Question

Company A has an operating cycle of 43 days and Company B has an operating cycle of 97 days. If Company B pays 6% to finance its $720,000 investment in inventory, the longer operating cycle reduced Company B's earnings by $___________

Answer 1

Company B's longer operating cycle of 97 days, as compared to Company A's 43 days, results in an additional interest expense of $6,405.41 due to the financing cost of 6% annually on their inventory investment.

The question at hand involves calculating the impact of Company B's longer operating cycle on its earnings, considering the cost to finance its inventory investments. Company A has an operating cycle of 43 days, whereas Company B has an operating cycle of 97 days. The cost of financing inventory for Company B is 6% annually. To find out how much the longer operating cycle reduced Company B's earnings, we need to calculate the additional interest expense incurred due to the longer operating cycle.

First, let's determine the daily interest rate from the annual rate:
Annual Interest Rate / 365 days = Daily Interest Rate

6% / 365 = 0.016438% (Daily Interest Rate)

Next, we calculate the difference in operating cycles between the two companies:
Company B's Operating Cycle - Company A's Operating Cycle = Difference in Operating Cycle

97 days - 43 days = 54 days (Difference in Operating Cycle)

Now we can compute the additional interest expense for Company B due to the additional 54 days in its operating cycle:

$720,000 x 0.016438% x 54 days = Additional Interest Expense

Performing this calculation gives us:

$720,000 x 0.016438% x 54 days = $6,405.41

The longer operating cycle reduced Company B's earnings by $6,405.41.

Answer 2

If the firm were to borrow to invest, it would face an 8% interest rate, which is higher than the 6% return on the investment, leading to a net loss. However, since the firm has the cash, and hence no borrowing is needed, the investment's 6% return makes it profitable.

Step-by-step explanation:

When a company is considering an investment decision, it should compare the potential rate of return with the cost of any associated debt. In the scenario, a firm can potentially earn a 6% return on an investment. If the company were to take a loan to fund the investment, it would incur an 8% interest rate. However, as the firm currently has the cash available, it would not need to take on debt to make the investment.

Comparing the potential return of 6% with the avoided debt interest of 8%, we can see that if the firm were to borrow, the cost of the investment would be greater than the potential earnings, resulting in a net loss. But since the firm has the necessary funds, the investment offers a 6% return without incurring any interest costs. Therefore, the firm should proceed with the investment using its own funds, as it would yield a positive rate of return at 6%.

It's essential to always consider both the return on investment and the cost of capital when making investment decisions. In this case, using internal funds bypasses the higher cost of borrowing, making the investment a financially sound decision.