UNIT V: Working Capital

Management and Contemporary

Issues in Finance

1
WCM: Concept and Need
• WCM – management of level of all individual current assets as well as total working capital.
• Current assets include the ones:
• Which are convertible into cash or equivalents within period of one year
• Which are required to meet day to day expectations
• Individual assets- have unique characteristics
• Cash and bank balance
• Marketable securities
• Receivables
• Inventories
• Need of WCM
• Existence of WC is imperative in any firm- for optimum utilization of fixed assets.
• WC involves investment of funds of the firm.

2
 1. Tying up of funds which
could be utilized elsewhere.
Excessive 2. May expose firm to undue
risk
investments Ex: if inventory cannot be sold
or receivables cannot be
collected
Current
Assets
May prove expensive.
Shortage of Ex: insufficient inventory may
mean that sales are lost as
investments goods which a customer wants
are not available.

3
 • What should be total investment in working
capital of firm?
• What should be the level of individual current
assets?
WC • What should be the relative proportion of
different sources to finance the WC requirements?
Decisions
• WCM- management of firm’s sources and uses of
working capital in order to maximize the wealth of
shareholders.

4
 GROSS/TOTAL WC NET WC

Firm’s investment in all CA taken Excess of total current assets

together over total current liabilities
Types
of
Ex: firm has cash balance of Ex: firm has cash balance of
Working 50,000; debtors of 70,000 and 50,000; debtors of 70,000 and
creditors of 20,000 creditors of 20,000
Capital GWC= 1,20,000 NWC= 1,00,000

Optimum GWC NWC may be +ve or –ve.

-Avoids unnecessary stoppage of work It measures firm’s liquidity.
or chance of liquidation due to
insufficient WC
-effect on profitability
5
 • Operating cycle may be defined as time duration
starting from the procurement of goods or raw
materials and ending with the sales realization.
• Length and nature of OC depends on size and
Operating nature of firm.
• Sequence in case of OC:
and Cash • Procurement of raw material and services
• Conversion of raw materials into WIP
Cycle • Conversion of WIP into FG
• Sale of FG
• Conversion of receivables in cash

6
 • TOCP= ICP +RCP
• TOCP-total operating cycle period
• ICP= inventory conversion period- time for
conversion of RM into FGs
Operating • RCP= receivables conversion period- time for
converting credit sales into cash realization
Cycle
• In case firm gets certain credit facilities from
Period suppliers of raw materials, wage earners etc. then
such delays by parties are referred to as deferral
period (DP)
• NOC= TOCP-DP
• NOC-net operating cycle

7
 AVG. RAW MATERIAL STOCK * 365
RMCP
TOTAL RM CONSUMPTION

WPCP AVG. WIP * 365

TOTAL COST OF PRODUCTION

FGCP AVG. FG * 365

Calculation of TOTAL COGS

TOCP and NOP RCP AVG. RECEIVABLES * 365

TOTAL CREDIT SALES

DP AVG. CREDITORS * 365

TOTAL CREDIT PURCHASE

8
PARTICULARS NUMBER OF DAYS
RMCP ____________ DAYS
+WPCP ____________ DAYS
+FGCP ____________ DAYS
+RCP ____________ DAYS
TOCP ____________ DAYS
-DP ____________ DAYS
NOC ____________ DAYS
9
 While preparing a project report on behalf of a client you have collected following facts. Estimate the
working capital required for that project. Add 10% of debtors and current liabilities to your computed
figure to allow contingencies:

ADDITIONAL INFORMATION
1. Level of activity: 1,04,000 units of production per annum
PARTICULARS AMOUNT
PER UNIT 2. Raw material in stock: Average 4 weeks
3. Work-in-progress: Average 2 weeks
RAW MATERIAL 80
DIRECT LABOUR 30 4. Finished goods in stock: Average 4 weeks
OVERHEADS 60 5. Credit allowed by suppliers: Average 4 weeks
(EXCLUSIVE OF
DEPRECIATION; INR 6. Credit allowed to debtors: Average 8 weeks
10 PER UNIT) 7. Lag in payment of wages: Average 1.5 weeks
COST OF PRODUCT 170
8. Cash at bank is expected to be INR 25,000
PROFIT 30
9. Cash sales are on 25% basis
SELLING PRICE 200
You may assume that production is carried on evenly throughout
the year (52 weeks) and wages and overheads accrue similarly.
 WORKING NOTES

1. Level of activity: 1,04,000 units of production per annum =104000/52=2000

2. Raw material in stock: Average 4 weeks= 80*4*2000= 6,40,000

PARTICULARS AMT P.U. 3. Work-in-progress: Average 2 weeks= RM: 80*2*2000=3,20,000
RAW MATERIAL 80 DL: 50% (30*4000)=60,000
O/H: 50%(60*4000)= 1,20,000
DIRECT LABOUR 30
= 5,00,000
OVERHEADS 60
4. Finished goods in stock: Average 4 weeks: 170*2000*4= 13,60,000
(EXCLUSIVE OF
DEPRECIATION;
INR 10 PER UNIT) 5. Credit allowed by suppliers: Average 4 weeks= 80*4*2000= 6,40,000

COST OF 170 6. Credit allowed to debtors: Average 8 weeks= 170*2000*8*75%= 20,40,000

PRODUCT
PROFIT 30 7. Lag in payment of wages: Average 1.5 weeks= 30*2000*1.5=90,000
SELLING PRICE 200
8. Cash at bank is expected to be INR 25,000

9. Cash sales are on 25% basis

You may assume that production is carried on evenly throughout the year (52 weeks)
and wages and overheads accrue similarly.
11
CURRENT ASSETS: AMOUNT AMOUNT
MIN CASH BALANCE 25,000
INVENTORIES:
RM 6,40,000
WIP 5,00,000
FG 13,60,000
DEBTORS 20,40,000
A) GROSS WC 45,65,000
CURRENT LIABILITIES:
CREDITORS FOR MATERIAL 6,40,000
CREDITORS FOR WAGES 90,000
B) TOTAL CL 7,30,000
EXCESS OF CA OVER CL (A-B) 38,35,000
+SAFETY MARGIN 10%(20,40,000+7,30,000) 2,77,000
NWC 41,12,000

12
Qs.
• From the following information taken from the books of a manufacturing concern, compute the
OC in days:
Period covered 365 days
Avg period of credit allowed by suppliers 16 days
INR (in 000’s)
Avg. debtors outstanding 480
RM consumption 4,400
Total production cost 10,000
Total COGS 10,500
Sales for the year 16,000
Value of avg stock maintained
RM 320
WIP 350
FG 260
13
Period covered 365 days
Avg period of credit allowed 16 days RMCP AVG. RAW MATERIAL STOCK * 365 320/4400*365
by suppliers TOTAL RM CONSUMPTION =27 days
INR (in WPCP AVG. WIP * 365 350/10,000*36
000’s) TOTAL COST OF PRODUCTION 5= 13 days
Avg. debtors outstanding 480
RM consumption 4,400
FGCP AVG. FG * 365 260/10500*36
Total production cost 10,000 TOTAL COGS 5= 9 days
Total COGS 10,500
Sales for the year 16,000 RCP AVG. RECEIVABLES * 365 480/16000*36
TOTAL CREDIT SALES 5=11 days
Value of avg stock maintained
RM 320 TOCP = 27+13+9+11= 60 DAYS
WIP 350 NCP= 60-16= 44 DAYS

FG 260

14
 CURRENT ASSETS: AMOUNT AMOUNT
MIN CASH BALANCE XXX
INVENTORIES:
RM XXX
WIP XXX
Estimation FG XXX XXX

of working RECEIVABLES
DEBTORS XXX
capital BILLS XXX XXX
requirement A) GROSS WC XXX

s CURRENT LIABILITIES:
CREDITORS FOR PURCHASE XXX
CREDITORS FOR WAGES XXX
CREDITORS FOR OVERHEADS XXX
B) TOTAL CL XXX
EXCESS OF CA OVER CL (A-B) XXX
+ SAFETY MARGIN XXX
NWC XXX
15
Qs.
• Cost sheet of PQR ltd. provides the following data:
Cost per unit (INR)

RM 50

DIRECT LABOUR 20

OVERHEADS (INCLUDING DEPRECIATION OF INR 10) 40

TOTAL COST 110

PROFITS 20

SP 130

16
1. Avg raw material in stock is for 1 month
2. Avg material in WIP is for half month
3. Credit allowed by suppliers: 1 month
Cost per unit
4. Credit allowed to debtors: 1 month
(INR)
5. Avg time lag in payment of overheads: 30 days RM 50
6. Avg time lag in payment of wages: 10 days DIRECT LABOUR 20
7. 25% of sales are on cash basis.
OVERHEADS (INCLUDING 40
8. Cash balance expected to be INR 1,00,000 DEPRECIATION OF INR 10)
9. FG lie in warehouse for 1 month TOTAL COST 110

PROFITS 20
• Prepare a statement of the WC needed to finance a SP 130
level of activity of 54,000 units of output.
Production is carried on evenly throughout the year
and wages and overheads accrue similarly. State
your assumptions if any, clearly.
17
 • Working notes:
• Level of output per month: 54000/12= 4500 units
1. Avg raw material in stock is for 1 month- 4500*50=
2,25,000
Cost per
2. Avg material in WIP is for half month- unit (INR)
1. Material: (4500*50)/2= 1,12,500
2. Wages: 50%(4500*20)/2= 22,500
RM 50
3. Overheads: 50%(4500*30)/2= 33,750
DIRECT LABOUR 20
3. Credit allowed by suppliers: 1 month- 4500*50=
2,25,0000 OVERHEADS (INCLUDING 40
4. Credit allowed to debtors: 1 month- DEPRECIATION OF INR 10)
4500*100*75%=3,37,500
TOTAL COST 110
5. Avg time lag in payment of overheads: 30 days-
4,500*30=1,35,000 PROFITS 20
6. Avg time lag in payment of wages: 10 days- (4500*20)*10/30=
30,000 SP 130
7. 25% of sales are on cash basis.
8. Cash balance expected to be INR 1,00,000
9. FG lie in warehouse for 1 month= 4500*100=4,50,000
18
CURRENT ASSETS: AMOUNT AMOUNT
MIN CASH BALANCE 1,00,000
INVENTORIES:
RM 2,25,000
WIP 1,12,500
1. Material: (4500*50)/2= 1,12,500 22,500
2. Wages: 50%(4500*20)/2= 22,500 33,750
3. Overheads: 50%(4500*30)/2= 33,750
FG 4,50,000
DEBTORS 3,37,500
A) GROSS WC 12,81,250
CURRENT LIABILITIES:
CREDITORS FOR MATERIAL 2,25,000
CREDITORS FOR WAGES 30,000
CREDITORS FOR OVERHEADS 1,35,000
B) TOTAL CL 3,90,000
EXCESS OF CA OVER CL (A-B)/ NWC 8,91,250
19
 Qs.
Cost Structure 1. Activity level: 1,80,000 units of output for the year.
RM INR 20 P.U. 2. Min. desired cash balance: 20,000
DL INR 5 P.U.
3. RM are held in stock, on avg., for 2 months
OVERHEADS INR 15 P.U.
(INCLUDING DEP. 4. WIP (assume 50% completion stage) will approx. to
OF INR 5 P.U.) half-a-month’s production.
______ 5. FG remain in warehouse, on avg, for a month
40
PROFIT 10 6. Suppliers of materials extend a month’s credit and
S.P. 50
debtors are provided two month’s credit; cash sales
are 25% of total sales.
7. Time lag in payment of wages of a month, and half a
month in case of overheads.

20
 CURRENT ASSETS: AMOUNT AMOUNT
MIN CASH BALANCE 20,000
INVENTORIES:
RM 15000*20*2 6,00,000
Units per month: WIP : (20+5+10)*7500*50% 1,31,250

1,80,000/12= 15,000 Half a month production: 15000/2: 7500

FG 35*15000 5,25,000
DEBTORS 15000*35*2*75% 7,87,500
A) GROSS WC 20,63,750
CURRENT LIABILITIES:
CREDITORS FOR MATERIAL 15000*20 3,00,000
CREDITORS FOR WAGES 15000*5 75,000
CREDITORS FOR OVERHEADS 15000/2*10 75,000
B) TOTAL CL 4,50,000
EXCESS OF CA OVER CL (A-B)/ NWC 16,13,750
21
 Basic nature of business (retail shop vs.
manufacturing concern)
Business cycle fluctuations (boom, recession,
recovery)
Factors Seasonal operations
determining
working capital Market competitiveness (liberal credits, higher
inventories)
requirement
Credit policy (supplier and customers)

Supply conditions (time taken by suppliers)

22
Risk-Return Trade Off: Liquidity vs Profitability
• By maintaining a large investment in CA like cash, inventory, etc., the firm
reduces the chances of
• Production stoppages
• Lost sales from inventory shortages
• Inability to pay creditors on time
• However, with increase in investments in WC, there is no corresponding increase
in its expected returns.

Increase in
Unchanged Drop in
WC
profits firm’s ROI
investments

23
 • Firm’s use of CL vs. long term debt also involves
risk-return trade off
• Ceteris paribus, greater the firm’s reliance on the
Risk-Return Trade short-term debts or CL in financing its current
Off: Liquidity vs assets, greater is the risk of illiquidity.
Profitability • CL however is less costly and flexible means of
financing.
• A firm can reduce its risk of illiquidity using
long-term debts at the cost of reduction in its ROI.

24
 Types of WC

Permanent Temporary

Min level of CA which must Extra WC needed to

be maintained by firm all support increased vol of
the times is PWC sales is temp WC

25
Financing of WC:
Hedging/Matchin
g Approach
• Based on general rule that
length of finance should
match with the life
duration of assets.
• PWC needs are financed
by long-term sources
• TWC needs are financed
by short-term sources

26
Financing of WC:
Conservative
Approach
• All WC needs are
primarily financed by
long-term sources.
• Use of short-term sources
is restricted to
unexpected and
emergency situations
only.

27
Financing of
WC: Aggressive
Approach
• Firm finances part of WC
by short-term sources
• Purpose is to minimize
excess liquidity while
meeting short-term
requirements.

28
Cash Management
• Management of cash balance and the bank balance including the short-term deposits.
• Extreme Liquidity: Firm may make uneconomic investments
• Insufficiency of Cash: may prevent firm from discharging its liabilities or force it to sell
some assets immediately.
• Finance manager
• manage cash flows arising out of operations of firm
• has to forecast cash inflows and cash outflows
• helps to identify timings as well as amount of future cash flows
• identifies sources from which cash may be procured or outlets where excess cash
may be invested on short term basis.

29
 Cash
Management
Motives

Transaction Precautionary Speculative

30
 Accelerating cash
inflows

Cash Management:
Control Aspects
-delay the payments to the
extent possible
Controlling cash -discount offered by creditors
outflows for prompt payment must be
evaluated in terms of costs &
benefits of discount

31
Float

Collection

• Time span between collection of cheque and its actual realization

• Amount of cheque deposited in bank but not yet cleared
• Minimize it

Disbursement

• Time span between payment of cheque & its realization by the payee
• Cheque issued but not presented for payment
• Maximize to the extent possible

32
Monthly Cash Budget for the Year…. January February March April
Opening Cash Balance
Cash Inflows:
Cash Sales
Collection from Debtors
Loans and Borrowings
Other Incomes
Total Cash Available (A)
Cash Outflows:
Payment to creditors
Wages and salaries
Other expenses
Purchase of fixed assets
Interest and taxes
Total Payments (B)
Closing Balance (A-B)
+Funds required
- Excess cash to be invested 33
• Qs. Following forecasts were made for the company for the period January- April.
January February March April
Sales 75,000 1,05,000 1,80,000 1,05,000
Raw Material 70,000 1,00,000 80,000 85,000
Manufacturing Expenses 10,000 20,000 29,000 16,000
Loan Instalment 1,000 11,000 21,000 21,000

• Additional Information:
• All sales are made on credit basis. 2/3 debtors are collected in the same month and balance in the
next month. There is no expected bad debt. Debtors on January 1 were 30,000
• Minimum cash balance of 5,000 is to be maintained. However, cash balance on January 1 was
6,500.
• Borrowings if any can be made in multiples of INR 100 only.

34
Sales Jan Feb March Apr
Dec 30,000
Jan (75,000) 75000*2/3=50,000 25,000
Feb (105000) 70,000 35,000
March 120000 60000
(180000)
April (105000) 70,000
80,000 95,000 1,55,000 1.30,000

35
 January February March April
Opening Cash Balance 6500 5500 5000 5000
Inflows:
Debtors 80,000 95,000 1,55,000 1,30,000
Total cash available (A) 86,500 1,00,500 1,60,000 1,35,000
Outflows:
Raw material 70,000 1,00,000 80,000 85,000
Manu. Exp 10,000 20,000 29,000 16,000
Loan Inst. 1,000 11,000 21,000 21,000
Total Outflows (B) 81,000 1,31,000 1,30,000 1,22,000
Cash Balances (A-B) 5,500 -30,500 30,000 13,000
Borrowings (Refund) - 35,500 (25000) (8000)

36
 • You are required to find out the cash inflows and outflows for the 1-6 months based on
following information:
Month Credit Sales Variable Cost Wages (INR) 1. Fixed expenses amount to 1,500 per month.
(INR) (INR)
2. Half year’s preference dividend of 1,400 is due on June
November 10,000 7,000 1,000 30th.
2021 3. Advance tax amounting to 8,000 is payable in January
and progress payment under a building contract are
December 12,000 7,500 1,100
due as follows:
January 2022 14,000 8,000 1,200 a. March 31: 5,000; May 31: 6000
4. Terms on which goods are sold are net cash in the
February 13,000 7,700 1,000 month following delivery.
5. Variable costs are payable in the month following that
March 10,000 7,000 1,000
in which they are incurred, and 50% are subject to
April 12,000 7,500 1,100 2.5% discount and the balance are net.
May 13,000 7,750 1,200 6. It is found that 75% of debtors to whom sales are
made pay within the period of credit, and the
June 16,000 8,750 1,300
remainder do not pay until the following month.
7. Company pays all its accounts promptly.

37
SALES JAN FEB MAR APR MAY JUNE

Nov 10,000*25%
Dec 12000*75% 12000*25%
Jan 14000*75% 14000*25%
Feb 13000*75% 13000*25%
March 10000*75% 10000*25%
Apr 12000*75% 12000*25%
May 13000*75%
June

VARIABLE JAN FEB MAR APR MAY JUNE

COST
50% WITH 3656 3900 3754 3412 3656 3778
DISCOUNT
50% 3750 4000 3850 3500 3750 3875
WITHOUT
DISCOUNT
TOTAL 7406 7900 7604 6912 7406 7653 38
 JAN FEB MAR APR MAY JUNE
A. CASH INFLOWS
DEBTORS 11500 13500 13250 10750 11500 12750
TOTAL CASH RECEIPTS 11500 13500 13250 10750 11500 12750
B. CASH OUTFLOWS
FIXED EXPENSES 1500 1500 1500 1500 1500 1500
PREFERENCE DIVIDEND 1400
ADVANCE TAX 8000
PAYMENT UNDER BUILDING 5000 6000
VARIABLE COST 7406 7900 7604 6912 7406 7653
WAGES 1200 1000 1000 1100 1200 1300
TOTAL CASH PAYMENTS 18106 10400 15104 9512 16106 11853
SURPLUS (DEFICIENCY) (6606) 3100 1854 1238 (4606) 897

39
 • Assumptions:
• It assumes that the firm uses cash at an already known rate
per period and that this rate of use is constant
• Total cash required during a given period is known with
certainty
Optimum Cash • Cash is used uniformly throughout the given period
• Cash conversion cost/ transaction cost of converting
Balance: marketable securities into cash are known and constant
• Opportunity cost of holding cash is known and constant
Baumol’s • Holding cost: There is always cost of holding cash by a firm. The
cost may be the opportunity cost in terms of the interest
Model foregone on the investment of this cash.
• Transaction cost: Whenever cash is to be converted into
marketable securities or vice-versa; there is always a cost
involved in the form of brokerage, commission etc.

40
Optimum Cash Balance: Baumol’s Model

•C =
1. C= Cash required each time to restore balance to minimum
2. F= Total cash required during the year
3. T= Cost of each transaction between cash and marketable securities
4. r= Rate of interest on marketable securities
5. Unit of measurement of C and r should have same period

Total Cost of Holding Cash = Total Transaction Cost + Total opportunity Cost
= (F/C) x T + (C/2) x r
Against Optimal Lot Size
TC= (F/C*) x T + (C*/2) x r

TOTAL COST IS MINIMUM AT C*

41
Qs.
• A company needs INR 30,00,000 cash to meet its transaction needs during the next quarter cash
planning period. It holds marketable securities of an equal amount.
• The annual yield on these securities is 20%. The conversion of these securities into cash requires a
fixed cost of INR 3,000 per transaction to be incurred.
• Using Baumol's model compute the optimum amount of marketable securities to be converted
into cash per transaction. Also show that the total transaction cost and total operating cost at
that level are equal.

1) What will happen to total cost if marketable securities worth 3,00,000 are converted into cash
per order/ transaction.
2) What will happen to total cost if marketable securities worth 7,50,000 are converted into cash
per order/ transaction.

42
Transaction Cost Opportunity Cost Total Cost
(F/C) x T = (C/2) x r= (6,00,000/2)*0.2/4= 30,000
(30,00,000/6,00,000)*3000=15000 15000

Transaction Cost Opportunity Cost Total Cost

3,00,000 (F/C) x T = (C/2) x r= (3,00,000/2)*0.2/4=7,500 37,500

(30,00,000/3,00,000)*3000=30,000

7,50,000 (30,00,000/7,50,000)*3000=12,000 (7,50,000/2)*0.2/4= 18750 30,750

43
44
 Miller-Orr Model
• Works under conditions of uncertainty.
• It assumes that the requirement/ use of cash does not occur uniformly throughout the given period rather the cash
flows fluctuate randomly.
• However, it further assumes that cash flows although fluctuate randomly, they follow a normal distribution with zero
mean and constant standard deviation i.e., variability in usage level is constant.
• In this model, a particular level is not given as optimal cash level, in fact calculations done include:
• Return Point
• Upper Control Limit (UL)
Established by the company
• Lower Control Limit (LL)

• Total cash balance should vary between upper and lower limit.
• When cash level crosses upper limit; buy marketable securities.
• When cash level crosses lower limit; sell marketable securities.
45
 Miller-Orr Model A company earns an annual yield of 12% on its marketable
securities. The fixed cost of effecting marketable securities
transaction is INR 1,600. The standard deviation of changes in
• Return Point (RP) = daily cash balance is INR 5,000. The company wants to maintain a
(3TV/4i)1/3+ LL minimum cash balance of INR 50,000. Based on above
information, calculate RP and UL for cash balance in the
• Average Cash= (4RP-LL)/3
company. What should management do if the actual cash balance
• Upper Limit= 3RP-2LL in the company becomes INR 2,00,000 or INR 40,000.
• T= transaction cost of conversion Assume 360 days in a year.
• V= Variance of daily cash flows RP= (3*1600*(5000)2/4*0.12/360) 1/3+ 50,000
• i= daily % interest rate on = INR 94,962
investments
UL= 3*94962 – 2*50,000= 184886
If CB is 2,00,000; buy securities worth 2,00,000-1,84,886=
• “All variables should be on daily
basis” 105038
If CB is 40,000; sell securities worth 94962-40,000= 54,962
46
Receivables Management
• Receivables represent credit allowed to customer and thereby allowing them to
delay the payment.
• Receivables management is important for companies having huge amount of
investments in credit sales.
• As amount is blocked in debtors; company loses interest income and opportunity
cost is involved with debtors.

47
 Credit Standards

• Should be applied in selecting customers for credit sales

Credit Period

• 15, 30, 45, 90- greater risk, greater opportunity cost

Credit associated with higher credit period

Cash discount

Policy • Eg: 1/10 net 30- this means if payment in 1-10 days, then
1% cash discount will be given.
• If payment is done on 25th day- no discount
• Credit period-30 days

Collection efforts

• Credit policy can be liberal or tight policy

48
Qs.
• Current sales of a company are INR 100 lakh. Company classifies customers into 4
categories 1-4. The credit rating of customers diminishes as one moves from category 1
to 4. The company presently extends unlimited credit to category 1 & 2 customers,
limited credit to category 3 customers and no credit to category 4 customers.
• As a result of this credit policy, the company is foregoing sales to the extent of INR
10,00,000 in case of category 3 customers and another INR 10,00,000 in case of
category 4 customers.
• Firm is considering adoption of more liberal credit policy under which unlimited credit
would be extended to category 3 customers and limited credit to category 4 customers.
• Such a relaxation would increase the credit sales by INR 15,00,000 on which bad debts
loss is expected to be 10%.
• Contribution-margin ratio: 20%, Tax Rate: 40%
• Average collection period is 40 days, Cost of Capital: 10%
• Days in a year: 360
• Recommend whether company should change its credit policy or not.

49
• P/V RATIO: 20%
• VARIABLE COST RATIO= 100-20%= 80%
• CHANGE IN RECEIVABLES INVESTMENT: 15,00,000*80%= 12,00,000

BENEFITS COSTS
INCREASE IN CREDIT SALES 15,00,000 INCREASE IN RECEIVABLES INVESTMENT: 12,00,000
15,00,000*80%
INCREASE IN CONTRIBUTION 3,00,000 OPPORTUNITY COST OF INVESTMENT: 13,333
MARGIN: 15,00,000*20% 10%* (12,00,000*40/360)
LESS BAD DEBT EXPENSES (1,50,000)
(15,00,000*10%)
1,50,000
LESS TAXES (@40%) (60,000)
NET INCREASE IN OPERATING 90,000
PROFIT
NET EFFET ON INCOME: 90,000 – 13,333 = 76,667, SHOULD CHANGE POLICY

50
Qs.
• A company provides 30 days of credit to its customers. Its present level of sales is
INR 50,00,000.
• The cost of capital is 10%. The variable cost ratio is 85%.
• The company is considering extending its credit period to 60 days.
• Such an extension is likely to push up sales by INR 5,00,000.
• The bad debts proportion on additional sales would be 8% and corporate tax rate
is 40%.
• Advice the company whether to extend its credit period or not.

51
 • VARIABLE COST RATIO= 85%
• 5,00,000*85%= 4,25,000

BENEFITS COSTS
INCREASE IN CREDIT SALES 5,00,000 OPPORTUNITY COST OF NEW INVESTMENT: 7083.33
10%* (4,25,000*60/360)

INCREASE IN CONTRIBUTION MARGIN: 75,000 OPPORTUNITY COST OF OLD INVESTMENT: 35416.67

5,00,000*15% 10%* (42,50,000*30/360)
ON EXISTING SALES WITH EXTENDED PERIOD: 60-30= 30
DAYS
LESS BAD DEBT EXPENSES (5,00,000*8%) (40,000) 42,500

35,000
LESS TAXES (@40%) (14,000)
NET INCREASE IN OPERATING PROFIT 21,000

NET EFFET ON INCOME: 21,000-42,500= (21,500); SHOULD NOT EXTEND

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Qs.

• A company is considering introduction of cash discount in its credit policy. The

company’s credit terms are “net 40” which it wants to change to “1/15 net 40”.
• The current average collection period is 60 days and is expected to decrease to
30 days with the new credit terms.
• It is expected that 50% of the customers will take advantage of cash discount.
• The company’s total sales are INR 60,00,000 and cost of capital is 15%.
• Assume corporate tax rate is 50%.
• Advice company regarding new credit terms.

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• Discount expense: 60,00,000*50%*1%= 30,000
• Tax saving on discount (@50%)= (15,000)
• Net cost after tax discount: 15,000

• Decrease in opportunity cost:

• 15% { 60,00,000*30/360 – 60,00,000*60/360}

NEW OLD

• Change in investment: 15% (5,00,00)= (75000)

• Benefit of new credit terms= Benefit – Cost: 75,000- 15,000= 60,000

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Qs.
• A company realizes that its collection efforts are very tight & therefore it is losing
some amount of sales. Hence it wants to relax its collection effort.
• At present, company’s sales are INR 40 lakh; average collection period (ACP) is 20
days, variable cost ratio: 80%, cost of capital is 12% and bad debts ratio is 0.05.
• Relaxation in collection efforts is expected to push up sales by INR 5,00,000,
increase the ACP to 40 days and raise the bad debts ratio to 0.06.
• Corporate tax rate: 40%
• Advice the company regarding relaxation in collection efforts.

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 BENEFITS COSTS
INCREASE IN CREDIT SALES 5,00,000 OPPORTUNITY COST OF NEW INVESTMENT: 48,000
12%* (45,00,000*80%*40/360)

INCREASE IN CONTRIBUTION MARGIN: 1,00,000 OPPORTUNITY COST OF OLD INVESTMENT: 21,333

5,00,000*20% 12%* (40,00,000*80%*20/360)

LESS BAD DEBT EXPENSES (70,000) 26,667

(45,00,000*6%-40,00,000*5%)

30,000
LESS TAXES (@40%) (12,000)
NET INCREASE IN OPERATING PROFIT 18,000

NET EFFET ON INCOME: 18,000-26,667= (8667); SHOULD NOT EXTEND

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