Fagins, a nationwide department store chain, currently processes all of its credit sales payments at its St. Louis headquarters. The firm is considering the establishment of a lockbox arrangement with a Los Angeles bank to process payments from its customers in 10 western states. With the lockbox system, average mailing time for customers from this region would be reduced from 3 days to 1.5 days. Check-clearing time would also be reduced from 4 days to 2.5 days. Annual collections from the western region are $150 million. Establishment of this lockbox system would reduce the compensating balance requirement at the firm's St. Louis bank by $600,000 and reduce annual payment processing costs at the St. Louis office by $30,000. Funds released by the lockbox arrangement can be invested elsewhere in the firm to earn 12% before taxes. The Los Angeles bank has agreed to process Fagins' customer payments for an annual fee of $100,000. What are the annual net pretax benefits to Fagins of establishing a lockbox system with the Los Angeles bank? (Assume 365 days per year.)

Question

Quizplus · Accepted Answer

The annual net pretax benefits of establishing the lockbox system can be calculated by considering the reduction in mailing and check-clearing times, the reduction in the compensating balance requirement, the reduction in payment processing costs, and the cost of the lockbox service. First, calculate the total reduction in float time (mailing time + check-clearing time) which is (3 - 1.5) + (4 - 2.5) = 3 days. The value of the reduced float time is calculated as: $$ \text{Annual collections} \times \frac{\text{Reduced float time}}{365} \times \text{Interest rate} = \$150,000,000 \times \frac{3}{365} \times 0.12 = \$147,945 $$Add the savings from the reduced compensating balance requirement and the reduced payment processing costs: $$ \$147,945 + (\$600,000 \times 0.12) + \$30,000 = \$147,945 + \$72,000 + \$30,000 = \$249,945 $$Subtract the cost of the lockbox service: $$ \$249,945 - \$100,000 = \$149,945 $$Therefore, the annual net pretax benefits to Fagins of establishing the lockbox system are \$149,945.

Fagins, a Nationwide Department Store Chain, Currently Processes All of Its