CORPORATE FINANCE (UKFF 3013)

JANUARY 2023 TRIMESTER

TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

QUESTION 1
Discuss briefly the factors which influence the formulation of working capital policy.

SOLUTION
Working capital policies can cover the level of investment in current assets, the way
in which current assets are financed, and the procedures to follow in managing
elements of working capital such as inventory, trade receivables, cash and trade
payables. The twin objectives of working capital management are liquidity and
profitability, and working capital policies support the achievement of these objectives.

There are several factors which influence the formulation of working capital policies
as follows:
Nature of the business: The nature of the business influences the formulation of
working capital policy because it influences the size of the elements of working
capital. A manufacturing company, for example, may have high levels of inventory
and trade receivables, a service company may have low levels of inventory and high
levels of trade receivables, and a supermarket chain may have high levels of
inventory and low levels of trade receivables.

The operating cycle: The length of the operating cycle, together with the desired
level of investment in current assets, will determine the amount of working capital
finance needed. Working capital policies will therefore be formulated so as to
optimise as much as possible the length of the operating cycle and its components,
which are the inventory conversion period, the receivables conversion period and
payables deferral period.

Terms of trade: Since a company must compete with other companies to be

successful, a key factor in the formulation of working capital policy will be the terms
of trade offered by competitors. The terms of trade must be comparable with those of
competitors and the level of receivables will be determined by the credit period
offered and the average credit period taken by customers.

Risk appetite of company: A risk-averse company will tend to operate with higher
levels of inventory and receivables than a company which is more risk-seeking.

Similarly, a risk-averse company will seek to use long-term finance for permanent
current assets and some of its fluctuating current assets (conservative policy), while
a more risk-seeking company will seek to use short-term finance for fluctuating
current assets as well as for a portion of the permanent current assets of the
company (an aggressive policy).

QUESTION 2
Discuss the key elements of a trade receivables management policy.

SOLUTION
The key elements of a trade receivables policy are credit analysis, credit control and
receivables collection.

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

Credit analysis: Credit analysis helps a company to minimise the possibility of bad
debts by offering credit only to customers who are likely to pay the money they owe.
Credit analysis also helps a company to minimise the likelihood of customers paying
late, causing the company to incur additional costs on the money owed, by indicating
which customers are likely to settle their accounts as they fall due.

Credit analysis, or the assessment of creditworthiness, is undertaken by analysing

and evaluating information relating to a customer’s financial history. This information
may be provided by trade references, bank references, the annual accounts of a
company or credit reports provided by a credit reference agency. The depth of the
credit analysis will depend on the potential value of sales to the client, in terms of
both order size and expected future trading. As a result of credit analysis, a company
will decide on whether to extend credit to a customer.

Credit control: Having granted credit to customers, a company needs to ensure that
the agreed terms are being followed. The trade receivables management policy will
stipulate the content of the initial sales invoice that is raised. It will also advise on the
frequency with which statements are sent to remind customers of outstanding
amounts and when they are due to be paid. It will be useful to prepare an aged
receivables analysis at regular intervals (e.g. monthly), in order to focus
management attention on areas where action needs to be taken to encourage
payment by clients.

Receivables collection: Ideally, all customers will settle their outstanding accounts
as and when they fall due. Any payments not received electronically should be
banked quickly in order to decrease costs and increase profitability. If accounts
become overdue, steps should be taken to recover the outstanding amount by
sending reminders, making customer visits and so on. Legal action could be taken if
necessary, although only as a last resort.

QUESTION 3
Williams Wholesalers Berhad currently asks its credit customers to pay by the end of
the month after the month of delivery. In practice, customers take rather longer to
pay – on average 70 days. Sales revenue amounts to RM4 million a year and bad
debts to RM20,000 a year.

It is planned to offer customers a cash discount of 2 per cent for payment within 30
days. Williams estimates that 50 per cent of customers will accept this facility but that
the remaining customers, who tend to be slow payers, will not pay until 80 days after
the sale. At present the business has an overdraft facility at an interest rate of 13 per
cent a year. If the plan goes ahead, bad debts will be reduced to RM10,000 a year
and there will be savings in credit administration expenses of RM6,000 a year.

Should Williams Wholesalers Berhad offer the new credit terms to customers?

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

SOLUTION
Step 1: Determine the reduction in trade receivables arising from the new policy.

Existing level of trade (RM4m x 70/365) 767,123

receivables

New level of trade RM2m x 80/365 438,356

receivables:
RM2m x 30/365 164,384 (602,740)

Reduction in trade 767,123 – 602,740 164,383

receivables

The costs and benefits of offering the discount can be set out as follows:

Cost of discount (RM2m 40,000

x 2%)

Less

Interest saved on the (RM164,383 x 13%) 21,370

reduction in trade
receivables

Administration cost 6,000

saving

Cost of bad debts saved 1RM20,000 - 10,000 (37,370)

RM10,0002

Net cost of policy 2,630

These calculations show that the business will be worse off by offering the new
credit terms.

QUESTION 4
T Berhad has annual credit sales of RM4.5 million. Credit terms are 30 days, but its
management of trade receivables has been poor and the average collection period is
50 days, with 0.4 percent of sales resulting in bad debts.

A factor has offered to take over the task of debt administration and credit checking,
at an annual fee of 1 percent of credit sales. T Berhad estimates that it could save
RM35,000 per year in administrative costs as a result. Due to the efficiency of the
factor, the average collection period would fall to 30 days and bad debts would be
eliminated. The factor would advance 80 percent of invoiced debts at an annual
interest rate of 11 percent. T Berhad currently finances trade receivables from an
overdraft costing 10 percent per year.

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

Required:
If credit sales occur smoothly throughout the year, determine whether the factor’s
services should be accepted. Will accepting the services of the factor maximize
shareholders’ wealth?

SOLUTION
RM
Current level of trade RM4.5m x (50 days/365 days) 616,438
receivables
Under the factor, trade RM4.5m x (30 days/365 days) 369,863
receivables will fall to
Decrease in receivable 616,438 – 369,863 246,575
Interest saving from using 246,575 x 0.1 (10%) 24,657.5
overdraft

The costs of the current policy are:

RM
Cost of financing current 616,438 x 0.1 (10%) 61,644
receivables
Cost of bad debts RM4.5m x 0.4% (0.004) 18,000
Cost of current policy 61,664 + 18,000 79,644

The costs under the factor are:

(369,863 x 0.8 x 11%) + (369,863 x 0.2 x 10%)
= (32,548 + 7,397)
Factor’s annual fee
Saved administrative cost
Net cost under factor
Comment
RM
39,945
Rm4.5m x 0.01 45,000
(35,000)
49,945
Cost-benefit analysis shows the factor’s services
are cheaper than the current practice by
RM29,699 (79,644 – 49,945) per year. On
financial grounds, the services of the factor
should be accepted as it will maximize
shareholders’ wealth.

Alternative calculation- From the slides

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

RM
Interest saving +24,658
Decrease in bad debts +18,000
Admin cost saving +35,000
Factor Fee 4,500,000 x 0.01 (45,000)
Interest on advance 369,863 x (11 – 10) x 0.8 (2,959)
Saving using factor 29,699

QUESTION 5
The Finance director of M Berhad is trying to improve the company’s slack working
capital management. Although M’s trade terms require settlement with 30 days, its
customers take an average of 45 days to pay. In addition, out of total credit sales of
RM15 million per year, the company suffers bad debts of RM235,000 annually
Proposal: It has been suggested that the average settlement period should be
reduced if an early settlement discount were offered and the finance director is
considering a reduction of 1.5 per cent of the face value of invoice for payment within
30 days It is expected that 40 percent of customers would use the discount but that
the average time taken by the remaining customers would not be affected. It is also
expected that, if the new credit terms are introduced, bad debts will fall by RM60,000
per year and administration costs will fall by RM15,000 per year.
Required:
(a) If total sales are unchanged and if working capital is financed by an overdraft at
9 per cent per year, are the new credit terms of any benefit to M Berhad?

SOLUTION

Current receivables 15m x 45 days/365 1,849,315

days
New level of receivables
Those taking discount 15m x 30/365 x 0.4 493,151
Those not taking discount 15m x 45/365 x 0.6 1,109589 1,602,740
Change in level of 1,849,315 – 1,602,740 246,575
receivables - reduction

Finance savings on 246,575 x 0.09 (9%) 22,192

receivables

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

Decrease in bad debts 60,000

(benefit)
Savings in administration 15,000
costs (benefit)
Total Benefits to the co 22192 + 60,000 + 97,192
15,000
Cost of discount 15m x 0.4 (40%) x 90,000
0.015 (discount)
Net benefit of proposal 7,192
Conclusion: This benefit is so small that it is unlikely it can be justified. Further
investigation of likely costs and benefits is called for.

QUESTION 6
G Berhad, a manufacturer of steel toys, has annual sales of RM20 million. Cost of
goods sold is 70% of sales, and purchases are 65% of cost of goods sold. All the
sales and purchases are on credit. Assume a 360-day year, and G Berhad has the
following ratios:
Average Inventory Holding Period 45 days
Average Payment Period 30 days
Average Collection Period 25 days
Required:
Compute the Cash Conversion Cycle (CCC) of G Berhad and the amount of net
working capital invested in the CCC.
If G Berhad wishes to improve its working capital management, recommend FOUR
(4) strategies to improve its CCC.

SOLUTION
(i) CCC = Inventory days + Trade receivable days – Trade payable days

Cash Conversion Cycle 45 days + 25 days – 30 40 days

(CCC) days
Investment in Inventory (RM20m  0.70)  45/360 RM1.75m
RM14m  45 days/360
days
Investment in RM20m  (25 days/360 RM1.39m (or RM
Receivables 1,388,888.89)

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

days)
Investment in Payables (RM20m  0.70  0.65)  RM0.76m (or RM
30 days/360 days 758,333.33)
= RM9.1m  30/360
Amount invested in RM1.75m + RM1.39m – RM2.38m (or RM
CCC RM0.76m 2,380,555.56)

(ii)
Strategies to improve CCC:
1. Turn over inventory as quickly as possible without stock outs that result in lost
sales.
2. Collect accounts receivable as quickly as possible without losing sales from high-
pressure collection techniques.
3. Manage mail, processing, and clearing time to reduce them when collecting from
customers and to increase them when paying suppliers.
4. Pay accounts payable as slowly as possible without damaging the firm’s credit
rating.

QUESTION 7
K Berhad is an e-business which trades solely over the internet. In the last year the
company had sales of RM15 million. All sales were on 30 days’ credit to commercial
customers.
Extracts from the company’s most recent statement of financial position relating to
working capital are as follows:
RM’000
Trade receivables 2,466
Trade payables 2,220
Overdraft 3,000
In order to encourage customers to pay on time, K Berhad proposes introducing an
early settlement discount of 1% for payment within 30 days, while increasing its
normal credit period to 45 days. It is expected that, on average, 50% of customers
will take the discount and pay within 30 days, 30% of customers will pay after 45
days, and 20% of customers will not change their current paying behaviour.

K Berhad currently orders 15,000 units per month of Product Z, demand for which is
constant. There is only one supplier of Product Z and the cost of Product Z
purchases over the last year was RM540,000. The supplier has offered a 2%
discount for orders of Product Z of 30,000 units or more. Each order costs K Berhad

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

RM150 to place and the holding cost is 24sen per unit per year. K Berhad has an
overdraft facility charging interest of 6% per year.

Required:
A. Calculate the net benefit or cost of the proposed changes in trade receivables
policy and comment on your findings.
B. Calculate whether the bulk purchase discount offered by the supplier is
financially acceptable and comment on the assumptions made by your
calculation.
SOLUTION
(a) Calculation of net cost/benefit

Current receivables given RM2,466,000

Receivables paying within 15m x 0·5 x 30/365 RM616,438

30 days

Receivables paying within 15m x 0·3 x 45/365 RM554,795

45 days

Receivables paying within 15m x 0·2 x 60/365 RM493,151

60 days

Revised receivables 616,438 + 554,795 + RM1,664,384

493,151

Reduction in receivables 2,466,000 – 1,664,384 RM801,616

Reduction in financing cost 801,616 x 0·06 RM48,097

Cost of discount 15m x 0·5 x 0·01 RM75,000

Net cost of proposed 75,000 – 48,097 RM26,903

changes in receivables
policy

Alternative approach to calculation of net cost/benefit

Current receivables days (2,466/15,000) x 365 60 days

Revised receivables days (30 x 0·5) + (45 x 0·3) + (60 40·5 days
x 0·2)

Decrease in receivables 60 – 40·5 19·5 days

days

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

Decrease in receivables 15m x 19·5/365 RM801,370

(The slight difference compared to the earlier answer is due to rounding)

Decrease in financing cost 801,370 x 0·06 RM48,082

Net cost of proposed 75,000 (cost) – RM26,918

changes in receivables 48,082(benefit)
policy

Comment:
The proposed changes in trade receivables policy are not financially
acceptable. However, if the trade terms offered are comparable with those
of its competitors, KXP Co needs to investigate the reasons for the (on
average) late payment of current customers. This analysis also assumes
constant sales and no bad debts, which is unlikely to be the case in
reality.

(b) Cost of current inventory policy

Cost of materials RM540,000 per

year

Annual ordering cost 12 x 150 RM1,800 per year

Annual holding cost 0·24 x (15,000/2) RM1,800 per year

Total cost of current 540,000 + 1,800 + RM543,600 per

inventory policy 1,800 year

Cost of inventory policy after bulk purchase discount

Cost of materials after bulk 540,000 x 0·98 RM529,200 per

purchase discount year

Annual demand 12 x 15,000 180,000 units per

year

K Berhad will need to increase its order size to 30,000 units to gain the
bulk discount

Revised number of orders 180,000/30,000 6 orders per year

Revised ordering cost 6 x 150 RM900 per year

Revised holding cost 0·24 x (30,000/2) RM3,600 per year

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

Revised total cost of 529,200 + 900 + 3,600 RM533,700 per

inventory policy year

Evaluation of offer of bulk purchase discount Net benefit of taking bulk

purchase discount = 543,600 – 533,700 = RM9,900 per year. The bulk
purchase discount looks to be financially acceptable. However, this
evaluation is based on a number of unrealistic assumptions. For example,
the ordering cost and the holding cost are assumed to be constant, which
is unlikely to be true in reality. Annual demand is assumed to be constant,
whereas in practice seasonal and other changes in demand are likely.

QUESTION 8
V Berhad sells stationery and office supplies on a wholesale basis and has an
annual revenue of RM4 million. The company employs four people in its sales
ledger and credit control department at an annual salary of RM12,000 each. All
sales are on 40 days’ credit with no discount for early payment. Bad debts represent
3% of revenue and V Berhad pay annual interest of 9% on its overdraft. The most
recent accounts of the company offer the following information:

RM’000 RM’000
Non-current assets
Tangible non-current assets 17,500
Current assets
Inventory of goods for resale 900
Receivables 550
Cash 120
1,570
Total assets 19,070

Equity and liabilities

Ordinary shares 3,500
Reserves 11,640
15,140
Non-current liabilities

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

12% bonds due 20Y0 2,400

Current liabilities
Trade payables 330
Overdraft 1,200
1,530
Total equity and liabilities 19,070

V Berhad is considering offering a discount of 1% to customer paying within 14 days,

which it believes will reduce bad debts to 2.4% of revenue. The company also
expects that offering a discount for early payment will reduce the average credit
period taken by customers to 26 days. The consequent reduction in time spent
chasing customers where payment are overdue will allow one member of the credit
control team to take early retirement. Two-thirds of customers are expected to take
advantage of the discount.

Required:
Using the information provided, determine whether a discount for early payment of 1
per cent will lead to an increase in profitability for V Berhad.

SOLUTION

Receivables currently take an (RM550,000)/RM4,000,00 x 50 days to

average of 365 days pay

This is in excess of V Berhad’s stated terms

Cost of discount to company RM4,000,000 x 1% x 2/3 RM26,667

Receivables payment period 26 days

New receivables level RM4,000,000 x 26/365 RM284,932

Reduction in receivables RM550,000 – RM284,932 RM265,068

Savings on overdraft costs RM265,068 x 0.09 RM23,856

Reduction in bad debts RM4,000,000 x 0.006 RM24,000

Savings in salary RM12,000

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 CORPORATE FINANCE (UKFF 3013)
JANUARY 2023 TRIMESTER
TUTORIAL 4 (WEEK STARTING 20 FEB 2023)
SHORT TERM FINANCE AND
THE MANAGEMENT OF WORKING CAPITAL (CHAPTER 3)

Net effect on V Berhad’s profitability

Savings on overdraft 23,856

Decrease bad debts 24,000

Salary savings 19,000

Less: cost of discount (26,667)

Net savings 33,189

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