Joliet Junior CollegeFIN 201

Sluggo, Inc. Makers of the World's Best 9-inch Nails Financials (in thousands):

ASSETS: Cash $500; Inventory $100; Accounts Receivables $200; Plant & Equipment $2000, Depreciation $200; Land $2000, Goodwill $100, Trademark $100

LIABILITIES: Current Liabilities $50; Long-Term Liabilities $1650

Gross income for 2020 is $1500 (all credit sales); COGS is $400, Administrative and General expenses are $400, Sluggo pays 4% interest on its liabilities and it's corporate tax rate is 20%.

Capital Improvement:

Sluggo wants to build a factory which would produce the steel for the 9-inch nails. The initial cash outlay is $1000, the factory is expected to be productive for 5 years, the required rate of return is 5%, and the free cash flow each year is expected to be $250.

Capital Structure:

Currently, when Sluggo finances a capital improvement, it uses: bonds (debt) and raises 35% of raised money in debt; common stock where 60% of raised money is from retained earnings, and 5% of raised capital is from preferred stock. Capital structure: 35% bonds, 60% common stock, 5% preferred stock.

Bonds: 10-year, 4% coupon, market value is $975, corporate tax rate is 20%

Common stock: Beta of 1.25, risk free rate of 2%, market risk of 9%

Preferred stock: Par value of $100.00, dividend rate is 10%, market value of $100.00

Because Sluggo wants to be efficient when ordering the steel to make the 9-inch nails, it needs to calculate the efficient order quantity (EOQ) and the total inventory cost (TIC). It sells 50,000 9-inch nails each year, the carrying costs are 30% of the product price of $5, and the supplier always charges a $250 delivery charge for each shipment of steel.

 

When borrowing short-term cash (a 270-day, 9-month loan), Sluggo uses commercial paper, that is an unsecured 9-month loan from a large corporation. If Sluggo's cash conversion cycle is less than 60 days, the APR is 4%. Sluggo may consider raising short term cash by selling a 10-year, 4% coupon bond. However, it realizes lenders will require 6%. 

questions :

 

1)   Using the WACC:

a.    Calculate the after-tax interest required from bonds

b.    Using the CAPM, calculate the required rate of return on common stock

c.    Calculate the preferred stock dividend.

2)   Since Sluggo wants to be efficient when ordering steel to produce its product (9-inch nails), calculate the EOQ.

3)   Prove the EOQ is correct by calculating the TIC

4)   What is Sluggo's cash conversion cycle (remember to state the answers in days and use the standard 360-day year)

a.    What is the ICP?

b.    What is the DSO?

c. What is the DPO?

Answer:

1)

a)The after tax interest expense is 1.21%

b)The required return is 6.45%

c)The preferred dividend is $0.50

 

2) The Economic order quantity (EOQ)is 4,082.48

3) The Total Inventory costs(TIC) at EOQ of 4082.48 units is $6,123.72 which is minimum as compared to others.

 

4) The Cash conversion cycle(CCC) is 93 days.

a)The Inventory conversion period(ICP) or the days of sales outstanding (DSO) is 90 days.

b) The Days of sales outstanding(DSO) is 48 days

c) The Days of payables outstanding(DPO) is 45 days

1)

a.

Calculation 

Note - 

• The formula of after tax interest cost is Weight of debt * Interest cost(1 - t)

Whereas -

Interest cost = PV= 975; FV=1000; PMT=40; N=10

T is the tax rate

b) Calculation 

• The required return under CAPM is -

Return = Risk free rate + ( Market return - Risk free rate )* Beta

c)

Calculation -

2)

Calculation -

Note -

Q = √ (2DS / H)

Whereas - 

Q is the Economic order quantity

D is the demand in units i.e. 50,000

S is the order cost i.e. delivery cost here

H is the carrying cost per unit i.e. $1.5 (30% of $5)

 

3)

Calculation -

To verify that EOQ is correct , it is shown in the above table through the minimum inventory cost incurred at EOQ level when compared to other quantity orders.

 Hence ,It is proved that EOQ will always result in a minimum total inventory cost.

 

Notes -

•  No. orders = total demand/ order quantity(assumed except 4082.48)
• The formula for Ordering cost = Ordering cost per order * Number of orders
• The carrying cost i.e.$1.5(30% of $5) * Number of orders
• The total inventory cost = carrying cost + ordering cost

 

4)Calculation -

Note -

• DSO or ICP is the same.
• The formula for CCC = DIO + DSO - DPO

 

a)

Calculation -

Note-

• The formula for ICP = (Average inventory / COGS ) * 360
• In case of no beginning inventory the annual inventory has been taken as average inventory.

 

b)

Calculation -

Note - 

• The formula for DSO = Average Accounting receivables / Credit sales)*360
• In case of no beginning accounting receivables, the annual accounting receivables has been taken as average accounting receivables.

c)

Calculation -

• The formula for DPO = (Average accounting payables / COGS )*360
• In case of no beginning accounting payables, the annual accounting payables has been taken as average accounting payables.

Reference -

https://www.investopedia.com/terms/e/economicorderquantity.asp#:~:text=Economic%20order%20quantity%20(EOQ)%20is,shortage%20costs%2C%20and%20order%20costs.&text=1%EF%BB%BF%20The%20formula%20assumes,holding%20costs%20all%20remain%20constant.

https://corporatefinanceinstitute.com/resources/knowledge/accounting/cash-conversion-cycle/

https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-eoq-formula/

please use this google drive link to download the answer file.

https://drive.google.com/file/d/167QyHYw0NJK0WsDAbnU7OMF67SlbuFbi/view?usp=sharing

note: if you have any trouble in viewing/downloading the answer from the given link, please use this below guide to understand the whole process.

https://helpinhomework.org/blog/how-to-obtain-answer-through-google-drive-link