Self-Test Problems

Q.1 The Calgary Company is attempting to establish a current assets policy. Fixed asset are
$600,000, and the firm plans to maintain a 50 percent debt-to-assets ratio. The interest rate
is 10 percent on all debt. Three alternative current asset policies are under consideration:
40, 50 and 60 percent of projected sales. The company expects to earn 15 percent before
interest and taxes on sales of $3 million. Calgarys effective federal-plus-state tax rate is 40
percent. What is the expected return on equity under each alternative?

Q.2 The Upton Company is setting up a new checking account with Howe National Bank. Upton
plans to issue checks in the amount of $1 million each day and to deduct them from its own
records at the close of business on the day they are written. On average, the bank will
receive and clear the checks at 5 P.M. the third day after they are written; for example, a
check written on Monday will be cleared on Thursday afternoon. The firms agreement with
the bank requires it to maintain a $500,000 average compensating balance; this is $250,000
greater than the cash balance the firm would otherwise have on deposit. It makes a
$500,000 deposit at the time it opens the account.

a. Assuming that the firm makes deposits at 4 P.M. each day (and the bank includes them
in that day's transactions), how much must it deposit daily in order to maintain a
sufficient balance once it reaches a steady state? Indicate the required deposit on Day 1,
Day 2, Day 3, if any, and each day thereafter, assuming that the company will write
checks for $1 million on Day 1 and each day thereafter.
b. How many days of float does Upton have?
c. What ending daily balance should the firm try to maintain (1) on the banks records and
(2) on its own records?

Problems
Q.1 The Boudreaux Corporation has an inventory conversion period of 75 days, a receivable
collection period of 38 days, and a payables deferral period of 30 days.
a. What is the length of the firms cash conversion cycle?
b. If Boudreauxs annual sales are $3,375,000 and all sales are on credit, what is the firms
investment in accounts receivable?
c. How many times per year does Boudreaux turn over its inventory?

Q.2 On a typical day, Troan Corporation writes $10,000 in checks. It generally takes 4 days for
those checks to clear. Each day the firm typically receives $10,000 in checks that take 3 days
to clear. What is the firm's average net float?

Q.3 Williams & Sons last year reported sales of $10 million and an inventory turnover ratio of 2.
The company is now adopting a just-in-time inventory system. If the new system is able to
reduce the firms inventory level and increase the firms inventory turnover ratio to 5, while
maintaining the same level of sales, how much cash will be freed up?

Q.4 Medwig Corporation has a DSO of 17 days. The company averages $3,500 in credit sales
each day. What is the companys average account receivable?
Q.6 McDowell Industries sells on terms of 3/10, net 30. Total sales for the year are $900,000.
Forty percent of the customers pay on the 10th day and take discounts; the other 60
percent pay, on average, 40 days after their purchases.

a) What is the days-sales-outstanding?

b) What is the average amount of receivables?
c) What would happen to average receivables if McDowell toughened up on its collection
policy with the result that all non-discount customers paid on the 30th day?

Q.7 The Rentz Corporation is attempting to determine the optimal level of current assets for the
coming year. Management expects sales to increase to approximately $2 million as a result
of an asset expansion presently being undertaken. Fixed assets total $1 million, and the firm
wishes to maintain a 60 percent debt ratio. Rentzs interest cost is currently 8 percent on
both short-term and longer-term debt (which the firm uses in its permanent structure).
Three alternatives regarding the projected current asset level are available to the firm: (1) a
tight policy requiring current assets of only 45 percent of projected sales, (2) a moderate
policy of 50 percent of sales in current assets, and (3) a relaxed policy requiring current
assets of 60 percent of sales. The firm expects to generate earnings before interest and
taxes at a rate of 12 percent on total sales.

a) What is the expected return on equity under each current asset level? (Assume a 40
percent effective federal-plus-state tax rate.)
b) In this problem, we have assumed that the level of expected sales is independent of
current asset policy. Is this a valid assumption?
c) How would the overall riskiness of the firm vary under each policy?

SOLUTION
Q.7 (b) No, this assumption would probably not be valid in a real world situation. A firms current
assets policies, particularly with regard to accounts receivables, such as discount,
collection period, and collection policy, may have a significant effect on sales. The exact
nature of this function may be difficult to quantify, however, and determining an optimal
current assets level may not be possible in actuality.

Q.7 (c) As the answer to part (a) indicate, the tighter policy leads to a higher expected return.
However, as the current asset level is decreased, presumably some of this reduction
comes from accounts receivable. This can be accomplished only through higher discounts,
a shorter collection period, and / or tougher collection policies. As outlined above, this
would in turn have some effect on sales; possibly lowering profits more restrictive
receivables policies might involve some additional costs (collection, and so forth) but
would also probably reduced bad debts expenses. Lower current assets would also imply
lower liquid assets; thus, the firms ability to handle contingencies would be impaired.
Higher risk of inadequate liquidity would increase the firms risk of insolvency and thus
increase its chance of failing to meet fixed charges. Also, lower inventories might mean
lost sales and / or expensive production stoppage. Attempting to attach numerical values
to these potential losses and probabilities would be extremely difficult.