Question

Knob, Inc., is a nationwide distributor of furniture hardware. The company now uses a central billing system for credit sales of $180 million annually. First National, Knob’s principal bank, offers to establish a new concentration banking system for a flat fee of $100,000 per year. The bank estimates that mailing and collection time can be reduced by three days. Assume a 360-day year. a. By how much will Knob’s cash balances be increased under the new system? (Enter your answer in dollars not in millions.) Increase in cash balance $ b. Assume that the borrowing rate is 12%. How much extra interest income will the new system generate if the extra funds are used to reduce borrowing under Knob’s line of credit with First National? (Enter your answer in dollars not in millions.) Interest savings $ c. Calculate the total annual cost of the old system if collection costs under the old system are $40,000 per year? (Enter your answer in dollars not in millions.)

Answer 1

a) As the total credit sales is $180 million annually and collection time is reduced by 3 days so we can say that the cash balance would be increasing as under:

Annual Credit Sales:

$180,000,000.00

3 days sales: $180,000,000.00 x 3/360 = $1,500,000.00 ( This would be the increase in cash balance.)

b) The increased cash balance of $1,500,000.00 will save extra interest of $1,500,000.00 x 12% = $180,000.00

c) Total annual cost of the old system = $40,000.00 + $180,000.00 (Additional interest cost incurred because of delayed collection) = $220,000.00