Cash Conversion Cycle Problem Set

Cash Conversion Cyclefin 565em15 Possible Pointsproblem Set 2show All

Compute XYZ Corps cash conversion cycle given that the inventory turnover ratio is 6.0, receivable turnover ratio is 10, and payable turnover ratio is 12.

XYZ Corp is offered terms of 2/10 net 45 by ABC Corp. It is XYZ Corp's policy to pay discounts so long as the annual percentage yield (APY) of the credit is greater than 20%. What is the cost of the trade credit offered by ABC Corp? Should XYZ take the discount, given their policy?

XYZ Corp is considering borrowing $50,000 from ABC Bank. The loan must be paid back with monthly payments of $4,667.67 over the next year. The nominal interest rate is 12%. A total of $6,000 will be paid by XYZ in interest. What is the annual percentage yield (APY) of this loan?

Using the data below, determine the net present value (NPV) of each sale and decide on credit extension based on this NPV:

  • Snowmobile: sale price $1,200; cost of goods sold $1,000; collection time 3 months; required return 12%; probability of repayment 80%
  • Bracelet: sale price $300; cost of goods sold $150; collection time 1 month; required return 14%; probability of repayment 95%
  • Computer: sale price $800; cost of goods sold $550; collection time 6 months; required return 13%; probability of repayment 90%

Paper For Above instruction

The current financial landscape necessitates a comprehensive understanding of key financial concepts such as the cash conversion cycle (CCC), trade credit costs, loan APY calculations, and credit decision-making based on net present value (NPV). This paper aims to analyze these areas in detail, providing insights that are essential for effective financial management and decision-making within a corporation.

Introduction

Financial management involves the efficient planning, organizing, directing, and controlling of financial activities. Among the most critical aspects are managing liquidity, optimizing working capital, and making prudent credit and borrowing decisions. The cash conversion cycle, trade credit evaluation, loan APY calculation, and NPV analysis form the backbone of strategic financial decision-making. Understanding and applying these concepts allow firms to enhance profitability, minimize risks, and ensure liquidity sustainability. This paper explores each of these topics, demonstrating their practical relevance through detailed calculations and evaluations.

Calculating the Cash Conversion Cycle

The cash conversion cycle (CCC) measures the time span between cash outflows for inventory purchases and cash inflows from sales revenues (Brigham & Ehrhardt, 2016). It is composed of three components: inventory days, receivable days, and payable days. The formula is expressed as:

CCC = Inventory Days + Receivable Days – Payable Days

Using the given turnover ratios, each component is calculated as:

Inventory Days = 365 / Inventory Turnover Ratio = 365 / 6.0 ≈ 60.83 days

Receivable Days = 365 / Receivable Turnover Ratio = 365 / 10 = 36.5 days

Payable Days = 365 / Payable Turnover Ratio = 365 / 12 ≈ 30.42 days

Hence, the CCC is approximately:

CCC = 60.83 + 36.5 – 30.42 ≈ 66.91 days

This indicates that XYZ Corp's cash is tied up in operations for nearly 67 days, highlighting potential areas for liquidity optimization (Ross, Westerfield, Jaffe, & Jordan, 2018).

Cost of Trade Credit

XYZ Corp’s offered terms are 2/10 net 45, meaning a 2% discount if paid within 10 days; otherwise, the full amount is due in 45 days. The annual percentage yield (APY) of this credit term can be calculated to evaluate if taking the discount aligns with XYZ’s policy of requiring a minimum 20% APY (Brigham & Ehrhardt, 2016).

The effective annual interest rate, considering the discount period difference, is calculated as:

Effective Interest Rate = [(1 + Discount / (1 – Discount))]^{Number of periods per year} – 1

Substituting the numbers:

Discount = 2% = 0.02

Period = 10 days; so, the number of periods per year:

Number of periods = 365 / 10 ≈ 36.5

The interest per period is:

Interest per period = 0.02 / (1 – 0.02) ≈ 0.02041

The APY is therefore:

APY = (1 + 0.02041)^{36.5} – 1 ≈ (1.02041)^{36.5} – 1 ≈ 1.999 – 1 ≈ 99.9%

Since this APY far exceeds 20%, XYZ should take the discount if cash flow allows, optimizing liquidity and cost.\(^{(Brigham & Ehrhardt, 2016)}\)

Calculating the APY of a Bank Loan

The loan details indicate a principal of $50,000, monthly payments of $4,667.67, over 12 months, with total interest paid being $6,000. The nominal interest rate is 12%, but the APY provides a clearer picture of the actual annual yield considering compounding.

The effective interest rate for this loan can be determined via the internal rate of return (IRR) of the cash flows, or alternatively, using the formula for APY based on nominal rate and compounding frequency:

APY = (1 + r/n)^{n} – 1

Where r is the nominal rate, and n is the number of compounding periods per year. With monthly compounding (n=12):

APY = (1 + 0.12/12)^{12} – 1 = (1 + 0.01)^{12} – 1 ≈ 1.1268 – 1 ≈ 12.68%

Alternatively, considering the total interest and payments, the IRR calculation yields an APY around 12.68%, aligning with the nominal annual rate compounded monthly (Higgins, 2012). Thus, XYZ’s effective annual yield on this debt is approximately 12.68%, indicating the cost of borrowing after considering compounding effects.

NPV-Based Credit Decision

The net present value (NPV) helps evaluate the profitability of extending credit. The formula used is:

NPV = (Probability of repayment) × [(Sale Price – Cost of Goods Sold) / (1 + Required Return)^{Collection Time in years}] – (Cost of Goods Sold)

Calculating each scenario:

Snowmobile

NPV = 0.80 × [($1,200 – $1,000) / (1 + 0.12)^{0.25}] – $1,000

NPV = 0.80 × [$200 / (1.12^{0.25})] – $1,000 ≈ 0.80 × [$200 / 1.0287] – $1,000 ≈ 0.80 × $194.55 – $1,000 ≈ $155.64 – $1,000 = –$844.36

Bracelet

NPV = 0.95 × [($300 – $150) / (1 + 0.14)^{1/12}] – $150

NPV = 0.95 × [$150 / 1.0115] – $150 ≈ 0.95 × $148.37 – $150 ≈ $141.95 – $150 = –$8.05

Computer

NPV = 0.90 × [($800 – $550) / (1 + 0.13)^{0.5}] – $550

NPV = 0.90 × [$250 / 1.065] – $550 ≈ 0.90 × $234.57 – $550 ≈ $211.11 – $550 = –$338.89

In all three cases, the NPV is negative, indicating that extending credit under these conditions would lead to a net loss. Therefore, the firm should refrain from extending credit on these sales unless adjustments in terms or risk mitigation strategies are implemented.

Conclusion

This analysis underscores the importance of quantitative metrics such as CCC, APY, and NPV in making informed financial decisions. The calculation of the CCC suggests areas where XYZ Corp can improve liquidity management, while the trade credit APY assessment indicates that taking discounts can significantly reduce financing costs if cash flows permit. The loan APY calculation reveals the true cost of borrowing, crucial for repayment planning. The NPV analysis emphasizes caution in extending credit when the expected returns do not justify the risk, highlighting the need for rigorous credit appraisals.

Overall, a strategic approach rooted in quantitative analysis enhances financial stability and profitability, ensuring that firms can navigate complex financial environments confidently.

References

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  • Higgins, R. C. (2012). Analysis for Financial Management (10th ed.). McGraw-Hill Education.
  • Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. D. (2018). Corporate Finance (12th ed.). McGraw-Hill Education.
  • American Psychological Association. (2009). Publication Manual of the American Psychological Association (6th ed.). Washington, DC: Author.
  • Gibson, C. H. (2018). Financial Reporting and Analysis (14th ed.). Cengage Learning.
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