FIN2101 BUSINESS FINANCE II MODULE 4- WORKING CAPITAL MANAGEMENT (Week 2) QUESTION 1 Undercounter Wholesalers Ltd currently sells entirely on a cash basis. Undercounter's management is considering introducing cred it sales with discounts to attract new customers The company is considering two alternative options. The first is offering discount terms of 2.5/30, n/60. It is estimated this would increase sales by $500 000 and 30% of these would take advantage of the discount. The second option is discount terms of 10/30, n/ 60, a policy which would increase sales by $600 000 with 50% of these customers taking the discount The variable cost of sales is 75% of sales. The company's required rate of return on all accounts receivable is 1% per month. Undercounter's exis ting custo mers will not seek the credit terms Using the NPV approach, ad vise Undercounter as to which discount policy it should adopt QUESTION 2 Starlight Industries Ltd has to date been a"cash only"company. Management is concerned however, that sales are slipping and is contemplating a move to offer credit in an effort to boost sales. At the moment sales are $1 500 000 per annum and it is anticipated that sales will increase to $2 250 000 per annum if cred it is offered. The firms accountant has prepared the following schedule for the payment of accounts by all customers(new and existing) I month from the time of sale% 2 months from the time of sale% 3 months from the time of sale% The remaining 5% of sales will result in bad debts which will not be collected The variable cost of sales is 75% of sales and these costs are paid at the same time that sales are made. Starlight,'s cost of capital is 1. 25%per month Using the NPv approach, advise management whether the company should proceed with the proposal to offer cred it terms
August 2003 FIN2101 BUSINESS FINANCE II MODULE 4 – WORKING CAPITAL MANAGEMENT (Week 2) QUESTION 1 Undercounter Wholesalers Ltd currently sells entirely on a cash basis. Undercounter's management is considering introducing credit sales with discounts to attract new customers. The company is considering two alternative options. The first is offering discount terms of 2.5/30, n/60. It is estimated this would increase sales by $500 000 and 30% of these would take advantage of the discount. The second option is discount terms of 10/30, n/60, a policy which would increase sales by $600 000 with 50% of these customers taking the discount. The variable cost of sales is 75% of sales. The company's required rate of return on all accounts receivable is 1% per month. Undercounter's existing customers will not seek the credit terms. Using the NPV approach, advise Undercounter as to which discount policy it should adopt. QUESTION 2 Starlight Industries Ltd has to date been a "cash only" company. Management is concerned, however, that sales are slipping and is contemplating a move to offer credit in an effort to boost sales. At the moment sales are $1 500 000 per annum and it is anticipated that sales will increase to $2 250 000 per annum if credit is offered. The firm's accountant has prepared the following schedule for the payment of accounts by all customers (new and existing): - 1 month from the time of sale - 35% - 2 months from the time of sale - 25% - 3 months from the time of sale - 35% The remaining 5% of sales will result in bad debts which will not be collected. The variable cost of sales is 75% of sales and these costs are paid at the same time that sales are made. Starlight's cost of capital is 1.25% per month. Using the NPV approach, advise management whether the company should proceed with the proposal to offer credit terms
QUESTION 3 In order to increase sales from their present annual level of $240 000, the Heap Corporation is considering a more liberal credit policy. Currently the firm has an average collection period of thirty(30)days. However, it is believed that as the collection period is lengthened, les will increase by the following amounts Credit Increase in Increase in Policy Average Collection Sales $10000 30 days 5000 45 days s17000 Note: Increases in sales are cumulative, not incremental, ie adopting po licy b will increase sales by another s5 000(from $10 000 to $15 000), while moving from policy b to policy C will increase sales by a further S2 000(from $15 000 to $17000) The firm has the following cost pattern at present Price of the only product manufactured $100 Variable costs per unit $0.60 Required (a) If the firm requires a pre-tax return on investment of 20%, which cred it policy should be pursued? Assume a 360-day year (b) The firms current bad debt loss is 1%of sales. The company has estimated that the following pattern of bad debts will prevail if it initiates more liberal credit terms Increase in ACP Bad Debts Given the other assumptions made, which cred it policy should be pursued?
August 2003 QUESTION 3 In order to increase sales from their present annual level of $240 000, the Heap Corporation is considering a more liberal credit policy. Currently the firm has an average collection period of thirty (30) days. However, it is believed that as the collection period is lengthened, sales will increase by the following amounts: Credit Policy Increase in Average Collection Period Increase in Sales A 15 days $10 000 B 30 days $15 000 C 45 days $17 000 Note: Increases in sales are cumulative, not incremental, ie adopting policy B will increase sales by another $5 000 (from $10 000 to $15 000), while moving from policy B to policy C will increase sales by a further $2 000 (from $15 000 to $17 000) The firm has the following cost pattern at present: Price of the only product manufactured $1.00 Variable costs per unit $0.60 Required: (a) If the firm requires a pre-tax return on investment of 20%, which credit policy should be pursued? Assume a 360-day year. (b) The firm's current bad debt loss is 1% of sales. The company has estimated that the following pattern of bad debts will prevail if it initiates more liberal credit terms: Increase in ACP Bad Debts 15 days 3% 30 days 6% 45 days 10% Given the other assumptions made, which credit policy should be pursued?
QUESTION 4 Each month, Jumbo Pty Ltd sells 10 000 units at $25 per unit. The marg inal cost of roducing each unit is $15. At present all of Jumbo's sales are made on a strict cash only basis. Jumbo's manager believes that the cash only' policy has led to many sales being lost as there have been a number of inquiries concerning the possibil ity of credit sales. Jumbo's manager estimates that a credit policy of 1/30, n/60 could increase sales by 1 000 units per month, of which 500 would be paid for at the end of month I and 400 would be paid for at the end of month 2. Of the remaining 100 units, 70 are expected to be paid for a month late and 30 are expected to be bad debts. Administration and collection costs are estimated to be $250(month 0), $100(month 1), $100(month 2)and $150(month 3) However, it is expected that some existing customers will also seek cred it in order to obtain the discount offered. This is likely to affect the sale of 600 units, with the buyers of the remaining 9 400 units expected to continue to pay cash. Administration costs are estimated to be $150(month 0)and $60(month 1) Jumbo's required rate of return is 1.5% per month Should Jumbo adopt the proposed credit arrangements?
August 2003 QUESTION 4 Each month, Jumbo Pty Ltd sells 10 000 units at $25 per unit. The marginal cost of producing each unit is $15. At present all of Jumbo’s sales are made on a strict ‘cash only’ basis. Jumbo’s manager believes that the ‘cash only’ policy has led to many sales being lost as there have been a number of inquiries concerning the possibility of credit sales. Jumbo’s manager estimates that a credit policy of 1/30, n/60 could increase sales by 1 000 units per month, of which 500 would be paid for at the end of month 1 and 400 would be paid for at the end of month 2. Of the remaining 100 units, 70 are expected to be paid for a month late and 30 are expected to be bad debts. Administration and collection costs are estimated to be $250 (month 0), $100 (month 1), $100 (month 2) and $150 (month 3). However, it is expected that some existing customers will also seek credit in order to obtain the discount offered. This is likely to affect the sale of 600 units, with the buyers of the remaining 9 400 units expected to continue to pay cash. Administration costs are estimated to be $150 (month 0) and $60 (month 1). Jumbo’s required rate of return is 1.5% per month. Should Jumbo adopt the proposed credit arrangements?
FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS MODULE 4- WORKING CAPITAL MANAGEMENT (Week 2)
August 2003 FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS MODULE 4 – WORKING CAPITAL MANAGEMENT (Week 2)
QUESTION 1 OPTION 1 5000000.30.975500000.7 -37500 1.01 1.0) 144802+3430437500 I106 OPTION 2 6000000.5×0.96000000.5 NPV 45000 l.01 1.0) 2672729408945000 =$ll16 Conclusion: Adopt Option 1(2.5/30, n/60)as it has the higher NPV
August 2003 QUESTION 1 (a) OPTION 1 ( ) = $112906 =144802+ 343104- 375000 - 375000 1 .0 1 500000 0 .7 + 1.0 1 500000 0 .3 0 .9 7 5 NPV = 2 OPTION 2 ( ) = $111416 = 267327+ 294089- 450000 - 450000 1 .0 1 600000 0 .5 + 1.0 1 600000 0 .5 0 .9 NPV = 2 Conclusion: Adopt Option 1 (2.5/30, n/60) as it has the higher NPV
QUESTION 2 1. The NPV of the existing cash only policy is $l500000-$1125000 $375000 2. NPV of the proposed cred it policy is NPV=∑(FxPⅤHF1)I (0.35225000,(0.252250000(0.35225000 1.0125 1.0125 (1.102 -(0.75225000 787500562500787500 1687500 1.0125(1.0125(1.012 777778+54897758921687500 39b67 3. The NPv of the credit policy the NPv of the cash only" policy, therefore proceed ALTERNATIVE SOLUTION △ Sales △ Costs NCF PVE Present a125% 0-15000004-562500*-2062500 2062500 787500 787500098765477778 562500 5625000975461548697 787500 7875000963418758692 NPV=$22667# Current cash sales now foregone * 75% of add itional sales #$22667 is equal to$397667-$375000
August 2003 QUESTION 2 1. The NPV of the existing ‘cash only’ policy is: = $1 500 000 - $1 125 000 = $375 000 2. NPV of the proposed credit policy is: ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) = $ 3 9 7667 = 777778+ 548697+ 758692-1 687500 -1 687500 1 .0 1 2 5 787500 + 1 .0 1 2 5 562500 + 1 .0 1 2 5 787500 = - 0 .7 5 2 250000 1 .1 0 2 5 0 .3 5 2 250000 1 .0 1 2 5 0 .2 5 2 2 5 0000 1 .0 1 2 5 0 .3 5 2 250000 NP V = C F P VIF - I I 2 3 2 3 n t =1 t k ,t + + = 3. The NPV of the credit policy > the NPV of the ‘cash only” policy, therefore proceed with the proposed change. ALTERNATIVE SOLUTION t Sales Costs NCF PVIF @ 1.25% Present Value 0 -1 500 000* -562 500** -2 062 500 1 -2 062 500 1 787 500 787 500 0.987654 777 778 2 562 500 562 500 0.975461 548 697 3 787 500 787 500 0.963418 758 692 NPV = $22 667# * Current cash sales now foregone. ** 75% of additional sales. # $22 667 is equal to $397 667 - $375 000
August 2003 QUESTION 3 a to B 1. Marginal profit from add itional sales (10000×04) 5000 (2000×0.4) 2. Beginning level of receivables 0000 31250 42500 (Sales/360/ACP) (2400006030)(2500006045)(255000(36060) level of receivables 42500 (New sales/360/New A.C. P) 25000036045)(25500036060)(25700036075) 4. Add itional receivables 11250 11250 11042 31250-20000 42500-31250)(53542-42500 5. Add itional investment in receivables 6750 6750 6625 4. x variable cost %) (11250×0.6 (11042×06) 6. Required return on additional investment 1350 1325 (5. x required rate of return (6750×0.2 (6750×0.2) (6625×0.2) 7. Net position +2650 +650 (4000-1350) (2000-1350) (800-1325) Conclusion: It is worthwhile extending the average collection period by 30 days to 60 days( Plan B)but not beyond that point
August 2003 QUESTION 3 (a) To A A to B B to C 1. Marginal profit from additional sales (New sales x profit margin) 4 000 (10 000 ×0.4) 2 000 (5 000 ×0.4) 800 (2 000 ×0.4) 2. Beginning level of receivables (Sales/(360/A.C.P.)) 20 000 (240 000/(360/30)) 31 250 (250 000/(360/45)) 42 500 (255 000/(360/60)) 3. New average level of receivables (New sales/(360/New A.C.P.)) 31 250 (250 000/(360/45)) 42 500 (255 000/(360/60)) 53 542 (257 000/(360/75)) 4. Additional receivables (3. - 2.) 11 250 (31 250 - 20 000) 11 250 (42 500 - 31 250) 11 042 (53 542 - 42 500) 5. Additional investment in receivables (4. x variable cost %) 6 750 (11 250 ×0.6) 6 750 (11 250 ×0.6) 6 625 (11 042 ×0.6) 6. Required return on additional investment (5. x required rate of return) 1 350 (6 750 ×0.2) 1 350 (6 750 ×0.2) 1 325 (6 625 ×0.2) 7. Net position (1. - 6.) +2 650 (4 000 - 1 350) +650 (2 000 - 1 350) -525 (800 - 1 325) Conclusion: It is worthwhile extending the average collection period by 30 days to 60 days (Plan B) but not beyond that point
QUESTION 3 (Continued) )) It is possible to use the incremental approach in answering this part of the question However, given that Options a and b are the only policies that are viable, we can restrict ourselves to these policies a to B 1. Previous net position (see Part 2650 650 2. Current bad debt loss 2400 7500 Bad debts %x sales (001×240000)(003×25000 3. New bad debt loss 7500 15300 New bad debts %6x new sales (003×25000(006×255000 4. Increase in bad debts 5100 7800 3.-2 (7500-2400)(15300-7500) 5. Revised net position 2450 7150 2650-5100 650-7800 Conclusion: When bad debts are taken into consideration. the firm should maintain its existing policy
August 2003 QUESTION 3 (Continued) (b) It is possible to use the incremental approach in answering this part of the question. However, given that Options A and B are the only policies that are viable, we can restrict ourselves to these policies. To A A to B 1. Previous net position (see Part (a)) 2 650 650 2. Current bad debt loss (Bad debts % x sales) 2 400 (0.01 ×240 000) 7 500 (0.03 ×250 000) 3. New bad debt loss (New bad debts % x new sales) 7 500 (0.03 ×250 000) 15 300 (0.06 ×255 000) 4. Increase in bad debts (3. - 2.) 5 100 (7 500 - 2 400) 7 800 (15 300 - 7 500) 5. Revised net position (1. - 4.) -2 450 (2 650 - 5 100) -7 150 (650 - 7 800) Conclusion: When bad debts are taken into consideration, the firm should maintain its existing policy
QUESTION 4 The incremental net cash flows are shown in the table below. Inflows are shown as a plus outflows as a minu End of Incremental nin. Switch from cash Admin. costs of Total month sales revenue collection costs to credit sales switched sales and unit costsofincremental sales -15000* 15000+ 150 12375* 100 14850++ 27065 1750 -150 1600 Cost of new sa les ** 500 sold at $25 each less 1% discount =1000×$15 099)(500×$25) s15000 =$l2375 Lost cash sales ++600 sold at $25 each less 1%discount =(0.99)(600×$25) s15000 14850 Therefore NPVS27065$9900,S1600 30400 5(.01)1.015 =$26665.0$9609.55$1530.1-30400 =$7404.68 Jumbo Ltd should adopt the proposed cred it arrangements as the NPv of the proposal is ositive
August 2003 QUESTION 4 The incremental net cash flows are shown in the table below. Inflows are shown as a plus, outflows as a minus. End of month Incremental sales revenue and unit costs ($) Admin. & collection costs of incremental sales ($) Switch from cash to credit sales ($) Admin. costs of switched sales ($) Total (S) 0 -15 000* -250 -15 000+ -150 -30 400 1 12 375** -100 14 850++ -60 27 065 2 10 000 -100 9 900 3 1 750 -150 1 600 * Cost of new sales ** 500 sold at $25 each less 1% discount = 1 000 × $15 = (0.99) (500 × $25) = $15 000 = $12 375 + Lost cash sales ++ 600 sold at $25 each less 1% discount = 600 × $25 = (0.99) (600 × $25) = $15 000 = $14 850 Therefore: ( ) $ 74 0 4 .6 8 $266 6 5 .0 2 $ 96 0 9 .5 5 $ 15 3 0 .1 1- $30400 - $30400 1 .0 1 5 $ 1600 1 .0 1 5 $ 9900 1 .0 1 5 $27065 NP V 2 3 = = + + = + + Jumbo Ltd should adopt the proposed credit arrangements as the NPV of the proposal is positive
QUESTION 4 (Continued) Alternative Approach NPVofcash policy=(S 2 51000g-(S 1 5x1 000g =$25⑩00$15000 $10⑩0 NPVofcred it p olicy=(S g+ ($250.99600(S250.99k500 1.015 1.015 25×400$2570 l5⑩00$100$250 (1.015(.015 $100$100$150 S150$60 1.0150.015(1.015 (1.015 $23500+$1463H$1292+$9707$1674$15⑩0 -$1300$259$99$97$143$159$59 $10706 NPV of the cred it policy NPV of the cash policy(by $7 406), therefore adopt the proposed cred it arrangements
August 2003 QUESTION 4 (Continued) Alternative Approach ( ) ( ) $100000 $250000- $150000 NP V o f cash p o licy $25 1 0000 - $15 1 0000 = = = ( ) ( ) ( ) ( ) ( ) ( ) ( ) ( ) $107406 - $15000- $250- $99- $97- $143- $150- $59 $235000 $14631 $12192 $ 9707 $ 1674- $150000 1 .0 1 5 $60 - $150- 1 .0 1 5 $150 - 1 .0 1 5 $100 - 1 .0 1 5 $100 - - $150000- $15000- $250 1 .0 1 5 $25 7 0 1 .0 1 5 $25 400 1 .0 1 5 $25 0 .9 9 500 1 .0 1 5 $25 0 .9 9 600 NP V o f cred it p o licy $25 9 400 2 3 2 3 = = + + + + + + + = + NPV of the credit policy > NPV of the cash policy (by $7 406), therefore adopt the proposed credit arrangements
