Sheth and Sons Inc. is considering changing its pay period for its salaried management from paying salaries every two weeks to paying salaries monthly. The firm’s CFO, Ken Smart, believes that such action will free up cash that can be used elsewhere in the business, which currently faces a cash crunch. In order to avoid a strong negative response from the salaried managers, the firm will simultaneously announce a new health plan that will lower managers’ cost contributions without cutting benefits.
Ken’s analysis indicates that the salaried managers’ bimonthly payroll is $1.8 million and is expected to remain at that level for the foreseeable future. With the bimonthly system, there were 2.2 pay periods in a month. Because the managers will be paid monthly, the monthly payroll will be about $4.0 million (2.2 × $1.8 million). The annual cost to the firm of the new health plan will be $180,000. Ken believes that because managers’ salaries accrue at a constant rate over the pay period, the average salaries over the period can be estimated by dividing the total amount by 2. The firm believes that it can earn 15% annually on any funds made available through the accrual of the managers’ salaries.
a. How much additional financing will Sheth and Sons obtain as a result of switching the pay period for managers’ salaries from every two weeks to monthly?
b. Should the firm implement the proposed change in pay periods?