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### PROBLEM SET FOR FINANCIAL MANAGEMENT CH#6- Financial Statement analysis

6-1 Debt Ratio Vigo Vacations has an equity multiplier of 2.5. The companys assets are financed with some combination of long-term debt and common equity. What is the companys debt ratio?

6-2 Du Pont Analysis Donaldson & Son has an ROA of 10%, a 2% profit margin, and a return on equity equal to 15%. What is the companys total assets turnover? What is the firms equity multiplier?

6-3 Profit Margin and Debt Ratio Assume you are given the following relationships for the Clayton Corporation:

Sales/total assets 1.5 Return on assets (ROA) 3% Return on equity (ROE) 5% Calculate Claytons profit margin and debt ratio.

Current and Quick Ratios 6-4 The Nelson Company has \$1,312,500 in current assets and \$525,000 in current liabilities. Its initial inventory level is \$375,000, and it will raise funds as additional notes payable and use them to increase inventory. How much can Nelsons short-term debt (notes payable) increase without pushing its current ratio below 2.0? What will be the firms quick ratio after Nelson has raised the maximum amount of short-term funds?

Times-Interest-Earned Ratio

6-5 The Manor Corporation has \$500,000 of debt outstanding, and it pays an interest rate of 10% annually: Manors annual sales are \$2 million, its average tax rate is 30%, and its net profit margin on sales is 5%. If the company does not maintain a TIE ratio of at least 5 to 1, then its bank will refuse to renew the loan and bankruptcy will result. What is Manors TIE ratio?

Balance Sheet Analysis 6-6 Complete the balance sheet and sales information in the table that follows for Hoffmeister Industries using the following financial data:

 Debt ratio: 50% Quick ratio: 0.80 Total assets turnover: 1.5

Days sales outstanding: 36.5 days Gross profit margin on sales: (Sales Cost of goods sold)/Sales = 25% Inventory turnover ratio: 5.0 aCalculation is based on a 365-day year.

Balance Sheet

Cash

________________ Accounts receivable ____________ Inventories

____________________ Fixed assets _________________

Accounts payable _____________

Long-term debt

Common stock

60,000

_________________

Retained earnings

97,500

 Total assets \$300,000 Total liabilities and equity ______________ Sales _______________ Cost of goods sold _______________

Comprehensive Ratio Calculations 6-7 The Kretovich Company had a quick ratio of 1.4, a current ratio of 3.0, an inventory turnover of 6 times, total current assets of \$810,000, and cash and marketable securities of \$120,000. What were Kretovichs annual sales and its DSO? Assume a 365-day year.

6-8 Profi t Margin. Donna’s Donuts has total assets of \$9,500,000 and a total asset turnover of 2.85 times. If the return on assets is 12 percent, what is Donna’s profit margin?

6-9 Using the Du Pont Identity. Y3K, Inc., has sales of \$8,750, total assets of \$2,680, and a debt-equity ratio of .75. If its return on equity is 15 percent, what is its net income?

6-10 Ratios and Fixed Assets. The Hooya Company has a long-term debt ratio (i.e., the ratio of long-term debt to long-term debt plus equity) of 0.70 and a current ratio of 1.3. Current

liabilities are \$750, sales are \$3,920, profi t margin is 9 percent, and ROE is 18.5 percent.

What is the amount of the firm’s net fixed assets?

6-11 Profi t Margin. In response to complaints about high prices, a grocery chain runs the following advertising campaign: “If you pay your child 50 cents to go buy \$25 worth of

groceries, then your child makes twice as much on the trip as we do.” You’ve collected the following information from the grocery chain’s financial statements:

(millions)

 Sales \$520.0 Net income 5.2 Total assets 110.0 Total debt 71.5

Evaluate the grocery chain’s claim. What is the basis for the statement? Is this claim

6-12 Using the Du Pont Identity. The Concordia Company has net income of \$147,650. There are currently 32.80 days’ sales in receivables. Total assets are \$980,000, total receivables are \$138,600, and the debt-equity ratio is .80. What is Concordia’s profit margin? Its total asset turnover? Its ROE?

6-14 Calculating the Times Interest Earned Ratio. For the most recent year, Wanda’s Candles, Inc., had sales of \$425,000, cost of goods sold of \$104,000, depreciation expense

of \$51,000, and additions to retained earnings of \$63,750. The fi rm currently has 20,000

shares of common stock outstanding, and the previous year’s dividends per share were

\$1.80. Assuming a 34 percent income tax rate, what was the times interest earned ratio?

### PROBLEM SET FUNDS AND CASH FLOW ANALYSIS

Q1) From the following balance sheet of A Company Ltd. you are required to prepare a schedule of changes in working capital and statement of flow of funds.

Balance Sheet of A Company Ltd., as on 31st March

 Liabilities 2004 2005 Assets 2004 2005 Share Capital 1,00,000 1,10,000 Land and Building 60,000 60,000 Profit and Loss a/c 20,000 23,000 Plant and Machinery 35,000 45,000 Loans — 10,000 Stock 20,000 25,000 Creditors 15,000 18,000 Debtors 18,000 28,000 Bills payable 5,000 4,000 Bills receivable 2,000 1,000 Cash 5,000 6,000 1,40,000 1,65,000 1,40,000 1,65,000

Q2) Suppose the income statement for Goggle Company reports \$70 of net income, after deducting

depreciation of \$35. The company bought equipment costing \$60 and obtained a long-term bank loan

for \$60. The company’s comparative balance sheet, at December 31, indicates the following.

• 1. Calculate the change in each balance sheet account, and indicate whether each account relates to operating, investing, and/or financing activities.

• 2. Prepare a statement of cash flows using the indirect method.

• 3. In one sentence, explain why an increase in Accounts Receivable is subtracted.

• 4. In one sentence, explain why a decrease in Inventory is added.

• 5. In one sentence, explain why an increase in Wages Payable is added.

• 6. Are the cash flows typical of a start-up, healthy, or troubled company? Explain.

Q3) Below are a list of balance sheet accounts with beginning and ending balances. For each of the accounts, identify 1) the category or type of activity (Operating, Investing or Financing) that will be affected, and 2) the increase or (decrease) in cash that would be reflected in a statement of cash flows prepared using the indirect method.

 Ending Beginning Activity Increase Account Balance Balance Type (Decrease) Accounts Receivable \$10,000 \$9,000 __________ __________ Long-term Debt \$120,000 \$100,000 __________ __________ Accounts payable \$30,000 \$35,000 __________ __________ Common Stock \$50,000 \$45,000 __________ __________ Treasury Stock \$6,000 \$4,000 __________ __________ Inventory \$15,000 \$18,000 __________ __________ Taxes payable \$8,000 \$7,000 __________ __________ Retained Earnings \$50,000 \$30,000 Net Earnings were \$40,000 __________ __________ Dividends were __________ __________ __________ Accumulated Depreciation \$20,000 \$15,000 __________ __________ Fixed Assets \$100,000 \$90,000 __________ __________
 Q4) Required: Place an X in the appropriate columns for each of the following situations. Situation Operating Investing Financing Effect on Cash - Non- Activity Activity Activity + cash Trans- action
 a. Paying off accounts payable b. Issuance of bonds for cash c. Sale of land for cash d. Retirement of common stock with cash e. Acquired land for common stock Q5) Jones Clothing Store presented the following statement of cash flows for the year ended December 31, 2010. Jones Clothing Store Statement of Cash Flows For the Year Ended December 31, 2010 Cash received: a. From sales to customers \$200,000 b. Interest income 10,000 c. Loans from banks 50,000 d. From sale of property, plant, and equipment 100,000 e. From issuance of common stock 150,000 f. From issuance of bonds 100,000 Total cash received Cash payments: \$610,000 g. For dividends \$ 20,000 h. For purchase of stock of another company 150,000 i. For purchase of equipment 200,000 j. For acquisition of inventory 80,000 k. To employees 60,000 Total cash payments \$510,000 Net increase in cash \$100,000 Required: a. Prepare a statement of cash flows in proper form. b. Comment on the major flows of cash.

Q6)

The balance sheet for December 31, 2010, December 31, 2009, and the income statement for the year ended December 31, 2010, for Rocket Company follows.

Rocket Company Balance Sheet December 31, 2010 and 2009

 Assets 2010 2009 Cash \$ 25,000 \$20,000 Accounts receivable, net 60,000 70,000 Inventory 80,000 100,000 Land 50,000 50,000 Building and equipment 130,000* 115,000 Accumulated depreciation (85,000) (70,000) Total assets \$ 260,000 \$285,000 Liabilities and Stockholders' Equity Accounts payable \$ 30,000 \$ 35,000 Income taxes payable 4,000 3,000 Wages payable 5,000 3,000 Current notes payable 50,000** 60,000 Common stock 110,000*** 100,000 Retained earnings 61,000 84,000 Total liabilities and stockholders' equity \$260,000 \$285,000

* During 2010 cash payments for building and equipment \$15,000. ** During 2010 cash paid for retirement of notes payable \$10,000. *** During 2010 cash received from issuance of stock.

Rocket Company Income Statement For the Year Ended December 31, 2010

 Sales Less expenses: \$500,000 Cost of goods sold \$330,000 Selling and administrative expenses 90,000 (includes depreciation of \$15,000) Interest expense 5,000 Total expenses 425,000 Income before taxes \$ 75,000 Income tax expense 30,000 Net income \$ 45,000

Note: Cash dividends of \$68,000 were paid during 2010.

Required:

• a. Prepare the statement of cash flows for 2010. (Present cash flows from operations using the indirect approach.)

• b. Compute the ratio operating cash flow/current maturities of long-term debt and current notes payable.

• c. Comment on the statement of cash flows and the ratio computed in (b).

Q7) The following statements are presented for Melvin Company.

Melvin Company Balance Sheet December 31, 2010, and 2009

 Assets 2010 2009 Cash \$ 625 \$ 499 Marketable securities, 260 370 Trade accounts receivable, less allowances of 36 in 2010 and 18 in 2009 1,080 820 Inventories, FIFO 930 870 Prepaid expenses 230 220 Total current assets \$3,125 \$2,779 Investments \$ 820 \$ 600 Property, plant, and equipment: Land \$ 130 \$ 127 Buildings and improvements 760 670 Machinery and equipment 2,100 1,400 \$2,990 \$2,197 Less allowances for depreciation 1,100 890 \$1,890 \$1,307 Goodwill 500 550 Total assets Liabilities and Shareholders' Equity \$6,335 \$5,236 Accounts payable \$1,200 \$ 900 Accrued payroll 100 80 Accrued taxes 300 200 Total current liabilities \$1,600 \$1,180 Long-term debt 900 750 Deferred income taxes Shareholders' equity: 300 280 Common stock 1,000 1,000 Retained earnings 2,535 2,026 Total liabilities and shareholders' equity \$6,335 \$5,236 Melvin Company Income Statement For the Year Ended December 31, 2010 Net sales \$8,000 Cost of goods sold 3,900 Gross profit \$4,100 Selling, administrative, and general expenses 2,600 Operating income \$1,500 Interest expense 100 Income before income taxes \$1,400 Income taxes 400
 Net income \$1,000 Net income per share \$ 2.00

Note: 500 shares of common stock were outstanding.

Required:

• a. Prepare the statement of cash flows for 2010. (Present cash flows from operations using the indirect approach.)

• b. Compute the ratio operating cash flow/current maturities of long-term debt and current notes payable.

• c. Comment on the statement of cash flows and the ratio computed in (b).

Q8) Ordinaire, Inc., ells a single product (Dynamo) exclusively through newspaper advertising. The comparative income statements and balance sheets are for the past two years.

ORDINAIRE, INC. Comparative Income Statement For the Years Ended December 31, 2001 and 2002

 2001 2002 Sales \$ 610,000 \$ 370,000 300,000 150,000 310,000 210,000 250,000 240,000 Loss on sale of marketable securities............................... 0 2,000 Net income (loss) ................................................................... \$ 60,000 (\$ 32,000) ORDINAIRE, INC. Comparative Balance Sheets December 31, 2001 2002 Assets Cash and cash equivalents \$ 24,000 \$ 59,000 26,000 14,000 Accounts receivable ............................................................... 32,000 18,000 Inventory 125,000 130,000 270,000 263,000

Totals................................................................................

\$477,000 \$484,000

 Liabilities and Stockholders’ Equity Accounts payable ................................................................... 52,000 77,000 Accrued expenses payable ..................................................... 18,000 15,000 Notes payable ......................................................................... 240,000 245,000 Capital stock (no par value) ................................................... 115,000 132,000 Retained earnings 52,000 15,000 Totals................................................................................ \$477,000 \$484,000

The following information regarding the company’s operations in 2002 is available from the

company’s accounting records:

• 1. Early in the year the company declared and paid a \$5,000 cash dividend.

• 2. During the year marketable securities costing \$12,000 were sold for \$10,000 cash, resulting in a \$2,000 nonoperating loss.

• 3. The company purchased plant assets for \$25,000, paying \$5,000 in cash and issuing a note payable for the \$20,000 balance.

• 4. During the year the company repaid a \$15,000 note payable, but incurred an additional \$20,000 in long-term debt as described in 3, above.

• 5. The owners invested a \$17,000 cash in the business as a condition of the new loans described in paragraph 4, above.

Instructions

• a. Prepare a formal statement of cash flows for 2002, including a supplementary schedule of noncash investing and financing activities.

• b. Explain how Ordinaire, Inc. achieved positive cash flows from operating activities, despite incurring a net loss for the year.

• c. Does the company’s financial position appear to be improving or deteriorating? Explain.

• d. Does Ordinaire, Inc. appear to be a company whose operations are growing or contracting? Explain.

• e. Assume that management agrees with your conclusions in parts b, c, and d. What decisions should be made and what actions (if any) should be taken? Explain.

### PROBLEM SET: TIME VALUE OF MONEY

• 1. You are planning to retire in twenty years. You'll live ten years after retirement. You want to be able to draw out of your savings at the rate of \$10,000 per year. How much would you have to pay in equal annual deposits until retirement to meet your objectives? Assume interest remains at 9%.

• 2. You can deposit \$4000 per year into an account that pays 12% interest. If you deposit such amounts for 15 years and start drawing money out of the account in equal annual installments, how much could you draw out each year for 20 years?

• 3. Johnny wants to buy a BMW for his son at his 25 th birthday which is 10 years from today. Johnny has \$900,000 in his account today and BMW will cost \$100,000 at that time. What maximum amount can Johnny draw out from his bank every year so that he is only left with \$100,000 to purchase BMW at his son’s 25 th birthday? Assume interest rate 12% annually.

• 4. Your parents will retire in 18 years. They currently have \$250,000, and they think they will need \$1,000,000 at retirement. What annual interest rate must they earn to reach their goal, assuming they don’t save any additional funds?

5.

Deryl wishes to save money to provide for his retirement. Beginning one year

from now, he will begin depositing the same fixed amount each year for the next

• 30 years into a retirement savings account. Starting one year after making his

final deposit, he will withdraw \$100,000 annually for each of the following 25 years (i.e. he will make 25 withdrawals in all). Assume that the retirement fund earns 12% annually over both the period that he is depositing money and the period he makes withdrawals. In order for Deryl to have sufficient funds in his account to fund his retirement, how much should he deposit annually (rounded to the nearest dollar)?

• 6. Kerri James is considering the purchase of a car. She wants to buy the new VW Beetle, which will cost her \$17,600. She will finance 90% of the purchase price (i.e., make a 10% down payment) at an interest rate of 5.9 percent, with monthly payments over three years. How much money will she still owe on the loan at the end of one year (to the nearest dollar)?

• 7. You plan to buy a new HDTV. The dealer offers to sell the set to you on credit. You will have 3 months in which to pay, but the dealer says you will be charged a

• 15 percent interest rate; that is, the nominal rate is 15 percent, quarterly

compounding. As an alternative to buying on credit, you can borrow the funds from your bank, but the bank will make you pay interest each month. At what

nominal bank interest rate should you be indifferent between the two types of credit?

• 8. You expect to receive \$15,000 at graduation in two years. You plan on investing it at 11 percent until you have \$85,000. How long will you wait from now?

• 9. You are scheduled to receive \$15,000 in two years. When you receive it, you will invest it for six more years at 7.1 percent per year. How much will you have in eight years?

10. You wish to accumulate \$1 million by your retirement date, which is 25 years from now. You will make 25 deposits in your bank, with the first occurring today. The bank pays 8% interest, compounded annually. You expect to get an annual raise of 3%, so you will let the amount you deposit each year also grow by 3% (i.e., your second deposit will be 3% greater than your first, the third will be 3% greater than the second, etc.). How much must your first deposit be to meet your goal?

11. It is now January 1. You plan to make 5 deposits of \$100 each, one every 6 months, with the first payment being made today. If the bank pays a nominal interest rate of 12% but uses semiannual compounding, how much will be in your account after 10 years?

12. Reaching a Financial Goal You need to accumulate \$10,000. To do so, you plan to make deposits of \$1,250 per year, with the first payment being made a year from today, in a bank account that pays 12% annual interest. Your last deposit will be less than \$1,250 if less is needed to round out to \$10,000. How many years will it take you to reach your \$10,000 goal, and how large will the last deposit be?

13. You are planning for retirement 34 years from now. You plan to invest \$4,200 per year for the first 7 years, \$6,900 per year for the next 11 years, and \$14,500 per year for the following 16 years (assume all cash flows occur at the end of each year). If you believe you will earn an effective annual rate of return of 9.7%, what will your retirement investment be worth 34 years from now?

### Cash and marketable securities management

Q1) Williams & Sons last year reported sales of \$10 million and an inventory turnover ratio of 2. The company is now adopting a new inventory system. If the new system is able to reduce the

firm’s inventory level and increase the firm’s inventory turnover ratio to 5 while maintaining

the same level of sales, how much cash will be freed up?

Q2) A large retailer obtains merchandise under the credit terms of 1/15, net 45, but routinely takes 60 days to pay its bills. (Because the retailer is an important customer, suppliers allow the firm to stretch its credit terms.) What is the retailer’s effective cost of trade credit?

Q3) MAX Company has annual sales of \$10 million, cost of goods sold of 75% of sales, and purchases that are 65% of cost of goods sold. MAX has an average age of inventory (AAI) of 60 days, an average collection period (ACP) of 40 days, and an average payment period (APP) of 35 days. (Assume the year has 365 days)

Calculate the CCC. Calculate cash resources invested or tied up to the cash conversion cycle. How will a5-day reduction in ACP affect the resources invested in the CCC?

Q4) Aztec Products wishes to evaluate its cash conversion cycle (CCC). Research by one of the

firm’s financial analysts indicates that on average the firm holds items in inventory for 65 days,

pays its suppliers 35 days after purchase, and collects its receivables after 55 days. The firm’s annual sales (all on credit) are about \$2.1 billion, its cost of goods sold represent about 67 percent of sales, and purchases represent about 40 percent of cost of goods sold. Assume a 365-day year.

• a) What is Aztec Products’ operating cycle (OC) and cash conversion (CCC)?

• b) How many dollars of resources does Aztec have invested in (1) inventory, (2) accounts receivable, (3) accounts payable, and (4) the total CCC?

• c) If Aztec could shorten its cash conversion cycle by reducing its inventory holding period by 5 days, what effect would it have on its total resource investment found in part b(4)?

• d) If Aztec could shorten its CCC by 5 days, would it be best to reduce the inventory holding period, reduce the receivable collection period, or extend the accounts payable period? Why?

Q5) Hamilton Inc. is considering the use of a lockbox system for the first time. If the system is

adopted, it will increase the firm’s check processing cost by \$0.20 per check processed. The firm

estimates that the average check size sent to the firm is \$1,000. Moreover, the firm estimates that it can earn only 1.5 percent on funds freed up by the lockbox program as a result of the current recession and the willingness of investors to hold short-term risk-free securities that earn very low rates of return. How many days does Hamilton have to save by using the lockbox program to compensate them for the additional \$0.20 per check cost of implementing the system?

Q6) As CFO of Portobello Scuba Diving Inc. you are asked to look into the possibility of adopting a lockbox system to expedite cash receipts from clients. Portobello receives check remittances totaling \$24 million in a year. The firm records and processes 10,000 checks in the same period. The National Bank of Brazil has informed you that it could provide the service of expediting checks and associated documents through the lockbox system for a unit cost of \$0.25 per check. After conducting an analysis, you project that the cash freed up by the adoption of the system can be invested in a portfolio of near-cash assets that will yield an annual before-tax return of 8 percent. The company usually uses a 365-day year in its procedures.

• a) What reduction in check collection time is necessary for Portobello to be neither better nor worse off for having adopted the lockbox system?

• b) How would your solution to part (a) be affected if Portobello could invest the freed-up balances at an expected annual return of only 4 percent?

• c) What is the logical explanation for the differences in your answers to part (a) and part (b)?

### Accounts Receivable management

Q1) Medwig Corporation has a DSO of 17 days. The company averages \$3,500 in credit sales

each day. What is the company’s average accounts receivable?

Q2) McDowell Industries sells on terms of 3/10, net 30. Total sales for the year are \$912,500. Forty percent of customers pay on the 10th day and take discounts; the other 60% pay, on average, 40 days after their purchases.

• a. What is the days sales outstanding?

• b. What is the average amount of receivables?

• c. What would happen to average receivables if McDowell toughened its collection policy with the result that all non-discount customers paid on the 30th day?

Q3) A firm is currently selling a product for \$10 per unit. Sales (all on credit) for last year were 60,000 units. The variable cost per unit is \$6. The firm’s total fixed costs are \$120,000. The firm is currently considering a relaxation of credit standards that is expected to result in the following:

• 1. a 5% increase in unit sales to 63,000 units.

• 2. an increase in the average collection period from 30 days (the current level) to 45 days.

• 3. an increase in bad-debt expenses from 1% of sales (the current level) to 2%.

• 4. The firm determines that its cost of tying up funds in receivables is 15% before taxes.

Should the firm relax its credit policy?

Q4) A company has annual sales of \$10 million and is considering initiating a cash discount by changing its credit terms from net 30 to 2/10 net 30. The firm has an average collection period ACP of 40 days and expects this change to result in an average collection period ACP of 25 days. The company has current annual usage of 1,100 units at a variable cost of \$2,300 per unit and sells for \$3,000 on terms of net 30. The company estimates that the discount will increase sales of the finished product by 50 units (from 1,100 to 1,150 units) per year. The company estimates

that 80% of its customers will take the 2% discount. The company estimates that the cash discount will not alter its bad debt percentage. Opportunity cost of funds invested in accounts receivable is 14%. Should the company offer the proposed cash discount?

Q5) A company currently makes all sales on credit and offers no cash discount. The firm is considering offering a 2% cash discount for payment within 15 days. The firm’s current average collection period is 60 days, sales are 40,000 units, selling price is \$45 per unit, and variable cost per unit is \$36.The firm expects that the change in credit terms will result in an increase in sales to 42,00

0 units, that 70% of the sales will take the discount, and that the average collection period will fall to 30 days. If the firm’s required rate of return on equal-risk investments is 25%, should the proposed discount be offered?

Q6) Belton Company is considering relaxing its credit standards to boost its currently sagging sales. It expects its proposed relaxation will increase sales by 20 percent from the current

annual level of \$10 million. The firm’s average collection period is expected to increase from 35

days to 50 days and bad debts are expected to increase from 2 percent of sales to 7 percent of

sales as a result of relaxing the firm’s credit standards as proposed. The firm’s variable costs equal 60 percent of sales and their fixed costs total \$2.5 million per year. Belton’s opportunity

cost is 16 percent. Assume a 365-day year.

Use your analysis and determine the net profit (cost) of Belton’s proposed relaxation of credit

standards. Should they relax credit standards?

Q7) The Cowboy Bottling Company will generate \$12 million in credit sales next year. Collection

of these credit sales will occur evenly over this period. The firm’s employees work 270 days a year. Currently, the firm’s processing system ties up 4 days’ worth of remittance checks. A

recent report from a financial consultant indicated procedures that will enable Cowboy Bottling to reduce processing float by 2 full days. If Cowboy invests the released funds to earn 6 percent,

what will be the annual savings?

Q8) Steve smith is a credit manager for the south east branch of the Earnest, Pearce, and Brown

clothing stores. The stores currently under Steve’s responsibility have annual credit sales of \$60

Million. Operating costs total 90% of sales. The average collection period is 40 days and bad debt losses total 2% of sales. The Muller Credit Corporation has guaranteed that it can reduce the average collection period to 30 days bad-debt loss to 0.5 % of sales. However, Steve estimates that the changes necessary to implement the Muller proposal will reduce annual credit sales to \$50 Million. Any reduction in current assets will allow Steve to reduce current liabilities by the same amount. The estimated cost of short-term credit is 10%. Muller Credit will charge an annual fee of \$75,000 for their service. Steve is determining the marginal benefits and costs of hiring Muller before making a final decision. If Muller is hired:

• a) What is the marginal savings from the reduced bad-debt loss?

• b) What is the marginal savings from the reduced investments in accounts receivables?

• c) What is the marginal expense of lost sales?

• d) What should Steve do?

Q9) The Car Audio store is considering a change in credit policy to stimulate sales. Annual sales are currently \$5 Million, and 85% of this amount is operating costs. The average collection period is 20 days, and bad debt losses currently total 1%. Naim Sipra, owner and manager of the store, is considering relaxing the credit standards with one of three plans:

 PLAN SALES AVERAGE COLLECTION PERIOD (DAYS) BAD-DEBT LOSS (%) A \$6,000,000 25 1.5 B 6,750,000 30 2.2 C 7,250,000 36 3.0

Any money saved from reduction in account receivable will be invested in marketable securities yielding 8%. Find the net marginal cash flow for each of the three plans (compared with the current operations). Which plan should Naim choose?

### Inventory control

Q12) An automobile manufacturer uses about 60,000 pairs of bumpers (front bumper and rear bumper) per year, which it orders from a supplier. The bumpers are used at a reasonably steady rate during the 240 working days per year. It costs \$3.00 to keep one pair of bumpers in inventory for one month, and it costs \$25.00 to place an order. A pair of bumpers costs

\$150.00.

• a) Write the annual carrying cost function.

• b) Write the annual ordering cost function.

• c) Write the annual total cost function.

• d) What is the EOQ?

• e) What is the significance of the EOQ?

• f) What is the total annual expense of ordering the EOQ every time?

• g) How many orders will be placed per year?

• h) What is the total annual expense of ordering 600 pairs of bumpers every time? How much is saved per year by ordering the EOQ?

Q13) An auto parts supplier sells Hardy-brand batteries to car dealers and auto mechanics. The annual demand is approximately 1,200 batteries. The supplier pays \$28 for each battery and estimates that the annual holding cost is 30 percent of the battery's value. It costs approximately \$20 to place an order (managerial and clerical costs). The supplier currently orders 100 batteries per month.

• a) Determine the ordering, holding, and total inventory costs for the current order quantity.

• b) Determine the economic order quantity (EOQ).

• c) How many orders will be placed per year using the EOQ?

• d) Determine the ordering, holding, and total inventory costs for the EOQ. How has ordering cost changed? Holding cost? Total inventory cost?

Q14) Vargas enterprises wishes to determine the economic order quantity (EOQ) for a critical and expensive inventory item that is used in large amounts at a relatively constant rate throughout the year. The firm uses 450,000 units of the item annually, has order costs of \$375 per order, and its carrying costs associated with this item are \$28 per unit per year. The firm plans to hold safety stock of the item equal to 5 days of usage, and it estimates that it takes 12 days to receive an order of the item once placed. Assume a 365-day year.

• a) Calculate the firm’s EOQ for the item of inventory described above.

• b) What is the firm’s total cost based upon the EOQ calculated in part a?

• c) How many units of safety stock should Vargas hold?

• d) What is the firm’s reorder point for the item of inventory being evaluated? (Hint: Be sure to include the safety stock.)

Q15) A downtown bookstore is trying to determine the optimal order quantity for a popular novel just printed in paperback. The store feels that the book will sell at four times its hardback figures. It would, therefore, sell approximately 3,000 copies in the next year at a price of \$1.50. The store buys the book at a wholesale figure of \$1. Costs for carrying the book are estimated at 10 cents a copy per year, and it costs \$10 to order more books.

• a) Determine the EOQ.

• b) What would be the total costs for ordering the books 1, 4, 5, 10, and 15 times a year?

• c) What questionable assumptions are being made by the EOQ model?

Q16) Knutson Products Inc. is involved in the production of airplane parts and has the following inventory, carrying, and storage costs:

• 1. Orders must be placed in round lots of 100 units.

• 2. Annual unit usage is 250,000. (Assume a 50-week year in your calculations.)

• 3. The carrying cost is 10 percent of the purchase price.

• 4. The purchase price is \$10 per unit.

• 5. The ordering cost is \$100 per order.

• 6. The desired safety stock is 5,000 units. (This does not include delivery-time stock.)

• 7. The delivery time is 1 week.

Given the forgoing information:

• a. Determine the optimal EOQ level.

• b. How many orders will be placed annually?

• c. What is the inventory order point? (That is, at what level of inventory should a new order be placed?)

• d. What is the average inventory level?

• e. What would happen to the EOQ if annual unit sales doubled (all other unit costs and safety stocks remaining constant)? What is the elasticity of EOQ with respect to sales? (That is, what is the percentage change in EOQ divided by the percentage change in sales?)

• f. If carrying costs double, what will happen to the EOQ level? (Assume the original sales level of 250,000 units.) What is the elasticity of EOQ with respect to carrying costs?

• g. If the ordering costs double, what will happen to the level of EOQ? (Again assume original levels of sales and carrying costs.) What is the elasticity of EOQ with respect to ordering costs?

• h. If the selling price doubles, what will happen to EOQ? What is the elasticity of EOQ with respect to selling price?

Q1)

### CAPITAL BUDGETING

You are a financial analyst for the Hittle Company. The director of capital budgeting has asked

you to analyze two proposed capital investments, Projects X and Y. Each project has a cost of \$10,000, and the cost of capital for each is 12%. The projects’ expected net cash flows are as follows:

Expected Net Cash Flows

Year

Project X

Project Y

• 0 \$10,000 \$10,000

• 1 3,500

6,500

• 2 3,500

3,000

• 3 3,500

3,000

• 4 3,500

1,000

• a) Calculate each project’s payback period, net present value (NPV), internal rate of return (IRR), and profitability index (PI).

• b) Which project or projects should be accepted if they are independent?

• c) Which project should be accepted if they are mutually exclusive?

• d) How might a change in the cost of capital produce a conflict between the NPV and IRR rankings of these two projects? Would this conflict exist if r were 5%?

• e) Why does the conflict exist?

Q2)

Edelman Engineering is considering including two pieces of equipment, a truck and an overhead

pulley system, in this year’s capital budget. The projects are independent. The cash outlay for the truck is \$17,100 and that for the pulley system is \$22,430. The firm’s cost of capital is 14%. After-tax cash flows, including depreciation, are as follows:

 Year Truck Pulley 1 \$7,500 \$5,100 2 7,500 5,100 3 7,500 5,100 4 7,500 5,100 5 7,500 5,100

Calculate the IRR, the NPV, and the MIRR for each project, and indicate the correct acceptreject decision for each.

Q3)

The Aubey Coffee Company is evaluating the within-plant distribution system for its new

roasting, grinding, and packing plant. The two alternatives are (1) a conveyor system with a high initial cost but low annual operating costs, and (2) several forklift trucks, which cost less but have considerably higher operating costs. The decision to construct the plant has already been made, and the choice here

will have no effect on the overall revenues of the project. The cost of capital for the plant is 8%, and the

projects’ expected net costs are listed in the following table:

Year

Expected Net Cost Conveyor

Forklift

• 0 \$500,000 \$200,000

• 1 160,000

120,000

• 2 160,000

120,000

• 3 160,000

120,000

• 4 160,000

120,000

• 5 160,000

20,000

• a) What is the IRR of each alternative?

• b) What is the present value of the costs of each alternative? Which method should be chosen?

Q4)

The Ewert Exploration Company is considering two mutually exclusive plans for extracting oil on

property for which it has mineral rights. Both plans call for the expenditure of \$10 million to drill development wells. Under Plan A, all the oil will be extracted in 1 year, producing a cash flow at t = 1 of \$12 million; under Plan B, cash flows will be \$1.75 million per year for 20 years.

• a) What are the annual incremental cash flows that will be available to Ewert Exploration if it undertakes Plan B rather than Plan A? (Hint: Subtract Plan A’s flows from B’s.)

• b) If the company accepts Plan A and then invests the extra cash generated at the end of Year 1, what rate of return (reinvestment rate) would cause the cash flows from reinvestment to equal the cash flows from Plan B?

• c) Suppose a firm’s cost of capital is 10%. Is it logical to assume that the firm would take on all available independent projects (of average risk) with returns greater than 10%? Further, if all available projects with returns greater than 10% have been taken, would this mean that cash flows from past investments would have an opportunity cost of only 10%, because all the firm could do with these cash flows would be to replace money that has a cost of 10%? Finally, does this imply that the cost of capital is the correct rate to assume for the reinvestment of a project’s cash flows?

• d) Construct NPV profiles for Plans A and B, identify each project’s IRR, and indicate the crossover rate.

Q5)

The Moby Computer Corporation is trying to choose between the following two mutually

exclusive design projects:

• a) If the required return is 9 percent and Moby Computer applies the profitability index decision rule, which project should the firm accept?

• b) If the company applies the NPV decision rule, which project should it take?

• c) Explain why your answers in (a) and (b) are different

 Year Cash Flow (I) Cash Flow (II) 0 -\$3,000 -\$20,000 1 10,000 2,500 2 10,000 2,500 3 10,000 2,500