Exercise 4 – Working Capital Management Cash

Assistant Professor Ron Reyes

Part 1. Answer the following problems.

1. The management of Rica Co. anticipates P12,500,000 in cash outlays during the coming year. The firm
has determined that it costs P75 to convert marketable securities to cash and vice versa. The marketable
securities portfolio currently earns an 12% annual rate return.

Required: (1) What is the optimal transaction size (OTS)? (2) Compute the total cost of the cash.

2. Palma Company uses a continuous billing system that results in average daily receipts of P750,000.
The company treasurer estimates that a proposed lock-box system could reduce its collection time by 3 days.

a. How much cash would the lock-box system free up for the company?

b. What is the maximum amount that Palma would be willing to pay for the lock-box system if it can earn 6
percent on available short-term funds?

c. If the lock-box system could be arranged at an annual cost of P45,000, what would be the net gain from
instituting the system?

3. American Products is concerned about managing cash efficiently. On the average, inventories have an
age of 90 days, and accounts receivable are collected in 60 days. Accounts payable are paid approximately
30 days after they arise. The firm spends P30 million on operating –cycle investments each year, at a
constant rate. Assume a 360-day year.

a. Calculate the firm’s operating cycle.

b. Calculate the firm’s cash conversion cycle.

c. Calculate the amount of resources needed to support the firm’s cash conversion cycle.

d. Discuss how management might be able to reduce the cash conversion cycle.

4. Jessa, Inc. currently has sales of P3.0 million. Its credit period and days sales outstanding (DSO) are both
30 days, and 1 percent of its sales end up as bad debts. The credit manager estimates that, if the firm
extends its credit period to 45 days so that its days sales outstanding increase in 45 days, sales will
increase
By P600, 000 but its bad debt losses on the incremental sales would be 2.5 percent. Variable costs are 60
percent, and the cost of carrying receivables, k, is 12.5 percent. Assume a tax rate of 40 percent and 360
days per year.

a. Compute the incremental investment required to finance the increase in receivables if the change is
effected.

b. What would be the incremental cost of carrying receivable

c. What would be the effect of those changes in net income?

5. Willbur co. last year reported sales of P10, 000, 000 and an inventory turnover ratio of 2. The company is
now adopting a just-in-time inventory system. If the new system is able to reduce the firm’s inventory level
and increase the firm’s inventory turnover to 5, while maintaining the same level of sales, how much cash
will be freed up?

6. Alexis Company uses 800 units of product per year on a continuous basis. The product has a fixed cost of
P50 per order, and its carrying cost is P2 per unit per year. It takes 5 days to received a shipment after an
order is placed, ad the firm wishes to hold 10 days’ usage in inventory as a safety.
a. Calculate the EOQ.
b. Determine the average level of inventory. (Note; Use a 360-day year to calculate daily usage.)
c. Determine the reorder point.

7. Dimaggio Sports Equipment, Inc., is considering a switch to level production. Cost efficiency will occur
ender level production and after tax costs would declined by P35, 000 but inventory costs would increase
by P400, 000. Dimaggio would have to finance the extra inventory at costs of 10.5 percent.

a. Should a company go ahead and switch the level production?

b. How low would interest rates need fall before level production would be feasible?

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 Exercise 4 – Working Capital Management Cash
Assistant Professor Ron Reyes

Part 2. Answer the following problems

1. Saludo Company project that cash outlays of P 36 million will occur uniformly through out the year. Saludo
plans to meet its cash requirements by periodically selling marketable securities from its portfolio. The
firm’s marketable securities are invested to earn 10 percent, and the cost per transaction of converting
securities to cash P25

a. What is the optimal transaction size of transfer from marketable securities to cash?

b. What will be Salado’s average cash balance?

c. Compute the annual cost of cash based on optimal transaction size.

2. The Rein Corporation is attempting to determine the optimal level of current assets for the coming year.
Management expects sales to increase to approximately P2 million as a result of an assets expansion
presently being undertaken. Fixed assets total P1 million, and the firm wishes to maintain a 60percent debt
ratio. Rein’s interest cost is currently 8 percent on both short-term and longer term debt (which the firm
uses in its permanent structure). Three alternatives regarding the projected current assets level are
available to the firm: (1) a tight policy requiring current assets of only 45 percent of projected sales; (2) A
moderate policy of 50 percent in sales in current assets, and (3) a relaxed policy requiring current assets of
60 percent of sales. The firm expects to generate earning before interest and taxes at an rate of 12 percent
on total sales.

What is the expected return on equity under each current asset level? Assume a 40
Percent tax rate.

3. Camp Manufacturing turns over its inventory 8 times each year, has average payment period of 35 days,
and has an average collection period of 60 days. The firm’s total annual outlays for operating-cycle
investment are 3.5 million. Assume a 360 day-year.

a. Calculate the firm’s operating and cash conversion cycles.

b. Calculate the firm’s daily cash operating expenditure. How much in resources must be invested to support
its cash conversion cycle?

c. If firm’s pays 14% for these resources, by how much would it increase its annual profits by favorably
changing its current cash conversion cycle by 20 days?

4. Wall Mart has sales of P5 million. Its credit period and average collection period are both 30 days, and
1.5% of its sales end as bad debts. The manager intends to extend the credit term to 45 days which will
increase sales to P5.75 million. However, bad debts losses on the incremental sales would be 3%. Cost of
products and related expenses amount at 60%, exclusive of the cost of carrying receivables of 12.5% and
bad debts expenses. Assuming 360 days a year, what incremental cost of investment is required to support
the change in policy.

5. Agri Insurance Co. has collection centers across the country to speed up collections. The company also
makes its disbursement from remote disbursement center so that checks written by Agri take longer to
clear the bank. Collection time has been reduced by two days and disbursement time increased by one day
because of these policies. Excess funds are being invested in short-term instrument yielding 12 percent per
annum.

a. If Agri Insurance has P5 million per day in collections and P3 million per day in disbursements, how much
cash has the cash management system freed up?

b. How much can Agri Insurance earn in peso per year on short-term investments made possible by freed-up-
cash?

c. If the cash management system costs Agri Insurance P1,600,000 per annum, should the company continue
with its system?

5. Samson Corporation, a leading producer automobile batteries, turns out 1,500 batteries a day at a cost of
P600 per battery for materials and labor. It takes the firm 22 days to convert raw materials into battery.
Samson allows its customers 40 days in which to pay for the batteries, and the firm generally pays suppliers in
30 days.

A. What is the length of Samson’s cash conversion cycle?

B. At a steady state in Which Samson Produces 1,500 batteries a day, what amount of working capital must it
finance?

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 Exercise 4 – Working Capital Management Cash
Assistant Professor Ron Reyes

C. By what amount could Samson reduce its working capital financing needs if it was able to stretch its
payables deferral period to 35 days?

D. Samson’s Management is trying to analyze of a proposed new production process on the working capital
investment. The new process would allow Samson to decrease its inventory conversion period to 20 days and
to increase its daily production to 1,800 batteries. However, the new process would cause the cost of materials
and labor to increase to P700. Assuming the change does not affect receivables collection period (40 days) or
the payables deferral period (30 days), what will be the length of the cash conversion cycle and the working
capital financing requirement if the new production process is implemented?

6. Candid Company currently has an average collection period of 50 days and annual credit sales of
P1,200,000. Assume a 360-day year.

a. What is the firms average accounts receivables balance?

b. If the variable cost of each product is 60% of sales, what is the average investment in accounts
receivable?

c. If the equal-risk opportunity cost of the investment in accounts receivable is 15%, what is the total
opportunity cost of the investment in accounts receivable?

7. McPan Company S\sells on terms of 3/10 net 30. total sales for the year are P900,000. Forty percent of
the customers pay on 10th day and take discounts; the other 60 percent pay, on average, 40 days after their
purchases. Assume 360 days per year:

A. What is the days sales outstanding?

B. What is the average amount of receivables?

C. What would happen to average receivables if McPan toughened up on its collection policy with the
result that all no discount customers paid on the 30th day?

8. Carolina Company currently has annual sales of P5 million. Its days outstanding is 40 days, and bad debts
are 4 percent of sales. The credit and collection manager is considering a stricter collection policy whereby
bad debts would be reduced to 2 percent of total sales, and the days sales outstanding would be reduced to 30
days. However, sales are expected to decrease by 500,000 annually. Variable costs are 60 percent of sales
and the cost of carrying receivables is 15 percent. The company pays 40 percent tax. Assume a 360- day
year.

How would the foregoing changes affect the amount of investment in receivables and net income?

9.Howell Corporation is trying to improve its inventory control system and has installed an on-line computer at
its retail stores. Howell anticipates sales of 126,000 units per year, an ordering cost of P4 per order, and
carrying cost of P1.008 per unit.

a. What is the economic ordering quantity?

b. How many orders will be placed during the year?

c. What will the average inventory be?

d. What is the total cost of inventory expected to be?

10. Markado Company uses a small casting of its finished products. The castings are purchased from a
foundry located in another Asian country. In total, Markado Company purchase 54,000 castings per years at a
cost of P8 per casting. The castings are used evenly throughout the year in the production process on a 360-
day-per year basis. The company estimates that it costs P90 to place a single purchase order and about P3 to
carry one casting in inventory for a year. The high carrying costs result from the need to keep the castings in
carefully controlled temperature and humidity conditions, and from the high cot insurance. Delivery from the
foundry generally takes 6 days, but it can take as much s 10 days. The days of delivery time and the
percentage of their occurrence are shown in the following tabulation:

Delivery Time (days) Percentage of Occurrence

6 75
7 10
8 5
9 5
10 5
100

a) Compute the economic order quantity (EOQ).

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 Exercise 4 – Working Capital Management Cash
Assistant Professor Ron Reyes

b) Assume that the company is willing to assume a 15% risk of being out of stock. What would be the safety
stock? The reorder point?

c)Assume that the company is willing to assume only a 5% risk of being out of stock. What would be the safety
stock? The reorder point?

d) Assume a 5% stock-out risk is stated in (3) above. What would be the total cost of ordering and carrying
inventory of the year?

e) Refer to the original data. Assume that using the process reengineering the company reduces its cost of
placing a purchase order only to P6. Also, The company estimates that when the waste and inefficiency
caused by inventories are considered true cost of carrying a unit in stock is P7.20 per year.

1) Compute the new (EOQ).

2) How frequently would the company be placing an order, as compared to the old purchasing policy?

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