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PFM 3-2

Question 01 (XYZ Co)
Question 02 (Hall Co)
Question 03 (Fry Co)
Question 04 (Vinco Co)
Question 05 (Myra Co)
Question 01 (Oscar Co)
Question 02 (Nesud Co)
Question 03 (Pangil Co)
Question 04 (ZSE Co)
Question 05 (KXP Co)
Question 06 (PKA Co)
Question 07 (Windor Co)
Question 08 (FLG Co)
Question 09 (Wobnig Co)
Question 10 (PNP Plc)
Question 01 (XYZ Co)

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1 / 5

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?

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

3 / 5

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)?

4 / 5

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

5 / 5

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.

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Question 02 (Hall Co)

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1 / 5

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.

Month 3 4 5 6 7
Sales volume (000s) 10 11 13 16 20

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?

2 / 5

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?

3 / 5

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

4 / 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.

5 / 5

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

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Question 03 (Fry Co)

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1 / 6

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)?

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

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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?

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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.

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

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

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Question 04 (Vinco Co)

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1 / 8

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.

Year 20X1 20X2 20X3 20X4 20X5 (forecast)
  $000 $000 $000 $000 $000
 Sales 200 400 800 1,200 1,600
Cost of sales (100) (200) (400) (600) (800)
Gross profit 100 200 400 600 800
Administration costs (50) (60)  (200) ( (500)  (640)
Net profit ($000) 50 140 200 100 160

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

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B. Suppliers’ terms

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C. Financing costs

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D. Risk of irrecoverable debts

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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?

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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?

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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?

8 / 8

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

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Question 05 (Myra Co)

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1 / 6

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:

  20X7 20X6
  $’000 $’000
Sales (all on credit) 37,400 26,720
Cost of sales (34,408) (23,781)
Operating profit 2,992 2,939

 

  20X7 20X6
  $’000 $’000 $’000 $’000
Current assets        
Inventory 4,600   2,400  
Trade receivables 4,600   2,200  
    9,200   4,600
Current liabilities   7,975   3,600

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

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

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

A. 1 Accounts receivable days have increased

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B. 2 Inventory turnover has slowed down

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

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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?

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Question 01 (Oscar Co)

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1 / 3

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.

Option 1

$ $
Current trade receivables 5,370,000
Revised trade receivables (28,000,000 x 30/365) 2,301,370
Reduction in receivables 3,068,630
Reduction in financing cost = 3,068,630 x 0.07 214,804
Reduction in admin costs 30,000
Benefits 244,804
Factor’s fee = 28,000,000 x 0.005 (140,000)
Net benefit 104,804

Option 2

$ $
Reduction in financing cost = 3,068,630 x 0.07 214,804
 Reduction in admin costs 30,000
Bad debts saved = 28,000,000 x 0.02 560,000
Benefits 804,804
Increase in finance cost = 2,301,370 x 0.80 x 0.02 36,822
Factor’s fee = 28,000,000 x 0.015 420,000
Costs (456,822)
Net benefit 347,982

Both options are financially acceptable to Oscar Co, with Option 2 offering the greatest benefit and therefore it should be accepted.

2 / 3

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

3 / 3

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

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Question 02 (Nesud Co)

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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.

2 / 3

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

3 / 3

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

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Question 03 (Pangil Co)

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1 / 4

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:

Inventory $455,000
Trade receivables $408,350
Trade payables $186,700
Overdraft $240,250

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

November 20X6 (actual) $270,875
December 20X6 (forecast) $300,000
January 20X7 (forecast) $350,000

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.

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

Inventory at end of January 20X7 = 455,000 + 52,250 = $507,250

At the start of January 20X7, 100% of December 20X6 receivables will be outstanding ($300,000), together with 40% of November 20X6 receivables ($108,350 = 40% x 270,875), a total of $408,350 as given.

  $
Trade receivables at start of January 20X7 408,350
Outstanding November 20X6 receivables paid (108,350)
December 20X6 receivables, 60% paid (180,000)
January 20X7 credit sales 350,000
Trade receivables at end of January 20X7 470,000

 

  $
Trade payables at start of January 20X7 186,700
Payment of 70% of trade payables (130,690)
January 20X7 credit purchases 250,000
Trade payables at end of January 20X7 306,010

 

  $
Overdraft at start of January 20X7 240,250
Cash received from customers (288,350)
Cash paid to suppliers 130,690
Interest payment 70,000
Operating cash outflows 146,500
Overdraft expected at end of January 20X7 299,090

3 / 4

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

4 / 4

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

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Question 04 (ZSE Co)

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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.

Period 1 cash flow Probability Period 2 cash flow Probability
$000   $000  
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 $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.

(i) Period 1 closing balance

Opening balance Cash flow Closing balance Probability Expected value
$000 $000 $000   $000
(500) 8,000 7,500 0.1 750
(500) 4,000 3,500 0.6 2,100
(500) (2,000) (2,500) 0.3 (750)
        2,100

The expected value of the period 1 closing balance is $2,100,000.

 

(ii) Period 2 closing balance

Period 1 closing balance Probability Period 2 cash flow Probability Period 2 closing balance Joint probability Expected value
$000   $000   $000   $000
7,500 0.1 7,000 0.3 14,500 0.03 435
    3,000 0.5 10,500 0.05 525
    (9,000) 0.2 (1,500) 0.02 (30)
3,500 0.6 7,000 0.3 10,500 0.18 1,890
    3,000 0.5 6,500 0.30 1,950
    (9,000) 0.2 (5,500) 0.12 (660)
(2,500) 0. 3 7,000 0.3 4,500 0.09 405
    3,000 0.5 500 0.15 75
    (9,000) 0.2 (11,500) 0.06 (690)
            3,900

The expected value of the period 2 closing balance is $3,900,000.

 

(iii) The probability of a negative cash balance at the end of period 2

= 0.02 + 0.12 + 0.06 = 20%

 

(iv) The probability of exceeding the overdraft limit in period 2 is 0.12 + 0.06 = 18%.

Discussion

The expected value analysis has shown that, on an average basis, ZSE Co will have a positive cash balance at the end of period 1 of $2.1 million and a positive cash balance at the end of period 2 of $3.9 million. However, the cash balances that are expected to occur are the specific balances that have been averaged, rather than the average values themselves.

There could be serious consequences for ZSE Co if it exceeds its overdraft limit. For example, the overdraft facility could be withdrawn. There is a 30% chance that the overdraft limit will be exceeded in period 1 and a lower probability, 18%, that the overdraft limit will be exceeded in period 2. To guard against exceeding its overdraft limit in period 1, ZSE Co must find additional finance of $0.5 million ($2.5m – $2.0m). However, to guard against exceeding its overdraft limit in period 2, the company could need up to $9.5 million ($11.5m – $2.0m). Renegotiating the overdraft limit in period 1 would therefore be only a short-term solution.

One strategy is to find now additional finance of $0.5 million and then to reevaluate the cash flow forecasts at the end of period 1. If the most likely outcome occurs in period 1, the need for additional finance in period 2 to guard against exceeding the overdraft limit is much lower.

The expected value analysis has been useful in illustrating the cash flow risks faced by ZSE Co. Although the cash flow forecasting model has been built with the aid of a firm of financial consultants, the assumptions used in the model must be reviewed before decisions are made based on the forecast cash flows and their associated probabilities.

Expected values are more useful for repeat decisions rather than one-off activities, as they are based on averages. They illustrate what the average outcome would be if an activity was repeated a large number of times. In fact, each period and its cash flows will occur only once and the expected values of the closing balances are not closing balances that are forecast to arise in practice. In period 1, for example, the expected value closing balance of $2.1 million is not forecast to occur, while a closing balance of $3.5 million is likely to occur.

2 / 3

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

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

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Question 05 (KXP Co)

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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.

2 / 4

B. Calculate whether the bulk purchase discount offered by the supplier is financially acceptable and comment on the assumptions made by your calculation.

3 / 4

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

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

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Question 06 (PKA Co)

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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.

2 / 3

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

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

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Question 07 (Windor Co)

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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.

The factor’s offer will be financially acceptable to Widnor Co if it results in a net benefit rather than a net cost.

  $ $
Current trade receivables 4,458,000  
Revised trade receivables = 26,750,000 x 35/360 = 2,600,694  
Reduction in trade receivables 1,857,306  
     
Reduction in financing cost = 1,857,306 x 0.05 = 92,865  
Saving in bad debts = 26,750,000 x 0.01 x 0.7 = 187,250  
Reduction in administration costs 50,000  
Benefits   330,115
     
Increase in financing cost = 2,600,694 x 0.8 x 0.07 – 0.05 = 41,611  
Factor’s annual fee = 26,750,000 x 0.0075 = 200,625  
Costs   (242,236)
Net benefit   87,879

The factor’s offer is therefore financially acceptable.

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

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

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Question 08 (FLG Co)

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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.

2 / 5

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

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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.

4 / 5

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.

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

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Question 09 (Wobnig Co)

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113. Wobnig Co (6/12, amended)

The following financial information relates to Wobnig Co.

  20X1 20X0
  $’000 $’000
Revenue 14,525 10,375
Cost of sales (10,458) (6,640)
Profit before interest and tax 4,067 3,735
Interest 355 292
Profit before tax 3,712 3,443
Taxation (1,485) (1,278)
Distributable profit 2,227 2,165

 

  20X1 20X0
  $’000 $’000 $’000 $’000
Non-current assets   15,284   14,602
Current assets Inventory 2,149   1,092  
Trade receivables 3,200   1,734  
    5,349   2,826
Total assets   20,633   17,428
Equity        
Ordinary shares 8,000   8,000  
Reserves 4,268   3,541  
    12,268   11,541
Non-current liabilities        
7% bonds   4,000   4,000
Current liabilities        
Trade payables 2,865   1,637  
Overdraft 1,500   250  
    4,365   1,887
Total equity and liabilities   20,633   17,428

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

Current ratio 1.7 times
Quick ratio 1.1 times
Inventory days 55 days
Trade receivables days 60 days
Trade payables days 85 days
Sales revenue/net working capital 10 times

Required

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

Signs of overtrading:

Rapid increase in sales revenue: Wobnig Co’s sales revenue has increased by 40% from $10,375k in 20X0 to $14,525k in 20X1. This rapid growth in revenue is not supported by a similar increase in long-term financing, which has only increased by 4.7% ($16,268k in 20X1 compared to $15,541k in 20X0).

Rapid increase in current assets: Wobnig Co’s current assets have also nearly doubled, increasing from $2,826k in 20X0 to $5,349k in 20X1 (89%). This is striking, given that longterm financing has only increased by 4.7%. Trade receivables have increased by 85% ($1,734k in 20X0 and $3,200k in 20X1), and inventory levels have increased by 97% ($2,149k from $1,092k in 20X0).

Increase in inventory days: Linked to the above, inventory turnover has slowed noticeably, from 60 days in 20X0 to 75 days in 20X1, well above the industry average of 55 days. This may indicate that Wobnig Co is expecting further increases in sales volumes in the future.

Increase in receivable days: Perhaps a matter of greater concern is the fact that trade receivables are being paid much more slowly. Receivable days have increased from 61 days in 20X0 to 80 days in 20X1, again significantly above the industry average. It could be that in order to encourage sales, Wobnig Co has offered more favourable credit terms to its customers. However, the increase in receivable days may also indicate that Wobnig Co is lacking sufficient resources to effectively manage its receivables, and/or that its customers may be unable to settle their debts on time, as they are struggling financially.

Reduction in profitability: Although Wobnig Co’s sales revenue has increased by 40% over the past year, its profit before interest and tax (PBIT) has only increased by 8.9%. The net profit margin has actually decreased, from 36% in 20X0 to 28% in 20X1. This may be due partly to the company selling at lower margins to increase sales volumes, but most likely points to increased costs of sales and operating costs.

With the additional costs associated with holding larger inventories, and increasing financing costs from overdrafts (see below), the company’s profitability is likely to suffer even more in the future.

Increase in current liabilities: Wobnig Co is increasingly financed through current liabilities, which has increased by 131% (from $1,887k in 20X0 to $4,365k in 20X1) while long-term financing has increased only marginally by 4.7%. The sales revenue/net working capital ratio has increased from 11 times to 15 times in 20X1. In particular, overdraft has increased by 500% from 20X0 to 20X1. Payables days have lengthened from 90 days to 100 days, indicating that Wobnig Co is finding it more difficult to settle trade debts.

All of this will put further strain on financing costs, eroding the distributable profits. The company’s interest expense has increased from $292k to $355k.

Reduced liquidity: The cause of Wobnig Co’s increasing dependence on overdrafts and lengthening payables days lies in its reduced liquidity. Wobnig Co’s current ratio has reduced from 1.5 times to 1.2 times, compared to the industry average of 1.7 times. The more sensitive quick ratio has reduced from 0.9 times to 0.7 times, against the average of 1.1 times. Wobnig Co does not yet have a liquid deficit, though, as its current assets still exceed its current liabilities.

Conclusion

From the trends discussed above, we can conclude that Wobnig Co is overtrading.

Workings :

Ratio Formula 20X1 20X0
Net profit margin PBIT/Revenue x 100% 28% 36%
Current ratio Current assets/current liabilities 1.2 times 1.5 times
Quick ratio (Current assets – inventory)/current liabilities 0.7 times 0.9 times
Inventory days Inventory/cost of sales x 365 75 days 60 days
Receivables days Trade receivables/revenue x 365 80 days 61 days
Payables days Trade payables/cost of sales x 365 100 days 90 days
Net working capital Current assets – current liabilities $984,000 $949,000
Revenue/net working capital Revenue/net working capital 15 times 11 times

(Note that the Revenue/net working capital ratio can also be calculated excluding cash balances or overdraft.)

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

(i) Working capital investment

(ii) Working capital financing

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