Finance Problems: Net Cost and Sales
1) Penn Steelworks is a distributor of cold-rolled steel products to the automobile industry. All of its sales are on a credit basis, net 30 days. Sales are evenly distributed over its 10 sales regions throughout the United States. Delinquent accounts are no problem. The company has recently undertaken an analysis aimed at improving its cash management procedures. Penn determined that it takes another full day in processing time prior to depositing the checks with a local bank. Annual sales average $4.8 million for each regional office. Reasonable investment opportunities can be found that yield 7 percent per year.
To alleviate the float problem confronting the firm, the use of a lockbox system in each of the 10 regions is being considered. This would reduce mail float by 1.2 days. One day in processing float would also be eliminated, plus a full day in transit float. The lockbox arrangement would cost each region $250 per month.
a) Determine the net cost or savings from use of the proposed cash acceleration technique? Should Penn adopt the system?
2. Far Out Tech (FOT) has a debt ratio of 0.3 and it considers this to be its optimal capital structure. FOT has no preferred stock. FOT has analyzed four capital projects for the coming year as follows:
Project Net Investment IRR
1 $3,000,000 13.5%
2 $1,500,000 18.0%
3 $2,000,000 12.6%
4 $1,600,000 16.0%
FOT expects to earn $2.7 million after tax next year and pay out $700,000 in dividends. Dividends are expected to be $1.05 a share during the coming year and are expected to grow at a constant rate of 10 percent a year for the foreseeable future. The current market price of FOT stock is $22 and up to $2 million in new equity can be raised for a flotation cost of 10 percent. If more than $2 million is sold then the flotation cost will be 15 percent. Up to $2 million in debt can be sold at par with a coupon rate of 10 percent. Any debt over $2 million will carry a 12 percent coupon rate and should be sold at par. If FOT has a marginal tax rate of 40 percent, in which projects should it invest?
3. Components Manufacturing Corporation (CMC) has an all-common-equity capital structure. It has 200,000 shares of $2 par value common stock outstanding. When CMC's founder, who was also its research director and most successful inventor, retired unexpectedly to the South Pacific in late 2008, CMC was left suddenly and permanently with materially lower growth expectations and relatively few attractive new investment opportunities. Unfortunately, there was no way to replace the founder's contributions to the firm. Previously, CMC found it necessary to plow back most of its earnings to finance growth, which averaged 12% per year. Future growth at a 6% rate is considered realistic, but that level would call for an increase in the dividend payout. Further, it now appears that new investment projects with at least the 14% rate of return required by CMC's stockholders (r9 = 14%) would amount to only $800,000 for 2009 compared to a projected $2,000,000 of net income. If the existing 20% dividend payout was continued, retained earnings would be $1.6 million in 2009; but as noted, investments that yield the 14% cost of capital would amount to only $800,000.
The one encouraging point is that the high earnings from existing assets are expected to continue, and net income of $2 million is still expected for 2009. Given the dramatically changed circumstances, CMC's management is reviewing the firm's dividend policy.
a) Assuming that the acceptable 2009 investment projects would be financed entirely by earnings retained during the year and assuming that CMC uses the residual dividend model, calculate DPS in 2009.
b) What payout ratio does your answer to Part a imply for 2009?
4. Allied Food Products is considering expanding into the fruit juice business with a new fresh lemon juice product. Assume that you were recently hired as assistant to the director of capital budgeting and you must evaluate the new project.
The lemon juice would be produced in an unused building adjacent to Allied's Fort Myers plant; Allied owns the building, which is fully depreciated. The required equipment would cost $200,000, plus an additional $40,000 for shipping and installation. In addition, inventories would rise by $25,000, while accounts payable would increase by $5,000. All of these costs would be incurred at t = 0. The machinery would be depreciated on a straight-line basis.
The project is expected to operate for 4 years, at which time it will terminated. The cash inflows are assumed to begin 1 year after the project is undertaken, or at t=1, and to continue out to t= 4. At the end of the projects life (t=4), the equipment is expected to have a salvage value of $25,000.
Unit sales are expected to total 100,000 units per year, and the expected sales price is $2.00 per unit. Cash operating costs for the project (total operating costs less depreciation) are expected to total 60% of dollar sales. Allied's tax rate is 40%, and its WACC is 10%. Tentatively, the lemon juice project is assumed to be of equal risk to Allied's other assets.
You have been asked to evaluate the project and to make a recommendation as to whether it should be accepted or rejected.
5. Cover's, Inc. (CI) sells its stainless steel products on terms of "2/10, net 40". CI is considering granting credit to retailers with total assets as low as $500,000. Currently the lowest asset limit is $750,000. CI believes sales will increase $7 million from the new credit group but the average collection period for this new group will be 60 days versus the current average collection period of 35 days. If management estimates that 40% of the new customers will take the cash discount but 10% of the new business will be written off as bad-debt loss, should CI lower its credit standards? Assume CI's variable cost ratio is 0.7 and its required pretax rate of return on current assets investment is 15%. CI also estimates that an additional investment in inventory of $850,000 is necessary for the anticipated sales increase.
6. Eraser Dust Company currently has $30 million of gross working capital. They wish to increase this to $40 million. Currently their liabilities and capital consist of:
Current liabilities (short term debt) $20 million
Long Term debt $10 million
Common equity $30 million
They are considering financing the additional working capital in three different ways; interest costs depend on the method of financing chosen. Relevant facts are summarized as:
Policy Increase STD Increase LTD Cost STD Cost LTD
A $2 million $8 million 10.5 percent 12.5 percent
B 5 million 5 million 10.0 percent 12.0 percent
C 8 million 2 million 9.5 percent 11.5 percent
Assume an EBIT of $10 million and a 40% tax rate.
a) Determine the return in equity for each policy.
b) Indicate which policy you would recommend.