FINANCIAL MANAGEMENT COVENANT FINANCIAL CONSULTANTS

WORKING CAPITAL MANAGEMENT EXAMPLES AND REVIEW QUESTIONS:

Question 1 (Estimation of WC)
Assume that Carmed plc that is based in Tanzania expects credit sales of £7,500 in the next year
and has budgeted production costs as follows: (Fig in million TZS)
- Raw materials 4M
- Direct labour 5M
- Production overheads 3M
- Total production costs 12 M
Raw materials are in inventory for an average of three weeks and finished goods are in inventory
for an average of four weeks. All raw materials are added at the start of the production cycle, which
takes five weeks and incurs labour costs and production overheads at a constant rate. Suppliers of
raw materials allow four weeks’ credit, whereas customers are given 12 weeks to pay. If production
takes place evenly throughout the year, what is the total working capital requirement in TZS given
that the average TZS/£ exchange rate is 2400?

Question 2 (Economic Order Quantity)

Oleum plc sells a soap called Fragro, which it buys in boxes of 1000 bars with ordering costs of
c5 per order. Retail sales are 200 000 bars per year and holding costs are TZS 2.22 per year per
1000 bars. What is the economic order quantity and average inventory level for Fragro? What is
Fragro’s Total Cost of Inventory?

Question 3: (Credit Relaxation)

Mine plc has annual credit sales of TZS15m and allows 90 days’ credit. It is considering
introducing a 2 per cent discount for payment within 15 days, and reducing the credit period to 60
days. It estimates that 60 per cent of its customers will take advantage of the discount, while the
volume of sales will not be affected. The company finances working capital from an overdraft at
a cost of 10 per cent. Is the proposed change in policy worth implementing?
Example 4 (Cost benefit Analysis of Factoring)
Trebod has annual credit sales of TZS4.5m. 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 per cent 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 per cent of credit sales. Trebod plc estimates that it would save
TZS35 000 per year in administration 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 per cent of invoiced debts at an annual interest rate of 11 per cent. Trebod plc

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currently finances trade receivables from an overdraft costing 10 per cent per year. If credit sales
occur smoothly throughout the year, determine whether the factor’s services should be accepted.

Example 5: (Cash management)

A company disburses a total of TZS 50M per year in cash. It costs TZS 75 on every time securities
are sold for cash. The treasury manager estimates that the variance of change in daily CFs balance
is TZS 20M. He also establishes that the lower cash limit is 50,000.
Req. Calculate the return point and the upper Cash limit if the current short term investment rate
is 5%

Question 6 ACCA June 2015 (Mixed)

The finance director of Widnor Co has been looking to improve the company’s working capital
management. Widnor Co has revenue from credit sales of $26,750,000 per year and although its
terms of trade require all credit customers to settle outstanding invoices within 40 days, on average
customers have been taking longer. Approximately 1% of credit sales turn into bad debts which
are not recovered.
Trade receivables currently stand at $4,458,000 and Widnor Co has a cost of short-term finance of
5% per year.
The finance director is considering a proposal from a factoring company, Nokfe Co, which was
invited to tender to manage the sales ledger of Widnor Co on a with-recourse basis. Nokfe Co
believes that it can use its expertise to reduce average trade receivables days to 35 days, while
cutting bad debts by 70% and reducing administration costs by $50,000 per year. A condition of
the factoring agreement is that the company would also advance Widnor Co 80% of the value of
invoices raised at an interest rate of 7% per year. Nokfe Co would charge an annual fee of 0·75%
of credit sales.
Assume that there are 360 days in each year.
Required:
(a) Advise whether the factor’s offer is financially acceptable to Widnor Co. (7 marks)
(b) Briefly discuss how the creditworthiness of potential customers can be assessed. (3 marks)

Question 7
FLG Co has annual credit sales of TZS4·2 million and cost of sales of TZS1·89 million. Current
assets consist of inventoryand accounts receivable. Current liabilities consist of accounts payable
and an overdraft with an average interest rateof 7% per year. The company gives two months’

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credit to its customers and is allowed, on average, one month’s creditby trade suppliers. It has an
operating cycle of three months.
Other relevant information:
Current ratio of FLG Co1·4
Cost of long-term finance of FLG Co11%
Required:
(a) Discuss the key factors which determine the level of investment in current assets.(6 marks)
(b) Discuss the ways in which factoring and invoice discounting can assist in the management
of accountsreceivable.(6 marks)
(c) Calculate the size of the overdraft of FLG Co, the net working capital of the company and
the total cost offinancing its current assets.(6 marks)
(d) FLG Co wishes to minimise its inventory costs. Annual demand for a raw material costing
TZS12 per unit is 60,000units per year. Inventory management costs for this raw material
are as follows:

Ordering cost: TZS6 per order

Holding cost: TZS0·5 per unit per year

The supplier of this raw material has offered a bulk purchase discount of 1% for orders of
10,000 units or more.If bulk purchase orders are made regularly, it is expected that annual
holding cost for this raw material willincrease to TZS2 per unit per year.
Required:
(i) Calculate the total cost of inventory for the raw material when using the economic
order quantity.(4 marks)
(ii) Determine whether accepting the discount offered by the supplier will minimise the
total cost ofinventory for the raw material. (3 marks)

Question 8 - ACCA June 2009 qn 3

The following financial information relates to HGR Co:

Statement of financial position at the current date (extracts)
TZS000 TZS000
TZS000
Non-current assets 48,965
Current assets
Inventory 8,160
Accounts receivable 8,775
16,935

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Current liabilities
Overdraft 3,800
Accounts payable 10,200
14,000
Net current assets 2,935
Total assets less current liabilities 51,900
Cash flow forecasts from the current date are as follows:
Month 1 Month 2 Month 3
Cash operating receipts (TZS000) 4,220 4,350 3,808
Cash operating payments (TZS000) 3,950 4,100 3,750
Six-monthly interest on traded bonds (TZS000) 200
Capital investment (TZS000) 2,000
The finance director has completed a review of accounts receivable management and has proposed
staff training andoperating procedure improvements, which he believes will reduce accounts
receivable days to the average sector valueof 53 days. This reduction would take six months to
achieve from the current date, with an equal reduction in eachmonth. He has also proposed changes
to inventory management methods, which he hopes will reduce inventory daysby two days per
month each month over a three-month period from the current date. He does not expect any
changein the current level of accounts payable.

HGR Co has an overdraft limit of TZS4,000,000. Overdraft interest is payable at an annual rate of
6·17% per year, withpayments being made each month based on the opening balance at the start
of that month. Credit sales for the yearto the current date were TZS49,275,000 and cost of sales
was TZS37,230,000. These levels of credit sales and cost ofsales are expected to be maintained in
the coming year. Assume that there are 365 working days in each year.
Required:
(a) Discuss the working capital financing strategy of HGR Co. (7 marks)
(b) For HGR Co, calculate:
(i) the bank balance in three months’ time if no action is taken; and
(ii) the bank balance in three months’ time if the finance director’s proposals are implemented.
Comment on the forecast cash flow position of HGR Co and recommend a suitable course of
action.(10 marks)
(c) Discuss how risks arising from granting credit to foreign customers can be managed and
reduced.(8 marks)

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Question 9June 2010

ZSE Co is concerned about exceeding its overdraft limit of TZS2 million in the next two periods.
It has been experiencing considerable volatility in cash flows in recent periods because of trading
difficulties experienced by its customers, who have often settled their accounts after the agreed
credit period of 60 days. ZSE has also experienced an increase in bad debts due to a small number
of customers going into liquidation.
The company has prepared the following forecasts of net cash flows for the next two periods,
together with their associated probabilities, in an attempt to anticipate liquidity and financing
problems. These probabilities have been produced by a computer model which simulates a number
of possible future economic scenarios. The computer model has been built with the aid of a firm
of financial consultants.
Period 1 cash flow Probability Period 2 cash flow Probability
TZS000 TZS000
8,000 10% 7,000 30%
4,000 60% 3,000 50%
(2,000) 30% (9,000) 20%
ZSE Co expects to be overdrawn at the start of period 1 by TZS500,000.
Required:
(a) Calculate the following values:
(i) The expected value of the period 1 closing balance;
(ii) the expected value of the period 2 closing balance;
(iii) the probability of a negative cash balance at the end of period 2;
(iv) the probability of exceeding the overdraft limit at the end of period 2.
Discuss whether the above analysis can assist the company in managing its cash flows. (13 marks)
(b) Identify and discuss the factors to be considered in formulating a trade receivables
management policy for ZSE Co. (8 marks)
(c) Discuss whether profitability or liquidity is the primary objective of working capital
management. (4 marks)

Question 10 ACCA June 2014

The current assets and current liabilities of CSZ Co at the end of March 2014 are as follows:
TZS000 TZS000
Inventory 5,700

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Trade receivables 6,575 12,275

Trade payables 2,137
Overdraft 4,682 6,819
Net current assets 5,456
For the year to end of March 2014, CSZ Co had domestic and foreign sales of TZS40 million, all
on credit, while costof sales was TZS26 million. Trade payables related to both domestic and
foreign suppliers.
For the year to end of March 2015, CSZ Co has forecast that credit sales will remain at TZS40
million while cost ofsales will fall to 60% of sales. The company expects current assets to consist
of inventory and trade receivables, andcurrent liabilities to consist of trade payables and the
company’s overdraft.
CSZ Co also plans to achieve the following target working capital ratio values for the year to the
end of March 2015:
Inventory days: 60 days
Trade receivables days: 75 days
Trade payables days: 55 days
Current ratio: 1·4 times
Required:
(a) Calculate the working capital cycle (cash collection cycle) of CSZ Co at the end of March 2014
and discusswhether a working capital cycle should be positive or negative. (6 marks)
(b) Calculate the target quick ratio (acid test ratio) and the target ratio of sales to net working
capital of CSZ Coat the end of March 2015. (5 marks)
(c) Analyse and compare the current asset and current liability positions for March 2014 and March
2015, anddiscuss how the working capital financing policy of CSZ Co would have changed. (8
marks)
(d) Briefly discuss THREE internal methods which could be used by CSZ Co to manage foreign
currency transaction risk arising from its continuing business activities. (6 marks)
Question 11:NBAA MAY 2015
Umoja Company has annual sales of Tshs 120,000,000 and all salea are on 30 day’s credit,
although customers on average take ten days more than this to pay. Contribution represents 60%
of sales and the company currently has no bad debts. Accounts receivable are financed by an
overdraft at an annual interest rate of 7%

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Umoja Company plans to offer an early settlement discount of 2% for payment within 15 days to
extend the maximum credit offered to 60 days. The discount is expected to be taken by 30% of
customers, with the remaining customers taking an average of 60 days to pay. The company
expects that these changes will increase annual credit sales by10%, while also leading to additional
incremental costs equal to 1% turnover.

REQUIRED:
(a) Assuming a 360 day year, evaluate whether the proposed changes in credit policy will
increase the profitability of Umoja Company. Advice the company on the key factors to be
considered when formulating working capital funding policy.

(b) Shilo Design Company is a small sized manufacturing entity engaged in the manufacturing
of electrical parts. The shares are listed on the stock exchange and currently command a
price earnings ratio. (P/E) of 11.5

Other details are as follows:

Earnings of the company Tshs 500 million
Dividends Tshs 375 million
Number of equity shares 20,000,000 @ Tshs 250 per share

The firm is estimated to maintain the current rate of earnings on investment.

REQUIRED:
By applying Walter’s dividend model:
(i) Determine the share price (5 marks)
(ii) Establish whether the Dividend/Price ratio is optimal (5 marks)

Question 12: NBAA Nov 2016 Qn2

FARANGA Company produces and sells a detergent product, the Faran. To produce the Faran,
the company uses a special raw material, the Farra . The company wishes to reduce the raw
material inventory cost. Annual demand management costs for this material are as follows:

Ordering cost TZS 60,000 per order

Holding cost TZS 500 per unit per year

The supplier of this material has offered a bulk purchase discount of 1% for orders of
10,000 units or more. If bulk purchase are made regularly, its expected that the annual
holding cost of this material will increase to TZS 600 per unit per year.
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REQUIRED

(a) (i) Calculate the total cost for inventory for the raw materials when using the Economic
order Quantity(EOQ)
(5marks)

(ii) Determine whether accepting the offer for the supplier will minimize the total cost of
inventory of raw materials (5 marks)

(a) Discuss the factors to be considered when forming the dividend policy of a stock exchange
listed company. (10 marks)

(Total: 20 marks)

Question 13: NBAA Nov 2015-Qn3b

(a) FalujaCompany has annual credit sales of TZS 4.2 Million and cost of sales of TZS 1.89
Million. Currentassets consists of inventory and receivables. Current liabilities consists of
account payables and overdraft with an average interest rate of 7% per year. The company
gives two months credit its customers and is allowed on average one month credit by trade
suppliers .it has an operating cycle of three months.

Other relevant information

Current ratio of Faluja company 1.4

Cost of long-term finance of Faluja company 11%

REQUIRED

(ί) Calculate the size of the overdraft of Faluja Company, the net working capital of the
company and the total cost of financing its current assets. (8 marks)

(ίί) Discuss the key factors which determine the level of investments in current assets

(6 marks)
QUESTION 14

TGA Co, a multinational company, has annual credit sales of $5·4 million and related cost of
sales are $2·16 million. Approximately half of all credit sales are exports to a European
country, which are invoiced in euros. Financial information relating to TGA Co is as follows:

$000 $000

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Inventory 473·4
Trade receivables 1,331·5 1,804·9
–––––––
Trade payables 177·5
Overdraft 1,326·6 1,504·1
––––––– –––––––
Net working capital 300·8
–––––––

TGA Co plans to change working capital policy in order to improve its profitability. This
policy change will not affect the current levels of credit sales, cost of sales or net working
capital. As a result of the policy change, the following working capital ratio values are
expected:

Inventory days 50 days

Trade receivables days 62 days

Trade payables days 45 days

Other relevant financial information is as follows:

Short-term dollar borrowing rate 5% per year

Short-term dollar deposit rate 4% per year

Assume there are 365 days in each year.

Required:

(a) For the change in working capital policy, calculate the change in the operating cycle,
the effect on the current ratio and the finance cost saving. Comment on your findings.
(8 marks)

(b) Discuss the key elements of a trade receivables management policy. (7 marks)

(c) Explain the different types of foreign currency risk faced by a multinational company.
(6 marks)

(d) TGA Co expects to receive €500,000 from export sales at the end of three months. A

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forward rate of €1·687 per $1 has been offered by the company’s bank and the spot rate is
€1·675 per $1. TGA Co can borrow short term in the euro at 9% per year.

Required:
Calculate the dollar income from a forward market hedge and a money market
hedge, and indicate which hedge would be financially preferred by TGA Co. (4 marks)

QUESTION 15

Plot Co sells both Product P and Product Q, with sales of both products occurring evenly
throughout the year.

Product P

The annual demand for Product P is 300,000 units and an order for new inventory is placed
each month. Each order costs $267 to place. The cost of holding Product P in inventory is 10
cents per unit per year. Buffer inventory equal to 40% of one month’s sales is maintained.

Product Q

The annual demand for Product Q is 456,000 units per year and Plot Co buys in this product
at $1 per unit on 60 days credit. The supplier has offered an early settlement discount of 1%
for settlement of invoices within 30 days.

Other information
Plot Co finances working capital with short-term finance costing 5% per year. Assume that
there are 365 days in each year.

Required:
(a) Calculate the following values for Product P:
(i) The total cost of the current ordering policy; (3 marks)
(ii) The total cost of an ordering policy using the economic order quantity;(3 marks)
The net cost or saving of introducing an ordering policy using the economic order
quantity. (1 mark)

(b) Calculate the net value in dollars to Plot Co of accepting the early settlement discount
for Product Q.

Discuss how invoice discounting and factoring can aid the management of trade
(c) receivables.
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Identify the objectives of working capital management and discuss the central role
(d) of working capitalmanagement in financial management.

Question 16 (NBAA Nov 2016)

(a) Arcadeco Company has the following information:

Current annual credit sales: TZS.24,000,000

Collection period: 3months
Terms: net/30
Cost of funds: 18%

The Company is considering offering a 4/10, net/30 discount. It anticipated that 30 percent of its
customers will take advantage of the discount. The collection period is expected to decrease to two
(2) months.

REQUIRED:

Should the discount policy be implemented? Justify with computations and interpret your answer.
(6 marks)

(b) Anjali Company has been experiencing fluctuations in demand for its products the
consequences of which is volatility in its cash balances. Currently, Anjali’s daily net cash
flow has a variance of TZS.I0,000. The yield on marketable securities is 6 percent per
annum and the fixed cost of each transaction in marketable securities is TZS.1,000.

REQUIRED:
i) Using the Miller-Orr Model, determine the optimal cash balance, the upper and lower limit
of cash needed and average cash balance (Assume a year has 360 days).
(6 marks)

ii) Briefly explain what the firm will do when each of the limits is reached and/or breached.
(2 marks)

(c) Discuss the key factors which determine the level of investment in current assets.
(6 marks) (Total: 20 marks)

Question 17 (NBAA Nov 2016 Qn-7)

(a) A company currently has annual sales of TZS.500,000,000andan average collection period of
30 days. It is considering four alternatives of a more liberal credit policy, If the credit period

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is extended, the company expects sales and bad debts losses to increase in the following
manner:
Bad debts (%
Credit policy Increase in credit Increase in sales
as of total sales)
Alternative period (TZS.)

A 10 days 25,000,000 1.2

B 15 days 35,000,000 1.5
C 30 days 40,000,000 1 .8
D 42 days 50,000,000 2.2

The selling price per unit is TZS.2,000, average cost per unit at current level of operation is
TZS.1,500 and variable cost per unit is TZS.l,200.

REQUIRED:

If the current bad debt loss is 1 percent of sales and the required rate of return in investment is 20
percent, which credit policy should be undertaken? Ignore taxation, and assume a year with 360
days. (15 marks)
(b) Critically evaluate the internal rate of return as a capital investment appraisal technique.
(5 marks) (Total: 20 marks)

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