FM11 Ch 22 Test Bank

CHAPTER 22 WORKING CAPITAL MANAGEMENT (Difficulty: E = Easy, M = Medium, and T = Tough)

True-False Easy: Net working capital 1

.

Answer: b

Diff: E

Net working capital may be defined as current assets minus current liabilities. This also defines the current ratio. a. True b. False

Net working capital 2

.

Answer: b

Diff: E

Net working capital is defined as current assets divided by current liabilities. a. True b. False

Working capital 3

.

An increase in a current asset account must corresponding increase in a liability account.

Answer: b be

Diff: E

accompanied

by

a

a. True b. False Working capital policy 4

.

Answer: a

Diff: E

Determination of a firm's investment in net operating working capital and how that investment is financed are elements of working capital policy. a. True b. False

Goal of cash management 5

.

Answer: a

Diff: E

Cash is often referred to as a "non-earning" asset. Thus, one goal of cash management is to minimize the amount of cash necessary to conduct business. a. True b. False

Chapter 22 - Page 1

Motives for holding cash 6

.

Answer: a

Diff: E

Firms hold cash balances in order to complete transactions that are necessary in business operations and as compensation to banks for providing loans and services. a. True b. False

Cash budget 7

.

Answer: a

Diff: E

A firm's peak borrowing needs will probably be overstated if it bases its monthly cash budget on uniform cash receipts and disbursements, but actual receipts are concentrated at the beginning of each month. a. True b. False

Cash budget 8

.

Answer: a

Diff: E

Shorter-term cash budgets, in general, are used for actual cash control while longer-term budgets are used primarily for planning purposes. a. True b. False

Float 9

.

Answer: a

Diff: E

For a firm that makes heavy use of float, being able to forecast its collections and disbursement check clearings is essential. a. True b. False

Lockbox 10

.

Answer: a

Diff: E

Lockbox arrangements are one way for a firm to speed up its collection of payments from customers. a. True b. False

Receivables balance 11

.

Answer: b

Diff: E

Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio will also have a high payables-to-sales ratio. a. True b. False

Chapter 22 - Page 2

Receivables balance 12

.

Answer: a

Diff: E

The average accounts receivables balance is determined jointly by the volume of credit sales and the days sales outstanding. a. True b. False

Receivables aging 13

.

Answer: b

Diff: E

If a firm has a large percentage of accounts over 30 days old, it is a sign that the firm's receivables management needs to be reviewed and improved. a. True b. False

Monitoring receivables 14

.

Answer: a

Diff: E

The aging schedule is a commonly used method of monitoring receivables. a. True b. False

Credit policy 15

.

Answer: a

Diff: E

The four major elements in a firm's credit policy are (1) credit standards, (2) discounts offered, (3) credit period, and (4) collection policy. a. True b. False

Cash discounts 16

.

Answer: b

Diff: E

If you receive some goods on April 1 with the following terms; 3/20, net 30, June 1 dating, it means that you will receive a 3 percent discount if the bill is paid on or before June 20 and that the full amount must be paid 30 days after receipt of the goods. a. True b. False

Trade discounts 17

.

Answer: b

Diff: E

Offering trade credit discounts is costly to a firm and as a result, firms that offer trade discounts are usually those that are performing poorly and need cash quickly. a. True b. False

Chapter 22 - Page 3

Change in credit policy 18

.

Answer: a

Diff: E

A firm changes its credit policy from 2/10, net 30, to 3/10, net 30. The change is meant to meet competition, so no increase in sales is expected. Average accounts receivable will probably decline as a result of this change. a. True b. False

Goal of inventory management 19

.

Answer: b

Diff: E

The central goal of inventory management is to provide sufficient incentives to ensure that the firm never suffers a stock-out (i.e., runs out of an inventory item). a. True b. False

Goal of inventory management 20

.

Answer: a

Diff: E

The principal goal of most inventory management systems is to balance the costs of ordering, shipping, and receiving goods with the cost of carrying those goods, while simultaneously meeting the firm's policy with respect to avoiding running short of stock and disrupting production schedules. a. True b. False

Inventory management interaction 21

.

Answer: b

Diff: E

Inventory management is largely self-contained, that is, only minimum coordination among other departments such as sales, purchasing, and production is required for successful inventory management. a. True b. False

Working capital financing 22

.

Answer: a

Diff: E

Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive working capital financing strategy because of the inherent risks of using short-term financing. a. True b. False

Chapter 22 - Page 4

Permanent working capital 23

.

Answer: a

Diff: E

Permanent net operating working capital reflects the fact that net operating working capital does not shrink to zero even when business is at a seasonal or cyclical low. Thus, permanent net operating working capital represents a minimum level of net operating working capital the firm must finance. a. True b. False

Conservative financing approach 24

.

Answer: a

Diff: E

A conservative financing approach to working capital will result in all permanent net operating working capital being financed using long-term securities. a. True b. False

Accruals 25

.

Answer: a

Diff: E

Accruals are "free" financing in the sense that no explicit interest is paid on accruals. a. True b. False

Accruals Answer: a Diff: E 26 . Accruals are “spontaneous,” but, unfortunately, due to law and economic forces, firms have little control over the level of these accounts. a. True b. False Accruals 27

.

Answer: b

Diff: E

The fact that no explicit interest cost is paid on accruals, and that the firm can exercise considerable control over their level, makes accruals an attractive source of additional funding. a. True b. False

Trade credit 28

.

Answer: b

Diff: E

If a firm is offered credit terms of 2/10, net 30, it is in the firm's financial interest to pay as early as possible during the discount period. a. True b. False

Chapter 22 - Page 5

Trade credit 29

.

Answer: b

Diff: E

Trade credit can be separated into two components: free trade credit, which involves credit received after the discount period ends, and costly trade credit, which is the cost of discounts not taken. a. True b. False

Trade credit 30

.

Answer: a

Diff: E

As a rule, managers should try to always use the free component of trade credit but should use the costly component only after comparing its costs to the costs of similar credit from other sources. a. True b. False

Trade credit 31

.

Answer: a

Diff: E

Trade credit is an inexpensive source of short-term financing if no discounts are offered. a. True b. False

Trade credit 32

.

Answer: a

Diff: E

When deciding whether or not to take a trade discount, the cost of borrowing funds should be compared to the cost of trade credit to determine if the cash discount should be taken. a. True b. False

Cost of trade credit 33

.

Answer: a

Diff: E

The calculated cost of trade credit is reduced by paying late. a. True b. False


.

Answer: a

Diff: E

The calculated cost of trade credit for a firm that buys on terms of 2/10, net 30, is lower (other things held constant) if the firm pays in 40 days than if it pays in 30 days. a. True b. False

Chapter 22 - Page 6


.

Answer: a

Diff: E

One of the disadvantages of not taking trade credit discounts when offered is that the firm's investment in accounts payable rises. a. True b. False

Net trade credit 36

.

Answer: b

Diff: E

A firm is said to be extending net trade credit when its accounts receivable are less than its accounts payable. a. True b. False

Net trade credit 37

.

Answer: a

Diff: E

When a firm has accounts payable that are greater than the level of its receivables, the firm is actually receiving net trade credit. a. True b. False

Stretching accounts payable 38

.

"Stretching" accounts financing technique.

Answer: b payable

is

a

widely

accepted

and

Diff: E costless

a. True b. False Short-term financing 39

.

Answer: a

Diff: E

Short-term financing may be riskier than long-term financing since, during periods of tight credit, the firm may not be able to rollover (renew) its debt. a. True b. False

Short-term financing 40

.

Answer: a

Diff: E

One of the advantages of short-term debt financing is that firms can expand or contract their short-term credit more easily than their longterm credit. a. True b. False

Chapter 22 - Page 7


.

Answer: a

Diff: E

Short-term loans generally are obtained faster than long-term loans because when lenders consider long-term loans they insist on a more thorough evaluation of the borrower's financial health and because the loan agreement is more complex. a. True b. False

Bank loans 42

.

Answer: b

Diff: E

A line of credit and a revolving credit agreement are similar except that a line of credit creates a legal obligation for the bank. a. True b. False

Bank loans 43

.

Answer: a

Diff: E

The maturity of most bank loans is short-term. Bank to business loans are frequently 90-day notes which are often rolled over, or renewed, at the end of their maturity. a. True b. False

Promissory note 44

.

Answer: b

Diff: E

A promissory note is the document signed when a bank loan is executed and it specifies financial aspects of the loan. The separate indenture note will specify items such as collateral and other terms and conditions. a. True b. False

Line of credit 45

.

Answer: a

Diff: E

A line of credit can be either a formal or informal agreement between borrower and bank regarding the maximum amount of credit the bank will extend to the borrower subject to certain conditions. a. True b. False

Revolving credit and risk 46

.

Answer: a

Diff: E

Under a revolving credit agreement the risk to the firm of being unable to obtain funds when needed is lower than with a line of credit. a. True b. False

Chapter 22 - Page 8

Medium: Cash and capital budgets 47

.

Answer: b

Diff: M

The cash budget and the capital budget are planned separately, and although they are both important to the firm, they are independent of each other. a. True b. False

Cash budget and depreciation 48

.

Answer: b

Diff: M

Since depreciation is a non-cash charge it does not appear nor have an effect on the cash budget. a. True b. False

Seasonal patterns and cash 49

.

Answer: b

Diff: M

The target cash balance is set optimally such that it need not be adjusted for seasonal patterns and unanticipated fluctuations although it is changed to reflect long-term changes in the firm's operations. a. True b. False

Synchronization of cash flows 50

.

Answer: a

Diff: M

Synchronization of cash flows is an important cash management technique and effective synchronization can actually increase a firm's profitability. a. True b. False

Float 51

.

Answer: b

Diff: M

Collections float offsets disbursement float. If a firm's collections float is greater than its disbursement float then a firm is said to operate with positive net float. a. True b. False

Float 52

.

Answer: b

Diff: M

A lockbox plan is one method of speeding up the check-clearing process for customer payments and decreasing the firm's net float position. a. True b. False

Chapter 22 - Page 9

Lockbox 53

.

Answer: b

Diff: M

A firm has a daily average collection of checks equal to $250,000. It takes the firm approximately 4 days to convert the funds into usable cash. Assume (1) a lockbox system could be employed which would reduce the cash conversion procedure to 2 ½ days and (2) the firm could invest any additional cash received at 6 percent after taxes. The lockbox system would be a good buy if it costs only $23,000 annually. a. True b. False

Receivables and growth 54

.

Answer: b

Diff: M

A firm which makes 90 percent of its sales on credit and 10 percent for cash is currently growing at a rate of 10 percent annually. If the firm maintains stable growth it will also be able to maintain its accounts receivable at its current level, since the 10 percent cash sales can be used to manage the 10 percent growth rate. a. True b. False

Receivables and growth 55

.

Answer: a

Diff: M

In managing a firm's accounts receivable it is possible to increase credit sales per day yet still keep accounts receivable fairly steady if the firm can shorten the length of its collection period. a. True b. False

Collection policy 56

.

Answer: b

Diff: M

A firm's collection policy and the procedures it follows to collect accounts receivable play an important role in keeping its deferrables period short, although too strict a collection policy can result in outright losses due to non-payment. a. True b. False

Collection policy 57

.

Answer: a

Diff: M

Changes in a firm's collection policy can affect sales, working capital and even additional funds needed. a. True b. False

Chapter 22 - Page 10

Cash versus credit sales 58

.

In part because money has time value, cash profitable and more valuable than credit sales.

Answer: b sales

are

Diff: M

always

more

a. True b. False Days sales outstanding 59

.

Answer: a

Diff: M

If a firm's sales and those of its customers are closely correlated with economic conditions, it is certainly possible for a firm's total investment in accounts receivable to decrease while its days sales outstanding increases. a. True b. False

Extending the credit period 60

.

Answer: a

Diff: M

Generally, the longer the normal inventory holding period of a customer the longer the credit period. One effect of extending the credit period to match the customer's merchandise holding period is to increase the deferrables period which actually serves to shorten the customer's cash conversion cycle. a. True b. False

DSO and past due accounts 61

.

Answer: b

Diff: M

If a firm's terms are 2/10, net 30 days, and its DSO is 28 days, we can be certain that the credit department is functioning efficiently and the percentage of past due accounts is minimal. a. True b. False

Aging schedule and credit policy 62

.

Answer: b

Diff: M

If your firm's DSO or aging schedule deteriorates from the first quarter of the year to the second quarter, this is a clear indication that your firm's credit policy has weakened. a. True b. False

Maturity matching 63

.

Answer: a

Diff: M

Uncertainty about the exact lives of assets prevents precise maturity matching in an ex post (i.e., after the fact) sense even though it is possible to maturity match on an expected basis. a. True b. False Chapter 22 - Page 11

Maturity matching 64

.

Answer: b

Diff: M

The maturity matching or "self-liquidating" approach involves the financing of permanent net operating working capital with combinations of long-term capital and short-term capital depending on the level of interest rates. When short-term rates are high, short-term assets will be financed with long-term debt to reduce cost and risk. a. True b. False

Aggressive financing approach 65

.

Answer: a

Diff: M

A firm adopting an aggressive working capital financing approach is more sensitive to unexpected changes in the term structure of interest rates than is a firm with a conservative financing policy. a. True b. False

Aggressive financing approach 66

.

Answer: b

Diff: M

A firm that employs an aggressive working capital financing policy stands to increase profitability when the yield curve changes from upward sloping to downward sloping. a. True b. False

Risk and short-term financing 67

.

Answer: a

Diff: M

The risk to the firm of borrowing using short-term credit is usually greater than with long-term debt. Added risk stems from greater variability of interest costs on short-term debt. Even if its long-term prospects are good, the firm's lender may not renew a short-term loan if the firm is even only temporarily unable to repay it. a. True b. False


.

Answer: b

Diff: M

Long-term loan agreements always contain provisions, or covenants, which constrain the firm's future actions. Short-term credit agreements are just as restrictive in order to protect the interests of the lender. a. True b. False



.

Answer: a

Diff: M

A firm constructing a new manufacturing plant and financing it with short-term loans that are scheduled to be converted to first mortgage bonds when the plant is completed, would want to separate the construction loan from other current liabilities associated with working capital management. a. True b. False

Trade credit 70

.

Answer: b

Diff: M

If a firm fails to take trade credit discounts it may cost the firm money, but generally such a policy has a negligible effect on the firm's income statement and no effect on the firm's balance sheet. a. True b. False


.

Answer: a

Diff: M

If a firm is involuntarily "stretching" its accounts payable then this is one sign that it is undercapitalized, that is, that it needs more working capital for operations. a. True b. False


.

Answer: b

Diff: M

A firm that "stretches" its accounts payable rather than paying on net terms is actually increasing its calculated cost of credit given that it already does not take discounts when offered, other things held constant. a. True b. False


.

Answer: b

Diff: M

If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but does not represent a real financial cost to your firm as long as the firm periodically pays off its entire balance. a. True b. False


Prime rate 74

.

Answer: b

Diff: M

The prime rate charged by big money center banks can vary greatly (for example, as much as 2 to 4 percentage points) across banks due to banks' ability to differentiate themselves and because particular banks develop particular clienteles, such as mainly making loans to small firms. a. True b. False

Revolving credit agreement 75

.

Answer: a

Diff: M

A revolving credit agreement is a formal line of credit usually used by large firms. The firm will pay a fee on the unused balance of the committed funds to compensate the bank for the commitment to extend those funds. a. True b. False

Multiple Choice: Conceptual Easy: Working capital 76

.

Other things held constant, increase in working capital?

Answer: c which

of

the

following

will

Diff: E cause

an

a. b. c. d.

Cash is used to buy marketable securities. A cash dividend is declared and paid. Merchandise is sold at a profit, but the sale is on credit. Long-term bonds are retired with the proceeds of a preferred stock issue. e. Missing inventory is written off against retained earnings. Cash conversion cycle 77

.

Answer: b

Diff: E

Helena Furnishings wants to sharply reduce its cash conversion cycle. Which of the following steps would reduce its cash conversion cycle? a. The company increases its average inventory without increasing its sales. b. The company reduces its DSO. c. The company starts paying its bills sooner, which reduces its average accounts payable without reducing its sales. d. Statements a and b are correct. e. All of the statements above are correct.


Cash budget 78

.

Payments lag. Payment for plant construction. Cumulative cash. Statements a and c are correct. All of the statements above are correct.

Cash budget .

Diff: E

Which of the following is typically part of the cash budget? a. b. c. d. e.

79

Answer: e

Answer: a

Diff: E

Which of the following statements concerning the cash budget is correct? a. Depreciation expense is not explicitly included, but depreciation effects are implicitly included in estimated tax payments. b. Cash budgets do not include financial expenses such as interest and dividend payments. c. Cash budgets do not include cash inflows from long-term sources such as bond issues. d. Statements a and b are correct. e. Statements a and c are correct.

Cash budget 80

.

Its monthly depreciation expense. Its cash proceeds from selling one of its divisions. Interest paid on its bank loans. Statements b and c are correct. All of the statements above are correct.

Marketable securities .

Diff: E

Which of the following items should a company explicitly include in its monthly cash budget? a. b. c. d. e.

81

Answer: d

Answer: a

Diff: E

Which of the following is not a situation that might lead a firm to hold marketable securities? a. The firm has purchased a fixed asset that will require a large writeoff of depreciable expense. b. The firm must meet a known financial commitment, such as financing an ongoing construction project. c. The firm must finance seasonal operations. d. The firm has just sold long-term securities and has not yet invested the proceeds in earning assets. e. None of the statements above is correct. (All of the situations might lead the firm to hold marketable securities.)


Monitoring receivables 82

.

Answer: b

Analyzing days sales outstanding (DSO) and the aging schedule are two common methods for monitoring receivables. However, they can provide erroneous signals to credit managers when a. b. c. d. e.

Customers’ payments patterns are changing. Sales fluctuate seasonally. Some customers take the discount and others do not. Sales are relatively constant, either seasonally or cyclically. None of the statements above is correct.

Credit policy 83

.

Answer: e

Credit period. Collection policy. Credit standards. Cash discounts. All of the statements above are credit policy variables.

Credit policy .

Answer: d

It normally stimulates sales. To meet competitive pressures. To increase the firm’s deferral period for payables. Statements a and b are correct. All of the statements above are correct.

Inventory management .

Diff: E

If easing a firm’s credit policy lengthens the collection period and results in a worsening of the aging schedule, then why do firms take such actions? a. b. c. d. e.

85

Diff: E

Which of the following is not commonly regarded as being a credit policy variable? a. b. c. d. e.

84

Diff: E

Which of the management? a. b. c. d. e.

Answer: e following

might

be

attributed

to

High inventory turnover ratio. Low incidence of production schedule disruptions. High total assets turnover. Statements a and c are correct. All of the statements above are correct.


efficient

Diff: E

inventory

Working capital financing policy 86

.

Firms generally choose to finance capital with short-term debt because

temporary

net

Answer: a

Diff: E

operating

working

a. Matching the maturities of assets and liabilities reduces risk. b. Short-term interest rates have traditionally been more stable than long-term interest rates. c. A firm that borrows heavily long-term is more apt to be unable to repay the debt than a firm that borrows heavily short-term. d. The yield curve has traditionally been downward sloping. e. Sales remain constant over the year, and financing requirements also remain constant. Commercial paper 87

.

Which of the incorrect?

Answer: d following

statements

concerning

commercial

Diff: E

paper

is

a. Commercial paper is generally written for terms less than 270 days. b. Commercial paper generally carries an interest rate below the prime rate. c. Commercial paper is sold to money market mutual funds, as well as to other financial institutions and nonfinancial corporations. d. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. e. Commercial paper is a type of unsecured promissory note issued by large, strong firms. Working capital financing 88

.

Answer: e

Diff: E

Which of the following statements is most correct? a. Trade credit is provided to a business only when purchases are made. b. Commercial paper is a form of short-term financing that is primarily used by large, financially stable companies. c. Short-term debt, while often cheaper than long-term debt, exposes a firm to the potential problems associated with rolling over loans. d. Statements b and c are correct. e. All of the statements above are correct.


Working capital financing 89

.

Answer: a

Diff: E

Which of the following statements is incorrect? a. Commercial paper can be issued by virtually any firm so long as it is willing to pay the going interest rate. b. Accruals are “free” in the sense that no explicit interest is paid on these funds. c. A conservative approach to working capital will result in all permanent assets being financed using long-term securities. d. The risk to the firm of borrowing with short-term credit is usually greater than with long-term debt. Added risk can stem from greater variability of interest costs on short-term debt. e. Bank loans have a lower interest rate than commercial paper.

Cash management 90

.

Answer: a

Diff: E

Which of the following statements is most correct? a. A cash management system which minimizes collections float and maximizes disbursement float is better than one with higher collections float and lower disbursement float. b. A cash management system which maximizes collections float and minimizes disbursement float is better than one with lower collections float and higher disbursement float. c. The use of a lockbox is designed to minimize cash theft losses. If the cost of the lockbox is less than theft losses saved, then the lockbox should be installed. d. Other things held constant, a firm will need an identical line of credit if it can arrange to pay its bills by the 5th of each month than if its bills come due uniformly during the month. e. The statements above are all false.

Cash management 91

.

Answer: e

Diff: E

Which of the following statements is most correct? a. A good cash management system would minimize disbursement float and maximize collections float. b. If a firm begins to use a well-designed lockbox system, this will reduce its customers' net float. c. In the early 1980's, the prime interest rate hit a high of 21 percent. In 1995 the prime rate was considerably lower. That sharp interest rate decline has increased firms' concerns about the efficiency of their cash management programs. d. If a firm can get its customers to permit it to pay by wire transfers rather than having to write checks, this will increase its net float and thus reduce its required cash balances. e. A firm which has such an efficient cash management system that it has positive net float can have a negative checkbook balance at most times and still not have its checks bounce.


Lockbox 92

.

Answer: d

Diff: E

A lockbox plan is a. b. c. d. e.

A method for safe-keeping of marketable securities. Used to identify inventory safety stocks. A system for slowing down the collection of checks written by a firm. A system for speeding up a firm's collections of checks received. Not described by any of the statements above.

Medium: Cash conversion cycle 93

.

Maintain the level of receivables as sales decrease. Buy more raw materials to take advantage of price breaks. Take discounts when offered. Forgo discounts that are currently being taken. Offer a longer deferral period to customers.

Cash conversion cycle .

Diff: M

Ignoring cost and other effects on the firm, which of the following measures would tend to reduce the cash conversion cycle? a. b. c. d. e.

94

Answer: d

Answer: d

Diff: M

Which of the following actions are likely to reduce the length of a company’s cash conversion cycle? a. Adopting a new inventory system that reduces the inventory conversion period. b. Reducing the average days sales outstanding (DSO) on its accounts receivable. c. Reducing the amount of time the company takes to pay its suppliers. d. Statements a and b are correct. e. All of the statements above are correct.


Cash balances 95

.

Answer: c

Diff: M

Which of the following statements is most correct? a. The cash balances of most firms consist of transactions, compensating, and precautionary balances. The total desired cash balance can be determined by calculating the amount needed for each purpose and then summing them together. b. The easier a firm’s access to borrowed funds, the higher its precautionary balances will be in order to protect against sudden increases in interest rates. c. For some firms holding highly liquid marketable securities is a substitute for holding cash, because the marketable securities accomplish the same objective as cash. d. All companies hold the same amount of funds for a transaction balance. e. None of the statements above is correct.

Cash budget 96

.

Answer: e

Diff: M

Which of the following statements is most correct? a. Shorter-term cash budgets, in general, are used primarily for planning purposes, while longer-term budgets are used for actual cash control. b. The cash budget and the capital budget are planned separately and although they are both important to the firm, they are independent of each other. c. Since depreciation is a non-cash charge, it does not appear on nor have an effect on the cash budget. d. The target cash balance is set optimally such that it need not be adjusted for seasonal patterns and unanticipated fluctuations in receipts, although it is changed to reflect long-term changes in the firm’s operations. e. The typical actual cash budget will reflect interest on loans and income from investment of surplus cash. These numbers are expected values and actual results might vary from budgeted results.

Marketable securities portfolio 97

.

Answer: d

Diff: M

Which of the following statement completions is most correct? If the yield curve is upward sloping, then a firm’s marketable securities portfolio, assumed to be held for liquidity purposes, should be a. b. c. d. e.

Weighted toward long-term securities because they pay higher rates. Weighted toward short-term securities because they pay higher rates. Weighted toward U.S. Treasury securities to avoid interest rate risk. Weighted toward short-term securities to avoid interest rate risk. Balanced between long- and short-term securities to minimize the effects of either an upward or a downward trend in interest rates.


Compensating balances 98

.

Answer: c

Diff: M

Which of the following statements is most correct? a. Compensating balance requirements apply only to businesses, not to individuals. b. Compensating balances are essentially costless to most firms, because those firms would normally have such funds on hand to meet transactions needs anyway. c. If the required compensating balance is larger than the transactions balance the firm would ordinarily hold, then the effective cost of any loan requiring such a balance is increased. d. Banks are prohibited from earning interest on the funds they force businesses to keep as compensating balances. e. None of the statements above is correct.

Receivables management 99

.

Answer: b

Diff: M

Which of the following statements is most correct? a. A firm that makes 90 percent of its sales on credit and 10 percent for cash is growing at a rate of 10 percent annually. If the firm maintains stable growth it will also be able to maintain its accounts receivable at its current level, since the 10 percent cash sales can be used to manage the 10 percent growth rate. b. In managing a firm’s accounts receivable it is possible to increase credit sales per day yet still keep accounts receivable fairly steady if the firm can shorten the length of its collection period. c. If a firm has a large percentage of accounts over 30 days old, it is a sign that the firm’s receivables management needs to be reviewed and improved. d. Since receivables and payables both result from sales transactions, a firm with a high receivables-to-sales ratio should also have a high payables-to-sales ratio. e. None of the statements above is correct.

DSO and aging schedule 100

.

Answer: c

Diff: M

Which of the following statements is most correct? a. If a firm’s volume of credit sales declines then its DSO will also decline. b. If a firm changes its credit terms from 1/20, net 40 days, to 2/10, net 60 days, the impact on sales can’t be determined because the increase in the discount is offset by the longer net terms, which tends to reduce sales. c. The DSO of a firm with seasonal sales can vary. While the sales per day figure is usually based on the total annual sales, the accounts receivable balance will be high or low depending on the season. d. An aging schedule is used to determine what portion of customers pay cash and what portion buy on credit. e. Aging schedules can be constructed from the summary data provided in the firm’s financial statements. Chapter 22 - Page 21

Days sales outstanding (DSO) 101

.

Answer: c

Diff: M

Which of the following statements is most correct? a. Other things held constant, the higher a firm’s days sales outstanding (DSO), the better its credit department. b. If a firm that sells on terms of net 30 changes its policy and begins offering all customers terms of 2/10, net 30 days, and if no change in sales volume occurs, then the firm’s DSO will probably increase. c. If a firm sells on terms of 2/10, net 30 days, and its DSO is 30 days, then its aging schedule would probably show some past due accounts. d. Statements a and c are correct. e. None of the statements above is correct.

Working capital policy 102

.

Answer: d

Diff: M

Which of the following statements is incorrect about working capital policy? a. A company may hold a relatively large amount of cash if it anticipates uncertain sales levels in the coming year. b. Credit policy has an impact on working capital since it has the potential to influence sales levels and the speed with which cash is collected. c. The cash budget is useful in determining future financing needs. d. Holding minimal levels of inventory can reduce inventory carrying costs and cannot lead to any adverse effects on profitability. e. Managing working capital levels is important to the financial staff since it influences financing decisions and overall profitability of the firm.

Miscellaneous concepts 103

.

Answer: e

Diff: M

Which of the following statements is most correct? a. Depreciation is included in the estimate of cash flows (Cash flow = Net income + Depreciation), so depreciation is set forth on a separate line in the cash budget. b. If cash inflows and cash outflows occur on a regular basis, such as the situation in which inflows from collections occur in equal amounts each day and most payments are made regularly on the 10th of each month, then it is not necessary to use a daily cash budget. A cash budget prepared at the end of the month will suffice. c. Sound working capital policy is designed to maximize the time between cash expenditures on materials and the collection of cash on sales. d. Statements b and c are correct. e. None of the statements above is correct.



.

Answer: c

Diff: M

Ski Lifts Inc. is a highly seasonal business. The following summary balance sheet provides data for peak and off-peak seasons (in thousands of dollars): Cash Marketable securities Accounts receivable Inventories Net fixed assets Total assets

Peak $ 50 0 40 100 500 $690

Off-peak $ 30 20 20 50 500 $620

Spontaneous liabilities Short-term debt Long-term debt Common equity Total claims

$ 30 50 300 310 $690

$ 10 0 300 310 $620

From this data we may conclude that a. Ski Lifts has a working capital financing policy of exactly matching asset and liability maturities. b. Ski Lifts’ working capital financing policy is relatively aggressive; that is, the company finances some of its permanent assets with short-term discretionary debt. c. Ski Lifts follows a relatively conservative approach to working capital financing; that is, some of its short-term needs are met by permanent capital. d. Without income statement data, we cannot determine the aggressiveness or conservatism of the company’s working capital financing policy. e. Statements a and c are correct. Working capital financing policy 105

.

Answer: b

Diff: M

Which of the following statements is most correct? a. Net working capital may be defined as current assets minus current liabilities. Any increase in the current ratio will automatically lead to an increase in net working capital. b. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive strategy because of the inherent risks of using short-term financing. c. If a company follows a policy of “matching maturities,” this means that it matches its use of common stock with its use of long-term debt as opposed to short-term debt. d. All of the statements above are correct. e. None of the statements above is correct.



.

Answer: c

Diff: M

Which of the following statements is most correct? a. Accruals are an expensive way to finance working capital. b. A conservative financing policy is one in which the firm finances all of its fixed assets with long-term capital and part of its permanent net operating working capital with short-term, nonspontaneous credit. c. If a company receives trade credit under the terms 2/10, net 30 days, this implies the company has 10 days of free trade credit. d. Statements a and b are correct. e. None of the answers above is correct.


.

Answer: a

Diff: M

Which of the following statements is most correct? a. Under normal conditions, a firm’s expected ROE would probably be higher if it financed with short-term rather than with long-term debt, but the use of short-term debt would probably increase the firm’s risk. b. Conservative firms generally use no short-term debt and thus have zero current liabilities. c. A short-term loan can usually be obtained more quickly than a longterm loan, but the cost of short-term debt is likely to be higher than that of long-term debt. d. If a firm that can borrow from its bank buys on terms of 2/10, net 30 days, and if it must pay by Day 30 or else be cut off, then we would expect to see zero accounts payable on its balance sheet. e. If one of your firm’s customers is “stretching” its accounts payable, this may be a nuisance but does not represent a real financial cost to your firm as long as the firm periodically pays off its entire balance.


Short-term versus long-term financing 108

.

Answer: d

Diff: M

Which of the following statements is most correct? a. Under normal conditions the shape of the yield curve implies that the interest cost of short-term debt is greater than that of long-term debt, although short-term debt has other advantages that make it desirable as a financing source. b. Flexibility is an advantage of short-term credit but this is somewhat offset by the higher flotation costs associated with the need to repeatedly renew short-term credit. c. A short-term loan can usually be obtained more quickly than a longterm loan but the penalty for early repayment of a short-term loan is significantly higher than for a long-term loan. d. Statements about the flexibility, cost, and riskiness of short-term versus long-term credit are dependent on the type of credit that is actually used. e. Short-term debt is often less costly than long-term debt and the major reason for this is that short-term debt exposes the borrowing firm to much less risk than long-term debt.

Cash management 109

.

Send Have Have Hold Make

payables over a wide geographic area. widely disbursed manufacturing facilities. a large marketable securities account to protect. inventories at many different sites. collections over a wide geographic area.

Float .

Diff: M

A lockbox plan is most beneficial to firms which a. b. c. d. e.

110

Answer: e

Answer: a

Diff: M

Which of the following statements is most correct? a. Poor synchronization of cash flows which results in high cash management costs can be partially offset by increasing disbursement float and decreasing collections float. b. The size of a firm's net float is primarily a function of its natural cash flow synchronization and how it clears its checks. c. Lockbox systems are used mainly for security purposes as well as to decrease the firm's net float. d. If a firm can speed up its collections and slow down its disbursements, it will be able to reduce its net float. e. A firm practicing good cash management and making use of positive net float will bring its check book balance as close to zero as possible, but must never generate a negative book balance.


Multiple Choice: Problems Easy: Sales collections 111

.

$55,000 $47,400 $38,000 $32,800 $30,000

Accounts receivable balance .

Diff: E

$194,444 $ 57,143 $ 5,556 $ 97,222 $212,541


Answer: a

If Hot Tubs Inc. had sales of $2,027,773 per year (all credit) and its days sales outstanding was equal to 35 days, what was its average amount of accounts receivable outstanding? (Assume a 365-day year.) a. b. c. d. e.

113

Diff: E

The Danser Company expects to have sales of $30,000 in January, $33,000 in February, and $38,000 in March. If 20 percent of sales are for cash, 40 percent are credit sales paid in the month following the sale, and 40 percent are credit sales paid 2 months following the sale, what are the cash receipts from sales in March? a. b. c. d. e.

112

Answer: d

Answer: d

Diff: E

Spartan Sporting Goods has $5 million in inventory and $2 million in accounts receivable. Its average daily sales are $100,000. The company’s payables deferral period (accounts payable divided by daily purchases) is 30 days. What is the length of the company’s cash conversion cycle? a. 100 days b. 60 days c. 50 days d. 40 days e. 33 days


Cash conversion cycle 114

.

87 90 65 48 66

days days days days days

Maturity matching .

Diff: E

21.71% 22.07% 22.95% 23.48% 24.52%

Cost of trade credit .

Answer: a

A firm is offered trade credit terms of 3/15, net 45 days. The firm does not take the discount, and it pays after 67 days. What is the nominal annual cost of not taking the discount? (Assume a 365-day year.) a. b. c. d. e.

117

Diff: E

$ 90,000 $260,000 $350,000 $410,000 $320,000

Cost of trade credit .

Answer: e

Wildthing Amusement Company’s total assets fluctuate between $320,000 and $410,000, while its fixed assets remain constant at $260,000. If the firm follows a maturity matching or moderate working capital financing policy, what is the likely level of its long-term financing? a. b. c. d. e.

116

Diff: E

For the Cook County Company, the average age of accounts receivable is 60 days, the average age of accounts payable is 45 days, and the average age of inventory is 72 days. Assuming a 365-day year, what is the length of the firm’s cash conversion cycle? a. b. c. d. e.

115

Answer: a

Answer: d

Diff: E

Dixie Tours Inc. buys on terms of 2/15, net 30 days. It does not take discounts, and it typically pays 35 days after the invoice date. Net purchases amount to $720,000 per year. What is the nominal annual cost of its non-free trade credit? (Assume a 365-day year.) a. b. c. d. e.

17.2% 23.6% 26.1% 37.2% 50.6%



.

Answer: b

Diff: E

Your company has been offered credit terms on its purchases of 4/30, net 90 days. What will be the nominal annual cost of trade credit if your company pays on the 35th day after receiving the invoice? (Assume a 365day year.) a. 30% b. 304% c. 3% d. 87% e. 156%

Free trade credit 119

.

$30,000 $40,000 $50,000 $60,000 $70,000

Revolving credit agreement cost .

Diff: E

Phillips Glass Company buys on terms of 2/15, net 30 days. It does not take discounts, and it typically pays 30 days after the invoice date. Net purchases amount to $730,000 per year. On average, how much “free” trade credit does Phillips receive during the year? (Assume a 365-day year.) a. b. c. d. e.

120

Answer: a

Answer: b

Diff: E

Inland Oil arranged a $10,000,000 revolving credit agreement with a group of small banks. The firm paid an annual commitment fee of onehalf of one percent of the unused balance of the loan commitment. On the used portion of the loan, Inland paid 1.5 percent above prime for the funds actually borrowed on an annual, simple interest basis. The prime rate was at 9 percent for the year. If Inland borrowed $6,000,000 immediately after the agreement was signed and repaid the loan at the end of one year, what was the total dollar cost of the loan agreement for one year? a. b. c. d. e.

$560,000 $650,000 $540,000 $900,000 $675,000


Inventory and NPV 121

.

Answer: d

Diff: E

Rojas Computing is developing a new software system for one of its clients. The system has an up-front cost of $75 million (at t = 0). The client has forecasted its inventory levels for the next five years as shown below: Year 1 2 3 4 5

Inventory $1.0 billion 1.2 billion 1.6 billion 2.0 billion 2.2 billion

Rojas forecasts that its new software will enable its client to reduce inventory to the following levels: Year 1 2 3 4 5

Inventory $0.8 billion 1.0 billion 1.4 billion 1.7 billion 1.9 billion

After Year 5, the software will become obsolete, so it will have no further impact on the client’s inventory levels. Rojas’ client is evaluating this software project as it would any other capital budgeting project. The client estimates that the weighted average cost of capital for the software system is 10 percent. What is the estimated NPV (in millions of dollars) of the new software system? a. b. c. d. e.

$233.56 $489.98 $625.12 $813.55 $956.43

Inventory turnover ratio and DSO 122

.

Answer: a

Diff: E

Bowa Construction’s days sales outstanding is 50 days (on a 365-day basis). The company’s accounts receivable equal $100 million and its balance sheet shows inventory equal to $125 million. What is the company’s inventory turnover ratio? a. b. c. d. e.

5.84 4.25 3.33 2.75 7.25


Float 123

.

Answer: d

Diff: E

Jumpdisk Company writes checks averaging $15,000 a day, and it takes 5 days for these checks to clear. The firm also receives checks in the amount of $17,000 per day, but the firm loses three days while its receipts are being deposited and cleared. What is the firm's net float in dollars? a. b. c. d. e.

$126,000 $ 75,000 $ 32,000 $ 24,000 $ 16,000

Medium: Cash budget 124

.

$2,600 $ 800 $ 776 $ 740 $ 728

ROE and working capital policy .

Diff: M

Chadmark Corporation’s budgeted monthly sales are $3,000. Forty percent of its customers pay in the first month and take the 2 percent discount. The remaining 60 percent pay in the month following the sale and don’t receive a discount. Chadmark’s bad debts are very small and are excluded from this analysis. Purchases for next month’s sales are constant each month at $1,500. Other payments for wages, rent, and taxes are constant at $700 per month. Construct a single month’s cash budget with the information given. What is the average cash gain or (loss) during a typical month for Chadmark Corporation? a. b. c. d. e.

125

Answer: c

Answer: c

Diff: M

Jarrett Enterprises is considering whether to pursue a restricted or relaxed current asset investment policy. The firm’s annual sales are $400,000; its fixed assets are $100,000; debt and equity are each 50 percent of total assets. EBIT is $36,000, the interest rate on the firm’s debt is 10 percent, and the firm’s tax rate is 40 percent. With a restricted policy, current assets will be 15 percent of sales. Under a relaxed policy, current assets will be 25 percent of sales. What is the difference in the projected ROEs between the restricted and relaxed policies? a. b. c. d. e.

0.0% 6.2% 5.4% 1.6% 3.8%


Inventory conversion period 126

.

Answer: d

Diff: M

On average, a firm sells $2,000,000 in merchandise a month. It keeps inventory equal to one-half of its monthly sales on hand at all times. If the firm analyzes its accounts using a 365-day year, what is the firm’s inventory conversion period? a. 365.0 days b. 182.5 days c. 30.3 days d. 15.2 days e. 10.5 days


.

Answer: d

Diff: M

Porta Stadium Inc. has annual sales of $80,000,000 and keeps average inventory of $20,000,000. On average, the firm has accounts receivable of $16,000,000. The firm buys all raw materials on credit, its trade credit terms are net 35 days, and it pays on time. The firm’s managers are searching for ways to shorten the cash conversion cycle. If sales can be maintained at existing levels but inventory can be lowered by $4,000,000 and accounts receivable lowered by $2,000,000, what will be the net change in the cash conversion cycle? Use a 365-day year. Round to the closest whole day. a. +105 days b. -105 days c. +27 days d. -27 days e. -3 days


.

Answer: e

Diff: M

You have recently been hired to improve the performance of Multiplex Corporation, which has been experiencing a severe cash shortage. As one part of your analysis, you want to determine the firm’s cash conversion cycle. Using the following information and a 365-day year, what is your estimate of the firm’s current cash conversion cycle?       

Current inventory = $120,000. Annual sales = $600,000. Accounts receivable = $157,808. Accounts payable = $25,000. Total annual purchases = $365,000. Purchases credit terms: net 30 days. Receivables credit terms: net 50 days.

a. b. c. d. e.

49 193 100 168 144




.

-40 -22 -13 +22 +40



-14.0 -18.8 -28.0 -25.6 -38.0

Diff: M


Accounts payable balance .

Answer: e

Gaston Piston Corp. has annual sales of $50,735,000 and maintains an average inventory level of $15,012,000. The average accounts receivable balance outstanding is $10,008,000. The company makes all purchases on credit and has always paid on the 30th day. The company is now going to take full advantage of trade credit and pay its suppliers on the 40th day. If sales can be maintained at existing levels but inventory can be lowered by $1,946,000 and accounts receivable lowered by $1,946,000, what will be the net change in the cash conversion cycle? (Assume there are 365 days in the year.) a. b. c. d. e.

131

Diff: M

Kolan Inc. has annual sales of $36,500,000 ($100,000 a day on a 365-day basis). On average, the company has $12,000,000 in inventory and $8,000,000 in accounts receivable. The company is looking for ways to shorten its cash conversion cycle, which is calculated on a 365-day basis. Its CFO has proposed new policies that would result in a 20 percent reduction in both average inventories and accounts receivables. The company anticipates that these policies will also reduce sales by 10 percent. Accounts payable will remain unchanged. What effect would these policies have on the company’s cash conversion cycle? Round to the nearest whole day. a. b. c. d. e.

130

Answer: b

Answer: e

Diff: M

Your firm buys on credit terms of 2/10, net 45 days, and it always pays on Day 45. If you calculate that this policy effectively costs your firm $159,621 each year, what is the firm’s average accounts payable balance? (Hint: Use the nominal cost of trade credit and carry its cost out to 6 decimal places.) a. b. c. d. e.

$1,234,000 $ 75,000 $ 157,500 $ 625,000 $ 750,000


EAR cost of trade credit 132

.

Answer: e

Diff: M

Suppose the credit terms offered to your firm by your suppliers are 2/10, net 30 days. Out of convenience, your firm is not taking discounts, but is paying after 20 days, instead of waiting until Day 30. You point out that the nominal cost of not taking the discount and paying on Day 30 is approximately 37 percent. But since your firm is not taking discounts and is paying on Day 20, what is the effective annual cost of your firm’s current practice, using a 365-day year? a. 36.7% b. 105.4% c. 73.4% d. 43.6% e. 109.0%

EAR cost of trade credit 133

.

$208,333; $416,667; $416,667; $625,000; $625,000;

17.81% 17.54% 27.43% 17.54% 23.45%

EAR cost of trade credit .

Diff: M

Hayes Hypermarket purchases $4,562,500 in goods over a 1-year period from its sole supplier. The supplier offers trade credit under the following terms: 2/15, net 50 days. If Hayes chooses to pay on time but not to take the discount, what is the average level of the company’s accounts payable, and what is the effective annual cost of its trade credit? (Assume a 365-day year.) a. b. c. d. e.

134

Answer: e

Answer: d

Diff: M

A firm is offered trade credit terms of 2/8, net 45 days. The firm does not take the discount, and it pays after 58 days. What is the effective annual cost of not taking this discount? (Assume a 365-day year.) a. b. c. d. e.

21.63% 13.35% 14.90% 15.89% 18.70%


Costly trade credit 135

.

$88,000 $33,000 $55,000 $50,000 $44,000

Stretching accounts payable .

Diff: M

Phranklin Pharms Inc. purchases merchandise from a company that gives sales terms of 2/15, net 40 days. Phranklin Pharms has gross purchases of $819,388 per year. What is the maximum amount of costly trade credit Phranklin could get, assuming it abides by the supplier’s credit terms? (Assume a 365-day year.) a. b. c. d. e.

136

Answer: a

Answer: e

Diff: M

C+ Notes’ business is booming, and it needs to raise more capital. company purchases supplies from a single supplier on terms of 1/10, 20 days, and it currently takes the discount. One way of getting needed funds would be to forgo the discount, and C+’s owner believes could delay payment to 40 days without adverse effects. What is effective annual rate of stretching the accounts payable? a. b. c. d. e.

10.00% 11.11% 11.75% 12.29% 13.01%


The net the she the

Changes in working capital and free cash flow 137

.

Answer: b

Diff: M

Allen Brothers is interested in increasing its free cash flow (which it hopes will result in a higher EVA and stock price). The company’s goal is to generate $180 million of free cash flow over the upcoming year. Allen’s CFO has made the following projections for the upcoming year:   

EBIT is projected to be $850 million. Gross capital expenditures are expected to total $360 million, and its depreciation expense is expected to be $120 million. Thus, its net capital expenditures are expected to total $240 million. The firm’s tax rate is 40 percent.

The company forecasts that there will be no change in its cash and marketable securities, nor will there be any changes in notes payable or accruals. Which of the following will enable the company to achieve its goal of generating $180 million in free cash flow? a. Accounts receivable increase $470 million, inventory increases $230 million, and accounts payable increase $790 million. b. Accounts receivable increase $470 million, inventory increases $230 million, and accounts payable increase $610 million. c. Accounts receivable decrease by $500 million, inventory increases by $480 million, and accounts payable decline by $80 million. d. Accounts receivable decrease by $400 million, inventory increases by $480 million, and accounts payable increase by $80 million. e. Accounts receivable increase by $500 million, inventory increases by $100 million, and accounts payable decline by $480 million.


Aging Schedule 138

.

Answer: b

Diff: M

Short Construction offers its customer’s credit terms of 2/10, net 30 days, while Fryman Construction offers its customer’s credit terms of 2/10, net 45 days. The aging schedules for each of the two companies’ accounts receivable are reported below: Short Construction Age of Account (Days) 0-10 11-30 31-45 46-60 Over 60 Total Receivables

Fryman

Value of Account

Percentage of Total Value

Value of Account

$58,800 19,600 14,700 2,940 1,960 $98,000

60% 20 15 3 2

$ 73,500 29,400 29,400 10,290 4,410 $147,000

Construction Percentage of Total Value 50% 20 20 7 3

Which company has the greatest percentage of overdue accounts and what is their percentage of overdue accounts? a. b. c. d. e.

Fryman; 50% overdue. Short; 20% overdue. Fryman; 30% overdue. Fryman; 3% overdue. Short; 40% overdue.

Lockbox 139

.

Answer: e

Diff: M

Cross Collectibles currently fills mail orders from all over the U.S. and receipts come in to headquarters in Little Rock, Arkansas. The firm's average accounts receivable (A/R) is $2.5 million and is financed by a bank loan with 11 percent annual interest. Cross is considering a regional lockbox system to speed up collections which it believes will reduce A/R by 20 percent. The annual cost of the system is $15,000. What is the estimated net annual savings to the firm from implementing the lockbox system? a. b. c. d. e.

$500,000 $ 30,000 $ 60,000 $ 55,000 $ 40,000


Tough: Cash conversion cycle 140

.

$ 101,900 $1,000,000 $ 136,986 $ 333,520 $ 0

Financial statements and trade credit .

Diff: T

-$23,520 -$31,440 +$23,520 +$38,448 +$69,888

Accounts payable balance .

Answer: d

Quickbow Company currently uses maximum trade credit by not taking discounts on its purchases. Quickbow is considering borrowing from its bank, using notes payable, in order to take trade discounts. The firm wants to determine the effect of this policy change on its net income. The standard industry credit terms offered by all its suppliers are 2/10, net 30 days, and Quickbow pays in 30 days. Its net purchases are $11,760 per day, using a 365-day year. The interest rate on the notes payable is 10 percent and the firm’s tax rate is 40 percent. If the firm implements the plan, what is the expected change in Quickbow’s net income? a. b. c. d. e.

142

Diff: T

Jordan Air Inc. has average inventory of $1,000,000. Its estimated annual sales are $10 million and the firm estimates its receivables conversion period to be twice as long as its inventory conversion period. The firm pays its trade credit on time; its terms are net 30 days. The firm wants to decrease its cash conversion cycle by 10 days. It believes that it can reduce its average inventory to $863,000. Assume a 365-day year and that sales will not change. By how much must the firm also reduce its accounts receivable to meet its goal of a 10day reduction in its cash conversion cycle? a. b. c. d. e.

141

Answer: c

Answer: d

Diff: T

Dalrymple Grocers buys on credit terms of 2/10, net 30 days, and it always pays on the 30th day. Dalrymple calculates that its annual costly trade credit is $375,000. What is the firm’s average accounts payable balance? Assume a 365-day year. a. b. c. d. e.

$187,475 $374,951 $223,333 $562,426 $457,443


Multiple Part: (The following information applies to the next three problems.) Callison Airlines is deciding whether to pursue a restricted or relaxed working capital investment policy. Callison’s annual sales are expected to total $3.6 million, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50 percent of total assets. EBIT is $150,000, the interest rate on the firm’s debt is 10 percent, and the firm’s tax rate is 40 percent. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy, its total assets turnover will be 2.2. Working capital investment policy 143

.

$ 3,233 $ 6,175 $ 9,818 $ 7,200 $10,136

Working capital investment policy and ROE .

Diff: M

2.24% 1.50% 1.00% 0.50% 0.33%

Working capital investment policy and ROE .

Answer: b

What is the difference in the projected ROEs between the restricted and relaxed policies? a. b. c. d. e.

145

Diff: M

If the firm adopts a restricted policy, how much will it save in interest expense (relative to what it would be if Callison were to adopt a relaxed policy)? a. b. c. d. e.

144

Answer: c

Answer: a

Diff: M

Assume now the company expects that if it adopts a restricted policy, its sales will fall by 15 percent, EBIT will fall by 10 percent, but its total assets turnover, debt ratio, interest rate, and tax rate will remain the same. In this situation, what is the difference in the projected ROEs between the restricted and relaxed policies? a. b. c. d. e.

2.24% 1.50% 1.00% 0.50% 0.33%


Financial Calculator Section Multiple Choice: Problems Medium: Permanent working capital financing 146

.

Answer: c

Diff: M

Wicker Corporation is determining whether to support $100,000 of its permanent working capital with a bank note or a short-term bond. The firm’s bank offers a two-year note for which the firm will receive $100,000 and repay $118,810 at the end of two years. The firm has the option to renew the loan at market rates. Alternatively, Wicker can sell 8.5 percent annual coupon bonds with a 2-year maturity and $1,000 par value at a price of $973.97. How many percentage points lower is the interest rate on the less expensive debt instrument? a. b. c. d. e.

0.0% 1.2% 1.0% 1.8% 0.6%

Tough: DSO and the cost of trade credit 147

.

Answer: e

Diff: T

Leiner Corp. is a retailer that finances its purchases with trade credit under the following terms: 1/10, net 30 days. The company plans to take advantage of the free trade credit that is offered. After all the free trade credit is used, the company can either finance the clothing purchases with a bank loan that has an effective rate of 10.1349 percent (on a 365-day year), or the firm can continue to use trade credit. The company has an understanding with its suppliers that within moderation, it is all right to “stretch out” its payments beyond 30 days without facing any additional financing costs. Therefore, the longer it takes the company to pay its suppliers, the lower the cost of trade credit. How many days would the firm wait to pay its suppliers in order for the cost of the trade credit to equal the cost of the bank loan? a. b. c. d. e.

30 36 40 46 48



CHAPTER 22 ANSWERS AND SOLUTIONS


1 .

Net working capital

Answer: b

Diff: E

2.

Net working capital

Answer: b

Diff: E

3.

Working capital

Answer: b

Diff: E

4.

Working capital policy

Answer: a

Diff: E

5.

Goal of cash management

Answer: a

Diff: E

6.

Motives for holding cash

Answer: a

Diff: E

7.

Cash budget

Answer: a

Diff: E

8.

Cash budget

Answer: a

Diff: E

9.

Float

Answer: a

Diff: E

10.

Lockbox

Answer: a

Diff: E

11.

Receivables balance

Answer: b

Diff: E

12.

Receivables balance

Answer: a

Diff: E

13.

Receivables aging

Answer: b

Diff: E

14.

Monitoring receivables

Answer: a

Diff: E

15.

Credit policy

Answer: a

Diff: E

16.

Cash discounts

Answer: b

Diff: E

17.

Trade discounts

Answer: b

Diff: E

18.

Change in credit policy

Answer: a

Diff: E

19.

Goal of inventory management

Answer: b

Diff: E

20.

Goal of inventory management

Answer: a

Diff: E

21.

Inventory management interaction

Answer: b

Diff: E

22.


Answer: a

Diff: E

23.

Permanent working capital

Answer: a

Diff: E

24.

Conservative financing approach

Answer: a

Diff: E

25.

Accruals

Answer: a

Diff: E

26.

Accruals

Answer: a

Diff: E

27.

Accruals

Answer: b

Diff: E

28.

Trade credit

Answer: b

Diff: E

29.

Trade credit

Answer: b

Diff: E

30.

Trade credit

Answer: a

Diff: E

31.

Trade credit

Answer: a

Diff: E

32.

Trade credit

Answer: a

Diff: E

33.

Cost of trade credit

Answer: a

Diff: E

34.


Answer: a

Diff: E

35.


Answer: a

Diff: E

36.

Net trade credit

Answer: b

Diff: E

37.

Net trade credit

Answer: a

Diff: E

38.

Stretching accounts payable

Answer: b

Diff: E

39.

Short-term financing

Answer: a

Diff: E

40.


Answer: a

Diff: E

41.


Answer: a

Diff: E

42.

Bank loans

Answer: b

Diff: E

43.

Bank loans

Answer: a

Diff: E

44.

Promissory note

Answer: b

Diff: E

45.

Line of credit

Answer: a

Diff: E

46.

Revolving credit and risk

Answer: a

Diff: E

47.

Cash and capital budgets

Answer: b

Diff: M

48.

Cash budget and depreciation

Answer: b

Diff: M

49.

Seasonal patterns and cash

Answer: b

Diff: M

50.

Synchronization of cash flows

Answer: a

Diff: M

51.

Float

Answer: b

Diff: M

52.

Float

Answer: b

Diff: M

53.

Lockbox

Answer: b

Diff: M

Interest earned = $250,000(1.5)(0.06) = $22,500. Thus, the cost ($23,000) exceeds the benefit ($22,500). 54.

Receivables and growth

Answer: b

Diff: M

55.

Receivables and growth

Answer: a

Diff: M

56.

Collection policy

Answer: b

Diff: M

57.

Collection policy

Answer: a

Diff: M

58.

Cash versus credit sales

Answer: b

Diff: M

59.

Days sales outstanding

Answer: a

Diff: M

60.

Extending the credit period

Answer: a

Diff: M

61.

DSO and past due accounts

Answer: b

Diff: M

62.

Aging schedule and credit policy

Answer: b

Diff: M

63.

Maturity matching

Answer: a

Diff: M

64.

Maturity matching

Answer: b

Diff: M

65.

Aggressive financing approach

Answer: a

Diff: M

66.

Aggressive financing approach

Answer: b

Diff: M

67.

Risk and short-term financing

Answer: a

Diff: M

68.


Answer: b

Diff: M

69.


Answer: a

Diff: M

70.

Trade credit

Answer: b

Diff: M

71.


Answer: a

Diff: M

72.


Answer: b

Diff: M

73.


Answer: b

Diff: M

74.

Prime rate

Answer: b

Diff: M

75.

Revolving credit agreement

Answer: a

Diff: M

76.

Working capital

Answer: c

Diff: E

77.

Cash conversion cycle

Answer: b

Diff: E

Statement a is false. If inventory increases, and sales do not, more cash is being “tied up” in inventory so the cash conversion cycle is increased, not reduced. Statement b is true. If the company reduces its DSO, it is collecting its accounts receivables more efficiently, so it reduces the cash conversion cycle. Statement c is false. If the company pays its bills sooner, it uses its cash to pay off accounts payable, and this increases its cash conversion cycle. 78.

Cash budget

Answer: e

Diff: E

79.

Cash budget

Answer: a

Diff: E

80.

Cash budget

Answer: d

Diff: E

Statement a is false because depreciation is not a cash item. (Although depreciation will affect taxes, depreciation itself will not be explicitly included in the cash budget. The question asks “explicitly.”) Statement b is true because this is a cash transaction, so it should be included in the cash budget. Statement c is true because this is a cash transaction and should be

included in the cash budget. is the correct choice.

Since statements b and c are true, statement d

81.

Marketable securities

Answer: a

Diff: E

82.

Monitoring receivables

Answer: b

Diff: E

83.

Credit policy

Answer: e

Diff: E

84.

Credit policy

Answer: d

Diff: E

85.

Inventory management

Answer: e

Diff: E

86.

Working capital financing policy

Answer: a

Diff: E

87.

Commercial paper

Answer: d

Diff: E

88.

Working capital financing

Answer: e

Diff: E

89.

Working capital financing

Answer: a

Diff: E

Statement a is false, and therefore the appropriate answer. Commercial paper is a type of unsecured promissory note issued by large, strong firms. Statements b, c, d, and e are all accurate statements. 90.

Cash management

Answer: a

Diff: E

Net float = Disbursements float - Collections float; therefore the larger the disbursements float and the lower the collections float the better the cash management system. A lockbox is used to speed cash collections. If a firm's outflows come due early in the month rather than uniformly this will necessitate a large line of credit. 91.

Cash management

Answer: e

Diff: E

A very efficient cash management system could allow a firm to operate with positive net float where the firm has a negative checkbook balance at most times but still does not bounce its checks. The other statements are false. A good cash management system maximizes disbursement float and minimizes collections float. A well-designed lockbox system minimizes collections float which would increase a firm's net float. Increases in interest rates raise the opportunity cost of idle cash. A firm prefers to write checks, maximizing its disbursement float and increasing its net float. 92 .

Lockbox

Answer: d

Diff: E

93.


Answer: d

Diff: M

94.


Answer: d

Diff: M

Statements a and b are true; therefore, statement d is the appropriate choice. Delaying payments to suppliers increases the length of the cash conversion cycle. 95.

Cash balances

Answer: c

Diff: M

96.

Cash budget

Answer: e

Diff: M

97.

Marketable securities portfolio

Answer: d

Diff: M

98.

Compensating balances

Answer: c

Diff: M

99.

Receivables management

Answer: b

Diff: M

100.

DSO and aging schedule

Answer: c

Diff: M

101.

Days sales outstanding (DSO)

Answer: c

Diff: M

102.


Answer: d

Diff: M

Statements a, b, c, and e are all true statements. Statement d is false, and thus the appropriate choice. Holding minimal levels of inventory may result in lost sales. 103.

Miscellaneous concepts

Answer: e

Diff: M

104.


Answer: c

Diff: M

105.


Answer: b

Diff: M

106.


Answer: c

Diff: M

Statement b illustrates an aggressive financing policy, not a conser-vative one. 107.

108 .


Answer: a

Diff: M

Statement a is true. Under normal conditions the yield curve is upward sloping, thus, short-term interest rates are lower than long-term interest rates. Consequently, a firm financing with short-term debt will pay less interest than a firm financing with long-term debt--increasing its ROE. However, a firm increases its risk by financing with short-term debt because such debt must be “rolled over” frequently, and the firm is exposed to the volatility of short-term interest rates. The other statements are false. Short-term versus long-term financing

Answer: d

Diff: M

109.

Cash management

Answer: e

Diff: M

110.

Float

Answer: a

Diff: M

111.

Sales collections

Answer: d

Diff: E

March receipts = (0.20)($38,000) + (0.40)($33,000) + (0.40)($30,000) = $32,800. 112 . 113 .

Accounts receivable balance

Answer: a

Diff: E

Accounts receivables = DSO  Sales per day = 35($2,027,773/365) = $194,444. Cash conversion cycle

Answer: d

Diff: E

Facts given: Payables deferral period = 30 days; Inv = $5,000,000; Rec. = $2,000,000; ADS = $100,000.

Cash conversion Inv. conversion Rec. collection Pay. deferral = + – . cycle period period period

114.

Step 1:

Determine the inventory conversion period: Inventory conversion period = Inventory/Daily sales = $5,000,000/$100,000 = 50 days.

Step 2:

Determine the receivables collection period: Receivables collection period = Receivables/Daily sales = $2,000,000/$100,000 = 20 days.

Step 3:

Given data and information calculated above, determine the firm’s cash conversion cycle: Cash conversion cycle = 50 + 20 - 30 = 40 days.



=

Answer: a

Diff: E

Inv. conversion Rec. collection Pay. deferral + – period period period

= 72 + 60 - 45 = 87 days. 115.

Maturity matching

Answer: e

Diff: E

A maturity matching policy implies that fixed assets and permanent current assets are financed with long-term sources. Thus, since the minimum balance that total assets approach is $320,000, and $260,000 of that balance is fixed assets, permanent current assets equal $60,000. The likely level of long-term financing is $320,000. Long-term debt financing = Permanent cash assets + Fixed assets. Permanent cash assets = Low end of total assets - Fixed assets = $320,000 - $260,000 = $60,000. 116 .

Long-term debt financing = $60,000 + $260,000 = $320,000. Cost of trade credit

Answer: a

Diff: E

Answer: d

Diff: E

Answer: b

Diff: E

365 3  = 21.71%. 97 52

Nominal percentage cost = 117 .


2 365  = 37.24%. 98 35 - 15

Nominal percentage cost = 118 .


 4   365      96   5 

Nominal percentage cost =  119 .

Free trade credit

= 3.042 = 304.2%. Answer: a

Diff: E

$730,000 = $2,000. 365 Free trade credit = $2,000  15 = $30,000. Daily purchases =

120.

Revolving credit agreement cost

Answer: b

Diff: E

Interest rate on borrowed funds = 0.09 + 0.015 = 10.5%. Cost of unused portion: $4,000,000  0.005 = $ 20,000 Cost of used portion: $6,000,000  0.105 = 630,000 Total cost of loan agreement $650,000 121.

Inventory and NPV

Answer: d

Diff: E

We are given the up-front cost. The new software system’s cash flows are the annual cash amounts freed up by not having to invest in inventory. 0 1 2 3 4 5 Years 10% | | | | | | -75,000,000 +200,000,000 +200,000,000 +200,000,000 +300,000,000 +300,000,000

$200,000,000 $200,000,000 $200,000,000 + + 2 (1.1) (1.1) (1.1)3 $300,000,000 $300,000,000 + + 4 (1.1) (1.1)5 NPV = -$75,000,000 + $181,818,000 + $165,289,000 + $150,263,000 + $204,904,000 + $186,276,000 NPV = $813,550,000. NPV = -$75,000,000 +

122.

Inventory turnover ratio and DSO Step 1:

Diff: E

Determine sales level using the DSO equation. DSO = 50 = $100,000,000 = $36,500,000,000 = $730,000,000 =

Step 2:

Answer: a

Receivables Sales/365 $100,000,000 Sales/365 50(Sales) 365 50(Sales) Sales.

Calculate inventory turnover ratio.

Sales Inv. $730,000,000 Inv. turnover = $125,000,000 Inv. turnover = 5.84. Inv. turnover =

123 .

Float Positive disbursement float = $15,000(5) = $75,000. Negative collections float = $17,000(3) = $51,000.

Answer: d

Diff: E

Net float = $75,000 - $51,000 = $24,000. 124.

Cash budget

Answer: c

Construct a simplified cash budget: Sales Collections (same month’s sales) Collections (last month’s sales) Total collections Purchases payments Other payments Total payments Net cash gain (loss) 125.

$3,000 1,176 1,800 2,976 1,500 700 2,200 $ 776

Diff: M

(0.98  0.40  $3,000) (1.00  0.60  $3,000)

ROE and working capital policy

Answer: c

Diff: M

Construct simplified comparative balance sheets and income statements for the restricted and relaxed policies (In thousands of dollars): 15% of Sales Restricted $ 60.0 100.0 $160.0

25% of Sales Relaxed $100.0 100.0 $200.0

Debt Equity Total liabilities and equity

$ 80.0 80.0 $160.0

$100.0 100.0 $200.0

Income statement: EBIT Interest (10%) EBT Taxes (40%) Net income

$ 36.0 (8.0) $ 28.0 (11.2) $ 16.8

$ 36.0 (10.0) $ 26.0 (10.4) $ 15.6

Balance sheet: Current assets Fixed assets Total assets

ROE = NI/Equity $16.8/$80 = 0.21 Difference in ROEs = 0.21 - 0.156 = 0.054 = 5.4%. 126.

$15.6/$100 = 0.156.

Inventory conversion period

Answer: d

Diff: M

Answer: d

Diff: M

365 days . Sales/Inventory Annual sales = 12  $2 million = $24 million. Inventory = 0.5  $2 million = $1 million. 365 ICP = = 15.2 days. $24/$1 Inventory conversion period (ICP) =

127.

Cash conversion cycle Old

365 365 ICP = $80 = = 4 $20

With Change 91.25 +

365 365 $80 = = 73.000 5 $16 +

$16 DSO = $80 = 365 DP =

35 days CCC =

73.00 -35.00 129.25 days

$14 $80 = 365 DP

63.875

New CCC =

-35.000 101.875 days

Change in CCC = 101.875 – 129.25 = -27.375 days  -27 days. Net change is –27 days (CCC is 27 days shorter). 128.


Answer: e

Diff: M

Calculate each of the three main components of the cash conversion cycle: Inventory Conversion period (ICP): $120,000 $120,000 ICP = = = 73 days. $600,000/365 $1,643.8356 Days sales outstanding (DSO): $157,808 $157,808 DSO = = = 96 days. $600,000/365 $1,643.8356 Payables deferral period (PDP): $25,000 $25,000 PDP = = = 25 days. $365,000/365 $1,000 Cash conversion cycle (CCC): CCC = ICP + DSO – PDP = 73 + 96 – 25 = 144 days.

129.


Answer: b

Diff: M

Cash conversion Inv. conversion Rec. collection Pay. deferral = + – . cycle period period period For this problem we are only interested in the change in the CCC. We may therefore ignore the Payables Deferral Period since it is assumed to remain unchanged. Old CCC (ignore payables) = $12,000,000/$100,000 + $8,000,000/$100,000 = 120 + 80 = 200 days. New CCC = $9,600,000/$90,000 + $6,400,000/$90,000 = 106.67 + 71.11 = 177.78 days. Change in CCC = New CCC – Old CCC = 177.78 – 200 = -22.22 days. Round to 22 days shorter. 130.


Answer: e

Diff: M

First, calculate Sales/Day = $50,735,000/365 = $139,000. Then, calculate the old inventory conversion period: Inventory/Sales per day = $15,012,000/$139,000 = 108 days. Then, find the new inventory conversion period: $13,066,000/$139,000 = 94 days. We have cut the inventory conversion period by 108 – 94 = 14 days. Then, calculate the old DSO: Accts. Rec./Sales per day = $10,008,000/$139,000 = 72 days. Then, find the new DSO = $8,062,000/$139,000 = 58 days. We have cut the DSO by 72 – 58 = 14 days. Finally, find the total net change = -14 + (-14) – 10 = -38 days. 131.

Accounts payable balance Approximate percentage cost = Accounts payable =

Answer: e

Diff: M

Answer: e

Diff: M

365 2  = 0.212828. 98 35

$159,621 = $750,000. 0.212828

132

.

EAR cost of trade credit

Calculate the nominal percentage, which is the nominal annual cost: Nominal cost =

2 365 days  = 0.0204  36.5 = 0.7449  74.5%. 100  2 20  10

Calculate the effective annual rate (EAR): Numerical solution: EAR = (1.0204)36.5 - 1.0 = 2.0905 - 1.0 = 109.05%  109%.

133 .

Financial calculator solution: (EAR) Inputs: P/YR = 36.5; NOM% = 74.49. Output: EAR cost of trade credit

EFF% = 109%. Answer: e

Diff: M

The company pays every 50 days or 365/50 = 7.3 times per year. Thus, the average accounts payable are $4,562,500/7.3 = $625,000. The effective cost of trade credit can be found as follows: EAR = (1 + 2/98)365/35 - 1 = 1.2345 - 1 = 0.2345 = 23.45%. 134.

EAR cost of trade credit Calculate the interest rate per period Periodic rate = 2/98 = 2.04%. Calculate the number of compounding periods

Answer: d

Diff: M

Number of compounding periods = 365/50 = 7.30. Use periodic rate and compounding periods to determine the annual nominal rate

2.04%  7.3 = 14.90%. Calculate EAR EAR = (1 + 2/98)365/50 – 1 = (1.0204)7.3 – 1 = 1.1589 – 1 = 0.1589 = 15.89%. 135.

Costly trade credit

Answer: a

Diff: M

Phranklin’s net purchases are $819,388  (1 - 0.02) = $803,000. Purchases per day are $803,000/365 = $2,200.00. Total trade credit is 40  $2,200 = $88,000. Free trade credit is 15  $2,200 = $33,000. Thus, costly trade credit, assuming discounts are taken, is $88,000 - $33,000 = $55,000. If discounts are not taken, then the maximum amount of costly trade credit is $88,000. 136.


Answer: e

Accounts payable: (1/99)(365/(40 - 10)) = 12.29%. nominal rate. EAR is calculated as follows: EAR = (1 + 1/99)12.1667 - 1 = 13.01%.

137.

Changes in working capital and free cash flow FCF $180,000,000 $180,000,000 $180,000,000 -$90,000,000 NOWC

= = = = = =

Diff: M

However, this is a

Answer: b

Diff: M

EBIT(1 – T) + DEP – CapExp - NOWC $850,000,000(0.6) + $120,000,000 - $360,000,000 - NOWC $510,000,000 + $120,000,000 - $360,000,000 - NOWC $270,000,000 - NOWC -NOWC $90,000,000.

Net operating working capital needs to increase by $90 million, so we need to find the response that shows working capital increasing by that amount. Statement a is false because NOWC = $470,000,000 + $230,000,000 - $790,000,000 = -$90,000,000. Statement b is true because NOWC = $470,000,000 + $230,000,000 - $610,000,000 = +$90,000,000. Statement c is false because NOWC = -$500,000,000 + $480,000,000 – (-$80,000,000) = +$60,000,000. Statement d is false because NOWC = -$400,000,000 + $480,000,000 - $80,000,000 = $0. Statement e is false because NOWC = $500,000,000 + $100,000,000 – ($480,000,000) = $1,080,000,000. 138.

Aging Schedule

Answer: b

Diff: M

Short’s credit policy is 2/10, net 30 days, so customers’ receivables are overdue after 30 days. The percentage of accounts overdue (after 30 days) is 15% + 3% + 2% = 20%. Fryman’s credit policy is 2/10, net 45 days, so customers’ receivables are overdue after 45 days. The percentage of accounts overdue (after 45 days) is 7% + 3% = 10%. Thus, Short has the greatest percentage of overdue accounts at 20%. (Note that you could also use the dollar amounts to develop the total percentage of overdue accounts, but you would arrive at the same answer.)

Alternative solution using dollar amounts of receivables:

($14,700  $2,940  $1,960) = 20%. $98,000 ($10,290  $4,410) Fryman: = 10%. $147,000 Short:

139 .

Lockbox

Answer: e

Diff: M

Calculate the net reduction in A/R: Current A/R = $2,500,000. New A/R with 20% reduction: $2,500,000 - 0.20($2,500,000) = $2,000,000. Net reduction in A/R = $500,000. Calculate the interest savings and net savings: Interest savings = $500,000(0.11) = $55,000. Net savings = Interest savings - Annual lockbox cost = $55,000 - $15,000 = $40,000. 140.


Answer: c

Diff: T

ICP = 365 days/($10 million/$1 million) = 36.5 days. DSO = 2.0  ICP = 73 days. Solve for accounts receivable: DSO = 73 = Accounts receivable/Sales per day = (A/R)/($10/365) = $2 million. Calculate new ICP, change in CCC, and new DSO required to meet goal: New ICP = 365/($10/$0.863) = 365/11.5875 = 31.5 days. Net change in ICP = -5 days. Total reduction in CCC required = 10 days. Reduction in DSO needed = 10 – 5 = 5 days. New DSO required = 73 – 5 = 68 days. Solve for new receivables level: DSO = 68 = [(A/R)/($10,000,000/365)] A/R = 68  $27,397.26 = $1,863,014. Old A/R = $2,000,000. New A/R = $1,863,014. Reduction required in A/R = $2,000,000 - $1,863,014 = $136,986. 141.

Financial statements and trade credit Calculate A/P with and without taking discounts:

Answer: d

Diff: T

A/PNo discount = $11,760  30 days = $352,800. A/PDiscount = $11,760  10 days = $117,600. Calculate financing amount in notes payable and interest cost. need to borrow the difference in notes payable. $352,800 - $117,600 = $235,200. The additional interest cost is $235,200  0.10 = $23,520.

The firm will

Calculate total purchases and discounts lost: Total purchases = 365 days  12,000 gross purchases = $4,380,000. Discounts lost = $4,380,000  0.02 = $87,600. Construct comparative financial statements: I. Partial balance sheet: Take Discounts Don’t Take Discounts (Borrow N/P) (Use Max. Trade Cdt) Difference Accounts payable $117,600 $352,800 -$235,200 Notes payable (10%) 235,200 +235,200 Total current liab. $352,800 $352,800 $ 0 II. Partial income statement: EBIT* $140,000 $140,000 $ 0 Less: Interest 23,520 0 +23,520 Discounts lost 0 87,600 -87,600 EBT $116,480 $ 52,400 +$ 64,080 Less: Taxes (at 40%) 46,592 20,960 +25,632 Net income $ 69,888 $ 31,440 +$ 38,448 *Any EBIT can be used, since the difference in EBIT from the two policies is zero. 142 .

Accounts payable balance Step 1:

Answer: d

Diff: T

Calculate the nominal annual cost of trade credit.

2 365  98 30  10 = 0.0204  18.25 = 37.24%.

Nominal annual cost =

Step 2:

Using the nominal annual cost from Step 1 determine the amount of free trade credit. Free trade credit 37.24% = Costly trade credit Free trade credit 37.24% = $375,000 Free trade credit = $139,650.

Step 3:

Determine gross and net sales. $139,650 = Discount, which represents 2% of sales. .02Sales = $139,650 Sales = $6,982,500. Net sales = 0.98Sales = 0.98($6,982,500) = $6,842,850.

Step 4:

Since accounts payable are shown net of discounts, determine daily sales based on net sales figure. Then multiply this amount by 30 days.

$6,842,850 365 = $18,747.53.

Daily net sales =

Accounts payable balance = $18,747.53  30 = $562,426.03  $562,426.

143.

Working capital investment policy Step 1:

Answer: c

Diff: M

Calculate net fixed assets, which will be the same under either policy.

S NFA $3,600,000 4.0 = NFA

FA turnover =

NFA = $900,000. Step 2:

Determine total assets under each policy, given the total assets turnover ratio for each one.

S TA $3,600,000 2.5 = TA

Restricted:

Total assets turnover =

TA = $1,440,000.

Relaxed:

2.2 =

$3,600,000 TA

TA = $1,636,364. Step 3:

Develop balance sheets for each policy to determine the debt level. Restricted Relaxed Current assets $ 540,000 $ 736,364 Fixed assets 900,000 900,000 Total assets $1,440,000 $1,636,364 Debt Equity

$

720,000 720,000

$

818,182 818,182

Total liabilities & equity

$1,440,000

$1,636,364

Step 4:

Determine interest under each policy: Restricted: $720,000  0.10 = $72,000. Relaxed: $818,182  0.10 = $81,818.

Step 5:

Calculate the difference in interest expense (the savings) between the 2 policies: $81,818 - $72,000 = $9,818.

144

.

145.

Working capital investment policy and ROE

Answer: b

Diff: M

Step 1:

From the previous problem we can now set up an income statement for each policy. Restricted Relaxed EBIT $150,000 $150,000 Interest (10%) 72,000 81,818 EBT $ 78,000 $ 68,182 Taxes 31,200 27,273 Net income $ 46,800 $ 40,909

Step 2:

Calculate ROE using common equity as calculated in the prior problem for each policy. $46,800 $40,909 Restricted: ROE = Relaxed: ROE = $720,000 $818,182 = 6.5%. = 5.0%.

Step 3:

Calculate the difference in ROEs. ROE = 6.5% - 5.0% = 1.5%.

Working capital investment policy and ROE

Answer: a

Diff: M

From the prior two problems, we know that the ROE for the relaxed policy is 5%. Now, we need to calculate the new ROE under the restricted policy. Step 1:

Calculate the new sales and EBIT levels. New sales = $3,600,000  0.85 = $3,060,000. New EBIT = $150,000  0.90 = $135,000.

Step 2:

Calculate the new level of assets under the restricted policy. S/TA = 2.5 $3,060,000/2.5 = $1,224,000.

Step 3:

Develop the firm’s balance sheet under the restricted policy. Total assets

$1,224,000

Debt

$

612,000

Equity Total liabilities & equity Step 4:

Develop the firm’s income statement under the restricted policy. EBIT Interest (10%) EBT Taxes (40%) Net income

146.

612,000 $1,224,000

$135,000 61,200 $ 73,800 29,520 $ 44,280

Step 5:

Calculate the firm’s ROE under the restricted policy. ROE = NI/E = $44,280/$612,000 ROE = 7.24%.

Step 6:

Calculate the difference in ROEs between the 2 policies. ROE = 7.24% - 5% = 2.24%.

Permanent working capital financing

Answer: c

Diff: M

Time lines: Note that the cash flows viewed from the firm’s perspective involve inflows at time 0, and repayment of coupon and/or maturity value in the future. 2-year note: 0 i = ? | +100,000 2-year bond: 0 i = ? | +973.97

1 |

2 Years | FV = -118,810

1 | -85

2 Years | -85 FV = -1,000

Note:

Inputs: Output:

N = 2; PV = 100,000; PMT = 0; FV = -118,810. I = 9.0%.

Bond:

Inputs: Output:

N = 2; PV = 973.97; PMT = -85; FV = -1,000. I = 10.0%.

The difference is 10.0% - 9.0% = 1.0%. 147.

DSO and the cost of trade credit

Answer: e

Diff: T

Determine the number of days the firm would wait to pay its suppliers so that the cost of the trade credit equals the cost of the bank loan: I/YR = 10.1349; PV = -99; PMT = 0; FV = 100; and then solve for N = 0.1041. Multiply 0.1041 by 365 0.1041(365) = 38 days.

to

convert

it

to

the

number

of

days

per

year:

To get the final answer we must add back the initial 10 days of “free” financing. This gives 38 + 10 = 48 days.

FM11 Ch 22 Test Bank

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