SECTION F

OTHERS - ANSWERS

ANSWER 100
(a) The reasons for holding cash are as follows:
(i)

The transactions motive. Cash will be required for the day-to-day operations of the business, e.g. to
pay creditors, to buy stocks or to make dividend payments.

(ii)

The precautionary motive. Contingent losses may materialise, e.g. legal claims against the
company or the dishonour of a bill of exchange which the company has accepted. Cash will need
to be held to satisfy such contingencies as they arise.

The company must, therefore, maintain a sufficient level of cash to satisfy the above three requirements.
However, any cash in excess of this level will result in lower profits. It is true that surplus cash can be
invested in the short term to earn a return in the form of interest. In this respect cash is different from
other assets. However, such returns will nearly always be less than the return which can be earned on the
business's other 'assets. Thus, in general, cash is really the same as any other working capital asset and
should be subject to similar management and control. Surplus cash which can only be invested at low
short-term interest rates or, worse still, which is lying idle, is not being properly utilised and will result in
decreased profitability.
On the other hand, if the company is holding too little cash it may encounter liquidity problems. Such a
shortage of cash could mean that the company is forced to reject certain worthwhile investment
opportunities owing to a lack of funds, or that its very survival is threatened. It should be realised that
several profitable companies have been forced into liquidation purely as a consequence of cash flow
problems.
Proper cash budgeting and planning should ensure that a company does not fall into the tap of holding
too little or too much cash.
(b) ABC Credit Collection Co.
Annual collections

Rs 5,200,000

Weekly collections (average)

Rs 5,200,000
52
Rs 100,000

=
Average daily collections

Rs 100,000
5
Rs 20,000
9%

=
Annual overdraft rate

Daily overdraft rate

9%
365

F- 3

SECTION F

OTHERS - ANSWERS

Cost of not banking

= Sums not banked x days not banked x daily rate
Monday:

Rs 20,000 x 4 days x

Tuesday:

Rs 20,000 x 3 days x

Wednesday

Rs 20,000 x 2 days x

Thursday:

Rs 20,000 x 1 day

Friday:
Total cost of not banking daily

No change to banking pattern

Annual cost

= Rs 49.31 x 52
= Rs2,564

9%
365
9%
365
9%
365
9%
365

=19.73
=14.79
=9.86
=4.93
49.31

F- 4

SECTION F

OTHERS - ANSWERS

Assumptions
(i)

There are 52 weeks in a year, five working days each week, and collections are made on each of
these days.

(ii)

Takings are evenly spread daily and weekly.

(iii)

Bankings are used to reduce the overdraft and thus the overdraft rate is suitable for calculating the
annual cost of weekly banking. If the company were able to make use of the funds released in
other ways then a different rate may be appropriate. For example, if the company had available
investment opportunities then the cost of capital should be used.

It appears that a daily remitting system would save the company Rs 2,564 per annum. However, this must
be assessed in the light of the possible effects on agents. At present they may be earning interest prior to
remitting collections to head office and might resent the change in company policy. Also, what effect will
the new system have on the number of agent defaults?
ANSWER 101
(a) The cost of the three alternatives will be examined in turn:
(i)

Short-term loan

As the liquidity problem is expected to last for six months, the loan will be outstanding for a period of half
a year. The interest charge, therefore, will be
0.5 x 18% Rs 100,000 = Rs 9,000
The company will not be paying corporation tax. Hence, it cannot benefit from the tax deductibility of
such interest payments.
(ii)

Foregoing cash discounts

The company could raise the extra Rs 100,000 of funds needed at the end of February 19-10, by:
(a)

Delaying payment for the December 19-9 purchases from the end of January 19-10 to the end of
March 19-10. This will raise Rs 50,000 and will cost in lot discounts:
2% x Rs 50,000 = Rs 1,000

(b)

Delaying payment for the January 19-10 purchases from the end of February 19-10 to the end of
April 19-10. This will raise a further Rs 50,000 and will again cost Rs 1,000.

The company will not be able to repay the funds raised in this way until six months after the date of
receipt. Thus, the company will have to wait until the end of July 19-10 (i.e. six months after the end of
January 19-10) until it can effectively repay the first amount of Rs 50,000 and start to claim discounts on
current purchases. The second Rs 50,000 can then be repaid at the end of August 19-10.
The additional finance raised by this method is tabulated below:

F- 5

SECTION F

Month of
purchase
December
January
February
March
April
May
Additional
Finance

OTHERS - ANSWERS

January
Rs 000
50

50

February
Rs 000
50
50

100

March
Rs 000
(50)
50
50

101

Month of payment
April
May
June
Rs 000
Rs 000
Rs 000
(50)
50
50

100

(50)
50
50
100

(50)
50
50
100

July

August

Rs 000

Rs 000

(50)
50
50

(50)
-

F- 6

SECTION F

OTHERS - ANSWERS

Note
Figures in brackets indicate the end of the month at which a particular month's purchases are paid. Other
figures show the effective amount of the finance outstanding.
As can be seen from the above table, payments will be postponed for a total of six months' purchases, i.e.
December to May. The total of cash discounts lost is, therefore:
6 x 2% x Rs 50,000 = Rs 6,000
Tutorial notes
(1)

In the absence of the policy to forego cash discounts, the company would only be paying to its
creditors:

Rs 50,000 x 98% = Rs 49,000 per month

The true amount of finance raised by this policy is thus only 2% x Rs 49,000 = Rs 980. The difference is
assumed to be immaterial.
(2)

As the Rs 49,000 raised at the end of January 19-10 is not required until the end of February 1910, it may be possible to use this to reduce the company's overdraft and save interest of 1% x Rs
49,000 = Rs 490.

(iii) Factoring trade debtors

The additional funds raised at January 19-10 as a result of factoring trade debtors can be calculated as
follows:
Rs
Funds advanced (75% x Rs 150,000)
Less: Factoring fee (2% x Rs 150,000)
Interest
15
x Rs 112,500
12
Additional funds
The cost of raising these funds is:
Factoring fee
Interest
Less: Saving on bad debts and credit control
Cost per month before interest savings
The cost for six months is as follows:
Cost before interest savings (6 x Rs 2,406)
Less: Interest savings (see working)

Rs
112,500

3,000
1,406

4,406
108,094
Rs
3,000
1,406
4,406
2,000
2,406
Rs
14,436
785
13,651

F- 7

SECTION F

OTHERS - ANSWERS

Working:
Overdraft interest saved
Surplus funds received from factor
Interest saved per month
Interest saved for six months

= Rs (108,094 100,000)
= Rs 8,094
= 1% x Rs 8,094
= Rs 80.94
= 6 x Rs 80.94
= Rs 485

In addition the company will be saving Rs 2,000 every month for six months.
The overdraft interest saved at 1% per month will be:
Interest on Rs 2,000 for five months
Interest on Rs 2,000 for four months
Interest on Rs 2,000 for three months
Interest on Rs 2,000 for two months
Interest on Rs 2,000 for one months

Rs
100
80
60
40
20
300

F- 8

SECTION F

OTHERS - ANSWERS

Therefore, total interest savings = Rs (485 + 300) = Rs 785

Tutorial note
The Rs 108,094 received from the factor at the end of January 19-10 is not needed until the end of
February. It may be possible to use this amount to save additional overdraft interest of:
Rs (108,094 8,094) x 1% = Rs 1,000
Overdraft interest saved by the figure of Rs 8,094 for February 19-10 has been included in the working
above.
The cheapest of the three alternative sources of finance is that of foregoing discounts which costs
Rs 6,000. This compares with the cost of the short-term loan of Rs 9,000 and the cost of factoring of
Rs 13,651.
(b) Cash flow position assuming factoring arrangement

End of month
January
February
March
April
May
June
July
August
September

Cash from debtors

Rs
150,000(December)

Cash from factor

Rs
108,094 (January)
108,094 (February)
108,094 (March)
108,094 (April)
108,094 (May)
108,094 (June)

Balance of debts
Rs
37,500 (January)
37,500 (February)
37,500 (March)
37.500 (April)
37.500 (May)
37,500 (June)

Cash savings
Rs
2,000
2,000
2,000
2,000
2,000
2,000

150,000 (July)
150,000 (August)

F- 9

SECTION F

OTHERS - ANSWERS

Notes:
(1)

The balance of debts is 25% x Rs 150,000 = Rs 37,500

(2)

In the absence of information in the question, bad debts have been ignored.

(3)

The months in brackets refer to the month of sale.

(c) When deciding between these alternatives the company should take the following non-cost factors into
account:
(i) Will suppliers take exception to a delay in the payment of their invoices? For example, supply and
delivery of goods may be affected.
(ii) Can the number of staff be reduced as a result of the sales ledger being administered by the factor?

ANSWER 102
(a) Meaning of dual prices
A dual price is the increase in the value of the objective function of a linear programme made possible by
a unit relaxation in one of the constraints.
The objective function of the companys programme involves the maximization of the present value of
ordinary dividends. The dual prices for resource in scarce supply, therefore, indicate the increase in the
present value of ordinary dividends made possible by a unit increase in the resource at any given time.
For example, an extra pound of cash found in year 1 would enable the company's overall plan to be
improved so that the present value of ordinary dividends could be increased by Rs 2.10. An extra unit of
raw material AFC found in year 3 would enable the present value of dividends to be improved by
Rs 6.50.
The argument also applies to small decrease in the scarce resources. A decrease of one hour of skilled
labour in year 2 would cause a decrease of Rs 1.30 in the present value of dividend.
The dual prices are thus associated with the opportunity costs of the resources. If the dual price is zero,
the constraint cannot be binding in the optimal solution because no improvement in the overall plan can
be effected by a small relaxation in the constraint.
(b) Calculation of maximum price for new machine
A saving of Rs 30,000 per annum in each of years 2 to 5 and the consequent release of cash will result in
an increase in the PV of dividends of:
= 30,000 x Rs (1.65 + 1.3 + 1.05 + 0.9) = 30,000 x Rs 4.9 = Rs147,000
A saving of 15,000 skilled labour hours in years 2 to 5 will result in an increase in the PV of dividends of:
= 15,000 x Rs (1.30 + 0.00 + 1.10 + 0.00) C = 15,000 x Rs 2.4 = Rs 36,000
An increase in material used in years 2 to 5 of 1,000 units means that the PV of dividends will be
decreased by:
= 1,000 x Rs (8.4 +6.5 + 4.8 + 1.6) = 1,000 x Rs 21.3 = Rs 21,300
The purchase of the machine enables the optimum plan to be improved by a present value of:

F- 10

SECTION F

OTHERS - ANSWERS

Rs (147,000 + 36,000 - 21,300) = Rs 161,700

This is before taking into account the cost of the machine.
The maximum outlay of cash in year 1 for the machine would be the amount which decreased the present
value of dividends by Rs 161,700. Since each pound used will reduce the present value by Rs 2.10:

Maximum price payable for the new machine =

Rs 161,700

= Rs 77,000

2.10
(c) Usefulness and limitations of dual prices in the situation given
Dual prices are effectively opportunity costs, and are, therefore, useful in valuing scarce resources used
in the firm's projects. The practical use of opportunity costs is not immediately clear, however. If they
could be estimated in some simple way, the information could be used to obtain an approximate
indication
of
the
best
plan
by
evaluating
each
project,
costing resources at opportunity costs, but the opportunity costs cannot be known unless the optimal plan
is first calculated. Hence, the opportunity costs might seem redundant.
However, much rests on the effect on the optimal plan of small changes in the assumptions about the
resources, designed to evaluate the implications of uncertainty in those assumptions. For example; if
there is uncertainty as to how much cash will be available at any given time, the dual price can
immediately be used to predict the effect of changes in the cash estimate on the value of the firm. An
investigation of dual prices will show which resources are the most crucial. The firm would be well advised
to put a good deal of effort into increasing the supply of resources which have the higher dual prices.
The dual prices can also be used, as in the example given in this question, to evaluate the effect on the
overall plan of a small additional project which uses or produces saving in the scarce recourses.
The main limitation in the use of dual prices is that a given set of dual prices may hold valid only for small
changes from the optimal plan. Large changes in the quantity of resources used might mean that the
nature of the optimal plan is changed so that constraints which were previously not binding become
critical and vice versa. Also the dual price is assumed to indicate an approximate cost for additional units
of a resource. This may not apply in practice as, for example, further units of raw material AFC may be
simply unobtainable. Other limitation stem from the fact that dual prices are calculated from the basic
linear programming model which is itself subject to certain shortcomings:
(i)

linearity is assumed;

(ii)

there is only one objective function;

(iii)

the situation may not be static;

(iv)

the forecasts of the future do not provide any indication of the spread of likely outcome; and

(v)

attitudes to risk are ignored.

It is likely, given the restricted validity of dual prices that a firm will not wish to rely entirely on the
approach described for sensitivity analysis. It may wish to study the effect of variations in availability of
resources by making fresh calculations from scratch.

F- 11