Question

In late August 1997, Jean Biglow, treasurer of Biglow Toy Company, was concerned with financing its sales operations during the upcoming Christmas selling season. To cope with the Christmas sales peak, Jean planned to build up Biglow’s toy inventory throughout the fall. This would generate substantial cash deficits in October, November, and December. Some means of short-term financing had to be found to cover these deficits. On the other hand, Jean anticipated a cash surplus in January and February, when Biglow’s retailers paid their Christmas invoices. A small cash surplus was also anticipated in September as a result of over-the-summer toy purchases.

Jean tried to maintain a minimum balance in Biglow’s cash account throughout the year. This was to protect against errors in estimating both the size and timing of future cash flows. The planned minimum balance was normally set as a fixed percentage of each month’s anticipated dollar sales volume. This procedure had proven adequate in the past against virtually all contingencies.

Except for deciding how to finance the fall buildup in inventory, Jean had already completed a six-month financial plan. This covered the period September 1997 through February 1998. Selected portions of the plan are shown in the table below.

SIX-MONTH FINANCIAL PLAN (ALL FIGURES IN THOUSANDS OF DOLLARS) SEP OCT NOV DEC Accounts Receivable Balance $700 $500 $ 700 $1200 Planned Payments for Purchases $800 $900 $1000 $600 Cash Surplus From Operations $200 --- --- --- Cash Deficit From Operations -- $250 $600 $900 JAN $1000 $400 $300 FEB $500 $500 $1500

The accounts receivable balances shown in the table refer to the beginning of each month. Thus, Jean anticipates $700,000 in accounts receivable at the beginning of September, $500,000 at the beginning of October, and so forth.

On the average, Biglow receives a 3% discount from its toy suppliers for prompt payment of purchases. Jean normally takes advantage of such discounts, whenever possible, and so, the planned payments shown in the table assume prompt payment and realization of the 3% average discount. If Biglow’s payments are delayed, the discount will be lost, and actual payments will exceed planned payments, accordingly.

The cash surplus and deficit figures shown in the table are net of all other operations, including anticipated sales receipts, planned payments for purchases, and all other planned receipts and payments. These figures are also net of the standard provision for each month’s minimum cash balance. Thus, Jean expects a surplus of $200,000 from operations during September, a deficit of $250,000 from operations during October, and so forth. Each of the surplus and deficit figures shown in the table represents the incremental (not cumulative) surplus or deficit anticipated during that month.

As anticipated , Jean has three sources of short-term borrowing to meet

Biglow’s monthly cash needs.

These are:

1_ Pledging accounts receivable balances, that is, factoring;

2_ Delaying payments of purchases; and

3_ Obtaining a six-month bank loan.

A local bank has agreed to loan Biglow funds at the beginning of any month against a pledge of its accounts receivable balance. The maximum loan that Biglow can obtain from this source is 75% of the accounts receivable balance outstanding at the beginning of that month. Whatever is borrowed, if anything, must be returned to the bank at the beginning of the next month, plus an interest payment of 1.5% of the amount actually borrowed.

Payments to suppliers for purchases may be delayed for a maximum of one month. Thus, up to $1,000,000 in payments currently scheduled for November may be delayed until December. Whatever portion, if any, of these planned payments is delayed would become available to finance the anticipated deficit from operations during November. However, Jean’s own policy strictly forbids delaying payments more than one month beyond the month when they are supposed to be paid. Also, the average 3% discount is lost on all payments that are actually delayed. For example, if Jean delays the planned payment of $1,000,000 for November, then the payment in December for this delayed amount will be 1,000,000/.97 = 1,000,000 x 1.031 = $1,031,000 approximately.

The local bank is also willing to make a one-time loan to Biglow of any amount from a minimum of $400,000 to a maximum of $1,000,000 for six months. If such a loan is taken, the entire loan will be received by Biglow at the beginning of September and repaid at the end of February. In addition, Biglow must pay the bank a 1% monthly interest charge at the end of each month. Once taken, it is not possible to increase the loan nor to repay any portion of it during the six-month period. The 1% mothly interest charge therefore applies to the entire amount, if any, actually borrowed.

At the end of every month, Jean inspects the current balance in Biglow’s cash account. Whatever excess funds remain over and above the minimum balance planned for the next month are invested immediately in 30-day government securities. Securities are purchased at the beginning of the next month and sold at the end of that month. Upon selling the securities, Biglow receives one-half percent interest on the excess funds, if any, actually invested. No excess funds are anticipated for month of August, but Jean plans to continue this investment procedure between September and February.

Jean must decide how to cover the operating deficits indicated in Table 1 by utilizing some combination of the three sources of short-term borrowing. Jean expects to maintain at least the planned minimum balances in Biglow’s cash account at the end of each month as a reserve for contingencies while minimizing the net dollar cost of whatever six-month financing plan is adopted.

Answer 1

Option1 - Pledging accounts receivables

By pledging the accounts receivables, an inflow of 75% of opening balance of accounts receivables is obtained and in the subsequent month outflow of 75% of accounts receivables + 1.5 % interest to be repaid. Any excess fund is to be deposited in securities which fetches a return of 1.5%. The excess fund is always lesser than the pledged amount.

Impact: Excess outflow of interest for factoring. Hence it is not feasible.

Option2 - Delaying payment of purchases

By delaying the payment, discount of 3% is lost which is higher than the pledging cost. Therefore, this is also not feasible

Option 3 - Obtaining six months bank loan

Interest outflow = $400,000*1% for 6 months

= $ 24,000

Savings on Investing in Securities = 1.5% for every month on outstanding balance

Toatal interst saving = 1.5%*6  

=9%

Which is more favourable than pledging and deferment of payments

Following shows the calculation:

September - No deficit. Hence $400,000 invested in secuities will fetch 1.5% interst i.e., $400,000*1.5% = $6000

October - Deficit of $250. Invest $399,[email protected]%($400,000-$250) will fetch $ 5996.25

November - Deficit of $600. Invest [email protected]%($399,750-$600) will fetch $ 5987.25

December - Deficit of $900. Invest [email protected]%($399,150-$900) will fetch $ 5973.75

January - No Deficit. Invest [email protected]%i n securities will fetch $5973.75

February - No Deficit. Invest [email protected]%i n securities will fetch $5973.75 and repayment of loan $400,000

Month	Interst payment	Interest Income+Loan	Net
September -Loan received	($4,000)	$400,000+6,000	$402,000
October	($4,000)	$5996.25	$1,996.25
November	($4,000)	$5987.25	$1987.25
December	($4,000)	$5973.75	$1,973.75
January	($4,000)	$5973.75	$1,973.75
Febuary- Repayment	($4,000+$400,000)	$5973.75	($398.26.25)

Net impact has a benefit of $11,904.75

Therefore option III obtaining loan from bank is more beeficial.