Solutions Manual t/a Business Finance 10e by Peirson et al.

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Chapter 21
Management of short-term assets:
liquid assets and accounts receivable
Solutions to questions
1. Themajor typesof short-termassetsare:
(a) inventory;
(b) liquidassets, comprisingcashandshort-terminvestments; and
(c) accountsreceivable.
SeeSection21.3for definitions.
2. Retailersmaintainrelatively largeinventories. Wholesalersalsomaintainrelativelylarge
inventories (to maintain supplies to retailers). They also hold high levels of accounts
receivable. Becausewholesalers haverelatively fewcustomers, most of whomdeal with
those wholesalers on a regular basis, this sector of business is well suited to credit
provision. Hencethehighlevel of accountsreceivable.
3. Cashis heldfor liquidity purposes rather thanprofit. Thereis, therefore, anincentiveto
keepcashbalancestoaminimum. Outsidethefinancesector, short-terminvestmentsare
generally held as a cash substitute rather than as investments for their own sake, so
similar principlesapply.
4. All of a companys actions should have the ultimate goal of maximising shareholders
wealth. However, cash and, to alesser extent, inventory, aremoreeasily considered as
cost-minimisation problems. In principle, accounts receivable could be treated as an
asset like any other asset. Chapter 22 applies NPV analysis to accounts receivable
management.
5. The maturity matching concept involves the maintenance of a balance between the
maturity structures of assets and liabilities. Many companies believethat such apolicy
reduces risk. For example, a long-termasset will probably yield returns throughout its
life, andthosereturnscanthenbeusedtomeet commitmentsonlong-termdebt.
6. Obviously, forecasting is more difficult where there is uncertainty than where there is
certainty. Note, however, that making a forecast of an aggregate amount (such as the
total value of accounts receivable) is generally easier than making a forecast of a
component amount (such as the value of a particular account receivable). Financial
managers areoftenmoreconcernedwiththetotal picturethanwiththeconstituent parts
of thepicture. Stepstominimiseriskincludethefollowing:
(a) examiningpast trendsinorder topredict futureneeds;
Solutions Manual t/a Business Finance 10e by Peirson et al. 1
(b) beingawareof regular cyclesincompanyactivityfor example, weeklywagesbills
andmonthlyor quarterlyinterest payments;
(c) holdingmarketablesecuritiesasasecondlineof defence; and
(d) arrangingsources of financeto becalledonwhenrequiredfor example, overdraft
or bill facilities.
7. The proportion of a companys assets held in inventory depends on the nature of the
business. Retailers, for example, areinthebusinessof supplyinggoodstocustomersand
will try toavoidastockout. Inventory is, therefore, relatively large. Intheservicesector,
inventory is smaller; it is impossible, for example, to maintain an inventory of dental
services or accountingservices.
8. Thebenefits of holding inventory for aretailer includeavoidanceof stockout costs and
maintenanceof customer goodwill. Inaddition, costs suchas thefixedcosts of ordering
will be incurred less frequently. It is convenient to think of the benefits as costs
avoided. Asaresult, inventorymanagement becomesaproblemof cost minimisation.
Costs include acquisition costs (such as the ordering costs, and freight and handling
costs), carrying costs (such as the opportunity cost of investment, costs of storage,
insurance, deteriorationandpricemovements) andstockout costs(suchaslost sales).
Similar costs apply to the raw materials inventory held by a manufacturer. The major
difference is that stockout costs refer to the costs of distribution to the production
process. For example, labour andequipment maybeleft idleif astockout occurs.
9. Many companies reorder inventory even though the inventory on hand exceeds the
expected inventory usage during the lead time between reordering and receiving new
supplies. The amount of the excess (over the expected usage) is often called safety
stock. For example, if averagemonthlyusageis1000unitsandtheleadtimeis1month,
a policy of reordering when the inventory level is 1250 units corresponds to a safety
stockof 250units.
A negativesafety stock means that aneworder is not placeduntil thecurrent inventory
level fallsbelowtheexpectedusageduringtheleadtime. It is, therefore, very likely that
a stockout will occur before the end of the lead time. However, provided that the
stockout (if it occurs at all) does not occur until towards the end of the lead time, the
company may still beableto provideahigh customer-servicelevel throughout most of
the lead time. Therefore, expected customer services can be at a high level
notwithstandingthat anegativesafetystockisheld.
10. Whileit is truethat it is impossibleto obtain precisemeasures of thenecessary data, it
does not follow that theoretical inventory management models are useless. This is
because most such models are fairly robust to estimation errors, and, hence, can still
workwell inpractice.
A demonstrationof therobustnessof theEOQ model canbefoundinSection22.10.2
Solutions Manual t/a Business Finance 10e by Peirson et al. 1
Solutions to problems
1. Use: Q
*
=
2
c
aD
where a = $25(per order)
D = 5000(bottlesper year)
c = $0.16(per bottleper year)
Then: Q
*
=
0.16
000) ( (25) (2) 5
= 1250bottles
Theeconomic order quantity is 1250bottles. As demandis 5000bottles per year, this
suggests that orders should be placed 5 000/1 250 =4 times per year. The period
betweenorderswill be3months.
2. Use: Q
*
=
2
c
aD
where a = $75(per order)
D = 1500 2=3000(per year)
c = $1.80(per handleper year)
Then: Q
*
=
1.80
000) (3 (75) (2)
= 500handles
Theeconomicorder quantityis500handles.
Total cost isthesumof acquisitioncostsandcarryingcosts:
2
cQ
Q
aD
TC = +
Under thepresent system, Q =1500andtherefore:
500 $1 =
350 $1 + $150 =
2
500) (1 ($1.80)
500 1
000) (3 ($75)
= + TC
Under theoptimal system, Q =500andtherefore:
$900 =
$450 + $450 =
2
(500) ($1.80)
+
500
000) (3 (75)
= TC
Comparedwiththepresent system, theoptimal systemwill thereforesave$1500 $900
=$600eachyear.
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3. FromProblem1, the optimal quantity to order in the absence of discounts is 1 250
bottlesper order. Theorder quantitiestobeinvestigatedaretherefore999, 1250, 2000,
3 000 and 4 000. Total cost consists of inventory purchasecosts, acquisition costs and
carryingcosts:
2
cQ
+
Q
aD
pD + TC =
where a = $25(per order)
D = 5000(per year)
c = $0.16(per itemper year)
Q
Q
p TC 0.08 +
000 $125
+ 000 5 = : is that
(a) Q = 999andP =2:
TC = (5000)($2) +
Q
000 125 $
+0.08Q
= $10205.05
(b) Q = 1250andp =$1.99:
TC = (5000)($1.99) +
250 1
000 125 $
+$(0.08)(1250)
= $10150.000
(c) Q = 2000andp =$1.98:
TC = (5000)($1.98) +
000 2
000 125 $
+$(0.08)(2000)
= $10122.50
(d) Q = 3000andp =$1.97:
TC = (5000)($1.97) +
000 3
000 125 $
+$(0.08)(3000)
= $10131.67
(e) Q = 4000andp =$1.96:
TC = (5000)($1.96) +
000 4
000 125 $
+$(0.08)(4000)
= $10151.25
Theneweconomicorder quantityis2000bottlesasthisachievesthelowest total cost.
4. If areorder point of 180isadopted, thenon2per cent of occasions, astockout will occur
during the lead time. On these 2 per cent of occasions, demand will be 200 which
exceedstheinventoryheld.
The easiest way to find the reorder point equivalent to an expected customer-service
level of 98 per cent is to use trial and error. For example, if a reorder point of 150 is
adopted, then:
Solutions Manual t/a Business Finance 10e by Peirson et al. 1
Probability Quantity demanded Customer-service level
0.060
0.150
0.460
0.166
0.144
0.020
100
120
140
160
180
200
1.0000
1.0000
1.0000
150/160=0.9375
150/180=0.8333
150/200=0.7500
Expectedcustomer-servicelevel = 0.060+0.150+0.460+(0.166) (0.9375)
+(0.144) (0.8333) +(0.020) (0.7500)
= 0.9606
Theexpectedcustomer-servicelevel is96.06per cent. Therefore, toachieveanexpected
customer-servicelevel of 98per cent, ahigher reorder point isneeded.
At areorder point of 160, expectedcustomer servicelevel is:
0.98 =
200
160
(0.020) +
180
160
(0.144) + 0.166 + 0.460 + 0.150 + 0.060
(

Therefore, areorder point of 160will achieveanexpectedcustomer-servicelevel of 98

per cent.
5. (a) TC =
2
cD
Q
aD
+
where Q = 1500metres
D = 4500metres
a = $250(per order)
c = $1(per metreper year)
TC = $250(4500/1500) +$1(1500/2)
= $1500
(b) If 1095metresareordered, then:
TC = $250(4500/1095) +$1(1095/2)
= $1575
If 2055metresareordered, then:
TC = $250(4500/2055) +$1(2055/2)
= $1575
% 5 100
500 1 $
500 1 $ 575 1 $
=

Consequently, if anyquantitybetween1095metresand2055metresisordered, the

annual cost is within 5 per cent of theminimum. This implies that thetotal annual
cost isrelativelyinsensitivetoerrorsmadeintheestimationprocess.