Question: What are the impacts on operating cycle and cash conversion cycle due to the increase in the payment period (i.e., average collection period) from 30 to 60 days? Also, assuming the company is currently selling 100 units per day, by how much should the firm increase or reduce its working capital financing to accommodate to this change in average collection period?

Case Study:

The marketing department is launching an aggressive 10-year marketing campaign whereby the payment period to wholesale customers is extended from 30 to 60 days, leading to (forecasted) increase in sales of 21,900 units per year. While the product (unit) is selling at $620/unit on average, Company A can purchase its material from its supplier at $300/unit and is liable to pay its supplier in 60 days on average. Manufacturing and selling the units takes a total of 25 days on average. To accommodate the increase in demand due to the campaign, company A would need to buy new machines costing $16,000,000 today, with a lifetime of 10 years (assume straight-line depreciation and 'zero' salvage value). Moreover, the marketing campaign will involve a cash cost of $4,000,000 per year.

As per the above forecasts and assume they remain the same every year, this 10-year campaign will be able to generate free cash flows of $2,585,600 per year (ignored the change in working capital). Company A currently has 80% equity and 20% debt in the balance sheet. Regarding the equity, Company A shares have a beta coefficient of 1.4, while the risk-free rate is 2.5% and the expected return on market portfolio is 8.5%. On the liability side, Company A is paying an average before-tax interest rate of 8% per annum on its borrowings (the tax-rate in the U.S. is 30%).

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