Modern Furnitures is considering a change in credit policy to 2/10 net 30. Under these terms, sales are expected to decrease by 10%; bad debt is expected to reduce to 1%; 20% of the customers are expected to take credit. This will lead to an increase in receivables turnover to 12. The opportunity cost of investing in receivables is the cost of equity.

Analyse the change in credit policy.

FIN303 Financial Management Assignment 1 - Individual Assignment/TMA01 January 2017 Presentation FIN303 Assignment 1 Individual Assignment This assignment is worth 25% of the final mark for FIN303 Financial Management. The cut-off date for this assignment is 3 April 2017, 2355hrs. In this assignment, you are expected to: Compute and interpret financial ratios Evaluate investment proposals Apply knowledge to decide appropriate financing plan and dividend policy ___________________________________________________________________________ Modern Furnitures was established in 2000. Its products include household and office furniture. It has grown organically with new designs of furniture as well as through acquisition of other furniture companies. It has high cash balance in order to provide funds for these opportunities. Its financial statements are shown in Exhibit 1 and 2. Exhibit 1 Income Statement for the year ending December 31, 2016 Sales Revenue Cost of goods sold Gross Profit Operating expenses Depreciation EBIT Interest Earnings before tax Tax (20%) Net income Dividend payment Addition to retained earnings 6,000,000 -1,800,000 4,200,000 -2,000,000 -200,000 2,000,000 -120,000 1,880,000 -376000 1,504,000 -601600 902,400 Exhibit 2 Balance Sheet as at December 31, 2016 Assets Cash and Cash Equivalents Receivables Inventory Total current assets Gross Fixed assets Accumulated Depreciation Net fixed assets Total assets SIM UNIVERSITY 1,200,000 560,000 500,000 2,260,000 1,350,000 -550,000 800,000 3,060,000 Assignment 1 - Page 2 of 5 FIN303 Assignment 1 Liabilities and Shareholder equity Payables Short-term debt Current Liabilities Long-term debt Total Liabilities Paid up capital Retained Earnings Total equity Equity + Liabilities 400,000 150,000 550,000 1,000,000 1,550,000 1,000,000 510,000 1,510,000 3,060,000 The number of shares outstanding is 1,000,000. The company expects that its dividend will grow at 6% every year indefinitely. The longterm debt is made up of 10-year 10% bonds issued 5 years back. The coupon will be paid once a year. The current yield to maturity on these bonds is 8% The beta of furniture industry is 1.2; the risk free rate is 4% and the expected market risk premium is 7%. The current credit terms offered by Modern Furnitures is 3/15 net 45. Under these terms, 30% of the customers take the discount and the expected bad debt is 2% of total sales. Question 1 (a) Calculate the market price per share using dividend growth model. (10 marks) (b) Compute the market value of bonds. (10 marks) Question 2 Typically, most companies use line of credit with a bank to finance its working capital needs as opposed to taking out a bank loan. Line of credit costs 8% per annum while term loan for 6 months costs 6% per annum. Modern Furnitures has worked out the working capital for the next 6 months as follows: Month 1 2 3 4 5 6 SIM UNIVERSITY Working Capital 60,000 70,000 100,000 80,000 60,000 40,000 Assignment 1 - Page 3 of 5 FIN303 Assignment 1 (a) Explain how line of credit will work for Modern Furnitures, indicating the amount of line of credit that will be taken from the bank. (4 marks) (b) Calculate the amount of interest that the company will pay if line of credit is taken up. (6 marks) (c) Calculate the amount of interest that the company will pay if term loan is taken up. (6 marks) (d) Compare the two (2) financing methods and discuss which of these alternatives will be good for the company. (4 marks) Question 3 Modern Furnitures is considering a change in credit policy to 2/10 net 30. Under these terms, sales are expected to decrease by 10%; bad debt is expected to reduce to 1%; 20% of the customers are expected to take credit. This will lead to an increase in receivables turnover to 12. The opportunity cost of investing in receivables is the cost of equity. Analyse the change in credit policy. (20 marks) Question 4 Cash conversion cycle is an important concept in working capital management. Analyse the importance of cash conversion cycle and explain the strategies to manage the cash conversion cycle. (10 marks) Question 5 Analyse why Modern Furnitures' ROE is different from that of the industry using Du Pont Identity and other ratios. The relevant ratios are shown in Exhibit 3. (30 marks) Exhibit 3 Relevant Ratios Ratios Current ratio Quick ratio Total asset turnover Fixed asset turnover Working capital turnover Inventory turnover SIM UNIVERSITY Modern Industry average 4.11 5.20 3.20 3.80 1.96 1.75 7.50 7.00 9.09 10.45 3.60 4.50 Assignment 1 - Page 4 of 5 FIN303 Assignment 1 Ratios Receivables turnover Payables turnover Gross profit margin Operating profit margin Net profit margin Return on assets Return on equity Total debt/Total assets LTD/Total assets LTD/(LTD+Equity) Equity multiplier Interest Coverage Modern Industry average 10.71 12.42 4.50 3.90 70.00% 60.00% 33.33% 38.00% 25.07% 28.00% 49.15% 50.00% 99.60% 85.00% 37.58% 32.00% 32.68% 28.00% 39.84% 35.00% 2.03 1.735 16.67 22.10 ---- END OF ASSIGNMENT ---- SIM UNIVERSITY Assignment 1 - Page 5 of 5