Time Bird\'s Eye Treehouses, Inc., a Kentucky company, has determined that a maj

Question

Time Bird's Eye Treehouses, Inc., a Kentucky company, has determined that a majority of its customers are located in the Pennsylvania area. It therefore is considering using a lockbox system offered by a bank located in Pittsburgh. The bank has estimated that use of the system will reduce collection time by 1.5 days. Based on the following information, should the lockbox system be adopted? Average number of payments per day 800 Average value of payment $ 750 Variable lockbox fee (per transaction) $ .15 Annual interest rate on money market securities 5.5 % How would your answer change if there were a fixed charge of $5,000 per year in addition to the variable charge? Assume 365 days per year

Explanation / Answer

Reduction in collection      = 1.5 days

Value of collection for 1.5 days = 1.5*800*750 = $ 900,000 (is the cash realesed by the system)

Lock box fee payble per day    = 800 * $0.15 = $ 120

Interest = 5.5%

Evaluation:

The PV of the lock box service is the average daily receipts times                                                                       the no of days collection is reduced                                               = 1.5 * 600000 = $ 900,000

The lock box cost per day of $ 120 is a perpetuity, whose PV is given by the daily cost/interest rate per day

                                                                                                  = 120(.055/365) = 120/0.0001506849

                                                                                                  = $ 796,364

Therefore< NPV of the lock-box system                = 900000-796364 =$ 103,636

As the NPV of the lock box system is positive, the firm can decide to avail off the Lock Box System offered by the Bank.

If the Bank charges a fixed fee of $ 5,000 per year in addition to the variable fee.

In such a case the PV of this fee, which is a perpetuity should be taken                                                                as an additional cost                                                                                 = 5000/0.055 = $ 90,909

NPV of the lock box system with the additional fixed fee = 103,636 - 90,909 = $ 12,727

As the NPV is still positive, the lock box system can be accepted with the aditional fixed fee also.

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