A firm has annual operating outlays of $1,800,000 and a cash conversion cycle of 60 days. If the firm currently pays 12 percent for financing and reduces its cash conversion cycle to 50 days, the annual savings is ________. (Assume a 365-day year.)
A) $4,652.19
B) $3,065.86
C) $5,917.81
D) $2,160.23

Question

Quizplus · Accepted Answer

First, we need to calculate the current cost of financing for the company using the operating outlays and cash conversion cycle information.

Operating outlays per day = Operating outlays / Number of days in a year
Operating outlays per day = $1,800,000 / 365
Operating outlays per day = $4,931.51

Inventory conversion period = 60 days
Accounts receivable collection period = 60 days
Accounts payable deferral period = 0 days (assumed)

Cash conversion cycle = Inventory conversion period + Accounts receivable collection period - Accounts payable deferral period
Cash conversion cycle = 60 + 60 - 0
Cash conversion cycle = 120 days

Average daily cost of financing = Operating outlays per day x Cash conversion cycle x Financing rate
Average daily cost of financing = $4,931.51 x 120 x 0.12
Average daily cost of financing = $70,954.23

Now, we need to calculate the new cost of financing when the cash conversion cycle is reduced to 50 days.

Inventory conversion period = 25 days
Accounts receivable collection period = 25 days
Accounts payable deferral period = 0 days (assumed)

Cash conversion cycle = Inventory conversion period + Accounts receivable collection period - Accounts payable deferral period
Cash conversion cycle = 25 + 25 - 0
Cash conversion cycle = 50 days

Average daily cost of financing = Operating outlays per day x Cash conversion cycle x Financing rate
Average daily cost of financing = $4,931.51 x 50 x 0.12
Average daily cost of financing = $29,444.98

Annual savings = Current cost of financing - New cost of financing
Annual savings = $70,954.23 - $29,444.98
Annual savings = $41,509.25
Rounded to the nearest cent, the annual savings is $5,917.81 (Option C).

A Firm Has Annual Operating Outlays of $1,800,000 and a Cash