Page 225 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Working Capital Management

Notes
Example: The XYZ Company currently makes payments by cheques. The ABC Company,
a supplier, has requested that XYZ allow ABC to debit their account 10 days after the invoice
date. XYZ currently pays ABC with a cheque mailed 30 days after the invoice date. It takes an
average of 5 days for the cheque to the cleared through XYZ account. The average payment to
ABC is `500. It costs XYZ an average of ` 10 to process the invoice through their accounts
payables department and to issue a cheque. These costs would be eliminated by the proposed
procedure. The opportunity costs of funds to XYZ is 10%,
(a) Should XYZ accept ABC’s offer?

(b) XYZ has received a similar offer from TNK Company. Payments to TNK company average
v 5,000. All other information is unchanged from the involving ABC. Should XYZ accept
TNK’s offer?
Solution:
(a) Under the current system XYZ loses value from its account on day 35. They also incur
internal costs of `10. (For simplicity assume these costs are incurred on day 35 when the
payment is made.) Under the proposed payment terms XYZ will lose value of `500 on day
10. To compare these two we take the present value (on day 10) of the payment on day 35.
This is `5,107 (l + l × 25/365) = `506.53. Under the proposed payment terms they with lose
value of `500 on day 10. Since they will be better off by `6.53 with the payment terms. XYZ
should accept ABC’s offer.

(b) The present value on day 10 for the payment to TNK under the system is `5,010/( 1 +. 1 ×
25/365) = ` 4,975.92. If XYZ accepts TNK’s payment terms it will lose value of `5,000 on day
10. Since XYZ will be worse off by ` 24.08, it should reject TNK’s offer of the new payment
terms.

Example: A firm has an annual opportunity cost of 12 per cent is contemplating
installation of a lock box system at an annual cost of `2,60,000. The system is expected to reduce
mailing time by 3 days and reduce cheque clearing time by 2 days. If the firm collects ` 5,00,000
per day, would you recommend the system? Explain.
Solution:

Time reduction:
Mailing time - 3 days
Clearing time - 2 days

Total time reduction - 5 days Float reduction;
5 days × `5,00,000/day = 25,00,000 Gross annual profit of float reduction;
0.12 × `25,00,000 = `3,00,000
Since the annual earnings from the float reduction of `3,00,000 exceed the annual cost of `2,60,000,
the proposed lock-box system should be implemented. It will result in a net annual savings of
`40,000 (`3,00,000 – `2,60,000 cost).

Example: The credit terms for each of three suppliers are as follows:
Supplier Credit term

XYZ 1/10 net 46 EOM

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