Heavy Machinery manufacturing Company (HMM) manufactures and sells heavy equipment used in mining, construction and shipbuilding industries.

The management is concerned about its financial performance. It considers Metal Stamping Company (MS) as a major player in the industry and would like to compare its performance with that of MS. One of the managers suggests that it is also useful to compare the performance with that of Hi-tech Software Company (HTS) to get a better picture. HTS is involved in providing software solutions to Machinery manufacturing companies. The balance sheet, income statement and relevant ratios for HMM,

MS and HTS are shown in Exhibit 1.

The management of HMM is planning to introduce a new machine in the market. The details of this investment are shown in Exhibit 2.

Exhibit 1 - Balance Sheet, Income Statement and Relevant Ratios Balance Sheet ($000) HMM MS HTS Current Assets 25,000 12,000 20,000 Cash 5,000 4,000 7,000 Accounts Receivables 10,000 5,000 10,000 Inventory 10,000 3,000 3,000 Gross Fixed Assets 85,000 80,000 100,000 Accumulated Depreciation 10,000 12,000 20,000 Net Fixed Assets 75,000 68,000 80,000 Total Assets 100,000 80,000 100,000 Accounts Payables 20,000 10,000 10,000 Long-term debt 40,000 40,000 0 Total Liabilities 60,000 50,000 10,000 Common Stock 15,000 10,000 25,000 Retained earnings 25,000 20,000 65,000 Total equity 40,000 30,000 90,000 Total Liabilities and Equity 100,000 80,000 100,000 Income Statement ($000) HMM MS HTS Sales 75,000 50,000 100,000 Cost of goods sold 45,000 35,000 20,000 Gross Profit 30,000 15,000 80,000 Selling and Administrative Expenses 20,000 5,000 40,000 Operating Profit 10,000 10,000 40,000 Interest Expenses 3,000 3,000 0 Earnings Before taxes 7,000 7,000 40,000 HMM MS HTS Taxes 2,800 2,800 16,000 Net Income 4,200 4,200 24,000 Ratios HMM MS HTS Return on equity 10.50% 14.00% 26.67% Return on Assets 4.20% 5.25% 24.00% Total Asset Turnover 0.75 0.625 1 Current Asset Turnover 3 4.17 5 Fixed Asset Turnover 1 0.74 1.25 Gross Profit margin 40.00% 30.00% 80.00% Operating profit margin 13.33% 20.00% 40.00% Net profit margin 5.60% 8.40% 24.00% Total Liabilities/assets 60.00% 62.50% 10.00% Long-term debt to assets 40.00% 50.00% 0.00% Long-term debt to equity 100.00% 133.33% 0.00% Interest Coverage 3.33 3.33 NA Inventory turnover 4.50 11.67 6.67 Average Collection period 48.00 36.00 36.00 Accounts Payables Turnover 2.25 3.50 2.00 Net working capital turnover 15.00 25.00 10.00 Equity Multiplier 2.50 2.67 1.11

Exhibit 2 - Details of the Project

Investment in new machinery $10,000,000 Useful life of the machinery 5 years Depreciated using straight line depreciation to zero salvage value over the useful life of machinery Expected life of the project 4 years Expected incremental annual sales in the next 4 years $12,500,000 Cost of goods sold 60% of sales Fixed Operating Expenses per year $500,000 Estimated selling price at the end of 4 years $1,750,000 Working capital needs to support sales of $12,500,000 $3,000,000 Working capital will be provided at the beginning of the project and recouped at the end of project Tax rate 40% Beta of HMM 1.5 Risk-free rate 3% Market risk premium 6% After tax cost of debt 6% Target debt ratio 40%

HMM is looking at the working capital policy.

(a) Analyse the need for working capital and calculate the cash conversion cycle for HMM.

(b) Analyse the importance of cash conversion cycle for management. (c) HMM is being offered a credit policy of 2/10 net 40 by its suppliers. The opportunity cost for HMM is 12%. Analyse the offer and advice whether discount should be taken.