Question

A company has contracted with their bank to do a collection float study of their current collections process. For an average month, the bank has determined that the company has three basic batches of collections with associated collection float as listed below: Local Average Collections = $10,000,000 Days of Float = 2 Regional Average Collections = $5,000,000 Days of Float = 4 Distant Average Collections = $25,000,000 Days of Float = 6 Using the information, assume that changing to a lockbox would have no effect on the local collections (Batch #1), but would reduce the regional float (Batch #2) by 1 day and the distant float (Batch #3) by 2 days. If the company's cost of capital is 7%, what is the value of the float reduction?

Answer 1

To find the value of float reduction when a company reduces its collection float by using a lockbox, we calculate the financial benefit by determining the funds available sooner and multiplying by the company's cost of capital which sums up to $10,548.49.

Step-by-step explanation:

The value of float reduction can be calculated by taking into account the reduction in float days and the company’s cost of capital to determine the financial benefit. To calculate this, we need to determine how much money will be available sooner due to the reduced float days and multiply it by the company's cost of capital.

For the regional collections, the float is reduced by 1 day, which means the $5,000,000 will be available 1 day earlier. For the distant collections, the float is reduced by 2 days, meaning the $25,000,000 will be available 2 days earlier.

The value of float for each batch is calculated as follows:

• Regional: $5,000,000 × (1/365) × 0.07 = $959.45
• Distant: $25,000,000 × (2/365) × 0.07 = $9,589.04

The total float value is the sum of the regional and distant values, which is $10,548.49.

Note: The calculation assumes a 365-day year for simplification.

Answer 2

The value of the float reduction by switching to a lockbox system is $10,547.94, with the reduction in regional and distant collections float considering a cost of capital of 7%.

Step-by-step explanation:

To calculate the value of the float reduction for the company's collections using the information provided, we'll consider the reduction in days of float for regional and distant collections and the company's cost of capital.

Firstly, for the regional collections, the float is reduced by 1 day, which on average collects $5,000,000:

• Value of 1-day float reduction for regional collections: $5,000,000 × (1 / 365) × 0.07 = $958.90

Secondly, for the distant collections, the float is reduced by 2 days, which on average collects $25,000,000:

• Value of 2-day float reduction for distant collections: $25,000,000 × (2 / 365) × 0.07 = $9,589.04

The total value of the float reduction equals the sum of the values for regional and distant collections:

Total value of float reduction = $958.90 (regional) + $9,589.04 (distant) = $10,547.94

Therefore, the value of the float reduction by switching to a lockbox system is $10,547.94, given the company's cost of capital is 7%.