Financial Management Topic 9

 

WORKING CAPITAL MANAGEMENT

 

     QUESTION 1

1. Discuss the conflicts that might arise among the objectives of working capital management.
   1. b) Conflicts that might arise among the objectives of working capital management The objectives of working capital management are profitability and liquidity. Profitability supports the shareholder wealth maximisation objective. Liquidity ensures that firms are able to meet their liabilities as they fall due.

    

   However, funds held in cash do not earn a return, while near-liquid assets such as short-term investments earn only a small return. Meeting the objective of liquidity will therefore conflict with the objective of profitability, which is met by investing over the longer term in order to achieve higher returns.

   Good working capital management, therefore, needs to achieve a balance between profitability and liquidity if shareholders wealth is to be maximised.

   1. c)
2. Wanga Ltd. maintains a minimum cash balance of Sh. 1,500,000.

The standard deviation of the daily cash is Sh.800, 000. The annual interest rate is 12%. The transaction cost of buying and selling of marketable securities is Sh.200 per transaction. Assume that one year has 365 days.

 

Required:

Using the Miller-Orr cash management model, determine: i) The return point.       ii) Average cash balance.  iii) The upper cash limit.

 

 

QUESTION 2

The board of directors of Rand Mills Limited have requested you to prepare a statement showing the working capital requirements for a level of activity of 30,000 units of output for the year.

The cost structure for the company’s product for the above mentioned activity level is given below:

 

Cost per unit (Sh.)  Raw materials Direct labour Overheads Total Profit Selling price

(Sh.) 200 50 150 400 100 500

 

Additional information: 

1. Past experience indicates that raw materials are held in stock on average for 2 months.
2. Work in progress (100% complete in regard to materials and 50% for labour and overheads) will be half a month’s production.
3. Finished goods are in stock on average for 1 month.
4. Credit allowed to suppliers is 1 month.
5. Credit allowed to debtors is 2 months.
6. A minimum cash balance of Sh.250, 000 is expected to be maintained.

 

Required: 

Prepare a statement of working capital requirements.

 

 QUESTION 3

1. a) The current credit terms of Fredcom Ltd. are 2/15- net 45 days. The company’s total annual sales are Sh.200 million with an average collection period of 30 days. Variable cost is 80% of the annual sales. 50% of customers take advantage of the current discount.

 

The company is considering relaxing its discount terms to 3/15 net 45 days. This relaxation of discount terms is expected to increase annual sales by Sh.10 million, reduce average collection period to 27 days and increase the proportion of customers who will take advantage of the discount to 60%. The company’s cost of capital is 12%.

Corporate tax rate is 30%.

Assume 360 days in a year.

 

Required:

Advise the management of Fredcom Ltd. on whether to relax its discount terms.

 

 

QUESTION 4

1. b) Magas Ltd. is considering relaxing its debt collection effort. The following data is provided for Magas Ltd.

Total shares	Sh. 40 million
Average collection period Variable costs to sales ratio Cost of capital Bad debt ratio	20 days 0.80 12% 0.05

 

The relaxation in the debt collection effort is expected to increase sales by sh. 5. million, increase the average collection period to 40 days and raise the bad debt ratio to 0.06.

 

The company’s tax rate is 30%.

Assume 360 days in a year.

 

Required:

Assess the effect of relaxing the debt collection effort on the net profit of Magas Ltd.

 

 

QUESTION 5

The following information relates to the current trading operations of Dindiri Ltd.

Annual sales                          Sh.900 Million

Contribution to sales ratio       15%

 

Debtors recovery period:

Percentage of debtors      Average collection period (days) 

25   32 60    50

15                                     80

Credit sales as a percentage of total sales 60% Required return on investments 15%

Level of bad debts is 2.5% of credit sales.

 

In an effort to improve the liquidity position of the company, the management proposed the following strategies aimed at reducing its operating cycle.

 

Strategy A 

To offer a 2% cash discount to customers who pay their accounts within 10 days. This will have the following effects:

1. 50% of the cred it customers and all cash customer, will take advantage of the discount.
2. Annual sales the percentage of credit sales and the contribution to sales ratio will not change.
3. There will be savings in debt collection expenses of Sh 4,125,000 per month.
4. Bad debts will decrease to 20% of total credit sales.
5. The average collection period will be reduced to 32 days.

 

 

Strategy B 

Contract the services of a factor at a cost of 2% of total credit sales while advancing Dindiri Ltd. 90% of total credit sales invoiced at the end of each month at an interest rate of 1.5% per month.

 

The effects of this strategy will be:

1. No change in the level of annual sales proportion of cred it sales and contribution margin ratio.
2. Savings on debt administration expenses of Sh.2, 100,000 per month will result.
3. All bad debt losses will be eliminated.
4. The average collection period will drop to 20 days.

 

Required: 

(i) Evaluate the financial benefits and Costs of each strategy (assume a 60 day year) (ii) Advise the management of Dindiri Ltd. on the viable strategy to implement.

 

 

QUESTION 6

Bahari Ltd. has the standard deviation of its daily net cash flow estimated at Sh.68, 250. The company maintains minimum cash balance Sh.500, 000.  The company’s transaction cost is Sh.360 from the money marker. The rate interest for the marketable securities is 9.865% per annum. The company uses the Miller-Oir model to set its target cash balance.

Assume 365 days a year.

 

Required: 

• The company’s return point.
• Upper cash limit.
• The average cash balance.

 

December 2012 Question Five D

QUESTION 7

1. a) The finance manager of Charisma Enterprises Ltd. has given the following financial estimates for the year ending 31 December 2012:

 

	Sh. “000”
Sales (all on credit) Trade receivables Gross profit margin Finished goods Work-in-progress Raw materials (balance held) Trade payables	3,600 306 25% on sales 200 350 150 130

 

Raw materials are 80% of cost of sales which are all on credit.

 

Required:

The cash operating cycle.

May 2012 Question Three C

QUESTION 8

1. b) The projected monthly working capital requirements for Chasimba Ltd. for the year ending 31 December 2012 is as follows:

 

 

 

Month                                    January    February     March     April       May      June

Amount of working capital

required    Sh.”000″                      4,500          4,500         6,250       8,000      11,500               16,750

 

Month                                     July       August               September October November December

Amount of working capital

required    Sh.”000″                22,000      25,250        16,750         9,750          8,000 6,250

 

The expected cost of short-term funds is 25% while that of long-term funds is 30%. Ignore taxation.

 

Required:

• A schedule showing the amount of permanent and seasonal working capital requirements for each month.
• The average amount of long-term and short-term finance that would be required monthly.
• The total cost of working capital finance, if the firm adopted an aggressive financing strategy.
• The total cost of working capital finance, if the firm adopted a conservative financing strategy. (v) The total cost of working capital using the matching policy.

 

 

QUESTION 9

30. b) Baren Ltd projects that cash outlays of Sh.45 million will occur uniformly throughout the year. The company plans to meet its cash requirements by selling marketable securities from its portfolio. The expected return from the company’s marketable securities is 8 per cent per annum, and the cost per transaction of converting securities into cash is Sh.30.

 

Required

• The optimal cash balance
• The average cash balance
• The number of transfers between cash and marketable securities per year.

 

 

QUESTION 10

1. c) You are given the following financial statement information for Moto Ltd. for the year ended 31

 

Item		Beginning	Ending
	Sh.”000”	Sh. “000”	Sh. “000”
Inventory Accounts receivable Accounts payable Net  Sales Cost of goods sold	17,340 42,240 35,510	120,000 92,000	15,960 37,250 27,370

December 2010:

 

 

Required;

 

The operating and cash conversion cycles assuming that the year has 360 days.

 

 

QUESTION 11

c)The following data relate to Store ltd, a manufacturing company

Cost as a percentage of sales: Direct materials Direct labour Variable overheads

% 30 25 10

Turnover for the year                               Sh.15,000,000

 

Fixed overheads Selling and distribution costs

15 5

Additional information;-

1. Debtors take 2.5 months before payment while raw materials are in stock for three months.
2. Work in progress represents one month’s worth of half processed goods 3. Finished goods represent one month’s production

Direct materials Direct labour Variable overheads Fixed overheads Selling and distribution overheads

2 1 1 1 0.5

4. Credit is taken as follows:

 

5. Work in progress and finished goods are valued at material, labour and variable expense cost Assume that the sales have been made on credit

 

Required;

Assuming a 50-week year compute Stores Ltd.’s working capital requirements.

 

 

QUESTION 12

1. a) The working capital policy of any business entity must address the twin issues of the level of current assets and the manner in which these current assets are financed.
   1. a) Explain how business entities can adopt aggressive , moderate and conservative working capital policies

   Aggressive approach-

   Under this approach the firm uses more of short term financing. The firm will finance the fluctuating current assets and some of the permanent current assets with short term financing. This approach presents an increased risk of liquidity and cash flow problems but there is potential profitability increase since short term finances are cheaper.

   Matching or hedging approach-

   Under this approach there is an attempt to match the maturity of the capital with the maturity of the asset  i.e. expected life of the asset is marched with expected source of funds raised to finance the assets. Long term funds will be matched with fixed assets and permanent current assets, while short term funds will be used to finance the fluctuating current assets.

   The profitability and liquidity risk are moderate; however there may be a challenge of exact matching because of uncertainty on the expected life of the asset.  Conservative approach-

   Under this approach the firm depends more on long term funds for its financial needs. The financing of all the fixed assets, all permanent current assets and part of the temporary current assets is through long term funds. During this period the firm invests extra capital in marketable securities and profitability levels are low since long term sources are expensive.

    

    

Required:

In relation to the above statement, explain how business entities can adopt aggressive, moderate and conservative working capital policies.

 

 

QUESTION 13

1. a) Chogoria Ltd., a manufacturing company, has applied for working capital finance from Zed Commercial Bank Ltd. The bank’s manager has requested for a working capital estimate from the company. The company has provided you with the following data for the next financial year.

Raw materials Direct labour Overheads Total cost per unit Profit Selling price per unit

104 39 78 221 39 260

Sh. (per unit)

 

 

 

1. 2 3 4. 5. 6. 7. 8. 9. 10.

Average finished goods in stock (holding period) Average raw materials in stock (holding period) A work in progress (holding period) Credit period allowed by suppliers Credit period allowed to debtors Time lag in payment of wages Time lag in payment of overheads One-quarter of the company’s sales are on cash basis. The cash balance is expected to be Sh.240,000 The level of activity is expected to be 100,000 units per annum.

1                 ½ Months. 2                 Months. 1Month. 2 Months. 3 Months ½ Month. 2 months.

  Additional information;- Required

• A statement showing the working capital estimate.
• Assume that production is carried on evenly throughout the year and wages and overheads also accrue evenly.

 

 

QUESTION 14

1. b) Mapema Ltd. manufactures and sells a product called “Rugs”. The company sells the product to its customers on credit terms. The company is considering easing the debtors collection efforts so as to increase its profitability.

The following information relates to the company:

• Average number of units sold per year 72,000,000
• Selling price per unit sh. 32.
• Variable cost per unit is sh. 28.
• Annual fixed collection expenses sh. 60,000,000.
• Average collection period is 40 day.

By easing the collection efforts. Mapema Ltd. expects to save sh. 40,000,000 per annum in collection expenses. However, this will lead to an increase in bad debts from 1% to 2% od sales and the average collection period from 40 days to 58 days. Sales will also increase by 1,000,000 units per annum. The company’s required rate of return is 24%

 

Assume a 360 day year.

 

Required:

Advice Mapema Ltd. on whether it is worthwhile to ease the collection efforts.

Advice 

It’s not worthwhile to ease collection efforts since additional annual financial cost will be more than additional financial benefits

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June 2010 Question Three B

 

QUESTION 15

1. Name and explain three approaches that could be used by a company to finance its working capital requirements.QUESTION 15June 2010 Question Three B
   1. b) Explanation of three approaches that could be used by a company to finance its working capital finance
   • Conservative approach-

   Under this approach the firm depends more on long term funds for its financial needs. The financing of all the fixed assets, all permanent current assets and part of the temporary current assets is through long term funds. During this period the firm invests extra capital in marketable securities and profitability levels are low since long term sources are expensive.

    

   • Aggressive approach-

   Under this approach the firm uses more of short term financing. The firm will finance the fluctuating current assets and some of the permanent current assets with short term financing. This approach presents an increased risk of liquidity and cash flow problems but there is potential profitability increase since short term finances are cheaper.

    

   • Matching or hedging approach-

   Under this approach there is an attempt to match the maturity of the capital with the maturity of the asset  i.e. expected life of the asset is marched with expected source of funds raised to finance the assets. Long term funds will be matched with fixed assets and permanent current assets, while short term funds will be used to finance the fluctuating current assets. The profitability and liquidity risk are moderate; however there may be a challenge of exact matching because of uncertainty on the expected life of the asset.

2. The following information was obtained from the financial statements of Alusa Ltd. A retail company, for the year ended 30 September 2009.

 

	Shs. “000”
Annual sales	10,000,000
Average stock	2,000,000
Average debtors	666,667
Average creditors	800,000

Additional information: 

1. The company’s gross profit margin is 40%.
2. All sales are on credit terms.
3. Assume a 360 day year.

 

Required: 

The company’s cash conversion cycle.

 

1. c) Kilimo Ltd. Manufactures a standard farm implement which it sells to distributors at sh. 100 per unit. The company intends to relax its credit policy which will result in an increase collection period from one month to two months.

The longer credit period is also expected to increase sales by 25%. Variable costs of production are sh. 85 per unit while annual sales are sh. 24,000,000. The increase in sales will result in additional stock of sh. 2,000,000 and additional creditors of sh. 200,000.

The company’s required rate of return is 20%.

 

Required: 

Advise the company on whether or not to extend the credit period assuming:

1. All customers take longer credit period of two months.
2. Existing customers do not change their payment habits and only the new customers take the full two months credit

 

 

QUESTION 16

Modern Appliance Ltd. sells on average 2,000 units of product “Zed” per month. The purchase price per unit of the product is sh. 2. The cost of placing each order is sh. 50 and the carrying cost is 10% of the purchase price.

Required: 

1. Economic order quantity.
2. Total relevant cost per annum.

• Assume that the company has received a discount offer of 1% for purchases of at least 4,500 units per order

Using supporting calculations, advise the company on whether to take advantage of the discount offer.

 

 

QUESTION 17

Fanaka Ltd. a large multi- national company is in the process of determining the optimal cash balance for the year ending 31 December 2009.

The management of the company has established the following information:

1. The company’s annual cash requirements amount to sh. 2,500 million.
2. The cost of each cash conversion transaction is sh. 500.
3. The opportunity cost of funds is 12%. Required:
4. Optimal cash balance that the company should hold.
5. Total cost of maintaining the cash balance determined in (b) (i) above.

 

 

QUESTION 18

2008. The following are the projected monthly working requirements of Tayari Ltd. for the year ending 31 December 2008.

 

Month	Amount of working capital required(sh. “000”)
January	3,500
February	3,500
March	5,250
April	7,000
May	10,500
June	15,750
July	21,000
August	24,250
September	15,750
October	8,750
November	7,000
December	5,250

The expected cost of short term funds is 20% while that of long term funds is 25%. Ignore taxation.

 

Required:

1. A schedule showing the amount of permanent and seasonal working capital requirements for each month.
2. Average amount of long term and short term finance that would be required monthly. iii) Total cost of working capital finance if the firm adopts an aggressive strategy.
3. iv) The total cost of working capital finance if the firm adopts a conservative finance strategy.

 

2007. The following information was extracted from the books of Changa Ltd. at the end of the financial year ended 31 October 2006 and 2007.

 

	2006	2007
	Sh “000	Sh “000
Stock of raw materials	40,000	60,000
Work in progress	10,000	18,000
Finished goods stock	50,000	70,000
Trade debtors	140,000	180,000
Annual sales	2,000,000	2,200,000
Cost of production	1,000,000	1,050,000
Annual cost of sales	1,200,000	1,250,000
Trade creditors	110,000	100,000
Annual purchase of raw materials	700,000	780,000

 

Required:

1. The working capital cycle (in days) of Changa Ltd.
2. Briefly explain two ways in which Changa Ltd. might reduce its working capital style.
   1. Ways of reducing working capital cycle
      • Reduce stock levels
      • Review the firm’s on slow moving stocks
      • Reduce stock price so that they can move faster
      • Reduce credit period offered to customers
      • Offer cash discounts to encourage prompt payment

    

   QUESTION 19

The following information was extracted from the books of Shama Ltd. as at 31 December 2006.

Trade debtors balance (31 December 2006)	Sh. 10 million
Trade debtors balance (31 December 2006)	Sh. 3 million
Sales of the year	Sh. 80 million
Purchases of the year	Sh. 60 million
Gross profit margin	25%
Inventory turnover	4.8 times

 

All sales and purchases were on credit. Assume a 360 – day year.

 

Required:

1. i) Operating cycle ii)         Cash conversion cycle

 

 

QUESTION 20

Upendo Traders Ltd. sells merchandise on credit terms of net 50 while the industrial average credit terms are net 30.

The company makes average sales of 3 million per annum. The average number of days sales in accounts receivables is 60 days.

The company is considering changing its credit terms to net 30 on all sales. This change of credit terms is expected to result in the following:

• Sales would reduce to sh. 2,600,000 per annum.
• Accounts receivable would drop to 35 days of sales.

 

Additional information: 1. The variable cost ratio is 70%

2. Corporation tax rate is 30%.
3. Interest on funds invested in accounts receivables is at a rate of 11% per annum. Assume a 360 – day year.

 

Required:

With the aid of appropriate computations, assess whether the company should change. Its credit terms to net 30.