A B C D E F G H I

1 Ch 22 Mini Case ###

2
3 Chapter 22. Mini Case for Other Topics in Working Capital Management
4
5 Part I. Click on the Part II tab for the second part to this case.
6 Rich Jackson, a recent finance graduate, is planning to go into the wholesale building supply business with his brother, Jim,
who majored in building construction. The firm would sell primarily to general contractors, and it would start operating next
7
January. Sales would be slow during the cold months, rise during the spring, and then fall off again in the summer, when new
8 construction in the area slows. Sales estimates for the first 6 months are as follows (in thousands of dollars):
9
10
11 JAN $100
12 FEB 200
13 MAR 300
14 APR 300
15 MAY 200
16 JUN 100
17
18 The terms of sale are net 30, but because of special incentives, the brothers expect 30 percent of the customers (by dollar value)
to pay on the 10th day following the sale, 50 percent to pay on the 40th day, and the remaining 20 percent to pay on the 70th
19 day. No bad debt losses are expected, because Jim, the building construction expert, knows which contractors are having
financial problems.
20
21
a. Assume that, on average, the brothers expect annual sales of 18,000 items at an average price of $100 per item. (use a 360
22 day year.) What is the firm's expected days sales outstanding (DSO)?
23
24 DSO = 0.3(10) + 0.5(40) + 0.2(70) = 37 DAYS
25
26 Compared to a 30-day credit period, this isn't too bad since one would expect some customers to pay slowly.
27
28 a. 2. What is its expected average daily sales (ADS)?
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30 AVERAGE DAILY SALES = ADS = 18,000 (100)/360 = $5,000 PER DAY.
31
32 a. 3. What is its expected average accounts receivable level?
33
34 (A/R) = (DSO)(ADS) = 37($5,000) = $185,000.
35
a. 4. Assume that the firm's profit margin is 25 percent. How much of the receivables balance must be financed? What would
the firm's balance sheet figures for accounts receivable, notes payable, and retained earnings be at the end of one year if notes
36 payable are used to finance the investment in receivables? Assume that the cost of carrying receivables had been deducted
when the 25 percent profit margin was calculated.

37
38 Since 25% of the sales price is profit, only 75% of the AR must be financed:
39 AR Financed = 0.75 x 185,000 138,750
40
41 Accounts Receivable 185,000 Notes Payable 138,750
42 Retained Earn. 46,250
43 185,000
44
45 a. 5. If loans have a cost of 12 percent, what is the annual dollar cost of carrying the receivables?
46
47 cost = 12% x 138,750 = $ 16,650.00
48 Also there is the opportunity cost of not having use of the profit component of the receivables.
49
b. What are some factors which influence (1) a firm's receivables level and (2) the dollar cost of carrying receivables?
50
51
52
53 (1) Receivables are a function of the average daily sales and the days sales outstanding. Exogeneous economic factors such
54 as the state of the economy and competition within the industry affect average daily sales, but so does the firm's credit policy.
55 The DSO depends mainly on credit polciy, although poor economic conditions can lead to a reduction in customers' ability
56 to make payments.
57
58 (2) For a given level of receivables, the lower the profit margin, the higher the cost of carrying receivables, because the
greater the portion of each sales dollar that must actually be financed. Similarly, the higher the cost of financing, the higher
59 the dollar cost of carrying receivables.
60
61
c. Assuming that the monthly sales forecasts given previously are accurate, and that customers pay exactly as was predicted,
what would the receivables level be at the end of each month? To reduce calculations, assume that 30 percent of the firm's
customers pay in the month of sale, 50 percent pay in the second month following the sale, and the remaining 20 percent pay
in the second month following the sale. Note that this is a different assumption than was made earlier.
 A B C D E F G H I
62 c. Assuming that the monthly sales forecasts given previously are accurate, and that customers pay exactly as was predicted,
what would the receivables level be at the end of each month? To reduce calculations, assume that 30 percent of the firm's
customers pay in the month of sale, 50 percent pay in the second month following the sale, and the remaining 20 percent pay
63 in the second month following the sale. Note that this is a different assumption than was made earlier.
64
65 A/R = 0.7(SALES IN THAT MONTH) + 0.2(SALES IN PREVIOUS MONTH).
66 Quarterly Statement
Credit Sales
67 for Month Receivables at
Month (1) (2) End of Month ADS (4) DSO (5)
68 January $100 $70
69 February $200 $160
70 March $300 $250 $6.67 37.5
71 April $300 $270
72 May $200 $200
73 June $100 $110 $6.67 16.5
74
75
d. What is the firm's forecasted average daily sales for the first 3 months? For the entire half-year? The days sales
76 outstanding is commonly used to measure receivables performance. What DSO is expected at the end of March? At the end
of June? What does the DSO indicate about customers' payments? Is DSO a good management tool in this situation? If
77 not, why not?
78
79 See above in question (c) for average daily sales and DSO at the end of the quarter.
80
81
82 Looking at the DSO, it appears that customers are paying significantly faster in the second quarter than in the first.
83 However, the receivables balances were created assuming a constant payment pattern, so the DSO is giving a false measure
of customers' payment performance. The underlying cause of the problem with the DSO is the seasonal variability in sales.
84 If there were no seasonal pattern, and hence sales were a constant $200 each month, then the DSO would be 27 days in both
85 march and June, indicating that customers' payment patterns had remained steady.
86
87 e. Construct aging schedules for the end of March and the end of June. Do these schedules prpoerly measure customers'
88 payment patterns? If not, why not?
89
90
91 Age of Account March June
92 (Days) A/R % A/R %
93 0-30 $210 84% $70 64%
94 31-60 $40 16% $40 36%
95 61-90 $0 0% $0 0%
96 $250 100% $110 100%
97
98 Note that the end of June ageing schedule suggests that customers are paying more slowly than in the earlier quarter.
99 However we know that the payment pattern has remained constant, so the firm's customers' payment performance has not
100 changed. The apparent change is due to the seasonal fluctuations.
101
102 f. Construct the uncollected balances schedules for the end of March and the end of June. Do these schedules properly
103 measure customers' payment patterns?
104
105 March

106 Monthly Contribution

Sales to A/R A/R to Sales Ratio
107 Quarter 1:
108 January $100 $0 0%
109 February $200 $40 20%
110 March $300 $210 70%
111 $250 90%
112
113 June
114 Quarter 2:
115 April $300 $0 0%
116 May $200 $40 20%
117 June $100 $70 70%
118 $110 90%
119
120
121 g. Assume that it is now July of Year 1, and the brothers are developing pro forma financial statements for the following
122 year. Further, assume that sales and collections in the first half-year matched the predicted leavels. Using the year 2 sales
123 forecasts as shown next, what are next year's pro forma receivables levels for the end of march and for the end of June?
124
 A B C D E F G H I
125 March
Predicted
126 Predicted Contribution Predicted A/R to
Sales to A/R Sales Ratio
127 Quarter 1:
128 January $150 $0 0%
129 February $300 $60 20%
130 March $500 $350 70%
131 $410 90%
132
133 June
134 Quarter 2:
135 April $400 $0 0%
136 May $300 $60 20%
137 June $200 $140 70%
138 $200 90%
139
140
h. Assume now that it is several years later. The brothers are concerned about the firm's current credit terms, which are
141
now net 30, which means that contractors buying building products from the firm are not offered a discount, and they are
142 supposed to pay the full amount in 30 days. Gross sales are now running $1,000,000 a year, and 80 percent (by dollar
143 volume) of the firms paying customers generally pay the full amount on day 30, while the other 20 percent pay, on average,
144 on day 40. Two percent of the firm's gross sales end up as bad debt losses.
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146
147
The brothers are now considering a change in the firm's credit policy. The change would entail (1) changing the credit
148 terms to 2/10, net 20, (2) employing stricter credit standards before granting credit, and (3) enforcing collections with
greater vigor than in the past. Thus, cash customers and those paying within 10 days would receive a 2 percent discount, but
149 all others would have to pay the full amount after only 20 days. The brothers believe that the discount would both attract
additional customers and encourage some existing customers to buy more from the firm--after all, the discount amounts to a
150 price recuction. Of course, these customers would take the discount and, hence, would pay in only 10 days.
151
152
The net expected result is for sales to increase to $1,100,000; for 60 percent of the paying customers to take the discount
153 and pay on the 10th day; for 30 percent to pay the full aomount on day 20; for 10 percent to pay late on day 30; and for bad
154 debt losses to fall from 2 percent to 1 percent of gross sales. The firm's operating cost ratio will remain unchanged at 75
155 percent, and its cost of carrying receivables will remain unchanged at 12 percent.
156
157 To begin the analysis, describe the four variables which make up a firm's credit policy, and explain how each of them
158 affects sales and collections. Then use the information given in part h to answer parts i through n.
159
160 The four variables which make up a firm's credit policy are (1) the discount offered, including the amount and period; (2)
161 the credit period; (3) the credit standards used when determining who shall receive credit, and how much credit; and (4) the
162 collection policy.
163
Cash discounts generally produce two benefits: (1) they attract both new customers and expanded sales from current
164 customers, because people view discounts as a price reduction, and (2) discounts cause a reduction in the days sales
165 outstanding, since both new customers and some established customers will pay more promptly in order to get the discount.
166 Of course, these benefits are offset to some degree by the dollar cost of the discounts themselves.
167
The credit period is the length of time allowed to all "qualified" customers to pay for their purchases. In order to qualify
168 for credit in the first place, customers must meet the firm's credit standards. These dictate the minimum acceptable financial
169 position required of customers to receive credit. Also, a firm may impose differing credit limits depending on the customer's
170 financial strength as judged by the credit department.
171 Finally, collection policy refers to the procedures that the firm follows to collect past-due accounts. These can range from
172 a simple letter or phone call to turning the account over to a collection agency.
173 How the firm handles each element of credit policy will have an influence on sales, speed of collections, and bad debt
174 losses. The object is to be tough enough to get timely payments and to minimize bad debt losses, yet not to create ill will and
175 thus lose customers.
176
177 i. Under the current credit policy, what is the firm's days sales outstanding (DSO)? What would the expected dso be if the
178 credit policy change were made?
179
180 Old (current) situation: DSO0 = 0.8(30) + 0.2(40) = 32 days. New situation: DSOn = 0.6(10) + 0.3(20) + 0.1(30) = 15 days.
181 Thus, the new credit policy is expected to cut the dso in half.
182
183
184 j. What is the dollar amount of the firm's current bad debt losses? What losses would be expected under the new policy?
185
186 old (current) situation: BDLo = 0.02($1,000,000) = $20,000. New situation: BDLn = 0.01($1,100,000) = $11,000. Thus, the
187 new policy is expected to cut bad debt losses sharply.
188
189 k. What would be the firm's expected dollar cost of granting discounts under the new policy?
190
191
Current situation: under the current, no discount policy, the cost of discounts is $0.
New situation: of the $1,100,000 gross sales expected under the new policy, 1 percent is lost to bad debts, so good sales =
0.99($1,100,000) = $1,089,000. Since 60 percent of the good sales are discount sales, discount sales = 0.6($1,089,000) =
$653,400. Finally, the discount is 2 percent, so the cost of discounts is expected to be 0.02($653,400) = $13,068.
 A B C D E F G H I
192 Current situation: under the current, no discount policy, the cost of discounts is $0.
193 New situation: of the $1,100,000 gross sales expected under the new policy, 1 percent is lost to bad debts, so good sales =
0.99($1,100,000) = $1,089,000. Since 60 percent of the good sales are discount sales, discount sales = 0.6($1,089,000) =
194 $653,400. Finally, the discount is 2 percent, so the cost of discounts is expected to be 0.02($653,400) = $13,068.
195
196 l. What is the firm's current dollar cost of carrying receivables? What would it be after the proposed change?
197
198
Current situation: the firm's average daily sales currently amount to $1,000,000/360 = $2,777.78. The dso is 32 days, so
199 accounts receivable amount to 32($2,777.78) = $88,889. However, only 75 percent of this total represents cash costs--the
200 remainder is profit--so the investment in receivables (the actual amount that must be financed) is 0.75($88,889) = $66,667.
201 At a cost of 12 percent, the annual cost of carrying the receivables is 0.12($66,667) = $8,000.
new situation: the cost of carrying the receivables balance under the new policy would be $4,125:
202
203 ($1,100,000/360)(15)(0.75)(0.12) = $4,125.
204
205 m. What is the incremental after-tax profit associated with the change in credit terms? Should the company make the
206 change? (assume a tax rate of 40 percent.)
207
208 New Old Difference
209 Gross sales 1,100,000 1,000,000 100,000
210 Less discounts 13,068 - 13,068
211 net sales 1,086,932 1,000,000 86,932
212 Production costs 825,000 750,000 75,000
213 profit before credit
214 costs and taxes 261,932 250,000 11,932
215 Credit-related costs:
216 carrying costs 4,125 8,000 (3,875)
217 bad debt losses 11,000 20,000 (9,000)
218 profit before taxes 246,807 222,000
219 Taxes (40%) 98,723 88,800 9,923
220 Net income 148,084 133,200 14,884
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222
223
224
Thus, if expectations are met, the credit policy change would increase the firm's annual after-tax profit by $14,884. Since
225 there are no non-cash expenses involved here, the $14,884 is also the incremental cash flow expected under the new policy.
226
However, the new policy is not riskless. If the firm's customers do not react as predicted, then the firm's profits could
227 actually decrease as a result of the change. The amount of risk involved in the decision depends on the uncertainty inherent
228 in the estimates, especially the sales estimate. Typically, it is very difficult to predict customers' responses to credit policy
changes. Further, a credit policy change may prompt the company's competitors to change their own credit terms, and this
229 could offset the expected increase in sales. Thus, the final decision is judgmental. If the prospect of an annual $14,884
230 increase in net income is sufficient to compensate for the risks involved, then the change should be made. (note: large,
national companies often make credit policy changes in a given region in an effort to determine how customers and
231
competitors will react, and then use the information gained when setting national policy. Note also that credit policy changes
232 may not be announced in a "broadcast" sense so as to slow down competitors' reactions.)
233
234 n. Suppose the firm makes the change, but its competitors react by making similar changes to their own credit terms, with
235 the net result being that gross sales remain at the current $1,000,000 level. What would the impact be on the firm's post-tax
236 profitability?
237
238 New
239 Gross sales 1,000,000
240 Less discounts 11,880
241 net sales 988,120
242 Production costs 750,000
243 profit before credit
244 costs and taxes 238,120
245 Credit-related costs:
246 carrying costs 3,750
247 bad debt losses 10,000
248 profit before taxes 224,370
249 Taxes (40%) 89,748
250 Net income 134,622
251
252 Under the old terms the net income was $133,200, so the policy change would result in a slight incremental gain of $134,622 -
253 $133,200 = $1,422
254
 A B C D E F G H I
1 Ch 22 Mini Case ###
2
3 Chapter 22. Mini Case for Other Topics in Working Capital Management
4
5 Part II. Click on the Part I tab for the second part to this case.
Andria Mullins, financial manager of Webster Eelectronics, has been asked by the firm's CEO, Fred Weygandt, to evaluate the
6 company's inventory control techniques and to lead a discussion of the subject with the senior executives. Andria plans to use
as an example one of Webster's "big ticket" items, a customized computer microchip which the firm uses in its laptop
computer. Each chip costs Webster $200, and in addition it must pay its supplier a $1,000 setup fee on each order. Further, the
7 minimum order size is 250 units; Webster's annual usage forecast is 5,000 units; and the annual carrying cost of this item is
estimated to be 20 percent of the average inventory value.
Andria plans to begin her session with the senior executives by reviewing some basic inventory concepts, after which she will
8 apply the EOQ model to Webster's microchip inventory. As her assistant, you have been asked to help her by answering the
following questions:
9

10
11 a. Why is inventory management vital to the health of most firms?
12
13 Inventory management is critical to the financial success of most firms. If insufficient inventories are carried, a firm will lose
14 sales. Conversely, if excess inventories are carried, a firm will incur higher costs than necessary. Worst of all, if a firm carries
15 large inventories, but of the wrong items, it will incur high costs and still lose sales.
16
17 b. What assumptions underlie the EOQ Model?
18
19 ·The
All standard
values areform
known with
of the certainty
eoq and constant
model requires over time.
the following assumptions:
20
21 · Inventory usage is uniform over time. For example, a retailer would sell the same number of units each day.
22 · All carrying costs are variable, so carrying costs change propor-tionally with changes in inventory levels

23 · All ordering costs are fixed per order; that is, the company pays a fixed amount to order and receive each shipment of
inventory, regardless of the number of units ordered.
These assumed conditions are not met in the real world, and, as a result, safety stocks are carried, and these stocks raise
24 average inventory holdings above the amounts that result from the "pure" EOQ model.
25

26 c. Write out the formula for the total costs of carrying and ordering inventory, and then use the formula to derive the EOQ
model.
27
28 TIC = total carrying costs + total ordering costs = CP(Q/2) + F(S/Q)
29
30 C = annual carrying cost as a percentage of inventory value.
31 P = purchase price per unit.
32 Q = number of units in each order.
33 F = fixed costs per order.
34 S = annual usage in units.
35
Note that S/Q is the number of orders placed each year, and, if no safety stocks are carried, Q/2 is the average number of units
36
carried in inventory during the year.
37
38 The economic (optimal) order quantity (eoq) is that order quantity which minimizes total inventory costs. Thus, we have a
39 standard optimization problem, and the solution is to take the first derivative of the TIC with respect to quantity and set it
40 equal to zero:
41
42 d (TIC ) ( C )(P ) ( F )( S )
43 = − =0
44
dQ 2 Q2
45
46 Solving for Q gives us:
47
( C )( P ) ( F )( S )
48 = 2
49 2 Q
50
2 ( F )( S)
51
Q2 =
52
53
( C )( P )

√
54
55 2( F )( S )
56 Q =EOQ= .
57 ( C )( P)
58
59
60
61 d. What is the EOQ for custom microchips? What are total inventory costs if the EOQ is ordered?
 A B C D E F G H I
62
63

√ 2( $ 1 , 000)(5 , 000 )
64
65 EOQ= =500 units
66 0. 2( $ 200 )
67 TIC = CP(Q/2) + F(S/Q)
68 = 0.2($200)(500/2) + $1,000(5,000/500)
69 = $40(250) + $1,000(10) = $10,000 + $10,000 = $20,000.
70
71 C= 20%
72 P= $ 200
73 F= $ 1,000
74 S= 5,000
75 EOQ = 500
76 TIC = $ 20,000
77

78
e. What is Webster's added cost if it orders 400 units at a time rather than the eoq quantity? What if it orders 600 per order?
79
80 C= 20%
81 P= $ 200
82 F= $ 1,000 @400, TIC = 20,500
83 S= 5,000 @600, TIC = 20,333
84 Order quantity = 600 plug in 400 and 600
85 TIC = $ 20,333
86
87 f. Suppose it takes 2 weeks for Webster's supplier to set up production, make and test the chips, and deliver them to Webster's
88 plant. Assuming certainty in delivery times and usage, at what inventory level should Webster reorder? (assume a 52-week
89 year, and assume that Webster orders the EOQ amount
90
91 With an annual usage of 5,000 units, Webster's weekly usage rate is 5,000/52 ~ 96 units. If the order lead time is 2 weeks, then
92 Webster must reorder each time its inventory reaches 2(96) = 192 units. Then, after 2 weeks, as it uses its last microchip, the
93 new order of 500 chips arrives
94
95
g. Of course, there is uncertainty in Webster's usage rate as well as in delivery times, so the company must carry a safety stock
96 to avoid running out of chips and having to halt production. If a 200-unit safety stock is carried, what effect would this have
97 on total inventory costs? What is the new reorder point? What protection does the safety stock provide if usage increases, or
98 if delivery is delayed?
99
100 There are two ways to view the impact of safety stocks on total inventory costs. Webster's total cost of carrying the operating
inventory is $20,000 (see part d). Now the cost of carrying an additional 200 units is CP(safety stock) = 0.2($200)(200) = $8,000.
101 Thus, total inventory costs are increased by $8,000, for a total of $20,000 + $8,000 = $28,000.
102
103 Another approach is to recognize that, with a 200-unit safety stock, Webster's average inventory is now (500/2) + 200 = 450
104 units. Thus, its total inventory cost, including safety stock, is $28,000:
105
106 TIC = CP(average inventory) + F(S/Q)
107 = 0.2($200)(450) + $1,000(5,000/500)
108 = $18,000 + $10,000 = $28,000.
109
110
Webster must still reorder when the operating inventory reaches 192 units. However, with a safety stock of 200 units in
111 addition to the operating inventory, the reorder point becomes 200 + 192 = 392 units. Since Webster will reorder when its
112 microchip inventory reaches 392 units, and since the expected delivery time is 2 weeks, Webster's normal 96 unit usage could
rise to 392/2 = 196 units per week over the 2-week delivery period without causing a stockout. Similarly, if usage remains at
113
the expected 96 units per week, Webster could operate for 392/96 » 4 weeks versus the normal two weeks while awaiting
114 delivery of an order.
115
116 h. Now suppose Webster's supplier offers a discount of 1 percent on orders of 1,000 or more. Should Webster take the
117 discount? Why or why not?
118
119 First, note that since the discount will only affect the orders for the operating inventory, the discount decision need not take
120 account of the safety stock. Webster's current total cost of its operating inventory is $20,000 (see part d). If Webster increases
121 its order quantity to 1,000 units, then its total costs for the operating inventory would be $24,800:
122
123 TIC = CP(Q/2) + F(S/Q)
124 = 0.2($198)(1,000/2) + $1,000(5,000/1,000) = $19,800 + $5,000
125 = $24,800.
126
 A B C D E F G H I
127 Note that we have reduced the unit price by the amount of the discount. Since total costs are $24,800 if Webster orders 1,000
128 chips at a time, the incremental annual cost of taking the discount is $24,800 - $20,000 = $4,800. However, Webster would save
1 percent on each chip, for a total annual savings of 0.01($200)(5,000) = $10,000. Thus, the net effect is that Webster would
129 save $10,000 - $4,800 = $5,200 if it takes the discount, and hence it should do so.
130
131 i. For many firms, inventory usage is not uniform throughout the year, but, rather, follows some seasonal pattern. Can the
132 EOQ model be used in this situation? If so, how?
133
134
135 The EOQ model can still be used if there are seasonal variations in usage, but it must be applied to shorter periods during
136 which usage is approximately constant. For example, assume that the usage rate is constant, but different, during the summer
and winter periods. The EOQ model could be applied separately, using the appropriate annual usage rate, to each period, and
137 during the transitional fall and spring seasons inventories would be either run down or built up with special seasonal orders.
138
139 j. 1. How would these factors affect an eoq analysis? 1. The use of just-in-time procedures.
140
141 Just-in-time procedures are designed specifically to reduce inventories. If a just in time system were put in place, it would
142 largely obviate the need for using the EOQ model.
143
144 j. 2. The use of air freight for deliveries.
145
146 Air freight would presumably shorten delivery times and reduce the need for safety stocks. It might or might not affect the
147 EOQ.
148
149
j. 3. The use of a computerized inventory control system, wherein as units were removed from stock, an electronic system
150 automatically reduced the inventory account and, when the order point was hit, automatically sent an electronic message to the
supplier placing an order. The electronic system ensures that inventory records are accurate, and that orders are placed
151 promptly.
152
153 Computerized control systems would, generally, enable the company to keep better track of its existing inventory. This would
154 probably reduce safety stocks, and it might or might not affect the EOQ.
155
156
157 j. 4. The manufacturing plant is redesigned and automated. Computerized process equipment and state-of-the-art robotics are
158 installed, making the plant highly flexible in the sense that the company can switch from the production of one item to another
159 at a minimum cost and quite quickly. This makes short production runs more feasible than under the old plant setup.