Question: Rich Jackson, a recent finance graduate, is
Rich Jackson, a recent finance graduate, is planning to go into the wholesale building supply business with his brother, Jim, who majored in building construction. The firm would sell primarily to general contractors, and it would start operating next January. Sales would be slow during the cold months, rise during the spring, and then fall off again in the summer, when new construction in the area slows. Sales estimates for the first 6 months are as follows (in thousands of dollars): 
The terms of sale are net 30 but, because of special incentives, the brothers expect 30% of the customers (by dollar value) to pay on the 10th day following the sale, 50% to pay on the 40th day, and the remaining 20% to pay on the 70th day. No bad-debt losses are expected because Jim, the building construction expert, knows which contractors are having financial problems. a. Discuss, in general, what it means for the brothers to set a credit and collections policy. b. Assume that, on average, the brothers expect annual sales of 18,000 items at an average price of $100 per item. (Use a 365-day year.) (1) What is the firm’s expected days sales outstanding (DSO)? (2) What is its expected average daily sales (ADS)? (3) What is its expected average accounts receivable (AR) level? (4) Assume the firm’s profit margin is 25%. How much of the receivables balance must be financed? What would the firm’s balance sheet figures be for accounts receivable, notes payable, and retained earnings at the end of 1 year if notes payable are used to finance the investment in receivables? Assume that the cost of carrying receivables had been deducted when the 25% profit margin was calculated. (5) If bank loans have a cost of 12%, what is the annual dollar cost of carrying the receivables? c. What are some factors that influence: (1) a firm’s receivables level and (2) the dollar cost of carrying receivables? d. Assuming the monthly sales forecasts given previously are accurate and that customers pay exactly as predicted, what would the receivables level be at the end of each month? To reduce calculations, assume that 30% of the firm’s customers pay in the month of sale, 50% pay in the month following the sale, and the remaining 20% pay in the second month following the sale. (Note: This is a different assumption than was made earlier.) Also assume there are 91 days in each quarter. Use the following format to answer parts d and e: 
e. What is the firm’s forecasted average daily sales for the first 3 months? For the entire half-year? The days sales outstanding is commonly used to measure receivables performance. What DSO is expected at the end of March? At the end of June? What does the DSO indicate about customers’ payments? Is DSO a good management tool in this situation? If not, why not? f. Construct aging schedules for the end of March and the end of June (use the format given below). Do these schedules properly measure customers’ payment patterns? If not, why not? 
g. Construct the uncollected balances schedules for the end of March and the end of June. Use the format given below. Do these schedules properly measure customers’ payment patterns? 
h. Assume that it is now July of Year 1 and that the brothers are developing projected financial statements for the following year. Further, assume that sales and collections in the first half-year matched the predicted levels. Use the Year-2 sales forecasts shown below to estimate next year’s receivables levels for the end of March and for the end of June. 
i. Now assume that it is several years later. The brothers are concerned about the firm’s current credit terms of net 30, which means that contractors buying building products from the firm are not offered a discount and are supposed to pay the full amount in 30 days. Gross sales are now running $1,000,000 a year, and 80% (by dollar volume) of the firm’s paying customers generally pay the full amount on Day 30; the other 20% pay, on average, on Day 40. Of the firm’s gross sales, 2% ends up as bad-debt losses. The brothers are now considering a change in the firm’s credit policy. The change would entail: (1) changing the credit terms to 2/10, net 20, (2) employing stricter credit standards before granting credit, and (3) enforcing collections with greater vigor than in the past. Thus, cash customers and those paying within 10 days would receive a 2% discount, but all others would have to pay the full amount after only 20 days. The brothers believe the discount would both attract additional customers and encourage some existing customers to purchase more from the firm—after all, the discount amounts to a price reduction. Of course, these customers would take the discount and hence would pay in only 10 days. The net expected result is for sales to increase to $1,100,000; for 60% of the paying customers to take the discount and pay on the 10th day; for 30% to pay the full amount on Day 20; for 10% to pay late on Day 30; and for bad-debt losses to fall from 2% to 1% of gross sales. The firm’s operating cost ratio will remain unchanged at 75%, and its cost of carrying receivables will remain unchanged at 12%. To begin the analysis, describe the four variables that make up a firm’s credit policy, and explain how each of them affects sales and collections. Then use the information given in part h to answer parts j through p. j. Under the current credit policy, what is the firm’s days sales outstanding? What would the expected DSO be if the credit policy change were made? k. What is the dollar amount of the firm’s current bad-debt losses? What losses would be expected under the new policy? l. What would be the firm’s expected dollar cost of granting discounts under the new policy? m. What is the firm’s current dollar cost of carrying receivables? What would it be after the proposed change? n. What is the incremental after-tax profit associated with the change in credit terms? Should the company make the change? (Assume a tax rate of 40 %.) o. Suppose the firm makes the change but its competitors react by making similar changes to their own credit terms, with the net result being that gross sales remain at the current $1,000,000 level. What would be the impact on the firm’s after-tax profitability? 
p. The brothers need $100,000 and are considering a 1-year bank loan with a quoted annual rate of 8%. The bank is offering the following alternatives: (1) simple interest, (2) discount interest, (3) discount interest with a 10% compensating balance, and (4) add-on interest on a 12-month installment loan. What is the effective annual cost rate for each alternative? For the first three of these assumptions, what is the effective rate if the loan is for 90 days but renewable? How large must the face value of the loan amount actually be in each of the four alternatives to provide $100,000 in usable funds at the time the loan is originated?
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January February March $100 $200 $300 April May June $300 $200 $100
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> Is it true that if a firm calculates its days sales outstanding, it has no need for an aging schedule? Explain your answer.
> Suppose a firm makes a purchase and receives the shipment on February 1. The terms of trade as stated on the invoice read “2/10, net 40, May 1 dating.” What is the latest date on which payment can be made and the discount still be taken? What is the date
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> Does its management typically have complete control over a firm’s credit policy? As a general rule, is it more likely that a company would increase its profitability if it tightened or loosened its credit policy?
> Suppose IBM signed a contract to buy a supply of computer chips from a German firm. The price is 10 million euros, and the chips will be delivered immediately, but IBM can delay payment for 6 months if it wants to. What risk would IBM be exposed to if it
> How do each of the items in a firm’s credit policy— defined to include the credit period, the discount and discount period, the credit standards used, and the collection policy—affect its sales, the level of its accounts receivable, and its profitability
> How does credit policy affect the cash conversion cycle as discussed in the last chapter?
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> Assuming the firm’s sales volume remained constant, would you expect it to have a higher cash balance during a tight-money period or during an easy money period? Why?
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> Discuss some of the techniques available to reduce risk exposures.
> List six reasons why risk management might increase the value of a firm.
> Give two reasons stockholders might be indifferent between owning the stock of a firm with volatile cash flows and that of a firm with stable cash flows.
> What is purchasing power parity? How might a firm use this concept in its operations?
> What are some ways banks can state their charges, and how should the cost of bank debt be analyzed? In the early 1970s, Congress debated the need for new legislation, and it ended up passing a “Truth in Lending” law. One part of the law was the requireme
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> The nominal yield on 6-month T-bills is 7%, while default-free Japanese bonds that mature in 6 months have a nominal rate of 5.5%. In the spot exchange market, 1 yen equals $0.009. If interest rate parity holds, what is the 6-month forward exchange rate?
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> What are horizontal, vertical, congeneric, and conglomerate mergers? Are the different types of mergers equally likely to pass muster with the Justice Department?
> Acquisitions can have important tax consequences depending on: (a) Whether the acquiring firm purchases the target’s stock or just its assets, (b) whether cash or stock is used for the payment, and (c) how the acquirer records the target’s assets on i
> Explain how purchase accounting is implemented in a merger. Does the accounting profession now require this method? How is any premium that the acquiring firm paid over the acquired firm’s book value treated subsequent to a merger?
> Southwestern Wear Inc. has the following balance sheet: The trustee’s costs total $281,250, and the firm has no accrued taxes or wages. The debentures are subordinated only to the notes payable. If the firm goes bankrupt and liquidates,
> If you were conducting a merger analysis, would you give the multiples method or one of the DCF methods (that is, the APV or corporate valuation model) more weight in your decision? Explain.
> Explain how the market multiples method is used to determine the value of a target firm to a potential acquirer. Give several examples of this procedure.
> Many companies have serious discussions about merging. Sometimes these discussions lead to mergers, sometimes not. What are some factors that should be considered and that affect the likelihood of a merger actually being completed?
> What is synergy? What are some factors that might lead to synergy? How is the amount of synergy in a proposed merger measured, and how is it allocated between the two firms’ stockholders? Would the four types of mergers as discussed in Question 1 be equa
> Marston Marble Corporation is considering a merger with the Conroy Concrete Company. Conroy is a publicly traded company, and its beta is 1.30. Conroy has been barely profitable, so it has paid an average of only 20% in taxes during the last several year
> Assuming the same information as for Problem 26-2, suppose Hastings will increase Vandell’s level of debt at the end of Year 3 to $30.6 million so that the target capital structure is now 45% debt. Assume that with this higher level of debt the interest
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> If the United States imports more goods from abroad than it exports, then foreigners will tend to have a surplus of U.S. dollars. What will this do to the value of the dollar with respect to foreign currencies? What is the corresponding effect on foreign
> If the Swiss franc depreciates against the U.S. dollar, can a dollar buy more or fewer Swiss francs as a result?
> Exchange rates fluctuate under both the fixed exchange rate and floating exchange rate systems. What, then, is the difference between the two systems?
> With the growth in demand for exotic foods, Possum Products’ CEO Michael Munger is considering expanding the geographic footprint of its line of dried and smoked low-fat opossum, ostrich, and venison jerky snack packs. Historically, jer
> Under the fixed exchange rate system, what was the currency against which all other currency values were defined? Why?
> Kimberly MacKenzie—president of Kim’s Clothes Inc., a medium-sized manufacturer of women’s casual clothing—is worried. Her firm has been selling clothes to Russ Brothers Department S
> SafeCo can issue floating-rate debt at LIBOR + 1% or fixed-rate debt at 8%, but it would prefer to use fixed-rate debt. RiskyCo can issue floating- rate debt at LIBOR + 2% or fixed-rate debt at 8.8%, but it would prefer to use floating rate debt. Explain
> Zhao Automotive issues fixed-rate debt at a rate of 7.00%. Zhao agrees to an interest rate swap in which it pays LIBOR to Lee Financial and Lee pays 6.8% to Zhao. What is Zhao’s resulting net payment?
> Are liquidations likely to be more common for public utility, railroad, or industrial corporations? Why or why not?
> Would it be a sound rule to liquidate whenever the liquidation value is above the value of the corporation as a going concern? Discuss.
> Distinguish between operating mergers and financial mergers.
> Why do creditors usually accept a plan for financial rehabilitation rather than demand liquidation of the business?
> a. Informal restructuring; reorganization in bankruptcy b. Assignment; liquidation in bankruptcy; fairness; feasibility c. Absolute priority doctrine; relative priority doctrine d. Bankruptcy Reform Act of 1978; Chapter 11; Chapter 7 e. Priority of claim
> Why do liquidations usually result in losses for the creditors or the owners, or both? Would partial liquidation or liquidation over a period limit their losses? Explain.
> a. Derivatives b. Enterprise risk management c. Financial futures; forward contract d. Hedging; natural hedge; long hedge; short hedge; perfect hedge; symmetric hedge; asymmetric hedge e. Swap; structured note f. Commodity futures
> How can swaps be used to reduce the risks associated with debt contracts?
> Explain how the futures markets can be used to reduce interest rate risk and contracts?
> Explain how the EOQ inventory model can be modified and used to help determine the optimal size of a firm’s cash balances. Do you think the EOQ approach to cash management is more or less relevant today than it was in precomputer, preelectronic communica
> Explain briefly what the EOQ model is and how it can be used to help establish an optimal inventory policy. Is the EOQ concept consistent with just-in-time procedures for managing inventories?
> The Gentry Garden Center sells 90,000 bags of lawn fertilizer annually. The optimal safety stock (which is on hand initially) is 1,000 bags. Each bag costs the firm $1.50, inventory carrying cost is 20%, and the cost of placing an order with its supplier
