Principles of Managerial Finance 14th Edition Chapter 16

Integrative Case 7 Casa de Diseo

In January 2015, Teresa Leal was named treasurer of Casa de Diseo. She decided that she could best orient herself by systematically examining each area of the companys financial operations. She began by studying the firms short-term financial activities.

Casa de Diseo, located in southern California, specializes in a furniture line called Ligne Moderna. Of high quality and contemporary design, the furniture appeals to the customer who wants something unique for his or her home or apartment. Most Ligne Moderna furniture is built by special order because a wide variety of upholstery, accent trimming, and colors is available. The product line is distributed through exclusive dealership arrangements with well-established retail stores. Casa de Diseos manufacturing process virtually eliminates the use of wood. Plastic and metal provide the basic framework, and wood is used only for decorative purposes.

Casa de Diseo entered the plastic-furniture market in late 2007. The company markets its plastic-furniture products as indooroutdoor items under the brand name Futuro. Futuro plastic furniture emphasizes comfort, durability, and practicality and is distributed through wholesalers. The Futuro line has been very successful, accounting for nearly 40 percent of the firms sales and profits in 2014. Casa de Diseo anticipates some additions to the Futuro line and also some limited change of direction in its promotion in an effort to expand the applications of the plastic furniture.

Leal has decided to study the firms cash management practices. To determine the effects of these practices, she must first determine the current operating and cash conversion cycles. In her investigations, she found that Casa de Diseo purchases all its raw materials and production supplies on open account. The company is operating at production levels that preclude volume discounts. Most suppliers do not offer cash discounts, and Casa de Diseo usually receives credit terms of net 30. An analysis of Casa de Diseos accounts payable showed that its average payment period is 30 days. Leal consulted industry data and found that the industry average payment period was 39 days. Investigation of six California furniture manufacturers revealed that their average payment period was also 39 days.

Next, Leal studied the production cycle and inventory policies. Casa de Diseo tries not to hold any more inventory than necessary in either raw materials or finished goods. The average inventory age was 110 days. Leal determined that the industry standard, as reported in a survey done byFurniture Age, the trade association journal, was 83 days.

Casa de Diseo sells to all its customers on a net-60 basis, in line with the industry trend to grant such credit terms on specialty furniture. Leal discovered, by aging the accounts receivable, that the average collection period for the firm was 75 days. Investigation of the trade associations and California manufacturers averages showed that the same collection period existed where net-60 credit terms were given. Where cash discounts were offered, the collection period was significantly shortened. Leal believed that if Casa de Diseo were to offer credit terms of 3/10 net 60, the average collection period could be reduced by 40 percent.

Casa de Diseo was spending an estimated $26,500,000 per year on operating-cycle investments. Leal considered this expenditure level to be the minimum she could expect the firm to disburse during 2015. Her concern was whether the firms cash management was as efficient as it could be. She knew that the company paid 15 percent annual interest for its resource investment. For this reason, she was concerned about the financing cost resulting from any inefficiencies in the management of Casa de Diseos cash conversion cycle. (Note: Assume a 365-day year, and assume that the operating-cycle investment per dollar of payables, inventory, and receivables is the same.)

TO DO

a. Assuming a constant rate for purchases, production, and sales throughout the year, what are Casa de Diseos existing operating cycle (OC), cash conversion cycle (CCC), and resource investment need?

Operating Cycle (OC) = 110 + 75 = 185

Cash Conversion Cycle (CCC) = 185 - 30 = 155

Resource Investment Need = 26,500,000 / 365 = 72,602.74

72,602.74 x 156 = 11,253,424.70

b. If Leal can optimize Casa de Diseos operations according to industry standards, what will Casa de Diseos operating cycle (OC), cash conversion cycle (CCC), and resource investment need to be under these more efficient conditions?

Operating Cycle (OC) = 83 + 75 = 158

Cash Conversion Cycle (CCC) = 158 39 = 119

Resource Investment Need = 72,602.74 x 119 = 8,639,726.06

D-1

Average Collection period = 75 days x (100%-40%)

(Average collection could be reduced by 40%) = 45 days

Operating cycle = 83 days + 45 days = 128 days

Cash conversion cycle = 128 days - 29 days = 89 days

Resources needed = $ 26,500,000 x 89

365

$6,461,643.84

Additional saving = $2,178,082.19

$326,712.33

D-2

$40,000 x 45% x 3% = 540,000.00

D-3

Average investment in accounts receivable with cash discount = ($40,000,000 x 80%)

(365/45)

(New average collection period is 45 days) = 3,945,205.48

Average investment in accounts receivable without cash discount = ($40,000,000 x 80%)

(365/75)

6,575,342.47

Reduction in investment in accounts receivable:

$6,575,342.47 - $3,945,205.48 = 2,630,136.99

Annual saving:

$2,630,136.99 * 15% = 394,520.55

D-4

$40,000,000 x (2% - 1.5%) = 200,000.00

D-5

Reduction in revenues as a result of the discount ($540,000)

Annual saving from reduction in investment in accounts receivable $394,520.55

Annual saving from bad debt expense $200,000

Saving due to Casa de Diseo discount $54,521

Yes, offering the cash discount as outlined would be justified financially. It would reduce the average collection period by 30 days and the average investment would decrease $2,630,136.99. This would save the company $394,520.55 in investment in account receivable. There would also be a reduction in bad debt expense of 0.5%. That would increase the companys saving by $200,000.

e. On the basis of your analysis in parts a through d, what recommendations would you offer Teresa Leal?

f. Review for Teresa Leal the key sources of short-term financing, other than accounts payable, that she may consider for financing Casa de Diseos resource investment need calculated in part b. Be sure to mention both unsecured and secured sources.