SOLUTIONS MANUAL

CHAPTER
Cash and Working
5 Capital Management

1 Inventory conversion period = Inventory × 365 days

Cost of goods sold
= 2,000,000 × 365
20,000,000
= 36.5 days

Debtors collection period = Receivables × 365 days

Sales
= 1,600,000 × 365
50,000,000
= 11.68 days

Payables credit period = Account payable × 365 days

Cost of goods sold
= 800,000
20,000,000
= 14.6 days

Inventory Debtors
Payables
Cash conversion cycle = conversion + collection –
credit period
period period
= 36.5 + 11.7 – 14.6
= 33.6 days
2T
2 To use the Baumol model, given by the formula: C* = √ K
×F

(a) The amount of cash it raises (obtains) each time it sells its securities

= 2T × F = 2 × 4,000,000 × F = RM188,561.81

√ K √ 0.09
(b) Number of times the firm sells securities is

4,000,000 = 21.21 i.e. 22 times a year

188,561.81
(c) Average cash balance is 188,561.81 = RM94,280.91
2
(d) Annual opportunity cost of funds = 0.09 × 188,561.81 = RM8,485.28
2

05FM_SM_Ch5_1LP.indd 1 8/19/13 4:48:12 PM

 Cash and Working Capital
Solutions
Management
Manual
2

Annual transactions costs = 400 × 4,000,000 = 400 × 22 = RM8,800

188,561.81
(students to note that had the value been calculated based on 400 × 21.21, then the annual
transaction costs would have been RM8,485.28)

Annual total costs = 8,485.28 + 8,800 = RM17,285.28

3 (a) RM960,000 × 15 / 360 = RM40,000

Assumption: RM960,000 represents the annual purchases of raw materials that ABC Berhad
makes, that accrues evenly throughout the year.
(b) RM960,000 × 60 / 360 = RM160,000
(c) This may be determined by computing the Annual Percentage Rate (APR) or the Annual
Percentage Yield (APY).
360
APR = 1 +
( Discount %
100 – discount % ) Total credit period – discount period –1

( )
360
= 1+ 1% 60 – 15 –1
100 – 1%
= 0.0837 or 8.37%

APY = Discount % × 360

100 – discount % Total credit period – discount period
= 1% × 360
100 – 1% 60 – 15
= 0.0808 or 8.08%
2SO
4 (a) EOQ = √ C
2 × 400,000 × 2,000
= √ 20
= 8,944

(b) Annual order cost = S × O

Q
= 400,000 × 2,000 = RM89,445
8,944
(c) The choice would be either 8,000 or 9,000 tons of raw materials. However, the preferred
choice would be 9,000 tons per order.

Annual order costs would be = 400,000 × 2,000 = RM88,889

9,000
5 (a) EOQ = 2SO
C√
= 2 × 100,000 × 250 = 5,000

√ 2
Total costs = Q × C + S × O
2 Q
= 5,000 × 2 + 100,000 × 250
2 5,000
= 5,000 + 5,000
= RM10,000

(b) The question should have stated a lower maximum units quantity.

05FM_SM_Ch5_1LP.indd 2 8/19/13 4:48:12 PM

 Cash and Working Capital Management
3

Assuming that maximum units should be 3,000.

This would mean that the maximum order (ignoring the effects of lead time issue) quantity
should also be set at 3,000 units.

Total costs = Q × C + S × O
2 Q
= 3,000 × 2 + 100,000 × 250
2 3,000
= 3,000 + 8,333
= RM11,333

(c) The maximum annual rent that would be paid would be that value such that one is indifferent
between
1. The sum total annual cost when ordering at EOQ quantity and rental
2. The total annual costs currently paid given the space constraint.

This works out to be:

RM10,000 + rental = RM11,333
Rental = 11,333 – 10,000 = RM1,133

6 This may be assessed through the following steps:

(i) Estimate change in profit arising from increase in sales:

Increase in sales
RM12,000,000 – 9,600,000 = RM2,400,000

Increase in contribution is
RM2,400,000 × 60% = RM400,000

Previous bad debts level is RM9,600,000 × 1% = RM96,000

New bad debts level is RM12,000,000 × 3% = RM360,000
Less: increase in bad debts
RM360,000 – 96,000 = RM264,000
Net RM136,000

(ii) Estimate the cost relating to the increase in debtors and inventory:

New level of debtors RM12,000,000 × 4 = RM4,000,000

12
Original level of debtors 3
RM9,600,000 × = RM2,400,000
12
Increase in level of debtors RM1,600,000
Additional investment cost at 12% RM 192,000

(iii) Estimate the combined effect:

Net increase in profits RM136,000
Less: net increase in investment cost RM192,000
Net benefit / (cost) RM (56,000)

Since the net outcome is a net cost of RM56,000, the firm is not recommended to implement
the new policy.

05FM_SM_Ch5_1LP.indd 3 8/19/13 4:48:12 PM

 Cash and Working Capital
Solutions
Management
Manual
4

7 When attempting to manage a firm’s stock and trade debtors, the objective should be to make
decisions that can maximise shareholder wealth. Towards this end, care should avoid decisions
that give rise to negative net present value (NPV) and instead, emphasis should be to generate
positive NPVs.

In this respect then, a firm’s stock and trade debtors management problems can be likened to a
capital budgeting problem.

8 Factors to be considered include:

(a) Forecast level of sales
(b) Potential for fluctuations in demand
(c) Production quantities budgeted for
(d) Variability in stock usage rate
(e) Supply reliability
(f) Cost of carrying the inventory
(g) Cost of ordering replacement stocks
(h) Cost of running out of stocks, especially in the form of loss of sales, loss of goodwill and
production down time

9 Your comments should include what pitfalls to avoid when making the necessary analysis, plus
review the ratios that have been identified and discussed in the article concerned. Make sure you
appreciate and understand how the ratios were computed and the interpretations that can be
derived from the results obtained.

10–12 Students to follow the web-links provided. Students would need to explain the points that
they have noted from the web-links. Answers to vary.

13 Students to go through the questions that may be obtained via the web-link provided, and to
review their answers against those as provided in the same attachment.

2SO
14 EOQ =
√ C
where S = 200,000; O = RM5; C = RM2.22 per 1000 bars

2 × 200,000 × 5
Hence, EOQ = = 30,000 (approx)
2.22
1000
Average stock = 30,015 = 15,000 (approx)
2
15 The matching concept explains that firms ought to consider matching the term of the borrowings
to the term of the asset that the firm seeks to invest in.

Accordingly, when a firm seeks financing for its assets, it should look at its needs and understand
the difference between the two options before determining which of these options is most
advantageous for the firm.

The best option for financing needs that last a year or less is short-term financing. Short-term
financing will provide the company with enough capital needed. Promissory noted, short-term
loans, inventory loans, bank overdrafts, and letter of credits are examples of short-term financing.
Short-term borrowings will help the firms by boosting the inventory orders, daily supplies of the
firm, and wage distribution aside from raising capital. Signing a short-term borrowing which is

05FM_SM_Ch5_1LP.indd 4 8/19/13 4:48:12 PM

 Cash and Working Capital Management
5

payable within six months is the best example of how short-term financing works. A firm can use
the profit from the sales to pay this loan. If the firm is confident in paying the loan back on the
due date, the firm should use such loan.

For a firm that needs financing for more than a year the best solution would be to use long-
term financing. Firms that use these are the one’s that need new equipment’s to support business
development. Some forms of long-term financing are term loans, mortgages, debentures and
convertible notes. Firms may see this as the less risky option because they will have plenty of time
to repay the borrowings.

Another consideration is the quality and availability of assets to act as collateral for the borrowings.
Typically, long term loans are used to finance the purchase of property, plant and equipment.
Hence, the property, plant and equipment may be used as collateral for the loan concerned. Short
term borrowings would generally not be used to finance such purchases.

The next consideration when deciding between short and long term borrowings would be the
financing costs. Generally, the interest rates on long term borrowings are higher than interest
rates on short term borrowings (liquidity preference argument for term structure of interest
rates).

Hence, firms should consider its cash flows and their ability to service interest cash flows, which
can affect their decision on short versus long term borrowings.

17 Working capital is defined as a combination of current assets and current liabilities of any
businesses or firms. The current assets are made up of the firm’s stocks / inventory, accounts
receivables, and any form of cash, whether held in cash terms or deposited in banks.

It is not exactly true that working capital spontaneously finances itself because it’s being turned
over all the time. It is merely that through the normal course of business transactions that firms
undertake, spontaneous sources of finance come about. These may take the form accounts
payables (creditors) and accruals.

Trade credit is the finance extended by the suppliers of services or goods. It is one of the
spontaneous sources of finance for the reason that it arises in the normal transactions of the
business firm without specific negotiations. The critical qualification is that the supplier views
the firm as being credit worthy. It is a very important financing tool for both small and large
businesses or firms.

However, it is not always straightforward for firms where the ideal is that only when the current
assets are realized and collected would firms seek to consider paying the creditors. Suppliers
would not be willing to wait that long a period of time.

Hence, creditors may sometimes have to be paid earlier than the time it takes for stocks and trade
debtors to be converted to cash.

It is in situations like this that other types of financing would have to be considered. The other types
of short term financing may take the form of working capital advance and bank overdrafts.

Working capital advance is a spontaneous source of financing provided by commercial banks.

This is the most important source of financing especially for small business. A customer is only
required to submit an application form for different categories of advances. The application
should be supported by various statements such as financial statements and financial projections
of the business.

05FM_SM_Ch5_1LP.indd 5 8/19/13 4:48:12 PM

 Cash and Working Capital
Solutions
Management
Manual
6

Finally, bank overdrafts are also spontaneous source of finance.  These are lines of credit attached
to a current account which allows businesses to operate on a day to day basis.  Its mechanism is
similar to working capital. The interest charged on overdrafts is variable and is calculated daily on
the balance outstanding. The characteristics of bank overdrafts include:
• Variable interest rate
• Fluctuating balance with no set repayments

18 (a) Estimate of the profits foregone by offering the discount:

Given that 60% of debtors would take advantage of the discount offer, this would result in
reduced profits of:
RM30,000,000 × 0.60 × 0.02 = RM360,000

(b) Estimate the cost savings arising from reduction in debtors:

New level of debtors RM30,000,000 × 15 × 0.60 = RM750,000
360
RM30,000,000 × 60 × 0.40 = RM2,000,000
360
RM2,750,000
Original level of debtors RM30,000,000 × 90 = RM7,500,000
360
Reduction in level of debtors RM4,750,000

Reduction in investment cost at 10% RM475,000

(c) Estimate the combined net effect:

Net reduction in profits RM(360,000)
Reduction in investment cost RM 475,000
Net benefit / (cost) RM 115,000

Given that there is a net benefit of RM115,000, the proposal appears worthwhile to be
implemented.

19 The net benefit / (cost) is calculated as follows:

(a) Elimination of bad debts balance RM4.5m × 0.4% = RM18,000

(b) Effect of change in debtors balance

Current debtors balance RM4.5m × 50 = RM625,000
360
New debtors balance RM4.5m × 30 = RM375,000
360
Decrease in debtors balance RM250,000

Reduction in investment cost @ 10% RM25,000

(c) Charges by factor

Annual fee charged by factor RM4.5m × 1% = RM45,000 (–)

Factor to advance 80% of invoiced debts,

i.e. current debtors balance RM625,000 × 80% = RM500,000
Incremental financing cost incurred (11 – 10)% RM5,000 (–)

05FM_SM_Ch5_1LP.indd 6 8/19/13 4:48:12 PM

 Cash and Working Capital Management
7

(d) Savings in administration cost by firm = RM35,000

Net gain RM28,000

Since there is a net gain, the factor’s services should be accepted.

05FM_SM_Ch5_1LP.indd 7 8/19/13 4:48:12 PM