DUMANDAN, KENNETH R BSA 302-A FINANCIAL MARKETS

P15–1
Cash conversion cycle Metal Supplies is concerned about its
cash management. On average, the day’s sales in inventory (duration
of inventory on shelf) is 90 days. Accounts receivable are collected
in 90 days, while accounts payable are paid in 60 days. Metal
Supplies has annual sales of $14 million, cost of goods sold of $9.5
million, and purchases of $5 million. (Note: Use a 365-day year.)

a. What is Metal Supplies’ operating cycle (OC)?

Operating Cycle = Average age of inventories+Average collection

period
=90+ 90
Operating Cycle =180 days

b. What is Metal Supplies’ cash conversion cycle?

Cash Conversion = Operating cycle-Average Payment period

Cylce
=180-60 days
Cash Conversion =120 days
Cylce

c. What is the amount of resources needed to support Metal

Supplies’ cash conversion cycle?

Inventory = COGS* (Ave.Age of Inventory/365 days)

= $9,500,000* (90/365) = $2,342,466
Accounts =Sales* (Ave. Collection Period/365 days)
Receivable = $14,000,000* (90/365) = $3,452,055
Accounts Payable =A/P* (Ave. Payment Period/365 days)
= $5,000,000* (60/365)= $821,918
Resource needed = Inventory + AR - AP
= $2,342,466 + $3,452,055 - $821,918
Resource needed =$4,972,603
d. What suggestions would you give Metal Supplies to reduce its cash
conversion cycle?

ANSWER: For me, I would suggest that the entity can make the Average
Payment Period longer.They can also make the Average Age of
Inventories or Average collection period shorter. Or they can have a
combination of 2 (Ave. Payment Period Longer + Operating Cycle
shorter)to be able to reduce cash conversion cycle.

P15-4

Aggressive versus conservative seasonal funding strategy Dynabase

Tool has forecast its total funds requirements for the coming year as
shown in the following table.

A.Divide the firm’s monthly funds requirement into (1) a permanent

component and (2) a seasonal component, and find the monthly average
for each of these components.

Month Total Funds Permanent Req Seasonal Req.

Requirements
Jan $2,000,000 $2,000,000 $ 0
Feb 2,000,000 2,000,000 0
Mar 2,000,000 2,000,000 0
Apr 4,000,000 2,000,000 2,000,000
May 6,000,000 2,000,000 4,000,000
June 9,000,000 2,000,000 7,000,000
Jul 12,000,000 2,000,000 10,000,000
Aug 14,000,000 2,000,000 12,000,000
Sept 9,000,000 2,000,000 7,000,000
Oct 5,000,000 2,000,000 3,000,000
Nov 4,000,000 2,000,000 2,000,000
Dec 3,000,000 2,000,000 1,000,000
Average Permanent = $2,000,000
Requirement
Average Seasonal = $48,000,000/12
Requirement
=$4,000,000

B. Describe the amount of long-term and short-term financing used to

meet the total funds requirement under (1) an aggressive funding
strategy and (2) a conservative funding strategy. Assume that, under
the aggressive strategy, long-term funds finance permanent needs and
short-term funds are used to finance seasonal needs.

ANSWER:
1.) based on the aggressive strategy shown above, the entity
would borrow from the range of $1,000,000- $12,000,000
(seasonal req). Also, the entity would borrow $2,000,000 based
on the permanent req. at the prevailing rate
2.) Based on conservative strategy, the entity would borrow at
the maximum of $14,000,000 at the prevailing rate.

C.Assuming that short-term funds cost 5% annually and that the cost
of long-term funds is 10% annually, use the averages found in part a
to calculate the total cost of each of the strategies described in
part b. Assume that the firm can earn 3% on any excess cash balances.

Aggressive =($2,000,000*0.10)+($4,000,000*0.05)
Strategy
=$200,000+$200,000
Total Finance Cost =$400,000
under Aggressive
Strategy

Under the conservative approach, the firm would borrow

$14,000,000 because that is required to cover its peak need during
the year. During much of the year, the firm will have excess cash to
invest. The average amount of excess cash is the average difference
between the peak need, $14 million, and the sum of the permanent need
($2,000,000) and the average seasonal need ($4,000,000), $6 million
($2M + $4M). So the average surplus cash is $8,000,000

Total interest paid $14,000,000*10% $ 1,400,000

Less: Total 8,000,000*3% 240,000
Interest Received
Total Finance Cost $1,160,000

C. Discuss the profitability–risk trade-offs associated with the

aggressive strategy and those associated with the conservative
strategy.

ANSWER: The Aggressive strategy is more profitable but more risky

since it has lower costs which means higher returns and higher risks.
On the other hand, conservative strategy requires the entity to pay
interest on unneeded funds that is why the cost is higher.
` The aggressive approach is less costly for two reasons.For
instance, any of the funds that the company borrows costs 5% rather
than 10%, while the conservative approach allows the firm to pay 10%
on all of its loans. Second, by taking a more aggressive method, the
company borrows less money than over the course of the year.

P15-5
EOQ analysis Enviro Exhaust Company purchases 1,200,000 units
per year of a component with a purchase price of $50. The fixed cost
is $15 per order, and the carrying cost is 30% of the purchase price.

a. Calculate the economic order quantity (EOQ) based on the data

given.
EOQ = (2 ∗ S ∗ O / C

= (2 ∗ 1,200,000 ∗ $15 / 50 ∗ 30%

=1,549.19 or 1,550 units

b. Calculate the EOQ if the order cost is zero. What is the

implication to the firm if there is a decrease in the order cost?

EOQ = (2 ∗ 1,200,000 ∗ $0 / $0.54 = 0

.
Note: If the order cost is 0, the EOQ is also zero. This is because
as ordering cost decreases EOQ decreases as well.. It will be more
cost effective for the firm to place more orders and keep less in
stock (reducing carrying cost) provided that no stockouts occur.

P15-6
EOQ, reorder point, and safety stock Outdoor Living
Manufacturers uses 1,000 units of a product per year. The fixed cost
is $28 per order, while the carrying cost is $5 per unit per year.
The lead time is 5 days and, therefore, the firm keeps 7 days’ usage
in inventory as safety stock. (Note: Use a 365-day year where
required.)

a. Calculate the economic order quantity (EOQ) and the average

inventory
.
EOQ = (2 ∗ S ∗ O / C

= (2 ∗ 1,000 ∗ $28 / 5
=105.83 or 106 units
Ave. = EOQ/ 2
Inventory
=106/2
=53 units

b. How many orders will Outdoor Living Manufacturers place during

one year?

No. Of Orders =1,000/106

=9.43 orders
= The entity will have to place 10 orders during
one year.

c. When should Outdoor Living Manufacturers place its orders?

Reorder point = Days of lead time* daily usade + safety stock

= 5 * (1,000/365) + (7 * (1,000/365))
=32.88 or 33 units
Reorder shoud take place whenever the stock will
reach to 33 units.
d. Suppose Outdoor Living Manufacturers does not keep safety stock.
Explain the changes, if any, that will occur in (1) order cost, (2)
carrying cost, (3) total inventory cost, (4) reorder point, and (5)
EO

Order cost The order cost is fixed and will not change
Carrying cost Remain unchanged.
Total inventory cost May increase if stock outs occur.
Reorder point The reorder point will decrease.
EOQ EOQ will not change as safety stock does not
influence the EOQ.

P15-7

Marginal costs Jimmy Johnson is interested in buying a new Jeep SUV.

There are two options available, a V-6 model and a V-8 model.
Whichever model he chooses, he plans to drive it for a period of 5
years and then sell it. Assume that the trade-in value of the two
vehicles at the end of the 5-year ownership period will be identical.
There are definite differences between the two models, and Jimmy
needs to make a financial comparison. The manufacturer’s suggested
retail price (MSRP) of the V-6 and V-8 are $30,260 and $44,320,
respectively. Jimmy believes that the difference of $14,060 to be the
marginal cost difference between the two vehicles. However, much more
data are available, and you suggest to Jimmy that his analysis may be
too simple and will lead him to a poor financial decision.

Assume that the prevailing discount rate for both vehicles is 5.5%
annually. Other pertinent informa tion on this purchase is shown in
the following table.
A. Calculate the total “true” cost for each vehicle over the 5-year
ownership period.

Items V-6 V-8

Depreciation over 5 $17,337 $25,531
years
Finance charges over 5,171 7,573
entire 5-year period
Insurance over 5 7,546 8,081
years
Taxes and fees over 5 2,179 2,937
years
Maintenance/repairs 5,600 5,600
over 5 years
Total “True” Cost $37,833 $49,722

B. Calculate the total fuel cost for each vehicle over the 5-year
ownership period.

Items V-6 V-8

Miles driven per year 15,000 15,000
over 5 year

Multiply by: *5 *5
Ownership period in
years

Total Miles Driven 75,000 75,000

Over 5 Yrs
Divide by:Average /19 /14
miles per gallon

Ave. Gallon needed 3,947.37 5,357.14

over 5 yrs
Multiply by: Cost per *$3.15 *$3.15
gallon of gas over 5-
year ownership

Total Fuel Cost over $12,434.215 or $16,874.991 or

5 yrs $12,434 $16,875

c. What is the marginal fuel cost from purchasing the larger V-8 SUV?

Marginal Fuel Cost = Total Fuel Cost of of V8- Total Fuel Cost of
of V-8 V6 over 5 yrs
= $16,875- $12,434
Marginal Fuel Cost =$ 4, 441
of V-8

d. What is the marginal cost of purchasing the larger and more

expensive V-8 SUV?

Marginal Cost of V-8 = Marginal Fuel Cost of of V8 + Marginal

“true” Cost of V6 over 5 yrs
= $4,441 + ($49,722- $37,833)
= $4,441 + $ 11,889
Marginal Cost of V- =$ 16,330
8

e. What is the total marginal cost associated with purchasing the V-8
SUV? How does this figure compare with the $14,060 that Jimmy
calculated?

ANSWER: The Total Marginal Cost is $16,330 which is higher than the
marginal cost amounting to $14,060 from the simple difference between
the suggested retail price of V-6 and V-8 ($44,320- $30,260)