Financial management revision question and answer

CPA-Financial-Management-Section-3 Revision kit

The following information relates to the current trading operations of Maji Mazuri Enterprises (MME) Ltd:

– Level of annual sales (uniform per month) – Sh.600 million
– Contribution to sales ratio – 15%
– Debtors recovery period:
Percentage Average collection of debtors period (days)
25                           32
60                              50
15                               80
– Credit sales as a percentage of total sales – 60%
– Required return on investments – 15%
– Level of bad debts (2% of credit sales) – Sh.7,200,000

The management of the company is in the process of reviewing the company‟s credit management system with the objectives of reducing the operating cycle and improving the firm‟s liquidity. Two alternative strategies, now being considered managementare detailed as follows:

Alternative A: change of credit terms:
The proposal requires the introduction of a 2% cash discount which is expected to have the following effects:
• 50 per cent of the credit customers (and all cash customers) will take advantage of the 2 per cent cash discount.
• There will be no change in the level of annual sales, the percentage of credit sales and the contribution of sales ratio.
• There will be savings in collection expenses of Sh.2,750,000 per month.
• Bad debts will remain at 2 per cent of total credit sales.
• The average collection period will be reduced to 32 days.

Alternative B: contracting the services of a factor:

The factor would charge a fee of 2% of total credit sales and advance MME Ltd. 90% of total credit sales invoiced the end of each month at an interest rate of 1.5% per month.

The effects of this alternative are expected to be as follows:

• No change is expected in the level of annual sales, proportion of credit sales and contributions margin ratio.
• Savings on debt administration expenses of Sh.1,400,000 per month will result
• All bad debt losses will be eliminated
• The average collection period will drop to 20 days.
Required:
i) Evaluate the annual financial benefits and costs of each alternative (Assume 360
–day year)

ii) Advise MME Ltd. management on the alternative to implement.

iii) Explain briefly other factors that should be considered in reaching the decision in (ii) above.
ANSWER

Proposal A


(ii) Preferred alternative (alternative A) is to introduce cash discount since it has a higher net benefit.

(iii) Other non-financial factors to consider include
– Effect of each policy on growth of the company
– Reliability of the factor
– How realistic the estimates are
– Reaction of employees and customers
– Expected trends/level of sales in the industry

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