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Growth Rate, A/R, Contribution Margin, and Collection Float

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Problem One:
Key financial data from the most recent annual report of Derson Manufacturing is listed below.

Sales \$12.7 million
Net income \$ 1.3 million
Total assets \$ 7.6 million
Total equity \$ 5.2 million
Dividends \$ 0.3 million

The firm's CFO wishes to use this data to estimate the firm's sustainable growth rate.
a. Use the data provided to calculate Derson's net profit margin, assets-to-equity ratio, asset turnover ratio, and its dividend payout ratio.
b. Use your findings in part (a) to find Derson's sustainable growth rate.
c. Interpret the sustainable growth rate calculated in part (b). Does this rate of growth assure shareholder wealth maximization? Explain.
d. If the firm's Board feels that it is best for its shareholders to grow the firm more slowly, what alternations in each of the baseline assumptions would be necessary to achieve this objective?

Problem Two:
A firm has actual sales of \$50,000 in January and \$70,000 in February. It expects sales of \$90,000 in March and \$110,000 in both April and May. Assuming that sales are the only source of cash inflow, and that 60 percent of these are for cash and the rest are collected evenly the following two months, what are the firm's expected cash receipts for March, April, and May?

Problem Three:
Heriot Company currently has an average collection period of 55 days and annual sales of \$1 billion. Assume a 365-day year.
a. What is the firm's average accounts receivable balance?
b. If the variable cost of each product is 64 percent of sales, what is the average investment in accounts receivable?
c. If the equal-risk opportunity cost of the investment in accounts receivable is 12 percent, what is the total annual cost of the resources invested in accounts receivable?

Problem Four:
Craves Company is considering relaxing its credit standards to boost its currently sagging sales. It expects its proposed relaxation will increase sales by 20 percent from the current annual level of \$10 million. The company's average collection period is expected to increase from 35 days to 50 days and bad debts are expected to increase from 2 percent of sales to 7 percent of sales as a result of relaxing the company's credit standards as proposed. The company's variable costs equal 60 percent of sales and their fixed costs total \$2.5 million per year. Craves' opportunity cost is 16 percent. Assume a 365-day year.
(a). What is Craves' contribution margin?
(b). Calculate Craves' marginal profit from increased sales.
(c). What is Craves' cost of the marginal investment in accounts receivable?
(d). What is Craves' cost of marginal bad debts?

Problem Five:
Apex Inc. estimates that its customers' payments are in the mail for 3 days, and once received they are processed in 2 days. After the payments are deposited in the firm's bank, the funds are made available to the firm by the bank in 2.5 days. The firm estimates its total annual collections, received at a constant rate, from credit customers to be \$87 million. Its annual opportunity cost of funds is 9.5 percent. Assume a 365-day year.
(a). How many days of collection float does Apex Inc. have?
(b). What is the current annual dollar cost of Apex Inc.'s collection float?
(c). If the installation of an electronic invoice presentment and payment (EIPP) system would result in a 4 day reduction in Apex's collection float, how much could the firm earn annually on this float reduction?
(d). Based on your findings in part c, should Apex Inc. install the EIPP system if its annual cost is \$85,000? Explain your recommendation.

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Solution Preview

Problem One:
Key financial data from the most recent annual report of Derson Manufacturing is listed below.

Sales
\$12.7 million
Net income
\$ 1.3 million
Total assets
\$ 7.6 million
Total equity
\$ 5.2 million
Dividends
\$ 0.3 million

The firm's CFO wishes to use this data to estimate the firm's sustainable growth rate.
a. Use the data provided to calculate Derson's net profit margin, assets-to-equity ratio, asset turnover ratio, and its dividend payout ratio.

Net profit margin = Net Income/Sales = 1.3/12.7 = 10.24%
Assets to equity = Total Assets/Total equity = 7.6/5.2 = 1.46
Asset turnover ratio = Sales/Total Assets = 12.7/7.6 = 1.67
Dividend payout ratio = Dividends/Net Income = 0.3/1.3 = 23.08%

b. Use your findings in part (a) to find Derson's sustainable growth rate.

Sustainable growth rate = Return on equity X (1-dividend payout ratio)
Return on equity = Net Income/Total equity = 1.3/5.2 = 25%
Sustainable growth rate = 25% X (1-0.2308) = 19.23%

c. Interpret the sustainable growth rate calculated in part (b). Does this rate of growth assure shareholder wealth maximization? Explain.

Sustainable growth is the growth rate at which the debt/equity ratio of a firm remains constant. It is called sustainable since the level of debt does not increase very much but increases depending on the equity to keep the debt to equity constant and so does not increase the financial risk of the firm.
This rate may not necessarily maximize shareholder wealth. If the firm has the capacity to service more debt, then the firm can increases its growth rate beyond the sustainable growth rate and so have a higher increase in shareholder wealth.

d. If the firm's Board feels that it is best for its shareholders to grow the firm more slowly, what alternations in each of the baseline assumptions would be necessary to ...

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