Chapter 17

Tutorial 5
1 Costs of Financial Distress Steinberg Corporation and Dietrich Corporation are identical firms except
that Dietrich is more levered. Both companies will remain in business for one more year. The
companies’ economists agree that the probability of the continuation of the current expansion is 80
percent for the next year, and the probability of a recession is 20 percent. If the expansion continues,
each firm will generate earnings before interest and taxes (EBIT) of $2.7 million. If a recession occurs,
each firm will generate earnings before interest and taxes (EBIT) of $1.1 million. Steinberg’s debt
obligation requires the firm to pay $900,000 at the end of the year. Dietrich’s debt obligation
requires the firm to pay $1.2 million at the end of the year. Neither firm pays taxes. Assume a
discount rate of 13 percent.
a. What is the value today of Steinberg’s debt and equity? What about that for Dietrich’s?
b. If there is no Financial Distress cost, calculate the value of Steinberg and Dietrich, comment on the
result.
Expansion : 80 % EBIT = $27m Int
putsteinberg = $900 ,
000 rd = 13 %

Recession : 20 % EBIT = $1 1 m
. Int potpietrion = $1 . 2m +c = 0 %

a .
Steinberg : Expansion : N1 = $2 .
7m -

$0 9m .
= $1 8. m

Recession : N1 = $1 .
1 m
-
$0 9m
. = $0 . 2m

S
$1 8 m 80 % $0 2m 20 %
=> VE =
. x + . x
=
$1 ,
309 , 735

13 %
1
Vsteinberg 2 106 , 195
+
=> = .

$900 000
$796 460
VD =
,
= ,

1 (3
.

S
Dietrich ($2 7m - $1 2m x 80 % + 0x20 %
$ 1 061 947
Ve
.
.

: ,
= = ,

1 13.
=> V = $2 106 195
,
Dietrich
,

$1 2m x 80 % + $1 1m x 20 %
VD $1 044 248
. .

= = , ,

1 13.

b
. If there is no Financial Distress cost => EBIT = NI

$2 7m + 80 % +
$1 1 m x 20 %
$2
Vsteinberg 106 , 194 69
. .

=
Dietrich = = , .

1 13
.
2. Financial Distress Good Time Company is a regional chain department store. It will remain in business
for one more year. The probability of a boom year is 60 percent and the probability of a recession is
40 percent. It is projected that the company will generate a total cash flow of $148 million in a boom
year and $61 million in a recession. The company’s required debt payment at the end of the year is
$88 million. The market value of the company’s outstanding debt is $67 million. The company pays no
taxes.
a. What payoff do bondholders expect to receive in the event of a recession?
b. What is the promised return on the company’s debt?
c. What is the expected return on the company’s debt?
Boom : 60 % EBIT = $148m FV of D = $88m

Recession : 40% EBIT = $61m MV of D = $67m

a .
In the event of a recession ,
the bondholders will receive $61m
.

debt
$88m
b Promise return the co's FVofD 1 31 34 %
.
on = .
= - 1 = .

D m

c .
Expected value of debt = $88m x 60 % +
$61m x 40 % =
$77 2m .

(pmt to bondholders)
value of D-1
Expected return on dubt :
Expected =
$77 2m
$67m
.

- 1 =
15 22 %
.

Leverage t >
Benefits : tax shield

<
Costs : Financial distress cost >
Direct :
Legal fees , lawyer
...

(Bankruptcy > >

Indirect : reputation ,
customer
...

>Chapter
Agency cost cost of Debt 17
Agency
cost of
Agency Equity
SELF-STUDY:
Read the Chapter 22
- Understand the Call and Put option at basic knowledge
- Understand the Put Call Parity, and synthetic instruments
- Understand the Intrinsic value of options and option price
Questions:
1 American and European Options What is the difference between an American option and a European
option?

2 Intrinsic Value What is the intrinsic value of a call option? Of a put option? How do we interpret
these values?

3 If the risk of a stock increases, what is likely to happen to the price of call options on the stock? To
the price of put options? Why?

4 Options and Stock Price Volatility What is the impact of an increase in the volatility of the
underlying stock’s return on an option’s value? Explain.

5 Put–Call Parity You find a put and a call with the same exercise price and maturity. What do you
know about the relative prices of the put and call? Prove your answer and provide an intuitive
explanation.

6 Put–Call Parity A put and a call have the same maturity and strike price. If they have the same
price, which one is in the money? Prove your answer and provide an intuitive explanation.

7 Put–Call Parity One thing put–call parity tells us is that given any three of a stock, a call, a put, and
a T-bill, the fourth can be synthesized or replicated using the other three. For example, how can we
replicate a share of stock using a call, a put, and a T- bill?
Chapter 26
Tutorial 6
1 Sources and Uses For the year just ended, you have gathered the following information about the
Holly Corporation:
a. A $200 dividend was paid.
b. Accounts payable increased by $500.
c. Fixed asset purchases were $900.
d. Inventories increased by $625.
e. Long-term debt decreased by $1,200.
Label each as a source or use of cash and describe its effect on the firm’s cash balance.
source of cash (+ use of cash 1-1 Effects on cash bal.

a .
Div paid ~ ↓ $200

b .
AP ~ ↑ $500

c .
Purchased FA ~ ↓ $900

d . ↑ inv ~ ↓ $625

.
e ↓ LT debt ~ ↑ $1 , 200

Net change in cash bal . = ($2 425)

,

2. Last month, BlueSky Airline announced that it would stretch out its bill payments to 45 days from
30 days. The reason given was that the company wanted to “control costs and optimize cash flow.” The
increased payables period will be in effect for all of the company’s 4,000 suppliers. What impact did
this change in payables policy have on BlueSky’s operating cycle? Its cash cycle?
Payable period- > Cash cycle (Cash cycle =
Operating cycle -

Payable period)
No impact on
operating cycle
Inv period ACP Receivable period
I I I I

Buy Payable Pay Sell collect

period
cash out cash in
CCC
 1 Changes in the Cash Account Indicate the impact of the following corporate actions on cash, using
the letter I for an increase, D for a decrease, or N when
(v) )
no change occurs. (+
a. A dividend is paid with funds received from a sale of debt.
)
N (+ )
(
b. Real estate is purchased and paid for with short-term debt. N
-

aggressive financing
c. Inventory is bought on credit. N
>

d. A short-term bank loan is repaid. D

e. Next year’s taxes are prepaid. D
repurchased =

f. Preferred stock is redeemed. D

g. Sales are made on credit. N
h. Interest on long-term debt is paid. D
i. Payments for previous sales are collected. I
j. The accounts payable balance is reduced. D
k. A dividend is paid. D
l. Production supplies are purchased and paid with a short-term note. N
m. Utility bills are paid. D
n. Cash is paid for raw materials purchased for inventory. D
o. Marketable securities are sold. I

2 Cash Equation Blizzard Corp. has a book value of equity of $14,750. Long-term debt is $8,300. Net
working capital, other than cash, is $1,950. Fixed assets are $20,730 and current liabilities are $1,930.
How much cash does the company have? What are current assets? A 1 E = +
other than cash
E = $14 ,
750 IT debt = $8 , 300 : $1 950 , FA = $20 , 730 CL = $1 ,
930 FA+CA = LTD + CL + E

Cash = 15 debt + E -
NWC -
FA = 8 300
,
+ 14 750
,
-

1 950
,
-

20 , 730 = $370 20 , 730 + A = 8 300

,
+ 1 , 930 + 14 , 750

NWC = CA -

CL => CA = 1 , 950 + 1 , 930 = $3 880

, => CA = 4 , 250

3 Changes in the Operating Cycle Indicate the effect that the following will have on the operating
cycle. Use the letter I to indicate an increase, the letter D for a decrease, and the letter N for no
365
change. ACP
↑
Receivable turnover sale =

a. Receivables average goes up. I AvgAR +

b. Credit repayment times for customers are increased. AR period increased => I
c. Inventory turnover goes from 3 times to 6 times. Inventory period decreased => D
d. Payables turnover goes from 6 times to 11 times. AP period decreased => N
e. Receivables turnover goes from 7 times to 9 times. AR period decreased => D
f. Payments to suppliers are accelerated. AP period decreased => N
Operating cycle
Inv period
I
AR period,
I

Apperiod -

cash cycle
 4. Calculating Cash Collections The Litzenberger Company has projected the following quarterly sales
amounts for the coming year:

a. Accounts receivable at the beginning of the year are $335. The company has a 45-day collection
period. Calculate cash collections in each of the four quarters by completing the following:

b. Rework (a) assuming a collection period of 65 days.

c. Rework (a) assuming a collection period of 25 days.
90-45 "2 :
this quarter
Collection amt "
a
45-day collection period => = go = " : next quarter
QI Q2 Q3 Q4

receivables $420
Beginning $335 $370 $455

sales $740 $848 $910 $970

748 84 970
Cash collection 335 + 2 = $705370 +
% = $790420 +
910
2 = $875455 +
2 = $940

Ending receivables 335 +

740 -

705 = $370370 + 840 790 -

= $420420 + 910 -

875 = $455455 + 970 -

940 = $485

90-25
c .

25-day collection period => Collection amt = 90 =

QI Q2 Q3 Q4

receivables
Beginning $335 $205 56 .
$233 33 .
$252 .
78

sales $740 $840 $918 $970

740 x 13
840 x 13 910 x 13 970 x 13
Cash collection 335 + 18 = $869 44205 56. .
+ 18 = $812 23233 33 +
. .
18 = $890 55252 78 +
.
. 18 = $953 34 .

Ending receivables 335 + 740 869 44 -

.
= 205 56205 56 + 840 812 23 = 233 33233 33 + 910 890 55 = 252 78252 78 + 970 953 34
. .
-

. . .
-

. . .
-

.
= $269 44 .

90-65 5
b
. 65-day collection period => Collection amt = 90 = 18

QI Q2 Q3 Q4

receivables $534 44 $606 $657

Beginning $335 . .
67 .
22

sales $740 $840 $910 $970

740 x 5 840 x 5 910 x5 970 x 5
Cash collection 335 + 18 = $540 56534 44
.
.
+ 18 = $767 77606 67. .
+ 18 = $859 45657 22 . .
+ 18 = $926 .
66

Ending receivables 335 + 740 540 56 = $534 44534 44 + 840 767 77 606 67606 67 + 910 859 45 657 22657 22
-

. . .
-

.
= . .
-

.
=
. .
+ 970 -
926 66 = $700 56
. .
 5. Calculating Cycles Consider the following financial statement information for the Rivers Corporation:

Calculate the operating and cash cycles. How do you interpret your answer?

Operating cycle= Inv period + AR period = 40 18

.
+ 22 9 .
= 63 08 .

days
cash cycle =
Operating cycle -
AP period = 63 08 .
-
. 45
10 = 52 63 .
days
COGS 165 763 365
turnover 9 085 = Inv period 40 18
days
,

Inv = = =
. =
= .

117 , 385 + 19 , 1081 Inv turnover

Argin
2

Net sales 216 , 384 365

AR turnover =
=
13 , 182 + 13, 973
=
15 937
.
=> Apperiod =

AR turnover
=
22 9 .
days
AR
Aug
2

Purchases Closing inv +

COGS-Opening in 19 , 108 + 165 , 763-17 385
AP turnover days
,

= = I =
10 45 .

AP 15 , 385 16 , 676
Aug AP Aug
+

-
6. Calculating Payments Lewellen Products has projected the following sales for the coming year:
p' Im low
Sales in the year following this one are projected to be 15 percent greater in each
quarter. Gross profit margin 10%.
a. Calculate payments to suppliers assuming that the company places orders during
each quarter to keep the ending balance of inventory equal to 30 percent of
projected sales for the next quarter. Assume that the company pays immediately.
What is the payables period in this case?
b. Rework (a) assuming a 105-day payables period.
c. Rework (b) assuming a 40-day period.
QI Q2 Q3 Q4

sales $660 $575 $7/5 $810

a .
Pmts to suppliers $575 x 30% = $172 5$715 x 30%. = $214 5$810 .
x 30% = $243$810 x 1 15.
x 30% = $279 45 .

(immidiately

&
⑧ Pits to suppliers 660x 3x . + 575x 3x .

! 575x . 3x + 715x .

3x 715x . 3x
6 + 80x 3x .

+ 810x . 3x + 810 x 1 15x

. .

3 x)
105-day payables periodQ2 $194 36 $178 5 $218 $248
L
= .
= .
= .
57 = .
21
90-105
516
- I muc
=
go T Q3

660x 3 3 3
c Pmts to suppliers $88 110 +
575x $186 67 95 83
719x 191 7 118 63
80x 2263
.
. .

= = + +
. . .
= . .
=
2 25

40-day period 940

.

: = 2 25
.

Ending payables 198 -

88 = $110 110 + 172 5 .
-
186 . 67 $95 8395 83 + 214
= .
. .
5 -

191 7 = $118 63 118 63

. . .
+
243 226 63 -

. = $135
7. Calculating the Cash Budget Here are some important figures from the budget of Cornell, Inc., for
the second quarter of 2016:

The company predicts that 5 percent of its credit sales will never be collected, 35 percent of its sales
will be collected in the month of the sale, and the remaining 60 percent will be collected in the
following month. Credit purchases will be paid in the month following the purchase.
In March 2016, credit sales were $332,640, and credit purchases were $247,100. Using this
information, complete the following cash budget:

April May June

Beginning cash balance $443 500 , $394 227 , $ 503 450 ,

cash receipts
Cash collection from credit sales 332 , 640x 6 .
+ 601 900x 35 , .
601 900
,
x 6 + 627 , 300 x .
35 627 300
,
x .
6 + 693 , 790x .
35

= $410 249
,
= $580 695
,
= $619 , 206 5 .

Total cash available 443 500

,
+ 410 , 249 = $853 749394 , 227,
+ 580 , 695 $974 922503 , 450
=
,
+ 619 206 5 , . = $1 122 656 5
, ,
.

Cash disbursements
Purcbases $247 , 100 $232 850 ,
$277 900 ,

$62 964 $76 364

Wages taxes ,
,
&
expenses , ,
$79 , 670

Interest $18 058 ,

$18 058 ,
$18 058 ,

Equipment purchases $131 , 400 $144 ,

200 $0

Total cash disbursements $459 ,

522 $471 472 ,
$375 628 ,

Ending cash balance $394 227 , $503 450 , $747 028 , .

5
 Chapter 27 - collection float
1. Calculating Float In a typical month, the Warren Corporation receives 140 checks totaling $113,500.
These are delayed four days on average. What is the average daily float?
113 500
Aug daily float
x 4
=
,
=
$15 133 33 , .

30

2. Calculating Net Float Each business day, on average, a company writes checks totaling $14,400 to
pay its suppliers. The usual clearing time for the checks is four days. Meanwhile, the company is
receiving payments from its customers each day, in the form of checks, totaling $25,300. The cash
from the payments is available to the firm after two days.
a. Calculate the company’s disbursement float, collection float, and net float.
b. How would your answer to part (a) change if the collected funds were available in one day instead
of two?
a
. Disbursement float

Collection float =
=

25 , 300
14 400 ,

x 2
x

=
4 =

$50 600
$57 , 600

,
S => Net float = 57 600
,
-

50 600 ,
= $7 ,
000

b
. Disbursement float $57 600
3 => Net float 57 , 600 25 300 $32 300
-

= = =
, , ,

Collection float = 25 300 ,

3. Costs of Float Purple Feet Wine, Inc., receives an average of $13,800 in checks per day. The delay in
clearing is typically three days. The current interest rate is .018 percent per day.
a. What is the company’s float?
b. What is the most the company should be willing to pay today to eliminate its float entirely?
c. What is the highest daily fee the company should be willing to pay to eliminate its float entirely?
.
a Co 's float
.
= 13 , 800 x 3 = $41 ,
400

b
. Max pmt = $41 400 ,

c .
Highest daily fee = 41 400 ,
x 0 018.
% = $7 .
452

4. NPV and Collection Time Your firm has an average receipt size of $119. A bank has approached you
concerning a lockbox service that will decrease your total collection time by two days. You typically
receive 5,650 checks per day. The daily interest rate is .015 percent. If the bank charges a fee of $160
per day, should the lockbox project be accepted? What would the net annual savings be if the service
were adopted?
Aug daily collections = $119 x 5 , 650 = $672 350 ,
Annual savinga % (3 1 344 700
, ,
= $75 669 19
, .

r)" 1]
PVx[(1-
savings of
lockbox services $672 350 x 2 $1 344 70 + EAR
-

= , = , , =
365

cost of Annual cost (1 + 0 015 % ) -1

PV of $1 066 666 67 PV
perpetuity > 160 $64 , 142 95
.

- x
=
0 015 % = , , .
= - = = .

0 015 %
.

f .

=> NPV 1 , 344 , 700 1 066 , 666 67 $278 , 033 33 > O FV of ord annuity > ((1 + r(" 17
-
-

= , . = . . = -

=> Lockbox project should be accepted .

=> Net annual savings = 75 , 669 19-64 , 142 95 .
.

= $11 526 24
,
.
 5. Value of Lockboxes Paper Submarine Manufacturing is investigating a lockbox system to reduce its
collection time. It has determined the following:

The total collection time will be reduced by three days if the lockbox system is adopted.
a. What is the PV of adopting the system?
b. What is the NPV of adopting the system?
c. What is the net cash flow per day from adopting? Per check?
a
.
Aug daily collection 410 =
x $865 = $354 650 ,

=> PV of
adopting system = $354 650 ,
x 3 = $1 063 , 950
,

.
b cost $0 PV of cost $205
Daily = . 5 x 410 = $205 => = =
$1 025 , 000
,

0 02 %
.

=> NPV = $1 063 950

, ,
-

$1 025 000
, ,
= $38 950 ,

.
c Net CF per day = $1 063 950
, ,
x 0 02 %
.
-

$205 = $7 79
.

$7.79
h
Net CF per transaction = = $0 019 .
 Chapter 28
1. Cash Discounts You place an order for 400 units of inventory at a unit price of $115. The supplier
offers terms of 1/10, net 30.
a. How long do you have to pay before the account is overdue? If you take the full period, how much
should you remit?
b. What is the discount being offered? How quickly must you pay to get the discount? If you do take
the discount, how much should you remit?
c. If you don’t take the discount, how much interest are you paying implicitly? How many days’ credit
are you receiving?

a
You have to within 30 days by the account is overdue.
.

pay
If you take the full period ,
you
should remit : 400 x $115 = $46 000 ,

b. Discount offered = 1%

You must within 10 days to get the discount. > remit 400 x $115 x 99 % $45 540
pay = : =
,

.
1 If
you don't take the discount ,
then
you're paying int : $46 , 000 -
$45, 040 = $460

Credit period = 30-10 = 20

days

2. Size of Accounts Receivable The Paden Corporation has annual sales of $29.5 million. The average
collection period is 27 days. What is the average investment in accounts receivable as shown on the
balance sheet?
Annual sale = $29 .
5m ACP = 27 days
AR turnover 365 365 $29 5 $2
13 52 => AugAR 145m
.

= = =
= .
= .

ACP 27 13 52.

3. Terms of Sale A firm offers terms of 1/10, net 30. What effective annual interest rate does the
firm earn when a customer does not take the discount? Without doing any calculations, explain
what will happen to this effective rate if:
a. The discount is changed to 2 percent.
b. The credit period is increased to 60 days.
c. The discount period is increased to 15 days.
a .
Effective rate =
11 +
r -1 discountrate ↑ >
-
r + >
-
effective rate ↑
365

b .
Credit period : 20 - 60
day => effective rate
↓ = 11 + r)504 -

I/I0 , net 60
365
15+
c .
Discount period : 10 - 15 days => effective rate + = (I tr) -

1/15 ,
net 30
 4. Size of Accounts Receivable Essence of Skunk Fragrances, Ltd., sells 5,450 units of its perfume
collection each year at a price per unit of $480. All sales are on credit with terms of 1/10, net 40.
The discount is taken by 35 percent of the customers. What is the total amount of the company’s
accounts receivable? In reaction to sales by its main competitor, Sewage Spray, Essence of Skunk is
considering a change in its credit policy to terms of 2/10, net 30 to preserve its market share. How
will this change in policy affect accounts receivable?
Q = 5 450 units
,
P = $480 1/10 ,
net 40 > 35 %

5 , 450 480 65 % 5 450 480 x 99 %

AR =
x
x 40 x +
,
x
x 10 x 35 % = $211 ,
524 21
.

(baity) 365 365

5 , 450 480 5 450 480 x 98 %

2/10 ,
net 30 => AR =
x
x 30 x 65 % +
,
x
x 10 x 35 % = $164 683 57
, .

( daily) 365 365

=> AR + $46 840 64

, .

Total credit sale/yr =

5 , 450 x 480 =
$2 ,
616 , 000

Avg ACP = 35 % x 10 + 65 % x 40 = 29 5 .

days
2 , 616 , 000
>
Receivable turnover =
365
=
12 37(x). => Amt receivables = = $211 430 14
, ·

I
29 5 . 12 37 .

OR

Aug daily credit sale =

2 616 , 000
,

365
x 29 5 = $211 430 14
.
,
.

5. Size of Accounts Receivable The Arizona Bay Corporation sells on credit terms of net 30. Its
accounts are, on average, 5 days past due. If annual credit sales are $8.95 million, what is the
company’s balance sheet amount in accounts receivable?
AR $8 95m
.
x 35 $858 219 18
= = , .

365

6. EOQ Fhloston Manufacturing uses 1,860 switch assemblies per week and then reorders another
1,860. If the relevant carrying cost per switch assembly is $6.25, and the fixed order cost is $730, is
the company’s inventory policy optimal? Why or why not?
Q= 1 860
,
units = T (C = $6 25 . F = $730 T = 1 860
,
x 52 = 96 , 720 units
2 FXT 2 730 96 720
EOQ = =
x x ,
= 4 753 29
, .
(units)
CC 6 25
.

Optimal quantity Carrying : cost =

Restocking cost
cost Q 1 , 860
Carrying = x (1 = x $6 . 25 = $5 812 5 ,
.

=2 Fx
2
Restocking
Wonder$730 96 ex
cost +
= $37 960 ,

1 , 860

= 730 = $37 960 ,

Co's not optimal=> optimal Restock. cost Norder

=> inv
policy is To be : :

[↑ size of order
7 Credit Policy Evaluation The Harrington Corporation is considering a change in its cash-only policy.
The new terms would be lagnet one period. Basedmonth
on the following information, determine if Harrington
1
should proceed or not. The required return is 2.5 percent per period.
Cash only

V C
.

45
Incremental analysis - > ACF
new-old
> NPV (Fnew = 1108-47) x 2 , 915 =
177 ,
815
(ACF)

sCFold = (104 -

47) x 2 , 870 = 163 590

,

> ACF = 14 , 225

14 225
>
PVACF (perpetuity) ↑ $569 000
,

= = = ,

2 5% .

> Incremental cost = (2 915-2 , 870)

,
x 47 = $2 115 .
(WCN)

PV (chria nhan t: tien.

Opportunity cost = - (XQ) AP >
-
-CF)

=> NPV = 569 000 -

2 115 (108 x 47) = $561 809
new-old
-

, . ,