Chapter 7 Current Asset Management

Discussion Questions 7- l.

7-2.

7-3.

7-4.

In the managemem 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 lirm and for contingency purposes. Because the funds must be avai lable when needed, the primary concern should be with safety and liquidity rather than the maximum profits.

Explain the simi larities

7-5.

7-6.

7-7.

7-8.

7-9.

Why are Treasury bills a favotite place for linancial managers to invest excess cash?

Treasury bills are popular because of the large lmd active market in which they trade. Because of this, the investor may literall)' pinpoint the maturit)' desired choosing anywhere irom one day to a year. The "T-bill" market provides maximum liquidity and can absorb almost any dollar amount of business.

Explain why the bad debt percentage or any other simi.lar credit-control percentage is not the uhimatc measure of success i.n 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 surtlcient rate of return to justi fy the investment? There is no such thing as too many or too few bad debts, only too low a return on capital.

What are three quantitative measures that can be applied to the collection policy of the Gmt?

Th" average coJJcction period, the ratio of bad debts 10 credit sales and !he aging of accounts receivable.

What are the 5 Cs of credit that are sometimes used by bankers and others to determine whether a potential loan "~ II be repaid?

The 5 C's of credi t are chmacter, capital , capacily, conditions, and collateral.

What does the EOQ formula tell us? What assumption is made about the usage rate for inventory?

The EOQ or economic order point ICJIS us at whal size order poiol we wiJJ minimize the overall i.oventory cos1s 10 the firm , with specific anenliou to inventory orde-ring costs and inventory carrying cosls. It does not directly te ll us the average size of inventory on hand and we must detennioe 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.

7-2

7-JO. Why might a lirm keep a safety stock? What effect is it likely to have on can-yiug cost of invemory?

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 wemher, production delays, e

b. $14,500,000 X 6%

$ 870,000

freed-up funds interest rate interest on freed-up cash

2. Cost-benefit analysis of cash management (L02) Neon light Company of Kansas Cily ships lamps and lighting appliances throughout the country. Ms. Neon has determined that through the establishment of local collection centers around the country, she can speed up the collection of payments by one and one-half days. Funhennore, the cash management departmem of her bank has indicated to her that she can defer her payments on her accounts by one-half day without affecting suppliers. The bank has a remote disbursement center in Florida. a. IJ Neon Light Company has $2 mi ll ion per day in collections and $1 million per day

in disbursemems, how many dollars will the cash management syste m free up"? b. u Neon Light Company can earn 9 percent per annum on freed-up funds, how much

will the income be? c. lJ the total cost of the new system is $375,000, should it be implemented?

7-2. Solution:

Neon Light Company of Kansas City a. $2,000,000 daily collections

b.

x 1.5 days speed up = $3,000,000 additional collections $ 1,000,000 daily disbursements x .5 days slow down = $500,000

$3,500,000

freed-up funds interest rate

delayed disbursemems freed-up funds

$3,500,000 X 9% $ 315,000 interest on freed-up cash

c. No. The income of $315,000 is $60,000 less than the cost of $375,000.

7-4

3. In ternational cash management (L02) Orbital Communications has operating plants .i n over 100 countries. lt also keeps Funds for transactions purposes in many foreign countries. Assume in 20 10 it held 100,000 kronas in Norway woth $35,000. The funds drew 12 percent interest, and the krona increased 6 percent against the dollar.

What is the value of the holdings, based on U.S. dollars, at year-end (Hint: multiply $35,000 times 1.12 and then mul!iply the resulling value by 106 percent)

7-3. Solution:

Orbital Communications

$35,000 X 1.12 = $39,200 $39,200 X 106% = $41,552

4. International cash management (L02) Postal Express has outlets throughout the world . I! also keeps funds lor transactions purposes in many loreign countries. Assume in 2010 it held 200,000 rcals in Brazil worth 130,000 dollars. It drew lO percent interest, blll 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: mul!iply

$130,000 times 1.10 and then mul!iply the r8 percent intere.st and the real went up by 12 percem against the dollar?

7-4. Solution:

Postal Express a. $130,000 x 1.10 = $143,000

$143,000 x 80% = $114,400 dollar value of real holdings

b. $130,000 X 1.08 = $140,040 $140,040 x 112% = $157,248 dollar value of real holdings

7-5

5. Average collection period (L04) Sanders' Prime Time Company ha~ annual credit sales of $1,800,000 and accounts receivable of $210,000. Compute the value of the average collection period.

7-5. Solution:

Sanders' Prime Time Co.

. . Accounts receivable Average collection penod = ----------Average dai I y credit sales

$210,000 $1,800,000/360

$210,000 $5,000

=42days

6. Average collection period (L04) Oral Roberts Dental Supplies has annual sales of $5,625,000. Eighty percent are on credit. The lirm has $475,000 in accounts receivable. Compute the value of the average collection period.

7-6. Solution:

Oral Roberts Dental Supplies

A II . . d Accounts receivable . verage co ectlOn peno = ----------Average daily credit sales

Credit Sales = 80% x $5,625,000 = $4,500,000

7-

II . . d $475,000 Average co ectiOn peno = ----'----4,500,000/360

$475,000 $12,500

=38 days

7. Accounts receivable balance (L04) Eco-Friendly Products has annual credit sales of $900,000 and an average collection period of 30 days. 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.

7-7. Solution:

Eco-Friendly Products $900,000annual credit sales $2 500 d' 1 d = , ere 1t sa es a ay

360days per year

$2,500 average x daily credit safes

30 average collection period

$75,000 average Accounts receivable balance

8. Accounts r eceivable balance (L04) Barney's Antique Shop has annual credit sales of $1,080,000 and an average collection period of 40 days. Assume a 360-day year. Wbat is the company's average accounts receivable balance" Accounts receivable are equal to the average daily credit sales times the average collection period.

11

7-8. Solution:

Barney's Antique Shop

$1,080,000annual credit sales $3 000 di 1 d -'---'-------'--------- = , ere t sa es a ay 360days per year

$3,000 averaoe x 40 average _ daily credit safes collection period -

$ 1.20,000 average accounts receivable balance

9. Credit polky (L04) In Problem 8, if accounts receivable change to $140,000, while cre

JO. Determination of tredit sales (L04) Mervyn's Fine Fashions has an average collection period of 40 days. The accounts receivable balance is $80,000. What is the value of its credit s~~es?

7-10. Solution:

Mervyn 's F ine Fashion

A II . . d Accounts receivable verage co ectwn peno = -----------Average daily credit sales

40 d $80,000

ays =

(Credit sales)

360

crediL sales $80,000 360 40

Credit sales/360 = $2,000 Credit sales = $2,000 x 360 = $720,000

l I. Aging of accounts receivable (L04) Route Canal Shipping Company has the following schedule for aging of accounts receivable:

(1)

Month of Sales Apri l ................................ . March ............. ............. .... . Febntary ... ....................... . January ..... ....................... .

Total receivables ... ... ... . .

Age of Receivables Apri.l 30, 2010 (2) (3)

Age of Account 0- 30 3 1-60 6 1- 90

91- 120

Amounts $ 105,000

60,000 90,000 45.000

$ 300,000

a. Fill in column (4) for each month.

(4) Percent of

Amount Due

100%

b. lJ the li1m had $1,440,000 in credit sales over the four-month period, compute the average collection period. Average daily sales should be based on a 120-day pe1iod.

c. If the fi rm likes to sec its bills collected in 30 days, should it be satis fied with the average collection period ?

7-9

d. Disregarding your answer to pan c and conside1ing the agi ng schedule for accounts receivable, shou.ld the company be satislled?

e. What additional informat ion does the aging schedule bring to the company that the average collection period may not show?

7-11. Solution: Route Canal Shipping Company

Age of Receivables, April 30, 2010 a.

(1) (2) (3) (4) Age of Percent of

Month of Sales Account Amounts Amount Due April 0-30 $105,000 35% March 31-60 60,000 20% February 61-90 90,000 30% January 91- 120 45,000 15%

Total receivables $300,000 100%

7-11. (Continued)

b. . . Accounts receivable Average CollectiOn Penod = . . Average datly credll sales

$300,000 - -----'---

$1,440,0001120

$300,000 $12,000

=25 days

c. Yes, the average collection of 25 days is less than 30 days.

7-10

d. No. The aging schedule provides additional insight that 65 percent of the accounts receivable are over 30 days old.

e. It goes beyond showing how many days of credit sales accounts receivables represent, to indicate the distribution of accounts receivable between various time frames.

12. Economic ordering quan tity (LOS) Midwest Tires has expected sales of 12,000 tires this year, an ordering cost of $6 per order, and carrying coSIS of $ 1.60 per tire. a. What is the economic ordering quantity? b. How many orders wi ll be placed c.Juliog the year? c. Whal will the average iovcolory be'?

7-12. Solution:

Midwest Tires

a. EOQ = ~2SO \ 2x 12,000x$6 c $1.60

\ $144000 =J90 000 =300 tires ~ $1.60 ,

b. 12,000 tires/300 tires= 40 orders

c. EOQ/2 = 300/2 = 150 tires (average inventory)

I 3. Economic ord ering quantity (LOS) Fisk Corporation is trying to improve its inventory control system and has installed an online computer al its retai I stores. Fisk anticipates s:Lies of 75,000 units per year, an ordering cos! of $8 per order, and carrying costs of $1.20 per unit. a. What is the economic ordering quantity? b. How many orders wi ll be placed doling the year? c. Whal will the average inveolory be?

7-l l

d. What is the total cost of ordel.ing and carrying inventory?

7-13. Solution:

Fisk Corp.

a. EOQ -~2SO _ 2x75,000x$8 _ 1 OOO . - C -\ $1.20 - ' UllJtS

b. 75,000 units/1,000 units= 75 orders

c. EOQ/2 = 1,000/2 = 500 units (average inventory)

d. 75 orders x $8 ordering cost 500 units x $1.20 carrying cost per unit Total costs

= $ 600 - 600 =$1,200

14. Economic ordering quantity (LOS) (See Problem 13 for basic data.) In the second year, Fisk Corporation finds that it can reduce ordel.ing costs to $2 per order but that carrying costs will s tay the same at $1 .20. Also, volume remains at 75,000 units. a. Recompute a, b, c, and d in Problem 13 for the second year. b. Now compare years one and two and explain what happened.

7-14. Solution:

a.

Fisk Corp. (Continued)

EOQ = ~2SO = 2x 75,000x$2 c \ $1.20

..., , $300000 = ~250,000 = 500 units ~ $1.20

75,000 units/500 units= 150 orders EOQ/2 = 500/2 = 250 units (average inventory) 150 orders x $2 ordering cost = $300

7-t2

250 units x $1.20 carrying cost per unit Total costs

= 300 =$600

b. The number of units ordered declines 50%, while the number of orders doubles. The average inventory and total costs both decline by one-half. Notice that the total cost did not decline in equal percentage to the decline in ordering costs. This is because the change in EOQ and other variables (V2) is proportional to the square root of the change in ordering costs ('A).

I 5. Economic. ordering quantity with safety stock {LOS) Diagtlostic Supplies has expected sales of 135,000 units per year, carrying costs of $3 per unit, and an ordering cost of $4 per order. a. What is the economic order

c. Average inventory= EOQ + Safety Stock 2

= 600

+80=300+80=380 2

380 inventory x $3 carrying cost per year = $ 1,140 total carrying cost

16. Level versus seasonal p roduction (LOS) Wiscons in Snowmobi le Corp. is considering a switch 10 level production. Cost efliciencies would occur under level production, and afte-rtax costs would decline by $30,000, but inventor)' would increase by $250,000. Wisconsin Snowmobi le have 10 linance the extra inventory at a cost of 13.5 percent. a. Should the company go ahead and switch to level production? b. How low would interest rates need to f

__ __c$_3_0.:...., O_O_O_S_a_v_in_,g"--s __ = 12% $250,000 increased invent01y However, the decision is more complicated because it depends on expectations for interest rates. If the extra inventory were considered permanent current assets and was financed by locking in long-term interest rates below 12%, then it would make sense to switch. However, given that short-term rates are volatile; this decision can't be made on a dip in short-term interest rates below 12%.

17 . Credit policy d ecision (L04) Johnson ElectrOnics is considering extending trade credit to some customers previously considered poor risks . Sales would increase by $100,000 if credit is extended to these new customers. Of the new accounts receivable generated, I 0 percent will prove to be uncollectible. Additional collection costs will be 3 percem of sales, and production and selling costs will be 79 percent of sales. The (jrm is in the 40 percem tax bracket. a. Compute the incremental income after taxes. b. What will Johnson 's incremental return on sales be if these new credit customers are

accepted? c. U' the receivable turnover ratio is 6 to I, and no other asset buildup is needed to serve

the new customers, what will Johnson 's incremental reiUrn on new average investment be?

7-17. Solution: Johnson Electronics

a. Additional sales ................................................... . Accounts uncollectible (10% of new sales) ........ . Annual incremental revenue ................ ............... . Collection costs (3% of new sales) ..................... . Production and selling costs

(79% of new sales) .......................... ....... ........ . Annual income before taxes .... ...... ...................... . Taxes (40%) ........................................................ . Incremental income after taxes ........................... .

715

$100,000 - 10,000 $90,000 - 3,000

- 79,000 $ 8,000

3,200 $ 4,800

b. Incremental income Incremental retum on sales = --------Incremental sales

= $4,800/$100,000 = 4.8%

c. Receivable tumover = Sales/Receivable turnover = 6x Receivables = Sales/Receivable turnover

= $100,00016 = $ 16,666.67

Incremental return on new average investment $4,800/$16,666.67 = 28.80%

18. Credit policy decision-recei vables an d inventory ( L04 & 5) 1-lcodcrson Office Supply is considering a more Liberal credit policy to increase sales, but expects that 8 percent of the new accounts will be uncollectible . Collection costs are 5 percent of new sales, production and selling costs are 78 percent; and accounts receivable turnover is five li mes. Assume income taxes of 30 percem and an increase in sales of $60,000. No other asset buildup will be required 10 service the new accounts. a. What is the level of accounts receivable to supporttllis sales expansion? b. What would be Henderson's incremental aftertax retum on investment? c. Should Henderson liberalize cmlit if lt 15 percent aftertax retum on investment is

required? Assume that Henderson also needs to increase its level or inventory to support new sales and that inventory turnover is four times.

d. What would be the total incremental investment in accounts receivable and inventory 10 support a $60,000 increase in sales'?

e. Gi ven the income de termined in pan b and the investment determined in pan d, should Henderson extend more liberal credit terms'?

7-18. Solution:

7-t6

Henderson Onice Supply

a. Investment in accoums receivable= $60000 = $12,000 5

b. Added sa]es ......................................................... . Accounts uncollectible (8% of new sales) .......... . Annual incremental revenue .......... .................... .. Collection costs (5% of new sales) .................... .. Production and sel ling costs (78% of new sales)

Annual income before taxes ................................ . Taxes (30%) ........................................................ . Incremental income after taxes .......................... ..

$60,000 - 4,800 $55,200 - 3,000

- 46,800 $ 5,400 - 1,620 $ 3 ,780

R . I . $3,780 3 1 5m etum on mcrementa mvestment = = . ro J 2,000

7-18. (Continued) c. Yes! 31.5% exceeds the required return of 15%.

d In . . $60,000 $ 15 000 . vestment tn mvemory = = ,

Total incremental investment

Tnvemory Accounts receivable T ncremental investment

7-17

4

$15,000 12,000

$27,000

$3,780/$27,000 = 14% return on investment

e. No! 14% is less than the required return of 15%.

J9 . Credit policy dedsion with changing va riables (L04) Comiskey Fence Co. is evaluating the extension of credit to a new group of customers. Ahhough these customers will provide $180,000 in additional cedit sale.s, 12 percent are like ly to be uncollectible. The company will also incur $ 15,700 in additional collection expense. Production and marketing costs represent 70 percent of sales. The lirm is in a 34 percemtax bracket and has a receivables turnover of five. times. No other asset buildup will be required to service the new customers. The lirm has a 10 percent desired return . a. Should Comiskey Fence Co. extend credit to these customers? b. Should cred it be extended if 15 percent of the new sales prove uncollectible? c. Should credit be ex tended if the receivables turnover drops to 1.5, and 12 percent of

the accou nts arc uncollectible (as in pan a)?

7-19. Solution:

Comiskey Fence Co.

a. Added sales ............................................................. $ 180,000 Accounts uncollectible (12% of new sales)............ 21,600 Annual incremental revenue................................... J 58,400 Collection costs............... ........ ................................ 15,700 Production and selling costs

(70% of new sales)......... ................... .. ....... ........... 126,000 Annual income before taxes .......... .......................... 16,700 Taxes (34%) ......................................... ................... 5,678 Incremental income after taxes .. . .. . .. . . .. . .. . . .. . .. .. ... ... . $ 11,022

$36,000 in

7-tS

R . bl -0 $180,000 ecetva e turnover=:>. x = bl 5.0 new recetva es

R . I . $11,022 30 62m etum on mcrementa mvestment = = . . 7o $36,000

Yes, extend credit to these customers since the incremental return of 30.62% is greater than 10%.

7-19. (Continued)

b. Same as above except accounts uncollectible are $15% of $180,000 or $27,000. This is $5,400 more than the value in part a. This means a reduction in incremental income after taxes of $3,564 to $7,458. The value can also be computed as:

Added sales ................ ............................ ...... ...... .. $180,000 Accounts uncollectible ( 15% of new sales)......... 27,000 Annual incremental revenue ................................ $153,000 Collection costs.................................................... 15,700 Production and selling costs (70% of new sales) ..... .......................... ........ ...... . Annual income before taxes ................... ....... ...... . Taxes (34%) ................................... .................. .. .. Incremental income after taxes .......................... ..

126,000 J 1,300 3,842

$ 7,458

R . tl . $7,458 20 72{)1 etum on mcrement< mvestment = = . 7o $36,000

7-19

Yes, extend credit.

c. If receivable turnover drops to .1.5x, the investment in accounts receivable would equal $180,000/1.5 = $120,000 instead of the $36,000 required in part a. The return on incremental investment, assuming a 12% uncollectible rate, is9.19%.

R . a]. $11,022 9 19nf eturn on mcrement mvestment = = . 7o $120,000 The credit should not be extended. 9.19% is less than the desired 10%.

20. Continuation of Problem 19 (L04) Reconsider problem 19C. Assume the average collection period is 120 days. Al l other factors are the same (including 12 percent uncollectibles). Should credit be extended?

7-20. Solution:

Comiskey Fence Company (Continued) First compute the new accounts receivable balance. Accounts receivable= average collection x average daily

period sales $180,000

120 daysx = 120x$500 = $60,000 360 days

or

Accounts receivable= sales/accounts receivable turnover . 360 days

Accounts recetvable twnover = = 3x 120 days

$ 180,000/3 = $60,000

7-20

Then compute return on incremental investment.

$ 11,022 =18.37% $60,000

Yes, extend credit. 18.37% is greater than 10%.

21 . Cr ed it policy and return on investment (L04) Global Services is considering a promolional campaign 1ha1 will increase annual credit sales by $400,000. The company will require investments in accoums rece ivable, inventory, and plam and equipmen1. The mmover for each is as follows:

ACCOUDIS receivable ....... .... ... ......... ............. 4x lnvemory ..................................................... 8x Plam and equipment .................................... 2x

All $400,000 of the sales wil l be collectible. However, collection costs will be 4 percent of sales, and produclion and sclliug costs will be 76 pcrecnl of sales. The cost to carry invemory will be 8 percent of invemory. DepreciaJion expense on plant and equipment will be 5 percent of plant and equipment. The tax rale is 30 percent. a. Compule the investments in ae

$100,000 = $400,000/4

Invemory = sales/inventory turnover $50,000 = $400,000/8

Plant and equipment = sales/(plant and equipment turnover) $200, 000 = $400, 000 I 2 $350,000 total investment

7-2 1. (Continued) b. Collection cost = 4% x $400,000 $ 16,000

Production and selling costs = 76% x $400,000 = 304,000 Total costs related to accounts receivable $320,000

c. Cost of carrying inventory 8% x inventory 8% X $50,000 $4,000

d. Depreciation expense 5% X $200,000 $10,000

c. Total costs related to accounts receivable $320,000 Cost of carrying inventory 4,000 Depreciation expense 10,000 Total costs $334,000

f. Sales $400,000 - total costs 334,000 Income before taxes 66,000

7-22

g.

Taxes (30%) Income after taxes

Income after taxes = $46,200 = 13.2% Total investment 350,000

Yes, it should undertake the campaign.

19,800 $46,200

The aftertax return of 13.2% exceeds the required rate of return of 12%.

22. Continuation of Problem (L04} In Problem 2 1, if inv~ntory turnover had only been 4 times: a. What would be the new value for inventory invc..tmcnr> b. What would be the return on invc>trncnt? You need to recompute the total investment

and the total costs of the campaign to work toward computing income after taxes. Should the campaign be undenaken?

7-22. Solution : Global Services (Continued)

a. Inventory = sales/inventory turnover $100,000 = $400,000/4

b. New Total Investment Accounts receivable inventory Plant and equipment

$ 100,000 100,000 200,000

$400,000 Total Cost of the Campaign

Cost of carrying inventory 8% X $100,000 = $8,000

723

Sales New Income After Taxes

$400,000 - lola! costs Income before taxes Taxes (30%) Income after taxes

342,000 58,000 17,400

$40,600

($334,000 + $8,000 additional inventory costs)

Return on inveslmenl Income after taxes Total investment

$40,600 = 10.15% 400,000

No, the campaign should not be undertaken.

The after tax return of 10.15% is less than the required rate of rerum of 12%.

(Problems 23-26 are t1 series and should be taken in order.)

23. Cr edit policy decision with changing variables (L04) Dome lliletals has credit sales of $144,000 yearly with credi t terms of net 30 days, which is also the average collection period. Dome does not offer a discount for early payment, so its customers take the full 30 days to pay. W hat is the avcrag" receivables balance? Receivables turnover?

7-23. Solution:

Dome Metals

Sales/360 days = average dai ly sales $144,000/360 = $400 Accounts receivable balance = $400 x 30 days= $ 12,000

R . bl Sales $144,000 12 eceJVa e turnover = = = Receivables $ 12,000

or

7-24

360 days/30 = I 2x

24. If Dome offered a 2 percent discount for paymem in 10 days and eve.y customer took advamage of the new terms, what would the new average receivables balance be? Use the full sales of $ 144,000 for your calculation of receivables.

7-24. Solution: $400 x I 0 days = $4,000 new receivable balance

25. If Dome reduces its bank loans, which cost 10 percent, by the cash generated from its reduced receivables, what will be the net gaio or loss 10 the firm (don ' t forget the 2 pcrccm)? Should it offer the d.iscount?

7-25. Solution:

Old receivables- new rece ivables with discount

$12,000 $4,000

Funds freed by discount

= $8,000 discount Savings on loan = LO% x $8,000 ........... . $ 800

(2,880) $(2,080)

Discount on sales= 2% x $144,000 ....... . Net change in income from discount ..... .

No! Don't offer the d.iscount since the income from reduced bank loans does not offset the loss on the discount.

26. Assume that the new trade tcm s of2110, net30 will increase sales by 15 percent because the discount makes the Dome's p1ice competitive. lfDome earns 20 percent on sales before discounts, should it o ffer the discount? (Consider the same variables as you did for problems 23 through 25 as wi ll as increase sales.)

7-26. Solution:

7-25

New sales Change in sales Sales per day Average receivables balance Increase profit on new sales Reduced profi t because

of discount

=$144,000x 1. 15 = $165,000 = $165,000 - $144,000 = $ 21,600 = $165,600/360 - $460 = $460 X J0 = $ 4,600

20% X $21,600 = $ 4 ,320 = 2% x $165,600 (3,312)

Savings in interest cost ($12,000 - $4,600) x 10% 740 Net change in income ........................................... . $ 1,748

Yes, offer the discount because total profit increases.

COMPREHENSIVE PROBLEM

Logan Oislri buling Company (receivables and invenlory policy) (LO 04 & 05) Log

c. Complete the following income statement.

Net sales (Sales- Cash discounts) .............. . Cost of goods sold ....................................... . Gross protit ....... .... ......... ...... ....................... . General and administrative expense ............ . Operating profit ........................................... . Interest on increase in accoums

receivable and invemory ( 14%) ............... . Income before taxes ...................... .............. . Taxes ...... ............ ...... ............... .... ................ . Income after taxes ....................................... .

Befor e Policy Change

d. Should the new cash discount policy be utilized? Brieny comment.

CP 7-1. Solution: Logan Distributing Company

After Policy Change

a. Accounts receivable= average collection x average daily period sales

Before Average collection period .30 x LO days = 3 .70 x 30 days = 21

24 days (average ace. receivables) Average daily sales

121

Credit sales- Discount _ $400,000 - (.OJ )(.30)($400,000) -360 days 360 days

-

$400,000 - $1,200 360days

$398,800 360days

Average daily sales = $1,107.78

Accounts receivable= 24 days x $1, .1 07.78 = $26,586.72 before policy change

After Average collection period .50 x 10 days = 5 .50 x 50 days = 25

30 days(avg. ace. receivables)

CP 7-1. (Continued) Average daily sales

Credit sales - discounl _ $600,000- (.03) (.50)($600,000) 360 days 360 days

$600,000 - $9, 000 360 days

$591,000 360 days

Average daily sales= $1,641.67

7-28

Accounts receivable= 30 days x $1,641 .67 = $49,250.10 after policy change

b. Before

EOQ = 2SO c

2xl5,000x$200- $6,000,000 = /4 000 000 = 2 000 un.its \ $ 1.50 . \ $1.50 " , , , After

2x22,000x$200 = $9,000,000 = 16 ()()() OOO = 2 449_49 ~ $1.50 ' $1.50 " , , ,

Average inventory Before 2, 000 "] 000 . ---'--- = , umts

2 1,000 unitsx$12 = $12,000

7-29

CP 7-1. (Continued) After 2,449.49 _ 1,224.75 units

2 or 1 ,225 (rounded) 1,224.75 units x$12 = $14,697 or $14,700 (rounded)

c.

Before Policy

Change Net sales (sales- cash discount) $398,800 Cost of goods sold (65%) 259,220 Gross Profit 139,580 General and adm.in. expense 59,820 (15%) Operating profit 79,760 *Interest on increase in accounts

receivable and inventory (14%) Income before taxes 79,760 Taxes (40%) 31,904 Income after taxes $ 47,856

*14% xAR = 14%x ($49,250. 10 - $26,586.72) = 14%x$22,663.38

J4%x1NV =14%x ($ 14,697 -$12,000) = 14%x$2.697

After Policy Change

$591,000 384,150 206,850

88,650

118,200

3,550.45 114,649.55 45,859.82

$ 68,789.73

=$3, 172.87

= $ 377.58

$3,550.45

d. The new cash discount policy should be util ized. The interest cost on the increased accounts receivable and inventory is

730

small in comparison Lo Lhe increased operating profil from the policy change.

7-31

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