Cash Budget.
The following data are from the budget of Ritewell Publishers.
Half the company`s sales are transacted on a cash basis. The other half are
paid for with a 1-month delay. The
company pays all of its credit purchases with a 1-month delay. Credit purchases
in January were $30 and total sales in January were $180.
1 a. The new values for the accounts receivable period
and inventory period are
Days in inventory = 250 = 25.9 days 3,518/365
This is a reduction of 22.8 days from the original
value of 48.7 days. Days in receivables = 300 = 27.6 days 3,968/365
This is a reduction of 16.2 days from the original
value of 43.8 days
The cash conversion cycle falls by a total of 22.8 +
16.2 = 39.0 days.
b. The inventory period, accounts receivable period,
and accounts payable period will all fall by a factor of 1.10. (The numerators
are unchanged, but the denominators are
higher by 10 percent.) Therefore, the conversion cycle will fall from 61 days
to 61/1.10 = 55.5 days.
2 a. An increase in the interest rate will incre ase
the cost of carrying current assets. The effect is to reduce the optimal level
of such assets. b. The just-in-time
system lowers the expected level of shortage costs and reduces the amount of
goods the firm ought to be willing to keep in inventory.
c. If the firm decides that more lenient credit terms
are necessary to avoid lost sales, it must then expect customers to pay their
bills more slowly. Accounts receivable will increase.
3 a. This transaction merely substitutes one current
liability (short-term debt) for another (accounts payable). Neither cash nor
net working capital is affected.
b. This transaction will increase inventory at the
expense of cash. Cash falls but net working capital is unaffected.
c. The firm will use cash to buy back the stock. Both
cash and net working capital will fall.
d. The proceeds
from the sale will increase both cash and net working capital
5 The major change in the plan is the substitution of
the extra $5 million of borrowing via the line of credit (bank loan) in the
second quarter and the corresponding
reduction in the stretched payables. This substitution is advantageous because
the bank loan is a cheaper source of funds.
Notice that the cash balance at the end of the year is higher under this
plan than in the original plan.
Capstan Autos operated an East Coast dealership for a
major Japanese car manufacturer. Capstan`s owner, Sidney Capstan,
attributed much of the business`s success to its no-frills
policy of competitive pricing and immediate cash payment. The business was
basically a simple one the firm imported
cars at the beginning of each quarter and paid the manufacturer at the end of
the quarter. The revenues from the sale of these cars covered the payment to the manufacturer and the expenses of
running the business, as well as providing Sidney Capstan with a good return
on
his equity investment.
By the fourth quarter of 2004 sales were running at
250 cars a quarter. Since the average sale price of each car was about $20,000,
this translated into quarterly revenues
of 250 $20,000 = $5
million. The average cost to Capstan of each imported car was $18,000. After
paying wages, rent, and other recurring
costs of $200,000 per quarter and deducting depreciation of $80,000, the
company was left with earnings before interest and taxes (EBIT) of $220,000 a quarter and net profits of $140,000.
The year 2005 was not a happy year for car importers in the United States. Recession led to a general decline in auto sales, while the fall
in the value of the dollar shaved profit margins for many dealers in imported
cars. Capstan more than most firms
foresaw the difficulties ahead and reacted at once by offering 6 months` free
credit while holding the sale price of
its cars constant. Wages and other costs were pared by 25 percent to
$150,000 a quarter and the company effectively eliminated all capital
expenditures. The policy appeared successful. Unit sales fell by 20
percent to 200 units a quarter, but the company continued to operate at a
satisfactory profit (see table).
The slump in sales lasted for 6 months, but as
consumer confidence began to return, auto sales began to recover. The company`s
new policy of 6 months` free credit was
proving sufficiently popular that Sidney Capstan decided to maintain the
policy. In the third quarter of 2005 sales had
recovered to 225 units; by the fourth quarter they were 250 units; and
by the first quarter of the next year they had reached 275 units. It looked
as if by the second quarter of 2006
that the company could expect to sell 300 cars. Earnings before interest and tax
were already in excess of their
previous high and Sidney Capstan was able to congratulate himself on
weathering what looked to be a tricky period. Over the 18-month period the firm had earned net profits of over
half a million dollars, and the equity had grown from just under $1 million to
about $2 million.
Sidney Capstan was first and foremost a superb
salesman and always left the financial aspects of the business to his financial
manager. However, there was one feature
of the financial statements that disturbed Sidney Capstan the mounting level of
debt, which by the end of the first quarter
of 2006 had reached $9.7 million. This unease turned to alarm when the
financial manager phoned to say that the bank was reluctant to extend further credit and was even questioning its
current level of exposure to the company.
Capstan found it impossible to understand how such a
successful year could have landed the company in financial difficulties. The
company had always had good
relationships with its bank, and the interest rate on its bank loans was a
reasonable 8 percent a year (or about 2 percent a quarter). Surely, Capstan reasoned, when the bank saw the
projected sales growth for the rest of 2006, it would realize that there were
plenty of profits to enable the company
to start repaying its loans.
Questions
1. Is Capstan Auto in trouble?
2. Is the bank correct to withhold further credit?
3. Why is Capstan`s indebtedness increasing if its
profits are higher than ever?
Category: Corporate finance
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