Free Download Chapter 28 Solution Manual Financial Management by Brigham

Chapter 28Advance Issues in Cash Management and Inventory ControlANSWERS TO END-OF-CHAPTER QUESTIONS

 

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Summary

This chapter discussed the goals of cash management and how a company might
determine its optimal cash balance using the Baumol model. It also discussed how
an optimal inventory policy might be identified using the economic ordering quan-tity (EOQ) model. The key concepts covered are listed below:
• A policy that strives for zero working capitalnot only generates cash but
also speeds up production and helps businesses operate more efficiently. This
concept has its own definition of working capital: Inventories Receivables
Payables. The rationale is that inventories and receivables are the keys to
making sales, and that inventories can be financed by suppliers through
accounts payable.
• The primary goal of cash management is to minimize the amount of cash a firm
holds while maintaining a sufficient target cash balanceto conduct business.
• TheBaumol modelprovides insights into the optimal cash balance. The model
balances the opportunity cost of holding cash against the transactions costs asso-ciated with obtaining cash either by selling marketable securities or by borrowing.
• Firms generally set their target cash balances at the level that holds the risk of
running out of cash to some acceptable level. Monte Carlo simulationcan be
helpful in setting the target cash balance.
• Firms use inventory control systems such as the red-line methodand the two-bin method,as well as computerized inventory control systems,to help them
keep track of actual inventory levels and to ensure that inventory levels are
adjusted as sales change. Just-in-time (JIT) systemsare used to hold down
inventory costs and, simultaneously, to improve the production process. Out-sourcingis the practice of purchasing components rather than making them
in-house.
• Inventory can be accounted for in four different ways: (1)specific identification,
(2)first-in, first-out (FIFO),(3)last-in, first-out (LIFO),and (4)weighted average.
• Inventory costscan be divided into three parts: carrying costs, ordering costs,
and stock-out costs. In general, carrying costsincrease as the level of inventory
rises, but ordering costsand stock-out costsdecline with larger inventory
holdings.
• Total carrying cost (TCC)is equal to the percentage cost of carrying inventory
(C) times the purchase price per unit of inventory (P) times the average number
of units held (A): TCC (C)(P)(A).
• Total ordering cost (TOC)is equal to the fixed cost of placing an order (F)
times the number of orders placed per year (N): TOC (F)(N).
• Total inventory costs (TIC)equal total carrying cost (TCC) plus total ordering
cost (TOC): TIC TCC TOC.
• The economic ordering quantity (EOQ)model is a formula for determining the
order quantity that will minimize total inventory costs:
Here F is the fixed cost per order, S is annual sales in units, C is the percentage
cost of carrying inventory, and P is the purchase price per unit.
• The reorder pointis the inventory level at which new items must be ordered.
• Safety stocksare held to avoid shortages, which can occur (1) if sales increase
more than was expected or (2) if shipping delays are encountered on inventory
ordered. The cost of carrying a safety stock, which is separate from that based
on the EOQ model, is equal to the percentage cost of carrying inventory times
the purchase price per unit times the number of units held as the safety stock.



Questions
(28-1) Define each of the following terms:
a. Baumol model
b. Total carrying cost; total ordering cost; total inventory costs
c. Economic ordering quantity (EOQ); EOQ model; EOQ range
d. Reorder point; safety stock
e. Red-line method; two-bin method; computerized inventory control system
f. Just-in-time system; outsourcing
(28-2) Indicate by a ( ), ( ), or (0) whether each of the following events would proba-bly cause average annual inventory holdings to rise, fall, or be affected in an inde-terminate manner:
a. Our suppliers change from delivering by train to air freight.
b. We change from producing just-in-time to meet seasonal
demand to steady, year-round production.
c. Competition in the markets in which we sell increases.
d. The general rate of inflation rises.
e. Interest rates rise; other things are constant.
(28-3) Assuming the firm’s sales volume remained constant, would you expect it to have
a higher cash balance during a tight-money period or during an easy-money
period? Why?
(28-4) Explain how each of the following factors would probably affect a firm’s target
cash balance if all other factors were held constant.
a. The firm institutes a new billing procedure that better synchronizes its cash
inflows and outflows.
b. The firm develops a new sales forecasting technique that improves its forecasts.
c. The firm reduces its portfolio of U.S. Treasury bills.
d. The firm arranges to use an overdraft system for its checking account.
e. The firm borrows a large amount of money from its bank and also begins to
write far more checks than it did in the past.
f. Interest rates on Treasury bills rise from 5 percent to 10 percent.

Problems
(28-1) The Gentry Garden Center sells 90,000 bags of lawn fertilizer annually. The opti-mal safety stock (which is on hand initially) is 1,000 bags. Each bag costs the firm
$1.50, inventory carrying costs are 20 percent, and the cost of placing an order
with its supplier is $15.
a. What is the economic ordering quantity?
b. What is the maximum inventory of fertilizer?
c. What will be the firm’s average inventory?
d. How often must the company order?
(28-2) Barenbaum Industries projects that cash outlays of $4.5 million will occur uni-formly throughout the year. Barenbaum plans to meet its cash requirements by
periodically selling marketable securities from its portfolio. The firm’s marketable
securities are invested to earn 12 percent, and the cost per transaction of convert-ing securities to cash is $27.
a. Use the Baumol model to determine the optimal transaction size for transfers
from marketable securities to cash.
b. What will be Barenbaum’s average cash balance?
c. How many transfers per year will be required?
d. What will be Barenbaum’s total annual cost of maintaining cash balances?
What would the total cost be if the company maintained an average cash
balance of $50,000 or of $0 (it deposits funds daily to meet cash
requirements)?

Spreadsheet Problem
(28-3) Start with the partial model in the file FM11 Ch 28 P3 Build a Model.xlsfrom
the textbook’s Web site. The following inventory data have been established for
the Adler Corporation:
(1) Orders must be placed in multiples of 100 units.
(2) Annual sales are 338,000 units.
(3) The purchase price per unit is $3.
(4) Carrying cost is 20 percent of the purchase price of goods.
(5) Cost per order placed is $24.
(6) Desired safety stock is 14,000 units; this amount is on hand initially.
(7) Two weeks are required for delivery.
a. What is the EOQ?
b. How many orders should the firm place each year?
c. At what inventory level should a reorder be made? [Hint: Reorder point
(Safety stock Weeks to deliver Weekly usage) Goods in transit.]
d. Calculate the total costs of ordering and carrying inventories if the order
quantity is (1) 4,000 units, (2) 4,800 units, or (3) 6,000 units. What are the
total costs if the order quantity is the EOQ?
e. What are the EOQ and total inventory costs if
(1) Sales increase to 500,000 units?
(2) Fixed order costs increase to $30? Sales remain at 338,000 units.
(3) Purchase price increases to $4? Leave sales and fixed costs at original values.
Andria Mullins, financial manager of Webster Electronics, has been asked by the firm’s CEO, Fred
Weygandt, to evaluate the company’s inventory control techniques and to lead a discussion of the
subject with the senior executives. Andria plans to use as an example one of Webster’s “big ticket”
items, a customized computer microchip that the firm uses in its laptop computer. Each chip costs
Webster $200, and in addition it must pay its supplier a $1,000 setup fee on each order. Further,
the minimum order size is 250 units; Webster’s annual usage forecast is 5,000 units; and the
annual carrying cost of this item is estimated to be 20 percent of the average inventory value.
Andria plans to begin her session with the senior executives by reviewing some basic inventory con-cepts, after which she will apply the EOQ model to Webster’s microchip inventory. As her assistant, you
have been asked to help her by answering the following questions:
a. Why is inventory management vital to the financial health of most firms?
b. What assumptions underlie the EOQ model?
c. Write out the formula for the total costs of carrying and ordering inventory, and then use the for-mula to derive the EOQ model.
d. What is the EOQ for custom microchips? What are total inventory costs if the EOQ is ordered?
e. What is Webster’s added cost if it orders 400 units at a time rather than the EOQ quantity? What
if it orders 600 per order?
f. Suppose it takes 2 weeks for Webster’s supplier to set up production, make and test the chips, and
deliver them to Webster’s plant. Assuming certainty in delivery times and usage, at what inventory
level should Webster reorder? (Assume a 52-week year, and assume that Webster orders the EOQ
amount.)
g. Of course, there is uncertainty in Webster’s usage rate as well as in delivery times, so the company
must carry a safety stock to avoid running out of chips and having to halt production. If a 200-unit
safety stock is carried, what effect would this have on total inventory costs? What is the new
reorder point? What protection does the safety stock provide if usage increases, or if delivery is
delayed?
h. Now suppose Webster’s supplier offers a discount of 1 percent on orders of 1,000 or more. Should
Webster take the discount? Why or why not?
i. For many firms, inventory usage is not uniform throughout the year, but, rather, follows some sea-sonal pattern. Can the EOQ model be used in this situation? If so, how?
j. How would these factors affect an EOQ analysis?
(1) The use of just-in-time procedures.
(2) The use of air freight for deliveries.
(3) The use of a computerized inventory control system, wherein as units were removed from stock,
an electronic system automatically reduced the inventory account and, when the order point was
hit, automatically sent an electronic message to the supplier placing an order. The electronic sys-tem ensures that inventory records are accurate, and that orders are placed promptly.
(4) The manufacturing plant is redesigned and automated. Computerized process equipment and
state-of-the-art robotics are installed, making the plant highly flexible in the sense that the
company can switch from the production of one item to another at a minimum cost and quite
quickly. This makes short production runs more feasible than under the old plant setup.
k. Webster runs a $100,000 per month cash deficit, requiring periodic transfers from its portfolio of
marketable securities. Broker fees are $32 per transaction, and Webster earns 7 percent on its
investment portfolio. How can Andria use the EOQ model to determine how Webster should liq-uidate part of its portfolio to provide cash?