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.