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Module04Week2Tutorial

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Module04Week2Tutorial

    August 2003

    FIN2101 BUSINESS FINANCE II

    MODULE 4 WORKING CAPITAL MANAGEMENT

    (Week 2)

QUESTION 1

    Undercounter Wholesalers Ltd currently sells entirely on a cash basis. Undercounter's management is considering introducing credit sales with discounts to attract new customers. The company is considering two alternative options. The first is offering discount terms of 2.5/30, n/60. It is estimated this would increase sales by $500 000 and 30% of these would take advantage of the discount. The second option is discount terms of 10/30, n/60, a policy which would increase sales by $600 000 with 50% of these customers taking the discount. The variable cost of sales is 75% of sales. The company's required rate of return on all accounts receivable is 1% per month. Undercounter's existing customers will not seek the

    credit terms.

    Using the NPV approach, advise Undercounter as to which discount policy it should adopt.

QUESTION 2

    Starlight Industries Ltd has to date been a "cash only" company. Management is concerned, however, that sales are slipping and is contemplating a move to offer credit in an effort to boost sales. At the moment sales are $1 500 000 per annum and it is anticipated that sales will increase to $2 250 000 per annum if credit is offered. The firm's accountant has prepared the following schedule for the payment of accounts by all customers (new and existing):

     - 1 month from the time of sale - 35%

     - 2 months from the time of sale - 25%

     - 3 months from the time of sale - 35%

    The remaining 5% of sales will result in bad debts which will not be collected.

    The variable cost of sales is 75% of sales and these costs are paid at the same time that sales are made. Starlight's cost of capital is 1.25% per month.

    Using the NPV approach, advise management whether the company should proceed with the proposal to offer credit terms.

    August 2003

    QUESTION 3

    In order to increase sales from their present annual level of $240 000, the Heap Corporation is considering a more liberal credit policy. Currently the firm has an average collection period of thirty (30) days. However, it is believed that as the collection period is lengthened, sales will increase by the following amounts:

    Credit Increase in Increase in

    Policy Average Collection Sales

    Period

    A 15 days $10 000

    B 30 days $15 000

    C 45 days $17 000

    Note: Increases in sales are cumulative, not incremental, ie adopting policy B will increase sales by another $5 000 (from $10 000 to $15 000), while moving from policy B to policy C will increase sales by a further $2 000 (from $15 000 to $17 000)

The firm has the following cost pattern at present:

     Price of the only product manufactured $1.00

     Variable costs per unit $0.60

Required:

    (a) If the firm requires a pre-tax return on investment of 20%, which credit policy should

    be pursued? Assume a 360-day year.

    (b) The firm's current bad debt loss is 1% of sales. The company has estimated that the

    following pattern of bad debts will prevail if it initiates more liberal credit terms:

    Increase in ACP Bad Debts

    15 days 3%

    30 days 6%

    45 days 10%

     Given the other assumptions made, which credit policy should be pursued?

    August 2003

    QUESTION 4

    Each month, Jumbo Pty Ltd sells 10 000 units at $25 per unit. The marginal cost of producing each unit is $15. At present all of Jumbo’s sales are made on a strict ‘cash only’ basis.

    Jumbo’s manager believes that the ‘cash only’ policy has led to many sales being lost as there have been a number of inquiries concerning the possibility of credit sales. Jumbo’s manager

    estimates that a credit policy of 1/30, n/60 could increase sales by 1 000 units per month, of which 500 would be paid for at the end of month 1 and 400 would be paid for at the end of month 2. Of the remaining 100 units, 70 are expected to be paid for a month late and 30 are expected to be bad debts. Administration and collection costs are estimated to be $250 (month 0), $100 (month 1), $100 (month 2) and $150 (month 3).

    However, it is expected that some existing customers will also seek credit in order to obtain the discount offered. This is likely to affect the sale of 600 units, with the buyers of the remaining 9 400 units expected to continue to pay cash. Administration costs are estimated to be $150 (month 0) and $60 (month 1).

Jumbo’s required rate of return is 1.5% per month.

Should Jumbo adopt the proposed credit arrangements?

    August 2003

    FIN2101 BUSINESS FINANCE II

    SOLUTIONS TO TUTORIAL QUESTIONS

    MODULE 4 WORKING CAPITAL MANAGEMENT

    (Week 2)

    August 2003

    QUESTION 1

(a)

     OPTION 1

    500 000 0.3 0.975500 000 0.7NPV = + - 375 000 21.011.01;;

     = 144 802 + 343 104 - 375 000

     = $112 906

     OPTION 2

    600 000 0.5 0.9600 000 0.5NPV = + - 450 000 21.011.01;;

     = 267 327 + 294 089 - 450 000

     = $111 416

     Conclusion: Adopt Option 1 (2.5/30, n/60) as it has the higher NPV.

    August 2003

    QUESTION 2

1. The NPV of the existing ‘cash only’ policy is:

     = $1 500 000 - $1 125 000

     = $375 000

    2. NPV of the proposed credit policy is:

    n

    ;;NPV = CF PVIF - IItk,tt=1

    ;;;;;;0.35 2 250 0000.25 2 2 50 0000.35 2 250 000 231.0125;;;;1.01251.1025

    ;;- 0.75 2 250 000

    787 500562 500787 500 = + + - 1 687 500231.0125;;;;1.01251.0125

     = 777 778 + 548 697 + 758 692 - 1 687 500

     = $397 667

3. The NPV of the credit policy > the NPV of the ‘cash only” policy, therefore proceed

    with the proposed change.

ALTERNATIVE SOLUTION

    t NCF PVIF Present Sales Costs

    @ 1.25% Value

    0 -1 500 000* -562 500** -2 062 500 1 -2 062 500

    1 787 500 787 500 0.987654 777 778

    2 562 500 562 500 0.975461 548 697

    3 787 500 787 500 0.963418 758 692

     NPV = $22 667#

    * Current cash sales now foregone. ** 75% of additional sales. # $22 667 is equal to $397 667 - $375 000.

    August 2003

    QUESTION 3

    (a)

     To A A to B B to C

    1. Marginal profit from additional sales 4 000 2 000 800

    (New sales x profit margin) (10 000 × 0.4) (5 000 × 0.4) (2 000 × 0.4)

    2. Beginning level of receivables 20 000 31 250 42 500

    (Sales/(360/A.C.P.)) (240 000/(360/30)) (250 000/(360/45)) (255 000/(360/60))

    3. New average level of receivables 31 250 42 500 53 542

    (New sales/(360/New A.C.P.)) (250 000/(360/45)) (255 000/(360/60)) (257 000/(360/75))

    4. Additional receivables 11 250 11 250 11 042

    (3. - 2.) (31 250 - 20 000) (42 500 - 31 250) (53 542 - 42 500)

    5. Additional investment in receivables 6 750 6 750 6 625

    (4. x variable cost %) (11 250 × 0.6) (11 250 × 0.6) (11 042 × 0.6)

    6. Required return on additional investment 1 350 1 350 1 325

    (5. x required rate of return) (6 750 × 0.2) (6 750 × 0.2) (6 625 × 0.2)

    7. Net position +2 650 +650 -525

    (1. - 6.) (4 000 - 1 350) (2 000 - 1 350) (800 - 1 325)

    Conclusion: It is worthwhile extending the average collection period by 30 days to 60 days (Plan B) but not beyond that point.

    August 2003

    QUESTION 3 (Continued)

(b) It is possible to use the incremental approach in answering this part of the question.

    However, given that Options A and B are the only policies that are viable, we can

    restrict ourselves to these policies.

     To A A to B

    1. Previous net position (see Part (a)) 2 650 650

    2. Current bad debt loss 2 400 7 500

    (Bad debts % x sales) (0.01 × 240 000) (0.03 × 250 000)

    3. New bad debt loss 7 500 15 300

    (New bad debts % x new sales) (0.03 × 250 000) (0.06 × 255 000)

    4. Increase in bad debts 5 100 7 800

    (3. - 2.) (7 500 - 2 400) (15 300 - 7 500)

    5. Revised net position -2 450 -7 150

    (1. - 4.) (2 650 - 5 100) (650 - 7 800)

Conclusion: When bad debts are taken into consideration, the firm should maintain its

    existing policy.

    August 2003 QUESTION 4

The incremental net cash flows are shown in the table below. Inflows are shown as a plus,

    outflows as a minus.

    End of Incremental Admin. & Switch from cash Admin. costs of Total

    month sales revenue collection costs to credit sales switched sales (S)

    and unit costs of incremental ($) ($)

    ($) sales

     ($)

    0 -15 000* -250 -15 000+ -150 -30 400

    1 12 375** -100 14 850++ -60 27 065

    2 10 000 -100 9 900

    3 1 750 -150 1 600

    * Cost of new sales ** 500 sold at $25 each less 1% discount = 1 000 × $15 = (0.99) (500 × $25)

    = $15 000 = $12 375

    + Lost cash sales ++ 600 sold at $25 each less 1% discount = 600 × $25 = (0.99) (600 × $25)

    = $15 000 = $14 850

Therefore:

    $27 065$9 900$1 600NPV - $30 400231.0151.0151.015;;

     $26 665.02 $9 609.55 $1 530.11 - $30 400

     $7 404.68

Jumbo Ltd should adopt the proposed credit arrangements as the NPV of the proposal is

    positive.

    August 2003

    QUESTION 4 (Continued)

Alternative Approach

    ;;;;NPV of cash policy $25 10 000 - $15 10 000

     $250 000 - $150 000

     $100 000

    ;;;;$25 0.99 600$25 0.99 500;;NPV of credit policy $25 9 400 1.0151.015

    $25 400$25 70 - $150 000 - $15 000 - $25023;;;;1.0151.015

    $100$100$150$60- - - - $150 - 23;;1.0151.015;;;; 1.0151.015

     $235 000 $14 631 $12 192 $9 707 $1 674 - $150 000

    - $15 000 - $250 - $99 - $97 - $143 - $150 - $59

     $107 406

NPV of the credit policy > NPV of the cash policy (by $7 406), therefore adopt the proposed

    credit arrangements.

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