Fundamentals of Managing Finance Chap 12

Organize the cash flows the company will pay 195000

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Unformatted text preview: ivables float that can be eliminated: Float now 5 days $1,000,000 $5,000,000 Float with new system 2 days $1,000,000 $2,000,000 Reduction in float $3,000,000 2. Organize the cash flows: The company will pay $195,000 each year after taxes to free up $3,000,000. Year 0 Investment—float eliminated Operating cash flow—fee Tax (35%) Net cash flows Years 1– $3,000,000 ($300,000) ($105,000 $3,000,000 ($195,000) 3. Calculate the value of the system using any of the three variations of the perpetuity model: a. NPV: PV of benefits $3,000,000 since all benefits come at year 0 PV of costs PMT/r $195,000/.12 $1,625,000 NPV $3,000,000 1,625,000 $1,375,000 b. IRR:8 IRR r PMT/PV $195,000/$3,000,000 6.50% c. NAB:9 Annual cost of float r PV .12 $3,000,000 $360,000 Annual cost of the proposed system $195,000 NAB $360,000 195,000 $165,000 Answer: The proposal has an NPV of $1,375,000, an IRR of 6.50%, and an NAB of $165,000. Since NPV and NAB exceed zero (and IRR is less than the cost of capital for this “opposite project”) the system should be implemented. Delaying disbursements is normally done by waiting until the last permissible date to make a payment. For example, if a company is given payment terms of “net 30 days” in which it is expected to pay 30 days from the invoice date, it will wait the full 30 days before it writes and mails its check. However, as with receivables, there are costs to maintaining an accounts payable system geared to 8 Elaboration and cross-reference: Notice that this is an “opposite project,“ in which a cash inflow is followed by cash outflows. In this case, the accept signal for the IRR measure is an IRR less than the cost of capital. Refer to Web Appendix 11C for further explanation. 9 Elaboration: Since this is an opposite project, the words describing the costs and benefits reverse from the example given on pages 291–292. There is a cash inflow projected for year 0, representing the money currently invested; when we multiply this by the cost of capital, we get the annual cost of having this money tied up (“annual cost of the float”). The year 1– flow represents the cost of freeing up the receivables float, hence the “annual cost of the proposed system.” The net annual benefit reflects the exchange: in each year paying the cost of the proposed system to avoid the cost of float. Chapter 12 Investing in Permanent Working Capital Assets 297 payment on the last day. Some companies are finding that these costs exceed their earnings from payables float, making it cost effective to pay suppliers as early as the date an order is placed. Permanent Accounts Receivable Accounts receivable represent money owed to the firm by its customers. Many large retailers (Walmart, Target, Macy’s, etc.), and companies that sell to other businesses extend credit themselves. They obtain data about each customer’s financial condition, determine whether the customer is creditworthy, establish the customer’s credit line—the maximum amount of credit the company is willing to extend, send the customer regular invoices, and then monitor the customer’s performance in paying when due. Some large companies do the same but through a wholly owned finance subsidiary: examples are Sears through Sears Roebuck Acceptance Corporation, IBM through IBM Credit Corporation, and General Electric through GE Credit Corporation. Small retailers, on the other hand, tend to avoid accounts receivable. Rather, they sign on with one or more of the national credit card organizations (Discover, Master Card, Visa). Customers can make purchases without cash, but it is the card company that extends the credit. The merchant is paid quickly by the card company, which then collects from the customer. Should the customer take longer than one month to pay, it is the card company that collects the interest.10 Whether a company sells for cash or chooses to extend credit depends on the nature of the customer and the nature of the product. Many business customers will pay for their purchases only when presented with an invoice and then only with a check, both to avoid holding currency and to ensure an adequate paperwork trail. Selling to these firms requires extending credit. At the retail level, large and expensive products—automobiles, refrigerators, etc.—tend to be sold on credit. They are easy to identify, making good loan collateral. Also, many customers cannot afford them unless they can pay over an extended period of time. SERVING FINANCE’S CUSTOMERS Paying Suppliers Upon Placing an Order at Motorola In response to complaints from suppliers about slow payment of invoices, Motorola’s finance department studied the company’s accounts payable process. The analysis found that 1% of Motorola’s expenditures accounted for fully 50% of its vendor-related paperwork. In response, Motorola scrapped its existing purchasing system and signed long-term commitments with suppliers of low-cost, high-volume goods, such as toilet paper and penc...
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