Mr. Homer Smith is the vice president of sales for Sunrise Corporation, which buys and sells mobile homes. He is sure that increasing the number of homes on display will cause sales to increase. He thinks that an increase in inventory effective January 1, 2016, from the present level of 60 units to 100 units will boost sales from 350 units per year to 450 units per year. Assume ordering cost to be $200 per order, carrying cost to be $600 per unit per year, unit sales price to be $10,000, unit purchase price to be $8,000, and applicable income tax rate to be 40 percent. Also assume that any increase in the current assets will be financed by short-term notes at an interest rate of 7 percent, long-term interest rate is 10 percent, cost of capital for Sunrise is 11 percent, cost of goods sold is 80 percent of sales, and other operating expenses is $100,000 under the old policy. The pro forma balance sheet items of the company under the old policy would be as follows:
Cash and Securities $ 55,000
Accounts Payable $ 100,000
Accounts Receivable 105,000
Notes Payable 95,000
Plant and Equipment 100,000
Long-Term Debt 65,000
Common Stock 60,000
Capital in Excess of Par 220,000
Retained Earnings 200,000
Also assume that the cost of goods sold and other operating expenses in the income statement and all current asset and current liability items vary directly with sales.
a. Calculate the EOQ, number of orders issued per year, and inventory cost.
b. Develop pro forma income statements and balance sheets under the old and the new policies.
c. Calculate the incremental cash flows for 2016 and the subsequent years.
d. Advise Mr. Smith if he should adopt the new policy.