ACF 103 – Fundamentals of Finance

Tutorial 6 - Solutions
Chapter 8
1. Lone Star Industries has current sales of $1 million and a net profit margin of
12%. It has fixed assets of $400,000 and current assets of $200,000. What
happens to the firm's asset turnover ratio and return on assets if it decides to
improve its liquidity by increasing current assets to $300,000? Assume that the
increase in current assets comes from new equity capital.

Answer:
Net profit = ($1,000,000)(0.12) = $120,000

Ratio Analysis:
Asset Turnover Ratio:
Old AT ratio = $1,000,000/$600,000 = 1.67
New AT ratio = $1,000,000/$700,000 = 1.43

The asset turnover ratio will decline because of current assets rising with no change in
current sales.

Return on Assets Ratio:

Old ROA ratio = $120,000/$600,000 = 20.0%
New ROA ratio = $120,000/$700,000 = 17.1%

The ROA ratio will decline because of current assets rising with no change in net
profit.

2. United Pickle Works needs to borrow $10 million for six years; no temporary
repayments are expected to occur during the period. One alternative is to issue
notes maturing in six years at a fixed annual interest rate of 10%. The other
alternative is to borrow the $10 million from its bank under an arrangement
requiring that the interest rate be adjusted annually. Management is willing to
accept a forecast that the six annual rates will be 8%, 9%, 10%, 12%, 12%,
and 12%. Based on the total amount of interest to be paid over the period,
which loan would require a smaller interest expense? Which financing method
is preferable?

Answer:
Total interest on notes
Total interest on bank debt
= ($10,000,000)(0.10)(6)
= $6,000,000
= ($10,000,000)[0.08 + 0.09 + 0.10 + (3)(0.12)]
= $6,300,000

While the present value of the interest paid on the bank debt may be lower
than the present value of the interest paid on the notes, there is no uncertainty
about the 10% rate. The bank debt is more risky because the possibility of up
to six forecasting errors exists.

ACF 103 HAUT 2015 Tutorial Solns 1

3. The Clearwater Corporation has determined that the after-tax return on its current
assets is 6% while the after-tax return on fixed assets is 12%. Clearwater's current
balance sheet is as follows:

ASSETS LIABILITIES
Current Assets $300,000 Current Liabilities $200,000
Fixed Assets 700,000 Long-term Debt 300,000
Equity 500,000
Total Assets $1,000,000 Total Liab+Equity $1,000,000

Management wishes to increase its net profits by shifting $100,000 out of current
assets and investing it in fixed assets. Assess the impact of this strategy on the firm's
return on assets, as well as on its liquidity.
Answer:
Old net profit = ($300,000)(0.06) + ($700,000)(0.12) = $102,000
New net profit = ($200,000)(0.06) + ($800,000)(0.12) = $108,000

Old return on assets = $102,000/$1,000,000 = 10.2%

New return on assets = $108,000/$1,000,000 = 10.8%

Old net working capital = $300,000 - $200,000 = $100,000

New net working capital = $200,000 - $200,000 = $0

Old current ratio = $300,000/$200,000 = 1.5

New current ratio = $200,000/$200,000 = 1.0

The company will be more profitable based on net profit and ROA figures, but will be
less liquid (NWC and Current Ratio) and, therefore, more financially risky.

Chapter 9
1. Goodmonth Enterprises expects credit sales of $800 million next year. If the
firm can invest funds at the rate of 8% a year, what is the value of collecting
accounts payable two days earlier (use a 365-day year)?

Answer: Sales per day = $800,000,000/365 = $2,191,781

Benefit = ($2,191,781)(0.08)(2) = $350,684

2, Bull Run Brewery has a weekly payroll of $400,000 and paychecks are issued
every Friday. On the average, Bull Run's employees cash their checks
according to the following pattern:

Day Checks Clear Percent of

Payroll Account Checks Cleared
Friday 30
Monday 40
Tuesday 20
Wednesday 10

Assuming the company maintains a minimum balance in the account so as not

to break any banking laws, how would you manage the payroll account?

ACF 103 HAUT 2015 Tutorial Solns 2

Answer:
The weekly $400,000 should be deposited in the following amounts and manner:
Friday = ($400,000)(0.30) = $120,000
Monday = ($400,000)(0.40) = $160,000
Tuesday = ($400,000)(0.20) = $80,000
Wednesday = ($400,000)(0.10) = $40,000

3. Chou Dou Fu receives an average of $500,000 a day in payments from its

franchisees through the mail. The average time it takes to have funds available
at its bank is seven days from the postmark date. The firm has asked you to
evaluate the following three alternatives. Which offers the greatest financial
benefit to Chou Dou Fu? (Assume that the firm can earn 8% annually on its
marketable securities investments.)

a. Bank Shanghai offers concentration banking that will reduce the time to have
funds available from seven to five days. Bank Shanghai charges a fee of
$65,000 annually to set up and administer the system.
b. Kaifeng Bank offers a system that will reduce the time to available funds to
four days. Kaifeng Bank requires a $1,000,000 compensating balance in order
to administer the system.
c. Bank of Henan offers to set up an Electronic Funds Transfer system that will
reduce the time to available funds to two days. Bank of Henan charges an
annual fee of $300,000 for this service.

Answer:
a. Bank Shanghai
Cash Available = Time Saved x Collections per Day
= 2 days x $500,000 = $1,000,000
Financial Benefit = Reduction in Cash x Opportunity Cost
= $1,000,000 x 0.08 = $80,000 benefit
Gain on change = $80,000 - 65,000 = $15,000 net gain

b. Kaifeng Bank
Additional Cash = Time Saved x Collections per Day
= 3 days x $500,000 = $1,500,000
Cash Available = $1,500,000 - $1,000,000 Compensating Balance
= $500,000
Financial Benefit = Reduction in Cash x Opportunity Cost
= $500,000 x 0.08 = $40,000 benefit
Gain on change = $40,000 net gain

c. Bank of Henan
Cash Available = Time Saved x Collections per Day
= 5 days x $500,000 = $2,500,000
Financial Benefit = Reduction in Cash x Opportunity Cost
= $2,500,000 x 0.08 = $200,000 benefit
Loss on change = $200,000 - 300,000 = -$100,000 net loss

Choose b, the system offered by Kaifeng Bank.

ACF 103 HAUT 2015 Tutorial Solns 3

Chapter 10
Homework problem
1. The ABC Company wishes to establish an EOQ for a particular item. The
annual usage is 12,000 units, order costs are $20, and the annual carrying cost
is $0.48 per unit. The EOQ equals ________.
A. 10 units
B. 100 units
* C. 1,000 units
D. 10,000 units

EOQ = √2(O)(S)/C = √(2 x 20 x 12,000)/0.48 = 1,000

2. Indo Processing Corp uses 20,000 gallons of solvent a year. The cost of
carrying the solvents is $1.62 a gallon per year, while the cost per order is
$200. What would the closest average inventory level be if Indio wished to
maintain a 400 gallon safety stock?
* A 1,511
B. 10,000
C. 812
D. 3,214

EOQ = √2(O)(S)/C = √2(200)(20,000)/1.62 = 2,222

Ave inventory = 2,222/2 + 400 = 1,511

3. (Relaxation of credit standards) Lewis Enterprises is considering relaxing its

credit standards in order to increase its currently sagging sales. As a result of
the proposed relaxation, sales are expected to increase by 10% from 10,000 to
11,000 units during the coming year; the average collection period is expected
to increase from 45 days to 60 days; and bad debts are expected to increase
from 1% to 3% of sales. The sale price per unit is $40 and the variable cost per
unit is $31. If the firm’s required return on equal-risk investments is 25%,
evaluate the proposed relaxation and make a recommendation to the firm.

Increase in unit sales = 11,000 – 10,000 = 1,000 new units

Additional profit contribution = ($40 – $31) × 1,000 units = $9,000

365 365
Turnover, present =   8.11 times
ACP 45
365 365
Turnover, proposed plan =   6.08 times
ACP 60

Variable cost: Present = 10,000 × $31 = $310,000

Proposed = 11,000 × $31 = $341,000

Total variable cost of annual sales

Average investment in accounts receivable =
Accounts receivable turnover

$310,000
Average investment, present = = $38,224
8.11

ACF 103 HAUT 2015 Tutorial Solns 4

 $341,000
Average investment, proposed plan = = $56,086
6.08

Marginal investment in accounts receivable = Change in average investment

= $56,086 – $38,224 = $17,872

Cost of marginal investment in accounts receivable

= Marginal investment × Required return
= $17,872 × 0.25 = $4,466

Bad debts: Present = 10,000 × $40 × 0.01 = $4,000

Proposed plan = 11,000 × $40 × 0.03 = $13,200

Marginal cost of bad debts = $13,200 – $4,000 = $9,200

Profit $9,000
less Investment in accounts receivable 4,466
Marginal cost of bad debts 9,200 13,666
Net loss -$4,666

The credit standards should not be relaxed.

4. The Morgan Company sold 100,000 units of a product last year for $30 each.
Variable costs for each unit are $25. The sales manager believes that sales
would increase by 20%, with no increase in bad-debt losses, if the credit
period is extended from 30 to 60 days. The new terms are expected to increase
the average collection period from 45 to 75 days. If the firm's opportunity cost
of funds is 20%, should it offer 60-day terms? (Assume a 360-day year.)

Answer:
Increased profits on sales = (20,000)($5) = $100,000
Cost of current terms = (100,000)($25)(45/360)(0.20)
= $62,500
Cost of new terms = (120,000)($25)(75/360)(0.20)
= $125,000
Increased cost of receivables = $125,000 - $62,500 = $62,500

Net change in profits = $100,000 - $62,500 = +$37,500.

The change should indeed be made as it will dramatically increase firm profits
since the benefit of profits from increased sales exceeds the increased cost of
financing sales.

5. Thermo Products, a manufacturer of solar heating panels, is currently selling

$6 million annually to dealers on 30-day credit terms. Management believes
that sales could be increased by changing its credit policy. The firm's present
collection period is 30 days and it is presently considering the following credit
policies:

ACF 103 HAUT 2015 Tutorial Solns 5

 Average Expected
Policy Collection Period Annual Sales
A 45 days $6.6 million
B 60 days 7.0 million
C 90 days 7.2 million

If the firm's variable costs average 75% and its opportunity cost of funds is
20%, which policy should be adopted? (Assume a 360-day year.)

Answer: POLICY A:
Increased profits on sales = ($600,000)(0.25) = $150,000
Cost of current terms = ($6,000,000)(0.75)(30/60)(0.20)
= $75,000
Cost of Policy A = ($6,600,000)(0.75)(45/360)(0.20)
= $123,750
Increased cost of receivables = $123,750 - $75,000 = $48,750
Net change in profits = $150,000 - $48,750 = +$101,250

POLICY B:
Increased profits on sales = ($1,000,000)(0.25) = $250,000
Cost of Policy B = ($7,000,000)(0.75)(60/360)(0.20)
= $175,000
Increased cost of receivables = $175,000 - $75,000 = $100,000
Net change in profits = $250,000 - $100,000 = +$150,000

POLICY C:
Increased profits on sales = ($1,200,000)(0.25) = $300,000
Cost of Policy C = ($7,200,000)(0.75)(90/360)(0.20)
= $270,000
Increased cost of receivables = $270,000 - $75,000 = $190,000
Net change in profits = $300,000 - $190,000 = +$110,000

POLICY B is the BEST choice as profits are expected to be at their highest

levels.

6. The Bentley Corporation uses 100,000 units a year of a particular item. The
firm has determined that the economic order quantity is 2,000 units, based on
order costs of $100 per order and inventory carrying costs of $0.50 per unit.
Suppose that a quantity discount of $0.05 per unit is available for order sizes
of 10,000 units or more. Should Bentley take advantage of the quantity
discount?

Answer:
Purchase cost savings = (100,000)($0.05) = +$5,000
Change in number of orders = 100,000/2,000 - 100,000/10,000
= 40 additional orders per year
Order cost savings = (40)($100) = +$4,000
Change in average inventory = 10,000/2 - 2,000/2
= 4,000

ACF 103 HAUT 2015 Tutorial Solns 6

 Carrying cost increase = (4,000)($0.50) = $2,000
Net savings = $5,000 + $4,000 - $2,000
= $7,000

The cost savings from the reduced number of orders and the quantity discount more
than offset the additional carrying costs in this case. Thus, the firm should take
advantage of the discount at $7,000 per year savings.

7. Text book Ch 10, problem # 1 (p.275)

Credit Policy A B C D
a. Incremental sales $2,800,000 $1,800,000 $1,200,000 $600,000
b. Incremental profitability1 280,000 180,000 120,000 60,000
c. New receivable turnover2 8 6 4 2.5
3
d. Additional receivables $ 350,000 $ 300,000 $ 300,000 $240,000
e. Additional investment4 315,000 270,000 270,000 216,000
3
f. Opportunity cost 94,500 81,000 81,000 64,800
g. (b) > (f)? yes yes yes no
1 (10% contribution margin) × (incremental sales)
2 (360 days/new average collection period)
3 (incremental sales/new receivable turnover)
4 (0.9) × (additional receivables)
5 (0.30) × (additional receivables)

The company should adopt credit policy C because incremental profitability

exceeds the increased carrying costs for policies A, B, and C, but not for
policy D.

8. Text book Ch 10, problem # 2 (p.275)

Credit Policy A B C D
a. Incremental sales $2,800,000 $1,800,000 $1,200,000 $600,000
b. Percent default 3% 6% 10% 15%
c. Incremental bad-debt losses
(a) × (b) 84,000 108,000 120,000 90,000
d. Opportunity cost
(from Ans. #1) 94,500 81,000 81,000 64,800
e. Total costs
(c) + (d) 178,500 189,000 201,000 154,800
f. Incremental profitability
(from Ans. #1) 280,000 180,000 120,000 60,000
g. (f) > (e)? yes no no no

Adopt credit policy A. It is the only one where incremental profitability

exceeds opportunity costs plus bad-debt losses.

9. Text book Ch 10, problem # 3 (p.276)

ACF 103 HAUT 2015 Tutorial Solns 7

 Credit Policy A B C D
a. Incremental sales $2,800,000 $1,800,000 $1,200,000 $600,000
b. Percent default 1.5% 3% 5% 7.5%
c. Incremental bad-debt losses
(a) × (b) 42,000 54,000 60,000 45,000
d. Opportunity cost
(from Ans. #1) 94,500 81,000 81,000 64,800
e. Total costs
(c) + (d) 136,500 135,000 141,000 109,800
f. Incremental profitability
(from Ans. #1) 280,000 180,000 120,000 60,000
g. (f) > (e)? yes yes no no

Credit policy B now would be best. Any more liberal credit policy beyond this
point would only result in more incremental costs than benefits.

10. Text book Ch 10, problem # 8 (p.277)

Answer:
a. Total number of dints required = 150,000 × 12 = 1,800,000
Q* √(2)($200)(1,800,000)/$8 = 90,000,000 = 9,487 units

b. TC = C(Q/2) + O(S/Q)
= $8(9,487/2) + $200(1,800,000/9,487)
= $37,948 + $37,947
= $75,895

c. 1,800,000/9,487 = (approx.) 190 times a year, or every 2 days

Chapter 11
1. The trade terms "2/15, net 30" indicate that a ________ discount is offered if
payment is made within ________ days.
* A. 2%; 15
B. 15%; 30
C. 2%;30
D. 30%; 15

2. In terms of an annual interest cost, would it be better for a firm to forego a

1/10, net 20 cash discount or a 2/10, net 30 discount (assume a 360 day year)?
Answer: Cost of foregoing 1/10, net 20:
($1/$99)(360/10) = 0.3636, or 36.4%
Cost of foregoing 2/10, net 30:
($2/$98)(360/20) = 0.3673, or 36.7%

It would be better to forego the least costly option of 1/10, net 20 (36.4%) and
take advantage of the 2/10 net 30 option (36.7%).

3. Taylor Industries needs to raise funds on a short-term basis. One alternative is

to borrow from the bank at an 18% annual interest rate, while the second
involves foregoing cash discounts from a supplier whose trade credit terms are

ACF 103 HAUT 2015 Tutorial Solns 8

 2/10, net 60. Which alternative has the lower effective interest cost (assume a
360 day year)?
Answer: Cost of foregoing 2/10, net 60:
($2/$98)(360/50) = 0.1469, or 14.69%
Foregoing the cash discount is cheaper than the 18% bank rate.

4. Lots of Leather, a boutique specializing in high fashion women's leather items,

purchases a line of sandals from a single manufacturer. Its $20,000 annual
sandal shipment is usually received on the first of April under net 60-day
terms. Its supplier has offered a 5% discount if it will take shipment on the
first of March under net 30-day terms. If it costs the firm $200 a month to
store the sandals, and its cost of borrowing is 1% per month, should it accept
the supplier's offer?
Answer; Savings on discount = ($20,000)(0.05) = $1,000
Extra storage cost = $ 200
Extra interest cost = ($20,000)(0.01)(2) = $ 400
Net savings = $1,000 - $200 - $400 = $ 400

5. Malaprop Systems, Inc. wants to borrow $200,000 in short-term funds. Bank

A is willing to lend at a 16% nominal interest rate, but will require
compensating balances equal to 30% of the loan amount. Bank B is charging a
nominal rate of 18%, but does not require any compensating balances. If
Malaprop normally keeps $50,000 in its checking account, which bank is
offering the better terms?
Answer: Bank A: interest = ($200,000)(0.16) = $32,000
compensating balance = ($200,000)(0.30) = $60,000
additional deposit = $60,000 - $50,000 = $10,000
effective cost = $32,000/($200,000 - $10,000) = 16.84%
Bank B at 18% is more expensive.

6. PDQ Co. has been using its receivables as collateral for a bank loan.
Receivables average $400,000 a month, and the bank is willing to lend up to
75% of the average amount at a 12% interest rate, while requiring a 1%
processing fee on the face amount of all receivables used as collateral. PDQ is
exploring an arrangement with a factor that is also willing to lend up to 75%
of the receivables factored, but at a rate of 15%. The factoring fee would be
2% of the face amount of all receivables factored. Under this arrangement,
PDQ would save the $3,000 per month its credit department costs, and it
would eliminate bad-debt losses equal to 1% of receivables. Should the firm
switch from the bank to the factor?
Answer: Available financing under either arrangement:
($400,000)(0.75) = $300,000
Bank interest = ($300,000)(0.12) = $36,000
Bank fee = ($400,000)(0.01)(12) = $48,000
Total bank cost = $36,000 + $48,000 = $84,000

Factor interest = ($300,000)(0.15) = $45,000

Factor fee = ($400,000)(0.02)(12) = $96,000
Savings on credit debt = ($3,000)(12) = $36,000
Savings on bad debt = ($400,000)(0.01)(12) = $48,000

ACF 103 HAUT 2015 Tutorial Solns 9

 Total factor cost = $45,000 + $96,000 - $36,000 - $48,000 = $57,000

Savings from switching to factor = $84,000 - $57,000 = $27,000

ACF 103 HAUT 2015 Tutorial Solns 10

 Gitman Solutions
1. 14–4 (Cash conversion cycle) Australian Products is concerned about
managing cash in an efficient manner. On average, inventories have an
average age of 90 days and accounts receivable are collected in 60 days.
Accounts payable are paid approximately 30 days after they arise. The firm
spends $30 million on operating cycle (OC) investments each year, at a
constant rate. Assuming a 365-day year:
a Calculate the firm’s OC.
b Calculate the firm’s CCC.
fc Calculate the amount of financing required to support the firm’s CCC.
d Discuss how management might be able to reduce the CCC.

Answer:
a. OC = AAI + ACP = 90 days + 60 days = 150 days
b. CCC = OC – APP = 150 days – 30 days = 120 days
c. Resources needed = (Total annual outlays  365 days) × CCC
= ($30,000,000  365) × 120 = $9,863,014
d. Shortening either the average age of inventory or the average
collection period, lengthening the average payment period, or a combination
of these, can reduce the cash conversion cycle.

2 14–5 (Changing the CCC) Camp Manufacturing turns over its inventory
eight times each year, has an APP of 35 days and an ACP of 60 days. The
firm’s total annual outlays for OC investments are $3.5 million. Assuming a
365-day year:
a. Calculate the firm’s OC and CCC.
b. Calculate the firm’s daily cash operating expenditure. How much
negotiated financing is required to support its CCC?
c. Assuming the firm pays 14% for its financing, by how much would it
increase its annual profits by favourably changing its current CCC by
20 days?
Answer:
Changing the CCC
a. AAI = 365 days ÷ Inventory turnover = 365  8 = 45.6 days
OC = AAl + ACP = 45.6 days + 60 days = 105.6 days

CCC = OC – APP = 105.6 days – 35 days = 70.6 days

b. Daily cash operating expenditure = Total outlays  365 days

= $3,500,000  365 = $9,589

Resources needed = Daily expenditure × CCC

= $9,589 × 70.6 = $676,983

c. Additional profit = (Daily expenditure × Reduction in CCC) × Financing rate

= ($9,589 × 20) × 0.14 = $26,849

Homework problem
3. 14–18 (EOQ, reorder point and safety stock) Alexis Limited uses 800 units
of a product per year on a continuous basis. The product has a fixed cost of

ACF 103 HAUT 2015 Tutorial Solns 11

 $50 per order and its carrying cost is $2 per unit per year. It takes five days to
receive a shipment after an order is placed, and the firm wishes to hold in
inventory 10 days’ usage as a safety stock.
a. Calculate the EOQ.
b. Determine the average level of inventory.
c. Determine the reorder point.

Answer:
EOQ, reorder point and safety stock
2S O 2  800  $50
a. EOQ = = = 200 units
C $2
b. Daily usage = Yearly usage / Days in operation = 800 / 365 = 2.19
EOQ
Average level of inventory = Minimum inventory +
2
200
= 2.19 × 10 + = 121.9 units
2
c. Reorder point = (Lead time + Safety stock) in days × Daily usage
= (5 + 10) × 2.19 = 32.85 units

4. 14–24 (Accounts receivable changes and bad debts) A firm is evaluating an

accounts receivable change that would increase bad debts from 2% to 4% of
sales. Sales are currently 50 000 units, the selling price is $20 per unit and the
variable cost per unit is $15. As a result of the proposed change, sales are
forecast to increase to 60 000 units.
a. What are bad debts in dollars at present and under the proposed
change?
b. Calculate the cost of the marginal bad debts to the firm.
c. Ignoring the additional profit contribution from increased sales, if the
proposed change saves $3,500 and causes no change in the average
investment in accounts receivable, would you recommend it? Explain.
d. Considering all changes in costs and benefits, would you recommend
the proposed change? Explain.
e. Compare and discuss your answers in parts c and d.

Answer:
Accounts receivable changes and bad debts
a. Bad debts: Present = 50,000 × $20 × 0.02 = $20,000
Proposed plan = 60,000 × $20 × 0.04 = $48,000

b. Marginal cost of bad debts = $48,000 – $20,000 = $28,000

c. No, since the marginal cost of bad debts exceeds the savings of $3,500.

d. Increase in unit sales = 60,000 – 50,000 = 10,000 new units

Additional profit contribution = ($20 – $15) × 10,000 units = $50,000

Marginal analysis
Profit $50,000
plus Cost savings 3,500
less Marginal cost of bad debts -28,000

ACF 103 HAUT 2015 Tutorial Solns 12

 Net benefit $25,500
This policy change is recommended because the increase in profit from
increased sales, as well as the cost savings of $3,500, exceeds the increased
bad debt expense.

e. When the additional sales are ignored, the proposed policy is rejected.
However, when all the benefits are included, the profitability from new sales
and savings outweigh the increased cost of bad debts. Therefore, the policy is
recommended. In order to be useful tool, marginal analysis must include all
costs and benefits in the decision-making process.

5. 14–27 (Relaxation of credit standards) Lewis Enterprises is considering

relaxing its credit standards in order to increase its currently sagging sales. As
a result of the proposed relaxation, sales are expected to increase by 10% from
10,000 to 11,000 units during the coming year; the average collection period is
expected to increase from 45 days to 60 days; and bad debts are expected to
increase from 1% to 3% of sales. The sale price per unit is $40 and the
variable cost per unit is $31. If the firm’s required return on equal-risk
investments is 25%, evaluate the proposed relaxation and make a
recommendation to the firm.
Answer:
Relaxation of credit standards

Increase in unit sales = 11,000 – 10,000 = 1,000 new units

Additional profit contribution = ($40 – $31) × 1,000 units = $9,000

365 365
Turnover, present =   8.11 times
ACP 45
365 365
Turnover, proposed plan =   6.08 times
ACP 60

Variable cost: Present = 10,000 × $31 = $310,000

Proposed = 11,000 × $31 = $341,000

Total variable cost of annual sales

Average investment in accounts receivable =
Accounts receivable turnover

$310,000
Average investment, present = = $38,224
8.11

$341,000
Average investment, proposed plan = = $56,086
6.08

Marginal investment in accounts receivable = Change in average investment

= $56,086 – $38,224 = $17,872

Cost of marginal investment in accounts receivable

= Marginal investment × Required return
= $17,872 × 0.25 = $4,466

ACF 103 HAUT 2015 Tutorial Solns 13

 Bad debts: Present = 10,000 × $40 × 0.01 = $4,000
Proposed plan = 11,000 × $40 × 0.03 = $13,200

Marginal cost of bad debts = $13,200 – $4,000 = $9,200

Profit $9,000
less Investment in accounts receivable 4,466
Marginal cost of bad debts 9,200 13,666
Net loss -$4,666

The credit standards should not be relaxed

6. 15–1 (Payment dates) Determine when a firm must make payment for
purchases made and invoices dated on 25 November under each of the
following credit terms.
a. net 30 date of invoice
b. net 30 EOM
c. net 45 date of invoice
d. net 60 EOM
Answer:
Payment dates

a. 25 December c. 9 January
b. 30 December d. 30 January

7. 15–2 (Cost of forgoing cash discounts) Determine the cost of forgoing cash
discount ts under each of the following terms of sale.
a. 2/10 net 30 e 1/10 net 60
b. 1/10 net 30 f 3/10 net 30
c. 2/10 net 45 g 4/10 net 180
d. 3/10 net 45

Answer:
CD 365
Cost of forgoing cash discounts: Cost = 
100%  CD N

2 365 1 365
a.   37.24% b.   18.43%
100  2 20 100  1 20

2 365 3 365
c.   21.28% d.   32.25%
100  2 35 100  3 35

1 365 3 365
e.   7.37% f.   56.44%
100  1 50 100  3 20

4 365
g.   8.95%
100  4 170

ACF 103 HAUT 2015 Tutorial Solns 14

8. 15–6 (Credit terms) Purchases made on credit are due in full by the end of the
billing period. Many firms extend a discount for payment made in the first part
of the billing period. The original invoice contains a type of ‘short-hand’
notation that explains the credit terms that apply. (Assume a 365-day year.)
a. Write the short-hand expression of credit terms for each of the
following.
Beginning of
Cash discount Discount period Credit period credit period
1% 15 days 45 days date of invoice
2 10 30 end of month
2 7 28 date of invoice
1 10 60 end of month
b. For each of the sets of credit terms in part a, calculate the number of
days until the bill is due in full for invoices dated 12 March.
c. For each of the sets of terms, calculate the cost of giving up the cash
discount.
d. If the firm’s cost of short-term financing is 8%, what would you
recommend in regard to taking the discount or giving it up in each
case?

Answer:
Credit terms

a. (i) 1/15 net 45 date of invoice (iii) 2/7 net 28 date of invoice
(ii) 2/10 net 30 EOM (iv) 1/10 net 60 EOM

b. (i) 45 days (iii) 28 days

(ii) 49 days (iv) 79 days

c. (i) CD 365
Cost of giving up cash discount  
100%  CD N
1 365
   12.29%
100  1 30
(ii) 2 365
Cost of giving up cash discount    37.24%
100  2 20
(iii) 2 365
Cost of giving up cash discount    35.47%
100  2 21
(iv) 1 365
Cost of giving up cash discount    7.37%
100  1 50

d. In the first three cases, the firm would be better off to borrow the funds and
take the discount, because the annual cost of not taking the discount is greater
than the firm’s 8% cost of capital. In the fourth case, the firm would be better
off to take the discount: the cost is less than the cost of borrowed funds.

9. 15–13 (Cost of bank loan) Data Back-up Systems has obtained a $10,000, 90-
day bank loan at an annual interest rate of 15%, payable at maturity.
a. How much interest (in dollars) will the firm pay on the 90-day loan?
b. Find the effective cost of the loan for the 90 days.

ACF 103 HAUT 2015 Tutorial Solns 15

 c. Annualise your finding in part b to find the effective annual rate of
interest for this loan, assuming it is rolled over each 90 days
throughout the year under the same terms and circumstances.
Answer:
Cost of bank loan
90
a. Interest  10,000  0.15   $369.86
365
$369.86
b. Effective cost of loan for 90 days = $10,000  3.70%
c. Effective annual rate = (1 + 0.037)4 – 1 = 15.64%

10 15–33 (Accounts receivable as collateral, cost of borrowing) Maximum

Bank has analysed the accounts receivable of Scientific Software Ltd. The
bank has chosen eight accounts totalling $134,000 that it will accept as
collateral. The bank’s terms include a lending rate set at prime + 3% and a 2%
commission charge. The prime rate is currently 8.5%.
a. The bank will adjust the accounts by 10% for returns and allowances.
It will then lend up to 85% of the adjusted acceptable collateral. What
is the maximum amount that the bank will lend to Scientific Software?
b. What is Scientific Software’s effective annual rate of interest if it
borrows $100 000:
i for 12 months,
ii for six months,
iii for three months?
(Assume that the prime rate remains at 8.5% during the life of the
loan.)

Answer:
Accounts receivable as collateral, cost of borrowing

a. $134,000 × (1 – 0.10) × 0.85 = $102,510

b. (i) Interest = $100,000 × (0.02 + 0.115) = $13,500

Interest $13,500
Effective annual interest rate  Amount received = $100,000  13.5%

 0.115 
(ii) Interest = $100,000 ×  0.02   = $7,750
 2 

Interest $7,750
Effective 6-month interest rate  Amount received = $100,000  7.75%

Effective annual interest rate = (1 + 0.0775)2 – 1 = 16.1%

 0.115 
(iii) Interest = $100,000 ×  0.02   = $4,875
 4 

ACF 103 HAUT 2015 Tutorial Solns 16

 Interest $4,875
Effective 3-month interest rate  Amount received = $100,000  4.875%

Effective annual interest rate = (1 + 0.04875)4 – 1 = 21.0%

11. 15–36 (Cost of factoring advance—single amount) Duff Industries wishes

to receive an advance from its factor on an account of $100,000 due in 30
days. The factor holds a 10% factor’s reserve, charges on and deducts from the
book value of factored accounts a 2% factoring commission, and charges 16%
annual interest (paid in advance) on advances.
a. Calculate the maximum dollar amount of interest to be paid.
b. What amount will the firm actually receive?
c. What is the effective annual interest cost of this transaction?
d. What is the annual factoring cost (in per cent) for this transaction?

Answer:
Cost of factoring advance – single amount
a. Book value of account $100,000
less Reserve (10% × 100,000) 10,000
less Factoring commission (2% × 100,000) 2,000
Funds available for advance $88,000

0.16
Interest on advance =  $88,000 = $1,173
12

b. Funds available for advance $88,000

less Interest on advance 1,173
Proceeds from advance $86,827

Interest $1,173
c. Effective annual interest rate  Amount received 12 = $86,827  12  16.2%

Interest  Commission $3,173

d. Effective annual factoring cost  Amount received
 12 =
$86,843
 12  43.8%

Homework problem
12. 15–38 (Inventory financing) Raymond Manufacturing faces a liquidity crisis
—it needs a loan of $100,000 for 30 days. Having no source of additional
unsecured borrowing, the firm must find a secured short-term lender. The
firm’s accounts receivable are quite low, but its inventory is considered liquid
and reasonably good collateral. The book value of the inventory is $300,000,
of which $120,000 is finished goods.
(1) City-Wide Bank will make a $100 000 loan against the finished goods
inventory. The annual interest rate on the loan is 12% on the
outstanding loan balance plus a 0.25% administration fee levied
against the $100,000 initial loan amount. Because it will be liquidated
as inventory is sold, the average amount owed over the month is
expected to be $75,000.
(2) Sun State Bank is willing to lend $100,000 on the book value of
inventory for the 30-day period at an annual interest rate of 13%.

ACF 103 HAUT 2015 Tutorial Solns 17

 (3) Citizens’ Bank will loan $100,000 against the finished goods inventory
and charge 15% annual interest on the outstanding loan balance. A
0.5% warehousing fee will be levied against the average amount
borrowed. Because the loan will be liquidated as inventory is sold, the
average loan balance is expected to be $60,000.
a. Calculate the dollar cost of each of the proposed plans for obtaining an
initial loan amount of $100,000.
b. Which plan do you recommend? Why?
c. If the firm had made a purchase of $100,000 for which it had been
given terms of 2/10 net 30, would it increase the firm’s profitability to
forgo the discount and not borrow as recommended in part b? Why or
why not?

Answer:
Inventory financing

a. City-Wide Bank: 0.12 12  $75,000  0.0025  $100,000  $1,000

Sun State Bank: 0.13 12  $100,000  $1,083

Citizens’ Bank: 0.15 12  $60,000  0.005  $60,000  $1,050

b. City-Wide Bank is the best alternative, since it has the lowest cost.

c.
CD 365 2 365
Cost of giving up cash discount      37.24%
100%  CD N 100  2 20

Interest $1,000
Effective interest rate on loan  Amount received  12 = $75,000 12  16.0%

Since the cost of giving up the discount (37.24%) is higher than borrowing at
City-Wide Bank (16%), the firm should borrow to take the discount.

ACF 103 HAUT 2015 Tutorial Solns 18