PROFITABILITYANDWORKINGCAPITALCHALLENGES

Tesa Limited has a relatively high level of current assets and thisis evidentin the amount ofinventory 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 accountsreceivables 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 accountsreceivable have a direct impact on both liquidity and profitability.

Ananalysisofthecurrentsituationrevealsthefollowing:

The selling price of the only product that it sells is R280 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 R18. The annual sales are 50 000 units, of which80%isoncredit.Thecredittermsare3/10net60daysbutittakesapproximately73daystocollectthedebtsfrom the credit customers. The discount applies to 40% of the credit sales. Bad debts usually account for 6% of the creditsales.

Inviewoftheabove,thefinancialmanagerproposedthefollowingtoimprovetheprofitabilityandliquidity:

PROPOSAL1

Thecompanyshouldtakeadvantageofthequantitydiscountofferedbyanothersupplierwhooffersadiscountof5%for anorder sizeof between 2 000 and 2 999 units and a discount of 6% for an order size of 3 000 units or more.

PROPOSAL2

The credit terms should be changed to 4.5/10 net 60 days. This is expected to increase credit sales to 55 000 units, reducethedebtorscollectionperiodto36.50days,lowerbaddebtsto4%ofcreditsalesandincreasethepercentageofthe credit sales to which the discount applies to 70%.

1. IfProposal1isimplementedwithoutconsideringProposal2,whatpurchasequantitywouldyourecommend?Motivate your answer with the relevant calculations. (11marks)
2. WouldyourecommendProposal2, iftherequiredrateofreturnonequal-riskinvestmentsis18%?

Motivateyouranswerwiththerelevantcalculations.Ignorethecarryingandorderingcosts. (12marks)