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Unformatted text preview: 0 + [3/4($40)($70)2/.00021]1/3 C* = $2,387.90 The upper limit is: U* = 3 × C* – 2 × L U* = 3($2,387.90) – 2($1,500) U* = $4,163.71 523 When the balance in the cash account drops to $1,500, the firm sells: Sell = $2,387.90 – 1,500 Sell = $887.90 of marketable securities. The proceeds from the sale are used to replenish the account back to the optimal target level of C*. Conversely, when the upper limit is reached, the firm buys: Buy = $4,163.71 – 2,387.90 Buy = $1,775.81 of marketable securities. This expenditure lowers the cash level back down to the optimal level of $2,387.90. 8. As variance increases, the upper limit and the spread will increase, while the lower limit remains unchanged. The lower limit does not change because it is an exogenous variable set by management. As the variance increases, however, the amount of uncertainty increases. When this happens, the target cash balance, and therefore the upper limit and the spread, will need to be higher. If the variance drops to zero, then the lower limit, the target balance, and the upper limit will all be the same. The average daily interest rate is: Daily rate = 1.071/365 – 1 Daily rate = .000185 or .0185% per day The target cash balance using the Miller-Orr model is: C* = L + (3/4 × F × σ 2 / R]1/3 C* = $160,000 + [3/4($300)($890,000)/.000185]1/3 C* = $170,260.47 The upper limit is: U* = 3 × C* – 2 × L U* = 3($170,260.47) – 2($160,000) U* = $190,781.41 10. Using the BAT model and solving for R, we get: C* = [(2T × F)/R]1/2 $2,700 = [2($28,000)($10)/R]1/2 R = [2($28,000)($10)]/$2,7002 R = .0768 or 7.68% 9. 524 CHAPTER 28 CREDIT AND INVENTORY MANAGEMENT
Answers to Concepts Review and Critical Thinking Questions 1. a. b. c. d. e. A sight draft is a commercial draft that is payable immediately. A time draft is a commercial draft that does not require immediate payment. A bankers acceptance is when a bank guarantees the future payment of a commercial draft. A promissory note is an IOU that the customer signs. A trade acceptance is when the buyer accepts the commercial draft and promises to pay it in the future. 2. 3. Trade credit is usually granted on open account. The invoice is the credit instrument. Credit costs: cost of debt, probability of default, and the cash discount No-credit costs: lost sales The sum of these are the carrying costs. 1. 2. 3. 4. 5. Character: Capacity: Capital: Collateral: Conditions: determines if a customer is willing to pay his or her debts. determines if a customer is able to pay debts out of operating cash flow. determines the customer’s financial reserves in case problems occur with operating cash flow. assets that can be liquidated to pay off the loan in case of default. customer’s ability to weather an economic downturn and whether such a downturn is likely. 4. 5. 1. 2. 3. 4. 5. 6. 7. Perishability and collateral value Consumer demand Cost, profitability, and standardization Credit risk The size of the account Competition Customer type If the credit period exceeds a customer’s operating cycle, then the firm is financing the receivables and other aspects of the customer’s business that go beyond the purchase of the selling firm’s merchandise. 6. a. b. c. d. B: A: A: B: A is likely to sell for cash only, unless the product really works. If it does, then they might grant longer credit periods to entice buyers. Landlords have significantly greater collateral, and that collateral is not mobile. Since A’s customers turn over inventory less frequently, they have a longer inventory period, and thus, will most likely have a longer credit period as well. Since A’s merchandise is perishable and B’s is not, B will probably have a longer credit period. e. 7. A: Rugs are fairly standardized and they are transportable, while carpets are custom fit and are not particularly transportable. The three main categories of inventory are: raw material (initial inputs to the firm’s production process), work-in-progress (partially completed products), and finished goods (products ready for sale). From the firm’s perspective, the demand for finished goods is independent from the demand for the other types of inventory. The demand for raw material and work-in-progress is derived from, or dependent on, the firm’s needs for these inventory types in order to achieve the desired levels of finished goods. JIT systems reduce inventory amounts. Assuming no adverse effects on sales, inventory turnover will increase. Since assets will decrease, total asset turnover will also increase. Recalling the DuPont equation, an increase in total asset turnover, all else being equal, has a positive effect on ROE. Carrying costs should be equal to order costs. Since the carrying costs are low relative to the order costs, the firm should increase the inventory level. 8. 9. 10. Since the price of components can decline quickly, Dell does not have inventory which is purchased and then declines quickly in value before it is sold. If this happens, the inventory may...
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