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MS41 WORKING CAPITAL MANAGEMENT

JUNE 2003

Note: There are two Sections A and B. Attempt any three questions from Section A. Each question carries 20 marks. Section B is compulsory and carries 40 marks. 

 

SECTION A

 

1 Why is no single working capital investment and financing policy optimal for all firms? What additional factors need to be taken in established a working capital policy?

    2 What is the general objective of accounts receivable management? In what ways is it similar and different from cash balance management        and inventory management?

 

3 Oriental Dyes has annual sales of Rs. 1,19,25,000, variable costs (two words of sales) of Rs. 79,50,000 and fixed costs (including interest) of Rs. 20,00,000. The company’s total assets are Rs, 80,00,000 of which accounts receivable comprise Rs. 7,50,000 and inventory Rs. 30,00,000. The company has been operating at substantially less than full capacity, and the management it eager to increase its sales. The financial manager suggest that sales may be stimulated by liberalisation of trade credit terms. His proposal is to modify credit terms from 2/10, n/30 to 2/30, n/60. The financial manager project a rise in sales to Rs. 1,52,04,000 under such circumstances but the company must borrow an additional Rs. 20,00,000 at 8.50% to finance its increased accounts receivable (Rs. 20,00,000) and inventory (Rs. 37,50,000) needs. The total costs related to the trade credit liberalisation and increased working capital investment are estimated to be Rs. 3,21,000. What return would such a policy change produce?

 

4 GES sells 5,00,000 standard electric switches a year. Each switch costs the GES Rs. 200. The percentage cost of carrying the switch inventory is 20 per cent of inventory value. GES can order these switches from either of two competing suppliers. Supplier ABC delivers in 3 days and requires a fixed ordering costs of Rs. 100 per order. Supplier XYZ. Which would require a fixed ordering cost of Rs. 75 per order, takes 5 days to deliver. To begin the analysis, assume that no safety stock is carried by GES.

(a) Calculate GES’s EOQ for switches for both suppliers (assuming that one supplier is used)

(b) What are the reorder points levels for ordering from each supplier?

(c) Considering only inventory costs, should the firm order its switches from supplier ABC or supplier XYZ?

 

5 Compare and constant the short-term borrowing strategies. Which strategy would result in the lowest borrowing cost? The highest borrowing cost? The most liquidity? The least liquidity?

 

SECTION B

 

6. Read the following case carefully and answer the questions given at the end.

 

STRAW PRODUCTS

    Globalisation embodies integration of international markets for goods, services technology, and finance and to some extent, labour. It impinges on the process of structure change, underpinned by transformation from an agricultural to an industrial economy, with critical implications for growth, equity and poverty. In this context, structural adjustment or liberalisation policies, symbolising measure to stimulate structural change by reoranising production, focus on shifting emphasis from national to the global market and forging closer interaction between, the national (domestic) and the global economy. In fact, shirking global economic frontiers have created opportunities and opened new markets.

 

    Straw Products has used these challenges to its advantage by consolidating is presence in the Middle East as well as Europe. Today, the company is looking globally, not merely with exports but also for establishing manufacturing bases. The company, policy is to commit corporate resources in areas where it is or can become leaders. In the current financial year the company aims to make inroads into new markets, both independently and through strategic business alliances. Egypt and Dubai units would be operational in the current financial year. Saudi Arabia, South Africa and North America are some of the areas, the company will be focusing on in the future. Like in the new products, strengthen and consolidate existing markets.

 

    Alongside this marketing thrust is a constant upgradation of manufacturing technology and a commitment to research and development. It is however, important to sustain these catalysts of growth through, dedicated manpower. To this end, Straw attracts professionals of high calibre while constantly upgrading the skills and knowledge of existing employees. And it is this optimum utilisation of corporate resources at all levels that is sustaining the company’s leadership profile. The second phase of expansion and modernisation has been completed expansions of projects have also been completed for products, like medicated oiled, ayurveda liquids, tablets, veterinary products and pharmaceutical products etc. Total investment in machines and land and building were Rs. 25.87 crore and 11.65 crore respectively. In Himachal Pradesh at Solan, the second unit for manufacturing of popular brand of the products has also been set up and production has commenced in the current year.

 

    A new plant in Madhya Pradesh at Katni is under construction for good processing to meet the requirements of growing demand for popular fruit juices. An integrated facility has also been designed at Alwar for the ayurveda range, which was found to be very popular and encouraging among consumers. At the same site in Alwar, a joint venture alongwith technical collaboration with Shikibo Limited of Japan is being commissioned to with extend the different range of natural gum products into profitable specially products. Beside this, the company has successfully faunched many new products viz. DENTA, RATIKA, and LACTO. These products have been well received in the market.

 

    Straw Finance Limited, a subsidiary of the company, has recorded an impressive growth of 168%. In the profits during 1996-97 and is activity pursuing the activities of leasing, hire purchase, investment etc. The company’s joint venture, namely, Super Products Pvt. Limited started commercial production in April 1995. A successful launch of its products has shown an encouraging response from the market Growth in the demand of the product of the company in European countries is satisfactory, particularly with the sale of Nature Care amongst other range of products. The operations at the London Branch have been consolidated during 1995-96. The turnover of the branch recorded an impressive growth of 25%.

 

    The company has ambitious plans to extend their range of consumer products to include other products like Shaving Foam. Hair Creams. Face Creams, Shampoos, Variants of Herbal Toothpaste. By adding these new products the company hopes to achieve a 35% growth in exports to Middle East and South East Asia. In this context, it may be pointed out that the company has floated two companies a manufacturing unit in Egypt in the name of Egypt-India Limited and another company, Straw International Limited in BVI. In Egypt-India Limited, this company has taken 76% equity and the balance 24% has already been contribute by M/s Headley Limited, London. The company has appointed legal and liaison consultants and the constructor of factory building is under progress. The expected date of commencement of commercial production is April 1999. The other company, Strew International Limited is appraising the possibility of setting up a pharmaceutical and bulk drug plant overseas either on its own or with a collaborator. The company has successfully developed an anti-cancer drug namely, Pacliraxel. The response to the drug in India and aborad is very encouraging. The company therefore, plans to set up a manufacturing facility for the above product in Canada to cater to the US market. In this context the company entered into a Joint Venture Agreement with M/s Lawry International Limited, an affiliate of Lawry Inc. USA. The Joint Venture Company will be named as Wough the with 50% equity holding by each collaborator. The commercial production at Wough Inc. is expected is commence in April, 1999.

 

    During the year 1997-98, the sales to the Middle East and South East Asia have been satisfactory. New markets were established in Morocco, Sudan and Malaysia. Further entry is planned in China and Vietnam. The company has set up a trading office if Jevel All, Dubai with the necessary permissions from the Government of India. Straw Nepal Pvt. Ltd., a Joint Venture Subsidiary Company set up in Nepal, in its 4th year of commercial production has completed the installation of the plant for the extraction of the Texus baccatta leaves and will commence production shortly. The company is in the process of implementing an expansion programme for manufacturing of Herbal Toothpaste, Shampoo and Shaving Cream. The company has been promoting research and development activities through the efforts of the Straw Research Foundation. The Straw Foundation is gaining more and more recognition because of the research work and successful completion of many of the research projects which have helped in providing necessary R & D inputs in the area of the company’s business both in health care and in consumer non-durable products Successful completion of the clinical trials and other products’ development works were dons on many new Herbals and Ayurveda products like LACTO, DENTA, and RATIKA. A high fibre, sugar free Nature Care variant has also been developed which is currently under-going a market research and is likely to be introduced in the current financial year. A number of cosmetic products are under development both for domestic and export markets. Many of these products are in their final stage of approval and are likely to be commercialised net year.

 

    The company has been able to successfully complete the clinical trials on human volunteers of the novel anti-concern drug PACLITAXEL. Two more bulk drugs technologies were developed scaled up and commercial production of these products, viz., Flucanozole (anti-fungal, anti-bottle) and Citizen dihydrochioride (a second generator anti-histamine) were started. Active management of business and disciplined execution of growth strategies by the company have delivered seven consecutive years of earnings growth and excellent return to shareholders, R.S. Nanda, the Chief Executive Director, expects that in the 1998 net sales Straw Producers will be at Rs. 245 crore and he believes that the firm will continue to market its products aggressively as it has done in the past. Before making these sales forecasts for 1998, Nanda analyst the impact of high interest costs on the firm’s debt. He began with the firm’s 1997 and 1996 balance sheets as prepared by the finance department. He did not ask for a proforma income statement because he was likely to prepare it himself. In addition to knowing the forecasted sales figure, Nanda knew that the firm is to budget three relatively stable items for 1998. Office end marketing salaries, Rs. 7.50 crore, sales expenses and promotion, Rs. 12.75 crore; and miscellaneous overhands, Rs. 5.65 crore. Nanda knew that if the firm did not borrow any additional funds, Straw Products would be facing an annual interest of Rs. 7.50 crore in 1998.

 

    Having gathered this data, Nanda has a look at collection costs and bad debt losses that were not included in the general and administrative expenses above. He decided to forecast these items using data from the firm’s risk class category that was reviewed on a regular basis. The finance manager normally prepared an estimate of the collection costs and bad-debt losses to be allocated to each category of customers. These estimates were compared against actual data at the end of each year and, for the last 5 years, the estimates were compared against actual data at the end of each year and, for the last 5 years, the estimate proved to be fairly accurate. The bad-debt losses were based on actual losses over the past 7 years and the collection costs well allocated, based on the routine expenses and special collection efforts required for each category of customers. The following table resulted from this process.

    Nanda decided to have a meeting will J.P, Anand, the firm’s Finance Manger after receiving this data on Straw Products. Anand supported that four months back, the company should have changed its credit policy from 2/10 net 30 to 2/10 net 60. He argued that the new policy would increase receivables, collection costs, and bad-debt losses but would provide additional sales and profits to the firm. Anand estimated that though selling expenses would rise but the level of receivables would also increase. If the additional profits were high enough, it would make sense to borrow money at 15 per cent to finance these receivables. Nanda asked Anand to check out the changing terms of trade to net 15. This would reduce receivables and allow the firm to pay off a portion of the 15 per cent notes. Anand indicated that selling expenses would probably drop by 1.25, but this saving would probably, be more than offset by the loss of sales and profits. From this discussion, it appeared that Anand was willing to make another appraisal of both alternatives and the indicated that he could get back to Nanda with the effect of each alternative on sales.

 

    Anand submitted his forecast for 1998 sales with each alternative to Nanda. He pointed out that during the period 1992 - 1997, Straw Products sold on term of 2/10 net 30 with these terms, in 1998, the company could expect Rs. 75 crore of sales to category 1 customers, Rs. 105 crore of sales to category 2 customers, Rs. 60 crore of sales to category 3 customers, and Rs. 5 crore of sales to category 4 customers. Based on past data, 30 per cent of the total customers would take the 2 per cent discount while the others would pay in 35 to 40

 

STRAW PRODUCTS BALANCE SHEET

(DECEMBER 31, 1997) (in Rs. crore.)

    A quick check of Anand’s calculation indicated to Nanda that they were in agreement on the 2/10 net 30 alternative. Since this was the case, he felt that estimates for the net 15 and 2/10 net alternatives could be relied. Nanda knew that the cost of goods sold would be approximately 75 per cent at Rs. 245 core of sales and he estimated that they could run 80 per cent at Rs. 202.50 crore of sales and 70 per cent at Rs. 300 crore. The general and administrative expenses, with the exception of the collection costs, bad-debt losses, and selling expenses, were, in effect, fixed for 1998. Using these assumptions, Nanda was prepared to develop the data and reach a decision on the optimal credit policy for Straw Products. He decided that he would not change policies in future unless the new policy gave either an increase in sales of 25 per cent or an increase in profits of 15 per cent. Nanda preferred both, but would accept a decline of 20 per cent or less, as long as profits rose by 15 per cent or more.

Straw Products 1998 Sales Estimates with

Different Terms of Trade (Rs. in crore)

Using Anand’s estimates, what per cent of customers will take discounts with each credit policy? Prepare a separate schedule of bad-debt and collection costs with each policy. Compute the likely size of the accounts receivable with each policy if the firm has relatively steady sales over the course of a year. Prepare a profoma statement for Straw Products for 1998 with each of the three credit policies. Using Anand’s estimates, what reactions can be expected from Straw’s competitors and customers to the new policies?

 

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