Ch6 Hw Answers

Chapter 06: W o rking Capital and the Financing Decision

Chapter 6 Working Capital and the Financing D ecis io n

Discussion Questions 6-l. E xplain how rapidly expanding sales can dxain the cash resources of a firm.

6-2.

6-3.

6 -4 .

R apidly expanding sales will require a buildup in assets to suppon the growth . ln paniculat, mme aod moJ:e of the inc.rease io cun-eot assets will be permanent in nature . A oon- liquidatiJ,g aggregate s tock o f cutTent assets will be necessary to allow fo floo clisplays , multiple ilems for selection, and othe purposes. All of these "asset" investments can drain the cas h esources of the fi m .

Discuss the relative volatility of shot- and long-te= imerest rates .

Figme 6- LO s hows the long-run view of s hort- and long-tenn interest rates. Nonnally, shon-term rates are much more volatile than long- term rates .

What is the significance lo working capital management of matching sales and production?

JJ sales and production can be matche d , the le ve l of iove nto.ty and the amount o f cunent assets needed can be kept to a minimum; the.tefo1e, lower financin g cos ts will be incurred. Matching sales and pmduction has the advantage of maintaining smaller amounts of current a ssets than level production, and theefore less financing costs are incurred. Howeve1, if sales are seasonal or cyclical , workers will be laid off in a declining sales climate and machiJJery (fixed assets) will be idle. H ere lies the tradeo(T bet ween level and seas onal production: FuU utilization of fixed assets with s killed workers and more t:ln~u1cing of c urrent assets versus unused capacityt training and retraining "vorkers, with lo"ver financing for c unent assets.

How is a cash bttdget used to he lp manage cun:ent :%e ts?

A cash budge t he lps minimize cun:ent assets by providing a forecast of int1ows and outflows of cas h . 1t also encourages the d evelopment of a schedule as to when inventory is produced and maintailled for s ales (production schedule), and accounts receivables are collected. The cas h budget allows us to forecast the level of each ctuTent asset and the timing of the buildup and reduction of each.

6- 1

Chap1e.r 06; Working C~:tphu l and the F'im;mcing Occis.i on

6-5.

6-6.

6 -7 .

6 -8 .

"The most ap prop riate financing pattern would be one in which asset buildup and length of financing terms is perfectly matched." D iscuss the difficulty involved in achiev ing this financing pau e rn .

O n l.y a financial manage r with unu s ual ins ig ht and timing could design a p lan .in which asset b u ildup and the length of financing terms ~ue pe1:fecUy matched. One wou ld need to know exactl y w ha t cu.rent assets are temporary and which ones ate permanent. Furthetmore, one is never quite sue how m uch o short-tenn or long-term financing is avai lable at a ll times . Even if this were known., it would be difficult to c hange the financing mix on a contin u a l bas is.

By using long-term financing to finance part of temporary c urrent assts, a firrn may have less risk b ut lower returns than a firm w ith a normal financing plan. Explain the signit:lc


6-9.

6- 10.

W hat ::u-e three theories for describing the s hape of the term s tructure of interest rate-s (the yield c urve)? Brie.fly descr.ibe each theory.

Liquidity premium theory, the market segrnentation theory, and the expectations theoly .

T he liquid ity premium theory indicates that long-te tm rates should be higher than short-term rates. T h is premium or long-term rates over short-term rates exists because short-term secwi ties have greater li quidity, and therefore higher rates have to be olTered to potential long-term bond bu yer to entice them to hold these less liqu id and more price sensitive secu riti es.

T he nuucket segmentation theory states that Treasury securities are divided into rna.rket segments by the various financia l instirutions investing in the market. The c hangin g n eeds. desires. and strategies of these investors tend to s tnmgly i.nnuence the natu1e and relationship of s hon- a.nd lo ng- term rates.

T he expectations hypothesis maintains that the yields on long-term secu rities ~u-e a fu nction of short-tetm rates. T he result of the hypothesis is that w hen long- term rates are m uch h igher than short-term rates, the market is saying tha t is expects s ho rt-term rates to r ise. Conversely, when loug-term rates are lower than short- term rates, the m arket is expecting short- term rates to fall.

Since the m id-l960s, corporate liquidity has been de-clining. W hat reasons can you give for this trend?

T he decrease is liquidity can be uaced in pan t.o m.o1e efficient inventory management such as just- in- time inventory an d point of sates terrnina.ls that provide benet invemory conttol. The decl ine in working capital can a l.so be attdbutecl to electronic cash tlow transfer systems, and the ability to sell accounts receivables thto ug h securitizat ion of assets (this is more fu lly explained in the next chapter). 1L n1.ight also be that management is simply w illing to ta ke more liquid ity risk as inlet-est rates decl ined.

6-3

Chapter 06: Working Capital and the F ir'Ulncing Decision

Chapter 6

Problems 1. Expected value (L0 6) Austin Electronics expects sales next year to be $900,000 if the

economy is strong, $650,000 if the economy is steady, and $375,000 if the economy is weak. The firm believes there is a l5 percent probability the economy will be stwog, a 60 percent probability of a s teady economy, and a 25 percent probability of a w eak economy.

What .is the expected level. of sales fox next year?

6 -1. Solution: Austin E lectronics

State of Economy Sales Probability

Stron o-""

$900,000 .15 Stead y 650,000 .60

W eak 375,000 .25

Exp ected level of sales =

Expected Outcome

$ 135,000 390 ,000

93,750

$618,750

2. Exp ected value (L06) Sh:upe Knife Company expects sales next yem to be $1,500,000 if the economy is strong, $800,000 if the economy is s teady,

Chapter 06: W o rking Capital and the F i r'Ulncing D ecision

Sharpe Knife Company

State of Expected Economy Sales Probability Outcome

Strong $ 1,500,000 .2 0 $300,000 Steady 800,000 .50 4 00,000

W eak 500,000 .30 150,000

Expected lev e l of sales = $ 850,000

3 . Ext.ernal financing (LOt) Axle S upply Co., expects sales next year to b e $300,000. Inventory and accounts receivable wi ll increase by $60 ,000 to accommodate this sales level. The company has a s teady profi t margin of 10 perceni w ith a 30 percent dividend payou t. How m uc h externaJ financing w ill the firm have lo seek? Assume there is no increase in liabiUties other than tha t w h.ich w ill occu r w ith the extemal financi11g.

6-3. Solution:

$300,000 .10

30,000 9 ,000

$ 2 1 ,000 $ 60,000

21 ,000 $ 39,000

Axle Supply Co.

6 -5

S a les Profit marg in Net income D ivide nds (30 % ) Inc rease in re tained earnings Inc rease in assets Increase in re tained e arnings Exte rnal funds need ed

Chapter 06: Working Ca.pitaJ and the F inancing Decision

4 . External financin g (LOJ) Antivirus, Inc ., expects its sales nex t year to be $2,000,000. Inventory and accounts receivable wi ll increa~e $430,000 to accommodate Lhis s ales level. The company has a s teady profit m~ugin of 12 percent wilh a 25 percent clividend payou t. How much external financing will the firm have to seek? Assume there is no increase in liabilit ies other than that which w ill occur with the external financing.

6-4. Solution:

$2,000,000 .12

240,000 6000 0

$ ] 80,000

$ 4 30 ,000 180,000

$250 ,000

Antivirus, Inc.

Sales Profit M arg in Net income Dividends (25%) Inc rease in re tained earnings

Inc rease in assets Inc rease in re tai ned earnings External funds needed

5 . Level ver s u s sea sonal produc tion (LOl ) Antonio Banderos & Scarves make s headweaJ that is very popular in the fall- winte r season. Units sold are anticipated as :

6-5.

October... .... .... ... . ..... . .... . . . ....... ........ ..... ..... 1,000 November........ . . ............. . ..... . . ........ . .... . .... 2 ,000 D ecen1ber ...... . .. .. .. . . .. . . . ...... .. .. .. ...... .. ... . .... . 4 ,000 Ja_nt,uy ..... .... .. .. .. ............ .. ...... ....... .. .. .. ... .. 3.000

10,000 uni ts

1f sea~onal production is u sed, it is assu med that invemory will directl y match s a le s for each month and there will be no invemory buildup. However, Antonio dec ides to go with level production to avoid being o ut of merchandis e. H e will produce the 10,000 items over four months ai a level of 2,500 per month. a. What is the ending inventory a t the end of each n1onth? Compare the u nits s ales to the

un.iL~ ptoduced and keep a runnjng total. b. JJ the inve nto ty cos ts $5 per unit and wi II be finance d at the bank at a cos1 of J 2

pe rce nt, what is the monthly f inancing cos t and Lhe total for the four months ? (Use 1 percem or the monthly rate).

Solution:

6-6

Chapter 06: Working Ca.pitaJ and Lhe F inancing Decision

a.

O ctobe r N ovember D ecember Ja nua ry

b.

O ctob er Nove mber D ecemb er Ja nuary

Antonio Banderos and Scarves

Units Units Change in Ending Sold Produced inventory Inventory 1,000 2,000 4,000 3,00 0

Ending Inventory

1,500 2,000

500 0

2 ,500 + 1,500 2,500 + 500 2,500 - 1,500 2,500 - 500

Total Cost Per Unit

($5 per unit) 7,500

10 ,000 2,500

0 T otal Finan cing Cost =

1,500 2 ,000

5 00 0

Inventory Financing Cost

at (1% per month)

75 10 0

25 0

$200 6. Level vers u s se>lSonal production (LOI) Bambino Sporting Goods makes baseball gloves

that ~u-e ver.y popular in the spr.iog :md ear.ly suromer season. Units sold a.re an(jcipated as follows:

March...... . ...... .. .. .......... . .. .. ....................... 3,000 April . .. .. .... .. ...... .. ..... ..... . .... .... .. .. .... .. ... .. .... 7 ,000 May .......................................................... 11,000 Ju11e ........................................... 9.000

30,000

If seas onal production is used, it is assu med that inventory w ill directl y match s ales fo each month aod thete w ill be no invent

Chapter 06: Working Capital and the Financing Decision

a. W hat is the ending inventory at the end of each month ? Compare the u nit sales to the units produced and keep a ru nning total.

b. If the inventory costs $20 per u nit and will be financed at the b

Chapter 06: W o rking Capital and the Financing Decision

7. S hort-term versus longer-term borrowing (L03) Boatler Used Cadillac Co. requires $800,000 in financing over the next two years . The finn can borrow the funds for two years at 9 percent interes t per year. Mr. Boatler d ecides to do forecasting ~Uld predicts that if he ut iUzes short-term financing ins tead , he will pay 6.75 percent interest in the fi rst year and 10.55 percent inte rest in the second year. D etem1ine the LOtal two-year interest cost under each plan. Which plan is less costly?

6 -7. Solution: Boatler Used Cadillac Co.

Cost of T wo Year Fixed Cost Financing $800,000 borrowed@ 9% per annum x 2 years= $144 ,000 interest cost

Cos t of T wo Year V ariable Short- term Financing l st year $800,000 x 6.75% per annum = $54,000 interest cost 2'"1 year $800,000 x 10.55% per annun"l = $84,400 interes t cost

138,400 to tal interes t cost

The short-term plan is less costly.

8. S hort-term versus lo n ger -term bonowing (L03) Biochemical Corp. requires $500,000 in financing over the next three yems. The finn can borrow the funds for three years at 10.60 p ercent inte rest per year. The CEO d ecides to do a forecast a nd predicts that i f she utilizes short-term financing instead, she will pay 7 .25 percent interest .in the first yettr, I 1..90 percent inte test in lhe second Y'-'ar, and 8.15 percent interest in the third year. D eterm.ine the total interest cosi u nder each plan. Which plan is less costly?

6-8. Solution: Biochemical Corp.

Cos t of Three Year Fixed Cost Financing $500,000 borrowed x 10.60% per annum x 3 years= $159,000

6 -9


l st year 2nd year 3rc1 year

Cost of Thtee Year Variable S h ort-term Financin g $500,00 0 x 7.25% Per annum = $ 36,250 Interest cost $500,000 x 11 .90% Per annum 59,500 Interest cost $500,000 x 8.15% Per a nnum 40,750 Interest cost

$136,500 3 -year total

The s h ort-term p lan is less costly. 9. S hort-term versus longer -term bonowing (L03) Stern Educational TV, Inc. , has

decided to buy a new computer sys tem w:ith an expected Jjfe of three years at a cos t of $200,000. The comp


b. If Short-term Rates Change lst year

2 d year 3rd year

$200,000 X .10 -$200,000 X . 15 $200,000 X . 1.8

Total

$20,000 $30,000 $36 ,000 $86,000

$86,000 - $72,000 = $14,000 extra interest costs borrowing short-term one yea r a t a tin1.e.

10. Optimal policy mix (LOS) Assume that Hogan Surgicallnstruments Co. has $2,000,000 in assets. Tf it goes with a low- Liquidity pl.an fo. the assets, il can earn a return of 18 percent, but with a h.ig h liquidity plan, the return will be 14 percent. JJ tbe firm goes with a sbon-te.rm fina ncing p lan , the financing costs on the $2,000,000 wi ll be 10 percent, and w ith a lo ng-term financing plan, the financing costs on the $2,000,000 w ill be J 2 percent. (Review Table 6-J I for parts 1, b, and c of this problem.) a. Compute the an ticipated re rum after financing costs w ith the most aggressive asset-

financing nux. b. Compute the anticipated return after financing costs w itb the most conservative asset-

financing mjx. c. Compute the anticipated return after financing cos ts w ith the two Jnoderate approaches

10 the asset-1.1naocing mix. d. Would you necessari l.y accept the plan with the hjghest rem.rn aftet tioaocing costs?

Bl'iefly expla in.

6-10. Solution: Hogan Surgical Instruments Company

a. l\1ost aggressive

Low liquidity Short-term financing Anticipated r e turn

6- 1 I

$2,000,000 X 18% = 2,000,000 X J. 0 % =

$360,000 - 2 00,000 $ 160,000

Chapter 06: Working Capi tal and the F i r'Ulncing Decision

6-10.

b. Most conservative

High liquidity $2,000,000 X 14% = $280,000 Long-term financing 2,000,000 X 12% = - 240,000 Anticipated return $ 40,000

c. Moderate approach

Low liquidity $2,000,000 X 18% = $360,000 Long-term finan c ing 2,000,000 X 12% = - 240,000

$ 120 ,000 OR

Hig h liquidity $2,000,000 X 14% = $280,000 S h ort- term financino-0 2,000 ,000 X 10 % = - 200,000

$ 80,000 (Continu ed) d. You m ay no t n ecessari ly select the pla n with the highest

r e turn. You m us t also con sider the risk inhe re nt in the plan . Of course, some firms are better able to take risks tha n others. The ultimate conce rn must be for n-:taxiiuiz ing the overall valuatio n of the firm through a judiciou s cons ide ration of r is k-return options.

I J . Optimal p olicy mix (LOS) Assume that A tlas Spoting Goods, Inc., has $800,000 in assets. If it goes w ith a low- liquidity plan for the assets, it can eam a return of 15 percent , but wi th a high-ljquiruty p lan the return will be 12 percent. l f the firm goes w ith a short-term financing plru1, the financing costs on the $800,000 will be 8 percem, and with a l.ong-term fimUlcing p lan, the financing costs on the $800,000 will be 10 percent. (R eview T able 6-1 1 for pmts a. b , and c of this problem.) a. Compute the anticipated return after financing costs with the most aggressive asset-

financing nJix. b. Compute the anticipated return aftet financin g costs w ith the most cons~ervative asset-

financing mix. c . Compme the anticipated return afte financing cosrs with the two moderate approaches

to the asset-f inancing mix.

6 - t2

Chapter 06: W o rking Capital and the F ir'Ulncing D ecision

d. JJ' the t:i.rm used the m ost aggressive asset-f inancing nux described i n part a and had the an ticipated return you computed for part a, w ha t would earnings per s hare be if the tax rate on the an ticipated return was 30 percent and there were 20,000 s hares o m standiog?

e . Now assume lhe most conservative asset-financing m ix described in part b will be u ti lized. The tax rate w ill be 30 percent. A lso assu me there w ill only be 5 ,000 s hares outs tanding. What wi ll earnings per sh are be? W ou ld it be hig her or lower than the erunings per s hare computed for the most aggressive p hm computed in prut d?

6-11. Solution: Atlas Sporting Goods, Inc.

a . Most aggtessive Low liquidity Sho rt-term financ ing A ntic ipa ted r e turn

b. Most conservative High liquid ity Long -te rm fina nc ing A nticip a ted r e turn

6-1.1. (Continued) c. Moderate approach

L o w liquidity Long-te rm financing A ntic ipa ted re n:trn

Hig h liquidity Sho rt-te rm financ ing A ntic ipa ted r e turn

OR

6 - 13

$800,000 X 15 % 800,000 X 8% -

$800,000 X 12% 800,000 X 10 %

$800,000 X 15% 800,000 X 10% -

$ 800,000 X 12 % 800,000 X 8 % -

$120,000 -64 ,000 $ 56,000

$ 9 6 ,000 - 80,000

$ 16 ,000

$12 0 ,000 -80,000 $ 40,000

$ 96,000 -64 ,000 $ 32,000


d. Anticip a ted return - taxes (30 %) Earnin o-s after taxes b Shares Earn in gs p e r s h are

e. Antic ipated return - taxes (30%) E arni ngs afte r taxes Shares Earnings p e r s h a re

It is h igher ($2 .24 vs . $1.96)

$56 ,000 16,800 39,200 2 0 ,000

$1 .96

$ 16,000 4 800

11,20 0 5,000 $2.24

12. Mal.ching a sset mix and financing plans (L03) Winfre y Diet Food Corp. has $ 4 ,500,000 in assets.

Temponuy current assets .. .. .. .... .. .. .......... . Permanent cur:rent assets .... ...... .. .. ... .. .... .. . Fixed assets .. ......... .. ... .. ........ ...... ............. .

T otal assets .. ............. .. .. .. .. .. .... .. .. .. .... ..

$1,000,000 I ,500,000 2. 000' 000

$4,500,000

Short-term rates are 8 percent. Long-term rates are 13 percent. Earnings before illlerest and taxes me $960,000. The tax rate is 40 percent.

JJ long- term financing is ped'ectly matched (synchronized) with Loog - te rm asset needs, and the same is tue of short- term l'inancing, what wil l earnings after taxes be? For an e xample of pcd'ecdy matched plans, sec Figure 6 -5 on page 168.

6-12. Solution:

6-14

Chapter 06: W o rking Ca.pitaJ and Lhe F inancing Decision

Winfrey Diet Food Corporation

Long-term financing equals : P ermanent curre nt assets Fixed assets

Short- term finan cing equals : T em porary current assets

Long - te rm inte rest exp ense= 13 % x $3,500,000 = Shor t-te rm interest exp en se = 8 % x 1,000,000 Total inte rest exp en se

Earnin gs b efore interest and taxes L ess Interest exp e n se

E arnings b e fore taxes T axes (40% )

Earnings afte r taxes

$1 ,500,000 2.000.000

$3,500,000

$.1. ,000,000 $ 4 55,000

80,000 $ 535,000

$ 960,000 535,000

$ 425,000 170,000

$ 2 55,000 13. Impact of term structur e of interest rates on tina n cing plans (L04) l n Problem J 2,

assu me the term s tr u c ture of in terest m tes becomes inverted, with short-term rates going to J 2 percent and long-term rates 4 percentage points lower tha n short-term rates. (fall o ther factors in t.he problem remain u nch anged, w hat w i ll erunings after taxes be?

6-13. Solution:

6-15

Chapter 06: Working Capital and the F inancing Decision

Winfrey Diet Food Corporation (Continued) Long-term interes t expe nse = 8% x $3,500,000 = Short-term interest expe nse = 12% x 1,000,000 = Total interest expe nse

Earni ngs before interest and taxes Interest expense

Earning s b efore taxes T axes (40% )

Eatnings after taxes

$280,000 12 0 ,000

$ 400,000 $960,000

400,000 $560,000

224 ,000 $33 6 ,000

14. Cons ervative ver s u s aggressive financing (LOS) Col)jns S ystems, Inc., is trying io deve lop an asset-fi.n~mcing p lan. The firm has $300,000 in tempo1a.ry ctttTent assets and $200.000 in permanenl cu rrent assets . Collins also has $400,000 .in fixed assets . a. Construct two alternative fi nancing p lans fo1 the f inn. One of the p lans should be

conservative, w ith 80 percent of assets f inanced b y long-te r m sources and the rest financed by s hort-term sou rces. T he o ther p lan shou ld b e aggressive, w ith only 30 percent of assets financed by lo ng -term sou rces and the rem aini ng assets financed by s hort-term sou rces. T he ctuTent in terest rate is .15 percent o n long -term funds and I 0 percent on sho n -tetm financing. Compu te the annual interest payments under each plan.

b. Given that Coll ins 's earnings before interest and taxes are $ 180,000 , calc ulate earnings after taxes for each of you r altem atives. Assum.e a tax rate of 40 percent.

6-14. Solution: Collins System Inc.

a. T e m porary c urre nt assets Pe rm anent current assets Fixe d assets Total assets

C onservative % of Total Amount

$ 900,000 X .80 = $720,000

6 - 16

Interest R ate x.l5 =

lnle test Expense

$300,000 200,000 400,000

$900,000

$ 108,000 Long-term

Chapter 06: Working Capital and the F inancing Dec ision

$900,000 x .20=$180,000 x .10 = 18,000 Short- te rm Total interest charge $126,000

Aggressive % of Interest

An10unt $900,000 $900,000

Total Rate X .30 = $270,000 X .15 X .70 = $630,000 X .10 =

6-14. (Continu ed) b.

EBIT - Int EBT Tax 40% EAT

Total interest charge

Conservative $180,000

126,000 54,000 21,600

$ 32,400

Interest Expense

$ 4 0 ,500 L o n g- term 6 3,000 Short- term

$103,500

Aggressive $180,000

103,500 76,500 30,600

$45,900

15. A lternative financing plans (LOS) Lem, inc. , has $800,000 in c urrent assets, $350,000 of wh.ich are considen~d permanem cu


6 - 15. Solution: Lear, Inc.

a.

Current assets- permanent current assets= temporary current assets $800,000 $350,000 $450,000

Long-term inte rest expense= 10% [$600,000 + Y2 ($350,000)] = 10% ($775,000) = $77,500

Short- term interest expense = 5% [$450,000 + "\h($350,000)] = 5 % X ($625,000)

Total interest expense

= $31,250 = $77,500 + $31,250 = $108,750

Earnings before interest and taxes Inte rest exp en se

$200,000 108,750

$ 91.,250 27,375

$ 63 ,875

Earnings before taxes T axes (30%)

Earnings after taxes 6-15. (Continued)

b. Alternative financing plan

Long-term interes t expense = 10% [$ 600,000 + $350,000 + Y2 ($450,000))

= 10% ($1 ,175,000) = $ 117,500

Short- term inte rest expense= 5% [Y2 ($450 ,000)] = 5 % (225 ,000)

6- 18


Tota l interest expense

= $11,250 =$117,500 + $11,250 =$128,750

Earnin gs before interest and taxes Interest

$200,000 128,750

$ 71 ,250 21,375

$ 49,875

Earnings before taxes Taxes (30% ) Earnings after taxes

c. The a ltern ative financing plan which calls for more fin ancing b y hig h-cost debt is more expen sive and redu ces aftertax income by $14,000. H owever , we m u st not automatically rej ect this plan b ecause of its hig her cost sin ce it h as l ess risk. The altern a tive provides the firm with long-term capital which a t times will be in excess of its needs and invested in marketable securities. It will not be forced to p ay higher s h ort-term ra tes o n a large portion of its d ebt w he n s h ort-term rates rise and will no t be faced with Lhe possibilily of no shon -term financing for a portion of its perman ent curre nt assets when it is ti m e to renew the sh ort-term loan.

16. Exp ectations h y pothesis and interesl ra te s (L04) Using the expectations hypothesis theory for the term struc ture o f interest rates, deterrnine the expected retw:n for securities with maturities of two, three, and four years based on the foUowiog data . Do ao a nalysis s imiJar to that in the right-hand portion of Table 6-6.

!-year T-bill at beginning of year 1 . ...... 5% 1-yeat T -bill at beginning of year 2 .. . .. . . 6 % 1-yeat T-bill at beginning of year 3 .. . .. . . 8 % ! - year T-bill at beginning of year 4 . .. . .. lO%

6-16. Solution:

6-19

Chapter 06: Working Capi tal and the F i r'Ulncing Decision

2 year security 3 year security 4 year security

(5% + 6 %)/2 -(5 % + 6% + 8%)/3

(5% + 6 % + 8 % + 10%)/4

5.5% 6 .33% 7.25%

17 . Expect.ations h y pothesis and interes t rates (L04) Using the expectalions hypothesis theory for the term structure of interest rates , determine the expected return for securities wi th maturiti.es of two, three, ~Uld fou r years based on the following data. Do an ~Ulal ysi s s imila to that in the right-hand porlion of Table 6-6.

6-17. Solution:

!-year T-bill at begilming of year l. .... . 3% 1-year T -bill at begilming of year 2...... 6% 1- year T - bill at beginning of year 3 . .. . .. 5% I. - year T -bHI at beginning of year 4 . ..... 8%

2 year security 3 year security 4 year security

(3% + 6%)/2 (3 % + 6% + 5%)/3

(3% + 6% + 5% + 8%)/4

4.50% 4 .67% 5 .50%

18 . Interes t costs unde r alternative plans (L03) Carmen's Beauty Salon has estimated monthl.y financing requiJements for the next six months as fo ll.ows:

January .... .. .......... . February .. .. .......... .

M~uch .. .... ............ .

$8,000 2,000 3,000

April ................ .. May .. ... ............ .. June ........ .. .. .. .... .

$8,000 9,000 4,000

Short-term financing will be u ti lized for the next six months. Projected ~Ulnual interest rates are:

Januru:y ................ . February ........ ...... . Mcuch ............... .. . .

8.0% 9.0%

12.0%

Apri I ... .............. . May .......... .. .. .. .. . Jtane .. ................ .

15.0% 1.2.0% 12.0%

a. Compme to ta l dolla interest payments for the s ix months. T o convert an annual ra1.e to a momhl y :ate, divide by J 2. Then multiply this value times the monthly balance. T o get your ru1swer s u m u p the month ly interest pay1nents.

6-20

Chapter 06: Working Capital and the F ir'Ulncing Decision

b. If long-term flmUJcing at 12 percent had been utilized throughout the six months, would the total-dollar jnterest payments be larger or smaller? Con1pute the interest owed over the sjx months and compare your answer to that in pm't a.

6 -18. Solution:

Carmen's Beauty Salon

a. Short-terrr1 fin a ncing

On Monthly Month Rate Basis A mount J anuary 8% .67% $8,000 February 9% .75% $2,000 M arch 12% 1.00% $3,000 April 12% I .2 5 % $8,000 May 12% 1.00% $9,000 June 12% 1.00% $4,000

6 - 18. (Continued) b. Long- term fin anc ing

On Monthly Month Rate Basis Amount Januar y 12% 1% $8,000 February 12% 1% $2,000 March 12% 1% $3,000 April 15% 1% $8,000

6 -21

Actual Interest $ 53.60 $ 15.00 $ 30.00 $100.00 $ 90.00 $ 40.00 $328.60

Actua l Interest

$ 80.00 $ 20.00 $ 30.00 $ 80.00


May 12% 1% $9,000 $ 90.00 June 12% 1% $4,000 $ 4 0 .00

$ 3 40.00 T o tal do llar interest p ayments would be la rger under the lo ng -term financi ng pla n as described in p art b.

19. Break-even point in interes t rates (L03) In Problem 18, what long-term in terest rate would rep1esent a b reak-even point between using s hort-term financing as described in part a and long-term nnancing? Hint: Div.ide the interest payments in J 8a by the amount of total funds provided for the six months and multip ly by 12.

6-19. Solution:

Carmen' s Beauty Salon (Continued) Divid e the to ta l i nterest p ayme nts in p a rt (a) of $328.60 b y the total amount of funds extended $34,000 ($ 8,000 + 2,000 + 3,000 + 8,000 + 9 ,0 00 + 4,000) and multip ly by 12 .

interest $328.60 96607 hl ----- = = . "/o 1nont y ra te principal $34, 000

12 x .966 % = 1 1.59% annual r.a te 20. C ash r eceipts sch ed u le (LOl) Easte rn Auto Parts , Inc. has 20 pe rcent of its sales paid for

in cash aod 80 pe rce nt oo credit. All cnxlit accounts are collected in the fo llowing month. Ass ume the following sales : .T anua.y $60,000 Febntruy 50,000 March 95,000 April 40 ,000 Sales in D ecember of the prio ye~u- were $70.000. P epare a c ash receipts schedule for January through April.

6-22


6-20. Solution: Eastern Auto Parts

Sales Jan

$ 60,000 1.2,000 5 6 ,000

$ 6 8,000

Feb $ 5 0 ,000

10,000 4 8 ,000

$ 5 8,000

Mar $95,000

19,000 4 0 ,000

$59,000

2 0 % Cash Sales 80 % Prior month's sales* Total cash receipts

* based o n D ecember sales of $70 ,000

21 . L ev el production and r elated financing effect-;; (L03) Bombs Away Video Games Corporation has forecasted the following monthly s ales:

J anu ary.............. $95,000 J uly ............. . FebnHu-y . ... . .. .. .. . 88,000 August ........ . Ma.rch ...... .. ...... .. 20,000 S eptember ... April .... ........... .. . 20,000 Octobe .r .... .. .. May... .......... .. .... 15,000 Novembec .. . J u ne .. ............ .. ... 30,000 December .. ..

Total annual sales = $696,000

$40,000 40,000 50,000 80,000

100,000 I l 8,000

Bombs Away Video Games sells the popula Strafe and Capture video game. Its sells for $5 per unit and costs $2 pe u nit to produce. A level production policy is followed. Each m~)nth 's production is e qual to annual s ales (in uni ts) divided by 12.

Of each month's sales, 30 percent are for cash and 70 percent are on accou nt. All accounts receivable are collected in the month after the sale is made. a. Construct a month ly production and inventory schedule .in u nits. Beginning inve ntory

in J anum-y is 20,000 units. (Note: To do part a , you should work in terms of units of production and units o f sales.)

Apr $40,000

8,000 76,000

$84,000

b. Prepare a monthly schedule of cash receipts. Sal.es in the D ecember before the p la.oning yea are $100,000. Work part busing dollars.

c . Determine a cash payments schedule for January through December. T he production costs of $2 per un it are paid for in the month in wh.ich they occu r. Other cas h paymems, besides those for production costs, are $ 40,000 p er month.

6-23

Chapter 06: Working Capital and the F inancing Dec ision

d. Prepare a month ly cash b udget for J anumy through December using the cash receipts sche dule from pan b :md the cash payments schedule from part c. The beginning cash b alance is $5,000 , which is also the m.inimum desired.

6 -21. Solution:

J an . F eb .

M ar.

Apr. M a y June July A ug. S ept. Oct. Nov. Dec.

Bombs A way Video Games Corporation

a. Production an d inventory sch edule in umts Beginning Inventory + Produc tion 1

20,000 + ll ,600 1.2,600 + 1 J ,600

6,600 + 11,600

1.4,200 + 11,600 21.,800 + 11,600 30,400 + 11 ,600 36,000 + 11,600 39,600 + 11,600 43,200 + 11,600 44,800 + 11 ,600 40,400 + 11,600 32,000 + 11 ,600

1 Total annual sales = $696,000

2 Sales 19,000 17,600

4 ,000

4 ,000 3,000 6 ,000 8,000 8,000

10,000 ] 6 ,000 20,000 23,600

$696,000/$5 per unit = 139,200 units 139,200 unitsll 2 months = 11,600 per month

2 M o nthly d o llar s ales/$5 price = unit s ales

6 - 24

--

--

--

--

--

--

--

--

Ending Inventory

12,600 6 ,600

14,200

21.,800 30,400 36,000 39,600 43,200 44,800 40,400 32,000 2 0 ,000

Chaplcr 06: Working Capiral and tl1e Financing Decision

6-21. (Continued) b.

Bombs Away Video Games Corporation

Cash Receipts Schedule

Jan. Feb. Mar. Apr. Sales (in dollars) $95,000 $88,000 $20,000 $20,000 30% Cash sales 28,500 26,400 6,000 6,000 70% Prior month's sales 70,000* 66,500 61,600 14,000 Total cash receipts $98,500 $92,900 $67,600 $20,000

*based on December sales of $100,000

July Aug. Sept. Oct. Sales (in dolJars) $40,000 $40,000 $50,000 $80,000 30% Cash sales 12,000 12,000 15,000 24,000 70% Prior month's sales 2LOOO 28,000 28,000 35,000 Total cash receipts $33,000 $40,000 $43,000 $59,000

625

May June $15,000 $30,000

4,500 9,000 14,000 10.500

$18,500 $19,500

Nov. Dec. $100,000 $118,000

30,000 35,400 56,000 70,000

$ 86,000 $105,400

Ch.1pter 06: Working Capital aod the Financing Decision

6-21. (Continued) c.

11,600 units x $2 Other cash payments Total cash payments

11,600 units x $2 Other cash payments Total cash payments

Bombs Away Video Games Corporation Cash Payments Schedule

Constant production

Jan. Feb. Mar. Apr. $23,200 $23,200 $23,200 $23,200 40,000 40,000 40,000 40,000

$63,200 $63,200 $63,200 $63,200

July Aug. Sept. Oct. $23,200 $23,200 $23,200 $23,200 40,000 40,000 40,000 40,000

I $63,200 $63,200 $63,200 $63,200

6-26

May June $23,200 $23,200 40,000 40.000

$63,200 $63,200

Nov. Dec. $23,200 $23,200 40,000 40,000

$63,200 $63,200

Ch.1pter 06: Working Capital aod the Financing Decision

6-21. (Continued) d.

Net cash flow Beginning cash Cumulative cash balance Monthly loan or (repayment) Cumulative loan Ending cash balance

Net cash flow Beginning cash Cumulative cash balance Monthly loan or (repayment) Cumulative loan Ending cash balance

Bombs Away Video Games Corporation Cash Budget

Jan. Feb. Mar. Apr. $35,300 $29,700 $ 4,400 ($43,200)

5,000 40,300 70,000 74,400 40,300 70,000 74,400 31,200

-0- -0- -0- -0--0- -0- -0- -0-

40,300 70,000 74,400 31,200

July Aug. Sept. Oct. ($30,200) ($23,200) ($20,200) ($4,200)

5,000 5,000 5,000 5,000 (25,200) (18,200) (15,200) 800 30,200 23,200 20,200 4,200 92,400 115,600 135,800 140,000 5,000 5,000 5,000 5,000

6-27

May June ($44,700) ($43,700)

31,200 5,000 (13,500) (38,700) 18,500 43,700 18,500 62,200 5,000 5,000

Nov. Dec. $22,800 $42,200

5,000 5,000 27,800 47,200

(22,800) (42,200) 117,200 75,000

5,000 5,000

Chapter 06: W o rking Capital and the F ir'Ulncing D ecision

22. Level produc tion and r elated fina n cing effects (L03) Esquire P roduc ts . Jnc., e xpects the following month ly sales:

January ..... .. . ... . . . $24,0 00 May .. .. . . .. . . .. . $4,000 Septembel .. .. .... . $25,000 Febr ua ry .. .......... 15 ,000 June ............. 2,000 Octo ber. ............. 30,000 M arch .. .. .. ... ... .. .. 8 ,000 July .... . ... .. .. . . J 8 ,000 N ovember .. ... .. .. . 38,00 0 April .. .. .... .. .. .. .. .. 10,000 A ugust .... .. .. . 22 ,000 D ecembe .... .. .. .. 20,000

T o ta l sales = $216.000

Cash sales are 4 0 percent in a given month, with the remainder going into accou nts receivable. A II receivables me collected in the month following the sale. Esqui re sells all of its goods for $2 each and prodtlces them for $J each. Esquire uses level produc tion, and a verage month ly production is equal to annual product ion d iv ided by l2. a . Generate a m o nthly p roduct ion and in ventory schedule .in un its . Beginning .inventory in

January is 8,000 u nits . (N ote: T o do pat ct, you should work in terms of units of pi'Oduc t ion and units of sales.)

b. De termine a cash receipts sch edule for Janu ary throu gh D ecember. Asstune that dollar sales in the pr.ior D ecemb er were $20,0 00 . W ork pan b u s ing do llars.

c. De tennine a cash payntents schedu le for J a nuary throug h Decemb er. T he production costs ($1 per u n it produced) are paid for in the month in which they occur. O ther cash payments (besides those for production costs) are $7,000 per n01on.th.

d. Construct a cash budget for January thwugb December. using the cash leceipts schedule from part b and the cash payments schedule fom part c. T he beginning cash balance is $3,000, w hich is also the minimu m desired.

e . D e termine tot~ll cunent assets for each month. I nc lude cash, accounts receivable, and inven tory. Accou n ts receivab le equ al sales m inu s 40 percent of sales for a g iven month. Inventory is equ al to ending invelllory (pmt a) times the cost of $ 1 per unit.

6-28

Chapter 06 : W o rking Capital and the F ir'Ul ncing D ecision

6-22. Solutio n :

J an . F eb. Mar . A pr. May June July A u g. S ept. O c t. Nov . D ec .

Esquire Products, Inc.

a. Pro duction an d inven tory sch edule i n u n its

B eginn ing Inve n tory

8,000 5 ,000 6 ,500

11,500 15,500 22 ,5 00 3 0 ,500 30 ,500 2 8 ,500 2 5 ,000 19 ,000 9,000

+ + + + + + + + + + + + +

Produ c tion 1 9,000 12,00 0 9,000 7,5 00 9 ,000 4,000 9,000 5 ,000 9,000 2 ,000 9,000 1,000 9 ,000 9 ,000 9 ,000 1 1,000 9 ,000 12 ,500 9,000 15,000 9,000 19,000 9,000 ] 0 ,000

1 $ 2 16,000 sales/$2 price = 108 ,000 units

--

--

--

--

--

--

108,000 units/12 months= 9 ,0 00 u n its per month 2 Mon thly d ollar sales/$2 = n umber of un its

6-2 9

Ending In ventory

5,000 6 ,500

1 1,500 15,500 22,500 30,5 00 3 0 ,500 2 8,500 25,000 19,000

9 ,000 8,000


6-22. (Continued) b.

Esquire Products, Inc. Cash Receipts Schedule (take dollar values from problem statement)

Jan. Feb. Mar. Apr. May Sales (in dollars) $24,000 $15,000 $ 8,000 $10,000 $4,000 40% Cash sales 9,600 6,000 3,200 4,000 1,600 60% Prior month's sales 12,000* 14,400 9,000 4,800 6,000 Total receipts $21,600 $20,400 $12,200 $ 8,800 $7,600

*based on December sales of$20,000

July Aug. Sept. Oct. Nov. Sales (in dollars) $18,000 $22,000 $25,000 $30,000 $38,000 40% Cash sales 7,200 8,800 10,000 12,000 15,200 60% Prior month's sales 1.200 10,800 13,200 15,000 18,000 Total receipts $ 8,400 $19,600 $23,200 $27,000 $33,200

630

June $2,000

800 2,400

$3,200

Dec. $20,000

8,000 22,800

$30,800


6-22. (Continued) c.

Jan. 9,000 units x $1 $ 9,000 Other cash payments 7,000 Total payments $16,000

July 9,000 units x $1 $ 9,000 Other cash payments 7.000 Total cash payments $16,000

Esquire Products, Inc. Cash Payments Schedule

Constant production

Feb. Mar. $ 9,000 $ 9,000

7,000 7,000 $16,000 $16,000

Aug. Sept. $ 9,000 $ 9,000

7,000 7,000 $16,000 $1 6,000

631

Apr. May June $ 9,000 $ 9,000 $ 9,000

7,000 7,000 7,000 $16,000 $16,000 $16,000

Oct. Nov. Dec. $ 9,000 $ 9,000 $ 9,000

7,000 7,000 7,000 $16,000 $16,000 $16,000

Chaplcr 06: Working Capiral and tl1e Financing Decision

6-22. (Continued) d.

Esquire Products, Inc. Cash Budget

Jan. Feb. Mar. Cash flow $5,600 $ 4,400 ($3,800) Beginning cash 3,000 8,600 13,000 Cumulative cash balance 8,600 13,000 9,200 Monthly loan or (repayment) I -0- -0- -0-Cumulative loan I -0- -0- -0-Ending cash balance $8,600 $13,000 $9,200

Julv

Aug . Sept. Cash flow ($ 7,600) ($3,600) $ 7,200 Beginning cash 3,000 3,000 3,000 Cumulative cash balance (4,600) 6,600 10,200 Monthly loan or (repayment) 7,600 (3,600) (7,200) Cumulative loan 29,800 26,200 19,000 Ending cash balance $3,000 $3,000 $3,000

6-32

Apr. May June ($ 7,200) ($ 8,400) ($12,800)

9,200 3,000 3,000 2,000 (5,400) (9,800) 1,000 8,400 12,800 1,000 9,400 22,200

$3,000 $3,000 $ 3,000

Oct. Nov. Dec. $ 11 ,000 $17,200 $ 14,800

3,000 3,000 12,200 14,000 20,200 27,000

(11 ,000) (8,000) -0-8,000 -0- -0-

$ 3,000 $12,200 $27,000

Chapter 06: W o rking Capital and the Financing Dec ision

6-22. (Continued) e.

Esquire Products, Inc. Assets

Accounts Total Cash Receivable Inventory Current

Jan . $ 8,600 $14,400 $5,000 $28,000 Feb. 13,000 9,000 6,500 28,500 Mar. 9,200 4,800 11,500 25,500 Apr. 3,000 6,000 15,500 24,500 May 3,000 2,400 22,500 27,900 June 3,000 1,200 30,500 34,700 July 3,000 10,800 30,500 44,300 Aug. 3,000 13,200 28,500 44,700 Sept. 3,000 15,000 25,000 43,000 Oct. 3,000 18,000 19,000 40,000 Nov. 12,200 22,800 9,000 44,000 Dec. 27,000 12,000 8,000 47,000

The instructor may wish to point out h ow c u rrent assets are at relatively high levels and illiquid during June through October. In November and p articularly December, the asset levels remain hig h, but they become increasingly more liquid as inventory clim.inis h es relative to cash.

6 33

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