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2 F9 Answer - 11 PKA Co Text references. Working capital management is covered in Chapters 4 and 5. Hedging foreign currency risk is covered in Chapter 19. Top tips. Part (b) requires a methodical step-by-step approach. Make sure you show all your workings so you can gain marks throughout even if you make a mistake or get stuck. In part (c) you must answer the specific requirements of the question. Identify the two problem areas and discuss how to address them. Don t just write everything you know about receivables management. Easy marks. Part (a) provides three easy marks for a textbook explanation and the calculations in part (d) are straightforward if you have learnt the techniques. Examiner's comments. There were many good answers to part (a) and most candidates gained high marks. However, some answers tended to be somewhat general rather than focusing on the objectives of working capital management and some answers were much too long for the three marks on offer. In part (b) many candidates incorrectly calculated the holding costs of each policy. Some candidates failed to consider the buffer inventory in calculating holding costs. Others used the re-order inventory level as the buffer level, failing to reduce inventory by consumption during the lead time it took for orders to arrive after being placed. Others added the re-order level to order quantity before dividing by two to calculate average inventory level, when only the order quantity is averaged. Candidates failing to gain high marks in part (c) tended to offer a limited number of possible methods, for example by focusing at length on factoring to the exclusion of internal accounts receivables management methods. Despite the requirement to discuss domestic accounts receivable, some candidates discussed export factoring and exchange rate hedging. In part (d) some candidates offered discursive answers, for which they gained little credit since the question asked for an evaluation of hedging methods. Many candidates were unable to calculate correctly the spot and forward exchange rates from the information provided. Many candidates failed to compare all three hedges from a common time horizon perspective, ie either from the current time or from three months hence. Marking scheme Marks (a) Profitability and liquidity 1 Discussion of conflict between objectives 2 3 (b) Cost of cutting ordering policy 3 Cost of EOQ based ordering policy 3 Saving by using EOQ model 1 7 (c) Reduction of bad debts 3 4 Reduction of average receivable period 3 4 Discussion of other improvements 1 2 Maximum 7 (d) Money market hedge 3

3 Forward market hedge 2 Lead payment 2 Evaluation (a) (b) (c) Objectives of working capital management The two main objectives of working capital management are to ensure it has sufficient liquid resources to continue in business and to increase its profitability. Every business needs adequate liquid resources to maintain day-to-day cash flow. It needs enough to pay wages, salaries and accounts payable if it is to keep its workforce and ensure its supplies. Maintaining adequate working capital is not just important in the short term. Adequate liquidity is needed to ensure the survival of the business in the long term. Even a profitable company may fail without adequate cash flow to meet its liabilities. On the other hand, an excessively conservative approach to working capital management resulting in high levels of cash holdings will harm profits because the opportunity to make a return on the assets tied up as cash will have been missed. These two objectives will often conflict as liquid assets give the lowest returns. Cost of current ordering policy Minimum inventory level = re-order level (average usage average lead time) Average usage per week = 625,000 units/ 50 weeks = 12,500 units Average lead time = 2 weeks Re-order level = 35,000 units Minimum inventory level = 35,000 (12,500 2) = 10,000 units Average inventory = Minimum level + = 10,000 + (100,000/2) = 60,000 units reorder quantity 2 Annual holding cost = 60, = 30,000 Annual ordering cost = 250 (625,000/100,000) = 1,563 Annual total cost = 30, ,563 = 31,563 Economic order quantity 2C EOQ = 0D = C h , = 25,000 units. Number of orders per year = 625,000/25,000 = 25 Annual ordering cost = = 6,250 Annual holding cost = (10,000 + (25,000/2)) 0.50 = 11,250 Annual total cost = 11, ,250 = 17,500 Saving as a result of using the economic order quantity model = 31,563 17,500 = 14,063 per year Areas for improvement The two areas of concern are the increase in the percentage of bad debts from 5% to 8% of sales and the excessive credit period being taken by customers. Reducing the percentage of bad debts

4 (d) The key to reducing the percentage of bad debts is to assess the credit worthiness of customers. The risks and costs of a customer defaulting will need to be balanced against the profitability of the business provided by that customer. PKA Co needs to examine its system for checking the credit worthiness of customers and instigate a policy or improve the current policy. For example, new customers should give two good references, including one from a bank, before being granted credit; credit ratings might be checked through a credit rating agency; a new customer's credit limit should be fixed at a low level and only increased if his payment record subsequently warrants it. Reducing the average accounts receivable period The average accounts receivable period was over twice the agreed 30 day credit period. This is costly for PKA in terms of the opportunity costs of interest on additional borrowed funds and also the loss of opportunity to make a return on the money tied up. Encouraging early payment PKA first needs to find out whether competitors receivables periods are similarly long. If they are, PKA would have to be careful not to lose business as a result of overstringent credit control action. A better approach would be to encourage early payment, perhaps through early settlement discounts. Improved credit control procedures If competitors are not experiencing the same problems, PKA needs to examine its own credit control policies and procedures. For example, accounts receivable' payment records must be monitored continually. This depends on successful sales ledger administration. A customer's payment record and the accounts receivable aged analysis should be examined regularly, as a matter of course. Breaches of the credit limit, or attempted breaches of it, should be brought immediately to the attention of the credit controller. PKA needs to have in place agreed procedures for dealing with overdue accounts. Examples include instituting reminders or final demands, chasing payment by telephone or making a personal approach. If this does not work, the company could refuse to grant any more credit to the customer, hire a specialist debt collecting agency or, as a last resort, take legal action. Money market hedge Money market hedging would involve borrowing in euros, converting the money borrowed into dollars and putting the money on deposit until the time the transaction is completed, hoping to take advantage of favourable interest rate movements. $ interest rate over six months = 3.5/2 = 1.75% $s required now in order to have $250,000 in six months time = 250,000/ = $245,700 Current spot selling rate = = $1.996 per 1 Cost of $s to be deposited = 245,700/1.996 = 123,096 interest rate over six months = 6.1/2 = 3.05% Value of loan in six months time = 123, = 126,850 Forward market hedge Forward exchange contracts hedge against transaction exposure by allowing the importer to arrange for a bank to buy a quantity of foreign currency at a future date, at a rate of exchange determined when the forward contract is made. Six months forward rate = = $1.975 per 1 cost using forward market hedge = 250,000/1.975 = 126,582 Lead payment

5 A lead payment is a payment in advance. This is particularly useful if the currency in which the payment is to be made is appreciating, as is the case here. cost now = 250,000/1.996 = 125,251 This money would need to be borrowed so there is an interest cost. value of loan in six months time = 125, = 129,071 Conclusion All of the hedging methods relate to six months in the future so can be directly compared. The lead payment is the most expensive method and the forward market hedge is the cheapest. It is therefore recommended that a forward market hedge be used.