4. The Greek Connection had sales of $32 million in 2012, and a cost of goods sold
of $20 million. A simplified balance sheet for the firm appears below:
THE GREEK CONNECTION
Balance Sheet
As of December 31, 2012 (in $ thousand)
Assets
Cash
$ 1,500
$ 2,000
Accounts receivable
1000
3, 950
Inventory
1,220
Total Current Assets
$3720
1,300
$7,250
Liabilities and Equity
Accounts payable
Notes payable
Accruals
Total Current Liabilities
Long Term Debt
3000
Net plant, property,
6,720
and equipment
9,030
Total assets
15,750
Total liabilities
$ 8,500
$ 15,750
$
Common equity
Total liabilities and equity
$
a. Calculate The Greek Connection’s net working capital in 2012.
b. Calculate the cash conversion cycle of The Greek Connection in 2012.
c. The industry average accounts receivable days is 30 days. What would the cash
conversion cycle for The Greek Connection have been in 2012 had it matched the
industry average for accounts receivable days?
a. Calculate The Greek Connection’s net working capital in 2012.
Greek Connection = 7,250 – 3,720 = 3,530
b. Calculate the cash conversion cycle of The Greek Connection in 2012.
CCC = Days inventory outstanding + Days sales outstanding – Days payable
outstanding
= 1300/(20000/365) + 3950/(32000/365) – 1500/(20000/365)
= 23.7 + 45.1 – 27.4
= 41.4 days
c. The industry average accounts receivable days is 30 days. What would the cash
conversion cycle for The Greek Connection have been in 2012 had it matched the
industry average for accounts receivable days?
CCC = 23.7 + 30 – 27.4 = 26.3 Days
Trade Credit
5. Assume the credit terms offered to your firm by your suppliers are 3/5, Net 30.
Calculate the cost of the trade credit if your firm does not take the discount and pays
on day 30
Cost of Trade (EAR) = ( 1 + 3/97)^(365/25) - 1 = 56.00%
Interest rate per period = 3/97 = 3.09%
EAR = (1 + 3.09%)^(365/25) -1 = 55.94%)
6. Your supplier offers terms of 1/10, Net 45. What is the effective annual cost of
trade credit if you choose to forgo the discount and pay on day 45?
Cost of Trade (EAR) = ( 1 + 1/99)^(365/35) - 1 = 11.05%
10. The Manana Corporation had sales of $60 million this year. Its accounts
receivable balance averaged $2 million. How long, on average, does it take the firm
to collect on its sales?
Accounts receivable days = 2000000/(60000000/365) = 12.2 Days
14. Your firm purchases goods from its supplier on terms of 3/15, Net 40.
a. What is the effective annual cost to your firm if it chooses not to take the discount
and makes its payment on day 40?
EAR = ( 1 + 3/97)^(365/25) – 1 = 56%
b. What is the effective annual cost to your firm if it chooses not to take the discount
and makes its payment on day 50?
EAR = ( 1 + 3/97)^(365/35) – 1 = 37.39%
17. Which of the following short-term securities would you expect to offer the highest
before-tax return: Treasury bills, certificates of deposit, short-term tax exempts, or
commercial paper? Why?
Commercial paper will offer highest before-tax return as its return is taxable and it
carried risk of default as well. Treasury bills and certificates of deposit are
considered to free of default risk whereas short-term tax exempts are free from
federal taxation.
19. Heavy Metal Corporation is expected to generate the following free cash flows
over the next five years:
Year
FCF($millions)
1
53
2
68
3
78
4
75
5
82
After then, the free cash flows are expected to grow at the industry average of 4%
per year. Using the discounted free cash flow model and a weighted average cost of
capital of 14%:
a. Estimate the enterprise value of Heavy Metal.
Value to End of Year 4 = 82/(14%-4%) = $820
Value
= 53 / 1.14 + 68/(1.14^2) + 78 /(1.14^3) + (75 + 820) /(1.14^4)
= $681.37
b. If Heavy Metal has no excess cash, debt of $300 million, and 40 million shares
outstanding, estimate its share price.
Price = (681.37-300)/40 = $9.53
D.1 How does management determine the total amount of working capital required?
The net working capital requirement will vary from company to company. And within
the company itself it may vary from month to month. It depends on two factors
namely, how much earnings a company has and what is the frequency of receiving
those earnings. Secondly, what are the expenses that a company has and how
frequently these payments have to be settled.
For determining how to calculate working capital for a new investment, the business
managers have to make forecasts of the earnings i.e. accounts receivable and
inventory as well as the expenses i.e. accounts payable. After the projections have
been made, you have to compare the actual earning and expenses with the
projections. Next, add the increase in accounts receivable and the increase in
inventory and subtract the accounts payable from this amount. The figure you then
get will reflect the probable change in working capital which can be used for the new
investment.
Change in working capital is also determined through the inflow and outflow of funds.
So these two things should also be taken into consideration while calculating the
working capital requirements. The mathematical formula for this is:
Working Capital Required = (Increase in accounts receivable + Increase in inventory
+ Cash inflows i.e. cash in bank, bank loan, other current assets) - (Increase in
accounts payable + Cash outflows i.e. prepaid expenses, payment to suppliers, other
current liabilities)
a. What are the two principal reasons for holding cash? Can a firm estimate it's
target cash balance by summing the cash held to satisfy each of the two
reasons?
The two principal reasons for holding cash are for transactions and
compensating balances. The target cash balance is not equal to the sum of
the holdings for each reason because the same money can often partially
satisfy both motives.
b. What are the advantages of matching the maturities of assets and liabilities? What
are the disadvantages?
The matching approach for meeting the financing needs of the company states that
fluctuating assets should be financed by the short term sources of financing while the
long term i.e. fixed assets of the business should be financed by the long term
sources of financing. The firm can maintain an optimum balance between the
liquidity and profitability by matching the maturity of the assets with the maturity of
the liabilities. However there is some difficulty in implementing this approach. It is not
always possible to finance the short term assets with short term financing or long
term assets with long term financing. The bank may not be willing to lend to the
company or the debtors may not pay the receivables on time.
D.2 How does management determine how working capital should be financed?
There are mainly 3 approaches to determine financing of working capital.
1) Hedging approach or matching approach: this approach means matching the
maturities of debt with the maturity of financial needs. It means the sources of funds
should match with the nature of assets to be financed. There are two types of
working capital permanent and temporary working capital. The hedging approach
suggests that the permanent working capital requirement should be financed through
long term funds, while temporary working capital should be financed through the
short term funds. There is low cost, high risk and high profit in this approach.
2) Conservative approach: as the name suggests it is a conservative approach
which suggests that the entire requirement of current assets should be financed
through long term sources and short term sources should be used only in case of
emergency. There is high cost, low risk and low profit in this approach.
3) Aggressive approach: as the name suggests it is an aggressive approach which
suggests that the entire requirement of current assets should be financed through
short term sources. There is low cost, high risk and high profit in this approach.
a. What are the four elements of a firm's credit policy? To what extent can firms
set their own credit policies as opposed to accepting policies that are dictated
by its competitors?
The four elements in a firm’s credit policy are (1) credit standards,
(2) credit period, (3) discount policy, and (4) collection policy. The firm is not
required to accept the credit policies employed by its competition,but the optimal
credit policy cannot be determined without considering competitors’ credit
policies. A firm’s credit policy has an important influence on its volume of sales,
and thus on its profitability
b. From, the standpoint of the borrower, is long-term or short-term credit riskier?
Please explain.
From the standpoint of the borrower, short-term credit is riskier because shortterm interest rates fluctuate more than long-term rates, and the company may be
unable to repay the debt. If the lender will not extend the loan, the company could
possibly be forced into bankruptcy.