Chapter 30 - Working Capital Management

CHAPTER 30
Working Capital Management

The values shown in the solutions may be rounded for display purposes. However, the answers were
derived using a spreadsheet without any intermediate rounding.

Answers to Problem Sets

1. By holding large inventories, the firm avoids the risk of running out of raw
materials and finished goods. By ordering materials in larger quantities, the
company can arrange longer production runs. On the other hand, inventories tie
up capital, must be stored and insured, and may be subject to damage or theft.

Similarly, large cash inventories reduce the risk of running out of cash or having
to sell securities with short notice. By reducing the number of security sales, the
fixed costs of such sales decline. On the other hand, inventories of cash tie up
capital and lower the return on assets.

Est. Time: 01- 05

2. a. Discount amount = discount rate × invoice amount

Discount amount = .01 × $1,000
Discount amount = $10

b. Rate = (full price – discount price) / discount price

Rate = (100 – 99) / 99
Rate = .010101

EAR = (1 + rate)365/days in loan period

EAR = (1 + .010101)365/30 – 1
EAR = .1301, or 13.01%

c. (i) Shorter; (ii) longer; (iii) shorter

Est. Time: 01- 05

3. a. Due lag decreases, therefore pay lag decreases.

b. Due lag increases, therefore pay lag increases.

c. Terms lag increases, therefore pay lag increases.

Est. Time: 01- 05

4. NPV = quantity × [(probability of payment × PV of payment) – cost]

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Chapter 30 - Working Capital Management

NPV = 1,000 × [(.75 × $50 / 1.106/12) – $40]

NPV = –$4,245.15

Reject; the NPV is negative.

Est. Time: 01- 05

5. a. Expected profit = p($1,200 − 1,050) − $1,050(1 − p) = 0

p = .875, or 87.5%

Therefore, grant credit if probability of payment exceeds 87.5%.

b. Expected profit on second order = .95($1,200 –1,050) – .05($1,050)

Expected profit on second order = $90

Break-even point for credit check:

Break-even point = (.05 × $90 × units) − $12 = 0

Units = 2.67

Est. Time: 06- 10

6. Expected profit first order = .8($1,200 – 1,000) – .20($1,000)

Expected profit first order = –$40

Now, to find p2:

−$40 + .80{[p2 × ($1,200 – 1,000) − (1 − p2)$1,000} / (1.20) = 0

p2 = .8833, or 88.33%

Est. Time: 06-10

7. a. False. Exporters use banker’s acceptances.

b. False. Credit managers should not concentrate on minimizing bad debts
but on maximizing expected profits.
c. False. Debt is turned over to a collection agency or attorney.

Est. Time: 01- 05

8. If variable increases (a) more willing; (b) less willing; (c) more willing.
Student examples will vary.

Est. Time: 01- 05

9. Concentration banking; CHIPS; Fedwire; lockbox banking

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Chapter 30 - Working Capital Management

Est. Time: 01- 05

10. Price of 6-month bill = 100 – (6/12) × 1.4

Price of 6-month bill = 99.30

Annual yield = (100 / 99.30)2 – 1

Annual yield = .01415, or 1.415%

Est. Time: 01- 05

11. a. Repurchase agreements

b. Commercial paper
c. Three-month bills
d. Treasury bills
e. Treasury bills

Est. Time: 06-10

12. Only 30% of the floating-rate preferred dividend is taxed versus 100% of bond
interest. The fixed-dividend preferred also offers this tax advantage but its price
fluctuates more than that of the floating-rate preferred. The best choice is time
dependent on market interest rates and company tax rates. Companies prefer
the highest after-tax expected rate of return.

Est. Time: 01-05

13. a. 2/30, net 60: A 2% discount is offered for payments within 30 days;
otherwise, full amount due in 60 days

b. 2/5, EOM, net 30: A 2% discount is offered for payments within 5 days of
the end of the month; otherwise, full payment due within 30 days of the
invoice date

c. COD: Cash on delivery; Full amount due at time of delivery

Est. Time: 01-05

14. a. [1 + (2 / 98)]365/(60 – 30) – 1 = .2786, or 27.86%

b. [1 + (2 / 98)]365/(30 – 5) – 1 = .3431, or 34.31%

Est. Time: 01-05

15. When the company sells its goods cash on delivery, for each $100 of sales,
costs are $95 and profit is $5. Assume now that customers take the cash

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Chapter 30 - Working Capital Management

discount offered under the new terms. Sales will increase to $104, but after
rebating the cash discount, the firm receives:

Payment = .98 × $104 = $101.92

Since customers pay with a 10-day delay, the present value of these sales is:

PV = $101.92 / 1.0610/365 = $101.76

Since costs remain unchanged at $95, profit becomes:

Profit = $101.76 – 95 = $6.76

If customers pay on day 30 and sales increase to $104, then the present value
of these sales is:
PV = $104 / 1.0630/365 = $103.50
Profit becomes:
$103.503 – 95 = $8.50
In either case, granting credit increases profits.

Est. Time: 06-10

16. The more stringent policy should be adopted because profit will increase. For
every $100 of current sales:
Current More Stringent
Policy Policy
Sales $100.00 $95.00
Bad debts 6.00 3.80
Cost of goods 80.00 76.00
Profit $14.00 $15.20

Est. Time: 06-10

17. Consider the NPV (per $100 of sales) for selling to each of the four groups:

Classification NPV per $100 Sales

1 –$85 + [$100 × (1 – 0)] / 1.1545/365 = $13.29

2 –$85 + [$100 × (1 – .02)] / 1.1542/365 = $11.44

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Chapter 30 - Working Capital Management

3 –$85 + [$100 × (1 – .1)] / 1.1540/365 = $3.63

4 –$85 + [$100 × (1 – .2)] / 1.1580/365 = –$7.41

If customers can be classified without cost, then Velcro should sell only to
Groups 1, 2, and 3. The exception would be if nondefaulting Group 4
accounts subsequently became regular and reliable customers (i.e., members
of Group 1, 2, or 3). In that case, extending credit to new Group 4 customers
might be profitable, depending on the probability of repeat business.

Est. Time: 11-15

18. By making a credit check, Velcro Saddles avoids a $7.41 loss per $100
sale 25% of the time. Thus, the expected benefit (loss avoided) from a
credit check is:

Benefit = .25 × $7.41 = $1.85 per $100 of sales, or 1.85%

A credit check is not justified if the value of the sale is less than x, where:

.0185x = $95
x = $5,135

Est. Time: 06-10

19. Original terms:

NPV per $100 of sales = –$80 + $100 / 1.1275/360

NPV per $100 of sales = $17.67

Revised terms:

NPV per $100 of sales = – $80 + [.60 × (1 – .02) × $100] / 1.1230/360 + (.40 ×
$100) / 1.1280/360
NPV per $100 of sales = $17.25

Est. Time: 06-10

20. For every $100 of previous sales, the firm now has sales of $102.

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Chapter 30 - Working Capital Management

NPV per $100 of initial sales = 1.02 × $17.25 = $17.60

Est. Time: 06-10

21. a. Increase in cash = daily sales × reduction in float days

Increase in cash = $180m / 360 × 3
Increase in cash = $1,500,000

b. Interest savings = interest rate × increase in cash

Interest savings = .12 × $1,500,000
Interest savings = $180,000

c. Annual cost of the old system = collection costs + opportunity cost of

interest savings lost
Annual cost of the old system = $40,000 + 180,000
Annual cost of the old system = $220,000

d. Annual cost savings = cost of old system – cost of new system

Annual cost savings = $220,000 – 100,000
Annual cost savings = $120,000

Knob should accept First National’s offer.

Est. Time: 06-10

22. a. The total daily cost based on the per check fee is:

Daily cost = number of daily checks – fee per check

Daily cost = 300 × $.40
Daily cost = $120

The total daily cost based on the compensating balance method is:

Daily cost = daily interest rate × compensating balance

Daily cost = (.09 / 365) × $800,000
Daily cost = $197

The per check charge is less expensive than the compensating balance.

b. Required daily cash = daily cost / daily interest rate

Required daily cash = $120 / (.09 / 365)
Required daily cash = $486,667

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Chapter 30 - Working Capital Management

Required float reduction = required daily cash / daily cash flow

Required float reduction = $486,667 / (300 × $1,500)
Required float reduction = 1.08 days
Est. Time: 06-10

23. The cost of a wire transfer is $10, and the cash is available the same day.
The cost of a check is $.80 plus the loss of interest for three days, or:

Cost of check = $10 = $.80 + [.12 × (3/365) × (amount transferred)]

Amount transferred = $9,327.78

The minimum amount needed to justify a wire transfer is $9,327.78.

Est. Time: 06-10

24. a. Additional available cash = daily cash × reduction in float days

Additional available cash = $10,000 × 3
Additional available cash = $30,000

Benefit of lockbox = additional available cash – cost

Benefit of lockbox = $30,000 – 20,000
Benefit of lockbox = $10,000

The lockbox system is worthwhile.

b. Let x equal the average check size. At break-even, the daily cost of both
systems must be equal, so:
Daily cost of compensating method = daily cost of fee per check method
(.06 / 365) × $20,000 = ($10,000 / x) × $.10
x = $304
Thus, if the average check size is greater than $304, paying per check
is less costly; if the average check size is less than $304, the
compensating balance arrangement is less costly.

c. In part a, we compare available cash to the compensating balance

requirement. In part b, we are comparing costs which requires the
interest rate.

Est. Time:11-15

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Chapter 30 - Working Capital Management

25. Price of 3-month bill = 100 – [(3/12) × 10]

Price of 3-month bill = 97.50

Annual yield = (100 / 97.50)4 – 1

Annual yield = .1066, or 10.66%

Price of 6-month bill = 100 – [(6/12) × 10]

Price of 6-month bill = 95.00

Annual yield = (100 / 95.00)2 – 1

Annual yield = .1080, or 10.80%

Therefore, the six-month Treasury bill offers the higher yield.

Est. Time: 06-10

26. a. The annually compounded yield of 5.16% is equivalent to a two-month

yield of:

2-month yield = 1.05162/12 – 1

2-month yield = .0084 = .84%

The price (P) must satisfy the following:

(100 / P) – 1 = .0084
P = $99.16

b. Monthly return = $99.16 / $98.75 – 1

Monthly return = .0042, or .42%

c. Annual yield = 1.004212 – 1

Annual yield = .0516, or 5.16%

Est. Time: 06-10

27. Price = 100 – [(1/12) × 3] = 99.75

Return = (100 / 99.75) – 1 = .002506 = .2506%
Yield = .002506 × 12 = .0301, or 3.01%

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Chapter 30 - Working Capital Management

Realized 2-month return = (99.75 / 98.75) – 1 = .0101, or 1.01%

Est. Time: 06-10

28. Answers will vary over time.

Est. Time: 06-10

29. Let x = the investor’s marginal tax rate. Then, the investor’s after-tax return
is the same for taxable and tax-exempt securities, so that:

.0532 (1 – x) = .037
x = .3045, or 30.45%

Numerous other factors might affect an investor’s choice between the two
types of securities, including the securities’ respective maturities, default risk,
coupon rates, and options (such as call options, put options, convertibility).

Est. Time: 01-05

30. If the IRS did not prohibit such activity, then corporate borrowers would borrow
at an effective after-tax rate equal to [(1 – tax rate) × (rate on corporate debt)], in
order to invest in tax-exempt securities if this after-tax borrowing rate is less
than the yield on tax-exempts. This would provide an opportunity for risk-free
profits.

Est. Time: 01-05

31. a. Individual: After-tax yield = 7%

Corporation: After-tax yield = 7%

b. Individual: After-tax yield = 10% × (1 – .35) = 6.5%

Corporation: After-tax yield = 10% × (1 – .35) = 6.5%

c. Individual: After-tax yield = 7.5% × (1 – .35) = 4.875%

Corporation: After-tax yield = 7.5% – [7.5% × (1 – .70) × .35] = 6.7125%

Before investing, you would also need to consider the variability of the floating-
rate dividend on the preferred stock, the credit worthiness of both the stock and
the municipal note, the maturities, and any relevant options.

Est. Time: 06-10

32. Note: We have assumed an interest rate of 10%.

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Chapter 30 - Working Capital Management

At a purchase price of $10, the sale of 30,000 umbrellas will generate $300,000
in revenue and $47,000 in profit. It follows that the cost of goods sold is:

COGS = ($300,000 – 47,000) / 30,000 = $8.43 per umbrella

Assume that, if Plumpton pays, it does so on the due date. Given an assumed
interest rate of 10%, the net present value per umbrella is:

NPV per umbrella = PV(sales price) – cost of goods

NPV per umbrella = [$10 / 1.1060/365] – $8.43
NPV per umbrella = $1.41

If Plumpton pays 30 days slow, i.e., in 90 days, then the NPV falls to $1.34.

Thus, the sales have a positive NPV if the probability of collection exceeds 86%.
However, if Reliant thinks this sale may lead to more profitable sales in Nevada,
then it may go ahead even if the probability of collection is less than 86%.
Relevant credit information includes a fair Dun and Bradstreet rating but some
indication of current trouble (i.e., other suppliers report Plumpton paying 30 days
slow) and indications of future trouble (a pending renegotiation of a term loan).
Financial ratios can be calculated and compared with those for the industry. Here
are some samples:

Total debt / total assets = 8 / 18.5 = .432

Net working capital / total assets = 7.2 / 18.5 = .389
Current ratio = 13.4 / 6.2 = 2.16
Quick ratio = 2.5 / 6.2 = .40
Sales / begin total assets = 55 / 18.7 = 2.94
Net income / sales = .6 / 55 = .01
COGS / begin inventory = 32.6 / 11.6 = 2.81
(After-tax interest + net income) / = [(.6 / 1.1)(.5) + .6] / 18.7 = .047
begin total assets
(After-tax interest + net income) / = [(.6 / 1.1)(.5) + .6] / 11.7 = .075
begin equity

Some things the credit manager should consider are:

i. What does the stock market seem to be saying about Plumpton?
ii. How critical is the term loan renewal? Can we get more information about
this from the bank or delay the credit decision until after renewal?
iii. Is there any way to make the debt more secure, e.g., use a promissory
note, time draft, or conditional sale?

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Chapter 30 - Working Capital Management

iv. Should Reliant seek to reduce risk, e.g., by a lower initial order or credit
insurance? How painful would default be to Reliant?
v. Are there better alternative means of entering the Nevada market? What is
the competition?

Est. Time: 16-20

33. a. For every $100 in current sales, Galenic has a cost of goods sold of $95,
resulting in a $5 profit, ignoring bad debts. If the bad debt ratio is 1%,
then per $100 sales the bad debts will be $1and actual profit will be $4,
which equates to a net profit margin of 4%.

b. Sales will fall to 91.6% of their previous level (9,160 / 10,000), or to

$91.60 per $100 of original sales. With a cost of goods sold ratio of 95%,
COGS will be $87.02. Bad debts will be: (60 / 9160) × $91.60 = $.60.
Therefore, the profit under the new scoring system, per $100 of original
sales, will be $3.98.

c. There are many reasons why the predicted and actual default rates may
differ. For example, the credit scoring system is based on historical data
and does not allow for changes in either the economy or customer
behavior. Also, the estimation process ignores data from loan
applications that have been rejected, which may lead to biases in the
credit scoring system. If a company overestimates the accuracy of the
credit scoring system, it will most likely reject too many applications.

d. If the credit scoring system includes a variable based on whether or not

the customer has an existing account, then the results are likely to be
biased unless the system considers the potential profit from new
customers who might generate repeat orders.

Est. Time: 16-20

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