Question

Melrose is a major retail clothing shop based in South Africa. It caters for all individuals, ranging from kids’ wear to corporate wear. Recently Melrose’s receivables book has been growing excessively due to a higher demand for shopping on credit. Melrose’s management is happy with the current credit facilities, as it keeps the stock on the floor moving, but the financial management team is concerned, as there is a growing number of defaults in credit payments. The management team is therefore considering tightening their credit standards in order to mitigate the risk of loss in income from customers defaulting on their credit balances. All sales by Melrose are on credit.

The average selling price of an item of which Melrose sells 2 million items a year is R250. The average variable cost per item is R100. Total fixed costs of Melrose amount to R50 million per year. Melrose currently allows a 90-day interest-free credit period. Any unpaid amounts after 90 days are written off as bad debts. The proposed tightening of credit standards is a 60-day interest-free credit period. This proposal will result in an estimated 10% loss in sales. However, bad debts will be reduced from 10% of credit sales to 2%. There are 365 days in a year. Melrose has a WACC of 16%.

6. 6 Calculate the impact of the change in sales revenue due to the new credit policy:

   (2)

   1. a) R30 000 000 profit gain.

   2. b) R30 000 000 profit loss.

   3. c) R20 000 000 profit gain.

   4. d) R20 000 000 profit loss.

7. 7 Calculate the investment in accounts receivable under the current policy: (2)

   1. a) R1 369 863,01

   2. b) R123 287 670,90

   3. c) R13 698 630,10

   4. d) R15 000 540

8. 8 Calculate the investment in accounts receivable under the new policy: (3)

   1. a) R1 369 863,01.

   2. b) R123 287 670 90.

   3. c) R73 972 602,60.

   4. d) R1 232 876,71.

9. 9 Calculate the cost of marginal investment in accounts receivable: (3)

   1. a) R13 767 663,29

   2. b) R60 273 972,50

   3. c) -R7 890 410,93.

   4. d) R7 890 410,93.

10. 10 Calculate the bad debts under the current policy: (2)

    1. a) R50 000 000

    2. b) R9 000 000

    3. c) R500 000 000

    4. d) R90 000 000

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Assignment Two: 1st Semester 2020

FM202B

© IMM Graduate School

11. 11 Calculate the bad debts under the new policy: (2)

    1. a) R50 000 000

    2. b) R9 000 000

    3. c) R500 000 000

    4. d) R90 000 000

12. 12 Calculate the cost of marginal bad debts: (2)

    1. a) R410 000 000

    2. b) -R41 000 000

    3. c) R41 000 000

    4. d) -R410 000 000

13. 13 Calculate the overall effect of tightening credit standards for Melrose Ltd: (4)

    1. a) R78 273 972,50

    2. b) R119 273 972,50

    3. c) R18 890 410,93

    4. d) R331 726 027,50

14. 14 Advise Melrose Ltd in the light of the calculations you conducted from Question

    6–13: (2)

    1. a) Should not implement the proposed credit policy

    2. b) Reject both policies

    3. c) Sunk costs are difficult to access, therefore irrelevant to the decision

    4. d) Should implement the proposed credit policy

Use the following information to answer questions 15–20

The existing capital structure of Leeds (Ltd) is as follows:

Notes:

•  The ordinary shares are currently trading at R46,45. A dividend of 80 cents per share has just been paid and the directors estimate that the dividends will increase by 8% each year in perpetuity.

•  Preference shares are trading at R2,75 and have a par value of R2,40.

•  The debentures have a par value of R50 and are currently trading at R45. The

  debentures are redeemable at R55 in ten years’ time.

•  The company tax rate is 28%.

  As an alternative to the existing capital structure for Leeds (Ltd), an outside consultant has suggested the following modifications:

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Ordinary shares (equity)	R500 000
11% non-redeemable preference shares	R150 000
Debt (10% debentures)	R350 000

Ordinary shares (equity)	35%
Preference shares	5%
Debt	60%

Under this new and more debt-orientated arrangement, the after-tax cost of debt is 10,8%, the cost of preference shares is 11% and the cost of equity is 15,6%.

15. 15 Under the CURRENT capital structure (before the suggested change) of Leeds Ltd, calculate the cost of equity: (3)

    1. a) 10,00%

    2. b) 9,86%

    3. c) 9,00%

    4. d) 9,43%

16. 16 Under the CURRENT capital structure (before the suggested change) of Leeds Ltd, calculate the cost of preference shares: (3)

    1. a) 9,43%

    2. b) 9,60%

    3. c) 10,00%

    4. d) 12,67%

17. 17 Under the CURRENT capital structure (before the suggested change) of Leeds Ltd, calculate the cost of debt. (3) a) 11,68%

    2. b) 9,67%

    3. c) 9,40%

    4. d) 9,43%

18. 18 Using your calculated cost of capital calculated in Question 1.15–1.17, calculate Leeds’s weighted average cost of capital (WACC) using the current capital structure. (3)

    1. a) 9,40%

    2. b) 9,60%

    3. c) 9,67%

    4. d) 9,00%

19. 19 Calculate Leeds’s weighted average cost of capital (WACC) using the ALTERNATIVE capital structure and alternative costs of capital. (3)

    1. a) 12,49%

    2. b) 13,00%

    3. c) 12,50%

    4. d) 20,00%

20. 20 If you owned your own organisation that was funded by your own capital, would the concept of WACC apply to you? (2)

    1. a) There would be no WACC as there would not be any form of a pool of

       external capital that would exist. However, your ‘own’ cost of funding (equity)

       will need a return level that will be set by yourself.

    2. b) Yes, there will be WACC as there would a pool of external capital that would

       exist.

    3. c) WACC is irrelevant to how capital is funded.

    4. d) Not necessarily, it depends on the company in question.

Answer 1

Answer – 6

Calculation of impact of the change in sales revenue due to the new credit policy:

Statement showing Profit/ Loss from current policy

Particulars	Working	Amount (R )
Sales	2,000,000 Units @ R250 p.u.	500000000
Variable Cost	2,000,000 Units @ R100 p.u.	-200000000
Fixed Cost		-50000000
Profit	250000000

Statement showing Profit/ Loss from new policy

Particulars	Working	Amount (R )
Sales	1,800,000 Units @ R250 p.u.	450000000
Variable Cost	1,800,000 Units @ R100 p.u.	-180000000
Fixed Cost		-50000000
Profit	220000000

Hence, impact of the change in sales revenue due to the new credit policy is the reduction in profit by R30,000,000

Therefore,

b) R30 000 000 profit loss is the correct answer.

Answer – 7

Calculation of investment in accounts receivable under the current policy:

Investment in accounts receivable = (Credit Sales * Credit period allowed) / 365

Where -

Credit Sales is R500,000,000 (assuming all the sales are on credit)

Credit period allowed is 90 days

On putting the figures in the above formula, we get -

Investment in accounts receivable = (Credit Sales * Credit period allowed) / 365

Investment in accounts receivable = (R500,000,000 * 90) /365

Investment in accounts receivable = R123,287,671.23 (approx)

Therefore,

b) R123 287 670,90 is the correct answer.

Answer – 8

Calculation of investment in accounts receivable under the new policy:

Investment in accounts receivable = (Credit Sales * Credit period allowed) / 365

Where -

Credit Sales is R450,000,000 (assuming all the sales are on credit) (decrease in sales by 10% with the new credit policy)

Credit period allowed is 60 days (decrease in interest-free credit period in new credit policy)

On putting the figures in the above formula, we get -

Investment in accounts receivable = (Credit Sales * Credit period allowed) / 365

Investment in accounts receivable = (R450,000,000 * 60) /365

Investment in accounts receivable = R73,972,602.74 (approx)

Therefore,

c) R73 972 602,60 is the correct answer.

Answer – 9

Calculation of cost of marginal investment in accounts receivable:

Marginal investment in accounts receivable = (Investment in accounts receivable under the new policy - Investment in accounts receivable under the current policy)

Where -

Investment in accounts receivable under the new policy is R73,972,602.74 (calculated above)

Investment in accounts receivable under the current policy is R123,287,671.23 (calculated above)

On putting the figures in the above formula, we get -

Marginal investment in accounts receivable = (Investment in accounts receivable under the new policy - Investment in accounts receivable under the current policy)

Marginal investment in accounts receivable = R73,972,602.74 - R123,287,671.23

Marginal investment in accounts receivable = -R49,315,068.49

Now, let us calculate -

Cost of marginal investment in accounts receivable = Marginal investment in accounts receivable * Cost of capital

Where -

Marginal investment in accounts receivable is -R49,315,068.49

Cost of capital is 16% (WACC)

On putting the figures in the above formula, we get -

Cost of marginal investment in accounts receivable = Marginal investment in accounts receivable * Cost of capital

Cost of marginal investment in accounts receivable = -R49,315,068.49 * 16%

Cost of marginal investment in accounts receivable = -R7,890,410,96 (approx)

Therefore,

c) -R7 890 410,93 is the correct answer.