Risk And Return: Laura Trust So I Was Stationed In Hong Kong

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Extracted from the user content, the core assignment involves analyzing various financial concepts and calculations related to risk, return, credit terms, exchange rates, and financial ratios. The tasks include calculating average accounts receivable based on DSO and sales data, assessing effective cost of trade credit, computing average accounts payable, determining exchange rates using purchasing power parity, and understanding implications of inventory turnover and interest rate parity. The assignment emphasizes applying financial formulas, understanding market conditions, and making strategic financial decisions based on the provided data.

Paper For Above instruction

Financial management is a vital discipline that guides businesses and investors in making informed decisions to optimize returns while managing risks. It involves numerous concepts and calculations that provide insights into a company's financial health, operational efficiency, and market dynamics. This paper explores key financial concepts such as assessing accounts receivable, understanding trade credit costs, calculating accounts payable, analyzing exchange rates through purchasing power parity, and evaluating the impact of inventory management and interest rate differentials. The discussion integrates practical examples derived from real-world data, illustrating how these calculations and concepts influence strategic decision-making in a competitive economic environment.

Understanding Accounts Receivable and DSO

Accounts receivable (AR) is a critical component of working capital that reflects the outstanding balances owed by customers. The days sales outstanding (DSO) metric indicates how long it typically takes for a company to collect payments from its credit sales. For instance, Medwig Corporation reports a DSO of 33 days, with an average daily sales of $7,500. The average accounts receivable can be calculated using the formula:

Average Accounts Receivable = DSO × Daily Sales

Applying the values:

Average Accounts Receivable = 33 days × $7,500 = $247,500

Similarly, if another company has a DSO of 17 days with daily sales of $6,750, then:

Average Accounts Receivable = 17 × $6,750 = $114,750

This metric helps businesses assess their credit policy effectiveness and cash flow management.

Trade Credit and Its Effective Cost

Trade credit terms like 1/10, net 40, offer buyers a discount if paid within 10 days, while the full payment is due in 40 days. However, some firms choose to delay payments beyond the credit period, which incurs a cost. To evaluate this, the effective annual cost of trade credit can be calculated using the formula:

Effective Cost = (Discount % / (1 - Discount %)) × (365 / (Net Days - Discount Days))

For a retailer with terms of 1/10, net 40, paying after 65 days, the cost of forgoing the discount is:

Effective Cost = (0.01 / (1 - 0.01)) × (365 / (65 - 10)) = (0.0101) × (365 / 55) ≈ 0.0101 × 6.636 ≈ 0.0670 or 6.70%

This indicates the percentage cost of delaying payment beyond the discount period and helps determine whether it is financially advantageous to pay early or late.

Accounts Payable and Credit Terms

Companies often purchase inventory under agreed credit terms, such as 1/15, net 35, meaning a 1% discount if paid within 15 days, with the full amount due in 35 days. If the company consistently takes the discount, the average accounts payable can be calculated as:

Average Accounts Payable = Daily Purchase Price × Number of Days

Using data where the purchase price is $200,000 daily, and the company takes the full 15 days to pay, the calculation is:

Average Accounts Payable = $200,000 × 15 = $3,000,000

Note: Since the purchase is $200,000 per day, over 15 days, total purchases amount to $3,000,000, which represents the average payable amount, assuming purchases are evenly spread and consistent over time.

Exchange Rate Analysis through Purchasing Power Parity

Purchasing Power Parity (PPP) suggests that identical goods should cost the same across countries when prices are converted at the spot exchange rate. For a computer costing $390 in the U.S. and 660 euros in France, the spot exchange rate is:

Spot Rate = Price in Euros / Price in Dollars = 660 / 390 ≈ 1.6923 euros per dollar

Similarly, for a different model costing $620 in the U.S. and 740 euros in France, the rate is:

Spot Rate = 740 / 620 ≈ 1.1935 euros per dollar

These calculations help traders and firms assess currency valuation and make informed foreign exchange transactions.

Cross Rate Calculation

If euros are priced at $1.29 per euro, then the cross rate between yen and pesos can be determined by the ratio of their USD prices:

Yen per Peso = (Yen per USD) / (Pesos per USD) = (111.34 / 9) ≈ 12.37 yen per peso

This cross rate allows investors to compare currencies indirectly through USD quotations, which is crucial in foreign exchange markets.

Interest Rate Parity and Forward Exchange Rate

Interest rate parity (IRP) links spot and forward exchange rates via interest rates. The forward rate can be calculated as:

Forward Rate = Spot Rate × (1 + i domestic) / (1 + i foreign)

Given the 6-month T-bill rate of 7% and Japanese bond rate of 5%, and spot rate of $0.007 per yen, the forward rate is:

Forward Rate = 0.007 × (1 + 0.07/2) / (1 + 0.05/2) = 0.007 × 1.035 / 1.025 ≈ 0.007 × 1.0098 ≈ 0.007068

This indicates the expected future exchange rate accounting for interest rate differentials, crucial for hedging currency risk.

Inventory Management and Cash Flow

Reducing inventory levels can free up cash. If Williams & Sons reports a sales of $86 million, with COGS of $70 million, and an inventory turnover ratio of 5, then the inventory value is:

Inventory = COGS / Inventory Turnover Ratio = 70 million / 5 = $14 million

When adopting a new system that increases turnover to 7, inventory reduces to:

Inventory = 70 million / 7 = $10 million

Thus, cash freed up = Previous inventory - New inventory = $14 million - $10 million = $4 million. This illustrates supply chain efficiency's impact on liquidity.

Conclusion

Understanding and applying these financial principles empower firms to make strategic decisions that optimize capital utilization, mitigate risks, and adapt to market fluctuations. Accurate calculations of accounts receivable and payable, comprehension of trade credit costs, exchange rates, and inventory management are essential for sustainable growth. Companies must also consider macroeconomic factors such as interest rate differentials and currency valuation to navigate the complexities of national and international markets effectively. These insights, when combined with sound financial analysis, form the cornerstone of prudent financial management and strategic planning.

References

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