Corporate finance fundamentals and applications

Business

Aziz Industries has sales of $100,000 and accounts receivable of $11,500, and it gives its customers 30 days to pay. The industry average DSO is 27 days, based on a 365-day year. If the company changes its credit and collection policy sufficiently to cause its DSO to fall to the industry average, and if it earns 8.0% on any cash freed-up by this change, how would that affect its net income, assuming other things are held constant?

DSO, or Days Sales Outstanding, is a measure of how many days it takes on average to collect sales revenue. The higher the DSO, the longer it takes to collect revenue. Calculating DSO is relatively simple, just divide accounts receivable ($11,500 in this scenario) by the total credit sales ($100,000), multiplied by the number of days (365 days). In this case, Aziz Industries' DSO is 41.95 (11,500/100,000 * 365).

In order to keep more capital for loans and wealth, Aziz would like to free up the credit by reducing its DSO to the industry average (27). Assuming that it is successful, and that the sales average doesn't increase or decrease, Aziz would have to have accounts receivable equal to around $7,397.26. I found this by setting the only independent variable, the accounts receivable (modified by changing company policy on collection and credit) to x and keeping all other variables the same. X / (100,000 *365) = 7397.26. This is $4,102.74 less in accounts receivable than before the transition. Eight percent of that number is $328.21 total. Freeing up that credit would give them $328.21 per year.

2) a new firm is developing its business plan. It will require $565,000 of assets, and it projects $452,800 of sales and $354,300 of operating costs for the first year. Management is quite sure of these numbers because of contracts with its customers and suppliers. It can borrow at a rate of 7.5%, but the bank requires it to have a TIE of at least 4.0, and if the TIE falls below this level the bank will call in the loan and the firm will go bankrupt. What is the maximum debt ratio the firm can use? (Hint: Find the maximum dollars of interest, then the debt that produces that interest, and then the related debt ratio.)

TIE stands for Time interest earned, which is a ratio found by dividing EBIT by total interest payable. EBIT is found by taking income and subtracting operating expenses (452,800 -- 354300). EBIT is $98,500 in this case. Now to find total interest, you have to find the interest rate and multiply it by the total loan. The business requires $565,500 of assets, so let us set our baseline at that. Multiply that by .075 (the interest rate) and one gets 42,412.5 total interest payable (in one year). Divide EBIT by total interest payable, and you get 2.3. Now the company needs to increase the TIE by decreasing the interest earned.

Simply set the total interest payable (the only changing variable) to x to get 98,500/x = 4.0. Divide by zero, divide by four, and you get $24,625 total payable interest. At 7.5%, the total loan would be $328,333. The debt ratio would then be $328,333 divided by total assets, 565,000. Which results in a .5 debt ratio.

3) LeCompte Corp. has $312,900 of assets, and it uses only common equity capital (zero debt). Its sales for the last year were $620,000, and its net income after taxes was $24,655. Stockholders recently voted in a new management team that has promised to lower costs and get the return on equity up to 15%. What profit margin would LeCompte need in order to achieve the 15% ROE, holding everything else constant?

ROE is simply net income divided by the shareholder's equity. The net income is $24,655. Shareholder's equity represents the amount of equity shareholder's hold in the company. Since all capital is raised on common equity capital, then all the capital is raised by shareholders. That also means that all assets bought by the company were indirectly bought by the stockholders. So divide 24,655 by 312,900 and you'll arrive at the ROE, which is around 7.8%. Assuming that equity is constant, in order to get an ROE of 15, you would need to change the net income to $46,935. That's the profit margin you would need to maintain to get a 15% ROE.