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Working Capital Management, Credit and Policies

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1. Why is some trade credit called free while other credit is called costly? If a firm buys on terms on 2/10,net 30, pays at the end of the 30th day, and typically shows $300,000 of accounts payable on its balance sheet, would the entire $300,000 be free credit? Would it be costly credit, or would some be free and some costly?. Please explain answer and no calculations is needed.

2. Working Capital policy: The Rentz corporation is investigating the optimal level of current rent assets for the coming year. Management expects sales to increase to approximately $2million as a result of an asset expansion presently being undertaken .Fixed assets total $1million, and the firm plans to maintain a 60% debt ratio. Rentz's interest rate is currently 8% on both short-term and longer-term debt (which the firm uses in its permanent structure) Three alternatives regarding the projected current assets level are under consideration:(1) a tight policy where current assets would be only 45% of projected sales, (2) a moderate policy where current assets would be 50% of sales, and (3) a relaxed policy where current assets would be 60% of sales. Earnings before interest and taxes should be 12% of total sales, and the federal -plus-state tax rate is 40%.

a). What is the expected return on equity under each current asset level?
b): In this problem, we assume that expected sales are independent of the current asset policy. Is this a valid assumption?
c): How would the firm's risk be affected by the different policies?

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Solution Preview

1. Trade credit is sometimes called free as there is no interest payable on amount taken for trade credit. So there is no explicit cost. However, in most cases there are cash discounts which the firm can avail which results in implicit cost of trade credit. Other forms of credit require payment of interest and hence called costly.

If the amount is paid on the 10th day, the company will get a 2% discount of the payments. However, if the amount is paid on the 30th day, there is no discount available. Thus, the initial 10 days of the credit is free credit (no implicit or explicit cost) and the remaining 20 ...

Solution Summary

This solution defines and explains the characteristics of trade credit and gives a detailed spreadsheet on the expected return on equity under the current asset level. It also explains how the firm's risk was affected by different policies.