Chapter 15: P1
1. Pretty Lady Cosmetic Products has an average production process time of forty days. Finished goods are kept on hand for an average of fifteen days before they are sold. Accounts receivable are outstanding an average of thirty-five days, and the firm receives forty days of credit on its purchases from suppliers.
a. Estimate the average length of the firm’s short-term operating cycle. How often would the cycle turn over in a year?
· Cash conversion cycle CCC = DIO + DSO – DPO
· CCC = 15+35-40 = 10 days
· Operating cycle CC starts from the day the firm raw material for production till realization of sales.
· So OC = 40+15+35-40 = 50 days
b. Assume net sales of $1,200,000 and cost of goods sold of $900,000. Determine the average investment in accounts receivable, inventories, and accounts payable. What would be the net financing need considering only these three accounts?
· Annual Sales = $1200,000
· COGS = $900,000
· Days Inventory Outstanding (DIO): This addresses the question of how many days it takes to sell the entire inventory. The smaller this number is, the better.
· DIO = Average inventory/COGS per day = Average inventory/($900,000/365) = 15days
· So Average inventory = $36,986.30
· Days Sales Outstanding (DSO): This looks at the number of days needed to collect on sales and involves AR. While cash-only sales have a DSO of zero, people do use credit extended by the company, so this number is going to be positive. Again, smaller is better.
· DSO = Average AR / Revenue per day = Average AR/($1200,000/365) =35 days
· So Average AR = $115,068.50
· Days Payable Outstanding (DPO): This involves the company’s payment of its own bills or AP. If this can be maximized, the company holds onto cash longer, maximizing its investment potential; therefore, a longer DPO is better.
· DPO = Average AP / COGS per day = Average AP/($900,000/365) =40 days
· Average AP = $98,630.14
· So net financing needs = Average Inv + Average A/R – Average A/P = 36986.30+115068.50-98630.14 = $53,424.66
Chapter 16: P1
A supplier is offering your firm a cash discount of 2 percent if purchases are paid for within ten days; otherwise, the bill is due at the end of 60 days. Would you recommend borrowing from a bank at an 18 percent annual interest rate to take advantage of the cash discount offer? Explain your answer.
Nominal Rate = 2/(98*50/365) = 14.9%
Effective Rate = (1.1490)^(50/365) – 1 = 19.2%
Yes, I would recommend borrowing from a bank at an 18 percent annual interest rate because the effective rate of the cash discount is greater than the interest rate charged by the bank.