Question

Freedom Oil Company is a fuel oil distributor in New England. Freedom purchases fuel oil from

large wholesalers and distributes the oil to its customers, primarily in single-family houses, within 20

miles of its home offices. The company owns a number of medium-sized delivery trucks and four

storage tanks. The tanks, when full, represent about 4 months’ worth of normal winter deliveries.

Freedom makes deliveries year-round, since many customers heat their water with oil. Most of

Freedom’s business, however, occurs between late September and early May, when fuel oil is used

for heating homes.

Freedom’s customers are normally billed at the end of each month for deliveries made during that

month; payment is due 15 days after the invoice date. Freedom pays its wholesalers about 30 days

after receipt of fuel oil deliveries to Freedom’s storage tanks. The company uses 2 storage tanks for

its own purposes and stores oil for other companies in the other 2 tanks.

Freedom has had a long relationship with its lending institution. Normally, the company borrows in

August and September, just before the winter season; the loan balance increases during the winter,

usually until February, depending on how cold the winter is. The company generally pays back the

loans by the end of April.

a/ Because of rising residential fuel oil prices and competition from other oil dealers as well as the

local gas company, Freedom decides to offer a “level payment plan”: customers pay 12 equal

monthly installments based on past usage rather than pay for the amount of oil actually delivered

each month. Payments on the new level payment plan will begin in May. Will this new program

increase or decrease the cash flow timing differences in Freedom’s asset conversion cycle? Why?

b/ Would you expect this level payment plan to affect the company’s need to borrow and the

timing of its borrowing needs? How?

c/ John Lodge, owner and manager of Freedom, has developed a keen sense for oil prices and New

England winters. This year he projected that the coming winter might be a little colder than usual.

Concerned about the availability of fuel oil during the coldest months, he decided to increase his

inventory of oil to 4 tanks, rather than the normal two. In June he began buying oil discreetly so

that, by September, he would have 4 full tanks. What effect will Lodge’s decision have on the

company’s cash flow timing differences? Explain.

d/ What effect will Lodge’s decision have on the pattern of the company’s borrowing from the

bank? Explain.

Answer 1

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