Answer to Part 2 Practice Questions

Answer: Question 2.1-FSL Industries

1. Since FSL requires the use of $9 million, it will have to borrow $10 million ($9 million / (1-10%)). This will result in 10% of the loan principle ($1 million) being used to satisfy the compensating balance. Annual interest would be 5% of the total loan of $10 million or $500,000.

2. a. The semi-annual interest cost of the term loan would be $9million*(7%/2)=$315,000. The annual interest cost would then be $315,000*2=$630,000 b. Advantages of this loan over the short term loan include:

• The loan would be outstanding for 10 years and would not have to be renegotiated each year. Since the need for these funds is quite long due to the need to carry the spare parts inventory, this is an advantage

• The interest rate is fixed for 10 years, eliminating interest rate risk which is inherent in the short term loan

Disadvantages of such a loan include:

• FSL would not be able to take advantage of falling interest rates in the future. The short term loan would allow the interest rate to adjust each year.

• The interest cost of this loan in the first year is $130,000 greater than the cost of the short term loan.

3. a. If the bank loan was used to finance the new inventory, net working capital would decrease since current assets (inventory) and long-term assets (equipment) would increase by a combined $9 million, and current liabilities (short term loan) would increase by $10 million b. If the term loan was used to finance the inventory, there would be an increase in net working capital since current assets would increase, and there would be no impact on current liabilities since the term loan is classified as long term.

4. Other costs related to this inventory would include carrying costs such as:

• Storage

• Security

• Losses due to theft

• Obsolescence

Answer: Question 2.2-Spreck

1. a. The entire life cycle of a product, including design and development, acquisition, operation, maintenance, and service.

b. Introduction, growth, maturity, and decline.

• Introduction stage – This stage of the cycle could be the most expensive for a company launching a new product. It is generally characterized by large cash outflows and little or no cash inflows. Expenditures for research and development, plant and equipment, retooling, distribution and promotion are required. During this stage, a project or company normally generates losses and may require an infusion of outside capital.

• Growth stage – Sales and revenues rise rapidly. Significant cash inflows are generally present. However, these inflows may be offset by cash outflows to build production capacity and for growing inventories and receivables. During this stage, manufacturing efficiencies will improve contribution margins as volume increases.

• Maturity stage – Net cash inflows are generally at an optimum. Production capacity is in place and inventories and receivables should approach steadystate. By this stage, competitors generally have entered the market which could result in higher promotional costs to maintain market share. As a consequence, margins could begin to decline.

• Decline stage – Both sales volume and profits fall. Increased price competition and the increased availability of alternative products will reduce margins. The declining volume will generally increase the unit cost at the manufacturing level. Sometimes, significant cash inflows can be generated from the liquidation of inventories and other product related assets.

2. Sales, costs, profits are different over the stages of the product life cycle. Marketing objectives are different. In growth stage, price is usually high to recover the investment. Pricing during maturity stage has to be competitive to hold onto market share. The price plummets during the decline stage.

3. Factors affecting cash inflow:

• The maturity stage, the period of optimum net cash flows, is missing from the product life cycle.

• Credit policies.

• Factors affecting cash outflow:

• Research and development, capital investment, and promotional costs during the introduction stage.

• Obsolescent inventory is actually cash outflow without future cash inflow to recover the cost.