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Working capital management mini-cases

You may do this case alone or with up to two others. If you work with others, please submit only one assignment, but be sure it includes all names.

Except for cases E and F, each case is separate. So, e.g., information from part A does not carry over to part B, and etc. All interest rates are stated as annual rates.

A. Terms of sale

A company has purchased $75 million of raw materials from a supplier whose terms of payment are 1½/10 net 30.

1. Explain what the company's options are for paying the invoice for these raw materials.

2. Explain the conditions that must exist for the company to elect to pay

a. on the earlier date?

b. on the later date?

B. Cash Management, Type 1.

A retail company receives most of its revenue from credit or debit card transactions or payments by check. Funds received from credit and debit card transactions automatically deposit in interest bearing accounts. However, the company does receive some cash payments from customers each day. The company estimates that annual cash receipts total $5,000,000. The company makes no cash payments to its suppliers or creditors. Money held in the cash account earns no interest. The company estimates that the transaction cost of moving funds from the cash account into investments that earn interest are $35.00 regardless of the amount transferred. The company earns on average 2.325% interest on funds held in interest bearing accounts and investments.

1. How much cash should the company allow to accumulate before making a deposit if it wants to minimize the total cost associated with carrying and converting cash?

2. If the company follows the optimal strategy identified in question 1, how frequently (on average) will the company move cash from the cash account into interest bearing investments?

3. If the company transfers funds as frequently as indicated in question 2:

a. what will the total annual costs to transfer funds be?

b. what will the average balance in the company's cash account be?

c. how much interest will the company forego annually by keeping funds in the cash account?

d. what is the total cost to maintain a cash account?

4a. Determine the total cost associated with the cash account if the company transfers funds to interest bearing investments weekly rather than as often as indicated in question 2.

b. Determine the total cost associated with the cash account if the company transfers funds to interest bearing investments semi-monthly rather than as often as indicated in question 2.

C. Cash Management, Type 2.

A company's cash balance varies randomly from day to day. It costs the company $35.00 per transaction to move funds from the cash account (which is non-interest bearing) to an account that earns interest or to move funds from the interest bearing account to the cash account. Its average return on interest bearing securities is 2.325%. The company wants to maintain a minimum cash balance of $25000. The variance of the company's daily cash balance is 620.000,000.

1. When the company's cash balance reaches $25000, how much money should be added to the cash account by selling interest bearing investments?

2a. At what cash account balance (upper limit) will funds from the cash account be used to purchase interest bearing investments?

b. What dollar amount of interest bearing investments will be purchased when the cash account balance reaches the amount indicated in part a.

3a. How would the results (answer to questions 1 and 2a and b) change if the variance of daily cash balance were to increase by 30%?

b. How would the results (answer to questions 1 and 2a and b) change if the interest rate were to increase to 4.00%?

c. How would the results (answer to questions 1 and 2a and b) change if the costs to convert to or from cash were to increase to $45?

D. Credit terms

A company is contemplating changing its terms of sale to allow customer purchases on account. It currently has sales of $45.25 million per year, all of which are cash sales. The company's current fixed costs are $15.5 million and variable costs are 45.5% of sales. The company expects that if it allows customers to pay in 45 days, total sales will increase by 12.5%. It anticipates that even if it extends credit to most customers, 5% of its sales will remain cash sales, and that 1.0% of the credit sales will be uncollectible. It expects credit customers will on average pay 42 days after the sale, that its annual fixed costs will increase by $1.75 million (which includes additional production capacity, maintenance, personnel cost to manage accounts receivable, and additional computing support), and that variables costs will remain at 45% of sales. The company expects the additional sales will cause an increase of $425,000 in the inventory holding costs, and that its annual cost to carry accounts receivable will be 4.5%.

1. What additional revenue does the company expect to receive if it makes this change in is terms of sale?

2. What is the expected change in the company's total fixed and variables costs with the expected sales increase?

3. What will the company's average account receivable balance be, and how much will it cost the company (in dollars) to carry those accounts receivable?

4. How does the company's net profit change in the company's credit policy? (Be sure to include the effect of losses due to uncollectible accounts and additional inventory costs.)

5. Based on the answers to questions 1-4, should the company make this change in its terms of sale? Explain.

6. What is the expected change in the company's operating profit margin with this change in credit policy? Does that change your answer to question 5? Explain.

E. Extension of credit, single order

A potential new customer has submitted an order totaling $750,000 to a company. It has requested the company to extend credit for this order, with payment 30 days after delivery. The company's contribution margin (price minus variable costs) on this order is 8.5%, and its fixed costs are not affected. The company will pay one third of its costs for the order 15 days after the order is accepted, another third 30 days later, and the balance when the order is delivered, 75 days after acceptance. The company believes there is a 90% chance the customer will make payment on the order (i.e., a 10% chance the account will be uncollectible). If payment is not made when due, the company does not expect to be able to recover any of its costs. The company's required return for this proposed transaction is 25%.

1. What are the company's expected cash outflows from this order and when will they occur?

2. What is the company's expected cash inflow from this order and when will it occur?

3. What is net present value of this order?

4. Should the company accept this order? Explain.

F. Extension of credit, multiple orders

The company from part E expects that if the customer makes payment on the initial order, there is a 75% probability the customer will submit an additional order. It expects the follow-on order will be placed at the time of payment for the first order and be for $1,500,000. The company's contribution margin on the follow-on order is expected to be 10% (some customer specific investments made for the first order will not need to be repeated for the follow-on order and the larger production run will also reduce costs). Timing for the company's costs will be the same for the follow-on order: one third of the company's total costs the will be paid 15 days after the order is placed, another third, 30 days later, and the rest 30 days after that, when the order is delivered to the customer. As with the first order, the customer's payment will be due 30 days after delivery. The company expects there is a 98% probability the customer will make payment on the follow-on order.

1. If payment is made on the first order and the follow-on order is placed, what are the company's expected cash outflows and when will they occur?

2. If payment is made on the first order and the follow-on order is placed, what is the company's expected cash inflow and when will it occur?

3. What is the company's expected net present value on the follow-on order?

4. What is the combined probability of payment on the first order and receipt of the follow-order?

5. Based on the answer to question 3 in case E, and questions 3 and 4 of this case, should the company accept the first order? Explain.

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