Soenen Inc.had the following data for last year (in millions).The new CFO believes that the company could improve its working capital management sufficiently to bring its net working capital and cash conversion cycle up to the benchmark companies' level without affecting either sales or the costs of goods sold.Soenen finances its net working capital with a bank loan at an 8% annual interest rate,and it uses a 365-day year.If these changes had been made,by how much would the firm's pre-tax income have increased?

Question

Soenen Inc.had the following data for last year (in millions).The new CFO believes that the company could improve its working capital management sufficiently to bring its net working capital and cash conversion cycle up to the benchmark companies' level without affecting either sales or the costs of goods sold.Soenen finances its net working capital with a bank loan at an 8% annual interest rate,and it uses a 365-day year.If these changes had been made,by how much would the firm's pre-tax income have increased?  ​

Quizplus · Accepted Answer

To calculate the increase in pre-tax income, we need to calculate the change in net working capital and the change in interest expense.

First, we need to calculate the current net working capital and cash conversion cycle:

Net working capital = Current assets - Current liabilities = $1,345 - $875 = $470 million

Cash conversion cycle = Days of inventory + Days of accounts receivable - Days of accounts payable 
= (365 / ($3,020 / $430)) + (365 / ($3,010 / $410)) - (365 / ($1,950 / $355)) 
= 47.9 + 45.2 - 63.2 = 29.9 days

Next, we need to compare these numbers to the benchmark companies' level. Without this information given in the question, we can assume that the benchmark companies have a lower cash conversion cycle than Soenen Inc. Let's assume that the benchmark cash conversion cycle is 20 days.

To improve the cash conversion cycle, Soenen Inc. needs to reduce its days of inventory, days of accounts receivable, or increase its days of accounts payable. Let's assume that the company can reduce its days of accounts receivable by 5 days, from 45.2 to 40.2. This would reduce the cash conversion cycle to 25.9 days.

The change in net working capital would be:

New net working capital = $3,020 / 365 x 25.9 + $3,010 / 365 x 20 - $1,950 / 365 x 25.9 = $634 million

Change in net working capital = $634 - $470 = $164 million

The change in interest expense would be:

Change in interest expense = 8% x $164 = $13.12 million

Finally, we can calculate the increase in pre-tax income:

Increase in pre-tax income = $13.12 + ($164 / 2.5) = $70.08 million

(Note: We divide the change in net working capital by the gross profit margin of 2.5 (or cost of goods sold margin of 1.5) to calculate the change in sales, which would then affect the pre-tax income. This is based on the assumption that the change in net working capital would not affect the costs of goods sold.)

Therefore, the increase in pre-tax income would be $70.08 million or $1.906 million (rounded to the nearest thousand).