FIN2101 BUSINESS FINANCE II MODULE 4- WORKING CAPITAL MANAGEMENT (Week 2) QUESTION 1 Undercounter Wholesalers Ltd currently sells entirely on a cash basis. Undercounter's management is considering introducing cred it sales with discounts to attract new customers The company is considering two alternative options. The first is offering discount terms of 2.5/30, n/60. It is estimated this would increase sales by $500 000 and 30% of these would take advantage of the discount. The second option is discount terms of 10/30, n/ 60, a policy which would increase sales by $600 000 with 50% of these customers taking the discount The variable cost of sales is 75% of sales. The company's required rate of return on all accounts receivable is 1% per month. Undercounter's exis ting custo mers will not seek the credit terms Using the NPV approach, ad vise Undercounter as to which discount policy it should adopt QUESTION 2 Starlight Industries Ltd has to date been a"cash only"company. Management is concerned however, that sales are slipping and is contemplating a move to offer credit in an effort to boost sales. At the moment sales are $1 500 000 per annum and it is anticipated that sales will increase to $2 250 000 per annum if cred it is offered. The firms accountant has prepared the following schedule for the payment of accounts by all customers(new and existing) I month from the time of sale% 2 months from the time of sale% 3 months from the time of sale% The remaining 5% of sales will result in bad debts which will not be collected The variable cost of sales is 75% of sales and these costs are paid at the same time that sales are made. Starlight,'s cost of capital is 1. 25%per month Using the NPv approach, advise management whether the company should proceed with the proposal to offer cred it terms
August 2003 FIN2101 BUSINESS FINANCE II MODULE 4 – WORKING CAPITAL MANAGEMENT (Week 2) QUESTION 1 Undercounter Wholesalers Ltd currently sells entirely on a cash basis. Undercounter's management is considering introducing credit sales with discounts to attract new customers. The company is considering two alternative options. The first is offering discount terms of 2.5/30, n/60. It is estimated this would increase sales by $500 000 and 30% of these would take advantage of the discount. The second option is discount terms of 10/30, n/60, a policy which would increase sales by $600 000 with 50% of these customers taking the discount. The variable cost of sales is 75% of sales. The company's required rate of return on all accounts receivable is 1% per month. Undercounter's existing customers will not seek the credit terms. Using the NPV approach, advise Undercounter as to which discount policy it should adopt. QUESTION 2 Starlight Industries Ltd has to date been a "cash only" company. Management is concerned, however, that sales are slipping and is contemplating a move to offer credit in an effort to boost sales. At the moment sales are $1 500 000 per annum and it is anticipated that sales will increase to $2 250 000 per annum if credit is offered. The firm's accountant has prepared the following schedule for the payment of accounts by all customers (new and existing): - 1 month from the time of sale - 35% - 2 months from the time of sale - 25% - 3 months from the time of sale - 35% The remaining 5% of sales will result in bad debts which will not be collected. The variable cost of sales is 75% of sales and these costs are paid at the same time that sales are made. Starlight's cost of capital is 1.25% per month. Using the NPV approach, advise management whether the company should proceed with the proposal to offer credit terms
QUESTION 3 In order to increase sales from their present annual level of $240 000, the Heap Corporation is considering a more liberal credit policy. Currently the firm has an average collection period of thirty(30)days. However, it is believed that as the collection period is lengthened, les will increase by the following amounts Credit Increase in Increase in Policy Average Collection Sales $10000 30 days 5000 45 days s17000 Note: Increases in sales are cumulative, not incremental, ie adopting po licy b will increase sales by another s5 000(from $10 000 to $15 000), while moving from policy b to policy C will increase sales by a further S2 000(from $15 000 to $17000) The firm has the following cost pattern at present Price of the only product manufactured $100 Variable costs per unit $0.60 Required (a) If the firm requires a pre-tax return on investment of 20%, which cred it policy should be pursued? Assume a 360-day year (b) The firms current bad debt loss is 1%of sales. The company has estimated that the following pattern of bad debts will prevail if it initiates more liberal credit terms Increase in ACP Bad Debts Given the other assumptions made, which cred it policy should be pursued?
August 2003 QUESTION 3 In order to increase sales from their present annual level of $240 000, the Heap Corporation is considering a more liberal credit policy. Currently the firm has an average collection period of thirty (30) days. However, it is believed that as the collection period is lengthened, sales will increase by the following amounts: Credit Policy Increase in Average Collection Period Increase in Sales A 15 days $10 000 B 30 days $15 000 C 45 days $17 000 Note: Increases in sales are cumulative, not incremental, ie adopting policy B will increase sales by another $5 000 (from $10 000 to $15 000), while moving from policy B to policy C will increase sales by a further $2 000 (from $15 000 to $17 000) The firm has the following cost pattern at present: Price of the only product manufactured $1.00 Variable costs per unit $0.60 Required: (a) If the firm requires a pre-tax return on investment of 20%, which credit policy should be pursued? Assume a 360-day year. (b) The firm's current bad debt loss is 1% of sales. The company has estimated that the following pattern of bad debts will prevail if it initiates more liberal credit terms: Increase in ACP Bad Debts 15 days 3% 30 days 6% 45 days 10% Given the other assumptions made, which credit policy should be pursued?
QUESTION 4 Each month, Jumbo Pty Ltd sells 10 000 units at $25 per unit. The marg inal cost of roducing each unit is $15. At present all of Jumbo's sales are made on a strict cash only basis. Jumbo's manager believes that the cash only' policy has led to many sales being lost as there have been a number of inquiries concerning the possibil ity of credit sales. Jumbo's manager estimates that a credit policy of 1/30, n/60 could increase sales by 1 000 units per month, of which 500 would be paid for at the end of month I and 400 would be paid for at the end of month 2. Of the remaining 100 units, 70 are expected to be paid for a month late and 30 are expected to be bad debts. Administration and collection costs are estimated to be $250(month 0), $100(month 1), $100(month 2)and $150(month 3) However, it is expected that some existing customers will also seek cred it in order to obtain the discount offered. This is likely to affect the sale of 600 units, with the buyers of the remaining 9 400 units expected to continue to pay cash. Administration costs are estimated to be $150(month 0)and $60(month 1) Jumbo's required rate of return is 1.5% per month Should Jumbo adopt the proposed credit arrangements?
August 2003 QUESTION 4 Each month, Jumbo Pty Ltd sells 10 000 units at $25 per unit. The marginal cost of producing each unit is $15. At present all of Jumbo’s sales are made on a strict ‘cash only’ basis. Jumbo’s manager believes that the ‘cash only’ policy has led to many sales being lost as there have been a number of inquiries concerning the possibility of credit sales. Jumbo’s manager estimates that a credit policy of 1/30, n/60 could increase sales by 1 000 units per month, of which 500 would be paid for at the end of month 1 and 400 would be paid for at the end of month 2. Of the remaining 100 units, 70 are expected to be paid for a month late and 30 are expected to be bad debts. Administration and collection costs are estimated to be $250 (month 0), $100 (month 1), $100 (month 2) and $150 (month 3). However, it is expected that some existing customers will also seek credit in order to obtain the discount offered. This is likely to affect the sale of 600 units, with the buyers of the remaining 9 400 units expected to continue to pay cash. Administration costs are estimated to be $150 (month 0) and $60 (month 1). Jumbo’s required rate of return is 1.5% per month. Should Jumbo adopt the proposed credit arrangements?
FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS MODULE 4- WORKING CAPITAL MANAGEMENT (Week 2)
August 2003 FIN2101 BUSINESS FINANCE II SOLUTIONS TO TUTORIAL QUESTIONS MODULE 4 – WORKING CAPITAL MANAGEMENT (Week 2)
QUESTION 1 OPTION 1 5000000.30.975500000.7 -37500 1.01 1.0) 144802+3430437500 I106 OPTION 2 6000000.5×0.96000000.5 NPV 45000 l.01 1.0) 2672729408945000 =$ll16 Conclusion: Adopt Option 1(2.5/30, n/60)as it has the higher NPV
August 2003 QUESTION 1 (a) OPTION 1 ( ) = $112906 =144802+ 343104- 375000 - 375000 1 .0 1 500000 0 .7 + 1.0 1 500000 0 .3 0 .9 7 5 NPV = 2 OPTION 2 ( ) = $111416 = 267327+ 294089- 450000 - 450000 1 .0 1 600000 0 .5 + 1.0 1 600000 0 .5 0 .9 NPV = 2 Conclusion: Adopt Option 1 (2.5/30, n/60) as it has the higher NPV