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Chapter 06: Wo rking Capital and the Financing Decision

Chapter 6
Working Capital and the Financing D ecisio n
Discussion Questi ons
6-l. Explain how rapidly expanding sales can dxain the cash resources of a firm.
6-2.
6-3.
6-4.
Rapidly expanding sales will require a buildup in assets to suppon the growth.
ln paniculat, mme aod moJ:e of the inc.rease io cun-eot assets will be permanent
in nature . A oon- liquidatiJ,g aggregate s tock o f cutTent assets will be necessary
to allow fo floo clisplays , multiple ilems for selection, and othe purposes. All
of these "asset" investments can drain the cas h esources of the fi m.
Di scuss the relative volatility of shot- and long-te= imerest rates.
Figme 6- LO s hows the long-run view of s hort- and long-tenn interest rates.
Nonnally, shon-term rates are much more volatile than long- term rates .
What is the signi ficance lo working capital management of matching sal es and
production?
JJ sales and production can be matche d, the le ve l of iove nto.ty and the amount
o f cunent assets needed can be kept to a minimum; the.tefo1e, lower financing
cos ts will be incurred. Matching sales and pmduction has the advantage of
maintaining smaller amounts of current a ssets than level production, and
theefore less financing costs are incurred. Howeve1, if sales are seasonal or
cyclical , workers will be laid off in a declining sales climate and machiJJery
(fixed assets) will be idle. Here lies the tradeo(T bet ween level and seas onal
production: FuU utilization of fixed assets with s killed workers and more
of c urrent assets versus unused capacityt training and retraining
"vorkers, with lo"ver financing for c unent assets.
How is a cash bttdget used to he lp manage cun:ent :%e ts?
A cash budge t he lps minimize cun:ent assets by providi ng a forecast of int1ows
and outflows of cas h. 1t also encourages the d evelopment of a schedule as to
when inventory is produced and maintailled for s ales (production schedule), and
accounts receivables are collected. The cas h budget allows us to forecast the
level of each ctuTent asset and the timing of the buildup and reduction of each.
6- 1
Chap1e.r 06; Working and the F'im;mcing Occis.i on
6-5.
6-6.
6 -7 .
6 -8 .
"The most ap prop riate financing pattern would be one in which asset buildup
and length of financing terms is perfectly matched." Discuss the difficulty
involved in achiev ing this financing pau e rn .
O n l.y a financial manage r with unu s ual ins ig ht and timing coul d design a p lan .in
which asset b u ildup and the length of financing terms pe1:fecUy matched.
One wou ld need to know exactl y wha t cu.rent assets are temporary and which
ones ate permanent. Furt hetmore, one is never quite sue how much o short-
tenn or long-term financing is avai labl e at a ll times . Even if this were known., it
would be difficult to c hange the financing mix on a contin u a l bas is.
By using long-term financing to finance part of temporary c urrent assts, a firrn
may have less risk b ut lower returns than a firm w ith a normal financing plan.
Explain the signit:lc<mce of thi s statement.
By establishi ng a l.ong- term financing anaogement for temporary current assets.
a firm is assure d of having necessary fu nd ing in good time s as we ll as bad, thus
we s ay there is low d s k. However, long-tetm financing is generall y more
expensive than short-term financing and profits may be lowe than t hos e which
could be achieved with a synchronized o normal financing anangement for
temporary cunetll asse ts.
A f irm tha t uses s hort- term financi ng methods for a portion of permanent
c ur rent assets is assu ming more risk bu t expects higher retun1s th:m a firm with
a normal llnancing p lan. Explain.
By financi ng a portion of pe rmane nt current asse ts on a s hon-term bas is, we
run the r.isk of inadequate fi nan cing in tight mone y pe dods. Howevet, s ince
shon-term floanci n.g is less e xpensive lban long- te mJ funds, a f iJ"m tends to
inctease its pofit ability over the l.ong ntn (assu ming it s u rvives) . 1n answer to
the pt-eceding questi on, we s ue ssed less l'isk a nd less return; here the emphasis
is on ris k and high return.
W hat does the term st ruc ture of interest rates indicate?
T he term s tructure of interest rates shows the relat ive level of s hort -term lmd
long-term interest rates at a poi nt in tjme ou U.S. treasury secu ri t ies. Jt is o ften
referred to as a y ield c u rve.
6-2
Chap1e.r 06; Working and the F'im;mcing Occis.i on
6-9.
6- 10.
What ::u-e three theories for describing the s hape of the term s tructure of i nterest
rate-s (the yield c urve)? Brie.fly descr.ibe each theory.
Liquidity premium theor y, the mar ket segrnentation theory, and the
expectations theoly.
T he liqui d ity premium theory indicates that long-te tm rates should be higher
than short-term rates. This premium or long-term rates over short -term rates
exists because short-term secwi ties have greater li quidity, and therefore higher
rates have to be olTered to potential long-term bond bu yer to entice them to
hold these less li quid and more price sensitive secu riti es.
T he nuucket segmentation theory st ates that Treasury securities are divided into
rna.rket segments by the various financia l instiruti ons investing in the market.
The c hanging needs. desires. and strategies of these investors tend to s tnmgly
i.nnuence t he natu1e and rel ationship of s hon- a.nd lo ng- ter m r ates.
T he expect ations hypothesis maintains that the yields on long-term secu rities
a fu nction of short -tetm rates. T he result of the hypothesis is that when
long- term rates are much higher than short-term rates, the market is saying tha t
is expects s ho rt-term rates to r ise. Conversely, when loug-term rates are lower
than short- term rates, the market is expecti ng short- term rates to fall.
Since the mid-l960s, corporate liquidit y has been de-clining. What reasons can
you gi ve for this trend?
T he decrease is liquidity can be uaced in pan t.o m.o1e efficient inventory
management such as just- in- time inventory and point of sates terrnina.ls that
provide benet invemory conttol. The decl ine in working capital can a l.so be
attdbutecl to electronic cash tlow transfer systems, and the ability to sell
accounts receivables thto ug h securitizat ion of assets (this is more fu ll y
explained in the next chapter). 1L n1.ight also be that management is simply
willing to ta ke more liqui d it y risk as inlet-est rates decl ined.
6-3
Chapter 06: Working Capital and the Fir'Ulncing Decision
Chapter 6
Problems
1. Expect ed value (L0 6) Austin Electronics expects sales next year to be $900,000 if the
economy is strong, $650,000 if the economy is steady, and $375,000 if the economy is
weak. The firm believes there is a l5 percent probability the economy will be stwog, a 60
percent probability of a s teady economy, and a 25 percent probability of a weak economy.
What .is the expected level. of sales fox next year?
6 -1. Solution:
Austin E lectronics
State of
Economy Sales Probability
Stron o-
""
$900,000 .15
Stead y 650,000 .60
W eak 375,000 .25
Exp ected level of sales =
Expected
Outcome
$ 135,000
390 ,000
93,750
$618,750
2. Expected value (L06) Sh:upe Knife Company expects sales next yem to be $1,500,000 if
the economy is strong, $800,000 if the economy is s teady, <Uld $500,000 if the economy is
weak. Mr. Shmpe believes there is a 20 percent probabi lity the economy wi.ll be strong, a
50 ptacent ptobabHity of a s teady economy. and a 30 percent probabi lity of a weak
economy. What is the expected level of sales for the next year'?
6-2. Solution:
6-4
Chapter 06: Wo rking Capital and the Fi r'Ulncing D eci si on
Sharpe Knife Company
State of Expected
Economy Sales Probability Outcome
Strong $ 1,500,000 .20 $300,000
Steady 800,000 .50 400,000
Weak 500,000 .30 150,000
Expected leve l of sales = $850,000
3 . Ext.ernal financing (LOt ) Axle S upply Co., expects sales next year to b e $300,000.
Inventory and accounts receivabl e wi ll increase by $60 ,000 to accommodate this sales
level. The company has a s teady profi t margin of 10 perceni with a 30 percent dividend
payou t. How muc h externaJ financing will the firm have lo seek? Assume there is no
increase in liabiUties other than tha t wh.ich w ill occu r with the extemal financi11g.
6-3. Solution:
$300,000
.10
30,000
9 ,000
$ 2 1,000
$ 60,000
21 ,000
$ 39,000
Axle Supply Co.
6 -5
S ales
Profit margin
Net income
Divide nds ( 30%)
Inc rease in re tained earnings
Inc rease in assets
Increase in re tai ned e arnings
Exte rnal funds needed
Chapter 06: Worki ng Ca.pitaJ and the F i nancing Decision
4. External financing (LOJ) Antivirus, Inc ., expects its sales next year to be $2,000,000.
Inventory and accounts receivabl e wi ll $430,000 to accommodate Lhis s ales level.
The company has a s teady profit of 12 percent wilh a 25 percent clividend payou t.
How much external financing will the firm have to seek? Assume there is no increase in
liabilit ies other than that which will occur with the external financing.
6-4. Solution:
$2,000,000
.12
240,000
60000
$ ] 80,000
$ 4 30 ,000
180,000
$250 ,000
Antivirus, Inc.
Sales
Profit Margin
Net income
Dividends (25%)
Inc rease in re tained earnings
Inc rease in assets
Inc rease in re tai ned earnings
External funds needed
5. Level ver s us sea s onal produc tion (LOl ) Antonio Banderos & Scarves make s headweaJ
that is very popular in the fall- winte r season. Units sold are anticipat ed as:
6-5.
October... .... .... ... . ..... . .... . . . ....... ........ ..... ..... 1,000
November. ....... . . ............. . ..... . . ........ . .... . .... 2,000
Decen1ber . . .... . .. .. .. . . .. . . . ...... .. .. .. ...... .. ... . .... . 4 ,000
Ja_nt,uy ..... .... .. .. .. ............ .. ...... ....... .. .. .. ... .. 3.000
10,000 uni ts
1f production is used, it is assu med that invemory will directl y match s a le s for
each month and there will be no invemory buildup.
However, Antonio decides to go with level production to avoid being o ut of merchandis e.
He will produce the 10,000 items over four months ai a level of 2,500 per month.
a. What is the ending inventory a t the end of each n1onth? Compare the u nits s ales to the
ptoduced and keep a runnjng total.
b. JJ the inve nto ty cos ts $5 per unit and wi II be finance d at the bank at a cos1 of J 2
pe rce nt, what is the monthly f inancing cos t and Lhe total for the four months ? (Use 1
percem or the monthl y rate).
Solution:
6-6
Chapter 06: Working Ca.pitaJ and Lhe F i nancing Decision
a.
Octobe r
November
D ecember
J a nuary
b.
O ctober
Nove mber
D ecember
J a nuary
Antonio Banderos and Scarves
Units Units Change in Ending
Sold Produced inventory Inventory
1,000
2,000
4,000
3,00 0
Ending
Inventory
1,500
2,000
500
0
2 ,500 + 1,500
2,500 + 500
2,500 - 1,500
2,500 - 500
Total Cost
Per Unit
($5 per unit)
7,500
10 ,000
2,500
0
T otal Financing Cost =
1,500
2 ,000
5 00
0
Inventory
Financing Cost
at (1% per
month)
75
10 0
25
0
$200
6. Level vers us se>l Sonal production (LOI) Bambino Sporting Goods makes baseball gloves
that ver.y popular in the spr.iog :md ear.ly suromer season. Units sold a.re an(jcipated as
follows:
March...... . ...... .. .. .......... . .. .. ....................... 3,000
April . .. .. .... .. ...... .. ..... ..... . .... .... .. .. .... .. ... .. .... 7 ,000
May .......................................................... 11,000
Ju11e ........................................... 9.000
30,000
If seas onal production is used, it is assu med that inventory will directl y match s ales fo
each month aod thete will be no invent<)J'Y bui ldup.
T he production thinks t he above assumption is too optimistic and decides to go
wi th level production to avoid being o u t of merchandise. He will produce the 3 0 ,000 uni ts
over 4 months at a level of 7 , 500 per month.
6-7
Chapter 06: Working Capital and the Financing Decision
a. What is the ending inventory at the end of each month ? Compare the u nit sales to the
units produced and keep a ru nni ng total.
b. If the inventory costs $20 per u nit and will be financed at the b<mk at a cost of 6
pelcent , what is the monthly financing cost and the total for t he four m.onths? (Use .5%
as the moothly late.)
6-6. Solution:
Bambino Sporting Goods
a. Units Units Change in Ending
Sold Produced Inventory Inventory
March
April
May
J u ne
3,000
7,000
11,000
9,000
6-6. (Continued)
b.
Ending
Inventory
March
Ap ril
May
June
4,500
5 000 ,
1,500
0
7,500 +4,500
7,500 + 5 00
7,50 0 -3,500
7 ,500 - ] ,500
Total Cost
($20 per unit)
90,000
100,000
30,000
0
T o tal F i na nci ng C ost =
6- 8
4,500
5,000
1,500
0
Inventory
Financing Cost
at (.5 % per
month)
$ 450
500
150
0
$1, 100
Chapter 06: Wo rking Capital and the Financing Decision
7. S hort-term versus longer-term borrowing ( L03) Boatler Used Cadillac Co. requires
$800,000 in financing over the next two years . The finn can borrow the funds for t wo years
at 9 percent interest per year. Mr. Boatler d ecides to do forecasting ~ l d predicts that if he
ut iUzes short-term financing ins tead, he will pay 6.75 percent interest in the fi rst year and
10.55 percent inte rest in the second year. Detem1ine the LOtal two-year interest cost under
each plan. Which plan is less costly?
6-7. Solution:
Boatler Used Cadillac Co.
Cost of T wo Year Fixed Cost Financing
$800,000 borrowed@ 9% per annum x 2 years= $144 ,000 interest cost
Cos t of T wo Year V ariable Short- term Financing
l st year $800,000 x 6.75% per annum = $54,000 interest cost
2'"
1
year $800,000 x 10.55% per annun"l = $84,400 interes t cost
138,400 to tal interes t cost
The short-term plan is less costly.
8. S hort-term versus lo n ger -term bonowing (L03) Biochemical Corp. requires $500,000
in financing over the next three yems. The finn can borrow the funds for three years at
10.60 percent inte rest per year. The CEO d ecides to do a forecast a nd predicts that i f she
utilizes short-term financing instead, she will pay 7 .25 percent interest .in the first yettr,
I 1..90 percent inte test in lhe second Y'-'ar, and 8.15 percent interest in the third year.
Determ.ine the total interest cosi u nder each plan. Which plan is less costly?
6-8. Solution:
Biochemical Corp.
Cos t of Three Year Fixed Cost Financing
$500,000 borrowed x 10.60% per annum x 3 years= $159,000
6-9
Chap1e.r 06; Working and the F'im;mcing Occis.i on
l st year
2nd year
3rc
1
year
Cost of Thtee Year Variable Short-term Financing
$500,00 0 x 7.25% Per annum = $ 36,250 Interest cost
$500,000 x 11.90% Per annum 59,500 Interest cost
$500,000 x 8.15% Per a nnum 40,750 Interest cost
$136,500 3 -year total
The s hort-term plan is less costly.
9. S hort-term versus longer -term bonowing (L03) Stern Educational TV, Inc. , has
decided to buy a new computer system w:ith an expected Jjfe of three years at a cos t of
$200,000. The comp<UJY can borrow $200,000 for three yems at I 2 percent annual interes t
or for one yem at I 0 percent annual interest.
6-9.
a. Row much would tht: fi.r.m s ave in interes t over the three- year l.ife of the comptner
system if the ooc- yeru loan is utilized , and the loan is rolled ov er (rebon:owed) each
year a.t !he same 10 percent rate? Compate th.is to the 12 petcent thtee- ycar Joan.
b. What if interestates on the 10 pecent loan go u p to 15 percem in the s econd year and
I 8 percent io the third year? What would be the total interes t cost comprued to the I 2
percent, t hree-yeru loan?
Solution:
Stern Educational TV, Inc.
a. If Rates Are Constant
$200,000 borrowed x 12% per annum x 3 years=
$72,000 interest cost (long- term)
$200,000 borrowed x 10% per annum x 3 years=
$60,000 interest cost (short-term)
$72,000 - $60,000 = $12,000 interest savings borrowing
short-tern"l
6-10
Chap1e.r 06; Working and the F'i m;mcing Occi s.i on
b. If Short-term Rates Change
lst year
2d year
3rd year
$200,000 X .10 -
$200,000 X . 15
$200,000 X . 1.8
Total
$20,000
$30,000
$36,000
$86,000
$86,000 - $72,000 = $14,000 extra interest costs
borrowing short-term one yea r at a tin1.e.
10. Optimal policy mix (LOS) Assume that Hogan Surgicallnstruments Co. has $2,000,000
in assets. Tf it goes with a low- Liquidity pl.an fo. the assets, il can earn a return of 18
percent, but with a h.ig h liquidity plan, the return will be 14 percent. JJ tbe firm goes with a
sbon-te.rm fina nci ng plan, the financing costs on the $2,000,000 wi ll be 10 percent, and
with a lo ng-term financing pl an, the financing costs on the $2,000,000 will be J 2 percent.
(Review Table 6-J I for parts 1, b, and c of this problem.)
a. Compute the anti cipated re rum after financing costs with the most aggressive asset -
financing nux.
b. Compute the anticipated return after financing costs witb the most conservative asset -
financing mjx.
c. Compute the anticipated return after financing costs with the two Jnoderate approaches
10 the asset- 1.1naocing mix.
d. Would you necessari l.y accept the plan with the hjghest rem.rn aftet tioaocing costs?
Bl'iefly expla in.
6-10. Solution:
Hogan Surgical Instruments Company
a. l\1ost aggressive
Low liquidity
Short-term financing
Anticipated r eturn
6- 1 I
$2,000,000 X 18% =
2,000,000 X J. 0 % =
$360,000
- 200,000
$ 160,000
Chapter 06: Working Capi tal and the Fi r'Ulncing Deci si on
6-10.
b. Most conservative
High liquidity $2,000,000 X 14% = $280,000
Long-term financing 2,000,000 X 12% = - 240,000
Anticipated return $ 40,000
c. Moderate approach
Low liquidity $2,000,000 X 18% = $360,000
Long-term finan c ing 2,000,000 X 12% = - 240,000
$ 120 ,000
OR
Hig h liquidity $2,000,000 X 14% = $280,000
S h ort- term financino-
0
2,000 ,000 X 10% = - 200,000
$ 80,000
(Continu ed)
d. You m ay no t n ecessari ly select the plan with the highest
r e turn. You mus t also con sider the risk i nher e nt i n the plan.
Of course, some firms are better able to take risks than
others. The ultimate conce rn must be for n-:taxiiuiz ing the
overall valuatio n of the firm through a judiciou s
cons ideration of r is k-return options.
I J . Optimal p olicy mix (LOS) Assume t hat Atl as Spoting Goods, Inc. , has $800,000 in
assets. If it goes with a low- liquidity plan for the assets, it can eam a return of 15 percent ,
but wi th a high-ljquiruty p lan the return will be 12 percent. l f the firm goes with a short-
term financing plru1, t he financing costs on the $800,000 will be 8 percem, and wit h a l.ong-
term fimUlcing p lan, the financing costs on the $800,000 will be 10 percent. (Review
Table 6-1 1 for pmts a. b, and c of this problem.)
a. Compute the anticipated return after financing costs with the most aggressive asset-
financing nJix.
b. Compute the anticipated return aftet financing costs with the most asset-
financing mix.
c. Compme the anticipated return afte financing cosrs with the two moderate approaches
to the asset-f inancing mix.
6- t2
Chapter 06: Working Capital and the Fir'Ulncing D ecision
d. JJ' the t:i.rm used the most aggressive asset-f inancing nux described i n part a and had t he
anticipated return you computed for part a, wha t woul d earnings per s hare be if the tax
r ate on the anticipated return was 30 percent and there were 20,000 s hares o mstandiog?
e . Now assume lhe most conservative asset-financing mix described in part b wi ll be
u ti li zed. The tax rate will be 30 percent. Also assu me there will only be 5 ,000 s hares
outs tandi ng. What wi ll earnings per sh are be? Wou ld it be hig her or lower than the
erunings per s hare computed for the most aggressive p hm computed in prut d?
6-11. Solution:
Atlas Sporting Goods, Inc.
a . Most aggtessive
Low liquidity
Sho rt-term financ ing
Anticipated r e turn
b. Most conservative
High liquid ity
Long -term financ ing
Anticip a ted r e turn
6-1.1. (Continued)
c. Moderate approach
L o w liquidity
Long-term financing
Anticipated re n:trn
Hig h liquidity
Sho rt-te rm financ ing
Anticipated r eturn
OR
6- 13
$800,000 X 15 %
800,000 X 8% -
$800,000 X 12%
800,000 X 10 %
$800,000 X 15%
800,000 X 10% -
$ 800,000 X 12 %
800,000 X 8% -
$120,000
-64 ,000
$ 56,000
$ 96,000
- 80,000
$ 16 ,000
$120,000
-80,000
$ 40,000
$ 96,000
-64 ,000
$ 32,000
Chapter 06: Working Ca.pitaJ and Lhe F inancing Decision
d. Anticipated return
- taxes (30 %)
Earnino-s after taxes
b
Shar es
Earnings per s hare
e. Antici pated return
- taxes (30%)
E arni ngs after taxes
Shar es
Earnings per s hare
It is higher ($2.24 vs . $1.96)
$56,000
16,800
39,200
20 ,000
$1.96
$ 16,000
4 800
11,20 0
5,000
$2.24
12. Mal.ching a sset mix and financing plans (L03) Wi nfre y Diet Food Corp. has $4,500,000
in assets.
Temponuy current assets .. .. .. .... .. .. .......... .
Permanent cur:rent assets .... ...... .. .. ... .. .... .. .
Fixed assets .. ......... .. ... .. ........ ...... ............. .
Total assets .. ............. .. .. .. .. .. .... .. .. .. .... ..
$1,000,000
I ,500,000
2. 000' 000
$4,500,000
Short-term rates are 8 percent. Long-term rates are 13 percent. Earnings before illlerest and
taxes me $960,000. The tax rate is 40 percent.
JJ long- term financing is ped'ectly matched (s ynchroni zed) with Loog- te rm asset needs,
and the s ame is tue of short- term l'inancing, what wil l earnings after taxes be? For an
exampl e of pcd'ecdy matched plans, sec Figure 6-5 on page 168.
6-12. Solution:
6-14
Chapter 06: Working Ca.pitaJ and Lhe F inancing Decision
Winfrey Diet Food Corporation
Long-term financing equals :
P ermanent curre nt assets
Fixed assets
Short- term financing equals :
T emporary current assets
Long- te rm inter est expense= 13 % x $3,500,000 =
Shor t-te rm interest expense = 8 % x 1,000,000
Total inter est expense
Earnings before interest and taxes
Less Interest expe nse
E arnings be fore taxes
T axes (40%)
Earnings after taxes
$1,500,000
2.000.000
$3,500,000
$.1. ,000,000
$ 4 55,000
80,000
$ 535,000
$ 960,000
535,000
$ 425,000
170,000
$ 255,000
13. Impact of term structur e of interest rates on tina n cing plans ( L04) l n Problem J 2,
assu me the term s tr u c ture of in terest mtes becomes inverted, with short-term rates going to
J 2 percent and long-term rates 4 percentage points lower tha n short-term rates.
(fall o ther factors in t.he problem remain u nch anged, what wi ll erunings after taxes be?
6-13. Solution:
6-15
Chapter 06: Working Capital and the Financing Decision
Winfrey Diet Food Corporation (Continued)
Long-term interest expe nse = 8% x $3,500,000 =
Short-term interest expe nse = 12% x 1,000,000 =
Total interest expe nse
Earni ngs before interest and taxes
Interest expense
Earnings before taxes
T axes (40%)
Eatnings after taxes
$280,000
120 ,000
$400,000
$960,000
400,000
$560,000
224 ,000
$336,000
14. Cons ervative ver s u s aggressi ve fi nancing (LOS) Col)jns S ystems, Inc., is trying io
develop an p lan. The firm has $300,000 in tempo1a.ry ctttTent assets and
$200.000 in per manenl current assets. Collins also has $400,000 .in fixed assets.
a. Construct two alternative fi nancing p lans fo1 the f inn. One of the pl ans s hould be
conservative, with 80 percent of assets f inanced b y long-te r m sources and the rest
financed by s hort-term sou rces. T he o ther plan should be aggressive, with only 30
percent of assets financed by lo ng -term sou rces and the remaini ng assets financed by
s hort-term sou rces. T he ctuTent in terest rate is .15 percent o n long -term funds and I 0
percent on sho n -tetm financing. Compu te the annual interest payments under each
plan.
b. Given that Coll ins' s earnings before interest and taxes are $ 180,000, calc ulate earni ngs
after taxes for each of you r altematives. Assum.e a tax rate of 40 percent.
6-14. Solution:
Collins System Inc.
a. Te mporary c urre nt assets
Pe rmanent current assets
Fixe d assets
Total assets
Conservative
% of
Total Amount
$900,000 X .80 = $720,000
6 - 16
Interest
Rate
x.l5 =
lnle test
Expense
$300,000
200,000
400,000
$900,000
$ 108,000 Long-term
Chapter 06: Working Capital and the Financing Dec ision
$900,000 x .20=$180,000 x . 10 = 18,000 Short- te rm
Total interest charge $126,000
Aggressive
% of Interest
An10unt
$900,000
$900,000
Total Rate
X .30 = $270,000 X .15
X .70 = $630,000 X .10 =
6-14. (Continu ed)
b.
EBIT
- Int
EBT
Tax 40%
EAT
Total interest charge
Conservative
$180,000
126,000
54,000
21,600
$ 32,400
Interest
Expense
$ 40 ,500 Lo ng- term
63,000 Short- term
$103,500
Aggressive
$180,000
103,500
76,500
30,600
$45,900
15. Alternative financing plans (LOS) Lem, i nc. , has $800,000 in c urrent assets, $350,000 of
wh.ich are permanem cu<ent assets. In add.irion, the fi.rru has $600.000 invested
in fixed assets .
a. Lear wishes to finance all f ixe(! assets and half of its pennanent cun:ent assets with
long-term financing costing 10 percent. The balance will be financed wit h short-term
financing, which currently costs 5 percent. Lear's earnings before inte.rest and taxes are
$200, 000. De termine Lear's earnings after taxes under this financing plan. The tax rate
is 30 percent.
b. As an a lternati ve, Lear mjght wish to finance a ll fixed assets and permanent ctu't'ellt
assets plus half of its temporary c urrent assets with long-term financing and the balance
with short-term financing. The same interest rates apply as in pan a. Earnings before
interest and taxes will be $200,000. What will be Lear's earnings after taxes'? The tax
rate is 30 percent.
c. What arc som.e of the r..isks a nd cost considerations associated with each of t hese
a lternative financing strategies?
6- 17
Chap1e.r 06; Working and the F'im;mcing Occis.i on
6 - 15. Solution:
Lear, Inc.
a.
Current assets- permanent current assets= temporary current assets
$800,000 $350,000 $450,000
Long-term interest expense= 10% [$600,000 + Y2 ($350,000)]
= 10% ($775,000)
= $77,500
Short- term interest expense = 5% [$450,000 + "\h($350,000)]
= 5 % X ($625,000)
Total interest expense
= $31,250
= $77,500 + $31,250
= $108,750
Earnings bef ore interest and taxes
Inter est expense
$200,000
108,750
$ 91.,250
27,375
$ 63,875
Earnings before taxes
T axes (30%)
Earnings after taxes
6-15. (Continued)
b. Alternative financing plan
Long-term interes t expense = 10% [$ 600,000 + $350,000
+ Y2 ($450,000))
= 10% ($1,175,000)
= $ 117,500
Short- term inter est expense= 5% [Y2 ($450 ,000)]
= 5 % (225,000)
6- 18
Chap1e.r 06; Working and the F'im;mcing Occis.i on
Total interest expense
= $11,250
=$117,500 + $11,250
=$128,750
Earnin gs before interest and taxes
Interest
$200,000
128,750
$ 71 ,250
21,375
$ 49,875
Earnings before taxes
Taxes (30%)
Earnings after taxes
c. The altern ative financing plan which calls for more fin ancing
b y hig h-cost debt is more expen sive and redu ces aftertax
income by $14,000. H owever , we mu st not automati cally
rej ect this plan b ecause of its hig her cost sin ce it h as l ess risk.
The altern ative provides the firm with long-term capital
which a t times will be in excess of its needs and invested i n
marketable securities. It will not be forced to p ay higher
s h ort-term r ates o n a large portion of i ts d ebt w he n s h ort-
term rates rise and will no t be faced with Lhe possibilily of no
shon -term financing for a portion of its per man ent curre nt
assets when it is ti me to renew the sh ort-term loan.
16. Exp ectations h y pothesis and interesl rate s (L04) Using the expectations hypothesis
theory for the term struc ture o f interest rates, deterrnine the expected retw:n for securities
with maturities of two, three, and four years based on the foUowiog data. Do ao a nalysis
s imiJar to that in the right-hand portion of Table 6-6.
!-year T-bill at beginning of year 1 . ...... 5%
1-yeat T-bill at beginning of year 2 .. . .. . . 6 %
1-yeat T-bill at beginning of year 3 .. . .. . . 8 %
! - year T-bill at beginning of year 4 . .. . .. lO%
6-16. Solution:
6-19
Chapter 06: Working Capi tal and the Fi r'Ulncing Deci si on
2 year security
3 year security
4 year security
(5% + 6 %)/2 -
(5% + 6% + 8%)/ 3
(5% + 6 % + 8 % + 10%)/4
5.5%
6 .33%
7.25%
17 . Expect.ations h y pothesis and interes t rates (L04) Using the expectalions hypot hesis
theory for the term structure of interest rates , determine the expected return for securities
wi th maturiti.es of two, three, fou r years based on the foll owing data. Do an
s imila to that in the right-hand porlion of Table 6-6.
6-17. Solution:
!-year T-bill at begilming of year l. .... . 3%
1-year T -bill at begilming of year 2...... 6%
1- year T- bill at beginning of year 3 . .. . .. 5%
I. - year T -bHI at beginning of year 4 . ..... 8%
2 year security
3 year security
4 year security
(3% + 6%)/2
(3% + 6% + 5%)/3
(3% + 6% + 5% + 8%)/4
4.50%
4 .67%
5 .50%
18 . Interes t costs unde r alternative plans (L03) Carmen's Beauty Salon has estimated
monthl.y financing requiJements for the next six months as foll.ows:
January .... .. .......... .
February .. .. .......... .
.. .... ............ .
$8,000
2,000
3,000
April ................ ..
May .. ... ............ ..
June ........ .. .. .. .... .
$8,000
9,000
4,000
Short-term financing will be u ti li zed for the next six months. Projected interest
rates are:
Januru:y ................ .
February ........ ...... .
Mcuch ............... .. . .
8.0%
9.0%
12.0%
Apri I ... .............. .
May .......... .. .. .. .. .
Jtane .. ................ .
15.0%
1.2.0%
12.0%
a. Compme to ta l dolla interest payments for the s ix mont hs. To convert an annual ra1.e
to a momhl y :ate, divide by J 2. Then multiply this value times the monthly balance. To
get your ru1swer s u m u p the monthly interest pay1nents.
6-20
Chapter 06: Working Capital and the Fir'Ulncing Decision
b. If long-term flmUJcing at 12 percent had been utilized throughout the six months, would
the total-dollar jnterest payments be larger or smaller? Con1pute the interest owed over
the sjx months and compare your answer to that in pm't a.
6 -18. Solution:
Carmen's Beauty Salon
a. Short-terrr1 fin a ncing
On Monthly
Month Rate Basis A mount
J anuary 8% .67% $8,000
February 9% .75% $2,000
M ar ch 12% 1.00% $3,000
April 12% I .2 5 % $8,000
May 12% 1.00% $9,000
June 12% 1.00% $4,000
6 - 18. (Continued)
b. Long- term fin anc ing
On Monthly
Month Rate Basis Amount
Januar y 12% 1% $8,000
February 12% 1% $2,000
March 12% 1% $3,000
April 15% 1% $8,000
6 -21
Actual
Interest
$ 53.60
$ 15.00
$ 30.00
$100.00
$ 90.00
$ 40.00
$328.60
Actua l
Interest
$ 80.00
$ 20.00
$ 30.00
$ 80.00
Chapter 06: Working Ca.pitaJ and Lhe F i nancing Decision
May 12% 1% $9,000 $ 90.00
June 12% 1% $4,000 $ 4 0 .00
$ 3 40.00
T o tal do llar i nterest payments would be lar ger under the
lo ng -term financi ng pla n as described i n part b.
19. Break-even point in interes t rates (L03) In Problem 18, what long-term in terest rate
would rep1esent a b reak- even point between using s hort-term financing as described in part
a and long-term nnancing? Hint: Di v.ide t he interest payments in J 8a by the amount of total
funds provided for the six months and multip ly by 12.
6-19. Solution:
Carmen' s Beauty Salon (Continued)
Divid e the to ta l i nterest payme nts i n part (a) of $328.60 b y the
total amount of funds extended $34,000 ($ 8,000 + 2,000 + 3,000
+ 8,000 + 9 ,0 00 + 4,000) and multipl y by 12 .
interest $328.60
96607
hl
----- = = . "/o 1nont y r ate
principal $34, 000
12 x .966 % = 1 1.59% annual r.ate
20. Cas h r eceipts sch edu le (LOl) Eastern Auto Parts, Inc. has 20 pe rcent of its sales paid for
in cash aod 80 perce nt oo credit. All cnxlit accounts are collected in the following month.
Ass ume the following sales :
.T anua.y $60,000
Febntruy 50,000
March 95,000
April 40,000
Sales in December of the prio y ~ u were $70.000.
P epare a c ash receipts schedule for January through April.
6-22
Chapter 06: Working Ca.pitaJ and Lhe F inancing Decision
6-20. Solution:
Eastern Auto Parts
Sales
Jan
$60,000
1.2,000
56,000
$6 8,000
Feb
$50 ,000
10,000
4 8,000
$5 8,000
Mar
$95,000
19,000
40 ,000
$59,000
20 % Cash Sales
80% Prior month's sal es*
Total cash receipts
*
based on December sales of $70 ,000
21 . L evel production and r elated financing effect-;; (L03) Bombs Away Video Games
Corporation has forecasted the foll owing monthly s ales:
J anuary.............. $95,000 J uly ............. .
FebnHu-y . ... . .. .. .. . 88,000 August ........ .
Ma.rch ...... .. ...... .. 20,000 S eptember . ..
April .... ........... .. . 20,000 Octobe .r .... .. ..
May. .. .......... .. .... 15,000 Novembec .. .
J u ne .. ............ .. ... 30,000 December .. ..
Total annual sales = $696,000
$40,000
40,000
50,000
80,000
100,000
I l 8, 000
Bombs Away Video Games sells the popula Strafe and Capture video game. Its sells
for $5 per unit and costs $2 pe u nit to produce. A level production policy is followed.
Each m ~ n t h 's production is e qual to annual s ales (in uni ts) divided by 12.
Of each month's sales, 30 percent are for cash and 70 percent are on accou nt. All
accounts receivable are collected in the month after the sale is made.
a. Construct a monthly production and inventor y schedule .in u nits. Beginning inve ntory
in J anum-y is 20,000 units. (Note: To do part a, you should work in terms of units of
production and units o f sales.)
Apr
$40,000
8,000
76,000
$84,000
b. Prepare a monthly schedul e of cash receipts. Sal.es in the December before the pla.oni ng
yea are $100,000. Work part busing doll ars.
c . Determine a cash payments schedule for J anuary through December. T he production
costs of $2 per unit are paid for in t he month in wh.ich they occu r. Other cas h paymems,
besides those for production costs, are $ 40,000 per month.
6-23
Chapter 06: Working Capital and the Financing Dec ision
d. Prepare a month ly cash b udget for J anumy through December using the cash receipts
sche dule from pan b :md the cash payments schedule from part c. The beginning cash
balance is $5,000 , which is also the m.ini mum desired.
6-21. Solution:
J an.
F eb.
Mar.
Apr.
Ma y
June
July
Aug.
Sept .
Oct.
Nov.
Dec.
Bombs A way Video Games Corporation
a. Production and inventory schedule in umts
Beginning
Inventory + Produc tion
1
20,000 + ll ,600
1.2,600 + 1 J ,600
6,600 + 11,600
1.4,200 + 11,600
21.,800 + 11,600
30,400 + 11,600
36,000 + 11,600
39,600 + 11,600
43,200 + 11,600
44,800 + 11,600
40,400 + 11,600
32,000 + 11,600
1
Total annual sales = $696,000
2
Sales
19,000
17,600
4 ,000
4 ,000
3,000
6 ,000
8,000
8,000
10,000
] 6,000
20,000
23,600
$696,000/$5 per unit = 139,200 units
139,200 unitsll 2 months = 11,600 per month
2
Monthl y dollar s ales/ $5 price = unit s ales
6 - 24
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
-
Ending
Inventory
12,600
6,600
14,200
21.,800
30,400
36,000
39,600
43,200
44,800
40,400
32,000
20,000
Chaplcr 06: Working Capiral and tl1e Financing Decision
6-21. (Continued)
b.
Bombs Away Video Games Corporation
Cash Receipts Schedule
Jan. Feb. Mar. Apr.
Sales (in dollars) $95,000 $88,000 $20,000 $20,000
30% Cash sales 28,500 26,400 6,000 6,000
70% Prior month's sales 70,000* 66,500 61,600 14,000
Total cash receipts $98,500 $92,900 $67,600 $20,000
*based on December sales of $100,000
July Aug. Sept. Oct.
Sales (in dolJars) $40,000 $40,000 $50,000 $80,000
30% Cash sales 12,000 12,000 15,000 24,000
70% Prior month's sales 2LOOO 28,000 28,000 35,000
Total cash receipts $33,000 $40,000 $43,000 $59,000
625
May June
$15,000 $30,000
4,500 9,000
14,000 10.500
$18,500 $19,500
Nov. Dec.
$100,000 $118,000
30,000 35,400
56,000 70,000
$ 86,000 $105,400
Ch.1pter 06: Working Capital aod the Financing Decision
6-21. (Continued)
c.
11,600 units x $2
Other cash payments
Total cash payments
11,600 units x $2
Other cash payments
Total cash payments
Bombs Away Video Games Corporation
Cash Payments Schedule
Constant production
Jan. Feb. Mar. Apr.
$23,200 $23,200 $23,200 $23,200
40,000 40,000 40,000 40,000
$63,200 $63,200 $63,200 $63,200
July Aug. Sept. Oct.
$23,200 $23,200 $23,200 $23,200
40,000 40,000 40,000 40,000
I
$63,200 $63,200 $63,200 $63,200
6-26
May June
$23,200 $23,200
40,000 40.000
$63,200 $63,200
Nov. Dec.
$23,200 $23,200
40,000 40,000
$63,200 $63,200
Ch. 1pter 06: Working Capital aod the Financing Decision
6-21. (Continued)
d.
Net cash flow
Beginning cash
Cumulative cash balance
Monthly loan or (repayment)
Cumulative loan
Ending cash balance
Net cash flow
Beginning cash
Cumulative cash balance
Monthly loan or (repayment)
Cumulative loan
Ending cash balance
Bombs Away Video Games Corporation
Cash Budget
Jan. Feb. Mar. Apr.
$35,300 $29,700 $ 4,400 ($43,200)
5,000 40,300 70,000 74,400
40,300 70,000 74,400 31,200
-0- -0- -0- -0-
-0- -0- -0- -0-
40,300 70,000 74,400 31,200
July Aug. Sept. Oct.
($30,200) ($23,200) ($20,200) ($4,200)
5,000 5,000 5,000 5,000
(25,200) (18,200) (15,200) 800
30,200 23,200 20,200 4,200
92,400 115,600 135,800 140,000
5,000 5,000 5,000 5,000
6-27
May June
($44,700) ($43,700)
31,200 5,000
(13,500) (38,700)
18,500 43,700
18,500 62,200
5,000 5,000
Nov. Dec.
$22,800 $42,200
5,000 5,000
27,800 47,200
(22,800) (42,200)
117,200 75,000
5,000 5,000
Chapter 06: Working Capital and the Fir'Ulncing D ecision
22. Level produc tion and r elated fina n ci ng effect s (L03) Esquire P roduc ts . Jnc. , e xpects the
foll owing monthly sales:
January . . . .. .. . ... . . . $24,0 00 May .. .. . . .. . . .. . $4,000 Septembel .. .. .... . $25,000
Febr ua ry .. . ......... 15 , 000 June ............. 2,000 Octo ber. ............. 30,000
March .. .. .. ... ... .. .. 8 ,000 Jul y . ... . ... .. .. . . J 8 ,000 November .. . .. .. .. . 38, 00 0
April .. .. .... .. .. .. .. .. 10,000 August .... .. .. . 22,000 Decembe .... .. .. .. 20,000
To ta l sales = $216.000
Cash sales are 40 percent in a gi ven month, with t he remainder going into accou nts
receivable. A II receivables me collected in the month following the sale. Esqui re sells all of
its goods for $2 each and prodtlces them for $J each. Esquire uses level produc tion, and
a verage mont hly production is equal to annual product ion d ivided by l 2.
a . Generate a mo nthly p roduct ion and i n ventor y schedule .in units . Beginni ng .inventory in
J anuary is 8,000 u nits. (Note: T o do pat ct, you should work in terms of units of
pi'Oduc t ion and units of sales.)
b. De termine a cash receipts schedule for J anuary t hrough December. Asstune that dollar
sales in the pr.ior December were $20,0 00 . Work pan b us ing doll ars.
c. De tennine a cash payntents schedule for J a nuary throug h December. T he production
costs ($1 per u nit produced) are paid for in the month in which they occur. Other cash
payments (besides those for pr oduction costs) are $7,000 per n01on.th.
d. Construct a cash budget for January thwugb December. usi ng the cash leceipts schedule
from part b and the cash payments schedule fom part c. T he beginning cash bal ance is
$3,000, which is also the minimu m desired.
e. De termine t o t ~ cunent assets for each month. I nclude cash, accounts receivable, and
inventory. Accou n ts receivable equal sales minus 40 percent of sales for a g iven month.
Inventory is equal to ending invelllory (pmt a) times the cost of $ 1 per unit.
6-28
Chapter 06 : Working Capital and the Fir'Ul ncing D ecision
6-22. Solutio n :
J an .
F eb.
Mar .
Apr.
May
June
July
Aug.
Sept.
Oc t.
Nov .
Dec .
Esquire Products, Inc.
a. Pro duction and inventory schedule i n un its
Beginning
Inve ntory
8,000
5,000
6,500
11,500
15,500
22 ,500
30,500
30 ,500
2 8,500
25,000
19,000
9,000
+
+
+
+
+
+
+
+
+
+
+
+
+
Produc tion
1
9,000 12,000
9,000 7,500
9,000 4,000
9,000 5 ,000
9,000 2 ,000
9,000 1,000
9,000 9,000
9,000 1 1,000
9,000 12 ,500
9,000 15,000
9,000 19,000
9,000 ] 0 ,000
1
$ 2 16,000 sales/$2 price = 108,000 uni ts
-
-
-
-
-
-
-
-
-
-
-
-
108,000 units/ 12 months= 9,000 units per month
2
Mon thly dollar sales/$2 = number of units
6-2 9
Ending
I nventory
5,000
6 ,500
11,500
15,500
22,500
30,500
30 ,500
2 8,500
25,000
19,000
9,000
8,000
Chapter 06: Working Capital and the Financing Decision
6-22. (Continued)
b.
Esquire Products, Inc.
Cash Receipts Schedule (take dollar values from problem statement)
Jan. Feb. Mar. Apr. May
Sales (in dollars) $24,000 $15,000 $ 8,000 $10,000 $4,000
40% Cash sales 9,600 6,000 3,200 4,000 1,600
60% Prior month's sales 12,000* 14,400 9,000 4,800 6,000
Total receipts $21,600 $20,400 $12,200 $ 8,800 $7,600
*based on December sales of $20,000
July Aug. Sept. Oct. Nov.
Sales (in dollars) $18,000 $22,000 $25,000 $30,000 $38,000
40% Cash sales 7,200 8,800 10,000 12,000 15,200
60% Prior month's sales 1.200 10,800 13,200 15,000 18,000
Total receipts $ 8,400 $19,600 $23,200 $27,000 $33,200
630
June
$2,000
800
2,400
$3,200
Dec.
$20,000
8,000
22,800
$30,800
Chapter 06: Working Capital and the Financing Decision
6-22. (Continued)
c.
Jan.
9,000 units x $1 $ 9,000
Other cash payments 7,000
Total payments $16,000
July
9,000 units x $1 $ 9,000
Other cash payments 7.000
Total cash payments $16,000
Esquire Products, Inc.
Cash Payments Schedule
Constant production
Feb. Mar.
$ 9,000 $ 9,000
7,000 7,000
$16,000 $16,000
Aug. Sept.
$ 9,000 $ 9,000
7,000 7,000
$16,000 $16,000
631
Apr. May June
$ 9,000 $ 9,000 $ 9,000
7,000 7,000 7,000
$16,000 $16,000 $16,000
Oct. Nov. Dec.
$ 9,000 $ 9,000 $ 9,000
7,000 7,000 7,000
$16,000 $16,000 $16,000
Chaplcr 06: Working Capiral and tl1e Financing Decision
6-22. (Continued)
d.
Esquire Products, Inc.
Cash Budget
Jan. Feb. Mar.
Cash flow $5,600 $ 4,400 ($3,800)
Beginning cash 3,000 8,600 13,000
Cumulative cash balance 8,600 13,000 9,200
Monthly loan or (repayment) I -0- -0- -0-
Cumulative loan
I
-0- -0- -0-
Ending cash balance $8,600 $13,000 $9,200
Julv

Aug . Sept.
Cash flow ($ 7,600) ($3,600) $ 7,200
Beginning cash 3,000 3,000 3,000
Cumulative cash balance (4,600) 6,600 10,200
Monthly loan or (repayment) 7,600 (3,600) (7,200)
Cumulative loan 29,800 26,200 19,000
Ending cash balance $3,000 $3,000 $3,000
6-32
Apr. May June
($ 7,200) ($ 8,400) ($12,800)
9,200 3,000 3,000
2,000 (5,400) (9,800)
1,000 8,400 12,800
1,000 9,400 22,200
$3,000 $3,000 $ 3,000
Oct. Nov. Dec.
$ 11,000 $17,200 $ 14,800
3,000 3,000 12,200
14,000 20,200 27,000
(11,000) (8,000) -0-
8,000 -0- -0-
$ 3,000 $12,200 $27,000
Chapter 06: Wo rking Capital and the Financing Dec ision
6-22. (Continued)
e.
Esquire Products, Inc.
Assets
Accounts Total
Cash Receivable Inventory Current
Jan. $ 8,600 $14,400 $5,000 $28,000
Feb. 13,000 9,000 6,500 28,500
Mar. 9,200 4,800 11,500 25,500
Apr. 3,000 6,000 15,500 24,500
May 3,000 2,400 22,500 27,900
June 3,000 1,200 30,500 34,700
July 3,000 10,800 30,500 44,300
Aug. 3,000 13,200 28,500 44,700
Sept. 3,000 15,000 25,000 43,000
Oct. 3,000 18,000 19,000 40,000
Nov. 12,200 22,800 9,000 44,000
Dec. 27,000 12,000 8,000 47,000
The instructor may wish to point out h ow cu rrent assets are at
relatively high levels and illiquid during June through
October. In November and p articularly December, the asset
levels remain hig h, but they become increasingly more liquid
as inventory clim.inis h es relative to cash.
6 33