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Manual For Finance Questions
Manual For Finance Questions
Page 1 of 50
a. Fill in the 20X3 column in the table that follows.
INFO-IND Company
Ratio 20X1 20X2 20X3 Industry Norms
1. Current Ratio 250% 200% 225%
2. Acid-test Ratio 100% 90% 110%
3. Receivable turnover 5.0x 4.5x 6.0x
4. Inventory turnover 4.0x 3.0x 4.0x
5. Long-term debt/total capitalization 35% 40% 33%
6. Gross profit margin 39% 41% 40%
7. Net profit margin 17% 15% 15%
8. Return on equity 15% 20% 20%
9. Return on investment 15% 12% 12%
10. Total Asset turnover 0.9x 0.8x 1.0x
11. Interest coverage ratio 5.5x 4.5x 5.0x
9. a)
(1) Current ratio = Current assets/Current liabilities
= $13M/$8M = 162.5%
(2) Acid-test ratio =
(Current assets - Inventories)/Current liabilities
= $6M/$8M = 75%
(3) Receivable turnover = Annual credit sales/Receivables
= $16M/$5M = 3.2x
(4) Inventory turnover = Cost of goods sold/Inventory
= $12M/$7M = 1.7x
(5) Long-term debt/Total capitalization
= $12M/($12M + $4M + $6M)
= $12M/$22M = 54.5%
(6) Gross profit margin = (Sales - Cost of goods sold)/Sales
= ($20M - $12M)/$20M = 40%
(7) Net profit margin = Net income after taxes/Sales
= $2M/$20M = 10%
(8) Net income
Return after taxes - Dividends on preferred stock on equity =
────────────────────────────────────────────
Net worth - Par value of preferred stock
= $1,760,000/($10,000,000 - $4,000,000) = 29.3%
(9) Return on assets = Net income after taxes/Total assets
= $2M/$30M = 6.7%
(10) Total asset turnover = Sales/Total assets
= $20M/$30M = 0.67x
(11) Interest coverage = EBIT/Interest charges
= $4.4M/$1.2M=3.67x
Page 2 of 50
b. Evaluate the position of the company using information from the table. Cite specific ratio levels and
trends as evidence.
b)
(1) Ratios 1-5 uniformly indicate that liquidity is deteriorating.
(2) The gross profit margin (#6) remains relatively constant and at the
industry norm, while the net profit margin(#7) is declining. This indicates
that interest, depreciation, and selling and administrative expenses are
rising relative to sales.
(3) Part of the margin decline is accounted for by the rapid rise in debt
(#5). This increase also explains why the return on equity (#8) has been
rising while the return on assets (#9) has been falling. The impact of the
increase in debt and overall decline in profitability is also shown by the
reduction in coverage (#11).
Page 3 of 50
c. Indicate which ratios would be of most interest to you and what your decision would be in each of
the following situations:
i) Info-Ind wants to buy Rs 500,000 worth of merchandise inventory from you, with payment
due in 90 days.
ii) Info-Ind wants you, a large insurance company, to pay off its not at the bank and assume it
on a 10-year maturity basis at a current rate of 14 percent.
iii) There are 100,000 shares outstanding, and the stock is selling for Rs 80 a share. The company
offers you 50,000 additional shares at this price.
(1) Primary interest should be in ratios 1-4. The overall reduction in
liquidity, together with the large amount involved and the lengthy terms,
would argue against granting the credit. Of course, this argument would have
to be balanced against the importance to the vendor of this sale and possible
repeat sales.
$26,000,000 100.0%
Pro forma interest coverage would be $4.4M/$1,760,000 = 2.5x (#11 pro forma.)
The student should be especially concerned with this ratio. In addition,
he/she would have to be concerned with all of the rest, as both deteriorating
liquidity and profitability would affect a 10-year note of the company. There
would appear to be little advantage in granting the loan.
(3) An easy answer would be to point to the high rate of return on equity (#8)
and say "buy." On the other hand, the high degree of leverage (#5) and the
declining profitability (#s 7, 8, and 9), would indicate caution. The student
should at least be aware of the multitude of fundamentally negative factors
Page 4 of 50
FUNDS ANALYSIS, CASH-FLOW ANALYSIS, AND FINANCIAL PLANNING
2. At December 31, the balance sheet of Royal Malting Company was the following (in thousands):
Cash Rs 50 Accounts Payable Rs 360
Accounts Receivable 530 Accrued expenses 212
Inventories 545 Bank Loan 400
Current Assets Rs 1,125 Current liabilities Rs 972
Net Fixed Assets 1,836 Long-term debt 450
Common stock 100
Retained earnings 1,439
The company has received a large order and anticipates the need to go to its bank to increase its
borrowings. As a result, it needs to forecast its cash requirements for January, February, and March.
Typically, the company collects 20 percent of its sales in the month of sale, 70 percent in the subsequent
month, and 10 percent in the second month after the sale. All sales are credit sales.
Purchases of raw materials to produce malt are made in the month prior to the sale and amount to 60
percent of sales in the subsequent month. Payments for these purchases occur in the month after the
purchase. Labor costs, including overtime, are expected to be Rs. 150,000 in January, Rs. 200,000 in
February, and Rs.160,000 in March. Selling, administrative, tax, and other cash expenses are expected to
be Rs. 100,000 per month for January through March. Actual sales in November and December and
projected sales for January through April are as follows (in thousands):
November Rs. 500
December 600
January 600
February 1,000
March 650
April 750
Page 5 of 50
On the basis of this information:
a. Prepare a cash budget for the months of January, February, and March.
2. a.
Cash budget (in thousands)
NOV DEC JAN FEB MAR APR
────────────────────────────────────────────────────────────────────────
Sales $500 $600 $600 $1,000 $650 $750
Cash Collections
20% of current month sales $120 $200 $130
70% of last month's sales 420 420 700
10% of 2-month old sales 50 60 60
──── ───── ────
Total cash receipts $590 $680 $890
Purchases $360 $600 $390 $450
cash disbursements
Page 6 of 50
b. Determine the amount of additional bank borrowings necessary to maintain a cash balance of Rs
50,000 at all times. (Ignore interest on such borrowings)
b.
DEC JAN FEB MAR
────────────────────────────────────────────────────────────────────────
Beginning bank borrowings $400 $420 $ 640
Additional borrowings 20 220 (240)
──── ──── ──────
Ending bank borrowings $400 $420 $640 $ 400
────────────────────────────────────────────────────────────────────────
The amount of financing peaks in February owing to the need to pay for
purchases made the previous month and higher labor costs. In March,
substantial collections are made on the prior month's billings, causing a
large net cash inflow sufficient to pay off the additional borrowings.
Page 7 of 50
c. Prepare a forecast balance sheet for March 31. (It should be noted that the company maintains
a safety stock of inventory and that depreciation for the three-month period is expected to be
Rs 24,000)
Forecast balance sheet at March 31 (in thousands)
______________________________________________________________________________
Actual Forecast
Assets 12-31 Change 3-31 Assumptions
Current assets
$1,125 +180 $1,305 6 times $2,250 in sales
(Jan.-Mar.).
Net fixed 1,836 - 24 1,812 ■ Depreciation expected to be $24
assets
------------------------------------------------------------------------------
Liabilities
Bank borrowings $ 400 0 $ 400 ■ Previous balance plus zero additional financing needed.
Accounts payable 360 + 90 450 ■ 100% March purchases.
Accrued expenses 212 0 212 ■ No change expected.
Current
liabilities $ 972 + 90 $1,062
Long-term debt 450 0 450 ■ No change expected.
Common Stock 100 0 100 ■ No change expected.
Retained earnings 1,439 + 66 1,505 ■ Change in retained earnings equals sales,
minus payment for purchases, minus labor and shareholders' costs,
depreciation, and other expenses, for Jan.-Mar.
Total liabilities
Page 8 of 50
3. Mahalakshmi Nautical Company expects sales of Rs 2.4 million next year and the same amount
following year. Sales are spread evenly throughout the year. On the basis of the following information,
prepare a forecast income statement and balance sheet for year end:
Profit before taxes 384 ■ 16% of net sales; based on an 8% net profit margin
and 50% tax rate.
retained earnings
Page 9 of 50
Forecast balance sheet (in thousands)
_______________________________________________________________________
End of
Assets year Assumptions
────────────────── ──────── ─────────────────────────────────────────
Cash $ 96 ■ Set at estimated minimum balance; 4% of annual sales of $2.4
M.
Receivables 400 ■ Based on 60-day average collection period; (net sales of $2.4
M)/(360/60).
Net fixed assets 500 ■ $500,000 at beginning of year and capital expenditures
expected to equal depreciation charge for the year.
Current
liabilities $ 159
Total liabilities
and shareholders'
equity $1,176
_______________________________________________________________________
Page 10 of 50
WORKING CAPITAL MANAGEMENT
4. What does working capital management encompass? What functional decisions are involved, and
what underlying principle or trade-off influences the decision process?
Page 11 of 50
5. Distinguish between “temporary” and “permanent” working capital.
When we speak of working capital, we mean current assets.
Therefore, "temporary" working capital is the amount of current assets that
varies with a firm's seasonal needs. "Permanent" current assets, on the other
hand, is the amount of current assets required to meet a firm's long-term
minimum needs.
Page 12 of 50
6. Some firms finance their permanent working capital with short-term liabilities (Commercial paper and
short-term notes). Explain the impact of this decision on the profitability and risk of these firms.
In general, short-term debt carries a lower explicit cost of capital. The
decision to finance the permanent component of working capital with short-term
debt may result in higher reported earnings per share. If stockholders do not
perceive a higher risk characteristic for the firm as a result of higher
proportions of short-term debt, the financial manager may be exploiting an
imperfection in the capital market to maximize the wealth of stockholders.
However, the existence of this imperfection is doubtful.
Page 13 of 50
7. What are the costs of maintaining too large level of working capital? Too small a level of working
capital?
Too large an investment in working capital lowers the firm's profitability
without a corresponding reduction in risk. (In fact, risk might actually
increase - - see answer to Question #8.) Too small a level of working capital
could also lower profitability due to stock outs and too few credit sales
(because of an overly strict credit policy).
Page 14 of 50
8. Amtek Company currently has total assets of Rs 3.2 million, of which current assets comprise Rs 0.2
million. Sales are Rs 10 million annually, and the before-tax net profit margin (the firm currently has
no interest-bearing debt) is 12 percent. Given renewed fears of potential cash insolvency, an overly
strict credit policy, and imminent stockouts, the company is considering higher levels of current
assets as a buffer against adversity. Specifically, levels of Rs 0.5 million and Rs 0.8 million are being
considered instead of the Rs 0.2 million presently held. Any addition to currents assets would be
financed with new equity capital.
a. Determine the total asset turnover, before-tax return on investment, and before-tax net
profit margin under the three alternative levels of current assets.
1. a.
Page 15 of 50
b. If the new additions to current assets were finance with long-term debt at 15 percent
interest, what would be the before-tax interest “cost” of the two new policies?
b.
Page 16 of 50
9. Ace Metal Specialties, Inc. has a seasonal pattern to its business. It borrows under a line of credit from
Central Bank at 1 percent over prime. Its total asset requirements now (at year end) and estimated
requirements for the coming year are (in millions):
Now 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Total asset Rs 4.5 Rs 4.8 Rs 5.5 Rs 5.9 Rs 5.0
requirement
Assume that these requirements are level throughout the quarter. At present the company has Rs 4.5
million in equity capital plus long-term debt plus the permanent component of current liabilities, and
this amount will remain constant throughout the year. The prime rate currently is 11 percent, and the
company expects no change in this rate for the next year. Ace Metal Specialties is also considering
issuing intermediate-term debt at an interest rate of 13.5 percent. In this regard, three alternative
amounts are under consideration: zero, Rs 500,000, and Rs 1 million. All additional funds requirements
will be borrowed under the company’s bank line of credit.
a. Determine the total rupee borrowing costs for short-and intermediate-term debt under each of
the three alternatives for the coming year. (Assume that there are no changes in current
liabilities other than borrowings.) Which alternative is lowest in cost?
2. a)
Bank loan
cost* 9,000 30,000 42,000 15,000 $96,000
Alternative 2:
Term Loan
Cost ($500,000 at 13.5%) $67,500
Incremental
borrowings 0 $500,000 $900,000 0
Bank loan
cost* 0 15,000 27,000 42,000
$109,500
Alternative 3:
Term Loan Cost ($1,000,000 at 13.5%) 135,000
Incremental
borrowings 0 0 $400,000 0
Bank Loan
Cost* 12,000 12,000
$147,000
Page 17 of 50
(11% + 1%)/4 = 3% per quarter.
Page 18 of 50
b. Is there a consideration other than expected cost that deserves our attention?
While alternative 1 is cheapest it entails financing the expected build up in
permanent funds requirements ($500,000) on a short-term basis. There is a risk
consideration in that if things turn bad the company is dependent on its bank
for continuing support. There is risk of loan renewal and of interest rates
changing.
Page 19 of 50
CASH AND MARKETABLE SECURITIES MANAGEMENT
11. Money market instruments are used as investment vehicles for otherwise idle cash. Discuss the most
important criterion for asset selection in investing temporarily idle cash.
The lock-box system may improve the efficiency of cash management by reducing
the float. The funds made available by this reduction in float may be invested
to produce additional profit.
Page 20 of 50
12. Assuming that the return on real assets of a company exceeds the return on marketable securities,
why should a company hold any marketable securities?
Page 21 of 50
14. The Zindler Company currently has a centralized billing system. Payments are made by all customers
to the central billion location. It requires, on average, four days for customers’ mailed payments to
reach the central location. An additional day and a half is required to process payments before a
deposit can be made. The firm has a daily average collection of Rs 500,000. The company has
recently investigated the possibility of initiating new system. Is has estimated that with such a
system customers’ mailed payments would reach the receipt location two and one-half days sooner.
Further, the processing time could be reduced by an additional day bank would pick up mailed
deposits twice daily.
a. Determine how much cash would be freed up (released) through the use of a new system.
a.
Page 22 of 50
b. Determine the annual gross rupee benefit of the new system, assuming the firm could earn
a 5 percent return on the released funds in Part (a) by investing in short-term instruments.
b. 5% X $1,750,000 = $87,500
Page 23 of 50
c. If the annual cost of the new system will be Rs 75,000, should such a system be initiated?
c. Since the dollar gross benefit of the lockbox system ($87,500) exceeds the
cost of the lockbox system ($75,000), the system should be initiated.
Page 24 of 50
15. Speedway Company franchises “Gas and Go” stations in Maharashtra and Gujarat. All payments by
franchisees for gasoline and oil products, which average Rs 420,000 a day, are by check. At present,
the overall time between the mailing of the check by the franchisee to Speedway and the time the
company has collected or available funds at its bank is six days.
a. How much money is tied up in this interval of time?
a) $420,000 x 6 = $2,520,000.
Page 25 of 50
b. To reduce this delay, the company is considering daily pickups from the stations. In all, three
cars would be needed that three additional people hired. This daily pickup would cost Rs
93,000 on annual basis, and it would reduce the overall delay by two days. Currently, the
opportunity cost of funds is 9 percent, that being the interest rate on marketable securities.
Should the company inaugurate the pickup plan? Why?
Page 26 of 50
c. Rather than mail checks to its bank, the company could deliver them by messenger service.
This procedure would reduce the overall delay by one day and cost Rs 10,300 annually.
Should the company undertake this plan? Why?
Page 27 of 50
16. The food world company has a weekly payroll of Rs 150,000 paid on Friday. On average, its
employees cash their check in following manner:
Day check cleared on company’s account Percentage of checks cashed
Friday 20
Monday 40
Tuesday 25
Wednesday 10
Thursday 5
As treasurer of the company, how would you arrange your payroll account? Are there any
problems?
Page 28 of 50
ACCOUNTS RECEIVABLE AND INVENTORY MANAGEMENT
17. Is it always good policy to reduce the firm’s bad debts by “getting rid of the deadbeats?”
No. Only if the added profitability of the additional sales to the "deadbeats"
(less bad debt loss and other costs) does not exceed the required return on
the additional (and prolonged) investment in accounts receivable should the
firm cease sales to these customers. Some firms (such as jewelry or audio
equipment dealers) are very happy to sell to almost any "deadbeat" because
their margins are very high.
Page 29 of 50
19. What are the various sources of information you might use to analyze a credit applicant?
To analyze a credit applicant, one might turn to financial statements provided by the applicant, credit
ratings and reports, a check with the applicant's bank (particularly if a loan is involved), a check with
trade suppliers, and a review of your own credit experience if the applicant has done business with you
in the past. Each step involves a cost and the value of additional information must be balanced against
the profitability of the order and the cost of the information.
20. What are the principal factors that can be varied in setting credit policy?
The quality of account accepted, the credit period, the discount,
Page 30 of 50
21. The analysis of inventory policy is analogous to the analysis of credit policy. Propose a measure to
analyze inventory policy that is analogous to the aging of accounts receivable.
22. What are the principal implications to the financial manager of ordering costs, storage costs, and
cost of capital as they relate to inventory?
The greater the ordering costs, the more inventory that will be maintained,
all other things the same, and the greater the funds that will be tied up in
inventory. The greater the storage costs and cost of capital, the less
inventory that will be maintained.
Page 31 of 50
23. How can the firm reduce its investment in inventories? What costs might the firm incur from a policy
of very low inventory investment?
Page 32 of 50
25. Should the required rate of return for investment in inventories of raw materials be the same as that
for finished goods?
Usually a company will use the same required rate of return for both. However,
if one type of inventory was significantly more risky than the other, one
might wish to apply a higher required rate of return. This might occur if the
raw materials had a ready market with little price fluctuation whereas the
finished products were subject to considerable uncertainty.
Page 33 of 50
26. Kids-Kemp Company currently gives credit terms of “net 30 days.” Is has Rs 60 million in credit sales,
and its average collection period is 45 days. To stimulate demand, the company may give credit
terms of “net 60 days.” If it does instigate these terms, sales are expected to increase by 15 percent.
After the change, the average collection period is expected to be 75 days, with no difference in
payment habits between old and new customers. Variable costs are Rs 0.80 for every Rs 1.00 of
sales, and the company’s before-tax required rate of return on investment in receivables is 20
percent. Should the company extend its credit period? (Assume a 360-day year.)
1.
Profitability of additional
sales = .2 x $9,000,000 = $1,800,000
Additional receivables
associated with the new sales = $9,000,000/4.8 = $1,875,000
Investment in additional
receivables associated
with the new sales = .8 x $1,875,000 = $1,500,000
Investment in additional
receivables associated
with original sales = $12.5M - $7.5M = $5,000,000
Total investment in
additional receivables = $1.5M + $5.0M = $6,500,000
Page 34 of 50
27. Clean Air company is a distributor of air filter to retail stores. It buys its filters from several
manufacturers. Filters are ordered in lot sizes of 1,000, and each order costs Rs 40 to place. Demand
from retails stores is Rs 20,000 filters per month, and carrying cost is Rs 0.10 a filter per month.
a. What is the optimal order quantity with respect to so many lot sizes ( that is, what
multiple of 1,000 units should be ordered)?
a. ┌───────── ┌─────────────
│ 2(O)(S) │ 2($40)(20)
Q* = │ ─────── = │ ─────────── = 4 (thousand-unit) lots
\│ C \│ 100
The optimal order size would be 4,000 filters, which represents
five orders a month.
(Note: carrying costs (C) per 1,000-unit lot = $.10 X 1,000 = $100)
Page 35 of 50
b. What would be the optimal order quantity if the carrying cost were cut in half to Rs 0.05
a filter per month?
b. ┌───────── ┌─────────────
│ 2(O)(S) │ 2($40)(20)
Q* =│ ─────── = │ ─────────── = 5.66 (thousand-unit) lots
\│ C \│ 50
Since the lot size is 1,000 filters, the company would order 6,000 filters
each time. The lower the carrying cost, the more important ordering costs
become relatively, and the larger the optimal order size.
Page 36 of 50
c. What would be the optimal order quantity if the carrying cost were reduced to Rs 10 per
order?
c. ┌───────── ┌─────────────
│ 2(O)(S) │ 2($10)(20)
Q* =│ ─────── = │ ─────────── = 2 (thousand-unit) lots
\│ C \│ 100
The lower the order cost, the more important carrying costs become relatively,
and the smaller the optimal order size.
Page 37 of 50
28. To increase sales from their present annual Rs 24 million, Kim Chi Company, a wholesaler, may try
more liberal credit standards. Currently, the firm has an average collection period of 30 days. It
believes that, with increasingly liberal credit standards, the following will result:
Credit Policy
A B C D
Increase in sales from previous level ( in millions) Rs 2.8 Rs 1.8 Rs 1.2 Rs 6
Average Collection period from incremental sales (days) 45 60 90 144
The prices of its products average Rs 20 per unit, and variable costs average Rs 18 per unit. No bad
debt losses are expected. If the company has a pre-tax opportuinity cost of funds of 30 percent,
which credit policy should be pursued? Why? (Assume 360 day year)
1.
________________________________________________________________________
Credit Policy A B C D
a. Incremental
sales $2,800,000 $1,800,000 $1,200,000 $600,000
b. Incremental
profitability1 280,000 180,000 120,000 60,000
c. New receivable
turnover 8 6 4 2.5
d. Additional
receivables3 $350,000 $300,000 $300,000 $240,000
e. Additional
investment 315,000 270,000 270,000 216,000
f. Opportunity cost
94,500 81,000 81,000 64,800
g. (b) > (f)? yes yes yes no
________________________________________________________________________
Page 38 of 50
29. The Amtek Manufacturing company is considering extending trade credit to the Saint Jones
Company. Examination of the records of Saint Jones has produced the following financial
statements:
Liabilities
Current liabilities
Notes Payable (8.5%) Rs 2.1 Rs 3.1 Rs 3.8
Trade payables 0.2 0.4 0.9
Other payables 0.2 0.2 0.2
Total Current liabilities Rs 2.5 Rs 3.7 Rs 4.9
Term loan 4.0 3.0 2.0
Total laibilities Rs 6.5 Rs 6.7 Rs 6.9
Net worth
Preferred stock (6.5%) 1.0 1.0 1.0
Common stock 5.0 5.0 5.0
Retained Earnings 2.0 3.0 4.0
Total liabilities and net worth Rs 14.5 Rs 15.7 Rs 16.9
Page 39 of 50
Total retained earnings Rs 1.0 Rs 1.0 Rs 1.0
Inquiries into its banking disclosed balances generally in the low millions. Five suppliers to Saint
Jones revealed that the firm takes its discounts from the three suppliers offering “2/10 net 30”
terms, though it is about 15 days slow in paying the two firms offering terms of “net 30.”
Analyze the Saint Jones Company’s application for credit. What positive factors are present? What
negative factors are present?
6. Positive factors:
a) The firm has maintained a reasonably good cash position over
the period.
b) The firm has reduced by 50% its outstanding long-term debt.
c) The firm has been increasing its net worth by $1 million
annually.
d) The firm has taken cash discounts when offered.
Negative factors:
a) The firm has only a "fair" Dun & Bradstreet rating.
b) The firm has been a slow payer to trade creditors not offering
a discount.
c) The liquidity of the firm has been reduced substantially over the past
three years as the acid-test ratio went from 1.28 to 1.05 to 0.92. Short-term
debt and trade credit from suppliers have increased faster than total
liabilities and net worth while inventory and receivable turnovers have
slowed.
Page 40 of 50
30. A college bookstore is attempting to determine the optimal order quantity for a populat bok on
Economics. The store sells 5,000 copies of this book a year at a retail price of Rs 125, and the cost to
the store is 20 percent less, which represents the discount from publisher. The store figures that it
costs Rs 1 per year to carry a book in inventory and Rs 100 to prepare an order for new books.
a. Determine the total inventory costs associated with ordering 1, 2, 5, 10, and 20 times a
year.
a) C(Q/2) + O(S/Q) = TC
(1X): $1(5,000/2) + $100(5,000/5,000) = $2,600
(2X): $1(2,500/2) + $100(5,000/2,500) = $1,450
(5X): $1(1,000/2) + $100(5,000/1,000) = $1,000
(10X): $1(500/2) + $100(5,000/500) = $1,250
Page 41 of 50
b. Determine the economic order quantity.
b) ┌──── ┌─────────────────
│ 2OS │ (2)($100)(5,000) ┌───────
Q* = │ ─── = │ ──────────────── = \│ 1 million = 1,000
\│ C \│ $1
Page 42 of 50
c. What implicit assumptions are being made about the annual sales rate?
It is assumed that sales are made at a steady rate, which may not be correct
for textbooks. The nature of academics suggests that sales would occur at the
beginning of each term.
Page 43 of 50
31. The Hedge Company manufactures only one product: planks. The single raw material used in making
planks is the dint. For each plank manufactured, 12 dints are required. Assume that the company
manufactures 150,000 planks per year, that demand for planks is perfectly steady throughout the
year, that it costs Rs 200 each time dints are ordered, and that carrying costs are Rs 8 per dint per
year.
a. Determine the economic order quantity of dints.
Page 44 of 50
b. What are total inventory costs for Hedge (total carrying costs plus total ordering costs)?
TC = C(Q/2) + O(S/Q)
= $8(9,487/2) + $200(1,800,000/9,487)
Page 45 of 50
c. How many times per year would inventory be ordered?
Page 46 of 50
SHORT-TERM FINANCING
32. Explain why trade credit from suppliers is a “spontaneous source of funds.”
33. Stretching payables provides “free” funds to customers for a short period. The supplier, however,
can face serious financial problems if all its customers stretch their accounts. Discuss the nature of
the problems the supplier may face, and suggest different approaches to cope with stretching.
Stretching payables creates problems for suppliers since their ability to
forecast cash flows is substantially impaired. The more uncertain the cash
projections, the higher the level of protective liquidity a firm must hold.
Also, investors may perceive a higher degree of risk for the supplier, thus
increasing the supplier's cost of capital. Methods of preventing the
stretching of payables include severe penalties for late payment (such as a
10% late charge), friendly reminders to the customers, and other acceptable
collection procedures.
Page 47 of 50
34. Would you rather have your loan on a “collect basis” or a “discount basis” if you were a borrower,
all other things being the same? If you were a lender?
A line of credit is an informal lending arrangement, usually for one year, where the bank expresses a
willingness to lend up to some specified amount of funds at an interest rate related to the prime rate or
to the bank's cost of funds. A revolving credit agreement is a legal commitment to extend credit up to
some maximum amount anytime a company wishes to borrow. Usually the commitment is for multiple
years, often three. Also, the company must satisfy certain restrictions (called protective covenants)
specified in the agreement. If satisfied, however, the loan cannot be denied whereas it can be legally
denied under a line of credit should the company evolve itself into financial difficulty.
Page 48 of 50
36. List assets that you would accept as collateral on a short-term loan in your order of preference.
Justify your priorities.
1. Hypothecation of Loan
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37. The Pawlowski Supply Company needs to increase its working capital by Rs 4.4 million. The following
three financing alternatives are available (assume a 365-day year):
a. Forgo cash discounts (granted on a basis of “3/10, net 30”) and pay on the final due
date.
b. Borrow Rs 5 million from a bank at 15 percent interest. This alternative would
necessitate maintaining a 12 percent compensating balance.
c. Issue Rs 4.7 million of six-month commercial paper to net Rs 4.4 million. Assume that
new paper would be issued every six months. (Note: Commercial paper has no
stipulated interest rate. It is sold at a discount, and the amount of the discount
determines the interest and cost to the issuer.)
Assuming that the firm would prefer the flexibility of bank financing, provided the additional
cost of this flexibility was no more than 2 percent per annum, which alternative should
Pawlowski select? Why?
The bank financing is approximately 3.4 percent more expensive than the
commercial paper; therefore, commercial paper should be issued.
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