Test 4: Management of Working Capital: answer key

Question 1 · 2 marks · Management of Working Capital · medium

Scenario. Bharat Renewables Ltd manufactures solar-inverter components and supplies them to distributors across India. The sales director proposes liberalising the company's existing credit policy to increase market penetration. The finance director has been asked to evaluate the proposal using the incremental approach. The following projected annual information is available: Particulars | Existing Policy | Proposed Policy Annual credit sales | ₹4.80 crore | ₹5.60 crore Variable costs | 70% of sales | 70% of sales Average collection period | 30 days | 45 days Bad-debt losses | 1% of sales | 2% of sales Credit administration expenses | ₹2,40,000 | ₹3,00,000 Collection expenses | ₹1,20,000 | ₹1,80,000 The contribution margin remains constant under both policies. The company requires a pre-tax return of 15% on the additional investment in receivables. The financial controller uses variable costs of credit sales to estimate the funds blocked in receivables. Assume a 360-day year and ignore changes in fixed production costs and cash discounts. Additional corporate information (₹ crore): Equity share capital: 8.00 Retained earnings: 2.00 10% long-term debentures: 5.00 Projected EBIT: 3.20 Corporate tax rate: 25% Equity beta: 1.10 Risk-free rate: 6.50% Market risk premium: 6.00% Forecast annual operating cash flow: 3.80 The company currently has an operating cycle of 85 days, comprising inventory holding of 55 days, debtor collection of 50 days and supplier credit of 20 days. Management expects the proposed policy to increase debtor days but believes that the additional contribution may compensate for higher financing and credit-related costs. All credit sales are assumed to be distributed evenly throughout the year. The finance director intends to adopt the proposal only if the incremental financial benefits exceed the incremental costs.

Calculate the incremental investment in receivables arising from the proposed credit policy of Bharat Renewables Ltd. Use variable costs of credit sales for estimating the funds blocked in receivables.

1. ₹21,00,000 (correct answer)
2. ₹18,00,000
3. ₹24,00,000
4. ₹28,00,000

Answer: A — ₹21,00,000

Explanation. Existing investment = ₹4.80 crore × 70% × 30/360 = ₹28 lakh. Proposed investment = ₹5.60 crore × 70% × 45/360 = ₹49 lakh. Incremental investment = ₹49 lakh − ₹28 lakh = ₹21 lakh. The variable-cost percentage is used because the profit element in receivables does not represent funds invested by the company. Option b understates the additional investment, while option c incorrectly uses the total sales value.

Where it goes wrong. Calculating receivables using selling price rather than variable cost, or considering only the increased collection period without accounting for the increase in credit sales.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 2 · 2 marks · Management of Working Capital · hard

Determine the net incremental annual benefit of adopting the proposed credit policy of Bharat Renewables Ltd, after considering additional contribution, incremental bad debts, additional credit administration and collection expenses, and the required return on additional investment in receivables.

1. ₹15,40,000
2. ₹11,15,000
3. ₹13,25,000 (correct answer)
4. ₹16,40,000

Answer: C — ₹13,25,000

Explanation. Incremental sales = ₹80 lakh; contribution = 30% × ₹80 lakh = ₹24 lakh. Incremental bad debts = (2% × ₹560 lakh) − (1% × ₹480 lakh) = ₹6.40 lakh. Additional administration and collection costs = ₹0.60 lakh + ₹0.60 lakh = ₹1.20 lakh. Carrying cost = ₹21 lakh × 15% = ₹3.15 lakh. Net benefit = ₹24 − ₹6.40 − ₹1.20 − ₹3.15 = ₹13.25 lakh. Option d omits financing cost.

Where it goes wrong. Considering total additional sales instead of contribution, omitting incremental bad debts, or failing to charge the opportunity cost of additional receivables.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 3 · 2 marks · Management of Working Capital · hard

Assuming the proposed policy's additional administration and collection expenses and incremental investment remain unchanged, determine the maximum bad-debt percentage on proposed credit sales at which Bharat Renewables Ltd would be financially indifferent between the existing and proposed policies.

1. 3.75%
2. 4.00%
3. 4.37% (correct answer)
4. 5.20%

Answer: C — 4.37%

Explanation. Incremental contribution is ₹24 lakh. Additional administration and collection costs are ₹1.20 lakh and carrying cost is ₹3.15 lakh. Existing bad debts are ₹4.80 lakh. At break-even, proposed bad debts must equal ₹24 − ₹1.20 − ₹3.15 + ₹4.80 = ₹24.45 lakh. Therefore, maximum proposed bad-debt percentage = ₹24.45 lakh/₹560 lakh × 100 = 4.366%, approximately 4.37%. A higher percentage makes the policy financially unattractive.

Where it goes wrong. Calculating the maximum bad-debt percentage using only incremental sales or forgetting to add back the existing bad-debt amount when solving for the proposed loss level.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 4 · 2 marks · Management of Working Capital · hard

Calculate the increase in the combined annual cost of bad debts, credit administration and collection activities under the proposed policy of Bharat Renewables Ltd compared with its existing policy.

1. ₹6,40,000
2. ₹7,60,000 (correct answer)
3. ₹8,80,000
4. ₹9,60,000

Answer: B — ₹7,60,000

Explanation. Existing bad-debt losses = 1% × ₹480 lakh = ₹4.80 lakh. Proposed bad-debt losses = 2% × ₹560 lakh = ₹11.20 lakh. Increase in bad debts = ₹6.40 lakh. Administration expenses increase by ₹0.60 lakh and collection expenses by ₹0.60 lakh. Total incremental cost = ₹6.40 + ₹0.60 + ₹0.60 = ₹7.60 lakh. Option a considers bad debts alone, while option c overstates the additional operating expenses.

Where it goes wrong. Treating only defaulting costs as receivables-management costs and overlooking the increase in credit administration and collection expenditure.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 5 · 2 marks · Management of Working Capital · medium

Scenario. Zenith Power Systems Ltd manufactures electrical distribution equipment and supplies it to industrial customers on credit. Competition has intensified, and the company is considering introducing a more attractive cash discount policy to accelerate collections while increasing sales. The finance manager has prepared the following estimates for evaluating the proposed change. Particulars | Existing Policy | Proposed Policy Annual credit sales | ₹3.60 crore | ₹4.32 crore Cash discount | 1% | 2% Percentage of customers availing discount (by sales value) | 40% | 70% Average collection period | 36 days | 24 days Bad debts | 1.50% | 2.00% The contribution margin on credit sales is 25%, and variable costs constitute the remaining 75%. Administrative and collection costs are expected to remain unchanged. The company estimates the pre-tax opportunity cost of funds blocked in receivables at 18% annually. Assume a 360-day year, no change in fixed expenses and no additional credit investigation expenses. Additional corporate information (₹ crore): Equity share capital: 6.00 Retained earnings: 1.50 10.5% term loan: 4.00 Projected EBIT: 2.80 Corporate tax rate: 25% Equity beta: 0.95 Risk-free rate: 6.25% Market risk premium: 7.00% Forecast annual operating cash flow: 3.25 The company's operating cycle currently comprises raw-material storage of 25 days, WIP holding of 15 days, finished-goods storage of 20 days, debtor collection of 36 days and supplier credit of 26 days. Management expects faster collection to release funds for other productive uses. However, the sales department anticipates that the higher discount rate may increase the cost of attracting customers. The finance manager must therefore quantify the incremental contribution, bad-debt losses, cash discounts and opportunity cost savings before making a recommendation. Assume all annual credit sales are generated uniformly.

Calculate the incremental annual cash discount cost to Zenith Power Systems Ltd arising from the proposed change in cash discount terms.

1. ₹3,60,000
2. ₹5,40,000
3. ₹4,60,800 (correct answer)
4. ₹6,04,800

Answer: C — ₹4,60,800

Explanation. Existing discount cost = ₹3.60 crore × 40% × 1% = ₹1.44 lakh. Proposed discount cost = ₹4.32 crore × 70% × 2% = ₹6.048 lakh. Incremental discount cost = ₹6.048 lakh − ₹1.44 lakh = ₹4.608 lakh or ₹4,60,800. Option d represents the proposed discount cost alone, while option a understates the incremental expense by using an incorrect uptake percentage.

Where it goes wrong. Applying the discount percentage to all annual sales instead of only the sales value of customers expected to avail the discount.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 6 · 2 marks · Management of Working Capital · medium

Determine the reduction in average investment in receivables and the corresponding annual financing-cost saving under Zenith Power Systems Ltd's proposed cash discount policy.

1. ₹5,40,000 and ₹97,200 (correct answer)
2. ₹6,00,000 and ₹1,08,000
3. ₹4,80,000 and ₹86,400
4. ₹5,40,000 and ₹1,20,000

Answer: A — ₹5,40,000 and ₹97,200

Explanation. Existing receivables investment = ₹360 lakh × 75% × 36/360 = ₹27 lakh. Proposed investment = ₹432 lakh × 75% × 24/360 = ₹21.60 lakh. Funds released = ₹27 lakh − ₹21.60 lakh = ₹5.40 lakh. Annual financing-cost saving = ₹5.40 lakh × 18% = ₹97,200. Option d uses an incorrect rate of return, while options b and c miscalculate the receivables investment.

Where it goes wrong. Calculating the investment using sales value rather than variable costs, or multiplying released funds by the collection period instead of the annual opportunity cost.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 7 · 2 marks · Management of Working Capital · hard

Calculate the net incremental annual benefit of Zenith Power Systems Ltd's proposed cash discount policy, after considering incremental contribution, bad debts, discount expenditure and savings in the cost of funds blocked in receivables.

1. ₹9,18,000
2. ₹12,60,000
3. ₹10,15,200
4. ₹11,12,400 (correct answer)

Answer: D — ₹11,12,400

Explanation. Incremental contribution = ₹72 lakh × 25% = ₹18 lakh. Incremental bad debts = (2% × ₹432 lakh) − (1.5% × ₹360 lakh) = ₹3.24 lakh. Incremental discount cost = ₹4.608 lakh. Financing saving = ₹0.972 lakh. Net benefit = ₹18 − ₹3.24 − ₹4.608 + ₹0.972 = ₹11.124 lakh or ₹11,12,400. Option c fails to deduct the full incremental discount expenditure.

Where it goes wrong. Ignoring the additional discount cost or treating the reduction in receivables as a cash sales increase rather than a financing-cost saving.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 8 · 2 marks · Management of Working Capital · hard

Assuming the expected incremental sales, bad debts, discount uptake and financing-cost saving remain unchanged, determine the maximum proposed cash discount rate at which the new policy would break even for Zenith Power Systems Ltd.

1. 4.75%
2. 5.68% (correct answer)
3. 6.25%
4. 7.20%

Answer: B — 5.68%

Explanation. Incremental contribution = ₹18 lakh. Incremental bad debts = ₹3.24 lakh. Current discount cost = ₹1.44 lakh. Financing saving = ₹0.972 lakh. Let the proposed discount rate be d. Proposed discount cost = ₹432 lakh × 70% × d. Break-even condition: 18 − 3.24 − (302.4d − 1.44) + 0.972 = 0. Thus, 302.4d = 17.172 and d = 5.6786%, approximately 5.68%.

Where it goes wrong. Ignoring the existing discount cost when calculating incremental discount expenditure or incorrectly excluding the financing benefit from the break-even equation.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 9 · 2 marks · Management of Working Capital · medium

Scenario. Aditya Automotive Ltd manufactures precision components for automobile manufacturers. The company currently manages its receivables internally, but its growing customer base has increased collection and credit administration expenses. The finance director is evaluating a non-recourse factoring proposal to improve liquidity and reduce the administrative burden. The following annual information is available: Annual credit sales: ₹4.80 crore Average collection period: 60 days Expected bad-debt losses: 2% of annual credit sales Avoidable credit administration expenses: ₹2,40,000 Avoidable collection expenses: ₹1,20,000 Average required return on funds: 9% The factoring agency has offered to purchase the company's receivables on a non-recourse basis. The factor will charge commission of 1.5% of annual credit sales and will retain 10% of average receivables as a reserve. The balance will be advanced to the company. Interest on the advance will be charged at 12% per annum. Assume the advance remains outstanding at its average level during the year, and the reserve is released after customers settle their balances. Use a 360-day year. Additional corporate information (₹ crore): Equity share capital: 7.00 Retained earnings: 2.00 10% term debt: 3.50 Projected EBIT: 3.60 Corporate tax rate: 25% Equity beta: 1.15 Risk-free rate: 6.50% Market risk premium: 6.00% Forecast annual operating cash flow: 4.00 The company's operating cycle consists of raw-material storage of 30 days, WIP of 15 days, finished-goods storage of 20 days, debtor collection of 60 days and supplier credit of 35 days. A competing bank offers an overdraft facility at 9% per annum against eligible receivables. The finance director must compare the annual net cost and effective financing cost of factoring with the alternative bank facility, while recognising that non-recourse factoring transfers the ultimate default risk to the factor.

Calculate the average receivables balance and the amount advanced by the factor to Aditya Automotive Ltd after withholding the stipulated reserve.

1. ₹80,00,000 and ₹64,00,000
2. ₹80,00,000 and ₹72,00,000 (correct answer)
3. ₹60,00,000 and ₹54,00,000
4. ₹72,00,000 and ₹64,80,000

Answer: B — ₹80,00,000 and ₹72,00,000

Explanation. Average receivables = Annual credit sales × Collection period/360 = ₹4.80 crore × 60/360 = ₹80 lakh. Reserve retained by factor = 10% × ₹80 lakh = ₹8 lakh. Amount advanced = ₹80 lakh − ₹8 lakh = ₹72 lakh. The reserve protects the factor against adjustments and is released according to the agreement. Option a incorrectly deducts 20%, while option c uses an incorrect collection period.

Where it goes wrong. Treating the reserve as the amount advanced or applying the reserve percentage to annual sales instead of average outstanding receivables.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 10 · 2 marks · Management of Working Capital · hard

Determine the total annual factoring commission and interest expense payable by Aditya Automotive Ltd under the proposed factoring arrangement.

1. ₹14,40,000
2. ₹12,96,000
3. ₹17,28,000
4. ₹15,84,000 (correct answer)

Answer: D — ₹15,84,000

Explanation. Annual factoring commission = ₹4.80 crore × 1.5% = ₹7.20 lakh. The factor advances ₹72 lakh and charges annual interest of 12%. Interest expense = ₹72 lakh × 12% = ₹8.64 lakh. Total annual factoring cost = ₹7.20 lakh + ₹8.64 lakh = ₹15.84 lakh. Option a understates interest, while option c overstates the advance-related financing expense. The annual commission and interest must both be included.

Where it goes wrong. Calculating factoring commission without including the financing interest charged on the advance, or charging interest on the full receivables balance instead of the advance.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 11 · 2 marks · Management of Working Capital · hard

Calculate the net annual cost and effective cost of factoring to Aditya Automotive Ltd after incorporating savings in bad-debt losses, credit administration and collection expenditure.

1. ₹2,64,000 and 3.67% (correct answer)
2. ₹3,84,000 and 5.33%
3. ₹4,80,000 and 6.67%
4. ₹5,04,000 and 7.00%

Answer: A — ₹2,64,000 and 3.67%

Explanation. Total factoring cost = ₹15.84 lakh. Savings include bad debts of ₹4.80 crore × 2% = ₹9.60 lakh, administration ₹2.40 lakh and collection expenses ₹1.20 lakh. Total savings = ₹13.20 lakh. Net annual factoring cost = ₹15.84 − ₹13.20 = ₹2.64 lakh. Effective cost = ₹2.64 lakh/₹72 lakh × 100 = 3.67%. The denominator is the amount advanced, not total annual credit sales.

Where it goes wrong. Failing to deduct bad-debt and administration savings, or calculating the effective factoring cost as a percentage of annual sales instead of the amount advanced.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 12 · 2 marks · Management of Working Capital · hard

Aditya Automotive Ltd can alternatively borrow against eligible receivables through a bank overdraft at 9% per annum. Compare the annual overdraft interest cost with the net annual factoring cost and determine the financial advantage of adopting factoring.

1. Overdraft cost ₹8,64,000; factoring advantage ₹4,80,000
2. Overdraft cost ₹7,20,000; factoring advantage ₹4,56,000
3. Overdraft cost ₹6,48,000; factoring advantage ₹3,84,000 (correct answer)
4. Overdraft cost ₹5,40,000; factoring advantage ₹2,76,000

Answer: C — Overdraft cost ₹6,48,000; factoring advantage ₹3,84,000

Explanation. Overdraft interest = ₹72 lakh × 9% = ₹6.48 lakh annually. Net annual factoring cost, after savings in bad debts and administration, is ₹2.64 lakh. Financial advantage from factoring = ₹6.48 lakh − ₹2.64 lakh = ₹3.84 lakh. The factoring arrangement is therefore preferable on the stated annual cost comparison. Option a overstates the overdraft cost by using an incorrect interest rate or financing amount.

Where it goes wrong. Comparing the overdraft interest with gross factoring charges instead of the net annual factoring cost after deducting relevant savings.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 13 · 2 marks · Management of Working Capital · medium

Scenario. A company has average accounts receivable of ₹40 lakh and incurs an annual cost of funds of 12%. Its annual credit administration expenses are ₹1,20,000, collection expenses are ₹80,000 and annual credit sales are ₹2 crore. Bad-debt losses are 1.5% of credit sales. Calculate the total annual cost of maintaining receivables.

A company has average accounts receivable of ₹40 lakh and incurs an annual cost of funds of 12%. Its annual credit administration expenses are ₹1,20,000, collection expenses are ₹80,000 and annual credit sales are ₹2 crore. Bad-debt losses are 1.5% of credit sales. Calculate the total annual cost of maintaining receivables.

1. ₹9,80,000 (correct answer)
2. ₹8,80,000
3. ₹10,40,000
4. ₹11,00,000

Answer: A — ₹9,80,000

Explanation. Capital cost of receivables = ₹40 lakh × 12% = ₹4.80 lakh. Administrative cost = ₹1.20 lakh. Collection cost = ₹0.80 lakh. Bad-debt cost = ₹2 crore × 1.5% = ₹3 lakh. Total cost = ₹4.80 + ₹1.20 + ₹0.80 + ₹3 = ₹9.80 lakh. These represent the four principal costs of maintaining receivables. Option b omits part of the defaulting cost.

Where it goes wrong. Considering only the cost of funds and bad debts while overlooking administration and collection costs.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 14 · 2 marks · Management of Working Capital · medium

Scenario. An enterprise has annual credit sales of ₹5.40 crore. Variable costs constitute 80% of sales and its average collection period is 30 days. If the required return on funds invested in receivables is 15%, determine the annual capital cost of maintaining debtors. Assume 360 days.

An enterprise has annual credit sales of ₹5.40 crore. Variable costs constitute 80% of sales and its average collection period is 30 days. If the required return on funds invested in receivables is 15%, determine the annual capital cost of maintaining debtors. Assume 360 days.

1. ₹4,50,000
2. ₹5,40,000 (correct answer)
3. ₹6,00,000
4. ₹7,20,000

Answer: B — ₹5,40,000

Explanation. Annual variable cost of credit sales = ₹5.40 crore × 80% = ₹4.32 crore. Average investment in receivables = ₹4.32 crore × 30/360 = ₹36 lakh. Annual capital cost = ₹36 lakh × 15% = ₹5.40 lakh. Option a incorrectly uses a lower variable-cost percentage, while option d overstates the investment by applying the collection period to sales revenue rather than variable cost.

Where it goes wrong. Calculating the capital cost on total debtor balances at selling price instead of the relevant cost of credit sales.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 15 · 2 marks · Management of Working Capital · medium

Scenario. A manufacturer has annual credit sales of ₹2.40 crore and offers a cash discount of 1.5% to customers paying within the discount period. Management estimates that customers representing 50% of credit sales will avail the discount. Calculate the annual cash discount cost.

A manufacturer has annual credit sales of ₹2.40 crore and offers a cash discount of 1.5% to customers paying within the discount period. Management estimates that customers representing 50% of credit sales will avail the discount. Calculate the annual cash discount cost.

1. ₹1,20,000
2. ₹2,40,000
3. ₹1,80,000 (correct answer)
4. ₹3,60,000

Answer: C — ₹1,80,000

Explanation. Annual sales eligible for the discount = ₹2.40 crore × 50% = ₹1.20 crore. Cash discount cost = ₹1.20 crore × 1.5% = ₹1.80 lakh. This represents the reduction in realisation from customers availing the discount. Option a applies the discount to only part of the eligible sales, while option b assumes that every customer takes the discount.

Where it goes wrong. Applying the discount percentage to total credit sales without considering the proportion of customers expected to avail the discount.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 16 · 2 marks · Management of Working Capital · medium

Scenario. A company has annual credit sales of ₹4 crore. Its collection policy is being tightened, reducing the average collection period from 40 days to 30 days. Variable costs are 75% of sales, the annual cost of funds is 12%, bad-debt losses reduce from 2% to 1.25% of sales and additional collection expenses of ₹1,50,000 are incurred. Determine the annual net financial benefit of the revised collection policy.

A company has annual credit sales of ₹4 crore. Its collection policy is being tightened, reducing the average collection period from 40 days to 30 days. Variable costs are 75% of sales, the annual cost of funds is 12%, bad-debt losses reduce from 2% to 1.25% of sales and additional collection expenses of ₹1,50,000 are incurred. Determine the annual net financial benefit of the revised collection policy.

1. ₹1,50,000
2. ₹2,00,000
3. ₹3,00,000
4. ₹2,50,000 (correct answer)

Answer: D — ₹2,50,000

Explanation. Reduction in debtor investment = ₹4 crore × 75% × 10/360 = ₹8.333 lakh. Financing saving = ₹8.333 lakh × 12% = ₹1 lakh. Bad-debt saving = ₹4 crore × (2% − 1.25%) = ₹3 lakh. Total benefits = ₹4 lakh. Deduct additional collection expenses of ₹1.50 lakh. Net annual benefit = ₹2.50 lakh. The proposed collection policy is financially beneficial.

Where it goes wrong. Using total sales instead of variable costs for the reduction in receivables or ignoring the additional collection expenditure required to implement the revised policy.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 17 · 2 marks · Management of Working Capital · hard

Scenario. A manufacturer currently has annual credit sales of ₹3 crore. It proposes increasing credit sales to ₹3.60 crore by liberalising its credit policy. Contribution margin is 30%, collection period increases from 30 days to 45 days, variable costs are 70% of sales, bad debts increase from 1% to 2% of sales, and additional annual administration and collection expenses total ₹1 lakh. The required return on additional receivables investment is 15%. Calculate the net incremental annual benefit.

A manufacturer currently has annual credit sales of ₹3 crore. It proposes increasing credit sales to ₹3.60 crore by liberalising its credit policy. Contribution margin is 30%, collection period increases from 30 days to 45 days, variable costs are 70% of sales, bad debts increase from 1% to 2% of sales, and additional annual administration and collection expenses total ₹1 lakh. The required return on additional receivables investment is 15%. Calculate the net incremental annual benefit.

1. ₹10,70,000 (correct answer)
2. ₹8,60,000
3. ₹12,80,000
4. ₹9,20,000

Answer: A — ₹10,70,000

Explanation. Incremental contribution = ₹60 lakh × 30% = ₹18 lakh. Existing receivables investment = ₹300 lakh × 70% × 30/360 = ₹17.50 lakh. Proposed investment = ₹360 lakh × 70% × 45/360 = ₹31.50 lakh. Incremental investment is ₹14 lakh and its cost is ₹2.10 lakh. Incremental bad debts = ₹7.20 − ₹3.00 = ₹4.20 lakh. Net benefit = ₹18 − ₹2.10 − ₹4.20 − ₹1 = ₹10.70 lakh.

Where it goes wrong. Using the contribution margin as the receivables investment base, or failing to deduct both additional bad-debt losses and financing costs.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 18 · 2 marks · Management of Working Capital · hard

Scenario. A company is comparing two alternative credit policies against its existing policy. The data are: Existing: Credit sales ₹3.60 crore; collection period 30 days; bad debts 1%. Policy A: Credit sales ₹4.32 crore; collection period 40 days; bad debts 1.5%; additional administration and collection expenses ₹60,000. Policy B: Credit sales ₹4.50 crore; collection period 45 days; bad debts 2.5%; additional administration and collection expenses ₹90,000. Variable costs constitute 70% of sales, contribution margin is 30% and the required return on additional receivables investment is 15%. Which policy provides the higher net incremental benefit? Assume 360 days.

A company is comparing two alternative credit policies against its existing policy. The data are: Existing: Credit sales ₹3.60 crore; collection period 30 days; bad debts 1%. Policy A: Credit sales ₹4.32 crore; collection period 40 days; bad debts 1.5%; additional administration and collection expenses ₹60,000. Policy B: Credit sales ₹4.50 crore; collection period 45 days; bad debts 2.5%; additional administration and collection expenses ₹90,000. Variable costs constitute 70% of sales, contribution margin is 30% and the required return on additional receivables investment is 15%. Which policy provides the higher net incremental benefit? Assume 360 days.

1. Policy B, with a net benefit of ₹15,69,375
2. Policy A, with a net benefit of ₹16,23,000 (correct answer)
3. Both policies provide equal benefits
4. Neither policy should be adopted

Answer: B — Policy A, with a net benefit of ₹16,23,000

Explanation. Existing receivables investment = ₹360 lakh × 70% × 30/360 = ₹21 lakh. For A, investment = ₹33.60 lakh; incremental financing cost = ₹12.60 lakh × 15% = ₹1.89 lakh. Benefit = ₹21.60 − ₹2.88 − ₹0.60 − ₹1.89 = ₹16.23 lakh. For B, investment = ₹39.375 lakh; financing cost = ₹2.75625 lakh. Benefit = ₹27 − ₹7.65 − ₹0.90 − ₹2.75625 = ₹15.69375 lakh. Policy A is superior.

Where it goes wrong. Selecting the policy with the highest incremental sales without evaluating its higher bad-debt exposure and additional receivables investment.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 19 · 2 marks · Management of Working Capital · hard

Scenario. A company currently generates credit sales of ₹2.40 crore, with a contribution margin of 25%, average collection period of 45 days, bad debts of 1.2%, and a cash discount of 1% availed by 30% of customers. Under a proposed policy, sales are expected to increase by 10%, collection period will reduce to 30 days, bad debts will rise to 1.4%, and a discount of 2% will be availed by 60% of customers. Variable costs are 75% of sales and the required return on receivables is 12%. Calculate the net incremental annual benefit. Assume 360 days.

A company currently generates credit sales of ₹2.40 crore, with a contribution margin of 25%, average collection period of 45 days, bad debts of 1.2%, and a cash discount of 1% availed by 30% of customers. Under a proposed policy, sales are expected to increase by 10%, collection period will reduce to 30 days, bad debts will rise to 1.4%, and a discount of 2% will be availed by 60% of customers. Variable costs are 75% of sales and the required return on receivables is 12%. Calculate the net incremental annual benefit. Assume 360 days.

1. ₹2,64,000
2. ₹4,20,000
3. ₹3,45,600 (correct answer)
4. ₹5,16,000

Answer: C — ₹3,45,600

Explanation. Incremental contribution = ₹24 lakh × 25% = ₹6 lakh. Bad-debt increase = (1.4% × ₹264 lakh) − (1.2% × ₹240 lakh) = ₹0.816 lakh. Discount cost: existing = ₹240 lakh × 30% × 1% = ₹0.72 lakh; proposed = ₹264 lakh × 60% × 2% = ₹3.168 lakh. Incremental cost = ₹2.448 lakh. Receivables investment falls from ₹22.50 lakh to ₹16.50 lakh, saving ₹0.72 lakh. Net benefit = ₹3.456 lakh.

Where it goes wrong. Ignoring the revised cash discount uptake or calculating the collection-period financing benefit using the entire credit sales value rather than variable cost.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 20 · 2 marks · Management of Working Capital · hard

Scenario. A company has annual credit sales of ₹3.60 crore and an average collection period of 60 days. A factoring agency offers to advance 85% of average receivables. It charges annual commission of 1% of credit sales and interest of 12% on the average advance. Factoring will avoid bad-debt losses of 1.8% of sales, credit administration expenses of ₹1,20,000 and collection expenses of ₹60,000. Calculate the net annual factoring cost and its effective cost based on the advance received. Assume 360 days.

A company has annual credit sales of ₹3.60 crore and an average collection period of 60 days. A factoring agency offers to advance 85% of average receivables. It charges annual commission of 1% of credit sales and interest of 12% on the average advance. Factoring will avoid bad-debt losses of 1.8% of sales, credit administration expenses of ₹1,20,000 and collection expenses of ₹60,000. Calculate the net annual factoring cost and its effective cost based on the advance received. Assume 360 days.

1. ₹2,40,000 and 4.71%
2. ₹1,20,000 and 2.35%
3. ₹1,80,000 and 3.53%
4. ₹1,44,000 and 2.82% (correct answer)

Answer: D — ₹1,44,000 and 2.82%

Explanation. Average receivables = ₹360 lakh × 60/360 = ₹60 lakh. Advance = ₹60 lakh × 85% = ₹51 lakh. Commission = ₹360 lakh × 1% = ₹3.60 lakh. Interest = ₹51 lakh × 12% = ₹6.12 lakh. Total factoring charges = ₹9.72 lakh. Savings = Bad debts ₹6.48 lakh + administration ₹1.20 lakh + collection ₹0.60 lakh = ₹8.28 lakh. Net cost = ₹1.44 lakh. Effective cost = ₹1.44/₹51 × 100 = 2.82%.

Where it goes wrong. Subtracting only bad-debt losses from factoring charges while ignoring avoidable administration and collection expenses, or using total receivables as the effective-cost denominator.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 21 · 2 marks · Management of Working Capital · hard

Scenario. A company has annual credit sales of ₹2 crore and average receivables of ₹20 lakh. It is evaluating two factoring proposals. Both factors will advance 90% of average receivables and charge interest of 12% annually on the advance. The recourse factor charges commission of 1% of annual credit sales, whereas the non-recourse factor charges 2.5%. The company will save annual administration and collection expenses of ₹1,50,000 under either arrangement. Expected annual bad debts are 2% of sales. Determine which factoring arrangement has the lower net annual cost.

A company has annual credit sales of ₹2 crore and average receivables of ₹20 lakh. It is evaluating two factoring proposals. Both factors will advance 90% of average receivables and charge interest of 12% annually on the advance. The recourse factor charges commission of 1% of annual credit sales, whereas the non-recourse factor charges 2.5%. The company will save annual administration and collection expenses of ₹1,50,000 under either arrangement. Expected annual bad debts are 2% of sales. Determine which factoring arrangement has the lower net annual cost.

1. Non-recourse factoring, with net annual cost of ₹1,66,000 (correct answer)
2. Recourse factoring, with net annual cost of ₹2,66,000
3. Both arrangements have equal net annual cost
4. Recourse factoring, with net annual cost of ₹1,66,000

Answer: A — Non-recourse factoring, with net annual cost of ₹1,66,000

Explanation. Advance under either proposal = ₹20 lakh × 90% = ₹18 lakh. Annual interest = ₹18 lakh × 12% = ₹2.16 lakh. Recourse commission = ₹2 crore × 1% = ₹2 lakh; net cost = ₹2 + ₹2.16 − ₹1.50 = ₹2.66 lakh because bad debts remain with the company. Non-recourse commission = ₹5 lakh. Bad-debt saving = ₹4 lakh. Net cost = ₹5 + ₹2.16 − ₹1.50 − ₹4 = ₹1.66 lakh. Non-recourse factoring is preferable.

Where it goes wrong. Assuming that recourse factoring transfers default risk to the factor, or ignoring the higher commission charged for non-recourse protection.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 22 · 2 marks · Management of Working Capital · hard

Scenario. A manufacturer has annual credit sales of ₹5.40 crore and an average collection period of 60 days. A factor retains 10% of average receivables as a reserve and advances the remaining balance. Commission is 0.8% of annual credit sales, and interest is 11% annually on the advance. The arrangement saves annual bad-debt losses of ₹2,70,000 and administration costs of ₹1,20,000. Calculate the net annual factoring cost and effective cost on the advance. Assume 360 days.

A manufacturer has annual credit sales of ₹5.40 crore and an average collection period of 60 days. A factor retains 10% of average receivables as a reserve and advances the remaining balance. Commission is 0.8% of annual credit sales, and interest is 11% annually on the advance. The arrangement saves annual bad-debt losses of ₹2,70,000 and administration costs of ₹1,20,000. Calculate the net annual factoring cost and effective cost on the advance. Assume 360 days.

1. ₹10,50,000 and 12.96%
2. ₹9,33,000 and 11.52% (correct answer)
3. ₹8,91,000 and 11.00%
4. ₹12,30,000 and 15.19%

Answer: B — ₹9,33,000 and 11.52%

Explanation. Average receivables = ₹540 lakh × 60/360 = ₹90 lakh. Reserve = 10% × ₹90 lakh = ₹9 lakh; advance = ₹81 lakh. Commission = ₹540 lakh × 0.8% = ₹4.32 lakh. Interest = ₹81 lakh × 11% = ₹8.91 lakh. Total charges = ₹13.23 lakh. Savings = ₹2.70 + ₹1.20 = ₹3.90 lakh. Net cost = ₹9.33 lakh. Effective cost = ₹9.33/₹81 × 100 = 11.52%.

Where it goes wrong. Calculating commission on average receivables rather than the specified annual sales base, or calculating the effective cost on the amount of reserve withheld.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 23 · 2 marks · Management of Working Capital · hard

Scenario. A company has average receivables of ₹50 lakh. A factor will advance 80% of this amount and charge annual commission of ₹8 lakh and annual interest of ₹4 lakh. The arrangement will eliminate bad-debt losses of ₹4 lakh and avoidable administration expenses of ₹2 lakh. A bank offers an overdraft of ₹40 lakh at 16% annually. Determine the annual financial advantage of choosing factoring instead of the overdraft.

A company has average receivables of ₹50 lakh. A factor will advance 80% of this amount and charge annual commission of ₹8 lakh and annual interest of ₹4 lakh. The arrangement will eliminate bad-debt losses of ₹4 lakh and avoidable administration expenses of ₹2 lakh. A bank offers an overdraft of ₹40 lakh at 16% annually. Determine the annual financial advantage of choosing factoring instead of the overdraft.

1. ₹1,00,000
2. ₹2,00,000
3. ₹40,000 (correct answer)
4. ₹3,00,000

Answer: C — ₹40,000

Explanation. Factoring charges = Commission ₹8,00,000 + Interest ₹4,00,000 = ₹12,00,000. Savings under factoring = Bad debt loss avoided ₹4,00,000 + Administration savings ₹2,00,000 = ₹6,00,000. Net cost of factoring = ₹12,00,000 − ₹6,00,000 = ₹6,00,000. Bank overdraft interest on ₹40,00,000 at 16% = ₹6,40,000. Financial advantage of factoring = Overdraft cost ₹6,40,000 − Factoring cost ₹6,00,000 = ₹40,000.

Where it goes wrong. Comparing the gross factoring charges with overdraft interest without accounting for the savings in bad debts and administration.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 24 · 2 marks · Management of Working Capital · hard

Scenario. A company has average receivables of ₹50 lakh. A factor advances 90% of this balance and charges interest of 12% annually on the advance. The arrangement saves ₹3 lakh annually through reduced bad-debt and administration expenses. The alternative bank overdraft costs 15% annually on the same amount advanced. If annual credit sales are ₹3 crore, determine the maximum factoring commission rate on annual credit sales at which factoring and overdraft finance would have equal annual net costs.

A company has average receivables of ₹50 lakh. A factor advances 90% of this balance and charges interest of 12% annually on the advance. The arrangement saves ₹3 lakh annually through reduced bad-debt and administration expenses. The alternative bank overdraft costs 15% annually on the same amount advanced. If annual credit sales are ₹3 crore, determine the maximum factoring commission rate on annual credit sales at which factoring and overdraft finance would have equal annual net costs.

1. 1.20%
2. 1.35%
3. 1.40%
4. 1.45% (correct answer)

Answer: D — 1.45%

Explanation. Factor advance = ₹50 lakh × 90% = ₹45 lakh. Factor interest = ₹45 lakh × 12% = ₹5.40 lakh. Bank overdraft cost = ₹45 lakh × 15% = ₹6.75 lakh. At break-even, commission + ₹5.40 lakh − ₹3 lakh savings = ₹6.75 lakh. Maximum commission = ₹6.75 − ₹5.40 + ₹3 = ₹4.35 lakh. Commission percentage = ₹4.35 lakh/₹300 lakh × 100 = 1.45%.

Where it goes wrong. Ignoring the annual savings generated by factoring or comparing only the factor's interest rate with the bank's overdraft rate without including commission.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital

Question 25 · 2 marks · Management of Working Capital · hard

Scenario. A manufacturer receives a credit order with a selling value of ₹8,00,000. The variable production and selling cost is ₹6,00,000. The customer has a probability of default, and the company incurs an additional credit administration and investigation cost of ₹40,000 if credit is granted. The company earns the contribution only when the customer pays; in case of default, the entire variable cost is lost. Determine the maximum probability of customer default at which the company would be indifferent between granting and refusing credit.

A manufacturer receives a credit order with a selling value of ₹8,00,000. The variable production and selling cost is ₹6,00,000. The customer has a probability of default, and the company incurs an additional credit administration and investigation cost of ₹40,000 if credit is granted. The company earns the contribution only when the customer pays; in case of default, the entire variable cost is lost. Determine the maximum probability of customer default at which the company would be indifferent between granting and refusing credit.

1. 20% (correct answer)
2. 15%
3. 25%
4. 30%

Answer: A — 20%

Explanation. Contribution if the customer pays = ₹8 lakh − ₹6 lakh = ₹2 lakh. Let p be the probability of payment; default probability is (1 − p). Expected benefit = p × ₹2 lakh − (1 − p) × ₹6 lakh − ₹0.40 lakh. At break-even: 2p − 6 + 6p − 0.40 = 0. Therefore, 8p = 6.40 and p = 80%. Maximum default probability = full − 80% = 20%.

Where it goes wrong. Applying the default probability to selling price instead of the variable cost lost, or ignoring the additional credit investigation and administration cost.

Authority. ICAI SM: Financial Management and Strategic Management, Management of Working Capital