CFIN5 - CHAPTER 14

Integrative Problem 14-1

Daniel Barnes, financial manager of New York Fuels (NYF), a heating oil distributor, is concerned about the

company’s working capital policy. NYF’s most recent financial statements and key ratios, plus some industry

average data, are given in the following table.

Financial Statements and Other Data on NYF ($ thousands)

A. Balance sheet

Cash and securities $ 100 Accounts payable and accruals $ 300

Accounts receivable 600 Notes payable (8%) 500

Inventories 1,000 Total current liabilities $ 800

Total current assets $1,700 Long-term debt (12%) 600

Net fixed assets 800 Common equity 1,100

Total assets $2,500 Total liabilities and equity $2,500

B. Income statement

Sales $5,000.00

Variable costs (3,700.00)

Fixed costs (1,000.00)

EBIT $ 300.00

Interest ( 112.00)

Earnings before taxes $ 188.00

Taxes (40%) ( 75.20)

Net income $ 112.80

Dividends (30%) $ 33.84

Addition to retained earnings $ 78.96

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 C. Key ratios

NYF Industry

Profit margin 2.3% 3.0%

Return on equity 10.3% 15.0%

Days sales outstanding (360 days) 43.2 days 30.0 days

Accounts receivable turnover 8.3x 12.0x

Inventory turnover 5.0x 7.5x

Fixed assets turnover 6.3x 6.0x

Total assets turnover 2.0x 2.5x

Debt/Assets 56.0% 50.0%

Times interest earned 2.7x 4.8x

Current ratio 2.1x 2.3x

Quick ratio 0.9x 1.3x

You have been asked to answer the following questions to help determine NYF’s working capital policy.

a. Based on the ratios and financial statements, what were the company’s inventory conversion period, its

receivables collection period, and, assuming a 29-day payables deferral period, its cash conversion

cycle? How could the cash conversion cycle concept be used to help improve the firm's working capital

management?

b. How does NYF’s current working capital policy, as reflected in its financial statements, compare with an

average firm’s policy? Do the differences suggest that NYF's policy is better or worse than that of the

average firm in its industry?

Integrative Problem 14-2

C. Charles Smith recently was hired as president of Dellvoe Office Equipment Inc., a small manufacturer of

metal office equipment. As his assistant, you have been asked to review the company’s short-term financing

policies and to prepare a report for Smith and the board of directors. To help you get started, Smith has

prepared some questions that, when answered, will give him a better idea of the company’s short-term

financing policies.

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a. What is short-term credit, and what are the four major sources of this credit?

b. Is there a cost to accruals, and do firms have much control over them?

c. What is trade credit?

d. Like most small companies, Dellvoe has two primary sources of short-term debt: trade credit and bank

loans. One supplier, which supplies Dellvoe with $50,000 of materials a year, offers Dellvoe terms of

2/10, net 50.

(1) What are Dellvoe’s net daily purchases from this supplier?

(2) What is the average level of Dellvoe’s accounts payable to this supplier if the discount is taken?

What is the average level if the discount is not taken? What are the amounts of free credit and

costly credit under both discount policies?

(3) What is the APR of the costly trade credit? What is its EAR?

e. In discussing a possible loan with the firm’s banker, Smith found that the bank is willing to lend Dellvoe

up to $800,000 for one year at a 9% simple, or quoted, rate. However, he forgot to ask what the specific

terms would be.

(1) Assume the firm will borrow $800,000. What would be the effective interest rate if the loan were

based on simple interest? If the loan had been an 8% simple interest loan for six months rather

than for a year, would that have affected the EAR?

(2) What would be the EAR if the loan were a discount interest loan? What would be the face amount

of a loan large enough to net the firm $800,000 of usable funds?

(3) Assume now that the terms call for an installment (or add-on) loan with equal monthly payments.

The add-on loan is for a period of one year. What would be Dellvoe’s monthly payment? What

would be the approximate cost of the loan? What would be the EAR?

(4) Now assume that the bank charges simple interest, but it requires the firm to maintain a 20%

compensating balance. How much must Dellvoe borrow to obtain its needed $800,000 and to meet

the compensating balance requirement? What is the EAR on the loan?

(5) Now assume that the bank charges discount interest of 9% and also requires a compensating

balance of 20%. How much must Dellvoe borrow, and what is the EAR under these terms?

(6) Now assume all the conditions in part 4—that is, a 20% compensating balance and a 9% simple

interest loan—but assume also that Dellvoe has $100,000 of cash balances that it normally holds

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 for transactions purposes, which can be used as part of the required compensating balance. How

does this affect (i) the size of the required loan and (ii) the EAR of the loan?

f. Dellvoe is considering using secured short-term financing. What is a secured loan? What two types of

current assets can be used to secure loans?

g. What are the differences between pledging receivables and factoring receivables? Is one type generally

considered better?

h. What are the differences among the three forms of inventory financing? Is one type generally considered

best?

i. Dellvoe had expected a really strong market for office equipment for the year just ended, and in

anticipation of strong sales, the firm increased its inventory purchases. However, sales for the last

quarter of the year did not meet its expectations, and now Dellvoe finds itself short on cash. The firm

expects that its cash shortage will be temporary, only lasting 3 months. (The inventory has been paid for

and cannot be returned to suppliers.) Dellvoe has decided to use inventory financing to meet its short-

term cash needs. It estimates that it will require $800,000 for inventory financing during this three-month

period. Dellvoe has negotiated with the bank for a three-month, $1,000,000 line of credit with terms of

10% annual interest on the used portion, a 1% commitment fee on the unused portion, and a $125,000

compensating balance at all times.

Expected inventory levels to be financed are as follows:

Month Amount
January $800,000
February 500,000
March 300,000

Calculate the cost of funds from this source, including interest charges and commitment fees. (Hint:

Each month’s borrowings will be $125,000 greater than the inventory level to be financed because of the

compensating balance requirement.)

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in whole or in part.