PFM 3-2

XYZ Co

The following scenario relates to questions 80–84.

XYZ Co places monthly orders with a supplier for 10,000 components which are used in its manufacturing processes. Annual demand is 120,000 components. The current terms are payment in full within 90 days, which XYZ Co meets, and the cost per component is $7.50. The cost of ordering is $200 per order, while the cost of holding components in inventory is $1.00 per component per year.

The supplier has offered a discount of 3.6% on orders of 30,000 or more components. If the bulk purchase discount is taken, the cost of holding components in inventory would increase to $2.20 per component per year due to the need for a larger storage facility.

80. What is the current total annual cost of inventory?

81. What is the total annual inventory cost if XYZ Co orders 30,000 components at a time?

82. XYZ Co has annual credit sales of $25m and accounts receivable of $5m. Working capital is financed by an overdraft at 10% interest per year. Assume 365 days in a year. What is the annual finance cost saving if XYZ Co reduces the collection period to 60 days (to the nearest whole number)?

83. XYZ Co is reviewing its working capital management. Which TWO of the following statements concerning working capital management are correct?

84. Management at XYZ Co are considering an aggressive approach to financing working capital. Which of the following statements relate to an aggressive approach to financing working capital management?

1. There is an increased risk of liquidity and cash flow problems.
2. All non-current assets, permanent current assets and part of fluctuating current assets are financed by long-term funding.

Hall Co

The following scenario relates to questions 85–89.

Hall Co is a decentralised organisation whose different divisions have approached the matter of cash control in different ways, partly because of their different circumstances. Assume 365 days in a year.

The Western division is facing a two-year major capital investment programme for which significant funds need to be raised to meet the steady demand for cash. The division intends to use the ‘Baumol model’ to decide when to raise funds, which will be done by selling off investments currently earning 5% per annum. The transaction cost of these sales will be $500 per transaction and the total amount needed over the two years is $2,000,000.

The Alpine division has no significant investment plans but finds itself regularly having to either sell investments to make funds available or invest surplus cash. This is because of the considerable variation in daily cash inflows which has been quantified as having a standard deviation of $7,000. As a result, the division uses the ‘Miller-Orr model’ to determine when to invest and when to make sales, using the same transaction cost and investment rate as the Western division.

The Southern division has just been created to manufacture a product used by other divisions but mainly sold to outside customers. The coming month, Month 1, will be spent converting and equipping existing corporate premises at a total cash cost of $800,000. Production will start in Month 2 and sales in Month 3. Planned sales volumes are as follows.

The product will sell for $24 per unit. 20% of sales will be for cash. Of the credit sales, 25% of credit customers (including other divisions) pay in the month following the sale, 50% will pay one month later and 25% after another month.

85. How much finance should the Western division raise in a single tranche according to the Baumol model?

86. What does the Miller-Orr model suggest is the spread between the upper and lower limits of cash levels that the Alpine division should maintain?

87. What will be the Southern division’s cash receipts from sales in Month 5?

88. It is important to distinguish between a cash budget and a cash forecast. What is the validity of the following statements?

Statement 1: A cash budget is a commitment to a plan for cash receipts and payments for a future period after taking any action necessary to bring the preliminary cash forecast into conformity with the overall plan of the business.

Statement 2: A cash forecast is an estimate of cash receipts and payments for a future period under existing conditions before taking account of possible actions to modify cash flows, raise new capital, or invest surplus funds.

Indicate whether t the relevant statements are true or false.

89. Which of the following is NOT an advantage to Hall Co of having a centralised treasury function?

Fry Co

The following scenario relates to questions 90–94.

Fry Co sells Product P with sales 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.

Other information

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

90. What is the total annual cost of the current purchasing policy (to the nearest whole number)?

91. What is the total annual cost of a policy based on using the economic order quantity (EOQ) (to the nearest $100)?

92. Fry Co is considering offering a 2% early settlement discount to its customers. Currently sales are $10m and customers take 60 days to pay. Fry Co estimates half the customers will take up the discount and pay cash. Fry Co. is currently financing working capital using an overdraft on which it pays a 10% charge. Assume 365 days in a year.

What will be the effect of implementing the policy?

93. Fry Co managers are considering the cost of working capital management. Are the following statements about working capital management true or false?

A. A conservative working capital finance approach is low risk but expensive.

B. Good working capital management adds to the wealth of shareholders.

94. If Fry Co were overtrading, which TWO of the following could be symptoms?

Vinco Co

The following scenario relates to questions 90–94.

Vinco Co is a retail organisation that buys goods from abroad for cash and sells them locally to both individuals and businesses. It has grown rapidly since its formation on 1 January 20X1 with results summarised below.

In the first year, sales were made on a purely cash basis, then credit sales were introduced for businesses. However Vinco Co has now found that its working capital position has deteriorated as business customers take longer and longer to pay. When making decisions that affect the company’s finances, a discount rate of 10% is used, which is the best estimate of the cost of capital. Assume credit sales equal business sales.

95. Indicate, by clicking in the relevant boxes, whether the following would influence or would not influence Vinco Co’s credit policy for accounts receivable;

A. Competitors’ terms

B. Suppliers’ terms

C. Financing costs

D. Risk of irrecoverable debts

96. During the period up to and including 20X5, the expected receivables period has been maintained. However, by 20X5, the actual business proportion of sales has grown from 50% to 60%. Credit periods are as follows: 40% of customers take 1 month’s credit, 40% of customers take 2 months’ credit and 20% of customers take 3 months’ credit. What is the annual cost in $ of financing 20X5 receivables?

97. If Vinco Co were to offer customers 1.5% discount for payments within one month, what would be the annual cost of that in respect of receivables who currently take two months or three months to pay?

98. Vinco Co is considering the use of debt factoring or invoice discounting. The following statements have been made in relation to these services.

1. It is apparent in both instances that someone else is collecting your debts.
2. The debts remain an asset of Hall Co under factoring.

Which of these statements are correct?

99. Which of the following is NOT a function of a credit control department?

Myra Co

The following scenario relates to questions 95–99.

The financial manager of Myra Co is worried about the level of working capital and that the company may be overtrading. The following extract financial information relates to the last two years:

100. What is the sales/net working capital ratio for 20X7 (to two decimal places)?

101. What is the increase in inventory days between 20X6 and 20X7 (to the nearest whole day)?

102. Are the following statements true or false for Myra Co?

A. 1 Accounts receivable days have increased

B. 2 Inventory turnover has slowed down

103. Myra Co is concerned about overtrading. Which TWO of the following are symptoms of overtrading?

104. Myra Co’s net working capital (i.e., current assets less current liabilities) is most likely to increase in which of the following situations?

105. Oscar Co (Sept/Dec 18)

Oscar Co designs and produces tracking devices. The company is managed by its four founders, who lack business administration skills.

The company has revenue of $28m, and all sales are on 30 days’ credit. Its major customers are large multinational car manufacturing companies and are often late in paying their invoices. Oscar Co is a rapidly growing company and revenue has doubled in the last four years. Oscar Co has focused in this time on product development and customer service, and managing trade receivables has been neglected.

Oscar Co’s average trade receivables are currently $5.37m, and bad debts are 2% of credit sales revenue. Partly as a result of poor credit control, the company has suffered a shortage of cash and has recently reached its overdraft limit. The four founders have spent large amounts of time chasing customers for payment. In an attempt to improve trade receivables management, Oscar Co has approached a factoring company.

The factoring company has offered two possible options:

Option 1

Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection, on a full recourse basis. The factor would charge a service fee of 0.5% of credit sales revenue per year. Oscar Co estimates that this would result in savings of $30,000 per year in administration costs. Under this arrangement, the average trade receivables collection period would be 30 days.

Option 2

Administration by the factor of Oscar Co’s invoicing, sales accounting and receivables collection on a non-recourse basis. The factor would charge a service fee of 1.5% of credit sales revenue per year. Administration cost savings and average trade receivables collection period would be as Option 1. Oscar Co would be required to accept an advance of 80% of credit sales when invoices are raised at an interest rate of 9% per year.

Oscar Co pays interest on its overdraft at a rate of 7% per year and the company operates for 365 days per year.

Required

(a) Calculate the costs and benefits of each of Option 1 and Option 2 and comment on your findings.

B. Discuss reasons (other than costs and benefits already calculated) why Oscar Co may benefit from the services offered by the factoring company.

C. Discuss THREE factors which determine the level of a company’s investment in working capital.

106. Nesud Co (Sep 16)

Nesud Co has credit sales of $45 million per year and on average settles accounts with trade payables after 60 days. One of its suppliers has offered the company an early settlement discount of 0.5% for payment within 30 days. Administration costs will be increased by $500 per year if the early settlement discount is taken. Nesud Co buys components worth $1.5 million per year from this supplier.

From a different supplier, Nesud Co purchases $2.4 million per year of Component K at a price of $5 per component. Consumption of Component K can be assumed to be at a constant rate throughout the year. The company orders components at the start of each month in order to meet demand and the cost of placing each order is $248.44. The holding cost for Component K is $1.06 per unit per year.

The finance director of Nesud Co is concerned that approximately 1% of credit sales turn into irrecoverable debts. In addition, she has been advised that customers of the company take an average of 65 days to settle their accounts, even though Nesud Co requires settlement within 40 days. Nesud Co finances working capital from an overdraft costing 4% per year. Assume there are 360 days in a year.

Required:

A. Evaluate whether Nesud Co should accept the early settlement discount offered by its supplier.

B. Evaluate whether Nesud Co should adopt an economic order quantity approach to ordering Component K.

C. Critically discuss how Nesud Co could improve the management of its trade receivables.

107. Pangli Co (Mar/Jun 17 )

It is the middle of December 20X6 and Pangli Co is looking at working capital management for January 20X7. Forecast financial information at the start of January 20X7 is as follows:

All sales are on credit and they are expected to be $3.5m for 20X6. Monthly sales are as follows:

Pangli Co has a gross profit margin of 40%. Although Pangli Co offers 30 days credit, only 60% of customers pay in the month following purchase, while remaining customers take an additional month of credit.

Inventory is expected to increase by $52,250 during January 20X7.

Pangli Co plans to pay 70% of trade payables in January 20X7 and defer paying the remaining 30% until the end of February 20X7. All suppliers of the company require payment within 30 days. Credit purchases from suppliers during January 20X7 are expected to be $250,000.

Interest of $70,000 is due to be paid in January 20X7 on fixed rate bank debt. Operating cash outflows are expected to be $146,500 in January 20X7. Pangli Co has no cash and relies on its overdraft to finance daily operations. The company has no plans to raise long-term finance during January 20X7.

Assume that each year has 360 days.

Required

A.

(i) Calculate the cash operating cycle of Pangli Co at the start of January 20X7.

(ii) Calculate the overdraft expected at the end of January 20X7.

(iii) Calculate the current ratios at the start and end of January 20X7.

B. Discuss FIVE techniques that Pangli Co could use in managing trade receivables.

108. ZSE Co (June 10 – Modified)

 ZSE Co is concerned about exceeding its overdraft limit of $2 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.

ZSE Co expects to be overdrawn at the start of period 1 by $500,000.

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.

B. Identify and discuss the factors to be considered in formulating a trade receivables management policy for ZSE Co.

C. Discuss whether profitability or liquidity is the primary objective of working capital management.

109. KXP Co (12/12, amended)

KXP Co is an e-business which trades solely over the internet. In the last year the company had sales of $15m. 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:

$’000

Trade receivables            2,466

Trade payables                2,220

Overdraft                         3,000

In order to encourage customers to pay on time, KXP Co 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.

KXP Co 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 $540,000. The supplier has offered a 2% discount for orders of Product Z of 30,000 units or more. Each order costs KXP Co $150 to place and the holding cost is 24 cents per unit per year. KXP Co 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.

C. Identify and discuss the factors to be considered in determining the optimum level of cash to be held by a company.

D. Discuss the factors to be considered in formulating a trade receivables management policy.

110. PKA Co (Dec 07 – Modified)

PKA Co is a European company that sells goods solely within Europe. They recently appointed financial manager of PKA Co has been investigating the working capital management of the company and has gathered the following information:

Inventory management

The current policy is to order 100,000 units when the inventory level falls to 35,000 units. Forecast demand to meet production requirements during the next year is 625,000 units. The cost of placing and processing an order is €250, while the cost of holding a unit in stores is €0.50 per unit per year. Both costs are expected to be constant during the next year. Orders are received two weeks after being placed with the supplier. You should assume a 50-week year and that demand is constant throughout the year.

Accounts receivable management

Domestic customers are allowed 30 days’ credit, but the financial statements of PKA Co show that the average accounts receivable period in the last financial year was 75 days. The financial manager also noted that bad debts as a percentage of sales, which are all on credit, increased in the last financial year from 5% to 8%.

Accounts payable management

PKA Co has used a foreign supplier for the first time and must pay $250,000 to the supplier in six months’ time. The financial manager is concerned that the cost of these supplies may rise in euro terms and has decided to hedge the currency risk of this account payable. The following information has been provided by the company’s bank:

Spot rate ($ per €):                                    1.998 ± 0.002

Six months forward rate ($ per €):            1.979 ± 0.004

Money market rates available to PKA Co:

Borrowing           Deposit

One year euro interest rates:                      6.1%                  5.4%

One year dollar interest rates:                    4.0%                  3.5%

Assume that it is now 1 December and that PKA Co has no surplus cash at the present time.

Required:

A. Calculate the cost of the current ordering policy and determine the saving that could be made by using the economic order quantity model.

B. Discuss ways in which PKA Co could improve the management of domestic accounts receivable.

C. Evaluate whether a money market hedge, a forward market hedge or a lead payment should be used to hedge the foreign account payable.

111. Widnor Co (6/15, amended)

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.

B. Briefly discuss how the creditworthiness of potential customers can be assessed.

C. Discuss how risks arising from granting credit to foreign customers can be managed and reduced.

112. FLG Co (June 08 – Modified)

FLG Co has annual credit sales of $4.2 million and cost of sales of $1.89 million. Current assets consist of inventory and accounts receivable. Current liabilities consist of accounts payable and an overdraft with an average interest rate of 7% per year. The company gives two months’ credit to its customers and is allowed, on average, one month’s credit by trade suppliers. It has an operating cycle of three months.

Other relevant information:

Current ratio of FLG Co                                   1.4

Cost of long-term finance of FLG Co               11%

Required:

A.  Discuss the key factors which determine the level of investment in current assets.

B. Briefly discuss the ways in which factoring can assist in the management of accounts receivable.

C. Calculate the size of the overdraft of FLG Co, the net working capital of the company and the total cost of financing its current assets.

D. FLG Co wishes to minimise its inventory costs. Annual demand for a raw material costing $12 per unit is 60,000 units per year. Inventory management costs for this raw material are as follows:

Ordering cost: $6 per order

Holding cost: $0.5 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 will increase to $2 per unit per year.

Required:

(i) Calculate the total cost of inventory for the raw material when using the economic order quantity.

(ii) Determine whether accepting the discount offered by the supplier will minimise the total cost of inventory for the raw material.

113. Wobnig Co (6/12, amended)

The following financial information relates to Wobnig Co.

Average ratios for the last two years for companies with similar business operations to Wobnig Co are as follows:

Required

(a) Using suitable working capital ratios and analysis of the financial information provided, evaluate whether Wobnig Co can be described as overtrading (undercapitalised).

B. Critically discuss the similarities and differences between working capital policies in the following areas:

(i) Working capital investment

(ii) Working capital financing