Chapter 7 Discussion Questions 7-1 In the management of cash and marketable securities, why should the primary concern be for safety and liquidity rather than maximization of profit? Cash and marketable securities are generally used to meet the transaction needs of the firm and for contingency purposes. Because the funds must be available primary concern han the maximum profits 7-2. Briefly explain how a corporation may use float to its ad vantage Float represents the difference between a corporation's recorded cash balances and the amount cred ited to the corporation by the bank. It is the latter item that is of particular interest to us. To the extent a corporation can accelerate check account, the cash balance at the bank may exceed the payments from its bank collections to the bank account and slow down check recorded amount on the company books. The differential or float may be thought of as a short-term source of funds to the corporation 7-3 Why does float exist and what effect do electronic funds transfer systems have on float? Float exists because of the delay time in check processing. Electronic funds transfer, or the electronic movement of funds between computer terminals would eliminate the need for checks and thus eliminate float 7-4 How can a firm operate with a negative cash balance on its corporate books? A firm could operate with a negative balance on the corporate books, as indicated in Table 7-2, knowing float will carry them through at the bank Checks written on the corporate books may not clear until many days later at the bank. For this reason, a negative account balance on the corporate books of $100,000 may still represent a positive balance at the bank CopyrightC2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-241 Chapter 7 Discussion Questions 7-1. In the management of cash and marketable securities, why should the primary concern be for safety and liquidity rather than maximization of profit? Cash and marketable securities are generally used to meet the transaction needs of the firm and for contingency purposes. Because the funds must be available when needed, the primary concern should be with safety and liquidity rather than the maximum profits. 7-2. Briefly explain how a corporation may use float to its advantage. Float represents the difference between a corporation's recorded cash balances and the amount credited to the corporation by the bank. It is the latter item that is of particular interest to us. To the extent a corporation can accelerate check collections to the bank account and slow down check payments from its bank account, the cash balance at the bank may exceed the recorded amount on the company books. The differential or float may be thought of as a short-term source of funds to the corporation. 7-3. Why does float exist and what effect do electronic funds transfer systems have on float? Float exists because of the delay time in check processing. Electronic funds transfer, or the electronic movement of funds between computer terminals, would eliminate the need for checks and thus eliminate float. 7-4. How can a firm operate with a negative cash balance on its corporate books? A firm could operate with a negative balance on the corporate books, as indicated in Table 7-2, knowing float will carry them through at the bank. Checks written on the corporate books may not clear until many days later at the bank. For this reason, a negative account balance on the corporate books of $100,000 may still represent a positive balance at the bank
7-5 Explain the similarities and differences of lockbox systems and regional collection offices Both lockbox systems and regional collection offices allow for the rapid processing of checks that originate at distant points. The difference is that a regional collection center requires the commitment of corporate resources and personnel to staff an office, while a lockbox system requires only the use of a post office box and the assistance of a local bank. Clearly, the lockbox system is less expensive 7-6. Why would a financial manager want to slow down disbursements? By slowing down disbursements or the processing of checks against the corporate account, the firm is able to increase float and also to provide a source of short-term financing 7-7 Use The Wall Street ournal or some other financial publication to find the going interest rates for the list of marketable securities in Table 7-3. Which security would you choose for a short-term investment? Why? The answer to this question may well depend upon the phase of the business cycle at the time the question is considered. In normal times, small CDs and savings accounts may prove adequate. However, in a tight money period, wide differentials may be established between the various instruments and maximum returns may be found in Treasury bills, large CDs, commercial paper, and money market funds 7-8 Why are Treasury bills a favorite place for financial managers to invest excess cash? Treasury bills are popular because of the large and active market in which they trade. Because of this, the investor may literally pinpoint the maturity desired choosing anywhere from one day to a year. The T-bill "market provides maximum liquid ity and can absorb almost any dollar amount of business 7-9 Explain why the bad debt percentage or any other similar cred it-control percentage is not the ultimate measure of success in the management of accounts receivable. what is the key consideration? An investment in accounts receivable requires a commitment of funds as is true of any other investment. The key question is: Will the dollar returns from the resource commitment provide a sufficient rate of return to justify the investment? There is no such thing as too many or too few bad debts, only too low a return on capital CopyrightC 2005 by The McGray-Hill Companies, Inc. S-242
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-242 7-5. Explain the similarities and differences of lockbox systems and regional collection offices. Both lockbox systems and regional collection offices allow for the rapid processing of checks that originate at distant points. The difference is that a regional collection center requires the commitment of corporate resources and personnel to staff an office, while a lockbox system requires only the use of a post office box and the assistance of a local bank. Clearly, the lockbox system is less expensive. 7-6. Why would a financial manager want to slow down disbursements? By slowing down disbursements or the processing of checks against the corporate account, the firm is able to increase float and also to provide a source of short-term financing. 7-7. Use The Wall Street Journal or some other financial publication to find the going interest rates for the list of marketable securities in Table 7-3. Which security would you choose for a short-term investment? Why? The answer to this question may well depend upon the phase of the business cycle at the time the question is considered. In normal times, small CDs and savings accounts may prove adequate. However, in a tight money period, wide differentials may be established between the various instruments and maximum returns may be found in Treasury bills, large CDs, commercial paper, and money market funds. 7-8. Why are Treasury bills a favorite place for financial managers to invest excess cash? Treasury bills are popular because of the large and active market in which they trade. Because of this, the investor may literally pinpoint the maturity desired choosing anywhere from one day to a year. The "T-bill" market provides maximum liquidity and can absorb almost any dollar amount of business. 7-9. Explain why the bad debt percentage or any other similar credit-control percentage is not the ultimate measure of success in the management of accounts receivable. What is the key consideration? An investment in accounts receivable requires a commitment of funds as is true of any other investment. The key question is: Will the dollar returns from the resource commitment provide a sufficient rate of return to justify the investment? There is no such thing as too many or too few bad debts, only too low a return on capital
7-10 What are three quantitative measures that can be applied to the collection of the firm? The average collection period, the ratio of bad debts to credit sales and the aging of accounts receivable 7-11 What are the 5 Cs of cred it that are sometimes used by bankers and others to determine whether a potential loan will be repaid? The 5 Cs of cred it are character, capital, capacity, cond itions, and collateral 7-12 What does the EoQ formula tell us? What assumption is made about the usage rate for inventory? The EoQ or economic order point tells us at what size order point we will minimize the overall inventory costs to the firm, with specific attention to inventory ordering costs and inventory carrying costs. It does not directly tell us the average size of inventory on hand and we must determine this as a separate calculation. It is generally assumed, however, that inventory will be used up at a constant rate over time, going from the order size to zero and then back again Thus, average inventory is half the order size 7-13 Why might a firm keep a safety stock? What effect is it likely to have on carrying cost of inventory? A safety stock protects against the risk of losing sales to competitors due to being out of an item. a safety stock will guard against late deliveries due to weather, production delays, equipment breakdowns and many other things that go wrong between the placement of an order and its delivery. With mor inventory on hand, the carrying cost of inventory will go UP on the number and location of suppliers em, what effect is that likely to have If a firm uses a just-in-time inventory syst A just-in-time inventory system usually means there will be fewer suppliers, and they will be more closely located to the manufacturer they supply iby The McGraw-Hill Co
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-243 7-10. What are three quantitative measures that can be applied to the collection policy of the firm? The average collection period, the ratio of bad debts to credit sales and the aging of accounts receivable. 7-11. What are the 5 Cs of credit that are sometimes used by bankers and others to determine whether a potential loan will be repaid? The 5 C's of credit are character, capital, capacity, conditions, and collateral. 7-12. What does the EOQ formula tell us? What assumption is made about the usage rate for inventory? The EOQ or economic order point tells us at what size order point we will minimize the overall inventory costs to the firm, with specific attention to inventory ordering costs and inventory carrying costs. It does not directly tell us the average size of inventory on hand and we must determine this as a separate calculation. It is generally assumed, however, that inventory will be used up at a constant rate over time, going from the order size to zero and then back again. Thus, average inventory is half the order size. 7-13. Why might a firm keep a safety stock? What effect is it likely to have on carrying cost of inventory? A safety stock protects against the risk of losing sales to competitors due to being out of an item. A safety stock will guard against late deliveries due to weather, production delays, equipment breakdowns and many other things that can go wrong between the placement of an order and its delivery. With more inventory on hand, the carrying cost of inventory will go UP. 7-14. If a firm uses a just-in-time inventory system, what effect is that likely to have on the number and location of suppliers? A just-in-time inventory system usually means there will be fewer suppliers, and they will be more closely located to the manufacturer they supply
Problems 7-1 Cats Copiers, Inc shows the following values on its corporate books Corporate books Initial amount $10,000 ,00 Checks 45.000 Balance $65,000 The initial amount on the banks books is $20,000. Only $85,000 in deposits have been recorded and only $18,000 in checks have cleared. Fill in the following table and ind icate the amount of float Bank’ s Books Initial amount 20000 Deposits Balance Flo Solution: Cats Copiers I Bank books Initial amount $20.000 Deposits +85000 18000 Balance $87000 Float $22000* *Based on the balance on the corporate books minus the balance on the bank's books CopyrightC 2005 by The McGray-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-244 Problems 7-1. Cats Copiers, Inc. shows the following values on its corporate books. Corporate Books Initial amount $ 10,000 Deposits +100,000 Checks – 45,000 Balance $ 65,000 The initial amount on the bank's books is $20,000. Only $85,000 in deposits have been recorded and only $18,000 in checks have cleared. Fill in the following table and indicate the amount of float. Bank’s Books Initial amount $20,000 Deposits Checks _______ Balance Float Solution: Cats Copiers, Inc. Bank Books Initial amount $20,000 Deposits +85,000 Checks –18,000 Balance $87,000 Float $22,000* *Based on the balance on the corporate books minus the balance on the bank's books
Ron s checkbook shows a balance of $400. a recent statement from the bank (received last week) shows that all checks written as of the Statement date have been paid except numbers 325 and 326, which were for $35and $58 respectively. Since the statement date, checks 327, 328, and 329 have been written for $22, $45, and $17, respectively There is an 80 percent probability that checks 325 and 326 have been paid by this time. There is a 50 percent probability that checks 327, 328, and 329 have been paid a. What is the total value of the five checks outstand ing? b. What is the expected value of payments for the five checks outstand ing? c. What is the difference between parts a and b? This represents a type of fld Solution: Ron's checkbook a.$35+$58+$22+45+17=$177 b Probability check Expected Amount has cleared value $35 80% $2800 $58 xxx 80% 46.40 $22 0% 1100 $45 50% 22.50 $17 50% 8.50 S116.40 expected value of payment or five checks outstanding c.(a-b)=$177.00-$11640=s6060foat Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-245 7-2. Ron's checkbook shows a balance of $400. A recent statement from the bank (received last week) shows that all checks written as of the Statement date have been paid except numbers 325 and 326, which were for $35and $58, respectively. Since the statement date, checks 327, 328, and 329 have been written for $22, $45, and $17, respectively. There is an 80 percent probability that checks 325 and 326 have been paid by this time. There is a 50 percent probability that checks 327, 328, and 329 have been paid. a. What is the total value of the five checks outstanding? b. What is the expected value of payments for the five checks outstanding? c. What is the difference between parts a and b? This represents a type of float. Solution: Ron's Checkbook a. $35 + $58 + $22 +45 +17 = $177 b. Amount Probability check has cleared Expected value $35 x 80% $ 28.00 $58 x 80% 46.40 $22 x 50% 11.00 $45 x 50% 22.50 $17 x 50% 8.50 $116.40 expected value of payment for five checks outstanding c. (a – b) = $177.00 – $116.40 = $60.60 float
7-3 City Farm Insurance has collection centers across the country to speed up collections. The company also makes its disbursements from remote disbursement centers so checks written by City Farm take longer to clear the bank Collection time has been reduced by two and disbursement time increased by one day because of these policies. Excess funds are being invested in short-term instruments yield ing 12 percent per annum a. If City Farm has $5 million per day in collections and $3 million per day in disbursements, how many dollars has the cash management system freed b. How much can City Farm earn in dollars per year on short-term investments made possible by the freed-up cash? Solution: City Farm Insurance a. $5000,000 daily collections x 2.0 days speed up $10,000,000 additional collections S3,000,000 daily disbursements x 1.0 days slow down= $3.000.000 delayed disbursements $13,000,000 freed-up funds b $13,000,000 freed-up funds 12% interest rate S 1, 560,000 interest on freed-up cash CopyrightC 2005 by The McGray-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-246 7-3. City Farm Insurance has collection centers across the country to speed up collections. The company also makes its disbursements from remote disbursement centers so checks written by City Farm take longer to clear the bank. Collection time has been reduced by two and disbursement time increased by one day because of these policies. Excess funds are being invested in short-term instruments yielding 12 percent per annum. a. If City Farm has $5 million per day in collections and $3 million per day in disbursements, how many dollars has the cash management system freed up? b. How much can City Farm earn in dollars per year on short-term investments made possible by the freed-up cash? Solution: City Farm Insurance a. $5,000,000 daily collections x 2.0 days speed up = $10,000,000 additional collections $3,000,000 daily disbursements x 1.0 days slow down = $ 3,000,000 delayed disbursements $13,000,000 freed-up funds b. $13,000,000 freed-up funds x 12% interest rate $ 1,560,000 interest on freed-up cash
Nicholas Birdcage Company of Hollywood ships cages throughout the country Nicholas has determined that through the establishment of local collection centers around the country, he can speed up the collection of payments by one d one-half days. Furthermore, the cash management department of his bank has indicated to him that he can defer his payments on his accounts by one-half day without affecting suppliers. The bank has a remote disbursement center in Florida a. If the company has $4 million per day in collections and $2 million per day in disbursements, how many dollars will the cash management system free b. If the company can earn 9 percent per annum on freed up funds, how much zill th e income c. If the total cost of the new system is $700,000, should it be implemented? Solution: Nicholas birdcage company of hollywood a.$4,000,000 daily collections x 1.5 days speed up=$6,000,000 additional collections $2,000,000 daily disbursements x 5 days slow down=$1,000000 delayed disbursements $7,000,000 freed-up funds b $7,000,000 freed-up funds interest rate $630.000 interest on freed-up cash c. No. The income of $630.000 is $70.000 less than the cost of $700,000 for the new system S-247 Copyright C2005 by The McGra-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-247 7-4. Nicholas Birdcage Company of Hollywood ships cages throughout the country. Nicholas has determined that through the establishment of local collection centers around the country, he can speed up the collection of payments by one and one-half days. Furthermore, the cash management department of his bank has indicated to him that he can defer his payments on his accounts by one-half day without affecting suppliers. The bank has a remote disbursement center in Florida. a. If the company has $4 million per day in collections and $2 million per day in disbursements, how many dollars will the cash management system free up? b. If the company can earn 9 percent per annum on freed up funds, how much will the income be? c. If the total cost of the new system is $700,000, should it be implemented? Solution: Nicholas Birdcage Company of Hollywood a. $4,000,000 daily collections x 1.5 days speed up = $6,000,000 additional collections $2,000,000 daily disbursements x .5 days slow down = $1,000,000 delayed disbursements $7,000,000 freed-up funds b. $7,000,000 freed-up funds x 9% interest rate $ 630,000 interest on freed-up cash c. No. The income of $630,000 is $70,000 less than the cost of $700,000 for the new system
7-5 Megahurtz International Car Rentals has rent-a-car outlets throughout the world. It also keeps funds for transactions purposes in many foreign countries Assume in 2003. it held 10.000 reals in Brazil worth 35.000 dollars. It drew 12 percent interest, but the Brazilian real declined 20 percent against the dollar. a. What is the value of its holdings, based on U.S. dollars, at year-end? (Hint multiply $35,000 times 1 12 and then multiply the resulting value by 80 drew 9 percent interest and the real went up by 10 percent agan the pi b. What is the value of its holdings, based on U.S. dollars, at year-end if it dollar? Solution Megahurtz international car rental a.$35,000x1.12=$39,200 S39.200 x 80%=$.360 dollar value of real holdings b.$35,000x109=$38,150 S38.150x 110%=$41.965 dollar value of real holdings 7-6 Thompson Wood Products has cred it sales of $2, 160,000 and accounts receivable of $288,000. Compute the value of the average collection period Solution: Thompson wood Products Accounts receivable Average collection period average daily credit sales $288.00 $2160,000/360 $288,000 $6.000 CopyrightC 2005 by The McGray-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-248 7-5. Megahurtz International Car Rentals has rent-a-car outlets throughout the world. It also keeps funds for transactions purposes in many foreign countries. Assume in 2003, it held 10,000 reals in Brazil worth 35,000 dollars. It drew 12 percent interest, but the Brazilian real declined 20 percent against the dollar. a. What is the value of its holdings, based on U.S. dollars, at year-end? (Hint: multiply $35,000 times 1.12 and then multiply the resulting value by 80 percent or 1 – .20). b. What is the value of its holdings, based on U.S. dollars, at year-end if it drew 9 percent interest and the real went up by 10 percent against the dollar? Solution: Megahurtz International Car Rental a. $35,000 x 1.12 = $39,200 $39,200 x 80% = $31,360 dollar value of real holdings b. $35,000 x 1.09 = $38,150 $38,150 x 110%= $41,965 dollar value of real holdings 7-6. Thompson Wood Products has credit sales of $2,160,000 and accounts receivable of $288,000. Compute the value of the average collection period. Solution: Thompson Wood Products 48 days $6,000 $288,000 $2,160,000/ 360 $288,000 Average daily credit sales Accounts Receivable Average collection period = = = =
7-7 Darla's Cosmetic has annual cred it sales of $1, 440, 000 and an average collection period of 45 days in 2004. Assume a 360-day year. What is the company's average accounts receivable balance? Accounts receivable are equal to the average daily cred it sales times the average collection period Solution: Thompson wood Products $1,440,000 annual credit sales/360=$4, 000 per day credit sales 84,000 credit sales x 45 average collection period=$180,000 average accounts receivable balance 7-8 In Problem 7, if accounts receivable change to $200,000 in the year 2005, whi cred it sales are $1.800.000. should we assume the firm has a more or a lesse lenient cred it policy? Soluti Darlas Cosmetics(Continued To determine if there is a more lenient credit policy, compute the average collection period Average collection period= Accounts Receivable Average daily credit sales $20000 $l800000/360 $200000 40 days $5,000 Since the firm has a shorter average collection period, it appears that the firm does not have a more lenient credit policy S-249 CopyrightC2005 by The McGraw-Hill Companies, Inc
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-249 7-7. Darla’s Cosmetic has annual credit sales of $1,440,000 and an average collection period of 45 days in 2004. Assume a 360-day year. What is the company's average accounts receivable balance? Accounts receivable are equal to the average daily credit sales times the average collection period. Solution: Thompson Wood Products $1,440,000 annual credit sales/360 = $4,000 per day credit sales $4,000 credit sales x 45 average collection period = $180,000 average accounts receivable balance 7-8. In Problem 7, if accounts receivable change to $200,000 in the year 2005, while credit sales are $1,800,000, should we assume the firm has a more or a less lenient credit policy? Solution: Darla’s Cosmetics (Continued) To determine if there is a more lenient credit policy, compute the average collection period. 40 days $5,000 $200,000 $1,800,000/ 360 $200,000 Average daily credit sales Accounts Receivable Average collection period = = = = Since the firm has a shorter average collection period, it appears that the firm does not have a more lenient credit policy
Hubbell Electronic Wiring Company has an average collection period of 35 days. The accounts receivable balance is $105,000. What is the value of cred it Solution Hubbell Electronic wiring Company Accounts receivable Average collection period Average daily credit sales $105 35 days credit sales 360 Credit sales/360 $105.000 Credit sales/360=$3,000 credit sales per da Credit sales=$3,000×360=$1,080,000 CopyrightC 2005 by The McGray-Hill Companies, Inc. -250
Copyright © 2005 by The McGraw-Hill Companies, Inc. S-250 7-9. Hubbell Electronic Wiring Company has an average collection period of 35 days. The accounts receivable balance is $105,000. What is the value of credit sales? Solution: Hubbell Electronic Wiring Company Credit sales $3,000 360 $1,080,000 Credit sales/360 $3,000 credit sales per day 35 days $105,000 Credit sales/360 360 credit sales $105,000 35 days Average daily credit sales Accounts receivable Average collection period = = = = = =
