UPTOWN APPAREL, INC.
EXECUTIVE SUMMARYThe insightful financial manager knows the importance of minimizing the length of time the firm's resources are tied-up. He knows that the longer the cash conversion cycle, the greater his working capital should be. The case highlights one of the ways a firm could shorten its cash conversion cycle -- float management. By establishing a lock box system, the firm hopes to shorten its average collection period by reducing the time needed between when payments are placed by the customers and when spendable funds become available to the firm. In other words, the firm intends to minimize mail float, processing float and clearing float thereby freeing some cash that can be used to finance operations. Obviously, a lockbox system reduces collection float time, but not without a cost. This is the message of the case: in considering implementation of a lockbox system, the firm must perform an extensive cost-benefit analysis to determine the viability of using such a system to make sure the firm doesn't spend more by trying to cut costs.
CASE CONTEXTUptown Apparel is a New York based manufacturer and designer of women's clothing. The president of the company is Ken Casey wherein during 1981 he reviewed the financial statement for the year ended 1980. The company had improved in operation efficiency yet net income went down about a third from the previous year. The net income had dropped below $1M for the first time since 1975.
In 1978, Uptown Apparel has expanded its clothing line by purchasing a small sportswear manufacturer and soon they began producing a sportswear line. This expansion required large funding. They had to contract a $22 million loan package. As a result their interest expense for the year ended 1980 ballooned. The interest rate for these loans was on a floating basis and tied to the prime rate plus two. Interest rate forecasts for the coming year don't look so good. Casey had to come up with strategies to cushion his firm from the storm ahead. He needs to avoid as much as possible further borrowings with would further enlarge interest expense for the upcoming fiscal year. Increasing case-collection process of the company was considered. Establishing a lockbox system was studied to determine if it would be feasible to setup.
PROBLEM DEFINITIONWould a lock-box arrangement be profitable for Uptown Apparel? Given the economic forecasts for the year 1981, should the firm resort to a lock-box system as proposed by the New York Bank? The group hopes to quantify the costs and benefits of establishing a lock-box system in order to know if it would be advisable to choose such an arrangement over borrowing considering the anticipated rise in interest rates in 1981.
ALTERNATIVE COURSES OF ACTIONThese are the options available to Uptown apparel:Ã¢ÂÂ¢lockbox system orÃ¢ÂÂ¢borrow money at 19% interestDECISION FRAMEWORKIn order to resolve the problem, we will follow the following steps:1.Compute for the freed cash using the lock-box system.
2.Derive the interest expense saved from the freed cash using the forecasted borrowing interest rate.
3.Compute for the total cost of the lock-box system.
4.Compare the interest saved and cost on the lock box systemBASES OF CHOICE / AREAS FOR CONSIDERATIONSÃ¢ÂÂ¢Interest Saved: $57, 764Ã¢ÂÂ¢Cost of lock box system: $72, 526CHOICESince the cost of the lock box system is 1.25 times greater than the interest expense saved by implementing the arrangement, it would be better not to use the lock-box system and just borrow money at 19% interest.
Also, it would be advisable to consider bargaining for lower lock-box costs from the bank.