Question

Working Capital Investment

Pasha Corporation produces motorcycle batteries. Pasha turns out 1,400 batteries a day at a cost of $7 per battery for materials and labor. It takes the firm 22 days to convert raw materials into a battery. Pasha allows its customers 40 days in which to pay for the batteries, and the firm generally pays its suppliers in 30 days.

a. What is the length of Pasha’s cash conversion cycle?
b. At a steady state in which Pasha produces 1,400 batteries a day, what amount of working capital must it finance?
c. By what amount could Pasha reduce its working capital financing needs if it was able to stretch its payables deferral period to 33 days?
d. Pasha’s management is trying to analyze the effect of a proposed new production process on its working capital investment. The new production process would allow Pasha to decrease its inventory conversion period to 17 days and to increase its daily production to 2,400 batteries. However, the new process would cause the cost of materials and labor to increase to $12. Assuming the change does not affect the average collection period (40 days) or the payables deferral period (30 days), what will be the length of its cash conversion cycle and its working capital financing requirement if the new production process is implemented?

Answer 1

Part a)

The cash conversion cycle is calculated as below:

Cash Conversion Cycle = Days Inventory Outstanding + Days Sales Outstanding - Days Payable Outstanding

Here, Days Inventory Outstanding = 22, Days Sales Outstanding = 40 and Days Payable Outstanding = 30

Using these values in the above formula, we get,

Cash Conversion Cycle = 22 + 40 - 30 = 32 days (answer for Part a)

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Part b)

The amount of working capital that must be financed is arrived as follows:

Amount of Working Capital to be Financed = Number of Batteries per Day*Cash Conversion Cycle*Cost per Battery

Here, Number of Batteries per Day = 1,400, Cash Conversion Cycle = 32 and Cost per Battery = $7

Using these values in the above formula, we get,

Amount of Working Capital to be Financed = 1,400*32*7 = $313,600 (answer for Part b)

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Part c)

Step 1: Calculate Revised Cash Conversion Cycle

The revised cash conversion cycle is calculated as below:

Revised Cash Conversion Cycle = 22 (Days Inventory Outstanding) + 40 (Days Sales Outstanding) - 33 (New Days Payable Outstanding) = 29 days

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Step 2: Calculate Revised Working Capital Needed

The value of revised working capital is determined as follows:

Revised Working Capital Needed = 1,400 (Number of Batteries)*29 (Revised Cash Conversion Cycle)*7 (Cost Pper Battery) = $284,200

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Step 3: Calculate Reduction in Working Capital Financing Needs

The reduction in working capital financing needs is arrived as below:

Reduction in Working Capital Needs = Original Working Capital Needed - Revised Working Capital Needed = 313,600 - 284,200 = $29,400 (answer for Part c)

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Part d)

The new cash conversion cycle is calculated as follows:

Cash Conversion Cycle (New Production Process) = 17 (New Days Inventory Outstanding) + 40 (Days Sales Outstanding) - 30 (Days Payable Outstanding) = 27 days

New Working Capital Financing Requirement (New Production Process) = 2,400 (New Production Level)*27 (New Cash Conversion Cycle)*12 (New Cost of Battery) = $777,600