39981444 Corporate Finance Case Problems Edited

INTEGRATIVE CASE 2ENCORE INTERNATIONALby Grace D. Nacion

A. WHAT IS THE FIRM’S CURRENT BOOK VALUE PER SHARE?

Book value per share =

B. WHAT IS THE FIRM'S CURRENT P/E RATIO?

C.

= Required Return = 14.8%= 6% + [1.10 x (14% - 6%)] Risk Premium = 8.80%= 6% + 8.8%= 14.8%

(2) WHAT ARE THE REQUIRED RETURN AND RISK PREMIUM FOR ENCORE STOICK USING THE CAPITAL ASSET PRICING MODEL, ASSUMING A BETA OF 1.25?

= Required Return = 16%= 6% + [1.25 x (14% - 6%)] Risk Premium = 10%= 6% + 10%= 16%

(3) WHAT WILL BE THE EFFECT ON THE REQUIRED RETURN IF THE BETA RISES AS EXPECTED?

(1) WHAT ARE THE REQUIRED RETURN AND RISK PREMIUM FOR ENCORE STOCK USING THE CAPITAL ASSET PRICING MODEL, ASSUMING A BETA OF 1.10?

ks RF + [bj x (km - RF)]

ks RF + [bj x (km - RF)]

Book value per share=$ 60 ,000 ,000

2, 500 ,000=$ 24

P/E ratio=$ 40$ 6. 25

=6. 4

As beta rises, the risk premium and required return also rise

D.

Zero Growth :

E.

Constant Growth:

Variable Growth Model: Present Value of Dividends

Steps 1 & 2: Value of Cash Dividends and Present Value of Annual Dividends

Present Value

Year t of Dividends

2004 1 $4.00 1.080 $4.32 0.86 $3.72

IF THE SECURITIES ANALYSTS ARE CORRECT AND THERE IS NO GROWTH IN FUTURE DIVIDENDS, WHAT WILL BE THE VALUE PER SHARE OF THE ENCORE STOCK? (NOTE: BETA = 1.25.)

(1) IF JORDAN ELLIS’S PREDICTIONS ARE CORRECT, WHAT WILL BE THE VALUE PER SHARE OF ENCORE STOCK IF THE FIRM MAINTAINS A CONSTANT ANNUAL 6% GROWTH RATE IN FUTURE DIVIDENDS? (NOTE: BETA = 1.25.)

(2) IF JORDAN ELLIS’S PREDICTIONS ARE CORRECT, WHAT WILL BE THE VALUE PER SHARE OF ENCORE STOCK IF THE FIRM MAINTAINS A CONSTANT ANNUAL 8% GROWTH RATE IN DIVIDENDS PER SHARE OVER THE NEXT 2 YEARS AND 6% THEREAFTER? (NOTE: BETA = 1.25.)

Po = Present value of dividends during initial growth period + present value of price of stock at end of growth period.

D0 FVIF8%,t Dt PVIF 16%,t

P 0=D 1

k sP 0=

$ 4 .00.16

=$ 25

P 0=D 1

k s−g P 0=

$ 4. 00×1. 06 .16−.06

=$ 4. 24.10

=$ 42. 40

P 0=∑t=1

n

D 0×1g 1 t

1k s t[ 1

1k s N×

D N1

k s−g 2 ]

2005 2 $4.00 1.17 $4.66 0.74 $3.46 $7.18

Step 3: Present Value of Price of Stock at End of Initial Growth Period

= $4.66 x (1 +.06) = $4.94 PV of Stock at the end of year 2 (2005)

= PV == = $49.40 x (.743)= $49.40 = $36.70

Step 4: Sum of present value of dividends during initial growth period and present value price of stock at end of growth period

= $7.18 + $36.70 = $43.88

E.

Valuation Method Per Share

Market Value $40.00 Book Value $24.00 Zero Growth $25.00 Constant Growth $42.40 Variable Growth $43.88

D2003

P2005 [D2006 ÷ (ks - g2)] P2 x (PVIF16%,2yrs.)

$4.94 ÷ (.16 - .06)

P2003

COMPARE THE CURRENT (2009) PRICE OF THE STOCK AND STOCK VALUES FOUND IN PARTS A, D, AND E. DISCUSS WHY THESE VALUES MAY DIFFER. WHICH VALUATION METHOD DO YOU BELIEVE MOST CLEARLY REPRESENTS THE TRUE VALUE OF THE ENCORE STOCK?

The book value has no relevance to the true value of the firm. Of the remaining methods, the most conservative estimate of value is given by the zero growth model. Wary analysts may advise paying no more than $25 per share, yet this is hardly more than book value. The most optimistic prediction, the variable growth model, results in a value of $43.88, which is not far from the market value. The market is obviously not as cautious about Encore International's future as the analysts.

(2) WHAT ARE THE REQUIRED RETURN AND RISK PREMIUM FOR ENCORE STOICK USING THE CAPITAL ASSET PRICING MODEL, ASSUMING A BETA OF 1.25?

IF THE SECURITIES ANALYSTS ARE CORRECT AND THERE IS NO GROWTH IN FUTURE DIVIDENDS, WHAT WILL BE THE VALUE PER SHARE OF THE ENCORE

(1) IF JORDAN ELLIS’S PREDICTIONS ARE CORRECT, WHAT WILL BE THE VALUE PER SHARE OF ENCORE STOCK IF THE FIRM MAINTAINS A CONSTANT ANNUAL

(2) IF JORDAN ELLIS’S PREDICTIONS ARE CORRECT, WHAT WILL BE THE VALUE PER SHARE OF ENCORE STOCK IF THE FIRM MAINTAINS A CONSTANT ANNUAL 8% GROWTH RATE IN DIVIDENDS PER SHARE OVER THE NEXT 2 YEARS AND 6% THEREAFTER? (NOTE: BETA = 1.25.)

Step 4: Sum of present value of dividends during initial growth period and present value price of stock at end of growth period

COMPARE THE CURRENT (2009) PRICE OF THE STOCK AND STOCK VALUES FOUND IN PARTS A, D, AND E. DISCUSS WHY THESE VALUES MAY DIFFER. WHICH VALUATION METHOD DO YOU BELIEVE MOST CLEARLY REPRESENTS THE TRUE VALUE OF THE ENCORE STOCK?

The book value has no relevance to the true value of the firm. Of the remaining methods, the most conservative estimate of value is given by the zero growth model. Wary analysts may advise paying no more than $25 per share, yet this is hardly more than book value. The most optimistic prediction, the variable growth model, results in a value of $43.88, which is not far from the market value. The market is obviously not as cautious about Encore

INTEGRATIVE CASE 3LASTING IMPRESSIONS COMPANYby Grace D. Nacion

A. For each of the two proposed replacement presses, determine:(1) Initial investment.

PRESS A PRESS B

Installed cost of new press:Cost of new press $830,000.00 $640,000.00

+ Installation cost $40,000.00 $20,000.00 Total Cost - New Press $870,000.00 $660,000.00

- After-tax proceeds-sale of old asset :Proceeds from sale of old press $(420,000.00)

+ Tax on sale of old press* $(121,600.00) $(298,400.00) $(298,400.00) $(298,400.00)

+ Change in net working capital** $90,400.00 $- Initial investment $662,000.00 $361,600.00

*Computation for Tax on sale of old pressSale Price $420,000.00

- $(116,000.00)Gain $304,000.00

x Tax Rate (40%) 40%Tax on sale of old press* $121,600.00

**Computation for Change in net working capitalCash $25,400.00 Accounts Receivable $120,000.00 Inventory $(20,000.00)Increase in current assets $125,400.00 Increase in current liabilities $(35,000.00)Increase net working capital** $90,400.00

Total proceeds-sale of old press 

Book Value $ 400,000 - [(.20 +.32 +.19) x $400,000]

(2) Operating cash inflows (considered depreciation in year 6)

Depreciation Press A Cost Rate Depreciation

1 $870,000.00 0.20 $174,000.00 2 $870,000.00 0.32 $278,400.00 3 $870,000.00 0.19 $165,300.00 4 $870,000.00 0.12 $104,400.00 5 $870,000.00 0.12 $104,400.00 6 $870,000.00 0.05 $43,500.00

$870,000.00

Press B Cost Rate Depreciation

1 $660,000.00 0.20 $132,000.00 2 $660,000.00 0.32 $211,200.00 3 $660,000.00 0.19 $125,400.00 4 $660,000.00 0.12 $79,200.00 5 $660,000.00 0.12 $79,200.00 6 $660,000.00 0.05 $33,000.00

$660,000.00

Existing Cost Rate Depreciation

1 $400,000.00 0.12 $48,000.00 Yr. 42 $400,000.00 0.12 $48,000.00 Yr.53 $400,000.00 0.05 $20,000.00 Yr.64 $- 5 $- 6 $-

$116,000.00

Operating Cash Inflows

Existing Press

Earnings Before Depreciation Earnings Earnings Cash FlowDepreciation and Taxes Before Tax After Tax

1 $120,000.00 $48,000.00 $72,000.00 $43,200.00 $91,200.00 2 $120,000.00 $48,000.00 $72,000.00 $43,200.00 $91,200.00 3 $120,000.00 $20,000.00 $100,000.00 $60,000.00 $80,000.00 4 $120,000.00 $120,000.00 $72,000.00 $72,000.00 5 $120,000.00 $120,000.00 $72,000.00 $72,000.00 6 $- $- $- $-

Press AEarnings Before Depreciation Earnings Earnings Old Incremental

Depreciation and Taxes before taxes after taxes Cash Flow Cash Flow 1 $250,000.00 $174,000.00 $76,000.00 $45,600.00 $219,600.00 $91,200.00 2 $270,000.00 $278,400.00 $(8,400.00) $(5,040.00) $273,360.00 $91,200.00 3 $300,000.00 $165,300.00 $134,700.00 $80,820.00 $246,120.00 $80,000.00 4 $330,000.00 $104,400.00 $225,600.00 $135,360.00 $239,760.00 $72,000.00 5 $370,000.00 $104,400.00 $265,600.00 $159,360.00 $263,760.00 $72,000.00 6 $- $43,500.00 $(43,500.00) $(26,100.00) $17,400.00

Press BDepreciation Earnings Earnings Old Incremental

before taxes after taxes Cash Flow Cash Flow 1 $210,000.00 $132,000.00 $78,000.00 $46,800.00 $178,800.00 $91,200.00 2 $210,000.00 $211,200.00 $(1,200.00) $(720.00) $210,480.00 $91,200.00 3 $210,000.00 $125,400.00 $84,600.00 $50,760.00 $176,160.00 $80,000.00 4 $210,000.00 $79,200.00 $130,800.00 $78,480.00 $157,680.00 $72,000.00 5 $210,000.00 $79,200.00 $130,800.00 $78,480.00 $157,680.00 $72,000.00 6 $- $33,000.00 $(33,000.00) $(19,800.00) $13,200.00

(3) Terminal Cash Flow (At the end of year 5)

PRESS A PRESS B

After tax proceed - sale of new pressProceeds of sale of new press $400,000.00 $330,000.00 Tax on sale of new press * $(142,600.00) $(118,800.00) Total Proceeds-new press $257,400.00 $211,200.00

- After-tax proceeds-sale of old press : $(150,000.00)

+ Tax on sale of old press** $(60,000.00) $(90,000.00) $(90,000.00) $(90,000.00)

+ Change in net working capital $90,400.00 $- Terminal Cash flow $257,800.00 $121,200.00

*Computation for Tax on sale of new pressPRESS A PRESS B

Sale price $400,000.00 $330,000.00 - Book Value (Yr 6) $(43,500.00) $(33,000.00)- Gain $356,500.00 $297,000.00

Tax Rate (40%) 40% 40%Tax on sale of new press* $142,600.00 $118,800.00

**Computation for Tax on sale of old pressSale price $150,000.00 Book Value (Yr 6) $- Gain $150,000.00 Tax Rate (40%) 40%Tax on sale of old press** $60,000.00

Proceeds on sale of old press 

Total proceeds-sale of old press 

PRESS A PRESS B

Initial Investment $662,000.00 $361,600.00

Cash Inflow Cash Inflow Year 1 $128,400.00 $87,600.00 Year 2 $182,160.00 $119,280.00 Year 3 $166,120.00 $96,160.00 Year 4 $167,760.00 $85,680.00 Year 5 * $449,560.00 $206,880.00

* Operating cash flow $191,760.00 $85,680.00 + Terminal cash inflow $257,800.00 $121,200.00

Cash inflows year 5* $449,560.00 $206,880.00

B.

Cash Flows

Press A $128,400.00 $182,160.00 $166,120.00 $167,760.00 $449,560.00

0 1 2 3 4 5 6 End of Year

Cash Flows

Press B $87,600.00 $119,280.00 $96,160.00 $85,680.00 $206,880.00

0 1 2 3 4 5 6

Using the data developed in Part A, find and depict on a time line the relevant cash flow stream associated with each of the two proposed replacement presses, assuming that each is terminated at the end of 5 years.

End of Year

C. Using the data developed in Part B, apply each of the following decision techniques:

CUMMULATIVE CASH FLOWSPRESS A PRESS B

Year 1 $128,400.00 $87,600.00 Year 2 $310,560.00 $206,880.00 Year 3 $476,680.00 $303,040.00 Year 4 $644,440.00 $388,720.00 Year 5 $1,094,000.00 $595,600.00

(1) Payback periodPress A Press B4 years + [(662,000 - 644,440)/191,760] 3 years + [(361,600 - 303,040)/85,680]

= 4 + (17,600/191,760) = 3 + (58,560/85,680)= 4 + 0.9178 = 3 + .68347= 4.09 years = 3.8 years

(2) Net Present Value (NPV)Press A Press B

PVlF 14% PV PVlF 14%1 $128,400.00 0.877 $112,631.58 1 $87,600.00 0.8772 $182,160.00 0.769 $140,166.20 2 $119,280.00 0.7693 $166,120.00 0.675 $112,126.27 3 $96,160.00 0.6754 $167,760.00 0.592 $99,327.39 4 $85,680.00 0.5925 $449,560.00 0.519 $233,487.38 5 $206,880.00 0.519

$697,738.82

Net Present Value = $677,769.21 - $662,000 Net Present Value = $379,383.92 - $361,600

Cash Flow  Cash Flow 

Net Present Value $35,738.82 Net Present Value $30,105.88

(3) Internal Rate of ReturnComputed from Online IRR CalculatorPress A 14.82%Press B 15.83%

D.

Net Present Value $

Discount Rate

E. Recommend which, if either, of the presses the firm should acquire if the firm has (1) unlimited funds or (2) capital rationing

(1)(2)

Draw net present value profiles for the two replacement presses on the same set of axes, and discuss conflicting rankings of the two presses, if any, resulting from use of NPV and IRR decision techniques.

When the cost of capital is below approximately 15 percent, Press A is preferred over Press B, while at costs greater than 15 percent, Press B is preferred.  Since the firm's cost of capital is 14 percent, conflicting rankings exist.  Press A has a higher value and is therefore preferred over Press B using NPV, whereas Press B's IRR of 15.83 percent causes it to be preferred over Press A, whose IRR is 14.82 percent using this measure. 

 If the firm has unlimited funds, Press A is preferred.If the firm is subject to capital rationing, Press B may be preferred. 

0

50000

100000

150000

200000

250000

300000

350000

400000

450000

500000

0 2 4 6 8 10 12 14 16 18

NPV - A

NPV - B

F. What is the impact on your recommendation of the fact that the operating cash inflows associated with press A are characterized as a very risky in contrast to the low-risk operating cash inflows of press B?

The risk would need to be measured by a quantitative technique such as certainty equivalents or risk-adjusted discount rates.  The resultant net present value could then be compared to Press B and a decision made.

CashInFlow

$128,400.00 $182,160.00 $166,120.00 $167,760.00 $191,760.00

$17,400.00

CashInFlow $87,600.00

$119,280.00 $96,160.00 $85,680.00 $85,680.00 $13,200.00

0 1 2 3 4 5 6

0 1 2 3 4 5 6

Using the data developed in Part A, find and depict on a time line the relevant cash flow stream associated with each of the two proposed replacement

Using the data developed in Part B, apply each of the following decision techniques:

3 years + [(361,600 - 303,040)/85,680]

PV $76,842.11 $91,782.09 $64,905.26 $50,729.44

$107,446.99 $391,705.88

Net Present Value = $379,383.92 - $361,600

Recommend which, if either, of the presses the firm should acquire if the firm has (1) unlimited funds or (2) capital rationing

for the two replacement presses on the same set of axes, and discuss conflicting rankings of the two presses, if any,

When the cost of capital is below approximately 15 percent, Press A is preferred over Press B, while at costs greater than 15 percent, Press B is preferred.  Since the firm's cost of capital is 14 percent, conflicting rankings exist.  Press A has a higher value and is therefore preferred over Press B using NPV, whereas Press B's IRR of 15.83 percent causes it to be preferred over Press A, whose IRR is 14.82 percent using this measure. 

What is the impact on your recommendation of the fact that the operating cash inflows associated with press A are characterized as a very risky in

The risk would need to be measured by a quantitative technique such as certainty equivalents or risk-adjusted discount rates.  The resultant net

INTEGRATIVE CASE 4O'GRADY APPAREL COMPANYby Grace D. Nacion

A. Calculation of After-tax cost

Source of Capital Range of new financing After-tax cost (%)Long-term debt $0 - $700,000 7.5%

$700,000 and above 10.8%Preferred stock $0 and above 17.9%Common stock equity $0 - $1,300,000 23.8%

$1,300,000 and above 26.0% see computations below

After-tax cost of debt: Cost of common stock equity:$0 - $700,000 $0 - $1,300,000

= == .125 x (1 -. 4) = ($1.76 / $20) + .15= 7.5% = 23.8%

$700,000 and above $1,300,000 and above

= == .18 x (1 -. 4) = ($1.76 / $16) + .15= 10.8% = 26%

Cost of preferred stock:$0 and above

= preferred dividend/preferred price= $10.20/$57= 17.9%

B.

Long-term debt = $700,000.00 = $2,800,000.00

kd (1 – T) (D1 / Nn) + g

kd (1 – T) (D1 / Nn) + g

(1) Determine the break points associated with each source of capital.

Break even point : BPj = AFj / Wj

0.25= $2,800,000.00

not applicable to preferred stock

Common Stock Equity = $1,300,000.00 = $2,000,000.00

0.65

Ranges of Total New financingCost of Component Source of Financing

Long-term debt Preferred stock Common stock equity

$0 - $2,000,000 7.5% 17.9% 23.8%

$2000,0001 - $2,800,000 7.5% 17.9% 26.0%

above $2,800,000 10.8% 17.9% 26.0%

formula for WACC =

Range Calculation WACC$0 - $2,000,000 (.25 x .075) + (.10 x .179) + (.65 x .238) 19.14%$2000,0001 - $2,800,000 (.25 x .075) + (.10 x .179) + (.65 x .260) 20.57%above $2,800,000 (.25 x .108) + (.10 x .179) + (.65 x .260) 21.39%

C.

(2) Using the break points developed in part (1), determine each of the ranges of total new financing over which the firm's weighted average cost of captal (WACC) remains constant.

(3) Calculate the weighted average cost of capital for each range of total new financing

wdkd (1 – T) + wpkp + wcks

(1) Using your findings in part B(3) with the investment opportunities schedule (IOS), draw the firm's weighted magrinal cost of capital (WMCC) scheduke and the IOS on the same set of axes, with total new financing or investment on the x axis and weighted average cost of capital and IRR on the y axis.

Total New Financing/Investment ($000)

Answer:

D.

Weighted Average Cost of Capital and IRR (%)

(2) Which, if any, of the available investments would you recommend that the firm accept? Explain your answer.

Projects D, C, F, and A should be accepted since each has an internal rate of return greater than the weighted average cost of capital.

(1) Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 10% preferred stock, and 40% common stock have on your previous findings?

Changing the capital structure to include more debt while keeping the cost of each financing source the same will change both the breaking points at which the weighted average cost of capital changes and the WACC. 

 Breaking points for 50% debt, 10% preferred stock, and 40% common stock: 

16

18

20

22

24

26

28

0 500 1000 1500 2000 2500 3000 3500

WMCC

IOS

D

C

F

A

B

E

G

Range Calculation WACC$0 - $1,400,000 (.50 x .075) + (.10 x .179) + (.40 x .238) 15.1%$1,400,001 - $3,250,000 (.50 x .108) + (.10 x .179) + (.40 x .238) 16.7%Above $3,250,000 (.50 x .108) + (.10 x .179) + (.40 x .260) 17.6%

Answer:

E.

Answer:

Answer:

Since the total for all investment opportunities is $3,200,000, the lowest IRR is 17%, and the cost of capital below $3,250,000 is less than 17% (15.1% and 16.7%), all 7 projects are acceptable.

(2) Which capital structure - the original one or this one - seems better? Why?

For any set of investment opportunities, the more highly leveraged capital structure will result in accepting more projects.  However, a more highly leveraged capital structure increases the firm's financial risk. 

(1) What type of dividend policy does the firm appear to employ? Does it seem appropriate given the firm's recent growth in sales and profits and given its current investment opportunities?

O’Grady follows a constant-payout-ratio dividend policy. For each of the years 2001 through 2003 the firm paid out a constant 40% of earnings.  The same payout percent is included in the projections for 2004.  Given the firm’s growth in sales and earnings it would seem appropriate to not continue the constant payout.  O’Grady’s could use the internally generated funds to help finance some of the growth. 

(2) Would you recommend an alternative dividend policy? Explain. How would this policy affect the investments recommended in part C(2)?

They should change their dividend policy to the regular dividend policy.  They can maintain the constant dividend as earnings increase, freeing up some cash for investment.  If earnings continue to increase the constant dividend policy could later be converted to a low-regular-and-extra dividend policy.  Retaining more of the income will increase the breakpoint for common stock equity financing.  This higher breakpoint will cause a shift downward in the WMCC schedule.  O’Grady’s should be able to undertake additional investment opportunities and further increase shareholders’ wealth.

Using the break points developed in part (1), determine each of the ranges of total new financing over which the firm's weighted average cost of

with the investment opportunities schedule (IOS), draw the firm's weighted magrinal cost of capital (WMCC) scheduke and the IOS on the same set of axes, with total new financing or investment on the x axis and weighted average cost of capital and IRR on

Which, if any, of the available investments would you recommend that the firm accept? Explain your answer.

Projects D, C, F, and A should be accepted since each has an internal rate of return greater than the weighted average cost of capital. 

Assuming that the specific financing costs do not change, what effect would a shift to a more highly leveraged capital structure consisting of 50% long-term debt, 10% preferred stock, and 40% common stock have on your previous findings?

Changing the capital structure to include more debt while keeping the cost of each financing source the same will change both the breaking points at which the weighted average cost of capital changes and the WACC. 

Since the total for all investment opportunities is $3,200,000, the lowest IRR is 17%, and the cost of capital below $3,250,000 is less than 17%

Which capital structure - the original one or this one - seems better? Why?

For any set of investment opportunities, the more highly leveraged capital structure will result in accepting more projects.  However, a more highly

does the firm appear to employ? Does it seem appropriate given the firm's recent growth in sales and profits and

follows a constant-payout-ratio dividend policy. For each of the years 2001 through 2003 the firm paid out a constant 40% of earnings.  The same payout percent is included in the projections for 2004.  Given the firm’s growth in sales and earnings it would seem appropriate to not continue the constant payout.  O’Grady’s could use the internally generated funds to help finance some of the growth. 

Would you recommend an alternative dividend policy? Explain. How would this policy affect the investments recommended in part C(2)?

They should change their dividend policy to the regular dividend policy.  They can maintain the constant dividend as earnings increase, freeing up some cash for investment.  If earnings continue to increase the constant dividend policy could later be converted to a low-regular-and-extra dividend policy.  Retaining more of the income will increase the breakpoint for common stock equity financing.  This higher breakpoint will cause a shift downward in the WMCC schedule.  O’Grady’s should be able to undertake additional investment opportunities and further increase shareholders’

INTEGRATIVE CASE 5Casa de Diseñoby Grace D. Nacion

A. Operating Cycle = Average age of inventory + Average Collection Period B. Industry OC= 110 days + 75 days == 185 days =

Cash Convertion Cycle = Operating Cycle - Average Payment Period Industry CCC= 185 days - 30 days == 155 days =

Resources Needed = Industry Resources Needed

= =

= ### =

C. Casa de DiseñoNegotiated Financing $11,409,722.22 Less: Industry Resourced Needed $(8,759,722.22)

$2,650,000.00

Cost of Inefficiency $2,650,000.00 x .15= $397,500.00

D.

Reduction in collection period =75 days x (1 - .4) Cash Conversion Cycle == 45 days =

Operating Cycle = 83 days + 45 days Resources Needed =

(1) Offering 3/10 net 60:

Total annual outlays360 days

×Cash Conversion Cycle

$ 26 , 500 , 000360

×155$ 26 , 500 , 000360

×119

$ 26 , 500 , 000360

×89 days

= 128 days=

Additional Savings = $8,759,722 - $6,551,389= $2,208,333.33 = $2,208,333.33 x .15= $331,250.00

$40,000,000.00 x .45 x .03= $540,000.00

New Average Collection Period = 45 days($40,000,000 x .80) / (360 / 45) = $4,000,000.00

Average investment in accounts receivable assuming no cash discount:(40,000,000 x .80) / (360 / 75) = $6,666,666.67

Reduction in investment in accounts receivable:$6,666,667 - $4,000,000 = $2,666,667.00

Annual Savings:$2,666,667 x .15 = $400,000.00

$40,000,000 x (.02 - .015) = $200,000.00

$(540,000.00)Annual savings from reduction in investment in accounts receivable $400,000.00 Annual savings from reduction

(2) Reduction in Sales:

(3) Average investment in accounts receivable assuming cash discount:

(4) Reduction in Bad Debt Expense:

(5) Cost of Offering Cash Discount

$ 26 , 500 , 000360

×89 days

in bad debt expense $200,000.00 Savings due to cash discount $60,000.00

E. Ms. Leal should bring working capital measures in line with the industry and offer the proposed cash discount

F. The other sources of financing available include both unsecured and secured sources.

Unsecured Sources:

Secured Sources:

Ø Short-term self-liquidating bank loans – usually used to help with seasonal needs where the loan is repaid as receivables are collected

Ø Single payment bank notes – normally a short-term (30 days to 9 months) loan to be repaid on the end of the loan period.

Ø Line of credit – a loan much like a credit card in that the borrow can draw down the money as needed and make various payments. The loan must often be paid in full at some point within each year.

Ø Revolving credit agreement – a guaranteed amount of funds available to the borrower. The borrower usually pays a commitment fee to the bank to compensate them for having the funds available “on demand.”Ø Commercial paper – a 3 day to 270 day loan sold as a security to the lender.

Ø Pledging accounts receivable – a lender purchases the receipts to be received from the accounts receivable accounts of the borrower. The lender advances the money to the borrower in an amount discounted from the book value of the receivables. When the borrower collects the receivables payments the money is remitted to the lender.

Ø Factoring accounts receivable – Selling the firms accounts receivable to a lender at a discount to the book value of the receivables. The factor normally receives the payment directly from the customer when they make payment.Ø Floating inventory liens – when inventory is used as collateral for a loan.Ø Trust receipt inventory loans – a loan against relatively expensive and easily identifiable assets, such as automobile. The loan is repaid when the asset is sold.

Ø Warehouse receipt loans – when assets in a warehouse are pledged against a loan. The lender takes control of the inventory items that are normally stored in a public warehouse.

83 days + 75 days158 days

158 days - 39 days119 days

Industry Resources Needed

$8,759,722.22

128 days - 39 days89 days

$ 26 , 500 , 000360

×119

$ 26 , 500 , 000360

×89 days

$6,551,388.89

$ 26 , 500 , 000360

×89 days

The other sources of financing available include both unsecured and secured sources.

Unsecured Sources:

Secured Sources:

Short-term self-liquidating bank loans – usually used to help with seasonal needs where the loan is repaid as receivables are collected

Single payment bank notes – normally a short-term (30 days to 9 months) loan to be repaid on the end of the loan period.

Line of credit – a loan much like a credit card in that the borrow can draw down the money as needed and make various payments. The loan must often

Revolving credit agreement – a guaranteed amount of funds available to the borrower. The borrower usually pays a commitment fee to the bank to

Commercial paper – a 3 day to 270 day loan sold as a security to the lender.

Pledging accounts receivable – a lender purchases the receipts to be received from the accounts receivable accounts of the borrower. The lender advances the money to the borrower in an amount discounted from the book value of the receivables. When the borrower collects the receivables

Factoring accounts receivable – Selling the firms accounts receivable to a lender at a discount to the book value of the receivables. The factor normally receives the payment directly from the customer when they make payment.

Floating inventory liens – when inventory is used as collateral for a loan.Trust receipt inventory loans – a loan against relatively expensive and easily identifiable assets, such as automobile. The loan is repaid when the asset

Warehouse receipt loans – when assets in a warehouse are pledged against a loan. The lender takes control of the inventory items that are normally

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