© Carlos Correia: Solutions to Financial Management, 9e, 2019

Ch 12 Current Asset Management 19 December 2018

CHAPTER 12

CURRENT ASSET MANAGEMENT AND SHORT-TERM

FINANCING

Solutions

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-1
FACTORS IN CHANGING WORKING CAPITAL POLICY

The financial manager wishes to control inventory levels due to the costs of holding
inventory. This includes the direct purchase cost, storage and security costs, financing
costs, obsolescence costs, insurance etc. If the financial manager is efficient in controlling
the firm’s inventory levels, this will result in a reduction in the above costs. Further, as the
financial manager is reducing the asset base, it means that the firm’s return on assets will
also improve. The investment in inventory is a cash outflow, which does not result in a tax
deduction until such inventory is sold. If a financial manager is able to control inventory, it
will mean that the firm is required to be highly organised in relation to the firm’s
relationships with its suppliers, plant layout, and production planning. The employees do
not have the safety net of inventory and production will be disrupted if there is no inventory
or if inventory is not delivered to the firm on a JIT basis. However, it also means that the
firm’s employees are highly focused and more productive in the management of the
production process and will ensure that product quality is right the first time. Any problems
with production may result in disruptions, as there is not the safety net of inventory to hide
mistakes.

12-2
ACCOUNTS RECEIVABLE AND BAD DEBTS

In the management of accounts receivable the level of bad debts is not considered to be
the ultimate measure of success as an extremely low level of bad debts could reflect an
unnecessarily cautious approach to granting credit. Such an approach would not be in line
with shareholder wealth maximisation as the firm’s sales would be restricted lowering the
firm’s profitability.

Management would need to analyse the firm's average collection period and its aging
schedule in comparison with industry averages, recent trends and the firm’s credit terms to
see how effectively the credit department is managing accounts receivable. If the average
collection period is much longer than the terms of sale, and the aging schedule shows a
significant percentage of past due accounts, then the credit standards may be too low. In
such an instance management would encourage the credit manager to enforce the
standards closely or establish a collection policy which was less lax.

12-3
ACCOUNTS RECEIVABLE, INVENTORY AND SALES

Like accounts receivable, inventory levels depend a great deal on sales. However,
whereas an increase in sales leads to an increase to accounts receivable, an increase in
sales cannot take place unless there has been a previous increase in inventory levels.
Thus, it is often stated that an increase in accounts receivable is spontaneous while the
increase in inventory is planned. For such planning to take place it is necessary to
establish a sales forecast. Thus, in establishing an inventory policy, the nature of the
business and the environment in which it operates are critical.

For example, if there is an increase in demand and a company does not have inventory, it
will lose sales. The high economic growth rate in South Africa from 2003 caught some
manufacturers by surprise, without the necessary capacity and inventory levels to
adequately meet demand.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-4
ECONOMIC ORDER QUANTITY
The objective of inventory management is the balancing of a set of costs that increase with
larger inventory holdings with a set of costs that decrease with larger order sizes. The
financial manager is concerned with the level of inventory because of its effect on
profitability. Excessive inventory levels erode profit margins as they reduce the total asset
turnover ratio and involve substantial holding costs.

The EOQ model identifies that there are two types of costs associated with inventory. The
model calculates the order quantity that will give the lowest combined cost by examining
the relationship of holding costs and that of ordering costs.

The EOQ assumes that the usage rate, lead-time and annual demand are constant.
However, certain adjustments can be made to establish the costs of holding buffer
inventory and the implications for the economic order quantity. In such an instance some
allowance has been made for uncertainty by holding “safety stock”.

12-5
The adoption of Just-in-Time (JIT) inventory systems offers a firm many advantages. Yet
adoption may increase operational risks for the following reasons;
o Disruption in production due to temporary disruptions in the supply of
materials
o A small problem at any stage may result in a halt in production
o Re-pricing of insurance risk relating to business disruptions
o Use of sole suppliers for particular components will increase the risk of
disruptions if there are problems at the supplier. The whole production
process may come to a standstill due to non-delivery by a single component
supplier. This has occurred in the automotive industry.

12-6
Management should take advantage of cash discounts by borrowing funds when the
opportunity cost of the cash discounts foregone is in excess of the cost of short term
borrowings.

It must be remembered that trade credit can be split into two components, that which is
already costed into the price of the goods and that which has an opportunity cost
associated with it. Trade credit already costed and foregone would consist of the credit
received during the discount period. Costly trade credit would consist of credit taken in
excess of the trade credit period thereby foregoing the discount offered. In general the firm
should always use the component already costed in, but only use the costly component
after analysing the cost of the source of finance and comparing this to the cost of
alternative forms of finance.

12-7
FACTORING OF DEBTORS
Frequently accounts receivable settlement terms strain the liquidity requirements of a firm.
In such instances factoring can be useful as a means of utilising these accounts receivable
to generate cash flow. Further, outsourcing the collection of debtors to the factoring firm
may enable management to focus on their core competencies. Normally the factoring firm
would also handle the administration and the credit rating of the debtors. Hence factors
provide not only a source of funds but also provide a credit service for the borrower.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-8
EFFECTIVE RATE OF BANK INTEREST

As the interest is payable in advance, it is equivalent to the bank lending only R48000 on
which interest is charged at R2000 for a period of 120 days.

Annual Interest rate = Interest/Capital (prorated for days)

= 2000/48000 x 365/120
= 12.67%
This is how the interest rate is often quoted in practice.

However, the effective interest rate is calculated as follows;

Effective rate = [1+(discount/discounted value)](365/120)] - 1

The effective rate of interest is; [1 + (2000/48000)](365/120) -1 = 13.22%

12-9
COST OF FOREGOING DISCOUNTS

a) Cost as annual rate = 2/98 x 365/20 = 37.24%

b) Cost as annual rate = 3/97 x 365/20 = 56.54%

c) Cost as annual rate = 3/97 x 365/50 = 22.58%

d) Cost as annual rate = 3/97 x 365/110 = 10.26%

The nominal and effective interest rate (cost) is as follows;

Discount Effective
Terms Discount Net Cost
period rate

a) 2/10, net 30 0.02 10 30 37.24% 45%

b) 3/10, net 30 0.03 10 30 56.44% 74%
c) 3/10, net 60 0.03 10 60 22.58% 25%
d) 3/10, net 120 0.03 10 120 10.26% 11%

Example of workings:

(a) Effective rate = (1+(0.02/0.98))(365/(30-10)))-1 = 45%

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-10
HEXCO LTD

a Determination of the average accounts payable balance

Average accounts payable = Credit purchases x acc payable conv time

Accounts payable if conversion time = 38 days 38

78,000,000 x = 8,120,548
365

b Accounts payable if conversion time = 45 days 45

78,000,000 x = 9,616,438
365

Increase in accounts payable balance 1,495,890

c Current Policy Proposed Policy

Inventory Conversion
Time (days) 100 100

Accounts Receivable Conversion

Time (days) 65 65
165 165
Less: Accts Payable Conversion
Time (days) -38 -45
Average Cash Cycle (days) 127 120

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-11
Moroka Ltd

a) EOQ = Ö2FS/C = Ö(2 x 36 000 x R120)/ R24

= ÖR8 640 000 / R24 = Ö360 000 = 600 units

b) 36 000/600 units = 60 orders

c) EOQ/2 = 600/2 = 300 units (average inventory)

Alternative spreadsheet approach of computing the total cost

Order size 240 480 600 800 1000

Number of orders 150 75 60 45 36

Ordering costs 18,000 9,000 7,200 5,400 4,320

Average inventory 120 240 300 400 500

Carrying costs 2,880 5,760 7,200 9,600 12,000

Total Costs 20,880 14,760 14,400 15,000 16,320

EOQ 0 0 600 0 0

Inventory: Economic Order Quantity

25,000
Ordering
Carrying
20,000
Total Costs

15,000

10,000

5,000

-
240 480 600 800 1000

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-12

é 2 FS ù
EOQ = ê ú
ë C û
2 x 400 x 200,000 0.5
EOQ Formula =
10.00

160,000,000 0.5
=
10.00

EOQ = 4,000
Number of orders 50 [Sales / EOQ]
Average Inventory 2,000 [EOQ / 2]

Note: The instructor is required to indicate that the annual sales (units) are 200 000 units. [This applies to 1st
impression of the 7th edition only]

12-13

Sales for the year 72,000,000

Accounts receivable 13,200,000

What is the company's average collection period?

72,000,000
Average daily sales = = 197,260.27
365

13,200,000
Average collection period = = 67
197,260.27
[Days sales outstanding]

Alternative method

Accounts receivable to Sales 13,200,000

= 0.18
72,000,000

Average collection period = 0.18 x 365.00 = 67 days

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-14

Sales turnover 180,000,000

Sales to inventory ratio 3.6

What is the company's inventory level?

Inventory
180,000,000
Investment in Inventory = = 50,000,000
3.60

New inventory level = 25,000,000

Cash Flow 25,000,000

The amount of cash flow that will be released is from JIT is 25,000,000

As the investment in inventory is not tax deductible, any savings will be after-tax.

The other benefits from changing to JIT, and which has not been quantified are as follows;

Reduction in financing costs

Reduction in inventory obsolescence
Improvement in the quality of inputs and materials used in the production process.
Reduction in insurance and storage and security costs
Preventative maintenance to ensure continuous production
Closer relationships with suppliers
Increase in the return on assets

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-15
Fixed cost per order 600.00
Cost 220.00
é 2 FS ù
EOQ = ê ú Usage 2,000
ë C û Carrying cost 100.00
No. of days per yr 240
No. of days for order 4.00

EOQ Formula = 2 x 600 x 2,000 0.5

100.00

= 2,400,000 0.5
100.00

EOQ = 154.9
Number of orders 13 [Sales / EOQ] `
Average Inventory 77.46 [EOQ / 2]

Average daily usage 8.33

Daily Days for

usage order
Re-order point 8.33 x 4.00 = 33.33 tons

No. of tons Cost p/ton

Value of average inventory in store: 77.46 x 220.00 = 17,041

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-16
Mayall Steel
Fixed cost per order 10,000.00
Cost 8.00
é 2 FS ù
EOQ = ê ú Usage 1,200,000
ë C û Carrying cost 2.00
No. of days per yr 365

EOQ Formula = 2 x 10,000 x 1,200,000 0.5

2.00

= 24,000,000,000 0.5
2.00

EOQ = 109,544.5
Number of orders 11 [Sales / EOQ] [rounded off to closest order]
Average Inventory 54,772.26 [EOQ / 2]

Average daily usage 3,287.67

No. of tons Cost p/ton R

Value of average inventory in store: 54,772.26 x 8.00 = 438,178

Total Cost Carrying cost Avg inventory

Total carrying cost for the year 2.00 x 54,772.26 = 109,545
Cost per order No. of orders
Total ordering costs for the year 10,000.00 x 11.00 = 110,000

219,545
Check
Let's assume that the company doesn't order at its EOQ and the company orders 200000 at a time.
The average inventory will therefore be 100000 The number of orders will be 6
This will result in the following total cost R
Total carrying cost for the year 2.00 x 100,000 = 200,000
Total ordering costs for the year 10,000.00 x 6.00 = 60,000
Total Cost 260,000
Therefore the total cost is higher than if the company orders at the EOQ

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-17

Natural Styles
Rm Rm
Current assets Current assets
Cash 4.2 Cash 4,200,000
Accounts receivable 9.6 Accounts receivable 9,600,000
Inventory 15.4 Inventory 15,400,000

Current liabilities Current liabilities

Accounts payable 13.5 Accounts payable 13,500,000

Sales 144,000,000
Cost of Sales 54,720,000
Working capital cycle

Accounts Receivable 15 Goods conversion 127.06

Average daily sales 394,521 Cash conversion 37.01
Debtors days sales 24.33
Working Capital Cycle
Inventory Inventory 102.72
Average daily cost of sales 149,917.81 Accounts receivable 24.33
Days inventory 102.72 Operating cycle 127.06
Accounts payable - 90.05
Accounts Payable Cash conversion cycle 37.01
Average daily purchases 149,917.81
Days creditors 90.05

2.
Cost of trade credit
Discount 0.025
1-discount 0.975
(365/(90-10))
[(1+2.5/97.5) -1]
Effective rate 12.245%

Effective cost of bank finance 0.096

Monthly rate 0.008
12
(1+0.08) -1
Effective rate 10.034%

3.
The effect on the operating cycle is nil. The effect on the cash conversion cycle is as follows:
Accounts payable 13,500,000 1.00
No. of days Days creditors
Payment on 10th day 2,700,000 0.20 10.00 2.00
Payment on 90 days 10,800,000 0.80 90.05 72.04
74.04

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-18

Current sales (units) 600 Price 900

New sales (units) 700 Cost per pack 360
Increase in sales 100 Cost of finance pm 1%

30 60 90 120

Lost sales - 540,000 - 540,000

Increase in contribution 54,000 54,000
Increase in variable cost - 36,000 - 36,000
Value of increase in contribution 5,400,000
- 576,000 - 576,000 5,454,000

NPV 4,200,238

Conclusion: The firm should offer trade credit to its customers.

Note:
We have assumed that sales revenue are received at the end of each month.
We are standing on day one of the month and last month's sales have been received.
We will not receive cash until the end of the 3rd month.
Sales that would normally be received at the end of the current month, will now be received at the end of 90 days.
That is, 60 days later. Note that we have had to make simplifying assumptions to work in units of months.
The value of the contribution is from the receipts due at the end of 120 days (the 4th month).
Ofcourse, the firm will receive the "lost sales" but at an indefinite time in the future.
If the firm continues to exist, then this will occur in the very distant future and we have assumed the PV to be zero.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-19
PREPAK LTD
Additional sales 24,000,000 tax rate 28%
Bad accounts (12% of new sales) 12% WACC 10%
Production & selling costs to sales 72% Rec. T/O 6
Additional collection costs 2,100,000
R

Added sales 24,000,000

Bad accounts (12% of new sales) 12% -2,880,000
Annual incremental revenue 21,120,000
Collection costs -2,100,000
Production & selling costs (72% of new sales) 72% -17,280,000
Annual income before taxes 1,740,000
Tax 28% -487,200
Incremental income after taxes 1,252,800

Receivables turnover = 6

24,000,000 in new
Investment in accounts receivable = = 4,000,000
6 receivables

1,252,800
Return on incremental investment = = 31.32%
4,000,000
Yes, the company should extend credit to these customers
The return exceeds the company's cost of capital.

What would happen if the bad debts amounted to 14% of sales? [not required in terms of the
question]
R
Added sales 24,000,000
Bad accounts (14% of new sales) 14% -3,360,000
Annual incremental revenue 20,640,000
Collection costs -2,100,000

Production & selling costs (72% of new sales) 72% -17,280,000

Annual income before taxes 1,260,000
Tax 28% -352,800
Incremental income after taxes 907,200

907,200
Return on incremental investment = = 22.68%
4,000,000

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-20
July August September October November December
Rm Rm Rm Rm Rm Rm

Cash Sales 4.0 5.0 6.0 6.0 4.0 2.0

Credit Sales (net 60 days) 7.0 8.0 10.0 15.0 10.0 6.0

Cash Expenses 3.0 4.0 4.0 5.0 2.0 2.0

Credit Purchases (net 30 days) 7.0 10.0 12.0 10.0 9.0 5.0

July Aug Sept Oct Nov Dec

Cash Sales 4.0 5.0 6.0 6.0 4.0 2.0
Debtors Collections 5.0 5.0 7.0 8.0 10.0 15.0
Total Cash Received 9.0 10.0 13.0 14.0 14.0 17.0

Cash Expenses 3.0 4.0 4.0 5.0 2.0 2.0

Creditor Payments 5.0 7.0 10.0 12.0 10.0 9.0
Total Cash Payments 8.0 11.0 14.0 17.0 12.0 11.0

Net Cash Flow 1.0 -1.0 -1.0 -3.0 2.0 6.0

Beginning Cash 5.0 6.0 5.0 4.0 1.0 3.0
Ending Cash 6.0 5.0 4.0 1.0 3.0 9.0
Minimum Cash -8.0 -8.0 -8.0 -8.0 -8.0 -8.0
Excess Cash (Cumulative Borrowings) -2.0 -3.0 -4.0 -7.0 -5.0 1.0

Note: Accounts receivable at the end of June is 10 m

Note: Credit purchases in June was 5m

The maximum borrowing will be for R7m at the end of October.

This seems to suggest the need for short-term seasonal financing since the loan can be repaid by the end
of December.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

 © Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-21
TUBATSE STEEL
a)

Cost per unit 200 Ordering cost 2,000

No. of units per year 10,000
Inventory cost (% of avg inventory) 25%

Average
No. of orders Order size Carrying cost Ordering cost Total Cost
Inventory
1 10,000 1,000,000 250,000 2,000 252,000
5 2,000 200,000 50,000 10,000 60,000
10 1,000 100,000 25,000 20,000 45,000
15 667 66,667 16,667 30,000 46,667
18 556 55,556 13,889 36,000 49,889
20 500 50,000 12,500 40,000 52,500
25 400 40,000 10,000 50,000 60,000
30 333 33,333 8,333 60,000 68,333
35 286 28,571 7,143 70,000 77,143
40 250 25,000 6,250 80,000 86,250
45 222 22,222 5,556 90,000 95,556
50 200 20,000 5,000 100,000 105,000
[Note: Gray = not required in terms of the question but used to produce the EOQ diagram].

(b)

EOQ
275,000

250,000

225,000

200,000

175,000

150,000
Carrying cost
125,000 Ordering cost
Total cost
100,000
EOQ = between
667 and 1000 but
closer to 1000 75,000

50,000

25,000

-
10,000 2,000 1,000 667 556 500 400 333 286 250 222 200
Order Size

c) EOQ = Ö(2 x 10 000 x R2000) / (R200 x .25)

= Ö(R40 000 000 / 50)

= ÖR800 000
= 894 units

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-22
CMS LIMITED

a
Gross Profit -2 000 000 25% -500 000

Cost of carrying accounts receivable Note

Remaining customers 1 -600 000 [((18-30) x 18m)/no. of days in year]
Past customers 2 -125 000
Decrease in level of investment in acc rec -725 000

Decrease in opportunity cost -725 000 12% -87 000

Bad Debts
Non-discount
Sales Bad debt % Bad debts
sales
Bad debt losses under existing policy 20 000 000 50% 3% 300 000
Bad debt losses under new policy 18 000 000 40% 2% 144 000
Net decrease in bad debts 156 000

Cost of Discounts
Cash discount under existing policy 20 000 000 50% 2% 200 000
Cash discount under new policy 18 000 000 60% 3% 324 000
-124 000

Change in Net Profit from change in Policy

Change in gross profit -500 000
Decrease in cost of financing accounts receivable 87 000
Decrease in bad debts 156 000
Change in cost of discount -124 000
Change in profitability from change in policy -381 000
Note
Customers w ho have remained and have reduced their average payment from 30 days to 18 days. We now receive
1
the total sales value in cash earlier.
Customers w ho have left represent a saving in investment equal to the cost of such a sale. The investment of a lost
2
sale is the cost of such sale. The loss of profitability is determined elsew here.

b Effective cost of trade creditor finance

Cost = [Discount%/(1- discount %)] x [no. of days in year/no. of days extension]
5% 360
x = 37.9%
95% 50

In terms of the question, in the above solution we have used 360 days in a year.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-22 (continued)
CMS LIMITED

If we used 365 days in the year, then the solution would be as follows;

a
Gross Profit -2 000 000 25% -500 000

Cost of carrying accounts receivable Note

Remaining customers 1 -591 781 [((18-30) x 18m)/no. of days in year]
Past customers 2 -123 288
Decrease in level of investment in acc rec -715 068

Decrease in opportunity cost -715 068 12% -85 808

Bad Debts
Non-discount
Sales Bad debt % Bad debts
sales
Bad debt losses under existing policy 20 000 000 50% 3% 300 000
Bad debt losses under new policy 18 000 000 40% 2% 144 000
Net decrease in bad debts 156 000

Cost of Discounts
Cash discount under existing policy 20 000 000 50% 2% 200 000
Cash discount under new policy 18 000 000 60% 3% 324 000
-124 000

Change in Net Profit from change in Policy

Change in gross profit -500 000
Decrease in cost of financing accounts receivable 85 808
Decrease in bad debts 156 000
Change in cost of discount -124 000
Change in profitability from change in policy -382 192
Note
Customers w ho have remained and have reduced their average payment from 30 days to 18 days. We now receive
1
the total sales value in cash earlier.
Customers w ho have left represent a saving in investment equal to the cost of such a sale. The investment of a lost
2
sale is the cost of such sale. The loss of profitability is determined elsew here.

b Effective cost of trade creditor finance

Cost = [Discount%/(1- discount %)] x [no. of days in year/no. of days extension]
5% 365
x = 38.4%
95% 50

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-23
Wetpak
1/n Discount % Net
Current sales 15,000,000 Credit terms - old 15 1% 45
New sales 17,000,000 Credit terms - new 10 2% 30
Gross profit margin 20% Bad debt losses - old 10% of non-discount sales
Opportunity cost 10% Bad debt losses - new 2% Unit sales-old 15,000
% of customers taking discount - old 20% Unit sales-new 17,000
% of customers taking discount - new 70% Ordering cost per order 200
Carrying cost per unit 5.00
Determination of Average Collection Period (ACP)
Old Policy New Policy
No. of days % ACP No. of days % ACP
Discount sales 15 x 20% = 3.0 10 x 70% = 7.0
Non-discount sales (less bd) 45 x 72% = 32.4 30 x 28% = 8.4
35.4 15.4
This is a reduction of 20 days

Note
The bad debts for the old policy is stated as 10% of non-discount sales which is 10% x 80% = 8% of credit sales.
The bad debts for the new policy is stated as 2% of credit sales.
We have excluded the bad debts from the collection period as we will never collect these debtors.
Impact on Profit
Change in gross profit 2,000,000 x 20% = 400,000

Change in cash discount

Old policy 1% x 15,000,000 x 20% = 30,000
New policy 2% x 17,000,000 x 70% = 238,000
-208,000

Change in bad debts

Old policy 10% x 15,000,000 x 80% = 1,200,000
New policy 2% x 17,000,000 x 100% = 340,000
860,000
Opportunity cost of debtors
No. days Sales No. days per yr Total
Reduction in debtors -20 x 15,000,000 / 360 = -833,333
[1 - GP%] No. days (new) Sales No. days per yr
Increase in debtors (variable cost)80% x 15.4 x 2,000,000 / 360 = 68,444
-764,889

Saving in the cost of financing debtors x -10% 76,489

Note: This is a reduction in the cost of financing debtors which results in a positive effect on profit.

Change in inventory holding and ordering costs

0.5
a b c d (a x b x c x d)
Old EOQ 2 x 15,000,000 x 200 x 5 = 173,205
New EOQ 2 x 17,000,000 x 200 x 5 = 184,391
-11,186

Determination of change in profit

Increase in gross profit 400,000
Increase in cash discount -208,000
Reduction in bad debts 860,000
Reduction in the opportunity cost of debtors 76,489
Increase in inventory holding and ordering costs -11,186
Total 1,117,303

On this basis Wetpak Limited should implement the new policy.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.24

Conserve
Price 110 Interest rate per mth 1%
Cost per unit 70
Sales - new 4 000
Sales - old 3 500
Assumption: Sales for March, due at end of March, to be received in 60 days time.
0 1 2
31-Mar 30-Apr 31-May

Lost sales receipts (385 000) (385 000)

Variable costs - incremental (35 000) (35 000)
Incremental contribution - May 20 000
PV of incremental contribution 2 000 000
(420 000) (420 000) 2 020 000
PV factor 1.0000 0.9901 0.9803
Present value (420 000) (415 842) 1 980 206
NPV 1 144 364

Using Excel NPV 1 144 356

The NPV analysis is based on the premise that the incremental contribution will continue indefinitely
into the future.
On this basis, the company should offer sales on credit.
We value the incremental perpetuity of (4000-3500) x (110-70) from 30 June onwards.
The incremental contribution receivable at the end of May is included in the cash flow for May.

Value of perpetuity commencing 30 June = [(4000-3500) x (110-70)]/0.01 = 2000 000

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.25
Pabala Ltd

Cash Budget
Actual Actual Forecast Forecast Forecast Forecast
August September October November December January
Sales 1 850 000 2 400 000 4 500 000 1 800 000 -

Sales cash inflows

Cash 10% 240 000 450 000 180 000 -
1 month 88% 1 628 000 2 112 000 3 960 000 1 584 000
2 months 0% - - - -
Total cash inflows 1 868 000 2 562 000 4 140 000 1 584 000

Forecast Forecast Forecast Forecast

September October November December January
Purchases - 1 440 000 - 2 700 000 - 1 080 000 - 900 000 -

Cash outflows
Purchases - - 1 440 000 - 2 700 000 - 1 080 000 - 900 000
Staffing - 220 000 - 250 000 - 200 000 -
Selling & Administrative - 180 000 - 240 000 - 150 000 -
Interest rate p.a. No. of mths Rate per mth - 1 840 000 - 3 190 000 - 1 430 000 - 900 000
Interest 12.00% 12 1.0% - 2 300 - 2 043 - 8 343 18 673
Total cash outflows - 1 842 300 - 3 192 043 - 1 438 343 - 881 327

Forecast Forecast Forecast Forecast

October November December January
Total cash inflows 1 868 000 2 562 000 4 140 000 1 584 000
Total cash outflows - 1 842 300 - 3 192 043 - 1 438 343 - 881 327
Net Cash Flow 25 700 - 630 043 2 701 657 702 673
Opening bank balance - 230 000 - 204 300 - 834 343 1 867 314
Closing bank balance - 230 000 - 204 300 - 834 343 1 867 314 2 569 987

Note: We have assumed that the firm will be able to invest at the same rate i.e. 12.0% per year

Cash Budget - closing bank balance

3 000 000
2 569 987

2 500 000

1 867 314
2 000 000

1 500 000

1 000 000

500 000

-
-204 300
-500 000

-1 000 000 -834 343

October November December January

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.26
Amount of Bank Bill 400,000
Term of Bill (days) 180
Number of days in year 365
Discounted value 392,000

As this is a discount yield, the interest rate implied by the discount is determined as follows:

Interest rate = [(Bank Bill - Discounted value)/Discounted value] x (No. of days in year/No. of days of bill)

Interest rate per year 365

2.04% x = 4.14%
180

The effective rate is determined as follows:

(365/180)
Effective rate = [1+(discount/discounted value)] ]-1

2.02777778
Effective rate = 102.04% = 104.18% -1 = 4.18%

12.27
Face Value of Bill 1,000,000
Term of Bill (days) 90
Number of days in year 365 Solution
Discount yield per year 6% Discounted value 985,421

The discounted value is determined as follows:

PV = F/(1+R(N/365))

Face Value of Bill F 1,000,000

R 6%
N 90
Discounted value = 985,421

Check by determining the interest rate from the discounted value (not required)
Interest rate = [(Bank Bill - Discounted value)/Discounted value] x (No. of days in year/No. of days of bill)

Interest rate per year 365

1.48% x = 6.00%
90

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.28
1/n Discount % Net
Current sales 170 Credit terms - old 10 2% 60
Cost of Sales 136 Credit terms - new 10 3% 30
New sales 136 % fall in sales 20%
Gross profit margin 20% Bad debt losses old 3%
Opportunity cost 12% Bad debt losses new 2%
% of customers taking discount - old 50%
% of customers taking discount - new 60%

Determination of Average Collection Period (ACP)

Old Policy New Policy
No. of days % ACP No. of days % ACP
Discount sales 10 x 50% = 5.0 10 x 60% = 6.0
Non-discount sales (less bd) 60 x 47% = 28.2 30 x 38% = 11.4
33.2 17.4
This is a reduction of 15.8 days
Note
The bad debts for the old policy is stated as 3% of credit sales.
The bad debts for the new policy is stated as 2% of credit sales.
We have excluded the bad debts from the collection period as we will never collect these debtors.
Impact on Profit Rm
Sales % fall in sales Change in sales GP%
Change in gross profit 170 x 20% = -34 x 20% = -6.800
Change in cash discount
Old policy 2% x 170 x 50% = 1.700
New policy 3% x 136 x 60% = 2.448
-0.748
Change in bad debts
Old policy 3% x 170 x 100% = 5.100
New policy 2% x 136 x 100% = 2.720
2.380
Opportunity cost of debtors
No. days Sales No. days per yr Total
Reduction in debtors -15.8 x 136 / 360 = -5.969
[1 - GP%] No. days Change in Sales No. days per yr
Change in debtors (variable cost) 80% x 33.2 x -34 / 360 = -2.508
-8.477

Saving in the cost of financing debtors x -12% 1.017

Note: This is a reduction in the cost of financing debtors which results in a positive effect on profit.

Determination of change in profit Rm

Increase in gross profit -6.800
Increase in cash discount -0.748
Reduction in bad debts 2.380
Reduction in the opportunity cost of debtors 1.017
Total -4.151
On this basis, NDD should not change to the new policy.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.29
Net
Discount - old 2% 30 General & Admin costs - % of sales 20%
Discount - new 3% 45 Tax rate 28%
Discount if pmt within 15 Interest rate 10%
No. of days in a year 360
% of customers taking discount - old 60%
% of customers taking discount - new 60%
Ordering cost 200 Carrying cost 20% x 70.00 = 14.00
Cost per unit 70 Selling price per unit 100
Annual sales (units) 10,000 Increase in sales (units) 4,000
Gross profit % 30%

(a )
Average collection period (ACP)

No. of days % ACP

Discount sales 15 x 60% = 9.0
Non-discount sales 30 x 40% = 12.0
21.0 days
Accounts receivable
Annual sales 10,000 x 100 = 1,000,000
Average daily sales 1,000,000 / 360 = 2,778

Accounts receivable 2,778 x 21.0 = 58,333

(b )
New Average collection period (ACP)

No. of days % ACP

Discount sales 15 x 60% = 9.0
Non-discount sales 45 x 40% = 18.0
27.0 days

Increase in sales 400,000 / 360 = 1,111 per day

Additional accounts receivable
6.0 x 2,778 = 16,667
New sales Acc Rec 70% x 27.0 x 1,111 = 21,000
37,667
(c )
Average inventory level under old policy
é 2 FS ù
EOQ = ê ú
ë C û

EOQ Formula = 2 x 200 x 10,000 0.5

14
= 4,000,000 0.5
14.00

EOQ = 535 units

Units Value
Average inventory level (monetary value) 535 / 2 = 267.5 x 70.00 = 18,725

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.29 (continued)

(d )
New credit policy
EOQ Formula = 2 x 14,000 x 200 0.5
14
= 5,600,000 0.5
14.00
EOQ = 632 units
Units Value
Average inventory level (monetary value) 632 / 2 = 316 x 70.00 = 22,120
-18,725
Change in average inventory 3,395

(e )
Old New
Gross Sales 1,000,000 1,400,000
Less: discount -12,000 -25,200 [Sales x %sales subject to discount x discount%]
Net Sales 988,000 1,374,800
Less: Cost of goods sold -700,000 -980,000
288,000 394,800
Gen.admin & selling exp. -200,000 -280,000
88,000 114,800
Interest * -4,106
88,000 110,694
Tax 28% -24,640 -30,994
Earnings after tax & interest 63,360 79,700

*Interest
Additional investment
Accounts receivable 37,667
Inventory 3,395
Total - 41,062

Interest x 10% 4,106

* The question indicates only that any new investment in accounts receivable & inventory will be financed at an interest rate
of 10%. We therefore have only applied the interest rate to the incremental investment in accounts receivable and
inventory. Current investment in accounts receivable and inventory is assumed to be invested with equity.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.30
Year 1 Year 2 Year 3
R000 R000 R000

Inventory Raw materials 10,800 14,580 18,000

Work-in-progress 7,560 9,720 9,336
Finished goods 8,640 12,960 14,288

Purchases 66,800 91,260 93,464

Cost of goods sold 64,800 81,000 89,100
Sales 86,400 108,000 118,800
Debtors 17,280 25,920 29,700
Trade creditors 8,640 10,530 12,600

Implications of credit control change R000

Change in sales 118,800 25% -29,700
Change in cost of sales 89,100 25% 22,275
Change in gross profit -7,425
Extra credit control cost -1,000
Reduction in bad debts 3,000
Change in annual cash flow -5,425

Saving in working capital investment

In the last 2 years, closing inventory has equaled 35% of sales.
If sales fall, then the investment in inventory and debtors is expected to fall by the same %.

Inventory
Reduction in Inventory (RM + WIP + FG) 41,624 25% 10,406

Debtors (accounts receivable)

Expected new level of sales 118,800 75% 89,100
New sales Days per year Daily sales
Average daily sales 89,100 365 244
Days sales
Expected accounts receivable 244 60 14,647
Current investment in accounts receivable 29,700
Reduction in debtors 15,053

Trade creditors (accounts payable)

Accounts payable to Purchases 12.93% 11.54% 13.48%
Expected new level of purchases 93,464 75% 70,098
Expected level of accounts payable 70,098 13.48% 9,449
Current level of accounts payable 12,600
Reduction in financing from creditors -3,151
R000
Present value of perpetuity -5,425 12% -45,208
Saving in net working capital Inventory 10,406
Debtors 15,053
Creditors -3,151
-22,900

The proposed change in credit control is not financially beneficial to the firm.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.31
If order => Discount
Fixed cost per order 1 000.00 0 0.00
100 5.00
Annual demand 5 000 500 10.00
Carrying cost 100.00 2000 20.00
What is the EOQ?
é 2 FS ù
EOQ = ê ú
ë C û

EOQ Formula = 2 x 1 000 x 5 000 0.5

100

= 10 000 000 0.5

100.00

EOQ = 316

No. of orders
Number of orders 5000 / 316 = 15.82
Number of orders 5000 / 500 = 10.00
Number of orders 5000 / 2000 = 2.50
Avg Inventory
Average inventory 316 / 2 = 158.00
Average inventory 500 / 2 = 250.00
Average inventory 2000 / 2 = 1000.00

Discount break points 500

2000
UNITS
Inventory Costs 316 500 2000
Ordering 15 823 10 000 2 500
Carrying 15 800 25 000 100 000
Opportunity cost (discount) 75 000 50 000 -
106 623 85 000 102 500

The economic order quantity is 316 without taking into account the additional expense of the foregone
discount. When the discount is taken into account the economic order size increases to 500 units as
the increased discount more than offsets the additional holding costs. This situation is reversed if the
order size is increased to 2 000 units i.e. the incremental cost of holding is greater than the additional
discounts. Any order quantity between 316, 500 and 2 000 units will be sub-optimal as there will be
additional holding costs at the same level of discount.
Note on determining the Opportunity Cost
What do we lose when we order 2000, 500 or 316 units at a time. Remember that we will be ordering
a total quantity of 5000 over the year. If we order 2000 units at a time, we lose nothing as we would
receive the discount of R20.00 per unit anyway. If we order 500 at a time, we lose the discount of R20
per unit but we receive R10 per unit. This means that the cost per unit increases by R10 per unit and
the opportunity cost is 5000 x R10 = R50000. If we order 316 at a time, we lose a discount of R20 per
unit and receive a discount of R5 per unit. The opportunity cost is equal to 5000 x R15 = R75000.

Note also that we have assumed orders of part- units, which is fine if we are assuming roll-overs into
the following year. We could round up to full orders so 15.82 orders becomes 16 orders and 2.5 orders
becomes 3 orders. However this means that the quantity ordered will no longer be at the EOQ.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.32
a) Gross Profit 10,000,000 20% 2,000,000
Cost of carrying accounts receivable Note
Existing customers 1 -342,466
New customers 2 383,562
Increase in level of investment in acc rec 41,096
Increase in opportunity cost 41,096 10% 4,110

Bad Debts Sales % Credit Sales Bad debt % Bad debts

Bad debt losses under existing policy 50,000,000 100% 2% 1,000,000
Bad debt losses under new policy 60,000,000 100% 3% 1,800,000
Net increase in bad debts -800,000

Cost of Discounts
Cash discount under existing policy 50,000,000 50% 1% 250,000
Cash discount under new policy 60,000,000 70% 2% 840,000
-590,000
Change in Net Profit from change in Policy
Change in gross profit 2,000,000
increase in cost of financing accounts receivable -4,110
increase in bad debts -800,000
Change in cost of discount -590,000
Change in profitability from change in policy 605,890
Notes
Note 1 - Existing customers Annual sales Average daily sales
Average daily sales 50,000,000 365 136,986
Increase in DSO
Avg daily sales x Incr. in Day Sales Outstanding 136,986 -2.5 -342,466
Note 2 - New customers Increase in sales Increase in daily sales
Incremental sales per day 10,000,000 365 27,397
DSO
Increase in debtors from incremental sales 27,397 17.50 479,452
Variable cost %
Incremental investment 479,452 0.80 383,562
Change in Average Collection Period
Old Collection Period
Customers taking the discount 10 50% 5
Customers not taking the discount 30 50% 15
20
New Collection Period
Customers taking the discount 10 70% 7
Customers not taking the discount 35 30% 10.5
17.5

Increase in Average collection period (Days sales outstanding) -2.5

Increase in Average collection period (Days sales outstanding) 0

Note: We have taken into account gross sales in determing the Days Sales Outstanding. It is argued that the bad debts percentage should be
excluded from DSO, as these represent sales that are effectively not there. We have taken the view in this case that the company will need to
finance the full balance of debtors and any change in the bad debt ratio will also mean a change in the cost of financing debtors. In any case, we
will need to finance the cost of such sales and any difference will tend to be immaterial. However, we do see firms adopting either approach.

(b) Effective cost of trade credit Days to pmt 45

Discount period 10
Amount 100 Period (no. of days) 35
Discount 3 Annual 365
Nominal Discount Net
100 3 97
3 365
Cost = x = 32.25%
97 35

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.33
a Gross Profit 5,000,000 25% 1,250,000
Cost of carrying accounts receivable Note
Existing customers 1 438,356
New customers 2 308,219
Increase in level of investment in acc rec 746,575
Increase in opportunity cost 746,575 12% 89,589
Bad Debts Sales % Credit Sales Bad debt % Bad debts
Bad debt losses under existing policy 20,000,000 100% 2% 400,000
Bad debt losses under new policy 25,000,000 100% 2% 500,000
Net increase in bad debts -100,000

Cost of Discounts
Cash discount under existing policy 20,000,000 40% 1% 80,000
Cash discount under new policy 25,000,000 50% 3% 375,000
-295,000
Change in Net Profit from change in Policy
Change in gross profit 1,250,000
increase in cost of financing accounts receivable -89,589
increase in bad debts -100,000
Change in cost of discount -295,000
Change in inventory holding & ordering costs -23,607
Change in profitability from change in policy 741,804

Total Cost at the EOQ= [2 x cost of placing an order x annual unit sales x carrying cost of one unit for one year] (0.5)
2x Cost per order Annual unit sales Carrying cost Total Total Cost
a b c d axbxcxd=e e0.5
Total cost at old EOQ 2 10,000 20,000 100 40,000,000,000 200,000.00
Total cost at new EOQ 2 10,000 25,000 100 50,000,000,000 223,606.80
Change in total cost at the EOQ 23,606.80

Notes
Note 1 - Existing customers Annual sales Average daily sales
Average daily sales 20,000,000 365 54,795
Increase in DSO
Avg daily sales x Incr. in Day Sales Outstanding 54,795 8.0 438,356

Note 2 - New customers Increase in sales Increase in daily sales

Incremental sales per day 5,000,000 365 13,699
DSO
Increase in debtors from incremental sales 13,699 30 410,959
Variable cost %
Incremental investment 410,959 0.75 308,219
Change in Average Collection Period
Old Collection Period
Customers taking the discount 10 40% 4
Customers not taking the discount 30 60% 18
22
New Collection Period
Customers taking the discount 10 50% 5
Customers not taking the discount 50 50% 25
30
Increase in Average collection period (Days sales outstanding) 8

Note: We have taken into account gross sales in determing the Days Sales Outstanding. It is sometimes argued that the bad debts
percentage should be excluded from DSO, as these represent sales that are effectively not there. We have taken the view that the company
will need to finance the full balance of debtors and any change in the bad debt ratio will also mean a change in the cost of financing debtors.
In any case, we will need to finance the cost of such sales and any difference will tend to be immaterial.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12.33 (continued)

b Additional Factors
If there is only a 10% increases in customers taking advantage of the cash discount, most of the increased sales (25%) must be as a result of
the increased credit terms. Hence the might be able to achieved the desired results with a lower cash discount rate ie say 2%.

Will the credit department be able to handle the additional credit transactions?
Does the company have an existing capacity which is sufficient to handle increased sales?
How accurate are the forecasts?
Will the company not need to spend additional funds on marketing to attract the new clients away from competitors.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-34
a) Average collection period = 25 days.
Average collection period for small customers: 0.25(10) + 0.75(30) = 25 days.
0,80 (x) + 0,20 (25) = 25
0.80x = 20
x = 25 days

Alternative 1
Increase in before-tax profit 8,000,000 25% 2,000,000
[Gross profit = 25/100]
Less: Increase in bad debts
Large customers 2,000,000 2% -40,000
Small customers 6,000,000 5% -300,000
Add: discounts no longer taken
Large customers 80,000,000 10% 2% 160,000
Small customers 20,000,000 5% 2% 20,000
Less: cost of increased investment in accounts receivable [see workings] -572,222
Net increase in before-tax profit 1,267,778
Workings
New average collection period (on old sales)
Large 40% 10 4
Large 60% 60 36
40

Small 20% 10 2
Small 80% 60 48
50
Increase in investment in current accounts receivable
LARGE
Large - new 40
Large - existing -25
Change in days sales 15 No. of days
80,000,000
Average sales = 222,222 15 3,333,333
360

SMALL
Small - new 50
Small - existing -25
Change in days sales 25

20,000,000
Average sales = 55,556 25 1,388,889
360
Increase in investment in current accounts receivable due to new sales
[None of the incremental sales will be subject to discount, therefore = 60 days]
[We will only take the increase in costs required to achieve these sales]
Sales x (1-GP%) 8,000,000 75% 6,000,000
6,000,000
Average investment = 16,667 60 1,000,000
360
Total investment 5,722,222
Cost 10% 572,222

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-34 (continued)

Alternative2
Increase in before-tax profit 12,000,000 25% 3,000,000
[Gross profit = 25/100]
Less: Increase in bad debts
Large customers 6,000,000 2% -120,000
Small customers 6,000,000 5% -300,000
Add: increase in discounts
Large customers 80,000,000 50% 1% -400,000
Small customers 20,000,000 25% 1% -50,000
Large customers 80,000,000 20% 3% -480,000
Small customers 20,000,000 5% 3% -30,000
Large customers 6,000,000 70% 3% -126,000
Small customers 6,000,000 30% 3% -54,000
Less: cost of increased investment in accounts receivable [see workings] -198,611
Net increase in before-tax profit 1,241,389
Newtron should select Alternative 1, that is, change its terms to 2/10, net 60.
Workings
New average collection period (on old sales)
Large 70% 10 7
Large 30% 60 18
25
Small 30% 10 3
Small 70% 60 42
45
Increase in investment in current accounts receivable
LARGE
Large - new 25
Large - existing -25
Change in days sales 0
No. of days
80,000,000
Average sales = 222,222 - -
360
SMALL
Small - new 45
Small - existing -25
Change in days sales 20
20,000,000
Average sales = 55,556 20 1,111,111
360
Increase in investment in current accounts receivable due to new sales
Large
Sales x (1-GP%) 6,000,000 75% 4,500,000
4,500,000
Average investment = 12,500 25 312,500
360
Small
Sales x (1-GP%) 6,000,000 75% 4,500,000
4,500,000
Average investment = 12,500 45 562,500
360
Total investment 1,986,111
Cost 10% 198,611

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-35
BRABLOW ELECTRONICS COMPANY

a) Expected average weekly usage is weekly usage multiplied by its probability of occurrence:

(280 units x .2) + (180 units x 8) = 200 units

b) Expected usage during lead-time is expected lead-time multiplied by expected average

weekly usage. Letting Y = expected usage during lead time, and using expected average
weekly usage from the previous answer:

Y = [(3 weeks x .1) + (2 weeks x .9)] x 200 units per week

Y = (.3 weeks + 1.8 weeks) x 200 units per week
Y = 2.1 weeks x 200 units per week
Y = 420 units

c) For a stockout to occur, lead time must be three weeks because maximum usage during a
two-week lead time is 280 units x 2 = 560 units, which would not exhaust the 700-unit
inventory. The probability that a stockout will occur when the reorder point equals 700
units can be calculated as follows:

Combinations in which usage for 3 consecutive weeks exceeds 700 units:

Week 1 Week 2 Week 3 Related Probability

280 units 280 units 280 units .2 x .2 x .2 = .008
280 units 280 units 180 units .2 x .2 x .8 = .032
280 units 180 units 280 units .2 x .8 x .2 = .032
180 units 280 units 280 units .8 x .2 x .2 = .032
Probability of usage for 3 consecutive weeks exceeding 700 units .104
Time probability of lead time being 3 weeks .100
Probability of stockout when reorder point equals 700 units .0104

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-36
A COMPANY CONSIDERING SPEEDING UP DELIVERY TIME

Workings
Level (000 units per annum) .. 10% 15% 20% 25%
310 ................ 139.5 93.0 46.5 -
320 ................ 128.0 144.0 160.0 128.0
330 ................ 49.5 82.5 99.0 132.0
340 ................ - - 17.0 68.0

Expected sales (000 units) .. 317.0 319.5 322.5 328.0

Current sales (000 units) ... 300.0 300.0 300.0 300.0
Increased sales (000 units) . 17.0 19.5 22.5 28.0
Increased contribution
(R3000-R1800 = R1200
per unit)................ R20.4m R23.4m R27.0m R33.6m

Capital Investment

Storage
Annual payment on R12m at 11% for seven years

From mathematical tables-value of R1 at 11% for 7 years

= cumulative factor of 4.7122

Therefore, annual payment for up to and including 10% increase

= R12 m = R2.547m
4.7122

and annual payment for over 10% increase

= R27.5m = R5.836m
4.7122

Handling equipment

Annual payment on R4 m at 14% for four years

From mathematical tables-value of R1 at 14% for 4 years
= cumulative factor of 2.9137

Therefore, annual payment for up to and including 15% increase

= R4 m = R1.3728m
2.9137

and annual payment for over 15% increase

= R9.5m = R3.2605m
2.9137

©Carlos Correia: Solutions to Financial Management, 9e, 2019

 © Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-36 (continued)
Cost of financing extra raw materials, work-in-progress and finished inventory

(Rm) 10% 15% 20% 25%

Finished inventory 132 138 144 150

Less base 120 12 120 18 120 24 120 30
Raw materials 23 23 25 25
Less base 20 20 20 20
Increase 3 3 5 5
Less 3 mnth cr 0.75 2.25 0.75 2.25 1.25 3.75 1.25 3.75
Work-in-progress 46 46 50 50
Less base 40 6 40 6 40 10 40 10
Total increase 20.25 26.25 37.75 43.75

Financing 10% pa R2,025 R2,625 R3,775 R4,375

Cost of financing additional debtors

(Rm) 10% 15% 20% 25%
Sales income
(Expected sales at R3000 each) 951 958.5 967.5 984
Base. 900 900_ 900_ 900
51 58.5 67.5 84

Credit x 30 / 365 4,192 4,808 5,548 6,904

Financing at 10% p.a. ,4192 ,4808 ,5548 ,6904
Cost of insurance on additional inventory

Increased inventory Rm (rounded up) 21 27 39 45

Extra premium at rate of 15 m / 180 m R1,750 R2,250 R3,250 R3,750

a) Profit/(loss) on changes in inventory levels

10% 15% 20% 25%
Rm Rm Rm Rm
Increased contribution... 20,400 23,400 27,000 33,600
Less:
Additional expenses:
Storage-capital cost .. 2,547 5,836 5,836 5,836
Storage-annual cost ... 1,500 4,500 4,500 4,500
Handling-capital cost. 1,373 1,373 3,261 3,261
Handling-annual cost .. ,550 ,550 ,750 ,750
Financing inventory ...... 2,025 2,625 3,775 4,375
Extra warehouse staff . 4,500 4,750 5,000 5,250
Financing debtors .... ,419 ,481 ,555 ,690
Inventory insurance ..... 1,750 2,250 3,250 3,750
Total extra costs ...... 14,664 22,365 26,927 28,412

Net increase/(decrease)
in profit (Rm)........... 5,736 1,035 0,073 5,188

Recommendation:
By increasing inventory by 10% profit will improve by R5 736 m and this is the most
beneficial to the company.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-36 (continued)
b) Financial factors relative to the 5% cash discount decision

Cost effectiveness
Will the discount offered bring sufficient extra sales contribution to recover the discount and
so increase total profit?
Customer compliance with discount rule
Most large companies, as part of their accounts payable system, will reduce every invoice
by the 5% cash discount.
There is no certainty that the invoices will pass through their system so that payment is
made in 10 days. If it is not then the result may be uncleared balances and acrimonious
letter writing.

Competitors' retaliatory action

If the discount gives an edge over competitors will they offer even better terms to maintain
their customers?

Increased administration
At present the trade terms are clear to both office staff, salesmen and customers. The first
suggestion may be the start of a series of discounts to meet specific customers and lead to
considerable extra administration.

Estimation of increased sales volumes

The calculations in (a) show that increased inventory immediately after 10% are not
beneficial. The same exercise needs to be done to follow through the effect of extra sales
on all aspects of the business.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-37
CHARLIE LIMITED

It should be fairly clear from the information that Charlie Ltd has a very serious cash flow
problem and that there are no easy or ready-made solutions to the problem. You might
think that the question ought to be answered by writing down briefly ideas about what
should be done and then producing a revised cash flow forecast with an overdraft limit
never higher than R50m. It would probably be more appropriate, however, to discuss
various options at some length, suggest whether or not these options might work, and then,
if there is time, re-draft a cash budget to see whether Charlie's problems would be
overcome.

Solution

It would seem that Charlie Ltd relies entirely on Delta for finance, and so cannot raise
money from a bank loan or overdraft. The maximum loan from Delta is R50m, but the cash
budget projects and 'overdraft' of up to R262m (month 10).

Charlie Ltd would appear to be profitable and growing. A very rough estimate of profits in
the year could have been made by preparing a sketchy funds flow statement in reverse.

Rm
Increase in bank balance (35-30) 5
Increase in finished goods inventory 114
Net increase in debtors and raw materials
inventory less creditors x
Purchases of fixed assets (70 + 10 + 15 + 5) 100
Dividend paid 80
Tax paid 120
419 + x
Less depreciation y
Profit before tax 419 + x - y

A combination of seasonal business, growth in trading and fixed asset purchases would
appear to be the reason why Charlie Ltd is only expected to increase its cash balance by
R5 m over the whole year, in spite of these profits.

The options for reducing the overdraft, which might be possible are:

* Don't pay the dividend to Delta in month 3. However, Delta is short of cash and is probably
relying on the dividend income. It would, therefore, seem unlikely that Delta Ltd would
agree to either cancel the dividend or to lend more than R50 m.

* Delay the payment of taxation from month 9. The Inland Revenue might allow Charlie Ltd
to do this, although there would be a penalty 'interest' charge for the delay.

* Inventory control. We do not know the total size of finished goods, but inventory levels will
rise by R114m in the year. Clearly, the increase in inventory is expected because of the
company's sales growth. However, some reductions in the investment in inventory might
be possible without prejudice to sales, in which case the cash flow position would be eased
by the amount of the value of the stores reduction.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-37 (continued)
* Creditors control. Three months' credit is taken from suppliers, but raw material purchases
are every 2 months. The credit period already seems generous, and some suppliers are
probably making a second delivery of materials before they are paid for the first. Taking
longer credit would be difficult to negotiate. However, if Charlie Ltd is on very good terms
with its suppliers, and is a valued customer of those suppliers, it might be possible to defer
payments by a further 1 month of amounts payable in months 6, 8 and 10, which cover the
cash crisis period.

* Debtors control. Two months' credit is allowed to customers. If all sales are on credit,
customers are likely to be commercial or industrial buyers, who would expect reasonable
credit terms. A shortening of the credit period is probably not possible, without damaging
goodwill and sales prospects, unless an incentive is offered for early payments, in the form
of a discount. The discount would have to be sufficiently larger to persuade customers to
take it. Suppose, for example, that from month 5 sales onwards, a 10% discount were
offered for payments inside a month. (10% would be very generous and unrealistic
perhaps, but is used here for illustration). If all customers accepted the offer, this would
affect cash flows from month 6 on, as follows.

Month Original Revised Net

budget budget change
Rm Rm Rm
6 75 + (90% of 80) 147 +72
7 80 -80 + (90% of 90) 81 +1
8 90 -90 + (90% of 110) 99 +9
9 110 -110 + (90% of 150) 135 +25
10 150 -150 + (90% of 220) 198 +48
11 220 -220 + (90% of 320) 288 +68
12 320 ? ? ?

The effects on cash flow would then be substantial, although the cost of the discounts
would reduce profits by a substantial amount too.

* Postponing capital expenditure. Since the company is growing, the option to postpone
capital expenditures on new equipment, building extensions and office furniture is probably
unrealistic. The routine replacement of motor vehicles should be deferred, but this would
only ease the cash situation by R10m.

* Charlie Ltd has an investment, which will pay a dividend of R45 m in month 7. This is
obviously a fairly large investment. If Charlie Ltd's cash flow problems are insuperable in
any other way, the company's directors might have to consider whether this investment
could be sold to raise funds.

Summary
Charlie Ltd is a profitable company, but is faced with serious cash flow problems, which
would seem to be hard to overcome without drastic measures being taken. Because
Charlie Ltd is profitable, closure of the company is unthinkable, and it would be against the
company's long-term interests to abandon its plans for growth. Delta Ltd is acting as a
serious restraining influence on Charlie Ltd.

However, the sort of radical action and response outlined above for debtors, coupled with a
postponement of the tax payment by 3 months or so and deferral of R10 m in motor vehicle
purchases until next year, would be virtually sufficient to overcome the firm's cash flow
problems in the year, with a slight problem still in month 8 - see workings below.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-37 (continued)

5 6 7 8 9 10 11 12
Postpone purchase
of vehicles 10
Defer tax payment 120 (120)
Discounts for early
payment by debtors
possible effect 72 1 9 25 48 68 ?
Change 10 72 1 9 145 48 68 ?
Cumulative change 10 82 83 92 237 285 353 ?
Original cash budget 1 (71) (66) (144) (216) (262) (130) 35
Revised cash budget
balances 11 11 17 (52) 21 23 223 ?

If Charlie Ltd is to overcome its problems within the constraints set by Delta Ltd's financial policy; it
is likely that action on debtors is the key to a practical solution.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-38
1.
Annual Relevant Costs of Current Purchasing Policy and JIT Purchasing Policy
for AgriCorp’s Service Division
Incremental Incremental
Costs Under Costs Under
Current JIT
Purchasing Purchasing
Policy Policy
Required return on investment in inventory R R
15% per year x R55m x 266/378 5 805 600
15% per year x R15m x 266/378 1 583 300
Annual insurance costs 8 000 000 3 200 000a
Warehouse rent 1 120 000 (380 000)b
Overtime costs
No overtime 0
Overtime premium (R56 x 75 000 units) 4 200 000
Stockout costs
No Stockouts 0
R100 contribution margin per unit x 38 000 units c 0 3 800 000
Total incremental costs 14 925 600 12 403 300

Difference in favour of JIT purchasing ­ R2 522 300­

a
R8 m x (1 - 0.60) = R3.2m
b
R(380 000) = Warehouse rent, R1.12m - sublet revenues, R1.5m [(75% x 8000) x R250].
c
Calculation of unit contribution margin:
Selling price (R616m ÷ 2.8m units) R220.00
Variable costs per unit:
Variable manufacturing costs per unit
(R266m ÷ 2.8m units) 95
Variable marketing and distribution costs per unit
(R70m ÷ 2.8m units) 25
Total variable costs per unit 120.00
Contribution margin per unit R100.00

Note: The incremental cost of R56 per unit for overtime is less than the additional R100.00
per unit contribution margin for the 75 000 units that would have been lost sales. AgriCorp
would rather incur overtime than lose sales. Also note that the cost of the two warehouse
employees is irrelevant. The same salary costs of R3.8m will be incurred under both
alternatives.

©Carlos Correia: Solutions to Financial Management, 9e, 2019

© Carlos Correia: Solutions to Financial Management, 9e, 2019
Ch 12 Current Asset Management 19 December 2018

12-38 (continued)

2. Factors, other than financial, that should be considered before a company

implements a just-in-time inventory program include:

a) Does AgriCorp have the technology and systems to network with both customers
and suppliers and is it compatible with the current MRP?

b) Does AgriCorp have the corporate culture and employee expertise required to
manage an integrated JIT system?

c) Customer dissatisfaction that may result from stock outs of finished goods and/or
spare parts resulting in customers’ downtime that may not be acceptable and may
also be costly.

d) Stock outs of spare parts and/or finished goods can impair the manufacturer’s
image with its distributors who represent the direct contacts with the ultimate
(customer) users.

e) Placement of smaller and more frequent orders can result in higher material and
delivery costs from suppliers. Additionally, with changes in the suppliers’
production and procurement processes, they may choose to discontinue being
suppliers to a just-in-time customer.

f) The marketplace will determine the impact of service degradation due to stock outs.
Brand loyalty can deteriorate when service standards are lowered.

©Carlos Correia: Solutions to Financial Management, 9e, 2019