Chapter 7

Current Asset Management

Discussion Questions
7- l. In the managemem of cash and marketable securities, why should the primary
concern be for safety and liquidity rather than maximization of profit?

Cash and marketable securities are generally used to meet the transaction needs
of the lirm and for contingency purposes. Because the funds must be avai lable
when needed, the primary concern should be with safety and liquidity rather
than the maximum profits.

7-2. Explain the simi larities <md difierences of lockbox systems and regional
collection offices.

Both lockbox systems and regional collection ofticcs allow for the rapid
processing of checks that originate at distant points. The diflerence is that a
regional collection center requires the commiun em of corporate resources and
personnel to stafT an oflice, while a lockbox system requires only the use of a
post oflice box <md the assistance of a local bank. Clearly, the lockbox system
is less expensive.

7-3. Why wouJd a fi nancial ma nager want to slow down disbursements?

By slowing down disbursements or the processing of checks against the

corporate account, the firm is able to increase 11oat and a lso to provide a source
of short-term financing.

7-4. Use The \Vall Street Journal or some other financial publication to fi nd the
going interest rates for the list of marketable securities in Table 7-1 on page
200. Which security would you choose for a s hort-term investment? Why?

The answer to this question may well depend upon the phase of the business
cycle at the time the question is considered. lo nom1al times, small COs and
savings accounts may prove adequate. However. in a tight money period~ wide
di fferentials may be established between the various instrurnc.nts and maximum
returos may be found in Treasury bills, large COs, COITUl•ercial paper, and
money mar!et fuods.

7-t
7-5. Why are Treasury bills a favot·ite place for linancial managers to invest excess
cash?

Treasury bills are popular because of the large lmd active market in which they
trade. Because of this, the investor may literall)' pinpoint the maturit)' desired
choosing anywhere irom one day to a year. The "T-bill " market provides
maximum liquidity and can absorb almost any dollar amount of business.

7-6. Explain why the bad debt percentage or any other simi.lar credit-control
percentage is not the uhimatc measure of success i.n the management of
accounts receivable. What is the key consideration?

An investment in accounts receivable requires a commitment of funds as is true

of any other investment. The key question is: Will the dollar returns from the
resource commitment provide a surtlcient rate of return to j usti fy the
investment? There is no such thing as too many or too few bad debts, only too
low a return on capital.

7-7. What are three quantitative measures that can be applied to the collection policy
of the Gmt?

Th" average coJJcction period, the ratio of bad debts 10 credit sales and !he
aging of accounts receivable.

7-8. What are the 5 Cs of credit that are sometimes used by bankers and others to
determine whether a potential loan "~ II be repaid?

The 5 C's of credi t are chm·acter, capital , capacily, conditions, and collateral.

7-9. What does the EOQ formula tell us? What assumption is made about the usage
rate for inventory?

The EOQ or economic order point ICJIS us at whal size order poiol we wiJJ
minimize the overall i.oventory cos1s 10 the firm , with specific anenliou to
inventory orde-ring costs and inventory carrying cosls. It does not directly te ll us
the average size of inventory on hand and we must detennioe this as a separate
calculation. It is generally assumed, however, that inventory will be used up at
a constant rate over time, going from the order size to zero and then back again.
Thus, average inventory is half the order size.

7-2
7- JO. Why might a lirm keep a safety stock? What effect is it likel y to have on
can-yiug cost of invemory?

A safety stock protects against the risk of losing sales to competitors due to
being out of an item. A safety stock will guard against late deliveries due to
wemher, production delays, e<Juipment breakdowns and m;my other things that
can go wrong between the placement of an order and its deli very. With more
inventory on hand. the can-)ring cost of inventor)' will go UP.

7- l l. lf a firm uses a just-in -time inventory system, what etTcct is that likely to have
on the nwnber and location of suppliers'

A just-in-time invemory system usually means there will be fewer suppliers,

and they will be more close))' located to the manufacturer they supply.

Chapter 7
Problems
I. Cost-benefit analysis of cash management (L02) Beth's Society Cloth iers, Toe., has
collection centers across the country to speed up collections. The company also makes
paymems from remote disbursement centers so the firm's checks wi ll take longer to clear
the bank. Collection time has been •·educed by two and half days and disbursement time
increased by one and one-half days because of these policies. Excess funds are being
invested in short-term instrumems yielding 6 pet·cent per annum.
a. lf the finn has $4 mill ion per day in collections and $3 million per day in
disbursements, how many dollars has the cash management system freed up?
b. How much c:mthe firm earn in dollars per year on short-tetm investments made
possible by the freed-up cash'?

7-1. Solution:
Beth's Society Clothiers, Inc.
a. $4,000,000 daily collections x 2.5 days speed up =
$10,000,000 additional collections
$3,000,000 daily disbursements x 1.5 days slow down=
$ 4,500,000 delayed disbursements
$10,000,000 additional collections
$4,500,000 delayed disbursements
$14,500,000 freed-up funds

7-3
 b. $14,500,000 freed-up funds
X 6% interest rate
$ 870,000 interest on freed-up cash

2. Cost-benefit analysis of cash management (L02) Neon light Company of Kansas Cily
s hips lamps and lighting appliances throughout the country. Ms. Neon has determined that
through the establishment of local collection centers around the country, she can speed up
the collection of payments by one and one-half days. Funhennore, the cash management
departmem of her bank has indicated to her that she can defer her payments on her
accounts by one-half day without affecting suppliers. The bank has a remote disbursement
center in Florida.
a. IJ Neon Light Company has $2 mi ll ion per day in collections and $1 million per day
in disbursemems, how many dollars will the cash management syste m free up"?
b. u·Neon Light Company can earn 9 percent per annum on freed-up funds, how much
will the income be?
c. lJ the total cost of the new system is $375,000, should it be implemented?

7-2. Solution:
Neon Light Company of Kansas City
a. $2,000,000 daily collections
x 1.5 days speed up = $3,000,000 additional collections

$ 1,000,000 daily disbursements

x .5 days slow down = $500,000 delayed disbursemems
$3,500,000 freed-up funds

b. $3,500,000 freed-up funds

X 9% interest rate
$ 315,000 interest on freed-up cash

c. No. The income of $315,000 is $60,000 less than the cost of

$375,000.

7-4
3. In ternational cash management (L02) Orbital Communications has operating plants .i n
over 100 countries. lt also keeps Funds for transactions purposes in many foreign countries.
Assume in 20 10 it held 100,000 kronas in Norway wo•th $35,000. The funds drew 12
percent interest, and the krona increased 6 percent against the dollar.
What is the value of the holdings, based on U.S. dollars, at year-end (Hint:
multiply $35,000 times 1.12 and then mul!iply the resulling value by 106
percent)

7-3. Solution:
Orbital Communications
$35,000 X 1.12 = $39,200
$39,200 X 106% = $41,552

4. International cash management (L02) Postal Express has outlets throughout the world .
I! also keeps funds lor transactions purposes in many loreign countries. Assume in 2010 it
held 200,000 rcals in Brazil worth 130,000 dollars. It drew lO percent interest, blll the
Brazilian real declined 20 percent against the dollar.
a. What is the value of its holdings, based on U.S . dollars, at year-end? (Hint: mul!iply
$130,000 times 1.10 and then mul!iply the r<!s ul!ing value by 80 percent.)
b. What is the value of its holdings, based on U.S. dollars, at year-end if instead it drew
8 percent intere.st and the real went up by 12 percem against the dollar?

7-4. Solution:
Postal Express
a. $130,000 x 1.10 = $143,000
$143,000 x 80% = $114,400 dollar value of real holdings

b. $130,000 X 1.08 = $140,040

$140,040 x 112% = $157,248 dollar value of real holdings

7-5
5. Average collection period (L04) Sanders' Prime Time Company ha~ annual credit sales
of $1,800,000 and accounts receivable of $210,000. Compute the value of the average
collection period.

7-5. Solution:
Sanders' Prime Time Co.
. . Accounts receivable
Average collection penod = - - - - - - - - - -
Average daiIy credit sales

$210,000
$1,800,000/360

$210,000
$5,000
=42days

6. Average collection period (L04) Oral Roberts Dental Supplies has annual sales of
$5,625,000. Eighty percent are on credit. The lirm has $475 ,000 in accounts receivable.
Compute the value of the average collection period.

7-6. Solution:
Oral Roberts Dental Supplies
. . d Accounts receivable
A. verage coIIectlOn peno = - - - - - - - - - -
Average daily credit sales

Credit Sales = 80% x $5,625,000 = $4,500,000

7-<:.
 . . d $475,000
Average coIIectiOn peno = - - - - ' - - - -
4,500,000/360

$475,000
$12,500

=38 days

7. Accounts receivable b alance (L04) Eco-Friendly Products has annual credit sales of
$900,000 and an average collection period of 30 days. Assume a 360-day year. What is the
company's average accounts receivable balance? Accounts receivable are equal to the
average daily credit sales times the average collection period.

7-7. Solution:
Eco-Friendly Products
$900,000annual credit sales $ d' d
· = 2 , 500ere 1t sa1es a ay
360days per year

$2,500 average x 30 average $75,000 average

daily credit safes collection period Accounts receivable balance

8. Accounts r eceivable balance (L04) Barney's Antique Shop has annual credit sales of
$1,080,000 and an average collection period of 40 days. Assume a 360-day year. Wbat is
the company's average accounts receivable balance" Accounts receivable are equal to the
average daily credit sales times the average collection period.

1·1
7-8. Solution:
Barney's Antique Shop
$1,080,000annual credit sales $ di d
-'---'-------'--------- = 3 ,000 ere t sa1es a ay
360days per year

$3,000 averaoe x 40 average _ $ 1.20,000 average

daily credit safes collection period - accounts receivable balance

9. Credit polky (L04) In Problem 8, if accounts receivable change to $140,000, while cre<tit
sales are $1 ,440,000, should we assume the firm has a more or a less lenient credit policy?
Hint: Recompute Ihe avemge collection period.

7-9. Solution:
Barney's Antique Shop (Continued)
. . Accounts receivable
Average collection penod = . .
Average daily credit sales
$140,000
$1,440,0001360
$ 140,000
$4,000
=35 days

Since the firm has a shorter average collection period, it appears that
the fum does not have a more lenient credit policy.

7·8
JO. Determination of tredit sales (L04) Mervyn's Fine Fashions has an average collection
period of 40 days. The accounts receivable balance is $80,000. What is the value of its
credit s~~es?

7-10. Solution:
Mervyn 's F ine Fashion
. . d Accounts receivable
Average co IIectwn peno = - - - - - - - - - - -
Average daily credit sales
$80,000
40 d ays =
Credit sales)
( 360
crediLsales $80,000
360 40
Credit sales/360 = $2,000
Credit sales = $2,000 x 360 = $720,000

l I. Aging of accounts receivable (L04) Route Canal Shipping Company has the following
schedule for aging of accounts receivable:

Age of Receivables
Apri.l 30, 2010
(1) (2) (3) (4)
Percent of
Month of Sales Age of Account Amounts Amount Due
Apri l ................................. 0- 30 $ 105,000
March ............. .................. 3 1-60 60,000
Febntary ........................... 6 1- 90 90,000
January ............................. 91- 120 45.000
Total receivables ........... $ 300,000 100%

a. Fill in column (4) for each month.

b. lJ the li1m had $1,440,000 in credit sales over the four-month period, compute the
average collection period. Average daily sales should be based on a 120-day pe1i od.
c. If the fi rm likes to sec its bills collected in 30 days, s hould it be satis fied with the
average collection period ?

7-9
 d. Disregarding your answer to pan c and conside1ing the agi ng schedule for accounts
receivable, shou.ld the company be satislled?
e. W hat additional informat ion does the aging schedule bring to the company that the
average collection period may not show?

7-11. Solution:
Route Canal Shipping Company
Age of Receivables, April 30, 2010
a.
(1) (2) (3) (4)
Age of Percent of
Month of Sales Account Amounts Amount Due
April 0-30 $105,000 35%
March 31-60 60,000 20%
February 61-90 90,000 30%
January 91- 120 45,000 15%
Total receivables $300,000 100%

7-11. (Continued)
. . Accounts receivable
b. Average CollectiOn Penod = . .
Average datly credll sales

$300,000
- -----'---
$1,440,0001120

$300,000
$12,000

=25 days

c. Yes, the average collection of 25 days is less than 30 days.

7-10
 d. No. The aging schedule provides additional insight that 65
percent of the accounts receivable are over 30 days old.

e. It goes beyond showing how many days of credit sales

accounts receivables represent, to indicate the distribution of
accounts receivable between various time frames.

12. Economic ordering quan tity (LOS) Midwest Tires has expected s ales of 12,000 tires this
year, an ordering cost of $6 per order, and carrying coSIS of $ 1.60 per tire.
a. What is the economic ordering quantity?
b. How many orders wi ll be placed c.Juliog the year?
c. Whal will the average iovcolory be'?

7-12. Solution:
Midwest Tires

a. EOQ = ~2SO \ 2x 12,000x$6

c $1.60

144 000
\ $ • =J90 000 =300 tires
~ $1.60 ,

b. 12,000 tires/300 tires= 40 orders

c. EOQ/2 = 300/2 = 150 tires (average inventory)

I 3. Economic ord ering quantity (LOS) Fisk Corporation is trying to improve its inventory
control system and has installed an online computer al its retai I stores. Fisk anticipates
s:Lies of 75,000 units per year, an ordering cos! of $8 per order, and carrying costs of $1.20
per unit.
a. What is the economic ordering quantity?
b. How many orders wi ll be placed doling the year?
c. W hal will the average inveolory be?

7-l l
 d. What is the total cost of ordel.ing and carrying inventory?

7-13. Solution:
Fisk Corp.

a. EOQ --~2SO _ 2x75,000x$8 _ 1 OOO .

C -\ $1.20 - ' UllJtS

b. 75,000 units/1,000 units= 75 orders

c. EOQ/2 = 1,000/2 = 500 units (average inventory)

d. 75 orders x $8 ordering cost = $ 600

500 units x $1.20 carrying cost per unit - 600
Total costs =$ 1,200

14. Economic ordering quantity (LOS) (See Problem 13 for basic data.) In the second year,
Fisk Corporation finds that it can reduce ordel.ing costs to $2 per order but that carrying
costs will s tay the same at $1 .20. Also, volume remains at 75,000 units.
a. Recompute a, b, c, and d in Problem 13 for the second year.
b. Now compare years one and two and explain what happened.

7-14. Solution:
Fisk Corp. (Continued)

a. EOQ = ~2SO = 2x 75,000x$2

c \ $1.20

300 000
..., , $• = ~250,000 = 500 units
~ $1.20

75,000 units/500 units= 150 orders

EOQ/2 = 500/2 = 250 units (average inventory)
150 orders x $2 ordering cost = $300

7-t2
 250 units x $1.20 carrying cost per unit = 300
Total costs =$600

b. The number of units ordered declines 50%, while the number

of orders doubles. The average inventory and total costs both
decline by one-half. Notice that the total cost did not decline
in equal percentage to the decline in ordering costs. This is
because the change in EOQ and other variables (V2) is
proportional to the square root of the change in ordering
costs ('A).

I 5. Economic.ordering quantity with safety stock {LOS) Diagtlostic Supplies has expected
sales of 135,000 units per year, carrying costs of $3 per unit, and an ordering cost of $4 per
order.
a. What is the economic order <JU<\ntity?
b. Whal is the average inventory? What is the total can·ying cosr?
c. Assume an additional 80 units of inventory wi ll be required as safety sLock. What will
the new average invenlory be? What will the new wtal caJTying cost be?

7-15. Solution:
Diagnostic Supplies

a. EOQ=~2SO = 2xl35,000x$4
c .\ $3

· ~' $ t,ogo,OOO = ..}$360 000 = 600 units

~ $3 ,

b. EOQ/2 = 600/2 = 300 units (average inventory)

300 units x $3 carrying cost/unit = $900 total carrying
cost

7- t 3
 c. Average inventory= EOQ + Safety Stock
2
600
= +80=300+80=380
2
380 inventory x $3 carrying cost per year
= $ 1,140 total carrying cost

16. Level versus seasonal p roduction (LOS) Wiscons in Snowmobi le Corp. is considering a
switch 10 level production. Cost efliciencies would occur under level production, and
afte-rtax costs would decline by $30,000, but inventor)' would increase by $250,000.
Wisconsin Snowmobi le have 10 linance the extra inventory at a cost of 13.5 percent.
a. Should the company go ahead and switch to level production?
b. How low would interest rates need to f<tll before level production would be feasible?

7-16. Solution:
Wisconsin Snowmobile Corporation
a. Inventory increases by $250,000
x interest expense 13.5%
Increased costs $ 33,750

Savings $30,000
Less: Increased costs ($33,750)
Loss ($ 3,750)
Don't switch to level prod uction.

b. If interest rates fall to 12% or less, the switch would be

feas ible.

7-t4
 _ ___c$_3_0.:....,O_O_O_S_a_v_in_,g"--s_ _ = 12%
$250,000 increased invent01y
However, the decision is more complicated because it depends on
expectations for interest rates. If the extra inventory were considered
permanent current assets and was financed by locking in long-term
interest rates below 12%, then it would make sense to switch.
However, given that short-term rates are volatile; this decision can't
be made on a dip in short-term interest rates below 12%.

17 . Credit policy d ecision (L04) Johnson ElectrOnics is considering extending trade credit to
some customers previously considered poor risks . Sales would increase by $100,000 if credit
is extended to these new customers. Of the new accounts receivable generated, I0 percent will
prove to be uncollectible. Additional collection costs will be 3 percem of sales, and production
and selling costs will be 79 percent of sales. The (jrm is in the 40 percem tax bracket.
a. Compute the incremental income after taxes.
b. What will Johnson 's incremental return on sales be if these new credit customers are
accepted?
c. U' the receivable turnover ratio is 6 to I, and no other asset buildup is needed to serve
the new customers, what will Johnson 's incremental reiUrn on new average
investment be?

7-17. Solution:
Johnson Electronics
a. Additional sales ................................................... . $ 100,000
Accounts uncollectible (10% of new sales) ........ . - 10,000
Annual incremental revenue ................ ................ $90,000
Collection costs (3% of new sales) ..................... . - 3,000
Production and selling costs
(79% of new sales) .......................... ....... ........ . - 79,000
Annual income before taxes .... ...... ...................... . $ 8,000
Taxes (40%) ........................................................ . 3,200
Incremental income after taxes ............................ $ 4,800

7· 15
 Incremental inco me
b. Incremental retum on sales = - - - - - - - -
Incremental sales
= $4,800/$100,000 = 4.8%

c. Receivable tumover = Sales/Receivable turnover = 6x

Receivables = Sales/Receivable turnover
= $100,00016
= $ 16,666.67
Incre mental return on ne w average investment
$4,800/$16,666.67 = 28.80%

18. C redit policy decision-recei vables an d inventory ( L04 & 5) 1-lcodcrson Office Supply
is considering a more Liberal credit policy to increase sales, but expects that 8 percent of the
new accounts will be uncollectible . Collection costs are 5 percent of new sales, production
and selling costs are 78 percent; and accounts receivable turnover is five li mes. Assume
income taxes of 30 percem and an increase in sales of $60,000. No other asset buildup will
be required 10 service the new accounts.
a. What is the level of accounts receivable to supporttllis sales expansion?
b. What would be Henderson's incremental aftertax retum on investment?
c. Should Henderson liberalize cmlit if lt 15 percent aftertax retum on investment is
required?
Assume that Henderson also needs to increase its level or inventory to support new sales and
that inventory turnover is four times.
d. What would be the total incremental investment in accounts receivable and inventory
10 support a $60,000 increase in sales'?
e. Gi ven the income de termined in pan b and the investment determined in pan d,
should Henderson extend more liberal credit terms'?

7-18. Solution:

7-t6
 Henderson Onice Supply

60 000
a. In vestment in accoums receivable= $ • = $12,000
5
b. Added sa]es ......................................................... . $60,000
Accounts uncollectible (8% of new sales) .......... . - 4,800
Annual incremental revenue .......... .................... .. $55,200
Collection costs (5% of new sales) .................... .. - 3,000
Production and sel ling costs
(78% of new sales) - 46,800
Annual income before taxes ................................ . $ 5,400
Taxes (30%) ........................................................ . - 1,620
Incremental income after taxes .......................... .. $ 3 ,780

Retum on .mcrementa I .mvestment = $3,780 = 3 1.5m

·ro
J2,000

7-18. (Continued)
c. Yes! 31.5% exceeds the required return of 15%.

d. In vestment .tn .mvemory =$60,000 =$ 15,000

4
Total incremental investment
Tnvemory $15,000
Accounts receivable 12,000
Tncremental investment $27,000

7- 17
 $3,780/$27,000 = 14% return on investment

e. No! 14% is less than the required return of 15%.

J9 . Credit policy dedsion with changing va riables (L04) Comiskey Fence Co. is evaluating
the extension of credit to a new group of customers. Ahhough these customers will provide
$180,000 in additional c•·edit sale.s, 12 percent are like ly to be uncollectible. The company
will also incur $ 15,700 in additional collection expense. Production and marketing costs
represent 70 percent of sales. T he lirm is in a 34 percemtax bracket and has a receivables
turnover of five. times . No other asset buildup will be required to service the new
customers. The lirm has a 10 percent desired return .
a. Should Comiskey Fence Co. extend credit to these customers?
b. Should cred it be extended if 15 percent of the new sales prove uncollectible?
c. Should credit be ex tended if the receivables turnover drops to 1.5, and 12 percent of
the accou nts arc uncollectible (as in pan a)?

7-19. Solution:
Comiskey Fence Co.

a. Added sales ............................................................. $ 180,000

Accounts uncollectible (12% of new sales)............ 2 1,600
Annual incremental revenue................................... J 58,400
Collection costs............... ........ ................................ 15,700
Production and selling costs
(70% of new sales)......... ................... .. ....... ........... 126,000
Annual income before taxes .......... .......................... 16,700
Taxes (34%) ......................................... ................... 5,678
Incremental income after taxes .. ... ....... ............... ... . $ 11,022
$36,000 in

7-tS
 . bl
R ecetva -0 $180,000
e turnover=:>. x = · bl
5.0 new recetva es

R etum on .mcrementaI mvestment

. =
$11,022 = 30. .62m
7o
$36,000

Yes, extend credit to these customers since the incremental

return of 30.62% is greater than 10%.

7-19. (Continued)

b. Same as above except accounts uncollectible are $15% of

$180,000 or $27,000. T his is $5,400 more than the value in
part a. This means a reduction in incremental income after
taxes of $3,564 to $7,458. T he value can also be computed
as:

Added sales ................ ............................ ...... ...... .. $180,000

Accounts uncollectible ( 15% of new sales)......... 27,000
Annual incremental revenue ................................ $153,000
Collection costs.................................................... 15,700
Production and selling costs
(70% of new sales) ..... .......................... ........ ...... . 126,000
Annual income before taxes .......................... ...... . J 1,300
Taxes (34%) ................................... .................... .. 3,842
Incremental income after taxes .......................... .. $ 7,458

.
R etum on mcrement<tl .mvestment = $ 7 ,458 = 20 .72{)1
7o
$36,000

7-19
 Yes, extend credit.

c. If receivable turnover drops to .1.5x, the investment in

accounts receivable would equal $180,000/1.5 = $120,000
instead of the $36,000 required in part a. The return on
incremental investment, assuming a 12% uncollectible rate,
is9.19%.
. mvestment = $11,022 = 9 . 19nf
a].
Return on mcrement· 7o
$120,000
The credit should not be extended. 9.19% is less than the
desired 10%.

20. Continuation of Problem 19 (L04) Reconsider problem 19C. Assume the average
collection period is 120 days. Al l other factors are the same (including 12 percent
uncollectibles). Should credit be extended?

7-20. Solution:
Comiskey Fence Company (Continued)
First compute the new accounts receivable balance.
Accounts receivable= average collection x average daily
period sales
$180,000
120 daysx · = 120x$500 = $60,000
360 days
or
Accounts receivable= sales/accounts receivable turnover
. 360 days
Accounts recetvable twnover = = 3x
120 days
$ 180,000/3 = $60,000

7-20
 Then compute return on incremental investment.

$ 11,022 =18.37%
$60,000
Yes, extend credit. 18.37% is greater than 10%.

21 . Cr ed it policy and return on investment (L04) Global Services is considering a

promolional campaign 1ha1 will increase annual credit sales by $400,000. T he company
will require investments in accoums rece ivable, inventory, and plam and equipmen1. The
mmover for each is as follows:

ACCOUDIS receivable .................................... 4x

lnvemory ..................................................... 8x
Plam and equipment .................................... 2x

All $400,000 of the sales wil l be collectible. However, collection costs will be 4 percent of
sales, and produclion and sclliug costs will be 76 pcrecnl of sales. The cost to carry
invemory will be 8 percent of invemory. DepreciaJion expense on plant and equipment will
be 5 percent of plant and equipment. The tax rale is 30 percent.
a. Compule the investments in ae<:otmts receivable, inventor)', and pl:ml and equipment
based on the turnover raJios. Add the three LOge Iher.
b. Compute the accoums receivable collection costs and production and selling costs
and add the two ligures together.
c. Compute lhe costs of carrying inventory.
d. Compute ihe depreciation expense on new plant and equipmenl.
e. Add together all the costs in pans b, c, and d.
f S ubiract the answer from part e from Jhe sales fib'llre of $400,000 to arrive at income
before taxes. S ubtract taxes ala rate of 30 percenl lo arrive at income after taxes.
g. Divide the aflen ax return figure in partf by 1he total investment figure in pan a. If Jhe
firm has a required retum on investment of 12 percent, should it undertake Ihe
promotional campaign described throughout this problem.

7-21. Solution:
Global Services
a. Accounts receivable = sales/accounts receivable turnover

7-2 1
 $100,000 = $400,000/4

Invemory = sales/inventory turnover

$50,000 = $400,000/8

Plant and equipment = sales/(p lant and equipment turnover)

$200, 000 = $400, 000 I 2
$350,000 total investment

7-2 1. (Continued)
b. Collection cost = 4% x $400,000 $ 16,000
Production and selling costs = 76% x $400,000 = 304,000
Total costs related to accounts receivable $320,000

c. Cost of carrying inventory

8% x inventory
8% X $50,000 $4,000

d. Depreciation expense
5 % X $200,000 $10,000

c. Total costs related to accounts receivable $320,000

Cost of carrying invento ry 4,000
Depreciation expense 10,000
Total costs $334,000

f. Sales $400,000
- total costs 334,000
Income before taxes 66,000

7-22
 Taxes (30%) 19,800
Income after taxes $46,200

Income after taxes = $46,200 = . %

g. 13 2
Total investment 350,000
Yes, it should undertake the campaign.
The aftertax return of 13.2% exceeds the required rate of
return of 12%.

22. Continuation of Problem (L04} In Problem 2 1, if inv~ntory turnover had only been 4 times:
a. What would be the new value for inventory invc..tmcnr>
b. What would be the return on invc>trncnt? You need to recompute the total investment
and the total costs of the campaign to work toward computing income after taxes.
Should the campaign be undenaken?

7-22. Solution :
Global Services (Continued)

a. Inventory = sales/inventory turnover

$ 100,000 = $400,000/4

b. New Total Investment

Accounts recei vable $ 100,000
inventory 100,000
Plant and equipment 200,000
$400,000
Total Cost of the Campaign
Cost of carrying inventory
8% X $100,000 = $8,000

7·23
 New Income After Taxes
Sales $400,000
- lola! costs 342,000 ($334,000 + $8,000
Income before taxes 58,000 additional inventory
Taxes (30%) 17,400 costs)
Income after taxes $40,600
Return on inveslmenl
Income after taxes $40,600 = 10.15%
Total inves tment 400,000
No, the campaign should not be undertake n.
T he after tax return of 10.15% is less than the required rate of
rerum of 12%.

(Problems 23-26 are t1 series and should be taken in order.)

23. Cr edit policy decision with changing variables (L04) Dome lliletals has credit sales of
$ 144,000 yearly with credi t terms of net 30 days, which is also the average collection
period. Dome does not offer a discount for early payment, so its customers take the full 30
days to pay. W hat is the avcrag" receivables balance? Receivables turnover?

7-23. Solution:
Dome Metals
Sales/360 days = average daily sales
$144,000/360 = $400
Accounts receivable balance = $400 x 30 days= $ 12,000

. bl Sales $144,000
R eceJVa e turnover = = = 12
Receivables $ 12,000

or

7-24
 360 days/30 = I 2x

24. If Dome offered a 2 percent discount for paymem in 10 days and eve.·y customer took
advamage of the new terms, what would the new average receivables balance be? Use the
full sales of $ 144,000 for your calculation of receivables.

7-24. Solution:
$400 x I 0 days = $4,000 new receivable balance

25. If Dome reduces its bank loans, which cost 10 percent, by the cash generated from its
reduced receivables, what will be the net gaio or loss 10 the firm (don ' t forget the 2
pcrccm)? Should it offer the d.iscount?

7-25. Solution:
Old receivables- new rece ivables Funds freed by
with discount discount
$12,000 $4,000 = $8,000 discount
Savings on loan = LO% x $8,000 ........... . $ 800
Discount on sales= 2% x $144,000 ....... . (2,880)
Net change in income from discount ..... . $(2,080)
No! Don't offer the d.iscount since the income from reduced bank
loans does not offset the loss on the discount.

26. Assume that the new trade tc•m s of2110, net30 will increase sales by 15 percent because
the discount makes the Dome's p1ice competitive. lfDome earns 20 percent on sales before
discounts, should it o ffer the discount? (Consider the same variables as you did for
problems 23 through 25 as wi ll as increase sales.)

7-26. Solution:

7-25
 New sales =$ 144,000x 1. 15 = $165,000
Change in sales = $165,000 - $ 144,000 = $ 21,600
Sales per day = $165,600/360 - $460
Average receivables balance = $460 X J0 = $ 4,600
I ncrease profit on new sales 20% X $21,600 = $ 4 ,320
Reduced profi t because = 2% x $165,600 (3,3 12)
of discount
Savings in interest cost ($12,000 - $4,600) x 10% 740
Net change in income ........................................... . $ 1,748

Yes, offer the discount because total profit increases.

COMPREHENSIVE PROBLEM

Logan Oislri buling Company (receivables and invenlory policy) (LO 04 & 05) Log<\n
D istributing Company or Atlanta sells fans and heaters to retail omlets through out the Southeast.
Joe Logan, the president of the company, is thinki ng about changing the Finn's credit policy to
anract customers away from competitors. T he present policy c:llls for a 1/1 0, n.et 30 cash
discount. The new policy would call for a 3/10, net 50 cash discount. Currently, 30 percent of
Logan customers are taking the discount, and it is amicipated that this number would go up to 50
percent with the new discoum policy. It is fun her anticipated that annual sales would increase
from a level of $400,000 to $600,000 as a result of the change in the cash discount pol icy.
T he increased sales would also a!Tect thc inventory level. T he average inventory carried by
Logan is based on a determination of an EOQ. Assume sales of fans and heaters inc.·ease from
15,000 to 22,500 units. The ordering cost for each order is $200 and the carrying cost per unit is
$1.50 (these values will not change with the discount). The average invemory is based on
EOQ/2. Each unit in invemory has an average cost of $ 12.
Cost of goods sold is equal to 65 percent of net sales: general and administrative expenses are
15 percent o f net sales, and imerest payments of 14 perce nt will only be necessary for the
increase in the accounts receivable and inventory balance's. Taxes will be 40 perce nt of before-
tax income.
a. Compute the accounts rece ivable balance before and after the ch~mge in the cash
discount pol icy. Use the net sales (toUtl sales minus cash discounts) to determ ine the
'werage daily S(lles.
b. Detennine EOQ before and after the change in the cash discount policy. Translate this
into average inventory (in units and dollars) before and after the change in the casb
discount policy.

7-26
 c. Complete the following income statement.

Befor e Policy After Policy

Change Change
Net sales (Sales- Cash discounts) ...............
Cost of goods sold ........................................
Gross protit ..................................................
General and administrative expense .............
Operating profit ............................................
Interest on increase in accoums
receivable and invemory ( 14%) ................
Income before taxes .....................................
Taxes ............................................................
Income after taxes ........................................

d. Should the new cash discount policy be utilized? Brieny comment.

CP 7-1. Solution:
Logan Distributing Company
a. Accounts receivable= average collection x average daily
period sales
Before
Average collection period
.30 x LO days = 3
.70 x 30 days = 21
24 days (average ace. receivables)
Average daily sales

1·21
 Credit sales- Discount _ $400,000 - (.OJ )(.30)($400,000)
360 days
- 360 days

$400,000 - $ 1,200
360days

- $398,800
360days

Average daily sales = $1,107.78

Accounts recei vable= 24 days x $1, 1. 07.78 = $26,586.72

before policy change

After
Average collection period
.50 x 10 days 5 =
.50 x 50 days = 25
30 days(avg. ace. receivables)

CP 7-1. (Continued)
Average daily sales
Credit sales - discounl _ $600,000- (.03) (.50)($600,000)
360 days 360 days
$600,000 - $9, 000
360 days
$591,000
360 days
Average daily sales= $1,641.67

7-28
 Accounts receivable= 30 days x $1,641 .67 = $49,250.10
after policy change

b. Before

EOQ = 2SO
c
2xl5,000x$200- $6,000,000 = /4 000 000 = 2 000 un.its
\ $ 1.50 .\ $1.50 " , , ,
After
2x22,000x$200 = $9,000,000 = 16 ()()() OOO = 2 449 _49
~ $1.50 ' $1.50 " , , ,

Average inventory
Before
2, 000 = "],000 umts
---'--- . 1,000 unitsx$12 = $12,000
2

7-29
CP 7-1. (Continued)
After
2,449.49 _ 1,224.75 units 1,224.75 units x$12 =
2 or 1,225 (rounded) $14,697 or $14,700
(rounded)
c.
Before After
Policy Policy
Change Change
Net sales (sales- cash discount) $398,800 $59 1,000
Cost of goods sold (65%) 259,220 384,150
Gross Profit 139,580 206,850
General and adm.in. expense
59,820 88,650
(15%)
Operating profit 79,760 118,200
*Interest on increase in accounts
receivable and inventory
(14%) 3,550.45
Income before taxes 79,760 114,649.55
Taxes (40%) 31,904 45,859.82
Income after taxes $ 47,856 $ 68,789.73

*14% xAR = 14%x ($49,250. 10 - $26,586.72)

= 14%x$22,663.38 =$3, 172.87
J4%x1NV =14%x ($ 14,697 -$12,000)
= 14%x$2.697 = $ 377.58

$3,550.45

d. The new cash discount policy should be utilized. The interest

cost on the increased accounts receivable and inventory is

7·30
small in comparison Lo Lhe increased operating profil from
the policy change.

7-3 1