Answer question 5 and 6 please

CASE 8 Fresh & Fruity Foods, Inc. Fresh & Fruity Foods is a mail-order were discussing the cash flow problem company operating out of a winery near over lunch. Santa Rosa, California. The company "You know, Tom," Alice said as she specializes in sending California specialties sliced a piece of avocado, "I was reading the to catalog customers nationwide. Sales are other day about a company called Kringle's seasonal, with most occurring in November Candles & Omaments, and it occurred to me and December when people select Fresh that we're a lot like them. Most of our assets & Fruity's Famous Fruit Fantasy boxes as are current ones like their accounts Christmas gifts. Although seasonal, the receivable and inventory: and over half of company's sales are fairly predictable, ours are financed just like theirs, by current because the bulk of Fresh & Fruity liabilities that is, accounts payable." She customers are regulars who come back year paused for a sip of chardonnay, and after year. The company has also managed continued. "They got around their cash flow to smooth out its sales somewhat by offering problems by issuing long-term debt, which incentives, such as the Fruit of the Month look the pressure off their current club, that encourage customers to buy obligations. I've been looking at that for our throughout the year company, too but then I got to thinking. The nature of the mail-order business there's another way that's a good deal easier is such that most of Fresh & Fruity's sales and would produce results just as quickly." are on credit: therefore, the company has "Oh? What's that? Tom replied, his historically had a high accounts interest captured receivable balance relative to sales. It has "All we have to do," she said, "is to also historically been short of cash. reduce our accounts receivable balance. forcing it to delay payments to suppliers That will help reduce our accounts as long as possible (its average time to payable balance-since, as our customers pay accounts in 2010, was 67 days). begin paying us earlier, we can pay our In January 2011, Tom Appleby and suppliers earlier in turn. If we could get Alice Plummer, the president and enough customers to pay us right away. treasurer of Fresh & Fruity, respectively, we could even pay some of the suppliers Figure 1 Current Situation S1.179.000 FRESH & FRUITY FOODS, INC Income Statement, 2010 Revenue from sales Gross sales (credit) Cost of goods sold: Beginning inventory $ 141.000 Purchases.... 5969.000 Less: Cash discounts...... Net purchases... 969,000 Goods available for sale 1.110,000 Less: Ending inventory 79.557 Cost of goods sold Gross profit... Selling and administrative expenses Earnings before interest and tax Interest expense Earnings before tak Income taxes 33% Net income.... 1.030,443 148.557 73.000 75.557 75.557 24.914 50.623 s Figure 2 Current Situation FRESH & FRUITY FOODS, INC S292,803 11.430 S304,233 Balance Sheet As of December 31, 2010 Assets: Cash $ 3.560 Accounts receivable 209,686 Inventory 79.357 Total current assets Property, plant and equipment, net... Total assets Liabilities and equity Accounts payable S180,633 Notes payable (bank loans). 0 Total current liabilities Long-term debt.... Total liabilities Common stock 13,600 Additional paid in capital 83.000 Retained earnings... 27.000 Total equity Total liabilities and equity Selected ratios Profit Margin 4.29% Return on equity 40.96% Inventory turnover 14.82 Receivables turnover 5.62 Average payment period 67 S180,633 9 180,633 123.600 $304.232 4. Alice's second initiative calls for Fresh & Fruity to obtain a bank loan of a sufficient size to enable the company to take all suppliers' discounts. What is the minimum size of this loan? (Hint: To take all suppliers' discounts, the average payment period must be 10 days, and net purchases will be purchases - (Purchases from Figure 1 x .02). Assume that all this happens, and solve the following formula for the new accounts payable balance, using: Accounts payable = Average payment period x Purchase per day* * Based on net purchases/360. Now compare the accounts payable you just solved with the new accounts payable balance you found in question 3. The difference is the size of the loan that is required. 5. Assume that Fresh &Fruity does obtain an 8 percent loan for one year in the amount you solved in question 5, and it reduces its accounts payable balance accordingly. Now the company is taking 2 percent discounts on all purchases and paying 8 percent a year on the loan balance. What is the net gain from taking the discounts and paying the interest on a before-tax basis? On an aftertax basis? 6. Suppose the 8 percent loan that Fresh & Fruity obtained was a discount loan, and the bank further required a 20 percent compensating balance of the full loan amount. What is the effective rate of interest to Fresh & Fruity? How does this compare to your answer in question 2 for the cost of not taking a cash discount? in time to take advantage of the 2 percent discount they offer for payments within 10 days." (Fresh & Fruity's suppliers operated on a 2/10, net 60 basis.) "That would increase our net income and free up even more cash to take advantage of even more discounts!" She looked excited at the prospect. "Sounds great, but how do we get people to pay us earlier?" Tom inquired, doubtfully. "Easy." Alice continued. "Up to now we've been giving them incentives to pay later. Remember our 'Buy Now, No Payments for Two Months' program? Well, a lot of our customers use it, and it's caused our accounts receivable balance to run way up. So what we have to do now is give them incentives to pay earlier. What I propose is to cancel the buy now/pay later plan and offer a 10 percent discount to everyone who pays with their order, instead." "But won't that cause our revenues to drop?" Tom asked, again still doubtful. "Yes, but the drop will be offset by even more new customers who will come in to take advantage of the discount. I figure the net effect on sales will be just about zero, but our accounts receivable balance could be cut in half! Now here's a kicker that I just thought of: After we've reduced our accounts receivable balance as far as practical. I'd like to look into the possibility of reducing our accounts payable still further by replacing them with a bank loan. The effective rate of interest that we pay by not taking our suppliers' discounts is, after all, pretty high. So what I'd like to do is take out a loan once a year of a sufficient size that would enable us to take all the discounts our suppliers offer. The interest that we'll pay on the loan is bound to be less than what we pay in discounts lost-so we'll see another gain in earnings on our income statement. In fact, these two initiatives together might have a really significant impact!" 'You've convinced me." Tom said, Let's go back to the office and run some figures to see what happens!" Financial statements for Fresh & Fruity Foods, Inc., are presented in Figure 1 (income statement) and Figure 2 (balance sheet). 1. Using the data in Figures 1 and 2, compute the company's average collection period (ACP) in days. Use a 360-day year when calculating sales per day. 2. Compute the cost, as a percent, that the company is paying for not taking the supplier's discounts. (The supplier's terms are 2/10, net 60; but note from the bottom of Figure 2 that Fresh & Fruity has been taking 67 days to pay its suppliers, making that the effective final due date for accounts payable.) 3. Assume that Alice Plummer's first initiative to offer a 10 percent discount was implemented, and the company's average collection period dropped to 32 days. If ner sales per day remained the same, as Alice expects, what would be the new accounts receivable balance? How much cash was freed up by the reduction in accounts receivable? What is the new accounts payable balance if the money is used to pay off suppliers? CASE 8 Fresh & Fruity Foods, Inc. Fresh & Fruity Foods is a mail-order were discussing the cash flow problem company operating out of a winery near over lunch. Santa Rosa, California. The company "You know, Tom," Alice said as she specializes in sending California specialties sliced a piece of avocado, "I was reading the to catalog customers nationwide. Sales are other day about a company called Kringle's seasonal, with most occurring in November Candles & Omaments, and it occurred to me and December when people select Fresh that we're a lot like them. Most of our assets & Fruity's Famous Fruit Fantasy boxes as are current ones like their accounts Christmas gifts. Although seasonal, the receivable and inventory: and over half of company's sales are fairly predictable, ours are financed just like theirs, by current because the bulk of Fresh & Fruity liabilities that is, accounts payable." She customers are regulars who come back year paused for a sip of chardonnay, and after year. The company has also managed continued. "They got around their cash flow to smooth out its sales somewhat by offering problems by issuing long-term debt, which incentives, such as the Fruit of the Month look the pressure off their current club, that encourage customers to buy obligations. I've been looking at that for our throughout the year company, too but then I got to thinking. The nature of the mail-order business there's another way that's a good deal easier is such that most of Fresh & Fruity's sales and would produce results just as quickly." are on credit: therefore, the company has "Oh? What's that? Tom replied, his historically had a high accounts interest captured receivable balance relative to sales. It has "All we have to do," she said, "is to also historically been short of cash. reduce our accounts receivable balance. forcing it to delay payments to suppliers That will help reduce our accounts as long as possible (its average time to payable balance-since, as our customers pay accounts in 2010, was 67 days). begin paying us earlier, we can pay our In January 2011, Tom Appleby and suppliers earlier in turn. If we could get Alice Plummer, the president and enough customers to pay us right away. treasurer of Fresh & Fruity, respectively, we could even pay some of the suppliers Figure 1 Current Situation S1.179.000 FRESH & FRUITY FOODS, INC Income Statement, 2010 Revenue from sales Gross sales (credit) Cost of goods sold: Beginning inventory $ 141.000 Purchases.... 5969.000 Less: Cash discounts...... Net purchases... 969,000 Goods available for sale 1.110,000 Less: Ending inventory 79.557 Cost of goods sold Gross profit... Selling and administrative expenses Earnings before interest and tax Interest expense Earnings before tak Income taxes 33% Net income.... 1.030,443 148.557 73.000 75.557 75.557 24.914 50.623 s Figure 2 Current Situation FRESH & FRUITY FOODS, INC S292,803 11.430 S304,233 Balance Sheet As of December 31, 2010 Assets: Cash $ 3.560 Accounts receivable 209,686 Inventory 79.357 Total current assets Property, plant and equipment, net... Total assets Liabilities and equity Accounts payable S180,633 Notes payable (bank loans). 0 Total current liabilities Long-term debt.... Total liabilities Common stock 13,600 Additional paid in capital 83.000 Retained earnings... 27.000 Total equity Total liabilities and equity Selected ratios Profit Margin 4.29% Return on equity 40.96% Inventory turnover 14.82 Receivables turnover 5.62 Average payment period 67 S180,633 9 180,633 123.600 $304.232 4. Alice's second initiative calls for Fresh & Fruity to obtain a bank loan of a sufficient size to enable the company to take all suppliers' discounts. What is the minimum size of this loan? (Hint: To take all suppliers' discounts, the average payment period must be 10 days, and net purchases will be purchases - (Purchases from Figure 1 x .02). Assume that all this happens, and solve the following formula for the new accounts payable balance, using: Accounts payable = Average payment period x Purchase per day* * Based on net purchases/360. Now compare the accounts payable you just solved with the new accounts payable balance you found in question 3. The difference is the size of the loan that is required. 5. Assume that Fresh &Fruity does obtain an 8 percent loan for one year in the amount you solved in question 5, and it reduces its accounts payable balance accordingly. Now the company is taking 2 percent discounts on all purchases and paying 8 percent a year on the loan balance. What is the net gain from taking the discounts and paying the interest on a before-tax basis? On an aftertax basis? 6. Suppose the 8 percent loan that Fresh & Fruity obtained was a discount loan, and the bank further required a 20 percent compensating balance of the full loan amount. What is the effective rate of interest to Fresh & Fruity? How does this compare to your answer in question 2 for the cost of not taking a cash discount? in time to take advantage of the 2 percent discount they offer for payments within 10 days." (Fresh & Fruity's suppliers operated on a 2/10, net 60 basis.) "That would increase our net income and free up even more cash to take advantage of even more discounts!" She looked excited at the prospect. "Sounds great, but how do we get people to pay us earlier?" Tom inquired, doubtfully. "Easy." Alice continued. "Up to now we've been giving them incentives to pay later. Remember our 'Buy Now, No Payments for Two Months' program? Well, a lot of our customers use it, and it's caused our accounts receivable balance to run way up. So what we have to do now is give them incentives to pay earlier. What I propose is to cancel the buy now/pay later plan and offer a 10 percent discount to everyone who pays with their order, instead." "But won't that cause our revenues to drop?" Tom asked, again still doubtful. "Yes, but the drop will be offset by even more new customers who will come in to take advantage of the discount. I figure the net effect on sales will be just about zero, but our accounts receivable balance could be cut in half! Now here's a kicker that I just thought of: After we've reduced our accounts receivable balance as far as practical. I'd like to look into the possibility of reducing our accounts payable still further by replacing them with a bank loan. The effective rate of interest that we pay by not taking our suppliers' discounts is, after all, pretty high. So what I'd like to do is take out a loan once a year of a sufficient size that would enable us to take all the discounts our suppliers offer. The interest that we'll pay on the loan is bound to be less than what we pay in discounts lost-so we'll see another gain in earnings on our income statement. In fact, these two initiatives together might have a really significant impact!" 'You've convinced me." Tom said, Let's go back to the office and run some figures to see what happens!" Financial statements for Fresh & Fruity Foods, Inc., are presented in Figure 1 (income statement) and Figure 2 (balance sheet). 1. Using the data in Figures 1 and 2, compute the company's average collection period (ACP) in days. Use a 360-day year when calculating sales per day. 2. Compute the cost, as a percent, that the company is paying for not taking the supplier's discounts. (The supplier's terms are 2/10, net 60; but note from the bottom of Figure 2 that Fresh & Fruity has been taking 67 days to pay its suppliers, making that the effective final due date for accounts payable.) 3. Assume that Alice Plummer's first initiative to offer a 10 percent discount was implemented, and the company's average collection period dropped to 32 days. If ner sales per day remained the same, as Alice expects, what would be the new accounts receivable balance? How much cash was freed up by the reduction in accounts receivable? What is the new accounts payable balance if the money is used to pay off suppliers