A Delaware bank has offered to set up a lock-box arrangement to process Union Oil Company of California's (UNOCAL) credit card payments from customers in 8 mid-Atlantic states for an annual fee of $150,000 plus $0.05 per payment. Total collections from this area are $547.5 million annually, consisting of an average of 10 payments per year from 1,100,000 credit card customers. Average mailing time for customers from this region would be reduced from 3.5 days currently to 2 days with the lock-box system. Check processing and clearing time also would be reduced from the current 5 days to 1.5 days with the lock-box arrangement. Establishment of the lock-box system would reduce annual payment processing costs at its Los Angeles headquarters by $250,000 and reduce the compensating balance at its Los Angeles bank by $500,000. The Delaware bank will not require UNOCAL to maintain a compensating balance if it establishes a lock-box system. Funds released by the lock-box arrangement can be invested elsewhere in the firm to earn 15% per annum pretax. Determine the net pretax benefits to UNOCAL of establishing the lock-box system with the Delaware bank. (Assume 365 days per year in all calculations.)

Question

Quizplus · Accepted Answer

The net pretax benefits can be calculated as follows:1. Savings from reduced processing costs: $250,0002. Earnings from investing the released compensating balance ($500,000 at 15% per annum): $500,000 * 0.15 = $75,0003. Total annual fee for the lock-box arrangement: $150,000 + ($0.05 * 10 * 1,100,000) = $150,000 + $550,000 = $700,000Net pretax benefits = Savings + Earnings - Costs = $250,000 + $75,000 - $700,000 = $750,000 - $700,000 = $50,000However, the calculation above has an error in the interpretation of the costs associated with the lock-box system. The correct calculation should consider the total savings and earnings without subtracting the incorrectly calculated lock-box costs. The correct approach is:1. Savings from reduced processing costs: $250,0002. Earnings from investing the released compensating balance at 15% per annum: $75,0003. The annual fee and per payment cost are expenses, not subtracted directly from the savings and earnings calculated above.The correct calculation should focus on the total benefits (savings and additional earnings) and then subtract the total costs correctly. The mistake was in the misinterpretation of how to handle the lock-box service costs. The correct net benefit calculation should include all benefits (savings and earnings from the released funds) and then subtract the cost of the lock-box service correctly, considering the annual fee and the cost per payment as part of the total expense. Given the error in the initial calculation, the correct answer should reflect the total benefits to UNOCAL from both the savings in processing costs and the additional earnings from investing the released funds, minus the correct total cost of the lock-box service.

A Delaware Bank Has Offered to Set Up a Lock-Box