FN1 Module 8
Handout #1
Cash Flow Time Line
Operating and Cash Conversion Cycles
Cash
received
Inventory
sold
Inventory
purchased
Inventory period
Accounts receivable period
Time
Accounts payable period
Cash paid for
inventory
Operating cycle (OC)
Cash Conversion Cycle (CCC)
Class Example 1:
A company presently receives an average of $10,000 in cheques per day from its
customers. It presently takes the company an average of five days to receive and
deposit these cheques. It is considering a lockbox arrangement that would reduce its
collection float time by 3 days, at a cost of $50 per month. If the opportunity cost of
funds tied up in float is 8%, should it adopt the new system?
Solution:
Receivables decrease by 3 days * $10,000 = $30,000
Savings = annual cost of financing $30,000 in receivables = $30,000 * .08 = $2,400
Annual Cost of lockbox = $50 * 12 =$600
Therefore, they should adopt it since it will save them $2,400 – $600 = $1,800 per
year.
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FN1 Module 8
Handout #1
Example 2: (past exam question)
WindJammer Inc. expects sales of $200,000, $250,000 and $400,000 in the months of
October, November, and December, respectively. All sales are on credit. Based upon
historical patterns, WindJammer expects to collect 50% in the month of sale, 30% one
month after the sale, and the final 20% two months after the sale. WindJammer’s costs
equal 90% of sales and are paid in the month after the sales are made. Based upon these
projections, what is WindJammer’s expected cash flow for the month of December?
1)
2)
3)
4)
A cash shortfall of $90,000
A cash shortfall of $45,000
A cash surplus of $90,000
A cash surplus of $135,000
Step 1: Forecast the sources of cash. This includes sales revenue and other sources of
revenue.
Step 2: Determine the timing and amount of cash inflows from the above.
REMEMBER: SALES and CASH INFLOW may differ
Step 3: Forecast the uses of cash. This includes purchases for inventory, required
payments of salaries, wages, rent, etc.
Step 4: Determine the timing and amount of cash outflows from the above.
PURCHASES + EXPENSES DOES NOT EQUAL CASH OUTFLOW.
Step 5: Determine the net cash balance; compare to required cash levels, to determine
cash surpluses or shortfalls.
Sales
Collections:
Current month (50%)
Last month (30%)
2 Months ago (20%)
Oct.
200,000
Nov
250,000
Dec.
400,000
100,000
125,000
60,000
200,000
75,000
40,000
Total
Purchases
Payments
315,000
180,000
225,000
180,000
Net cash flow
360,000
225,000
90,000
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FN1 Module 8
Handout #1
Class Example 3:
ABC Inc. currently grants credit terms net 25. It is considering a new policy that involves
a more stringent credit policy: net 20. As a result, the price of its product will stay the
same at $45. The expected sales will decrease by 2,000 per year to 10,000 units.
Variable costs will remain at $37 per unit and bad debt losses can be reduced by
$1,000 per year to $2,000. ABC Inc. will finance the additional investment in
receivables using its line of credit, which charges 6.5 percent interest after tax, and its
tax rate is 40 percent. Should ABC Inc. switch to the new policy?
Solution:
Identify incremental cash flows:
Sales will decrease by:
2,000 * 45
Variable costs will decrease by: 2,000 * 37
Bad debts will decrease by:
1,000
Taxes will decrease by:
Operating income will decrease by:
$ (90,000)
74,000
1,000
(15,000)
6,000
$( 9,000)
Old A/R = CP X CSPD
= 25 * 45*12,000/365 = 36,986.30
New A/R = CP X CSPD
= 20 * 45 * 10,000/365 = 24,657.53
Difference = 12,328.77 – this difference in A/R is NOT THE BENEFIT!!!
Opportunity cost/benefit = 0.065 * 12,328.77 = 801.37
Conclusion: Do not switch to the new policy.
Class Example 4
There are two suppliers of one input for a factory. Supplier A credit terms are 3/10,
net 75 days. Supplier B credit terms are 2/15, net 50 days. Both suppliers offer the
same good at the same price, and the current borrowing rates are 12%.
Which supplier should the firm buy from, and when should the payment be made?
Solution:
Assume for these types of questions that if the payment is made early, the firm will use
the line of credit or bank loan at 12%.
Analysis:
What are the choices available to the firm?
1. Pay Supplier A 97% in 10 days
2. Pay Supplier A 100% in 75 days
3. Pay Supplier B 98% in 15 days
4. Pay Supplier B 100% in 50 days.
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FN1 Module 8
Handout #1
Step 1: Determine the cost of the missed discount for each supplier, and compare this
cost to the current borrowing rate of 12%
Cost of missed discount = [1/(1-d)]n – 1
Supplier A:
n = 365/(75-10) = 5.6154
d = 3%
Cost of missed discount = [1/0.97]5.6154 - 1= 18.65%
Conclusion: It would be cheaper to borrow from the bank at 12% and pay early.
Supplier B:
n = 365/(50-15) = 10.4286
d = 2%
Cost of missed discount = [1/0.98]10.4286 – 1 = 23.45%
Conclusion: It would be cheaper to borrow from the bank at 12% and pay early.
Step 2:
Now that we have determined the cheapest option from each supplier, we must now
decide which supplier to purchase from. Remember, the firm is better off the less they
have to pay, but $1 paid in 10 days is better than $1 paid today.
What are the options?
1. Pay Supplier A 97% in 10 days
2. Pay Supplier B 98% in 15 days
For every $100, Supplier A costs $1 less BUT payment has to be made 5 days sooner.
How can we compare these two payments that occur at different times? By converting
them to economically equivalent values using discounting/compounding.
As long as we state the $ values at the same point in time, we can directly compare them.
Let’s discount both of the payments to time 0.
What is the appropriate discount rate? The bank rate is the opportunity cost, as it
represents the best alternative cost.
We need to determine the daily effective period rate that is economically equivalent to
12% EAR.
Using the equation: r = [1 + i/m]m/f – 1
i = 12%
m=1
f = 365
r = [1.12]1/365 – 1 = 0.03105%
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FN1 Module 8
Handout #1
PV of 97 in 10 days: = 97/(1.0003105)10 = 96.70
PV of 98 in 15 days = 98/(1.0003105)15 = 97.54
Conclusion: As Supplier A is cheaper, purchase from Supplier A, taking advantage of
the discount.
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