CHAPTER 16

Current Asset Management

CHAPTER ORIENTATION
This chapter initiates our study of liquidity management. Here, we focus on the cash flow
process and the reasons why a firm holds cash balances. The objectives of a sound cash
management system are identified. The concept of float is defined. Several techniques that
firms can use to favorably affect their cash receipts and disbursement patterns are examined.
Finally, the composition of the firm’s marketable securities portfolio is discussed.
Additionally, the risk-return tradeoff associated with the firm’s investment in accounts
receivable is discussed. For accounts receivable, this tradeoff occurs as less creditworthy
customers with a higher probability of bad debts are taken on to increase sales. The analysis is
similar for sound inventory management. Here a larger investment in inventory leads to more
efficient production and speedier delivery; this should result in increased sales. However,
additional financing costs to support the increase in inventory and increased handling and
carrying costs are required.

CHAPTER OUTLINE

I. Why a company holds cash

A. The firm’s cash balance is constantly affected by a variety of influences. Sound
cash management techniques are based on a thorough understanding of the cash
flow process.
1. On an irregular basis, cash holdings are increased from several external
sources, such as from the sale of securities.
2. In a similar fashion, irregular cash outflows reduce the firm’s cash
balance. Typical examples include cash dividend payments and the
interest requirements on debt agreements.
3. Other major sources of cash arising from internal operations occur on a
rather regular basis. Accounts receivable collections are an example.

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 1
B. Three motives for holding cash balances have been identified by Keynes.
1. The transactions motive is the need for cash to meet payments that arise
in the ordinary course of doing business. Holding cash to meet a payroll
or to acquire raw materials characterizes this motive.
2. The precautionary motive describes the investment in liquid assets that
are used to satisfy possible, but as yet indefinite, needs for cash.
Precautionary balances are a buffer against all kinds of things that might
happen to drain the firm’s cash resources.
3. The speculative motive describes holding cash to take advantage of
hoped-for, profit-making situations.
II. Variations in liquid asset holdings
A. Considerable variation is present in the liquid asset holdings of major industry
groups and individual firms.
1. This is because (l) not all of the factors noted above affect every firm
and (2) the executives in different firms who are ultimately responsible
for cash management tasks have different risk-bearing preferences.
2. Some industries invest very heavily in liquid assets. For example, the
total-liquid-assets-to-total-assets ratio of the contract construction
industry greatly exceeds that of the utility industry.
B. Because assets are acquired, used, and sold every day, the management of
liquid assets must be viewed as a dynamic process. The cash flow process is
complex. In order to cut through this complexity, it is necessary that the firm’s
cash management system operates within clearly defined objectives.
III. Cash management objectives and decisions
A. A properly designed cash management program forces the financial manager to
come to grips with a risk-return tradeoff.
1. He or she must strike an acceptable balance between holding too much
cash and holding too little cash.
2. A large cash investment minimizes the chances of insolvency, but it
penalizes company profitability.
3. A small cash investment frees excess (cash) balances for investment in
longer-lived and more profitable assets, which increases the firm’s
profitability.
B. The firm’s cash management system should strive to achieve two prime
objectives:
1. Enough cash must be on hand to dispense effectively with the disbursal
needs that arise in the course of doing business.

1
John Maynard Keynes, The General Theory of Employment Interest and Money (New York: Harcourt Brace
Jovanovich, Inc., 1936).

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 2. The firm’s investment in idle cash balances must be reduced to a
minimum.
C. In the attempt to meet the two objectives noted above, certain decisions
dominate the cash management process. These decision areas can be reduced to
the three following questions:
1. What can be done to speed up cash collections and slow down or better
control cash outflows?
2. What should be the composition of the marketable securities portfolio?
3. How should the investment in liquid assets be split between actual cash
holdings and marketable securities?
IV. Collection and disbursement procedures
A. Cash acceleration and deceleration techniques revolve around the concept of
float. Float can be broken down into four elements:
1. Mail float refers to funds that are tied up as a result of the time that
elapses from the moment a customer mails his or her remittance check
until the firm begins to process the check.
2. Processing float refers to funds that are tied up as a result of the firm’s
recording and processing remittance checks prior to their deposit in the
bank.
3. Transit float refers to funds that are tied up as a result of the time needed
for a deposited check to clear through the commercial banking system
and become "usable" funds to the firm.
4. Disbursing float refers to funds that are technically usable to the firm
until its payment check has cleared through the banking system and has
been charged against its deposit account.
B. Float reduction can result in considerable benefits in terms of (l) usable funds
that are released for company use and (2) in the returns produced on these
freed-up balances. A study problem at the end of this chapter illustrates the
calculation of such savings.
In October of 2003, President Bush signed into law the Check Clearing for the
21st Century Act. The law took effect on October 28, 2004. This new law is
now commonly referred to as “Check 21.” Prior to this new regulation ordinary
paper checks were physically transported by land carrier or air carrier from the
depositing location to the financial institution that would eventually pay the
check drawn against the firm’s or individual’s bank account.
Check 21 allows financial institutions the option of clearing a check image
instead of the original check. Such digital substitutes can then be quickly
processed within the banking clearing system in the same way that you use the
internet on your personal computer. These digital substitutes are being referred
to as substitute checks or image replacement documents.
The impetus for this new law was threefold: (1) bank regulators, like those at
the Federal Reserve System, feel that Check 21 will accelerate check collection

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 at the ultimate or payee bank, (2) it is forecast that out-of-pocket transportation
costs to the banking system will be reduced, this increasing individual bank
profitability, and (3) the high degree of physical risk exposure associated with
airline service can be minimalized.

From the viewpoint of the firm’s cash management system, “managing the
float” will eventually be directly impacted. What is called “disbursing float”
above could be dramatically reduced towards a few hours instead of a day or
two. But, Check 21 did not require banks to alter their “hold” time on specific
checks or substitute checks posted to the firm’s account within the bank (these
are ultimately cash inflows that become “good” funds).

So while the check may have cleared within the bank clearing mechanism, (i.e.,
from bank to bank), the firm may not have use of “good” funds until banks are
forced by a yet-to-be-defined regulatory change to reduce their “hold” time on
checks that have actually cleared. Thus, the effects of Check 21 on “transit
float” (the third type of float mentioned above) will occur gradually as pressure
is put on individual financial institutions to reduce hold times and make the
funds available for disbursement by the receiving firm.

The upshot for the firm, and its cash management system, is that the greatest
profitability opportunities are still associated with reducing mail float and
processing float.
C. Several techniques are available to improve the management of the firm’s cash
inflows. These techniques may also provide for a reduction in float.
1. The lock-box arrangement is a widely used commercial banking service
for expediting cash gathering.
a. The objective is to reduce both mail and processing float.
b. The procedure behind a lock-box system is very simple. The
firm rents a local post office box and authorizes a local bank in
which a deposit account is maintained to pick up remittances
from the box.
(l) Customers are instructed to mail their payments to the
numbered post office box.
(2) A deposit form is prepared by the bank for each batch of
processed checks.
(3) The bank may notify the firm daily as to the amount of
funds deposited on the firm’s behalf.
(4) The firm that receives checks from all over the country
establishes several lock boxes.
c. A lock-box arrangement provides for (l) increased working cash,
(2) elimination of clerical functions, and (3) early knowledge of
dishonored checks.
d. The firm must carefully evaluate whether this or any cash
management service is worth the added costs. Usually, the bank

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 levies a charge for each check processed through the system.
The marginal income generated from released funds must
exceed the added costs of the system to make it economically
beneficial. A study problem at the end of this chapter illustrates
this kind of calculation.
D. Techniques used by firms that hope to improve the management of their cash
outflows include: (l) zero balance accounts, (2) payable-through drafts, and (3)
remote disbursing.
1. Zero balance accounts (ZBAs) permit centralized control (i.e., at the
head office) over cash disbursements, but, at the same time, they allow
the firm to maintain disbursing authority at the local or divisional level.
a. The major objective of a ZBA system is to achieve better control
over cash payments. A secondary benefit of this technique
might be an increase in disbursement float.
b. Under a ZBA system, each profit center (division) has a
disbursing account located in the same concentration bank.
(l) The firm’s authorized employees write payment checks
in the usual manner.
(2) These checks then clear through the banking system and
are presented to the firm’s concentration bank for
payment.
(3) The checks are paid by the bank and negative balances
build up in the appropriate disbursing accounts.
(4) Daily, the negative balances are restored to a zero level
by means of credits to the various ZBAs and a
corresponding reduction in the firm’s master demand
deposit account in the concentration bank.
c. For the firm that has several operating units, the benefits from
using a ZBA system include:
(1) Centralized control over disbursements.
(2) Reduction of time spent on superficial cash management
activities.
(3) Reduction of excess cash balances held in outlying
accounts.
(4) An increase in disbursement float.

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 2. Payable-through drafts (PTDs) have the physical appearance of ordinary
checks but they are drawn on and paid by the issuing firm instead of the
bank. The bank serves as a collection point for the documents and
passes the documents on to the firm for inspection and authorization for
payment.
a. The objective of a payable-through draft system is to provide for
effective control of field authorized payments. An example
would be a claim settlement authorized by an insurance agent.
b. Stop payment orders can be initiated by the firm’s headquarters
on any drafts considered inappropriate.
c. Legal payment of individual drafts takes place after review and
approval of the drafts by the company. Disbursing float,
however, is usually not increased by the use of drafts. For
purposes of measuring usable funds to the firm, drafts presented
daily for payment are charged in total against the corporate
master demand deposit account.
3. Electronic funds transfer methods are serving to reduce transit, mail,
and processing float.
a. If Firm A owes money to Firm B, this situation ought to be
immediately reflected on both the books and bank accounts of
these companies.
b. This ideal within the U.S. financial system has not been reached;
the trend toward it is readily observable. Business firms, for
example, are using systems like terminal-based wire transfers to
move funds within their cash management systems.
c. The heart of electronic funds transfer (EFT) is the elimination of
the check as a method of transferring funds. The process of EFT
should provide for a more efficient economy, since funds (cash)
will be released for more productive purposes.
V. Evaluating the costs of cash management services
A. Whether a particular cash management system will provide an economic benefit
to the firm can be evaluated by use of this relationship:
added costs = added benefits
B. Clearly, if the benefits exceed the costs of using the system, then the system is
economically feasible.

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 C. On a per unit-basis, this relationship can be expressed as follows:
P = (D) (S) (i)

where P = increase in per-check processing cost, if the new system is

adopted,
D = days saved in the collection process, i.e., float reduction,
S = average check size in dollars,
i = the daily, before-tax opportunity cost (rate of return) of
carrying cash.
D. The sum of (D) (S) (i) must exceed P for the system to be beneficial to the firm.
A study problem at the end of this chapter provides an example of this logic.
VI. Composition of the marketable securities portfolio
A. When selecting a proper marketable securities mix, five factors should be
considered.
1. Financial risk is the uncertainty of expected returns from a security due
to unforeseeable changes in the financial capacity of the security issuer
to make future payments to the security owner.
2. Interest rate risk is the uncertainty in expected returns caused by
possible changes in interest rates. This is particularly important for
securities that have long, as opposed to short, terms of maturity. (See
study problem 5 for an illustration of this point.)
3. Liquidity is the ability to transform a security into cash. Consideration
should be given to (l) the time needed to sell the security and (2) the
likelihood that the security can be sold at or near its prevailing market
price.
4. The taxability of interest income and capital gains is seriously
considered by some corporate treasurers.
a. The interest income from municipal obligations is tax-exempt.

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 b. The following equation may be used to determine an equivalent
before-tax yield on a taxable security.
(1) Notation:
r = equivalent before-tax yield.
r* = after-tax yield on tax-exempt security.
T = firm’s marginal income tax rate.
(2) Computation
r*
r =
(1 − T)
(3) Example: Suppose a firm has a choice between investing
in a 1-year tax-free debt issue yielding 6% on a $1,000
outlay or a 1-year taxable issue that yields 7% on a
$1,000 outlay. The firm pays federal taxes at the rate of
34%. Which security is more beneficial to the firm?
0.06
r = = 9.09%
(1 − 0.34)
(4) Clearly, this firm should choose the tax-exempt security.
5. The yield criterion involves a weighing of the risks and benefits inherent
in the four previously mentioned factors. The higher the risks associated
with a particular security, the higher the expected yield (risk-return
tradeoff).
B. Marketable security alternatives
1. A Treasury bill is a direct obligation of the U.S. government sold on a
regular basis by the U.S. Treasury.
a. These bills may now be purchased in denominations as small as
$1,000.
b. The bills are currently offered with maturities of 91, 182, and
365 days.
c. Since Treasury bills are sold on a discount basis, the investor
does not receive an actual interest payment.
d. Since Treasury bills are backed by the U.S. government, they are
considered risk-free and consequently sell at lower yields than
those obtainable on other marketable securities.
e. The income from Treasury bills is subject only to federal income
taxes and is always taxed as an ordinary gain.

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2. Federal agency securities represent debt obligations of federal
government agencies and were created to carry out lending programs of
the U.S. government.
a. The Federal National Mortgage Association (FNMA) renders
supplementary assistance to the secondary market for mortgages.
b. The Federal Home Loan Banks (FHLB) function as a credit
reserve system for member banks.
c. The Federal Land Banks grant loans to members of Federal
Land Bank Associations who are engaged in agriculture, provide
agricultural services, or own rural homes.
d. The Federal Intermediate Credit Banks grant loans to and
purchase notes originating from loans made to farmers by other
financial institutions.
e. The Banks for Cooperatives make loans to cooperative
associations which are owned and controlled by individuals
involved in general farm business.
f. Securities of these "big five" federally sponsored agencies are
not directly backed by the U.S. government.
g. The maturities available range from 30 days to 15 years, with
most (80%) maturing in 5 years or less.
h. The yields available always exceed those of Treasury bills of
comparable maturity and are taxable at the federal, state, and
local level.
3. Bankers’ acceptances are largely concentrated in the financing of
foreign transactions; this acceptance is a draft (order to pay) drawn on a
specific bank by an exporter in order to obtain payment for goods
shipped to a customer who maintains an account with that bank.
a. The maturities run mostly from 30 to 180 days, with the most
common period being 90 days.
b. Like Treasury bills, the acceptances are sold on a discount basis.
c. Income generated from acceptances is fully taxable at all
governmental levels.
d. Acceptances provide investors with a higher yield than do
Treasury bills and agency obligations of comparable maturity.
4. A negotiable certificate of deposit (CD), is a marketable receipt for
funds that have been deposited in a bank for a fixed time period at a
fixed interest rate.
a. CDs are offered in denominations ranging from $25,000 to
$10,000,000, with popular sizes of $100,000, $500,000 and
$1,000,000.

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 b. Original maturities on CDs range from 1 to 18 months.
c. Yields on CDs are higher than yields on Treasury bills, and, in
recent years, they have exceeded those available on acceptances.
d. The income received from CDs is taxed at all governmental
levels.
5. Commercial paper refers to short-term, unsecured promissory notes sold
by large businesses in order to raise cash.
a. Paper is usually sold in relatively large denominations, typically
in excess of $25,000, and ranging up to $1,000,000.
b. The notes are sold on a discount basis with maturities ranging
from 3 to 270 days.
c. It is the only investment instrument discussed here that has no
active trading in a secondary market.
d. The return on commercial paper is fully taxable at all
governmental levels.
6. Repurchase agreements are legal contracts that involve the actual sale of
securities by a borrower to the lender, with a commitment on the part of
the borrower to repurchase the securities at the contract price plus a
stated interest charge.
a. These agreements are usually executed in sizes of $500,000 or
more.
b. The maturity is either for a specified time period (tailored to the
needs of the investor) or there is no fixed maturity date.
c. The yields are generally less than those of Treasury bill rates of
comparable maturities and are taxable at all governmental levels.
7. Money market mutual funds usually invest in a diversified portfolio of
short-term, high-grade debt instruments like those described in this
section.
a. These funds sell their shares to a large number of small investors
in order to raise cash.
b. The funds offer the investing firm a high degree of liquidity and
investment expertise.
c. The returns earned from owning shares in a money market fund
are taxable at all governmental levels.
d. Table 16.1 summarizes the salient features of the major money
market instruments important to businesses.

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 Table 16.1 Features of Selected Money Market Instruments

Instrument Denominations Maturities Basis Liquidity Taxability

U.S. Treasury Bills: $1,000 and increments 91 days Discount Excellent Exempt from state and
Direct obligations of the of $1,000 182 days secondary local income; do not
U.S. government 365 days market qualify for favorable
9-month not presently capital gains rate
issued
Federal Agency Wide variation from 5 days* to more than 10 Discount or coupon; Good for issues of "Big Generally exempt at
Securities: Obligations of $1,000 to $1,000,000 years (*Farm Credit usually on coupon Five" agencies local level; FNMA
corporations and agencies consolidated system- issues are not
created to affect the wide discount notes)
federal government's
lending programs.
Bankersí Acceptances: No set size; typically Predominantly from 30 Discount Good for acceptances of Taxed at all levels of
Drafts accepted for future range from $25,000 to to 180 days large "money market" government
payment by commercial $1,000,000 banks
banks
Negotiable Certificates of $15,000 to $10,000,000 1 to 18 months Accrued interest Fair to good Taxed at all levels of
500

Deposit: Marketable government

receipts for funds
deposited in a bank for a
fixed time period.
Commercial Paper: $5,000 to $5,000,000; 3 to 270 days Discount Poor; no active, Taxed at all levels of
Short-term, unsecured $1,000 and $5,000 secondary market in government
promissory notes. multiples above the usual sense
initial offering size are
sometimes available
Repurchase Agreements: Typical sizes are According to terms of Not applicable Fixed by the agreement, Taxed at all levels of
Legal contracts between a $500,000 or more contract i.e., borrower will government
borrower (security seller) repurchase
and lender (security
buyer.) The borrower
will repurchase at the
contract price plus an
interest charge
Money Market Mutual Some require an initial Shares can be sold at any Net asset value Good; provided by the Taxed at all levels of
Funds: Hold a diversified investment as small as time fund itself government
portfolio of short-term, $1,000
high-grade debt
instruments
 8. Money market deposit accounts became available to the public on
December 14, 1982, on authorization of the Depository Institutions
Deregulatory Committee.
a. These accounts are offered by commercial banks and thrift
institutions. The intent is to compete with money market
mutual funds, but they do differ in significant ways from
the funds.
b. One characteristic of the money market deposit accounts
(MMDAs) that makes them inappropriate for most
businesses is that the number of transactions per month on
each account is limited. Firms generally do not want to be
restricted on the number of times per month that they can
tap their liquid asset reserves. That runs counter to the very
logic of holding a buffer stock of liquidity.
c. Alternatively, the MMDAs have become very popular with
individual investors.
VII. Accounts receivable
A. Typically, accounts receivable represent just over 25% of a firm’s assets.
B. The size of the investment in accounts receivable varies from industry to
industry and is affected by several factors including the percentage of
credit sales to total sales, the level of sales, and the credit and collection
policies—more specifically the terms of sale, the quality of customer, and
collection efforts.
C. Although all these factors affect the size of the investment, only the credit
and collection policies are decision variables under the control of the
financial manager.
D. The terms of sale are generally stated in the form a/b net c, indicating that
the customer can deduct a percentage if the account is paid within b days;
otherwise, the account must be paid within c days.
E. If the customer decides to forgo the discount and not pay until the final
payment date, the annualized opportunity cost of passing up this a%
discount and withholding payment until the cth day is determined as
follows:
annualized opportunity
cost of foregoing the a 360
= x
discount 1− a c−b
Example: Given the trade credit terms of 3/20 net 60, what is the
annualized opportunity cost of passing up the 3% discount
and withholding payment until the 60th day?
Solution: Substituting in the values from the example, we get
0.03 360
27.8% = x
1 − 0.03 60 − 20

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F. A second decision variable in determining the size of the investment in
accounts receivable in addition to the trade credit terms is the type of
customer.
1. The costs associated with extending credit to lower-quality
customers include:
a. Increased costs of credit investigation
b. Increased probability of customer default
c. Increased collection costs
G. Analyzing the credit application is a major part of accounts receivable
management.
1. Several avenues are open to the firm in considering the credit
rating of an applicant. Among these are financial statements,
independent credit ratings and reports, bank checking, information
from other companies, and past experiences.
2. One commonly used method for credit evaluation is called credit
scoring and involves the numerical evaluation of each applicant in
which an applicant receives a score based upon the answers to a
simple set of questions. The score is then evaluated relative to a
predetermined standard, its level relative to that standard
determining whether or not credit scoring should be extended to
the applicant. The major advantage of credit scoring is that it is
inexpensive and easy to perform.
3. Once the decision to extend credit has been made and if the
decision is yes, a maximum credit line is established as a ceiling on
the amount of credit to be extended.
H. The third and final decision variable in determining the size of the
investment in accounts receivable is the firm’s collection policies.
1. Collection policy is a combination of letter sending, telephone
calls, personal visits, and legal actions.
2. The greater the amount spent on collecting, the lower the volume
of bad debts.
a. The relationship is not linear, however, and, beyond a
point, is not helpful.
b. If sales are independent of collection efforts, then methods
of collection should be evaluated with respect to the
reduction in bad debts against the cost of lowering those
bad debts.
I. Credit should be extended to the point that marginal profitability on
additional sales equals the required rate of return on the additional
investment in receivables necessary to generate those sales.

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 J. Credit policy changes involve direct tradeoffs between costs and benefits.
Determining whether the increased sales contribute more toward profits
than the increased costs take away from them is the job of marginal or
incremental analysis. Marginal analysis is performed as follows:
1. Estimate the change in profits from the new policy. This is equal
to the increased sales times the profit contribution less any
additional bad debts incurred.
2. Estimate the cost of the additional investment in accounts
receivable and inventory.
3. Estimate the change in the cost of the cash discount (if a change in
the cash discount is enacted).
4. Compare the incremental revenues with the incremental costs.
VIII. Inventory
A. Typically, inventory accounts for about 4.88% of a firm’s assets.
B. The purpose of carrying inventories is to uncouple the operations of the
firm. (i.e., to make each function of the business independent of each other
function.)
C. As such, the decision with respect to the size of the investment in
inventory involves a basic tradeoff between risk and return.
D. The risk comes from the possibility of running out of inventory if too little
inventory is held, while the return aspect of this tradeoff results because
increased inventory investment costs money.
E. There are several general types of inventory.
1. Raw materials inventory consists of the basic materials that have
been purchased from other firms to be used in the firm’s
productions operations. This type of inventory uncouples the
production function from the purchasing function.
2. Work in process inventory consists of partially finished goods that
require additional work before they become finished goods. This
type of inventory uncouples the various production operations.
3. Finished goods inventory consists of goods on which the
production has been completed but the goods are not yet sold. This
type of inventory uncouples the production and sales function.
4. Stock of cash inventory serves to make the payment of bills
independent of the collection of accounts due.
F. In order to manage the investment in inventory effectively, two problems
must be dealt with: the order quantity problem and the order point
problem.
G. The order quantity problem involves the determination of the optimal
order size for an inventory item given its expected usage, carrying, and
ordering costs.

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H. The economic order quantity (EOQ) model attempts to determine the
order size that will minimize total inventory costs. The EOQ is given as:
2SO
Q* =
C
where C = carrying costs per unit
O = ordering costs per order
S = total demand in units over the planning period
Q* = the optimal order quantity in units
I. The order point problem attempts to answer the following question: How
low should inventory be depleted before it is reordered?
J. In answering this question, two factors become important:
1. What is the usual procurement or delivery time, and how much
stock is needed to accommodate this time period?
2. How much safety stock does the management desire?
K. Modification for safety stocks is necessary, since the usage rate of
inventory is seldom stable over a given timetable.
L. This safety stock is used to safeguard the firm against changes in order
time and receipt of shipped goods.
M. The greater the uncertainty associated with forecasted demand or order
time, the larger the safety stock.
1. The costs associated with running out of inventory will also
determine the safety stock levels.
2. A point is reached where it is too costly to carry a larger safety
stock given the associated risk.
N. Inflation can also have an impact on the level of inventory carried.
1. Goods may be purchased in large quantities in anticipation of price
rises.
2. The cost of carrying goods may increase, causing a decline in Q*,
the optional order quantity.
O. The just-in-time inventory control system is more than just an inventory
control system; it is a production and management system.
1. Under this system, inventory is cut down to a minimum, and the
time and physical distance between the various production
operations are also minimized.
2. Actually, the just-in-time inventory control system is just a new
approach to the EOQ model which tries to produce the lowest
average level of inventory possible.
3. Average inventory is reduced by locating inventory supplies in
convenient locations and setting up restocking strategies that cut
time and thereby reduce the needed level of safety stock.

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 ANSWERS TO
END-OF-CHAPTER QUESTIONS

16-1. The procedure by which funds generated from company activity are
accommodated (directed) through the firm from the time of their initial receipt
until their ultimate disposition. Over the long run, accounts receivable collections
account for the largest regular source of cash in the typical manufacturing
company. Payment of accounts payable, payroll expenses, and the distribution of
income to the owners (cash dividends) are the major forms of cash disbursal.
Other sources of cash for a company may include receipts from the sale of assets,
assumption of additional debt, issuance of new stock, or gains realized from
investments. While these are important sources of cash to a company, the
proceeds are not available on a regular basis. Major capital expenditure
programs, new company acquisitions, and inventory stockpiling are examples of
irregular disbursals of cash outside the normal course of everyday business.
16-2. The three classical motives for holding cash and near-cash balances are: (1) the
transactions motive; (2) the precautionary motive; (3) the speculative motive.
Transactions balances allow the firm to make payments that arise in the ordinary
course of doing business. Precautionary balances provide a buffer stock of liquid
assets that can be drawn down if unexpected demands for cash arise. Speculative
balances permit the economic unit to take advantage of future profit-making
situations.
16-3. The firm must: (1) maintain adequate cash balances that will permit it to meet the
disbursal needs that occur in the course of doing business; (2) reduce idle cash
balances to a minimum.
16-4. a. Choosing among various methods available for speeding up cash receipts,
slowing down cash payments, and providing for more effective control
over cash outflows.
b. Splitting the firm’s liquid asset holdings among cash and marketable
securities.
c. Choosing the appropriate marketable securities mix.
16-5. a. Mail float: this represents funds which are not usable to the firm because
of the time necessary for a customer’s remittance check to travel through
the mail to a company collection center.
b. Processing float: this represents funds tied up due to the time needed for
the company to process the remittance checks and get them ready for
deposit in a demand deposit account.
c. Transit float: this represents funds tied up because of the time necessary
for a deposited check to clear through the commercial banking system and
become "good" funds to the firm.

505
 d. Disbursing float: this refers to funds available in the firm’s demand
deposit account due to the time needed for a payment check to clear
through the banking system.
16-6. In the context of cash management, financial risk is the uncertainty of future
returns from a security caused by possible changes in the financial capability of
the security-issuer to make future payments to the security-owner. This is
sometimes called default risk. On the other hand, the uncertainty related to the
expected returns from a financial asset caused by changes in interest rates is
called interest rate risk.
16-7. The size of the investment in accounts receivable is determined primarily by these
factors:
a. The percentage of credit sales to total sales. While this factor plays a
major role in determining the investment in accounts receivable, it is
generally not within the control of the financial manager. In essence, the
nature of the business tends to determine the blend between credit sales
and cash sales.
b. The level of sales. As sales increase, so will accounts receivable. Again,
this is not an effective decision tool.
c. Credit and collection policies. Specifically the terms of sale, the quality of
customer, and collection efforts are determinants of the level of
investment in receivables that are under the control of the financial
manager.
16-8. If a credit manager experienced no bad debt losses over the past year, then credit
was probably not extended to enough customers. Ideally, credit should be
extended to the point where marginal revenue from added sales due to increased
credit is equal to the marginal costs associated with increased bad debts, costs of
investigation, costs of collection, and increased required rate of return.
Obviously, the credit manager was nowhere near this level if no bad debts were
incurred.
16-9. The returns associated with a more liberal credit policy come from the fact that
extending credit to weaker customers or liberalizing the trade credit terms will
probably increase sales, resulting in a larger profit level. The risks involved
largely result from the increased possibility of extending credit that will
eventually become bad debts.
16-10. The purpose of carrying inventories is to uncouple the operations of the firm (i.e.,
to make each function of the business independent of each other’s function.) By
uncoupling the various operations of the firm, delays or shutdowns in one area no
longer affect the production and sale of the final product. Raw materials
inventory, for example, uncouples the production function from the purchasing
function. Goods in process inventory uncouples the various production
operations in the firm’s production and sales functions.

506
16-11. The major assumptions of the EOQ model include:
(1) Constant or uniform demand.
(2) Constant unit price regardless of amount ordered.
(3) Constant carrying costs per unit.
(4) Constant ordering costs per order regardless of the size of the order.
(5) Instantaneous delivery.

SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

16-1. a. Recommendation
1. $1,500,000 (0.0825) (1/12) = $10,312.50 < $30,000 No
2. $1,500,000 (0.0825)(2/12) = $20,625.00 < $30,000 No
3. $1,500,000 (0.0825)(3/12) = $30,937.50 > $30,000 Yes
4. $1,500,000 (0.0825)(6/12) = $61,875.00 > $30,000 Yes
5. $1,500,000 (0.0825)(12/12) = $123,750.00 > $30,000 Yes

b. Let (%) be the required yield. With $1,500,000 to invest for three months
and a three-month holding period, we have:
$1,500,000 (%) (3/12) = $ 30,000
$1,500,000 (%) = $ 120,000
(%) $120,000 / $1,500,000 = 8%
The break-even yield, therefore, is 8%.

16.2 a. First, it is necessary to compute Portobello’s average remittance check

size and the daily opportunity cost of carrying cash. The average check
size is:

$24,000,000
= $2,400 per check
10,000

The daily opportunity cost of carrying cash is:

0.08
= 0.00021692 per day
365

Second, the days saved in the collection process can be evaluated

according to the general format of:
Added Costs = Added Benefits

507
 or
P = (D) (S) (i)
0.25 = (D) ($2,400) (0.0002192)
0.4752 days D

Therefore, Portobello Scuba Diving will experience a financial gain if it

adopts the lock-box system and by doing so, will speed up its collections
by more than 0.4752 days.

b. In this situation, the daily opportunity cost of carrying cash is:

0.04
= 0.0001096 per day
365

For Portobello to break even should it choose to install the lock-box

system, the cash collections must be accelerated by 0.9504 days as
follows:

$0.25 = (D) ($2,400) (0.0001096)

0.9504 days = D

c. The break-even cash acceleration period of 0.9504 days is greater than the
0.4752 days found in part a. This is due to the lower yield available on
near cash assets (or 4% annually versus 8%). Since the alternative rate of
return on the freed-up balances is lower on the second situation, more
funds must be invested to cover the costs of operating the lock-box
system. The greater cash acceleration period generates this increased level
of required funds.

Annual revenues $438 million

16.3 = = $1,200,000
Days in year 365

Four days’ float reduction (i.e., 3 days’ mail float plus 1 day processing
float) will free up $4,800,000 (4 days x $1,200,000) which can be used to
lower the outstanding balance drawn against the line of credit.
The resulting annual saving in interest costs will equal:
(cash freed-up) x (interest rate on debt)
($4,800,000) x (.08) = $384,000

508
 The cost of the old centralized billing system is the sum of the interest costs being
incurred (see above) plus the processing costs of $66,000. Thus, we have:
Opportunity cost of current system $450,000
(Total cost of new system) (200,000)
Net annual gain (loss) $250,000
Byron Sporting Goods should switch to be concentration banking system. By so
doing, the company will save $250,000 annually.

Annual revenues $362 million

16-4. = = $991,781
Days in year 365

Four days’ float reduction (i.e., 3 days’ mail float plus 1 day processing
float) will free up $3,967,124 which can be used to lower the outstanding
balance drawn against the line of credit.
The resulting annual saving in interest costs will equal $277,699 as
follows:

$3,967,124 (.07) = $277,699

The cost of the old centralized billing system is the sum of the interest
costs being incurred (see above) plus the processing costs of $57,500.
Thus, we have:
Cost of centralized system: $335,199
Less: Flat Fee from bank $175,000
Net annual gain $160,199
Freemont Shops should switch to the concentration banking system. By
so doing, the company will save $160,199 annually.
16-5. a. Recommendation
1. $800,000 (.105) (1/12) = $7,000 < $20,000 No
2. $800,000 (.105) (2/12) = $14,000 < $20,000 No
3. $800,000 (.105) (3/12) = $21,000 > $20,000 Yes
4. $800,000 (.105) (6/12) = $42,000 > $20,000 Yes
5. $800,000 (.105) (12/12) = $84,000 > $20,000 Yes
b. Let (%) be the required yield. With $800,000 to invest for two months
and a two-month holding period, we have:
$800,000 (%) (2/12) = $ 20,000
$800,000 (%) = $120,000
(%) = $120,000/$800,000 = 15%
The break-even yield, therefore, is 15%.

509
16-6. a. First, it is necessary to compute Mustang’s average remittance check size
and the daily opportunity cost of carrying cash. The average check size is:
$12,000,000
= $2,000 per check.
6,000
The daily opportunity cost of carrying cash is:
0.07
= 0.0001918 per day
365
Second, the days saved in the collection process can be evaluated
according to the general format of
Added Costs = Added Benefits
or
P = (D) (S) (i)
0.20 = (D) ($2,000) (0.0001918)
0.5214 days = D.
Therefore, Mustang Ski-Wear will experience a financial gain if it adopts
the lock-box system and by doing so, will speed up its collections by more
than 0.5214 days.
b. In this situation, the daily opportunity cost of carrying cash is:
0.045
= 0.0001233 per day
365
For Mustang to break even should it choose to install the lock-box system,
the cash collections must be accelerated by 0.8110 days as follows:
$0.20 = (D) ($2,000) (0.0001233)
0.8110 days = D.
c. The break-even cash acceleration period of 0.8110 days is greater than the
0.5214 days found in part a. This is due to the lower yield available on
near-cash assets (or 4.5% annually versus 7.0%). Since the alternative rate
of return on the freed-up balances is lower in the second situation, more
funds must be invested to cover the costs of operating the lock-box system.
The greater cash acceleration period generates this increased level of
required funds.
16-7. a. Annual collections = ($4,800,000) x (10) = $48,000,000
Daily collections = $48,000,000/365 = $131,507
The opportunity cost of the mail and processing float is:
($131,507) x (4.2 days) x (0.07) = $38,663

510
 b. Use of the suggested cash acceleration system will result in a float
reduction of 3.2 days (i.e., 1.2 days mail float, 1 day processing float, and
1 day transit float). The gross annual savings from the system, then, can
be calculated as:

($131,507) x (3.2) x (.07) = $29,458

The cost of operation of the lock-box system is:

($250 per month) x (10 regions) x (12 months) = $30,000

Therefore, the net annual savings (costs) are:

($29,458) - ($30,000) = -$542

The firm should not adopt the system, as the net gain is negative and equal
to -$542.
16-8. a. Reduction in mail float:
(2 days) x ($1,000,000) = $ 2,000,000
Reduction in processing float:
(2 days) x ($1,000,000) = $ 2,000,000
Total float reduction = $ 4,000,000

b. (0.06) x ($4,000,000) = $ 240,000

c. The average number of checks to be processed each day through the lock-
box arrangement is:

($1,000,000)
= 500 checks per day
$2,000
Thus, the cost of the lock-box system on an annual basis is:
(500) x ($0.18) x (270 days) = $24,300
Next, we have to calculate the cost of the ADTC system. The First
Pennsylvania Bank will not contribute to the cost of the ADTC
arrangement because it is the lead concentration bank and thereby receives
the transferred data. This means Pierce Designs will be charged for six
ADTCs each business day. The ADTC system, then, costs ($15) x (6) x
(270) = $24,300. Note that only by mere coincidence does the cost of the
ADTC system equal that of the lock-box arrangement. Finally, we have
the total cost of the proposed system:
Lock-box cost $ 24,300
ADTC cost 24,300
Total cost $ 48,600

511
 d. The information just developed strongly indicates that Pierce Designs
should install the proposed cash receipts acceleration system. The net
annual gain associated with this recommendation is $191,400 as follows:

Projected return on freed balances $240,000

Less cost of new system (48,600)
Net annual gain $191,400
16-9. a. The average accrued wages under the monthly payment system are:
4 x ($500,000)
= $1,000,000
2
This means that the firm has, on the average, $750,000 (i.e., $1,000,000 -
$250,000) more to invest. This provides an annual return of ($750,000) x
(0.07) = $52,500. Therefore, Daniel Shoe should move to the monthly
payment system since it will generate $52,500 - $35,000 = $17,500 in net
annual savings.
b. Let r = the break-even rate of return on the near-cash portfolio:
$750,000 x (r) = $35,000
r = 0.0467 or 4.67%
A reasonable margin of safety favoring adoption of the monthly payment
proposal is present.

16-10. The value of one day of processing float is:

$12,000,000
= $44,444
270
The annual savings at 6% for two days are:
($44,444) x (2) x (0.06) = $5,333

16-11. This exercise attempts to illustrate that a change in the firm’s accounts payable
policy can properly be viewed as a part of the overall problem of cash
management. Before evaluating the 45-day and 60-day payment alternatives, it is
necessary to calculate the amount of purchases that are actually discounted and the
value of the annual purchase discount earned by Bradford Construction. These
amounts are calculated below:

Purchases discounted
($37,500,000 annual purchases) x (0.25) = $9,375,000

Purchase discounts earned

($9,375,000) x (0.03) = $281,250
with $281,250 in purchase discounts earned. Bradford actually pays:
($9,375,000) - ($281,250) = $9,093,750, 10 days after purchase.

512
The annual amount not discounted is ($37,500,000) - ($9,375,000) =
$28,125,000.
We are now in a position to evaluate first the 45-day proposal and, second, the 60-
day proposal.

45-day alternative:
(1) (2) (3) (4) = (1) x (2) x (3)
Principal Extra time Interest Interest
amount available rate earned
$ 28,125,000 15 days 0.12 ÷ 365 = $138,699
9,093,750 35 days 0.12 ÷ 365 = 104,640
Total added return $243,339
- $281,250 Lost discounts earned
+ 243,339 Total added return
- $ 37,911 Loss to Bradford by stretching payables to 45 days.

60-day alternative:
(1) (2) (3) (4) = (1) x (2) x (3)
Principal Extra time Interest Interest
amount available rate earned
$28,125,000 30 days 0.12 ÷ 365 = $277,397
9,093,750 50 days 0.12 ÷ 365 = 149,486
Total added return $426,883
- $281,250 Lost discounts earned
+ $426,883 Total added return
$145,633 Gained by Bradford by stretching payables to 60 days
Finally, we can evaluate the effect of the projected price increase to Bradford that
is associated with the 60-day alternative.

Price Increase:
$37,500,000 Purchases
.005
$ 187,500 Price increase
$187,500 Price increase
- 145,633 Net added return
$ 41,867 Loss to Bradford
Ultimately, none of the proposed courses of action would benefit the firm.

513
 18
$80 $1,000
16-12. a. P = ∑ (1.09) t
+
(1.09)18
= $912.44
t =1

The bond can be sold for $912.44. This was developed as follows:
$80 x (8.7556) + $1,000 x (.21199) = $912.44

b. $1,000 - $912.44 = $87.56 loss

c. First, we find the price of the 4-year bond, which now has 2 years
remaining to maturity:

2
$80 $1,000
P = ∑ (1.09) t
+
(1.09)2
= $982.41
t =1

Then, we can determine the expected capital loss on the shorter-term bond
as follows:

$1,000 - $982.41 = $17.59

The capital loss on the shorter-term bond is much less than that suffered on
the longer-term instrument.

d. Interest rate risk, which leads to a maturity premium, as discussed in

Chapter 2.

16-13. a. The after-tax yield to Aggieland Fireworks on the BBB-rated bond is

(0.09) x (1-0.46) = .0486 = 4.86%. Since the yield on the tax-exempt
issue is already stated on an after-tax basis, we can conclude the 5½%
return on the municipal is preferable.
r*
b. r =
(1 − T)
0.055 0.055
r = = = 0.10185 or 10.185%
(1 − 0.46) 0.54

514
 a 360
16-14. a. x
1− a c − b
where a = amount of the discount
b = the discount period
c = the net period
0.01 360
x = 0.3636 or 36.36%
1 − 0.01 20 − 10
0.02 360
b. x = 0.3673 or 36.73%
1 − 0.02 30 − 10
0.03 360
c. x = 0.5567 or 55.67%
1 − 0.03 30 − 10
0.03 360
d. x = 0.2227 or 22.27%
1 − 0.03 60 − 10
0.03 360
e. x = 0.1392 or 13.92%
1 − 0.03 90 − 10
0.05 360
f. x = 0.3789 or 37.89%
1 − 0.05 60 − 10
16-15. Applicant #1
Z = 3.3(0.2) + 1.0(0.2) + 0.6(1.2) + 1.4(0.3) + 1.2(0.5)
Z = 0.66 + 0.2 + 0.72 + 0.42 + 0.6
Z = 2.6 < 2.7 thus, reject

Applicant #2
Z = 3.3(0.2) + 1.0(0.8) + 0.6(1.0) + 1.4(0.3) + 1.2(0.8)
Z = 0.66 + 0.8 + 0.6 + 0.42 + 0.96
Z = 3.44 > 2.7 thus, accept

Applicant #3
Z = 3.3(0.2) + 1.0(0.7) + 0.6(0.6) + 1.4(0.3) + 1.2(0.4)
Z = 0.66 + 0.7 + 0.36 + 0.42 + 0.48
Z = 2.62 < 2.7 thus, reject

Applicant #4
Z = 3.3(0.1) + 1.0(0.4) + 0.6(1.2) + 1.4(0.4) + 1.2(0.4)
Z = 0.33 + 0.4 + 0.72 + 0.56 + 0.48
Z = 2.49 < 2.7 thus, reject

515
 Applicant #5
Z = 3.3(0.3) + 1.0(0.7) + 0.6(0.5) + 1.4(0.4) + 1.2(0.7)
Z = 0.99 + 0.7 + 0.30 + 0.56 + 0.84
Z = 3.39 > 2.7 thus, accept

Applicant #6
Z = 3.3(0.2) + 1.0(0.5) + 0.6(0.5) + 1.4(0.4) + 1.2(0.4)
Z = 0.66 + 0.5 + 0.30 + 0.56 + 0.48
Z = 2.5 < 2.7 thus, reject

Sales − cost of goods sold

16-16. a. = Gross Profit Margin
Sales
$600,000 − cost of goods sold
= 0.10
$600,000
Cost of goods sold = $540,000
Cost of goods sold
= Inventory turnover ratio
Average inventory
$540,000
= 6
Average inventory
Average inventory = $90,000
360
b. Inventory turnover ratio =
Average Collection Period
360
Inventory turnover =
40
Inventory turnover ratio = 9 times
Cost of goods sold
= 9 times
Average inventory
$480,000
= 9 times
Average inventory
Average inventory = $53,333

516
 Cost of goods sold
c. = Inventory turnover ratio
Average inventory
$1,150,000
= 5
Average inventory
Average inventory = $230,000

d. (1 - Gross profit margin) (Sales) = $21,500,000 cost of goods

(0.86)($25,000,000)
360
Inventory turnover ratio = = 8 times
45
$21,500,000
= 8 times
Average inventory
Average inventory = $ 2,687,500

2SO
16-17. a. Q* =
C
2( 3000 )10
=
0.10
= 600,000
= 775 units
Q S
b. Total costs =   C +   O
2 Q
Order one time:
 3000   3000 
=   $.10 +   $10
 2   3000 
= $150 + $10
= $160

517
 Order four times:
 750   3000 
=   $.10 +   $10
 2   750 
= $37.50 + $40
= $77.50
Order five times:
 600   3000 
=   $.10 +   $10
 2   600 
= $30.00 + $50.00
= $80
Order ten times:
 300   3000 
=   $0.10 +   $10
 2   300 
= $15.00 + $100
= $115
Order 15 times:
 200   3000 
=   $0.10 +   $10
 2   200 
= $10 + $150
= $160
c. (1) constant or uniform demand
(2) constant unit price
(3) constant carrying costs
(4) constant ordering costs
(5) instantaneous delivery
(6) independent orders

2SO
16-18. a. EOQ =
C

2( 250,000)100
=
1

= 7,071 units or 7,100 units

518
 250,000
b. = 35.2 orders per year
7,100

c. Inventory order point = Delivery time stock + safety stock

1
= x 250,000 + 5,000
50
= 5,000 + 5,000

= 10,000 units

EOQ
d. Average inventory = + Safety stock
2

7,100
= + 5,000
2
= 8,550 units

2(500,000)100
e. EOQ =
1

= 10,000 units

Elasticity of
EOQ with %∆EOQ
=
respect to a %∆Sales
double in sales

ΔEOQ ΔSale
= ÷
EOQ Sales

 10,000 − 7,100   500,000 − 250,000 

=   /  
 7,100   250,000 

.4085
= = .4085 or 40.85%
1.0

519
 2( 250,000)100
f. EOQ =
2

= 5,000

Elasticity of
EOQ with % ∆EOQ
respect to a =
double in % ∆Carrying Costs
carrying costs

5,000 − 7,100 2 −1
= ÷ = -0.2958 or -29.58%
7,100 1

2(250,000)200
g. EOQ =
1

= 10,000

Elasticity of
EOQ with % ∆EOQ
respect to a =
double in %∆Ordering Costs
ordering costs

10,000 − 7,100 200 − 100

= ÷ = 40.85%
7,100 100

(h) The selling price of the item does not enter the EOQ equation and does not
affect the level of EOQ (although the carrying cost which is 10% of the
selling price does). The EOQ equation attempts to minimize costs and, as
such, the selling price does not enter into its calculation; thus, the elasticity
of EOQ with respect to the selling price is 0.

520
SOLUTION TO COMPREHENSIVE PROBLEM

a. The amount of cash balances that will be freed if New Wave Surfing Stuff, Inc.
adopts the system proposed by the Bank of the U.S.:

Cash balances freed due to the reduction in mail float =

(# of days eliminated) x (Average daily cash remittances)

2.5 x $150,000 = $375,000

Cash balances freed due to the reduction in processing float =

(# of days eliminated) x (Average daily cash remittances)

3 x $150,000 = $450,000

Total float reduction $825,000

b. Opportunity cost of maintaining the current banking arrangement:

Opportunity Cost—Interest =

(Forecast yield on marketable securities portfolio) x (Total float reduction)

.05 x 825,000

Opportunity Cost—Interest = $41,250

Opportunity Cost—Clerical Expense = 55,000

Total Opportunity Cost $96,250

c. Projected annual cost of operating the proposed system:

Average number of checks to be processed each day through the lock-box

arrangement:

Daily remittance $150,000

= = 200 checks
Average Check Size $750

521
 Resulting cost of lock-box system on an annual basis:

Cost =

[(Average # of checks) x (Processing cost per check) x (# of business days per

year)]

200 x $0.30 x 270 =

Cost = $16,200

Next, the estimated cost of the automated deposit transfer center (ADTC) must be
calculated. The Bank of the U.S. will not contribute to the cost of the ADTC
because it is the lead concentration bank and thereby receives the transferred data.
As a result, New Wave will be charged for six ADTCs (three locations @ two
checks each) each business day. The ADTC system, therefore, costs:

Cost = [(# of daily transfers) x (cost per transfer) x (# of business days per
year)]

Cost = 6 x $ .35 x 270

Cost = $567

Accordingly, the total cost of the proposed system is:

Lock-box cost $16,200

ADTC cost 567

Total Cost $16,767

d. The net annual gain associated with adopting the proposed system is:

Opportunity cost of current system [STEP B] $96,250

(Total cost of new system) [STEP C] (16,767)

Net annual gain (loss) $79,483

As a result, the analysis suggests the company should adopt the proposed cash
receipts acceleration system.

522
 ALTERNATIVE PROBLEMS AND SOLUTIONS
ALTERNATIVE PROBLEMS

16-1A. (Lock-Box System) Regency Components is located in Nashville, Tennessee. The

firm manufactures components used in a variety of electrical devices. All the
firm’s finished goods are shipped to five regional warehouses across the United
States.
Tennessee State Bank of Nashville is Regency Components’ lead bank.
Tennessee State recently completed a study of Regency’s cash-collection system.
Tennessee State estimates that it can reduce Regency’s total float by 3.0 days with
the installation of a lock-box arrangement in each of the firm’s five regions.
The lock-box arrangement would cost each region $600 per month. Any funds
freed up would be added to the firm’s marketable securities portfolio and would
yield 11% on an annual basis. Annual sales average $10,000,000 for each regional
office. The firm and the bank use a 365-day year in their analyses. Should
Regency Components’ management approve the use of the proposed system?
16-2A. (Buying and Selling Marketable Securities) Universal Concrete Company has
generated $700,000 in excess cash that it could invest in marketable securities. In
order to buy and sell the securities, the firm will pay total transactions fees of
$25,000.
a. Would you recommend purchasing the securities if they yield 11.5%
annually and are held for
1. One month?
2. Two months?
3. Three months?
4. Six months?
5. One year?
b. What minimum required yield would the securities have to return for the
firm to hold them for two months (what is the break-even yield for a two-
month holding period)?
16-3A. (Costs of Services) Colorado Communications is investigating the possibility of
adopting a lock-box system as a cash receipts acceleration device. In a typical
year, this firm receives remittances totaling $10 million by check. The firm will
record and process 7,000 checks over this same time period. The Colorado
Springs Second National Bank has informed the management of Colorado Comm
that it will expedite checks and associated documents through the lock-box
system for a unit cost of $.30 per check. Colorado Comm’s financial manager has
projected that cash freed by adoption of the system can be invested in a portfolio

523
 of near-cash assets that yield an annual before-tax return of 7%. Colorado
Comm’s financial analysts use a 365-day year in their procedures.
a. What reduction in check collection time is necessary for Colorado Comm to
be neither better nor worse off for having adopted the proposed system?
b. How would your solution to a be affected if Colorado Comm could invest
the freed balances only at an expected annual return of 4.5%?
c. What is the logical explanation for the differences in your answers to a and
b?
16-4A. (Lock-Box System) Alpine Systems is a distributor of refrigerated storage units to
the meat products industry. All 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. Alpine determined
that it takes an average of 3.2 days for customers’ payments to reach the head
office in Pittsburgh from the time they are mailed. It takes another full day in
processing time prior to depositing the checks with a local bank. Annual sales
average $5,000,000 for each regional office. Reasonable investment opportunities
can be found yielding 8% per year. To alleviate the float problem confronting the
firm, the use of a lock-box system in each of the 10 regions is being considered.
This would reduce mail float by 1.0 days. One day in processing float would also
be eliminated, plus a full day in transit float. The lock-box arrangement would
cost each region $225 per month.
a. What is the opportunity cost to Alpine Systems of the funds tied up in
mailing and processing? Use a 365-day year.
b. What would the net cost or savings be from use of the proposed cash-
acceleration technique? Should Alpine adopt the system?
16-5A. (Cash Receipts Acceleration System) Carter’s Bicycles, Inc. is a vertically
integrated, national manufacturer and retailer of racing bicycles. Currently, the
firm has no coordinated cash-management system. A proposal, however, from the
First Pennsylvania Bank aimed at speeding up cash collections is being examined
by several of Carter’s corporate executives.
The firm currently uses a centralized billing procedure, which requires that all
checks be mailed to the Philadelphia head office for processing and eventual
deposit. Under this arrangement, all the customers’ remittance checks take an
average of 4 business days to reach the head office. Once in Philadelphia another
1.5 days are required to process the checks for ultimate deposit at the First
Pennsylvania Bank.
The firm’s daily remittances average $1 million. The average check size is
$2,000. Carter’s currently earns 7% annually on its marketable securities
portfolio.

524
 The cash-acceleration plan proposed by officers of First Pennsylvania involves
both a lock-box system and concentration bank. First Pennsylvania would be the
firm’s only concentration bank. Lock boxes would be established in (1) San
Francisco, (2) Dallas, (3) Chicago, and (4) Philadelphia. This would reduce funds
tied up by mail float to three days, and processing float will be eliminated. Funds
would then by transferred twice each business day by means of automated
depository transfer checks from local banks in San Francisco, Dallas, and Chicago
to the First Pennsylvania Bank. Each ADTC costs $16. These transfers will occur
all 270 business days of the year. Each check processed through the lock-box
system will cost $.22.
a. What amount of cash balances will be freed if Carter’s Bicycles adopts the
system suggested by First Pennsylvania?
b. What is the opportunity of maintaining the current banking setup?
c. What is the projected annual cost of operating the proposed system?
d. Should Carter’s adopt the new system? Compute the net annual gain or loss
associated with adopting the system.
16-6A. (Marketable Securities Portfolio) Katz Jewelers currently pays its employees on a
weekly basis. The weekly wage bill is $500,000. This means that on the average
the firm has accrued wages payable of ($500,000)/2 = $250,000.
Harry Katz works as the firm’s senior financial analyst and reports directly to his
father, who owns all of the firm’s common stock. Harry Katz wants to move to a
monthly wage payment system. Employees would be paid at the end of every
fourth week. The younger Katz is fully aware that the labor union representing the
company’s workers will not permit the monthly payments system to take effect
unless the workers are given some type of fringe benefit compensation.
A plan has been worked out whereby the firm will make a contribution to the cost
of life insurance coverage for each employee. This will cost the firm $40,000
annually. Harry Katz expects the firm to earn 8% annually on its marketable
securities portfolio.
a. Based on the projected information, should Katz Jewelers move to the
monthly wage payment system?
b. What annual rate of return on the marketable securities portfolio would
enable the firm to just break even on this proposal?
16-7A. (Valuing Float Reduction) Magic Hardware Stores, Inc. will generate $12 million
in credit sales next year. Collections of these credit sales will occur evenly over
this period. The firm’s employees work 270 days a year. Currently, the firm’s
processing system ties up 4.5 days’ worth of remittance checks. A recent report
from a financial consultant indicated procedures that will enable Magic Hardware
to reduce processing float by two full days. If Magic invests the released funds to
earn 7%, what will be the annual savings?

525
16-8A. (Accounts Payable Policy and Cash Management) Meadowbrook Paving
Company is suffering from a prolonged decline in new development in its sales
area. In an attempt to improve its cash position, the firm is considering changes
in its accounts payable policy. After careful study, it has determined that the only
alternative available is to slow disbursements. Purchases for the coming year are
expected to be $40 million. Sales will be $65 million, which represents about a
15% drop from the current year. Currently, Meadowbrook discounts
approximately 25% of its payments at 3% 10 days, net 30, and the balance of
accounts are paid in 30 days. If Meadowbrook adopts a policy of payment in 45
days or 60 days, how much can the firm gain if the annual opportunity cost of
investment is 11%? What will be the result if this action causes Meadowbrook
Paving suppliers to increase their prices to the company by 0.5% to compensate
for the 60-day extended term of payment? In your calculations, use a 365-day
year and ignore any compounding effects related to expected returns.
16-9A. (Interest Rate Risk) Two years ago, your corporate treasurer purchased for the
firm a 30-year bond at its par value of $1,000. The coupon rate on this security is
7%. Interest payments are made to bondholders once a year. Currently, bonds of
this particular risk class are yielding investors 9%. A cash shortage has forced you
to instruct your treasurer to liquidate his bond.
a. At what price will your bond be sold? Assume annual compounding.
b. What will be the amount of your gain or loss over the original purchase
price?
c. What would be the amount of your gain or loss had the treasurer originally
purchased a bond with a 4-year rather than a 30-year maturity? (Assume
all characteristics of the bonds are identical except their maturity periods.)
d. What do we call this type of risk assumed by your corporate treasurer?
16-10A. (Comparison of After-Tax Yields) The corporate treasurer of Ward Grocers is
considering the purchase of a BBB-rated bond that carries an 8.0% coupon. The
BBB-rated security is taxable, and the firm is in the 46 percent marginal tax
bracket. The face value of this bond is $1,000. A financial analyst who reports to
the corporate treasurer has alerted him to the fact that a municipal obligation is
coming to the market with a 5½% coupon. The par value of this security is also
$1,000.
a. Which one of the two securities do you recommend the firm purchase?
Why?
b. What must the fully taxed bond yield before tax to make it comparable with
the municipal offering?

526
16-11A. (Trade Credit Discounts) Determine the effective annualized cost of forgoing the
trade credit discount on the following terms:
a. 1/5, net 20
b. 2/20, net 90
c. 1/20, net 100
d. 4/10, net 50
e. 5/20, net 100
f. 5/30, net 50
16-12A. (Altman Model) The following ratios were supplied by six loan applicants. Given
this information and the credit-scoring model developed by Altman, which loans
have a high probability of defaulting next year and thus should be avoided?

Market
Value of
Equity Working
EBIT Sales Book Earnings Capital
Total Total Value Total Total
Assets Assets of Debt Assets Assets
Applicant 1 .3 .4 1.2 .3 .5
Applicant 2 .2 .6 1.3 .4 .3
Applicant 3 .2 .7 .6 .3 .2
Applicant 4 .1 .5 .8 .5 .4
Applicant 5 .5 .7 .5 .4 .6
Applicant 6 .2 .4 .2 .4 .4

16-13A. (Ratio Analysis) Assuming a 360-day year, calculate what the average
investment in inventory would be for a firm, given the following information in
each case.
a. The firm has sales of $550,000, a gross profit margin of 10%, and an
inventory turnover ratio of 5.
b. The firm has a cost of goods sold figure of $480,000 and an average age of
inventory of 35 days.
c. The firm has a cost of goods sold figure of $1,250,000 and an inventory
turnover ratio of 6.
d. The firm has a sales figure of $25 million, a gross profit margin of 15%,
and an average of inventory of 50 days.

527
16-14A. (EOQ Calculations) A downtown bookstore is trying to determine the optimal
order quantity for a popular novel just printed in paperback. The store feels that
the book will sell at four times its hardback figures. It would therefore sell
approximately 3,500 copies in the next year at a price of $1.50. The store buys
the book at a wholesale figure of $1. Costs for carrying the book are estimated at
$.20 a copy per year, and it costs $9 to order more books.
a. Determine the EOQ
b. What would be the total costs for ordering the books 1, 4, 5, 10, and 15
times a year?
c. What questionable assumptions are being made by the EOQ model?
16-15A. (Comprehensive EOQ Calculations) Good Gravy Products, Inc. is involved in
the production of tractor parts and has the following inventory, carrying, and
storage costs:
1. Orders must be placed in round lots of 100 units.
2. Annual unit usage is 300,000. (Assume a 50-week year in your
calculations.)
3. The carrying cost is 10% of the purchase price.
4. The purchase price is $12 per unit.
5. The ordering cost is $100 per order.
6. The desired safety stock is 4,000 units. (This does not include delivery time
stock.)
7. The delivery time is one week.
Given the above information:
a. Determine the optimal EOQ level.
b. How many orders will be placed annually?
c. What is the inventory order point? (That is, at what level of
inventory should a new order be placed?)
d. What is the average inventory level?
e. What would happen to the EOQ if annual unit sales doubled (all
other unit costs and safety stocks remaining constant)? What is the
elasticity of EOQ with respect to sales? (That is, what is the
percent change in EOQ divided by the percent change in sales?)
f. If carrying costs double, what would happen to the EOQ level?
(Assume the original sales level of 250,000 units.) What is the
elasticity of EOQ with respect to carrying costs?
g. If the ordering costs double, what would happen to the level of
EOQ? (Again assume original levels of sales and carrying costs.)
What is the elasticity of EOQ with respect to ordering costs?
h. If the selling price doubles, what would happen to EOQ? What is
the elasticity of EOQ with respect to selling price?

528
SOLUTIONS FOR ALTERNATIVE PROBLEMS

16-1A. Annual collections = $10,000,000 (5 regions) = $50,000,000

Daily collections = $50,000,000/365 = $136,986
The value of the 3.0 days’ float reduction is found by presuming the freed
balances will be added to the marketable securities portfolio and will earn 11%
(see text of problem). The gross annual savings from the system are:
($136,986) (3.0 days) (.11) = $45,205
The annual cost of operating the lock-box system is:
($600 per month) (5 regions) (12 months) = $36,000
The net annual savings are: $45,205
- 36,000
$9,205 Savings
The data indicate that Regency Components should adopt the lock-box system.
16-2A. a. Recommendation
1. $700,000 (.115) (1/12) = $6,708 < $25,000 No
2. $700,000 (.115) (2/12) = $13,417 < $25,000 No
3. $700,000 (.115) (3/12) = $20,125 < $25,000 No
4. $700,000 (.115) (6/12) = $40,250 > $25,000 Yes
5. $700,000 (.115) (12/12) = $80,500 > $25,000 Yes
b. Let (%) be the required yield. With $700,000 to invest for two months
and a two-month holding period, we have:
$700,000 (%) (2/12) = $ 25,000
$700,000 (%) = $150,000
(%) = $150,000/$700,000 = 21.43%
The break-even yield, therefore, is 21.43%.

16-3A.a. First, it is necessary to compute Colorado Comm’s average remittance

check size and the daily opportunity cost of carrying cash. The average
check size is:
$10,000,000
= $1,429 per check.
7,000
The daily opportunity cost of carrying cash is:
0.07
= 0.0001918 per day
365

529
 Second, the days saved in the collection process can be evaluated
according to the general format of
Added Costs = Added Benefits
or
P = (D) (S) (i)
0.30 = (D) ($1,429) (0.0001918)
1.0946 days = D
Therefore, Colorado Comm will experience a financial gain if it adopts the
lock-box system and by doing so, will speed up its collections by more
than 1.0946 days.
b. In this situation, the daily opportunity cost of carrying cash is:
0.045
= 0.0001233 per day
365
For Colorado Comm to break even should it choose to install the lock-box
system, the cash collections must be accelerated by 1.7027 days as
follows:
$0.30 = (D) x ($1,429) x (0.0001233)
1.7027 days = D
c. The break-even cash acceleration period of 1.7027 days is greater than the
1.0946 days found in part a. This is due to the lower yield available on
near-cash assets (or 4.5% annually versus 7.0%). Since the alternative rate
of return on the freed-up balances is lower in the second situation, more
funds must be invested to cover the costs of operating the lock-box system.
The greater cash acceleration period generates this increased level of
required funds.
16-4A. a. Annual collections = ($5,000,000) x (10) = $50,000,000
Daily collections = $50,000,000/365 = $136,986
The opportunity cost of the mail and processing float is:
($136,986) x (4.2 days) x (0.08) = $46,027
b. Use of the suggested cash acceleration system will result in a float
reduction of 3 days (i.e., 1 day mail float, 1 day processing float, and 1 day
transit float). The gross annual savings from the system, then, can be
calculated as:
($136,986) x (3) x (0.08) = $32,877
The cost of operation of the lock-box system is:
($225 per month) x (10 regions) x (12 months) = $27,000

530
 Therefore, the net annual savings (costs) are:
($32,877) - ($27,000) = $5,877
The firm should adopt the system, as the net gain is positive and equal to
$5,877.
16-5A. a. Reduction in mail float:
(1 day) x ($1,000,000) = $ 1,000,000
Reduction in processing float:
(1.5 days) x ($1,000,000) = $ 1,500,000
Total float reduction = $ 2,500,000
b. (0.07) x ($2,500,000) = $175,000
c. The average number of checks to be processed each day through the lock-
box arrangement is:
($1,000,000)
= 500 checks per day
$2,000
Thus, the cost of the lock-box system on an annual basis is:
(500) x ($0.22) x (270 days) = $29,700
Next, we have to calculate the cost of the ADTC system. The First
Pennsylvania Bank will not contribute to the cost of the ADTC
arrangement, because it is the lead concentration bank and, thereby,
receives the transferred data. This means Carter’s Bicycles will be charged
for six ADTCs each business day. The ADTC system, then, costs ($16) x
(6) x (270) = $25,920. Finally, we have the total cost of the proposed
system:
Lock-box cost $ 29,700
ADTC cost 25,920
Total cost $ 55,620
d. The information just developed strongly indicates that Carter’s Bicycles
should install the proposed cash receipts acceleration system. The net
annual gain associated with this recommendation is $119,380 as follows:
Projected return on freed balances $175,000
Less cost of new system (55,620)
Net annual gain $119,380

531
16-6A. a. The average accrued wages under the monthly payment system are:
4 x ($500,000)
= $1,000,000
2
This means that the firm has, on the average, $750,000 (i.e., $1,000,000 -
$250,000) more to invest. This provides an annual return of ($750,000) x
(0.08) = $60,000. Therefore, Katz Jewelers should move to the monthly
payment system since it will generate $60,000 - $40,000 = $20,000 in net
annual savings.
b. Let r = the break-even rate of return on the near-cash portfolio:
$750,000 x (r) = $40,000
r = 5.33%
A reasonable margin of safety favoring adoption of the monthly payment
proposal is present.
16-7A. The value of one day of processing float is:
$12,000,000
= $44,444
270
The annual savings at 7% for two days are:
($44,444) x (2) x (0.07) = $6,222
16-8A. This exercise attempts to illustrate that a change in the firm’s accounts payable
policy can properly be viewed as a part of the overall problem of cash
management. Before evaluating the 45-day and 60-day payment alternatives, it is
necessary to calculate the amount of purchases that are actually discounted and the
value of the annual purchase discount earned by Meadowbrook. These amounts
are calculated below:
Purchases discounted
($40,000,000 annual purchases) x (0.25) = $10,000,000
Purchase discounts earned
($10,000,000) x (0.03) = $300,000
with $300,000 in purchase discounts earned. Meadowbrook actually pays:
($10,000,000) - ($300,000) = $9,700,000, 10 days after purchase.
The annual amount not discounted is ($40,000,000) - ($10,000,000) =
$30,000,000.
We are now in a position to evaluate, first, the 45-day proposal and, second, the
60-day proposal.

532
 45-day alternative:
(1) (2) (3) (4) = (1) x (2) x (3)
Principal Extra time Interest Interest
amount available rate earned
$ 30,000,000 15 days 0.11 ÷ 365 = $135,616
9,700,000 35 days 0.11 ÷ 365 = 102,315
Total added return $237,931
- $300,000 Lost discounts earned
+ 237,931 Total added return
- $ 62,069 Loss to Meadowbrook by stretching payables to 45 days.

60-day alternative:
(1) (2) (3) (4) =(1)x(2)x(3)
Principal Extra time Interest Interest
amount available rate earned
$30,000,000 30 days 0.11 ÷ 365 = $271,233
9,700,000 50 days 0.11 ÷ 365 = 146,164
Total added return $417,397

- $300,000 Lost discounts earned

+$417,397 Total added return
$117,397 Gained by Meadowbrook by stretching payables to 60
days
Finally, we can evaluate the effect of the projected price increase to Meadowbrook
that is associated with the 60-day alternative.
Price Increase:

$40,000,000 Purchases
. x.005
$ 200,000 Price increase
$200,000 Price increase
- 117,397 Net added return
-$ 82,603 Loss to Meadowbrook
Ultimately, none of the proposed courses of action would benefit the firm.
28
$70 $1,000
16-9A. a. P = ∑ (1.09) t
+
(1.09) 28
= $797.68
t =1

T bond can be sold for $79768.

b. $1,000 - $797.68 = $202.32 loss

533
 c. First, we find the price of the 4-year bond, which now has 2 years
remaining to maturity:
2
$70 $1,000
P = ∑ + = $964.82
t = 1 (1.09)
t
(1.09) 2
Then we can determine the expected capital loss on the shorter-term bond
as follows:
$1,000 - $964.82 = $35.18
The capital loss on the shorter-term bond is much less than that suffered on
the longer-term instrument.
d. Interest rate risk.
16-10A. a. The after-tax yield to Ward Grocers on the BBB-rated bond is (0.08) x (1-
0.46) = .0432 = 4.32%. Since the yield on the tax-exempt issue is
already stated on an after-tax basis, we can conclude the 5½% return on
the municipal is preferable.
r*
b. r =
(1 − T)
0.055 0.055
r = = = 10.185%
(1 − 0.46) 0.54
a 360
16-11A. a. x
1− a c−b
where a = amount of the discount
b = the discount period
c = the net period
0.01 360
x = 24.24%
1 − 0.01 20 − 5
0.02 360
b. x = 10.50%
1 − 0.02 90 − 20
0.01 360
c. x = 4.55%
1 − 0.01 100 − 20
0.04 360
d. x = 37.50%
1 − 0.04 50 − 10
0.05 360
e. x = 23.68%
1 − 0.05 100 − 20
0.05 360
f. x = 94.74%
1 − 0.05 50 − 30

534
16-12A. Applicant #1
Z = 3.3(0.3) + 1.0(0.4) + 0.6(1.2) + 1.4(0.3) + 1.2(0.5)
Z = 0.99 + 0.4 + 0.72 + 0.42 + 0.6
Z = 3.13 > 2.7 thus, accept
Applicant #2
Z = 3.3(0.2) + 1.0(0.6) + 0.6(1.3) + 1.4(0.4) + 1.2(0.3)
Z = 0.66 + 0.6 + 0.78 + 0.56 + 0.36
Z = 2.96 > 2.7 thus, accept
Applicant #3
Z = 3.3(0.2) + 1.0(0.7) + 0.6(0.6) + 1.4(0.3) + 1.2(0.2)
Z = 0.66 + 0.7 + 0.36 + 0.42 + 0.24
Z = 2.38 < 2.7 thus, reject
Applicant #4
Z = 3.3(0.1) + 1.0(0.5) + 0.6(0.8) + 1.4(0.5) + 1.2(0.4)
Z = 0.33 + 0.5 + 0.48 + 0.7 + 0.48
Z = 2.49 < 2.7 thus, reject
Applicant #5
Z = 3.3(0.5) + 1.0(0.7) + 0.6(0.5) + 1.4(0.4) + 1.2(0.6)
Z = 1.65 + 0.7 + 0.30 + 0.56 + 0.72
Z = 3.93 > 2.7 thus, accept
Applicant #6
Z = 3.3(0.2) + 1.0(0.4) + 0.6(0.2) + 1.4(0.4) + 1.2(0.4)
Z = 0.66 + 0.4 + 0.12 + 0.56 + 0.48
Z = 2.22 < 2.7 thus, reject
Sales − cost of goods sold
16-13A. a. = Gross Profit Margin
Sales
$550,000 − Cost of goods sold
= 0.10
$550,000
Cost of goods sold = $495,000
Cost of goods sold
= Inventory turnover ratio
Average inventory
$495,000
= 5
Average inventory
Average inventory = $99,000

535
 360
b. Inventory turnover ratio =
Average Collection Period
360
Inventory turnover =
35
Inventory turnover ratio = 10.285 times
Cost of goods sold
= 10.285 times
Average inventory
$480,000
= 10.285 times
Average inventory
Average inventory = $46,669.90
Cost of goods sold
c. = Inventory turnover ratio
Average inventory
$1,250,000
= 6
Average inventory
Average inventory = $208,333
d. (1 - Gross profit margin) (Sales) = $21,250,000 cost of goods sold
(0.85)($25,000,000)
360
Inventory turnover ratio = = 7.2 times
50
$21,250,000
= 7.2 times
Average inventory
Average inventory = $ 2,951,389
2 SO
16-14A. a. Q* =
C
2(3500)9
=
0.2
= 315,000
= 562 units

536
 Q S
b. Total costs =   C +   O
2 Q
Order one time:
 3500   3500 
=   $.20 +   $9
 2   3500 
= $350 + $9
= $359
Order four times:
 875   3500 
=   $.20 +   $9
 2   875 
= $87.50 + $36
= $123.50
Order five times;
 700   3500 
=   $.20 +   $9
 2   700 
= $70.00 + $45.00
= $115
Order ten times:
 350   3500 
=   $0.20 +   $9
 2   350 
= $35.00 + $90
= $125
Order 15 times:
 234   3500 
=   $0.20 +   $9
 2   234 
= $23.40 + $134.62
= $158.02

c. (1) constant or uniform demand

(2) constant unit price
(3) constant carrying costs
(4) constant ordering costs
(5) instantaneous delivery
(6) independent orders

537
 2SO
16-15A. a. EOQ =
C
2(300,000)100
=
1.2
= 7,071 units or 7,100 units
300,000
b. = 42.25 orders per year
7,100
c. Inventory order point = Delivery time stock + safety stock
1
= x 300,000 + 4,000
50
= 6,000 + 4,000
= 10,000 units
EOQ
d. Average inventory = + Safety stock
2
7,100
= + 4000
2
= 7,550 units

2(600,000)100
e. EOQ =
1.2
= 10,000 units
Elasticity of
EOQ with %∆EOQ
=
respect to a %∆Sales
double in sales
ΔEOQ ΔSales
= ÷
EOQ Sales

 10,000 − 7,100   600,000 − 300,000 

=  /  
 7,100   300,000 
.4085
= = .4085 or 40.85%
1.0

538
 2( 250,000)100
f. EOQ =
2.4
= 5,000
Elasticity of
EOQ with %∆EOQ
respect to a =
double in %∆Carrying Costs
carrying costs
5,000 − 7,100
7,100
= = -29.58%
2.4 − 1.2
1.2
2(300,000) 200
g. EOQ =
1.2
= 10,000
Elasticity of
EOQ with % ∆EOQ
respect to a =
double in %∆Ordering Costs
ordering costs
10,000 − 7,100
7,100
= = 40.85%
200 − 100
100
h. The selling price of the item does not enter the EOQ equation and does not
affect the level of EOQ (although the carrying cost does, and it is 10% of
the sale price). The EOQ equation attempts to minimize costs, and, as
such, the selling price does not enter into its calculation; thus, the elasticity
of EOQ with respect to the selling price is 0.

539