Fundamentals of Managing Finance Chap 12

Solution steps 1 calculate the incremental cash flows

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Unformatted text preview: e additional accounts will cost $100,000 per year. 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 extend credit to these customers? Solution steps: 1. Calculate the incremental cash flows: a. Incremental investment: 300 Part IV Adding Value (1) From the concept of the collection period ratio,11 (90 days/360 days) 1/4 of the new sales will be outstanding as receivables at any time: 1/4 $20,000,000 $5,000,000 Of this, 70% represents the company’s cost, the amount the company invested to create the receivables: 70% $5,000,000 $3,500,000 (2) Existing customers are not changing their payment habits. (3) There is no change anticipated to other working capital. b. Incremental operating cash flows: (1) Contribution margin (1 70%) 30%, so contribution from new sales: 30% $20,000,000 $6,000,000 (2) New bad debt losses: 5% $20,000,000 $1,000,000 (3) No discounts are being offered to these customers. (4) Incremental administrative costs are given as $100,000 c. Income taxes will increase (an outflow) by: 35% ($6,000,000 1,000,000 100,000) $1,715,000 2. Organize the cash flows into a cash flow spreadsheet: Year 0 Investment Accounts receivable Operating cash flows Contribution from sales Bad debts Administrative costs Taxes on changed income Net cash flows Years 1– ($3,500,000) $6,000,000 ( 1,000,000) ( 100,000) ( 1,715,000) ($3,500,000) $3,185,000 3. Calculate the value of the proposal using any of the three variations of the perpetuity model: a. NPV: PV of costs $3,500,000 since all costs come at year 0 PV of benefits PMT/r $3,185,000/.12 $26,541,667 NPV $26,541,667 3,500,000 $23,041,667 b. IRR: IRR r PMT/PV $3,185,000/$3,500,000 91.00% c. NAB: Required annual benefit r PV .12 $3,500,000 $420,000 Actual annual benefit $3,185,000 NAB $3,185,000 420,000 $2,765,000 11 Cross-reference: Financial ratios are presented in Chapter 2 and summarized at the end of the book. The collection period ratio appears on page 39. Chapter 12 Investing in Permanent Working Capital Assets 301 Answer: The proposal has a NPV of $23,041,667, an IRR of 91.00%, and a NAB of $2,765,000. Since NPV and NAB exceed zero and IRR is greater than the cost of capital, credit should be extended to these new customers. In fact, the return is so attractive that Marie should consider analyzing the value of extending credit to potential customers scoring even lower on her company’s credit qualification scale. 2. Payment Date The invoice sent to a customer identifies when payment is due with terms such as net 30 (payment due in 30 days) or net 45 (payment due in 45 days). Permitting payment at a later date increases a company’s investment in accounts receivable and slows its collection of profits but might encourage customers to increase their purchases. Shortening the time for payment, on the other hand, reduces the investment in receivables and accelerates profit collection but may reduce sales. Example Payment Date Marie Kaye’s company has a product line with sales of $7,800,000. She is curious about the impact of changing payment terms from net 60 to net 30 as customers are not paying their bills until the seventy-fifth day on average. Marie has prepared the following forecasts: a. Customers will pay more quickly, reducing the collection period to 40 days (assume a 360-day year for convenience) b. Her company will be able to reduce its idle cash balance by $25,000, freeing that money for other use c. Some customers will take their business elsewhere and $600,000 of sales will be lost. 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 payment date be changed? Solution steps: 1. Calculate the incremental cash flows: a. Incremental investment: (1) From the collection period ratio, the accounts receivable balance is currently (75 days/360 days) $7,800,000 $1,625,000 If the change is implemented, the accounts receivable balance will decline to (40 days/360 days) $7,200,000 $800,000 a change of $1,625,000 800,000 $825,000 Of this, 70% represents the company’s cost, the amount the company invested to create the receivables: 70% $825,000 $577,500 302 Part IV Adding Value (2) The customers who do not leave will speed up their payments. Daily profit flow from these customers is 30% ($7,200,000/360) $6,000 and if collected (75 40 ) 35 days earlier, adds value of: $6,000 35 days $210,000 (3) Other working capital: idle cash will decline by $25,000 b. Incremental operating cash flows: (1) Contribution lost from departing sales: 30% $600,000 $180,000 (2) Bad debts are not forecast to change. (3) No discounts are being offered to these customers. (4) Administrative costs are not forecast to change. c. Income taxes will decrease (an inflow) by: 35% $180,000 $63,000 2. Organize the cash flows into a cash flow spreadsheet: Year 0 Investment Accounts receivable Changed collection period Other working capital Operating...
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