PROFITABILITY AND WORKING CAPITAL CHALLENGES

Tesa Limited has a relatively high level of current assets and this is evident in the amount of inventory it carries and the amount owed by trade debtors. A higher inventory level is maintained to absorb any sudden increases in product sales and any abnormal delays in procurement times. This achieves a higher level of customer satisfaction and leads to the smooth operations of the company. Higher levels of accounts receivables are due to the generous credit terms granted to debtors. This, in turn, attracts more customers leading to higher sales. The higher levels of inventory and accounts receivable have a direct impact on both liquidity and profitability.

An analysis of the current situation reveals the following:

The selling price of the only product that it sells is R$280$ per unit. The product is priced at cost plus $40\%.$ The holding cost is $10\%$ of the unit cost. The cost of placing an order for the product is R$18.$ The annual sales are $50000$ units, of which $80\%$ is on credit. The credit terms are $3/10$ net $60$ days but it takes approximately $73$ days to collect the debts from the credit customers. The discount applies to $40\%$ of the credit sales. Bad debts usually account for $6\%$ of the credit sales.

In view of the above, the financial manager proposed the following to improve the profitability and liquidity:

PROPOSAL $1$

The company should take advantage of the quantity discount offered by another supplier who offers a discount of $5\%$ for an order size of between $2000$ and $2999$ units and a discount of $6\%$ for an order size of $3000$ units or more.

PROPOSAL $2$

The credit terms should be changed to $4\mathrm{.}5/10$ net $60$ days. This is expected to increase credit sales to $55000$ units, reduce the debtors collection period to $36\mathrm{.}50$ days, lower bad debts to $4\%$ of credit sales and increase the percentage of the credit sales to which the discount applies to $70\%.$

REQUIRED

$1.$ Which working capital policy is Tesa Ltd following? Provide THREE $(3)$ reasons for your answer. $(4$ marks$)$

$2.$ Calculate the EOQ if discounts are not available. $(3$ marks$)$

$3.$ If Proposal $1$ is implemented without considering Proposal $2,$ what purchase quantity would you recommend? Motivate your answer with the relevant calculations. $(11$ marks$)$

$4.$ Would you recommend Proposal $2,$ if the required rate of return on equal$-$risk investments is $18\%?$

Motivate your answer with the relevant calculations. Ignore the carrying and ordering costs. $(12$ marks$)$