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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.

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