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C hapter 28

SOLUTIONS. C hapter 28. WORKING CAPITAL FINANCING. PROBLEM 28.10.

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C hapter 28

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  1. SOLUTIONS Chapter 28 WORKING CAPITAL FINANCING

  2. PROBLEM 28.10 • Udar Ltd sells goods on credit. Its current annual credit sales (turnover) amount to Rs 810 lakh. The variable cost ratio (ratio of variable costs to sales) is 0.80. The credit terms of Udar Ltd are 2/10, net 30. On the current level of sales, the bad debts are 1 per cent. The past experience has been that 50 per cent of the customers avail of the cash discount; the remaining customers pay on an average 70 days after the date of sale. • The book debts (receivables) of Udar Ltd, are at present being financed on a 67:33 basis by a mix of bank borrowings and owned funds which cost per annum 22 per cent and 24 per cent respectively.

  3. SOLUTION 28.10 Decision analysis: in-house management alternative Relevant costsAmount (Rs lakh) Cash discount 8.10 (Rs 810 X 0.02 X 0.5) Cost of funds in receivables 23.39 (see working note 1) Bad debt losses 8.10 (Rs 810 X 0.01) Total 39.59 Decision analysis; non-recourse factoring alternative Relevant costAmount (Rs lakh) Factoring commission 32.40 (Rs 810 X 0.04) Discount charge 9.69 (working note 2) Cost of owned funds invested in receivables 2.78 (Rs 810 lakh – Rs 660.96 lakh) X 0.28 X 24/360 Total 44.87 (Contd.)

  4. Working notes • 1 Cost of funds invested in receivables: • Average collection period = (10 days X 0.5) + (70 days X 0.5) = 40 days • Average investment in debtors = Rs 810 lakh/9 = Rs 90 lakh • Cost of bank funds = (Rs 90 lakh X 0.67 X0.25) = Rs 15.075 lakh • Cost of owned funds = (Rs 90 lakh X 0.33 X 0.28) = Rs 8.316 lakh • Total cost = Rs 15.075 lakh + Rs 8.316 lakh = Rs 23.39 lakh • 2. Eligible amount of advance = 0.85 X (Rs.810 lakh – Rs 32.4 lakh) = Rs 660.96 lakh • Discount charge = (Rs 660.96 lakh X 0.22 X 24/360) = Rs 9.69 lakh • Decision analysis: cost benefit of non-recourse factoring • Amount (Rs in lakh) • Benefits/savings of cost with in-house management alternative 39.59 • Cost (of non-recourse factoring alternative) 44.87 • Net loss (5.28) • Recommendation • Udar Limited should not go for factoring alternative.

  5. PROBLEM 28.11 • The following facts relate to the Avon Industries Ltd (AIL): • Annual credit turnover in the current financial year, Rs 1,200 lakh; • Average collection period, 75 days; • Variable cost ratio, 0.75; • Cost of funds, 0.21 per annum; • Annual credit and collection expenditure, Rs 20 lakh of which three- fourths is avoidable; • Bad debt, 1 per cent of sales. •  The Foremost Factors Ltd, offers a factoring deal to the AIL. It proposes to charge a commission as percentage of the value of book debts of 2 per cent for recourse factoring and 3.5 per cent for non-recourse factoring. In addition, it would charge 20 per cent per annum as discount/interest for prepayments (advance against uncollected and not due receivables) to the extent of 80 per cent of the value of the receivables. The guaranteed payment date/collection period is 60 days. • Making your own assumption where necessary, what advice would you give to AIL–to continue with the in-house management of receivables or accept the factoring arrangement?

  6. SOLUTION 28.11 Decision analysis: in-house management alternative       Relevant costs Amount (Rs in lakh) Annual credit and collection expenditure 20.00 Bad debts 12.00 (0.01 X 1,200) Cost of funds in receivables 52.50 (see working note 1) Total 84.50 Decision analysis; non-recourse factoring alternative        Relevant cost Amount (Rs in lakh) Factoring commission 42.00 (1,200 X 0.035) Discount charge 33.97 (see working note 2) Cost of owned funds invested in receivables 9.58 (1,200 – Rs 926.40) X 0.21x 60/360 Total 85.55 Relevant cost Amount (Rs in lakh) Factoring commission 42.00 (1,200 X 0.035) Discount charge 33.97 (see working note 2) Cost of owned funds invested in receivables 9.58 (1,200 – Rs 926.40) X 0.21x 60/360 Total 85.55

  7. 1 Cost of funds invested in receivables: Average investment in debtors = Rs 1,200 lakh/4.8 = Rs 250 lakh Cost of funds = (Rs 250 lakh X 0.21) = Rs 52.5 lakh 2 Eligible amount of advance = 0.80 X (Rs 1,200 lakh – Rs 42 lakh) = Rs 926.40 lakh Discount charge = (Rs 926.40 lakh X 0.22 X 60/360) = Rs 33.97 lakh Decision analysis: cost benefit of non-recourse factoring alternative Amount (Rs in lakh) Benefits (15 + 12 + 52.50) 79.50 Cost (of non-recourse factoring alternative) 85.55 Net loss (6.05) Cost of recourse factoring alternative Relevant cost        Amount (Rs in lakh) Factoring commission 24.00 (1,200 X 0.02) Discount charge 34.50 (working note 3) Cost of owned funds invested in receivables 9.07 (1,200 – Rs 940.80) X 0.21 X 60/360 Total 67.57 3 Eligible amount of advance = 0.80 X (Rs 1,200 lakh – Rs 24 lakh) = Rs 940.80 lakh    Discount charge = (Rs 940.80 lakh X 0.22 X 60/360) = Rs 34.50 lakh Decision analysis: recourse factoring alternative Amount (Rs lakh) Benefits (15 + 52.50) 67.5 Cost of recourse factoring alternative 67.57 Net loss (0.07) Working notes

  8. FINANCIAL END OF THE CHAPTER MANAGEMENT

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