the end of every fourth week. The younger Katz is fully aware that the labor union representing the company's workers will not permit the monthly payments system to take effect unless the workers are given some type of fringe benefit compensation. A plan has been worked out whereby the firm will make a contribution to the cost of life insurance coverage for each employee. This will cost the firm $40,000 annually. Harry Katz expects the firm to earn 8% annually on its marketable securities portfolio. a. b. Based on the projected information, should Katz Jewelers move to the monthly wage payment system? What annual rate of return on the marketable securities portfolio would enable the firm to just break even on this proposal? 16-7A. (Valuing Float Reduction) Magic Hardware Stores, Inc. will generate $12 million in credit sales next year. Collections of these credit sales will occur evenly over this period. The firm's employees work 270 days a year. Currently, the firm's processing system ties up 4.5 days' worth of remittance checks. A recent report from a financial consultant indicated procedures that will enable Magic Hardware to reduce processing float by two full days. If Magic invests the released funds to earn 7%, what will be the annual savings? 270 16-8A. (Accounts Payable Policy and Cash Management) Meadowbrook Paving Company is suffering from a prolonged decline in new development in its sales area. In an attempt to improve its cash position, the firm is considering changes in its accounts payable policy. After careful study, it has determined that the only alternative available is to slow disbursements. Purchases for the coming year are expected to be $40 million. Sales will be $65 million, which represents about a 15% drop from the current year. Currently, Meadowbrook discounts approximately 25% of its payments at 3% 10 days, net 30, and the balance of accounts are paid in 30 days. If Meadowbrook adopts a policy of payment in 45 days or 60 days, how much can the firm gain if the annual opportunity cost of investment is 11%? What will be the result if this action causes Meadowbrook Paving suppliers to increase their prices to the company by 0.5% to compensate for the 60-day extended term of payment? In your calculations, use a 365-day year and ignore any compounding effects related to expected returns. 16-9A. (Interest Rate Risk) Two years ago, your corporate treasurer purchased for the firm a 30-year bond at its par value of $1,000. The coupon rate on this security is 7%. Interest payments are made to bondholders once a year. Currently, bonds of this particular risk class are yielding investors 9%. A cash shortage has forced you to instruct your treasurer to liquidate his bond. a. b. c. At what price will your bond be sold? Assume annual compounding. What will be the amount of your gain or loss over the original purchase price? What would be the amount of your gain or loss had the treasurer originally purchased a bond with a 4-year rather than a 30-year maturity? (Assume all characteristics of the bonds are identical except their maturity periods.) What do we call this type of risk assumed by your corporate treasurer? d. 16-10A.(Comparison of After-Tax Yields) The corporate treasurer of Ward Grocers is considering the purchase of a BBB-rated bond that carries an 8.0% coupon. The BBB-rated security is taxable, and the firm is in the 46 percent marginal tax bracket. The face value of this bond is $1,000. A financial analyst who reports to the corporate treasurer has alerted him to the fact that a municipal obligation is coming to the market with a 5% coupon. The par value of this security is also $1,000. a. b. Which one of the two securities do you recommend the firm purchase? Why? What must the fully taxed bond yield before tax to make it comparable with the municipal offering? 271 16-11A.(Trade Credit Discounts) Determine the effective annualized cost of forgoing the trade credit discount on the following terms: a. b. c. d. e. f. 1/5, net 20 2/20, net 90 1/20, net 100 4/10, net 50 5/20, net 100 5/30, net 50 16-12A.(Altman Model) The following ratios were supplied by six loan applicants. Given this information and the credit-scoring model developed by Altman, which loans have a high probability of defaulting next year and thus should be avoided? Market Value Equity Book Value of Debt 1.2 1.3 .6 .8 .5 .2 of Working Earnings Capital Total Total Assets Assets .3 .5 .4 .3 .3 .2 .5 .4 .4 .6 .4 .4 Applicant 1 Applicant 2 Applicant 3 Applicant 4 Applicant 5 Applicant 6 EBIT Total Assets .3 .2 .2 .1 .5 .2 Sales Total Assets .4 .6 .7 .5 .7 .4 16-13A.(Ratio Analysis) Assuming a 360-day year, calculate what the average investment in inventory would be for a firm, given the following information in each case. a. b. c. d. The firm has sales of $550,000, a gross profit margin of 10%, and an inventory turnover ratio of 5. The firm has a cost of goods sold figure of $480,000 and an average age of inventory of 35 days. The firm has a cost of goods sold figure of $1,250,000 and an inventory turnover ratio of 6. The firm has a sales figure of $25 million, a gross profit margin of 15%, and an average of inventory of 50 days. 272 16-14A.(EOQ Calculations) A downtown bookstore is trying to determine the optimal order quantity for a popular novel just printed in paperback. The store feels that the book will sell at four times its hardback figures. It would therefore sell approximately 3,500 copies in the next year at a price of $1.50. The store buys the book at a wholesale figure of $1. Costs for carrying the book are estimated at $.20 a copy per year, and it costs $9 to order more books. a. Determine the EOQ b. What would be the total costs for ordering the books 1, 4, 5, 10, and 15 times a year? c. What questionable assumptions are being made by the EOQ model? 16-15A.(Comprehensive EOQ Calculations) Good Gravy Products, Inc. is involved in the production of tractor parts and has the following inventory, carrying, and storage costs: 1. Orders must be placed in round lots of 100 units. 2. Annual unit usage is 300,000. (Assume a 50-week year in your calculations.) 3. The carrying cost is 10% of the purchase price. 4. The purchase price is $12 per unit. 5. The ordering cost is $100 per order. 6. The desired safety stock is 4,000 units. (This does not include delivery time stock.) 7. The delivery time is one week. Given the above information: a. Determine the optimal EOQ level. b. How many orders will be placed annually? c. What is the inventory order point? (That is, at what level of inventory should a new order be placed?) d. What is the average inventory level? e. What would happen to the EOQ if annual unit sales doubled (all other unit costs and safety stocks remaining constant)? What is the elasticity of EOQ with respect to sales? (That is, what is the percent change in EOQ divided by the percent change in sales?) f. If carrying costs double, what would happen to the EOQ level? (Assume the original sales level of 250,000 units.) What is the elasticity of EOQ with respect to carrying costs? g. If the ordering costs double, what would happen to the level of EOQ? (Again assume original levels of sales and carrying costs.) What is the elasticity of EOQ with respect to ordering costs? h. If the selling price doubles, what would happen to EOQ? What is the elasticity of EOQ with respect to selling price? 273 SOLUTIONS FOR ALTERNATIVE PROBLEMS 16-1A. Annual collections = $10,000,000 (5 regions) = $50,000,000 Daily collections = $50,000,000/365 = $136,986 The value of the 3.0 days' float reduction is found by presuming the freed balances will be added to the marketable securities portfolio and will earn 11% (see text of problem). The gross annual savings from the system are: ($136,986) (3.0 days) (.11) = $45,205 The annual cost of operating the lock-box system is: ($600 per month) (5 regions) (12 months) = $36,000 The net annual savings are: $45,205 - 36,000 $9,205 Savings Recommendation $6,708 < $25,000 No $13,417 < $25,000 No $20,125 < $25,000 No $40,250 > $25,000 Yes $80,500 > $25,000 Yes The data indicate that Regency Components should adopt the lock-box system. 16-2A. a. 1. 2. 3. 4. 5. b. $700,000 (.115) (1/12) $700,000 (.115) (2/12) $700,000 (.115) (3/12) $700,000 (.115) (6/12) $700,000 (.115) (12/12) = = = = = Let (%) be the required yield. With $700,000 to invest for two months and a two-month holding period, we have: $700,000 (%) (2/12) = $ 25,000 $700,000 (%) = $150,000 (%) = $150,000/$700,000 = 21.43% The break-even yield, therefore, is 21.43%. 16-3A.a. First, it is necessary to compute Colorado Comm's average remittance check size and the daily opportunity cost of carrying cash. The average check size is: $10,000,000 = $1,429 per check. 7,000 The daily opportunity cost of carrying cash is: 0.07 = 0.0001918 per day 365 274 Second, the days saved in the collection process can be evaluated according to the general format of Added Costs = Added Benefits or P = (D) (S) (i) 0.30 = (D) ($1,429) (0.0001918) 1.0946 days = D Therefore, Colorado Comm will experience a financial gain if it adopts the lock-box system and by doing so, will speed up its collections by more than 1.0946 days. b. In this situation, the daily opportunity cost of carrying cash is: 0.045 = 0.0001233 per day 365 For Colorado Comm to break even should it choose to install the lock-box system, the cash collections must be accelerated by 1.7027 days as follows: $0.30 = (D) x ($1,429) x (0.0001233) 1.7027 days = D c. The break-even cash acceleration period of 1.7027 days is greater than the 1.0946 days found in part a. This is due to the lower yield available on near-cash assets (or 4.5% annually versus 7.0%). Since the alternative rate of return on the freed-up balances is lower in the second situation, more funds must be invested to cover the costs of operating the lock-box system. The greater cash acceleration period generates this increased level of required funds. Annual collections = ($5,000,000) x (10) = $50,000,000 Daily collections = $50,000,000/365 = $136,986 The opportunity cost of the mail and processing float is: ($136,986) x (4.2 days) x (0.08) = $46,027 b. Use of the suggested cash acceleration system will result in a float reduction of 3 days (i.e., 1 day mail float, 1 day processing float, and 1 day transit float). The gross annual savings from the system, then, can be calculated as: ($136,986) x (3) x (0.08) = $32,877 The cost of operation of the lock-box system is: ($225 per month) x (10 regions) x (12 months) = $27,000 16-4A. a. 275 Therefore, the net annual savings (costs) are: ($32,877) - ($27,000) = $5,877 The firm should adopt the system, as the net gain is positive and equal to $5,877. Reduction in mail float: (1 day) x ($1,000,000) = $ 1,000,000 Reduction in processing float: (1.5 days) x ($1,000,000) Total float reduction b. c. (0.07) x ($2,500,000) = = = $175,000 $ 1,500,000 $ 2,500,000 16-5A. a. The average number of checks to be processed each day through the lockbox arrangement is: ($1,000,000) = 500 checks per day $2,000 Thus, the cost of the lock-box system on an annual basis is: (500) x ($0.22) x (270 days) = $29,700 Next, we have to calculate the cost of the ADTC system. The First Pennsylvania Bank will not contribute to the cost of the ADTC arrangement, because it is the lead concentration bank and, thereby, receives the transferred data. This means Carter's Bicycles will be charged for six ADTCs each business day. The ADTC system, then, costs ($16) x (6) x (270) = $25,920. Finally, we have the total cost of the proposed system: Lock-box cost ADTC cost Total cost d. $ 29,700 25,920 $ 55,620 The information just developed strongly indicates that Carter's Bicycles should install the proposed cash receipts acceleration system. The net annual gain associated with this recommendation is $119,380 as follows: Projected return on freed balances Less cost of new system Net annual gain $175,000 (55,620) $119,380 276 16-6A. a. The average accrued wages under the monthly payment system are: 4 x ($500,000) = $1,000,000 2 This means that the firm has, on the average, $750,000 (i.e., $1,000,000 $250,000) more to invest. This provides an annual return of ($750,000) x (0.08) = $60,000. Therefore, Katz Jewelers should move to the monthly payment system since it will generate $60,000 - $40,000 = $20,000 in net annual savings. b. Let r = the break-even rate of return on the near-cash portfolio: $750,000 x (r) = $40,000 r = 5.33% A reasonable margin of safety favoring adoption of the monthly payment proposal is present. 16-7A. The value of one day of processing float is: $12,000,000 = $44,444 270 The annual savings at 7% for two days are: ($44,444) x (2) x (0.07) = $6,222 16-8A. This exercise attempts to illustrate that a change in the firm's accounts payable policy can properly be viewed as a part of the overall problem of cash management. Before evaluating the 45-day and 60-day payment alternatives, it is necessary to calculate the amount of purchases that are actually discounted and the value of the annual purchase discount earned by Meadowbrook. These amounts are calculated below: Purchases discounted ($40,000,000 annual purchases) x (0.25) = $10,000,000 Purchase discounts earned ($10,000,000) x (0.03) = $300,000 with $300,000 in purchase discounts earned. Meadowbrook actually pays: ($10,000,000) - ($300,000) = $9,700,000, 10 days after purchase. The annual amount not discounted is ($40,000,000) - ($10,000,000) = $30,000,000. We are now in a position to evaluate, first, the 45-day proposal and, second, the 60-day proposal. 277 45-day alternative: (1) Principal amount $ 30,000,000 $135,616 9,700,000 - $300,000 + 237,931 - $ 62,069 60-day alternative: (1) Principal amount $30,000,000 $271,233 9,700,000 - $300,000 +$417,397 $117,397 days (2) Extra time available 15 days 35 days (3) Interest rate 0.11 365 (4) = (1) x (2) x (3) Interest earned = 0.11 365 = 102,315 Total added return $237,931 Lost discounts earned Total added return Loss to Meadowbrook by stretching payables to 45 days. (2) Extra time available 30 days 50 days (3) Interest rate 0.11 365 (4) =(1)x(2)x(3) Interest earned = 0.11 365 = 146,164 Total added return $417,397 Lost discounts earned Total added return Gained by Meadowbrook by stretching payables to 60 Finally, we can evaluate the effect of the projected price increase to Meadowbrook that is associated with the 60-day alternative. Price Increase: . $40,000,000 Purchases x.005 $ 200,000 Price increase $200,000 Price increase - 117,397 Net added return -$ 82,603 Loss to Meadowbrook Ultimately, none of the proposed courses of action would benefit the firm. 16-9A. a. P = 28 t =1 $70 (1.09) t + $1,000 (1.09) 28 = $797.68 T bond can be sold for $79768. b. $1,000 - $797.68 = $202.32 loss 278 c. First, we find the price of the 4-year bond, which now has 2 years remaining to maturity: 2 $1,000 $70 P = = $964.82 t + (1.09) 2 t = 1 (1.09) Then we can determine the expected capital loss on the shorter-term bond as follows: $1,000 - $964.82 = $35.18 The capital loss on the shorter-term bond is much less than that suffered on the longer-term instrument. d. 16-10A.a. Interest rate risk. The after-tax yield to Ward Grocers on the BBB-rated bond is (0.08) x (10.46) = .0432 = 4.32%. Since the yield on the tax-exempt issue is already stated on an after-tax basis, we can conclude the 5% return on the municipal is preferable. r = r = b. r* (1 - T) 0.055 0.055 = = (1 - 0.46) 0.54 10.185% 16-11A.a. where a = amount of the discount b = the discount period c = the net period a 360 x 1- a c-b b. c. d. e. f. 0.01 1 - 0.01 0.02 1 - 0.02 0.01 1 - 0.01 0.04 1 - 0.04 0.05 1 - 0.05 0.05 1 - 0.05 x x 360 = 24.24% 20 - 5 360 = 10.50% 90 - 20 360 x = 4.55% 100 - 20 360 x = 37.50% 50 - 10 360 x = 23.68% 100 - 20 x 360 = 94.74% 50 - 30 279 16-12A.Applicant #1 Z = 3.3(0.3) + 1.0(0.4) + 0.6(1.2) + 1.4(0.3) + 1.2(0.5) Z = 0.99 + 0.4 + 0.72 + 0.42 + 0.6 Z = 3.13 > 2.7 thus, accept Applicant #2 Z = 3.3(0.2) + 1.0(0.6) + 0.6(1.3) + 1.4(0.4) + 1.2(0.3) Z = 0.66 + 0.6 + 0.78 + 0.56 + 0.36 Z = 2.96 > 2.7 thus, accept Applicant #3 Z = 3.3(0.2) + 1.0(0.7) + 0.6(0.6) + 1.4(0.3) + 1.2(0.2) Z = 0.66 + 0.7 + 0.36 + 0.42 + 0.24 Z = 2.38 < 2.7 thus, reject Applicant #4 Z = 3.3(0.1) + 1.0(0.5) + 0.6(0.8) + 1.4(0.5) + 1.2(0.4) Z = 0.33 + 0.5 + 0.48 + 0.7 + 0.48 Z = 2.49 < 2.7 thus, reject Applicant #5 Z = 3.3(0.5) + 1.0(0.7) + 0.6(0.5) + 1.4(0.4) + 1.2(0.6) Z = 1.65 + 0.7 + 0.30 + 0.56 + 0.72 Z = 3.93 > 2.7 thus, accept Applicant #6 Z = 3.3(0.2) + 1.0(0.4) + 0.6(0.2) + 1.4(0.4) + 1.2(0.4) Z = 0.66 + 0.4 + 0.12 + 0.56 + 0.48 Z = 2.22 < 2.7 thus, reject 16-13A.a. Sales - cost of goods sold Sales $550,000 - Cost of goods sold $550,000 Cost of goods sold = Gross Profit Margin = 0.10 = $495,000 = Inventory turnover ratio = 5 = $99,000 Cost of goods sold Average inventory $495,000 Average inventory Average inventory 280 b. Inventory turnover ratio Inventory turnover Inventory turnover ratio Cost of goods sold Average inventory $480,000 Average inventory Average inventory Cost of goods sold Average inventory $1,250,000 Average inventory Average inventory = = 360 Average Collection Period 360 35 = 10.285 times = 10.285 times = 10.285 times = $46,669.90 = Inventory turnover ratio = 6 = $208,333 = $21,250,000 cost of goods sold c. d. (1 - Gross profit margin) (Sales) (0.85)($25,000,000) Inventory turnover ratio = $21,250,000 Average inventory Average inventory 360 50 = 7.2 times = 7.2 times = $ 2,951,389 16-14A.a. Q* = = 2 SO C 2(3500)9 0.2 = = 562 units 281 b. Total costs Order one time: S Q = C + O Q 2 = 3500 3500 $.20 + $9 2 3500 = $350 + $9 = $359 Order four times: = 875 3500 $.20 + $9 2 875 = $87.50 + $36 = $123.50 Order five times; = 700 3500 $9 $.20 + 2 700 = $70.00 + $45.00 = $115 Order ten times: = 350 3500 $0.20 + $9 2 350 = $35.00 + $90 = $125 Order 15 times: = 234 3500 $9 $0.20 + 2 234 = $23.40 + $134.62 = $158.02 c. (1) (2) (3) (4) (5) (6) constant or uniform demand constant unit price constant carrying costs constant ordering costs instantaneous delivery independent orders 282 16-15A.a. EOQ = 2SO C = 2(300,000)100 1.2 = 7,071 units or 7,100 units b. c. 300,000 7,100 = 42.25 orders per year Inventory order point = Delivery time stock + safety stock = 1 x 300,000 + 4,000 50 = 6,000 + 4,000 = 10,000 units d. Average inventory = = EOQ + Safety stock 2 7,100 + 4000 2 = 7,550 units e. EOQ = 2(600,000)100 1.2 = 10,000 units Elasticity of %EOQ EOQ with respect to a = %Sales double in sales = EOQ Sales EOQ Sales = = 10,000 - 7,100 600,000 - 300,000 / 7,100 300,000 .4085 = .4085 or 40.85% 1.0 283 f. EOQ = 2(250,000)100 2.4 = 5,000 Elasticity of EOQ with respect to a double in carrying costs = %EOQ %Carrying Costs 5,000 - 7,100 7,100 = = -29.58% 2.4 - 1.2 1.2 g. EOQ = 2(300,000)200 1.2 = 10,000 Elasticity of EOQ with respect to a double in ordering costs = %EOQ %Ordering Costs 10,000 - 7,100 7,100 = = 40.85% 200 - 100 100 h. The selling price of the item does not enter the EOQ equation and does not affect the level of EOQ (although the carrying cost does, and it is 10% of the sale price). The EOQ equation attempts to minimize costs, and, as such, the selling price does not enter into its calculation; thus, the elasticity of EOQ with respect to the selling price is 0. 284 ... View Full Document

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