Question

Lower inventory reduces the need for working capital. If a firm reduces its working capital by $1 million by more efficient distribution, a reasonable estimate of the annual cost savings from reduced working capital needed for inventory because of efficient distribution is which of the following:

Between $800,000 and $1.2 million

Less than or equal to $0

Between $0 and $200,000

More than $1.2 million

Answer 1

Reduction in working capital reduces the Cost of Capital of an organization.

The Cost of Capital of an organization usually varies from 5%-15%

Estimated savings due to reduced working capital = 1000000*10% = $100000

The correct option is Between $0 and $200,000

Answer 2

Answer:

The most reasonable estimate of the annual cost savings from reducing working capital by $1 million due to efficient distribution is:

$$\boxed{{\displaystyle \text{Between \$0 and \$200,000}}}$$

Explanation:

1. Working Capital Cost Savings:

• Reducing working capital (e.g., inventory) lowers financing costs (e.g., interest on loans or opportunity cost of capital).

• Typical cost of capital for firms ranges 8–20% annually.

• 
  

2. Calculation:

• Savings = Reduced Working Capital × Cost of Capital

• Assuming a 10% cost of capital:

  $$\mathrm{\$}1\text{million}\times 10\mathrm{\%}=\mathrm{\$}100,000\text{annual savings}$$

• Even at a 20% cost of capital, savings would be $200,000.

• 
  

3. Why Not Higher?

• Savings cannot exceed the reduced amount ($1M) and are typically a fraction of it.

• $800K–$1.2M implies implausibly high costs (80–120% of the reduced capital).

• 
  

4. Why Not Zero?

• Efficient distribution avoids holding costs (storage, insurance, obsolescence), so savings are >$0.

• 
  

Key Assumption:

The estimate hinges on the firm’s cost of capital. For most businesses, 10% is a standard benchmark, placing savings firmly in the $0–$200K range.

Example:
If the firm’s cost of capital is 15%, savings = $150,000 (within the range).