TUTORIAL CHAPTER 15 & 16: WORKING CAPITAL MANAGEMENT & SHORT-TERM FINANCING
FNC3101 SEM I 2018/2019
Tutorial 3: Working Capital Management
P-15-1
Metal Supplies is concerned about its cash management. On average, the day’s sales in
inventory (duration of inventory on shelf) is 90 days. Accounts receivable are collected in 90
days, while accounts payable are paid in 60 days. Metal Supplies has annual sales of $14
million, cost of goods sold of $9.5 millions, and purchases of $5 million. (Note: Use a 365-day
year).
a. What is Metal Supplies’s operating cycle (OC)?
b. What is Metal Supplies’ cash conversion cycle?
c. What is the amount of resources needed to support Metal Supplies’ cash conversion
cycle?
d. What suggestion would you give Metal Supplies to reduce its cash conversion cycle?
ANSWER:
a. OC  Average age of inventory  Average collection period
 90  90
 180 days
b. CCC = OC ‒ Average payment period
= 180 ‒ 60
= 120 days
c. Inventory
 $9,500,000  (90 / 365) = $2,342,466
Accounts receivable
 $14,000,000  (90 / 365) = $3,452,055
Accounts payable  $5,000,000  (60 / 365) = $821,918
Resources
 Inventory  Accounts receivable ‒ Accounts payable
 $2,342,466  $3,452,055 − $821,918
 $4,972,603
d.
 Turn inventory as quickly as possible without stockouts that result in lost sales.
 Collect accounts receivable as quickly as possible without losing sales from highpressure collection techniques.
 Manage mail, processing, and clearing time to reduce them when collecting from
customers and to increase them when paying suppliers.
 Pay accounts payable as slowly as possible without damaging the firm’s credit
rating or its relationships with suppliers.
TUTORIAL CHAPTER 15 & 16: WORKING CAPITAL MANAGEMENT & SHORT-TERM FINANCING
FNC3101 SEM I 2018/2019
E15-3
Cohen Industrial Products uses 2,100 switch assemblies per month and then reorders another
2,100. The relevant carrying cost per switch assembly is $20 every year, and the fixed order
cost is $300. The plant operates 250 days in a year and maintains a safety stock of 2 days’
worth of switch assemblies since the lead time to receive orders is 3 days. Calculate the
economic order quantity (EOQ) and the reorder point.
Answer:
EOQ 

2 S O
C
2  12  2,100  300
20
 756,000
 869.48
 870 switch assemblies
Reorder point = Days of lead time  Daily usage  Safety stock
= 3  [{(2,100 12) / 250)}]  [2  {(2,100  12) / 250}]
= 504 switch assemblies
P15-11
Pebbles & Stones Enterprises currently sells on credit only and does not offer any discounts.
In an attempt to increase sales, the board is considering offering a 5% discount for payment
within 15 days. Currently, the average collection period is 60 days, sales are 30,000 units,
selling price is $40 per unit, and variable cost per unit is $32. If the discount is implemented,
it is expected that sales will increase to 38,000 units, 80% of sales will take the discount, and
the average collection period will fall to 30 days. The firm’s required rate of return is 20%.
Should the proposed discount be offered? (Note: Use a 365-day year).
ANSWER:
Additional profit contribution from sales
Current credit sales (units) = 30,000 units
Current credit sales = $1,200,000
New credit sales (units) = 38,000 units
New credit sales = $1,520,000
Increase in credit sales = $320,000 (8,000 units)
Profit per unit = $40  $32 = $8
Additional profit = $64,000
Average investment under present plan = ($32  30,000) / (365 / 60)
= $157,808.22
Average investment under proposed plan = ($32 38,000) / (365 / 30)
= $99,945.21
Reduction in accounts receivable investment = $57,863.01
Cost savings from reduced investment in accounts receivable = 0.20 $57,863.01 =
$11,572.60
Cost of cash discount = (0.05  0.8  38,000 $40)
= $60,800
Net profit from initiation of proposed cash discount = $14,772.60
TUTORIAL CHAPTER 15 & 16: WORKING CAPITAL MANAGEMENT & SHORT-TERM FINANCING
FNC3101 SEM I 2018/2019
Yes, the proposed plan should be implemented as the net profit is $14,772.60.
P16-9
The Floral Boutique approached two banks to obtain a $10,0000 bank loan. Bank A will give
a 120 day loan at an annual rate of 12% while Bank B will give a 90 day loan at an annual
rate of 15%. (Note: Assume a 365 day year.)
a) Based on the amount of interest to be paid, which bank loan should The Floral Boutique
choose?
b) Compare the 120-day and 90-day rates on the loans by finding the effective annual
rate for each loan. Assume each loan is rolled over throughout the year under the
same terms and circumstances.
c) Based on the effective annual rate for each loan, which bank loan should The Floral
Boutique choose?
ANSWER:
a. InterestA = ($10,000  0.12)  (120 / 365)
= $394.52
InterestB = ($10,000  0.15)  (90 / 365)
= $369.86
Bank B – lower interest payment.
b. Effective 120-day rate = $394.52 / $10,000
= 3.95%
Effective 90-day rate = $369.86 / $10,000
= 3.70%
c. Effective annual rateA = (1  0.0395)3 ‒ 1
= 12.32%
Effective annual rateA = (1  0.0370)4 ‒ 1
= 15.64%
Bank A – lower effective annual rate charged.
TUTORIAL CHAPTER 15 & 16: WORKING CAPITAL MANAGEMENT & SHORT-TERM FINANCING
FNC3101 SEM I 2018/2019
P16-12
Charlton Enterprises negotiated a line of credit at the bank that requires it pay 12.5% interest
on its borrowing. The firm is required to maintain a compensating balance equal to 10% of
the amount borrowed. The firm borrowed $500,000 during the year.
a. Calculate the effective annual rate on the firm’s borrowing if the firm normally
maintains no deposit balances at the bank.
b. Calculate the effective annual rate on the bank’s borrowing if the firm normally
maintains a deposit balance of $45,000 at the bank
c. Calculate the effective annual rate on the firm’s borrowing if the firm normally
maintains a deposit balance of $145,000 at the bank.
d. What is the change in the effective annual rate when the deposit balances increase?
ANSWER:
a. Compensating balance requirement = $500,000  0.1
= $50,000
Amount of loan available for use = $500,000  $50,000
= $450,000
Interest paid = $500,000  0.125
= $62,500
Effective interest rate = $62,500 / $450,000
= 13.89%
b. Additional balances required = $50,000  45,000
= $5,000
Effective interest rate = $62,500 / (500,000  5,000)
= 12.63%
c. Effective interest rate = 12.5%
d.
The lowest effective interest rate occurs when the Charlton Enterprises has
$145,000 on deposit.