Fundamentals of Managing Finance Chap 12

Npv pv of benefits 812500 since all at year 0 pv of

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Unformatted text preview: cash flows Contribution from sales Taxes on changed income Net cash flows Years 1— $577,500 210,000 25,000 ($180,000) 63,000 $812,500 ($117,000) 3. Calculate the value of the proposal using any of the three variations of the perpetuity model: a. NPV: PV of benefits $812,500 since all at year 0 PV of costs PMT/r $117,000/.12 $975,000 NPV $812,500 975,000 ($162,500) b. IRR: IRR r PMT/PV $117,000/$812,500 14.40% c. NAB: Annual cost of the existing investment r PV .12 $812,500 $97,500 Annual cost of the proposed investment $117,000 NAB $97,500 117,000 ($19,500) Answer: The proposal has a NPV of ($162,500), an IRR of 14.40%, and an NAB of ($19,500). Since NPV and NAB are less than zero (and IRR is greater than the cost of capital for this “opposite project”), payment terms should not be shortened. Chapter 12 Investing in Permanent Working Capital Assets 303 "I'm sorry that we can't extend credit, but our collection terms are net 30 and Zorgon 12 is three light years from here." © 2005 by Eric Werner. All rights reserved. 3. Price Changes Discounts are often offered to business customers for early payment, such as in the terms 2/10, net 30, which gives the customer a choice: take a 2% discount (pay 98%) within ten days, or pay 100% by the thirtieth day. Granting discounts reduces a company’s investment in accounts receivable and speeds up its collection of profits at the cost of the discount foregone. Eliminating existing discounts increases the investment in receivables and slows profit collection but does not give away profit dollars. A second form of price change occurs when interest is added to an overdue account balance. This is identical to transforming the receivables balance into a loan. Example Discounts Marie Kaye’s company has another product line with sales of $9,000,000 on terms of net 60. Customers pay on time, so the average collection period is 60 days. Marie is interested in the effect of offering a 2% discount by changing payment terms to 2/10, net 60. She has prepared the following forecasts: a. Eighty percent of the customers will take the discount and pay on the tenth day (assume a 360 day year for convenience) b. The other 20% of customers will continue to pay on the sixtieth day. Marie’s company has variable costs equal to 70% of sales, is in the 35% marginal income tax bracket, and has a 12% cost of capital. Question: Should the company offer the discount? Solution steps: 1. Calculate the incremental cash flows: a. Incremental investment: 304 Part IV Adding Value (1) From the collection period ratio, the accounts receivable balance is currently (60 days/360 days) $9,000,000 $1,500,000 If the change is implemented, the collection period will become (80% 10 days) (20% 60 days) 20 days and the accounts receivable balance will decline to (20 days/360 days) $9,000,000 $500,000 a change of $1,500,000 500,000 $1,000,000 Of this, 70% represents the company’s cost, the amount the company invested to create the receivables: 70% $1,000,000 $700,000 (2) On average, customers will speed up their payments. Daily profit flow is 30% ($9,000,000/360) $7,500 and if collected (60 20 ) 40 days earlier, adds value of: $7,500 40 days $300,000 (3) There is no change anticipated to other working capital. b. Incremental operating cash flows: (1) Sales is not forecasted to change. (2) Bad debts are not forecasted to change. (3) Customers taking the discount purchase 80% $9,000,000 $7,200,000 If they take a 2% discount they will reduce their payments by 2% $7,200,000 $144,000 (4) Administrative costs are not forecasted to change. c. Income taxes will decrease (an inflow) by: 35% $144,000 $50,400 2. Organize the cash flows into a cash flow spreadsheet: Year 0 Investment Accounts receivable Changed collection period Operating cash flows Discounts Taxes on changed income Net cash flows Years 1– $1,700,000 $1,300,000 ($144,000) 50,400 $1,000,000 ($ 93,600) 3. Calculate the value of the proposal using any of the three variations of the perpetuity model: Chapter 12 Investing in Permanent Working Capital Assets 305 a. NPV: PV of benefits $1,000,000 since all come at year 0 PV of costs PMT/r $93,600/.12 $780,000 NPV $1,000,000 780,000 $220,000 b. IRR: IRR r PMT/PV $93,600/$1,000,000 9.36% c. NAB: Annual cost of the existing investment r PV .12 $1,000,000 $120,000 Annual cost of the proposed investment $93,600 NAB $120,000 93,600 $26,400 Answer: The proposal has a NPV of $220,000, an IRR of 9.36%, and a NAB of $26,400. Since NPV and NAB exceed zero (and IRR is less than the cost of capital for this “opposite project”), the discount should be offered. “H ey, how about a break for lunch,” one member of the team asked, looking toward Marie Kaye. Marie glanced at her watch; it was almost 1:00PM! After what had seemed like an eternity waiting for the day to begin, the morning had flown by. Marie had invited members of her staff to brainstorm the company’s accounts receivable problems, and there was no shortage of volunteers. Everyo...
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