# ECON 4400 Study Guide - Final Guide: Cash Conversion Cycle, Working Capital, Capital Requirement

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8 Aug 2016

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Calculating Working Capital Required

The amount of working capital required by a company can be estimated

from the information on the value of relevant working capital inputs and

outputs, such as raw material costs and credit purchases, together with

information on the length of the components of the cash conversion cycle.

Assume that Carmed plc expects credit sales of £18m in the year and has

budgeted production costs as follows:

£m

Raw Materials 4

Direct labour 5

Production overheads 3

Total production costs 12

Raw materials are in inventory for an average of three weeks and finished

goods are in inventory for an average of four weeks. All raw materials are

added at the start of the production cycle, which takes five weeks and incurs

labour costs and production overheads at a constant rate.

Suppliers of raw materials allow four weeks credit, whereas customers are

given 12 weeks to pay. If production takes place evenly throughout the year,

what is the working capital requirement?

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Using the EOQ Model

Oleum plc sells a soap called Fragro, which it buys in boxes of 1000 bars

with ordering costs of €5 per order. Retail sales are 200,000 bars per year

and holding costs are €2.22 per year per 1000 bars.

What is the Economic Order Quantity and average inventory level for

Fragro?

Evaluating a change in Trade receivables policy

Mine plc has annual credit sales of £15m and allows 90 days credit. It is

considering introducing a 2% discounts for payment within 15 days, and

reducing the credit period to 60 days. It estimates that 60% of its customers

will take advantage of the discount, while the volume of sales will not be

affected. The company finances working capital from an overdraft at a cost

of 10%.

Is this proposed change in policy worth implementing?

Cost benefit analysis of factoring

Trebod has annual credit sales of €4.5 m. Credit terms are 30 days, but its

management of trade receivables has been poor and the average collection

period is 50 days, with 0.4 % of sales resulting in bad debts.

A factor has offered to take over the task of debt administration and credit

checking, at an annual fee of 1% of credit sales.

Trebod plc estimates that it would save €35,000 per year in administration

costs as a result. Due to the efficiency of the factor the average collection

period would fall to 30 days and bad debts would be eliminated. The factor

would advance 80% of invoiced debts at an annual rate of 11%. Trebod plc

currently finances trade receivables from an overdraft costing 10% per year.

If credit sales occur smoothly throughout the year, determine whether

the factor’s services would be accepted?

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Question 5

Sec uses 60,000 tons of salt over a 50-week working year. It costs £100 to order sales and

delivery follows 2 weeks later. Storage costs for the salt are expected to be £0.10 per ton

per year. The current practice is to order twice a year when inventory falls to 10,000 tons

(all orders are equal in size)

Recommend an ordering policy for Sec using the Economic Order Quantity model and

contrast its costs with the cost of the current policy.

Question 6

MW has sales of €700,000 per year. Its costs are a % of sales and as follows:

Raw Materials 20%

Direct Labour 35%

Overheads 15%

Raw materials are carried in inventory for 2 weeks and finished goods are held in

inventory for 3 weeks. Production takes 4 weeks. MW takes 4 weeks credit from

suppliers and gives 8 weeks credit to its customers. If both overheads and production are

incurred evenly throughout the year, what is MW’s total working capital requirement?

Question 7

MC has current sales of €1.5m per year. Cost of sales are 75% of sales and bad debts are

1% of sales. Cost of sales comprises of 80% variable costs and 20 fixed costs. The

company finances working capital from an overdraft at a rate of 7% per year.

MC currently allows customers 30 days credit, but is considering increasing this to 60

days credit in order to increase sales. It has been estimated that this change in policy will

increase sales by 15% while bad debts will increase from 1% to 4%. It is not expected

that the policy change will result in an increase in fixed costs and payables and inventory

will be unchanged.

Should MC introduce this proposed policy?

Question 8

A company is planning to offer a discount for payment within 10 days to its customers,

who are currently paying at 45 days. Only 40% of credit customers would take up the

discount, although administration cost savings of €4450 per year would be gained. If

credit sales, which are unaffected by the discount, are €1,600,000 per year and the cost of

short term finance is 8%, what is the maximum discount that could be offered?

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