Racy's Department Store

'

The treasurer of Racy's Department Store is perfornling his financia! planning for the next 6 months, September tl~roughFebruary. Because of the Christmas season, Racy's has need for large amounts of cash, particularly in the nlontlis of November and December, and a large cash inflow occurs in January and Febru;rry when customers pay their Christmas bills. These requirements are sun~marizedin the table below (in thousands of dollars):

Sept.
Accounts reccivsblc bal~nce (at beginnins of month) Planned payments of purchases (on assumption tliat ilisco~~nttnkcn) is Cast1 nccds for operations Cash surplus from operations

~ct.
$50

Nov.

Dec.

Jan.
$100
40

fib.

5 70
80

$ 70

$120
60 90

f 50
50

90 30

100 60

20

30

150

Tlie treasurer has three sources of short-term funds to rnect Racy's r~ccds. 'Tllcse arc:
1 . Pledge accolrtlts receivable. A local bank will loan Racy's funds on a month-by-month basis against a pledge on the accounts receivat)le balance at the beginning of a given month. The maximuni loan is 75% of the receivables in a given month. The cost of this loan is 1.5% per n ~ o n t h the amount borrowed. of 2. Stretch pqvrnent o f purchases. Payment of purchases can be delayed one month. Thus, for example, the $100,000 planned for payments for November could be delayed until December, and Racy's could use the funds to meet November needs. When purchase payments are thus

Itcprintcd with pcrrnission from Quanrltative Anal~~sir (lusirtess Decisions, 5th for c d . by ilicr~ilan, bonini, and llausman (Homewood, Ill.: Richard D. Irwin, Inc.),p. 277.

stretched, Racy's loses t h e 3% discount it n o r n ~ a l l yreceives for prornpt paylncnt. 3. Use sltort-tenn loan. A bank is willing to lerld Racy's a n y aniourlt frorn 540,000 t o $100,000 o n a 6-rnonll~ basis. 7 hc loan woulcl tic I ~ k t - 1oil1 1 in full in the beginning o f September for a fixed anlount and paid back in full a t the end o f February. I t would not he possible to urld to the loan o r t o pay off part of the loan during the period. The coc! of the loan would be 1% per m o n t h , payable each m o n t h .

In any period, if the firm has excess funds, tllcy can be ~ n v c s c c din short. term gctvernment securities that return 0.570 rnonrh. per The objective of t h e treasurer is t o minimize the net interest cost to Racy's while meeting the firm's cash needs.

Racy's Department Store Famulate t h e Racy's Department Store cash budgeting problem as a l i n e a r programming model, minimizing the financinc cost ~ f h i l e meeting a? 1 cask requirenents and loan r e s t r i c t i o n s . 1. Flote the fol lowing:

Planned payment figures assume pa-wlent f n the m o n t h due and

t h u s represent 97% of the face value of the payment.

2.

The accounts receivable balance i n a particular month represents those accounts which cannot be coll ected d u r l ng t h a t month. However, a local bank will loan Racy's up t o

75% of t h a t balance each month w f t h t h e i n t e r e s t and princ i pal due on t h e first day of t h e next month.

(This fs c a l l e d

"pledgf ng" accounts recievable.)

3.

The end-of-month cash needs o r surplus Includes on-tine payment of purchases. For exanple, i f a1 1 90,000 of

purchases f o r October a r e paid on time, there will be a 30,000 cash shortage i n l h a t month.
4.

I f t h e six-month loan i s taken out, i n t e r e s t payments s t a r t

i n October.