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The Prestopino Corporation is a leading U.S. producer of automobile batteries. Prestopino turns out 1,500 batteries a day at a cost of \(\$ 6\) per battery for materials and labor. It takes the firm 22 days to convert raw materials into a battery. Prestopino allows its customers 40 days in which to pay for the batteries, and the firm generally pays its suppliers in 30 days. a. What is the length of Prestopino's cash conversion cycle? b. At a steady state in which Prestopino produces 1,500 batteries a day, what amount of working capital must it finance? c. By what amount could Prestopino reduce its working capital financing needs if it was able to stretch its payables deferral period to 35 days? d. Prestopino's management is trying to analyze the effect of a proposed new production process on the working capital investment. The new production process would allow Prestopino to decrease its inventory conversion period to 20 days and to increase its daily production to 1,800 batteries. However, the new process would cause the cost of materials and labor to increase to \(\$ 7\). Assuming the change does not affect the receivables collection period (40 days) or the payables deferral period \((30\) days), what will be the length of the cash conversion cycle and the working capital financing requirement if the new production process is implemented.

Step by step solution

01

Determine the Components of the Cash Conversion Cycle (CCC)

The Cash Conversion Cycle is calculated as follows: - **Inventory Conversion Period (ICP):** Time it takes to produce and sell the product. Given as 22 days. - **Receivables Collection Period (RCP):** Time it takes to collect cash from customers. Given as 40 days. - **Payables Deferral Period (PDP):** Time the company takes to pay suppliers. Given as 30 days.

02

Calculate the Initial Cash Conversion Cycle

The Cash Conversion Cycle (CCC) is given by the formula: \[ CCC = ICP + RCP - PDP \] Substituting the given values: \[ CCC = 22 + 40 - 30 = 32 \] Therefore, Prestopino's initial CCC is 32 days.

03

Calculate the Working Capital to Finance under Initial Conditions

Working capital financing is calculated based on the cost per day times the CCC. The daily production is 1,500 batteries, and each costs $6. The daily cost is: \[ 1,500 \times 6 = 9,000 \] Therefore, the working capital needed is: \[ 9,000 \times 32 = 288,000 \]

04

Evaluate Impact of Change in Payables Deferral Period

If Prestopino increases the PDP to 35 days, recalculate the CCC: \[ CCC = 22 + 40 - 35 = 27 \] The working capital required would then be: \[ 9,000 \times 27 = 243,000 \] The reduction in working capital needed is: \[ 288,000 - 243,000 = 45,000 \]

05

Assess Impact of New Production Process on CCC and Working Capital

With the new process: - **ICP becomes 20 days** - **Daily production increases to 1,800 batteries** - **Cost per battery increases to $7** Recompute the CCC with the new ICP: \[ CCC = 20 + 40 - 30 = 30 \] Calculate the new daily cost: \[ 1,800 \times 7 = 12,600 \] New working capital needed: \[ 12,600 \times 30 = 378,000 \]

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Working Capital Management

Working capital management is essential for businesses to ensure they have enough liquidity to meet their short-term liabilities while maximizing efficiency. It involves balancing three primary components: assets, liabilities, and the cash conversion cycle (CCC). For a company like Prestopino Corporation, managing working capital effectively means ensuring that there is sufficient cash flow to fund day-to-day operations without holding excessive cash that could be better invested elsewhere.
This management process helps minimize costs and maximize returns by carefully deciding when to pay suppliers, how much inventory to hold, and how quickly to collect from customers. In the case of Prestopino, improving the payables deferral period or optimizing the inventory conversion process can lead to significant reductions in working capital requirements, thus freeing up cash for other investments.

Inventory Conversion Period

The inventory conversion period (ICP) refers to the time taken to convert raw materials into finished goods and subsequently sell them. This period is crucial in understanding how efficiently a business uses its inventory to generate sales. For Prestopino, the original ICP was 22 days, meaning it took that long to produce and sell its batteries.
Reducing the ICP can have a positive effect on a company’s cash flow, as it decreases the amount of inventory held at any one time, thus reducing storage and holding costs. For Prestopino, the new production process allows them to shorten the ICP to 20 days, making the operation more efficient. This improvement not only helps speed up the cash conversion cycle but also enables them to produce more units, fulfilling customer demand faster.

Receivables Collection Period

The receivables collection period (RCP) measures the time it takes a company to collect cash from its customers after a sale has been made. It is a critical component of the cash conversion cycle and affects a company's liquidity. Prestopino Corporation has an RCP of 40 days, indicating the average time they wait to receive payment.
Managing the RCP effectively ensures that a company does not face cash shortages. If a company can reduce this period, it can improve its cash flow and reduce the need for external financing. Strategies to improve the RCP include offering discounts for early payment or tightening credit terms.

• In Prestopino's case, maintaining a consistent RCP helps stabilize cash flow, even with changes in other components of the cash conversion cycle.

Payables Deferral Period

The payables deferral period (PDP) is the timeframe a company has to pay its suppliers. It is one of the levers in working capital management that can be adjusted to free up cash. For Prestopino, the original PDP was 30 days, giving them a month to pay bills.
By extending the PDP to 35 days, the company decreases its cash conversion cycle from 32 days to 27 days, effectively reducing the amount of working capital required. This extension means Prestopino can hold onto cash longer, thus reducing immediate financial pressure and improving liquidity.

• Finding the balance is crucial because stretching this period too far could harm supplier relationships. Businesses often negotiate better terms with suppliers to achieve the optimum PDP without affecting these relationships.