Chaset Corporation obtains average cash receipts of P200,000 per day. It usually takes 5 days from the time a
check is mailed to its availability for use. The amount tied up by the delay is:
5 days x P200,000 ¼ = P1,000,000
Page 1 of 44
It takes Travis Corporation about 7 days to receive and deposit payments from customers. Therefore, a lockbox
system is being considered. It is expected that the system will reduce the float time to 5 days. Average daily
collections are P500,000. The rate of return is 12 percent.
The reduction in outstanding cash balances arising from implementing the lockbox system is:
2 days x P500,000 ¼ = P1,000,000
The return that could be earned on these funds is:
P1,000,000 x 0.12 = P120,000
The maximum monthly charge the company should pay for this lockbox arrangement is therefore:
P120,000/12 = P10,000
Page 2 of 44
Charles Corporation is exploring the use of a lockbox system that will cost P100,000 per year. Daily collections
average P350,000. The lockbox arrangement will reduce the float period by 2 days. The firm’s rate of return is 15
percent.
Return on early collection of cash
0.15x2xP350,000 =
Cost
Advantage of lockbox
P105,000
100,000
P 5,000
Page 3 of 44
Travis Company has an agreement with Charter Bank in which the bank handles P3 million in collections a day and
requires a P700,000 compensating balance. Travis is thinking of canceling the agreement and dividing its western
region so that two other banks will handle its business instead. Bank A will handle P1 million a day of collections,
requiring a compensating balance of P300,000, and bank B will handle the other P2 million a day, asking for a
compensating balance of P500,000. Travis’s financial manager anticipates that collections will be accelerated ¼
day if the western region is divided. The company’s rate of return is 14 percent.
Acceleration in cash receipts
P3 million per day x ¼ day
Additional compensating balance required
Increased cash flow
Rate of return
Net annual savings
P750,000
100,000
P650,000
x
0.14
P 91,000
Page 4 of 44
Every 2 weeks, company X disburses checks that average P500,000 and take 3 days to clear. How much money
can the company save annually if it delays transfer of funds from an interest-bearing account that pays 0.0384
percent per day (annual rate of 14 percent) for those 3 days?
The interest for 3 days is:
P500,000 x (0:000384 x 3) = P576
The number of 2-week periods in a year is:
52 weeks/2 weeks = 26
The savings per year is:
P576 x 26 = P14,976
Opportunity Cost of Forgoing a Cash Discount
An opportunity cost is the net revenue lost by rejecting an alternative action. A firm should typically take
advantage of a discount offered by a creditor because of the associated high opportunity cost. For example, if the
terms of sale are 2/10, net/30, the customer has 30 days to pay the bill but will get a 2 percent discount if he or
she pays in 10 days. Some companies use seasonal datings such as 2/10, net/30, July 1 dating. Here, with an invoice
dated July 1, the discount can be taken until July 10.
The following formula may be used to compute the opportunity cost in percentage, on an annual basis, of not
taking a discount:
Page 5 of 44
The numerator of the first term (discount percent) is the cost per peso of credit, whereas the denominator (100discount percent) represents the money made available by forgoing the cash discount. The second term
represents the number of times this cost is incurred in a year.
The opportunity cost of not taking a discount when the terms are 3/15, net/60 is computed as
Determination of the Optimal Cash Balance
1. Baumol’s Model
2. Miller-Orr Model
Baumol’s Model
Page 6 of 44
You estimate a cash need for P4,000,000 over a 1-month period where the cash account is expected to be
disbursed at a constant rate. The opportunity interest rate is 6 percent per annum or 0.5 percent for a 1-month
period. The transaction cost each time you borrow or withdraw is P100.
Page 7 of 44
Miller-Orr Model
Delta Inc. has experienced a stochastic demand for its product, which results in fluctuating cash balances
randomly. The following information supplied:
Fixed cost of a securities transaction
P10
Variance of daily net cash flows
P50
Daily interest rate on securities (10%/360)
0.0003
Page 8 of 44
Lakeside Corporation provides the following data:
Current annual credit sales
P12,000,000
Collection period
2 months
Terms
net/30
Rate of return
15%
Lakeside proposes to offer a 3/10, net/30 discount. The corporation anticipates 25 percent of its customers will
take advantage of the discount. As a result of the discount policy, the collection period will be reduced to 1½
months. Should Lakeside offer the new terms?
Page 9 of 44
TGD Corporation has three credit categories (X, Y, Z) and is considering changing its credit policy for categories Y
and Z. The pertinent data are:
Gross profit approximates 15 percent of sales. The rate of return is 16 percent. Should credit be eased for both
categories?
Page 10 of 44
A company purchases 1,000 units of an item having a list price of P10 each. The quantity discount is 5 percent.
The net cost of the item is:
Page 11 of 44
Savon Corporation places an order for 5,000 units at the beginning of the year. Each unit costs P10. The average
investment is:
Carrying Cost and Ordering Cost
Page 12 of 44
Economic Order Quantity (EOQ)
Winston Corporation needs to know how frequently to place their orders. They provide the following information:
S = 500 units per month
P = P40 per order
C = P4 per unit
Page 13 of 44
Apex Appliance Store is determining its frequency of orders for toasters. Each toaster costs P15. The annual
carrying costs are approximated at P200. The ordering cost is P10. Apex expects to sell 50 toasters each month.
Its desired average inventory level is 40.
Page 14 of 44
Stockouts
Tristar Corporation uses 100,000 units annually. Each order placed is for 10,000 units. Stockout is 1,000 units; this
amount is the difference between the maximum daily usage during the lead time less the reorder point, ignoring
a safety stock factor. The stockout probability management wishes to take is 30 percent. The per-unit stockout
cost is P2.30. The carrying cost per unit is P5. The inventory manager must determine (a) the stockout cost and
(b) the amount of safety stock to keep on hand.
Page 15 of 44
Economic Order Point (EOP)
Blake Corporation provides the following data:
S = 2,000 units per month
EOQ = 75 units
L = ¼ of a month
z = 1.29; which represents the acceptable stockout level of 10 percent
Page 16 of 44
Frost Corporation is thinking of revising its inventory policy. The current inventory turnover is 16 times. Variable
costs are 70 percent of sales. If inventory levels are increased, Frost anticipates additional sales generated and
less of an incidence of inventory stockouts. The rate of return is 17 percent. Actual and estimated sales and
inventory turnover are as follows:
Sales (P)
Turnover
700,000
16
780,000
14
850,000
11
940,000
7
Frost’s financial manager can now compute the inventory level that will result in the highest net savings.
Page 17 of 44
Ajax Corporation issues P300,000 worth of 18 percent, 90-day commercial paper. However, the funds are needed
for only 70 days. The excess funds can be invested in securities earning 17 percent. The brokerage fee associated
with the marketable security transaction is 1.5 percent. The peso cost to the company in issuing the commercial
paper is:
Page 18 of 44
Charles Corporation anticipates it will need P500,000 cash for February 20X2 in order to purchase inventory. There
are three ways to finance this purchase, as follows:
a. Set up a 1-year credit line for P500,000. The bank requires a 1 percent commitment fee. The interest rate
is 18 percent on borrowed funds. Funds are needed for 30 days.
b. Do not take advantage of a 1/10, net/40 discount on a P500,000 credit purchase.
c. Issue P500,000 of commercial paper for 30 days at 17 percent.
Which is the least expensive method of financing?
Page 19 of 44
Inventory Financing
Jackson Corporation wishes to finance its P500,000 inventory. Funds are needed for 3 months. A warehouse
receipt loan may be taken at 16 percent with a 90 percent advance against the inventory’s value. The warehousing
cost is P4,000 for the 3-month period. The cost of financing the inventory is:
Page 20 of 44
Commercial Paper
Nelson Corporation issues P800,000 of commercial paper every 3 months at a 16 percent rate. Each issuance
involves a placement cost of P2,000. What is the annual percentage cost of the commercial paper?
Page 21 of 44
Float
Jumpdisk Company writes checks averaging $15,000 a day, and it takes five days for these checks to clear. The firm also
receives checks in the amount of $17,000 per day, but the firm loses three days while its receipts are being deposited
and cleared. What is the firm’s net float in dollars?
Positive disbursement float = $15,000(5) = $75,000.
Negative collections float = $17,000(3) = $51,000.
Net float = $75,000 - $51,000 = $24,000.
Page 22 of 44
Accounts receivable balance
If Hot Tubs Inc. had sales of $2,027,773 per year (all credit) and its days sales outstanding was equal to 35 days, what
was its average amount of accounts receivable outstanding? (Assume a 365-day year.)
Accounts receivables = DSO  Sales per day = 35($2,027,773/365) = $194,444.
Page 23 of 44
Inventory conversion period
A firm has $5,000,000 of inventory on average and annual sales of $30,000,000.
Assume there are 365 days per year. What is the firm’s inventory conversion period?
Inventory
Sales/365
$5,000,000
=
$30,000,000/365
Inventory conversion period =
= 60.83 days.
Page 24 of 44
Payables deferral period
Ammer Products has an average accounts payable balance of $850,000 and its annual
cost of goods sold is $8,750,000. Assume there are 365 days per year. What is
Ammer’s payables deferral period?
Payables
Cost of goods sold/365
$850,000
=
$8,750,000/365
Payables deferral period =
= 35.46 days.
Page 25 of 44
Cash conversion cycle
Spartan Sporting Goods has $5 million in inventory and $2 million in accounts
receivable. Its average daily sales are $100,000. The company’s payables deferral
period (accounts payable divided by daily purchases) is 30 days. What is the
length of the company’s cash conversion cycle?
Facts given: Payables deferral period = 30 days; Inv = $5,000,000; Rec. = $2,000,000; ADS = $100,000.
Cash conversion Inv. conversion Rec. collection Pay. deferral
=
+
–
.
cycle
period
period
period
Step 1:
Determine the inventory conversion period:
Inventory conversion period
= Inventory/Daily sales
= $5,000,000/$100,000
= 50 days.
Step 2:
Determine the receivables collection period:
Receivables collection period
= Receivables/Daily sales
= $2,000,000/$100,000
= 20 days.
Step 3:
Given data and information calculated above, determine the firm’s cash conversion cycle:
Cash conversion cycle
= 50 + 20 - 30
= 40 days.
Page 26 of 44
Cash conversion cycle
For the Cook County Company, the average age of accounts receivable is 60 days, the average age of accounts payable
is 45 days, and the average age of inventory is 72 days. Assuming a 365-day year, what is the length of the firm’s cash
conversion cycle?
Cash conversion
conversion Rec. collection Pay. deferral
= Inv. period
+
–
cycle
period
period
= 72 + 60 - 45 = 87 days.
Page 27 of 44
Cash conversion cycle
Kolan Inc. has annual sales of $36,500,000 ($100,000 a day on a 365-day basis). On average, the company has
$12,000,000 in inventory and $8,000,000 in accounts receivable. The company is looking for ways to shorten its cash
conversion cycle, which is calculated on a 365-day basis. Its CFO has proposed new policies that would result in a 20
percent reduction in both average inventories and accounts receivables. The company anticipates that these policies
will also reduce sales by 10 percent. Accounts payable will remain unchanged. What effect would these policies have
on the company’s cash conversion cycle?
Cash conversion Inv. conversion Rec. collection Pay. deferral
=
+
–
.
cycle
period
period
period
For this problem we are only interested in the change in the CCC. We
may therefore ignore the Payables Deferral Period since it is assumed
to remain unchanged.
Old CCC (ignore payables) = $12,000,000/$100,000 + $8,000,000/$100,000
= 120 + 80 = 200 days.
New CCC = $9,600,000/$90,000 + $6,400,000/$90,000
= 106.67 + 71.11 = 177.78 days.
Change in CCC = New CCC – Old CCC
= 177.78 – 200
= -22.22 days. Round to 22 days shorter.
Page 28 of 44
Cash conversion cycle
Gaston Piston Corp. has annual sales of $50,735,000 and maintains an average inventory level of $15,012,000. The
average accounts receivable balance outstanding is $10,008,000. The company makes all purchases on credit and has
always paid on the 30th day. The company is now going to take full advantage of trade credit and pay its suppliers on
the 40th day. If sales can be maintained at existing levels but inventory can be lowered by $1,946,000 and accounts
receivable lowered by $1,946,000, what will be the net change in the cash conversion cycle? (Assume there are 365
days in the year.)
First, calculate Sales/Day = $50,735,000/365 = $139,000.
Then, calculate the old inventory conversion period:
Inventory/Sales per day = $15,012,000/$139,000 = 108 days.
Then, find the new inventory conversion period:
$13,066,000/$139,000 = 94 days.
We have cut the inventory conversion period by 108 – 94 = 14 days.
Then, calculate the old DSO:
Accts. Rec./Sales per day = $10,008,000/$139,000 = 72 days.
Then, find the new DSO = $8,062,000/$139,000 = 58 days.
We have cut the DSO by 72 – 58 = 14 days.
Finally, find the total net change = -14 + (-14) – 10 = -38 days.
Page 29 of 44
Lockbox
Cross Collectibles currently fills mail orders from all over the U.S. and receipts come in to headquarters in Little Rock, Arkansas.
The firm’s average accounts receivable (A/R) is $2.5 million and is financed by a bank loan with 11 percent annual interest.
Cross is considering a regional lockbox system to speed up collections that it believes will reduce A/R by 20 percent. The
annual cost of the system is $15,000. What is the estimated net annual savings to the firm from implementing the lockbox
system?
Calculate the net reduction in A/R:
Current A/R = $2,500,000. New A/R with 20% reduction:
$2,500,000 - 0.20($2,500,000) = $2,000,000.
Net reduction in A/R = $500,000.
Calculate the interest savings and net savings:
Interest savings = $500,000(0.11) = $55,000.
Net savings = Interest savings - Annual lockbox cost
= $55,000 - $15,000 = $40,000.
Page 30 of 44
Maturity matching
Wildthing Amusement Company’s total assets fluctuate between $320,000 and $410,000, while its fixed assets remain
constant at $260,000. If the firm follows a maturity matching or moderate working capital financing policy, what is the
likely level of its long-term financing?
A maturity matching policy implies that fixed assets and permanent
current assets are financed with long-term sources. Thus, since the
minimum balance that total assets approach is $320,000, and $260,000 of
that balance is fixed assets, permanent current assets equal $60,000.
The likely level of long-term financing is $320,000.
Long-term debt financing = Permanent cash assets + Fixed assets.
Permanent cash assets = Low end of total assets - Fixed assets
= $320,000 - $260,000 = $60,000.
Long-term debt financing = $60,000 + $260,000 = $320,000.
Page 31 of 44
Cost of trade credit
A firm is offered trade credit terms of 3/15, net 45 days. The firm does not take the discount, and it pays after 67 days.
What is the nominal annual cost of not taking the discount? (Assume a 365-day year.)
Nominal percentage cost =
365
3

= 21.71%.
97
52
Page 32 of 44
Cost of trade credit
Dixie Tours Inc. buys on terms of 2/15, net 30 days. It does not take discounts, and it typically pays 35 days after the
invoice date. Net purchases amount to $720,000 per year. What is the nominal annual cost of its non-free trade credit?
(Assume a 365-day year.)
Nominal percentage cost =
2
365

= 37.24%.
98
35 - 15
Page 33 of 44
Cost of trade credit
Your company has been offered credit terms on its purchases of 4/30, net 90 days. What will be the nominal annual
cost of trade credit if your company pays on the 35th day after receiving the invoice? (Assume a 365-day year.)
365 
4
Nominal percentage cost =   
 = 3.042 = 304.2%.
 96   5 
Page 34 of 44
Free trade credit
Phillips Glass Company buys on terms of 2/15, net 30 days. It does not take discounts, and it typically pays 30 days after
the invoice date. Net purchases amount to $730,000 per year. On average, how much “free” trade credit does Phillips
receive during the year? (Assume a 365-day year.)
Daily purchases =
$730,000
= $2,000.
365
Free trade credit = $2,000  15 = $30,000.
Page 35 of 44
Free trade credit
HBC Inc. buys on terms of 2/10, net 30 days. It does not take discounts, and it typically pays 30 days after the invoice
date. Net purchases amount to $1,750,000 per year. On average, how much “free” trade credit does HBC receive
during the year? (Assume a 365-day year.)
Daily purchases =
$1,750,000
= $4,794.52.
365
Free trade credit = $4,794.52  10 = $47,945.21.
Page 36 of 44
Nominal interest rate
Coverall Carpets Inc. is planning to borrow $12,000 from the bank. The bank offers the choice of a 12 percent discount
interest loan or a 10.19 percent add-on, 1-year installment loan, payable in 4 equal quarterly payments. What is the
approximate (nominal) rate of interest on the 10.19 percent add-on loan?
Total to be repaid = $12,000(1.1019) = $13,222.80.
Interest = $13,222.80 - $12,000 = $1,222.80.
Approximate rateAdd-on =
$1,222.80
= 0.2038 = 20.38%.
$12,000 / 2
Page 37 of 44
Discount interest face value
Picard Orchards requires a $100,000 annual loan in order to pay laborers to tend and harvest its fruit crop. Picard
borrows on a discount interest basis at a nominal annual rate of 11 percent. If Picard must actually receive $100,000
net proceeds to finance its crop, then what must be the face value of the note?
Funds required
1.0 - Nominal rate (decimal)
$100,000
$100,000
=
=
= $112,359.55  $112,360.
1.0 - 0.11
0.89
Face value =
Page 38 of 44
Discount interest face value
Viking Farms harvests crops in roughly 90-day cycles based on a 360-day year. The firm receives payment from its
harvests sometime after shipment. Due in part to the firm’s rapid growth, it has been borrowing to finance its harvests
using 90-day bank notes on which the firm pays 12 percent discount interest. If the firm requires $60,000 in proceeds
from each note, what must be the face value of each note?
Convert the annual rate to a periodic rate (quarterly) in the denominator
of the face value formula:
Funds required
1.0 - Nominal rate _ 90 / 360
$60,000
$60,000
=
=
= $61,855.67  $61,856.
0.97
1.0 - 0.12(0.25)
Face value =
Page 39 of 44
Revolving credit agreement cost
Inland Oil arranged a $10,000,000 revolving credit agreement with a group of small banks. The firm paid an annual
commitment fee of one-half of one percent of the unused balance of the loan commitment. On the used portion of the
loan, Inland paid 1.5 percent above prime for the funds actually borrowed on an annual, simple interest basis. The
prime rate was at 9 percent for the year. If Inland borrowed $6,000,000 immediately after the agreement was signed
and repaid the loan at the end of one year, what was the total dollar cost of the loan agreement for one year?
Interest rate on borrowed funds = 0.09 + 0.015 = 10.5%.
Cost of unused portion: $4,000,000  0.005 = $ 20,000
Cost of used portion:
$6,000,000  0.105 = 630,000
Total cost of loan agreement
$650,000
Page 40 of 44
Accounts payable balance
Your firm buys on credit terms of 2/10, net 45 days, and it always pays on Day 45. If you calculate that this policy
effectively costs your firm $159,621 each year, what is the firm’s average accounts payable balance? (Hint: Use the
nominal cost of trade credit and carry its cost out to 6 decimal places.)
Approximate percentage cost =
Accounts payable =
365
2

= 0.212828.
98
35
$159,621
= $750,000.
0.212828
Page 41 of 44
Costly trade credit
Phranklin Pharms Inc. purchases merchandise from a company that gives sales terms of 2/15, net 40 days. Phranklin
Pharms has gross purchases of $819,388 per year. What is the maximum amount of costly trade credit Phranklin could
get, assuming it abides by the supplier’s credit terms? (Assume a 365-day year.)
Phranklin’s net purchases are $819,388  (1 - 0.02) = $803,000. Purchases
per day are $803,000/365 = $2,200.00. Total trade credit is 40  $2,200
= $88,000. Free trade credit is 15  $2,200 = $33,000. Thus, costly
trade credit, assuming discounts are taken, is $88,000 - $33,000 =
$55,000. If discounts are not taken, then the maximum amount of costly
trade credit is $88,000.
Page 42 of 44
Stretching accounts payable
C+ Notes’ business is booming, and it needs to raise more capital. The company purchases supplies from a single
supplier on terms of 1/10, net 20 days, and it currently takes the discount. One way of getting the needed funds would
be to forgo the discount, and C+’s owner believes she could delay payment to 40 days without adverse effects. What
is the effective annual rate of stretching the accounts payable?
Accounts payable: (1/99)(365/(40 - 10)) = 12.29%.
nominal rate. EAR is calculated as follows:
EAR = (1 + 1/99)12.1667 - 1 = 13.01%.
However, this is a
Page 43 of 44
Revolving credit agreement
Weiss Inc. arranged a $9,000,000 revolving credit agreement with a group of banks. The firm paid an annual
commitment fee of 0.5% of the unused balance of the loan commitment. On the used portion of the revolver, it
paid 1.5% above prime for the funds actually borrowed on a simple interest basis. The prime rate was 3.25%
during the year. If the firm borrowed $6,000,000 immediately after the agreement was signed and repaid the
loan at the end of one year, what was the total dollar annual cost of the revolver?
Total commitment
Fee on unused balance
Prime rate
Premium over prime
Amount borrowed
$9,000,000
0.50%
3.25%
1.50%
$6,000,000
Interest rate on borrowed funds = Prime + Premium =
Cost of used portion = Amount borrowed × Rate =
Cost of unused portion: Unused balance × Fee =
Total annual cost of loan agreement =
4.75%
$285,000
$15,000
$300,000
Alternative solution:
Rate per day = 4.75%/365 =
Interest per day = (Rate per day)(Amount borrowed) =
Interest per year = (Interest per day)(365) =
Cost of unused portion: Unused balance × Fee =
Total annual cost of loan agreement =
0.0130137%
$781
$285,000
$15,000
$300,000
Page 44 of 44