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21 CHAPTER WORKING CAPITAL MANAGEMENT (Difficulty: E = Easy, M = Medium, and T = Tough) True-False Easy: (21.2) Net working capital Register to View AnswerDiff: E 1 . Net working capital may be defined as current assets minus current liabilities. This also defines the current ratio. a. True b. False (21.2) Net working capital Register to View AnswerDiff: E 2 . Net working capital is defined as current assets divided by current liabilities. a. True b. False (21.2) Working capital 3 . An increase in a current asset account must corresponding increase in a liability account. a. True b. False (21.2) Working capital policy Register to View AnswerDiff: E 4 . 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 (21.3) Goal of cash management Register to View AnswerDiff: E 5 . 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 be Register to View AnswerDiff: E accompanied by a Chapter 21: Working Capital Management Page 1 (21.3) Motives for holding cash Register to View AnswerDiff: E 6 . 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 (21.4) Cash budget Register to View AnswerDiff: E 7 . 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 (21.4) Cash budget Register to View AnswerDiff: E 8 . 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 (21.5) Float Register to View AnswerDiff: E 9 . 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 (21.5) Lockbox Register to View AnswerDiff: E 10 . Lockbox arrangements are one way for a firm to speed up its collection of payments from customers. a. True b. False (21.6) Goal of inventory management Register to View AnswerDiff: E 11 . 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 (21.6) Goal of inventory management Register to View AnswerDiff: E 12 . 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. Page 2 Chapter 21: Working Capital Management a. True b. False (21.6) Inventory management interaction Register to View AnswerDiff: E 13 . 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 (21.7) Receivables balance Register to View AnswerDiff: E 14 . 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 (21.7) Receivables balance Register to View AnswerDiff: E 15 . The average accounts receivables balance is determined jointly by the volume of credit sales and the days sales outstanding. a. True b. False (21.7) Receivables aging Register to View AnswerDiff: E 16 . 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 (21.7) Monitoring receivables Register to View AnswerDiff: E 17 . The aging schedule is a commonly used method of monitoring receivables. a. True b. False (21.7) Credit policy Register to View AnswerDiff: E 18 . 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 (21.7) Cash discounts 19 . If you receive some goods on April 1 with net 30, June 1 dating, it means that you discount if the bill is paid on or before amount must be paid 30 days after receipt of Chapter 21: Working Capital Management Register to View AnswerDiff: E the following terms; 3/20, will receive a 3 percent June 20 and that the full the goods. Page 3 a. True b. False (21.7) Trade discounts Register to View AnswerDiff: E 20 . 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 (21.7) Change in credit policy Register to View AnswerDiff: E 21 . 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 (21.8) Accruals Register to View AnswerDiff: E 22 . Accruals are "free" financing in the sense that no explicit interest is paid on accruals. a. True b. False (21.8) Accruals Register to View AnswerDiff: E 23 . 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 (21.8) Accruals Register to View AnswerDiff: E 24 . 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 (21.8) Trade credit Register to View AnswerDiff: E 25 . 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 Page 4 Chapter 21: Working Capital Management (21.8) Trade credit Register to View AnswerDiff: E 26 . 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 (21.8) Trade credit Register to View AnswerDiff: E 27 . 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 (21.8) Trade credit Register to View AnswerDiff: E 28 . Trade credit is an inexpensive source of short-term financing if no discounts are offered. a. True b. False (21.8) Trade credit Register to View AnswerDiff: E 29 . 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 (21.8) Cost of trade credit Register to View Answer30 . The calculated cost of trade credit is reduced by paying late. a. True b. False (21.8) Cost of trade credit Register to View AnswerDiff: E 31 . 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 Diff: E Chapter 21: Working Capital Management Page 5 (21.8) Cost of trade credit Register to View AnswerDiff: E 32 . 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 (21.8) Net trade credit Register to View AnswerDiff: E 33 . A firm is said to be extending net trade credit when its accounts receivable are less than its accounts payable. a. True b. False (21.8) Net trade credit Register to View AnswerDiff: E 34 . 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 (21.8) Stretching accounts payable 35 . "Stretching" accounts payable financing technique. a. True b. False (21.9) Working capital financing Register to View AnswerDiff: E 36 . 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 (21.9) Short-term financing Register to View AnswerDiff: E 37 . 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 is a widely Register to View AnswerDiff: E accepted and costless Page 6 Chapter 21: Working Capital Management (21.9) Short-term financing Register to View AnswerDiff: E 38 . 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 (21.9) Short-term financing Register to View AnswerDiff: E 39 . 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 (21.12) Bank loans Register to View AnswerDiff: E 40 . 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 (21.12) Bank loans Register to View AnswerDiff: E 41 . 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 (21.12) Promissory note Register to View AnswerDiff: E 42 . 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 (21.12) Line of credit Register to View AnswerDiff: E 43 . 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 (21.12) Revolving credit and risk Register to View AnswerDiff: E 44 . 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. Chapter 21: Working Capital Management Page 7 a. True b. False Medium: (21.4) Cash and capital budgets Register to View AnswerDiff: M 45 . 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 (21.4) Cash budget and depreciation Register to View AnswerDiff: M 46 . Since depreciation is a non-cash charge it does not appear nor have an effect on the cash budget. a. True b. False (21.4) Seasonal patterns and cash Register to View AnswerDiff: M 47 . 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 (21.5) Synchronization of cash flows Register to View AnswerDiff: M 48 . Synchronization of cash flows is an important cash management technique and effective synchronization can actually increase a firm's profitability. a. True b. False (21.5) Float Register to View AnswerDiff: M 49 . 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 (21.5) Float Register to View AnswerDiff: M 50 . 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 Page 8 Chapter 21: Working Capital Management (21.5) Lockbox Register to View AnswerDiff: M 51 . 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 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 (21.7) Receivables and growth Register to View AnswerDiff: M 52 . 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 (21.7) Receivables and growth Register to View AnswerDiff: M 53 . 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 (21.7) Collection policy Register to View AnswerDiff: M 54 . 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 (21.7) Collection policy Register to View AnswerDiff: M 55 . Changes in a firm's collection policy can affect sales, working capital and even additional funds needed. a. True b. False (21.7) Cash versus credit sales 56 . In part because money has time value, cash profitable and more valuable than credit sales. a. True b. False sales Register to View AnswerDiff: M are always more Chapter 21: Working Capital Management Page 9 (21.7) Days sales outstanding Register to View AnswerDiff: M 57 . 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 (21.7) Extending the credit period Register to View AnswerDiff: M 58 . 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 (21.7) DSO and past due accounts Register to View AnswerDiff: M 59 . 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 (21.7) Aging schedule and credit policy Register to View AnswerDiff: M 60 . 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 (21.8) Trade credit Register to View AnswerDiff: M 61 . 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 (21.8) Stretching accounts payable Register to View AnswerDiff: M 62 . 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 Page 10 Chapter 21: Working Capital Management (21.8) Stretching accounts payable Register to View AnswerDiff: M 63 . 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 (21.8) Stretching accounts payable Register to View AnswerDiff: M 64 . 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 (21.9) Maturity matching Register to View AnswerDiff: M 65 . 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 (21.9) Maturity matching Register to View AnswerDiff: M 66 . 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 (21.9) Aggressive financing approach Register to View AnswerDiff: M 67 . 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 (21.9) Aggressive financing approach Register to View AnswerDiff: M 68 . 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 Chapter 21: Working Capital Management Page 11 (21.9) Risk and short-term financing Register to View AnswerDiff: M 69 . 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 longterm 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 (21.9) Short-term financing Register to View AnswerDiff: M 70 . 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 (21.9) Short-term financing Register to View AnswerDiff: M 71 . 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 72 (21.12) Prime rate Register to View AnswerDiff: 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 (21.12) Revolving credit agreement Register to View AnswerDiff: M 73 . 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 Page 12 Chapter 21: Working Capital Management Multiple Choice: Conceptual Easy: (21.1) Cash conversion cycle Register to View AnswerDiff: E 74 . 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. (21.2) Working capital 75 . Other things held constant, increase in working capital? a. b. c. d. which of the Register to View AnswerDiff: E following will cause an 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. 76 (21.4) Cash budget Register to View Answer. Which of the following is typically part of the cash budget? a. b. c. d. e. Payments lag. Payment for plant construction. Cumulative cash. Statements a and c are correct. All of the statements above are correct. Diff: E (21.4) Cash budget Register to View AnswerDiff: E 77 . 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. Chapter 21: Working Capital Management Page 13 (21.4) Cash budget Register to View AnswerDiff: E 78 . Which of the following items should a company explicitly include in its monthly cash budget? a. b. c. d. e. 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. Register to View AnswerDiff: E (21.5) Cash management 79 . 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. (21.5) Cash management 80 . Which of the following statements is most correct? Register to View AnswerDiff: E 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. Page 14 Chapter 21: Working Capital Management (21.5) Lockbox 81 . A lockbox plan is a. b. c. d. e. Register to View Answer Diff: 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. might be attributed to Register to View AnswerDiff: E efficient inventory (21.6) Inventory management 82 . Which of the following management? a. b. c. d. e. 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. (21.7) Monitoring receivables Register to View AnswerDiff: E 83 . 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. (21.7) Credit policy Register to View AnswerDiff: E 84 . Which of the following is not commonly regarded as being a credit policy variable? a. b. c. d. e. Credit period. Collection policy. Credit standards. Cash discounts. All of the statements above are credit policy variables. (21.7) Credit policy Register to View AnswerDiff: E 85 . If easing a firms 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. It normally stimulates sales. To meet competitive pressures. To increase the firms deferral period for payables. Statements a and b are correct. All of the statements above are correct. Chapter 21: Working Capital Management Page 15 86 (21.9) Working capital financing policy . Firms generally choose to finance capital with short-term debt because temporary net Register to View Answeroperating Diff: E 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. (21.9) Working capital financing 87 . Which of the following statements is most correct? Register to View AnswerDiff: E 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. (21.9) Working capital financing 88 . Which of the following statements is incorrect? Register to View AnswerDiff: E 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. (21.10) Marketable securities Register to View AnswerDiff: E 89 . 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 write-off 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.) Page 16 Chapter 21: Working Capital Management (21.13) Commercial paper 90 . Which of the following incorrect? statements concerning Register to View AnswerDiff: E commercial 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. Medium: (21.1) Cash conversion cycle Register to View AnswerDiff: M 91 . 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. 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. (21.1) Cash conversion cycle Register to View AnswerDiff: M 92 . Which of the following actions are likely to reduce the length of a companys 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. Chapter 21: Working Capital Management Page 17 (21.2) Working capital policy Register to View AnswerDiff: M 93 . 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. (21.3) Cash balances 94 . Which of the following statements is most correct? Register to View AnswerDiff: M 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 firms 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. (21.3) Compensating balances 95 . Which of the following statements is most correct? Register to View AnswerDiff: M 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. Page 18 Chapter 21: Working Capital Management (21.4) Cash budget 96 . Which of the following statements is most correct? Register to View Answer Diff: M 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 firms 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. (21.5) Cash management 97 . A lockbox plan is most beneficial to firms which a. b. c. d. e. Send Have Have Hold Make Register to View AnswerDiff: M 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. Register to View AnswerDiff: M (21.5) Float 98 . 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. Chapter 21: Working Capital Management Page 19 99 (21.7) Receivables management . Which of the following statements is most correct? Register to View Answer Diff: M 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 firms 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 firms 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. (21.7) DSO and aging schedule 100 . Which of the following statements is most correct? Register to View AnswerDiff: M a. If a firms 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 cant 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 firms financial statements. (21.7) Days sales outstanding (DSO) 101 . Which of the following statements is most correct? Register to View AnswerDiff: M a. Other things held constant, the higher a firms 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 firms 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. Page 20 Chapter 21: Working Capital Management 102 (Comp.) Miscellaneous concepts . Which of the following statements is most correct? Register to View Answer Diff: M 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. (21.9) Working capital financing policy Register to View AnswerDiff: M 103 . 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 Spontaneous liabilities Short-term debt Long-term debt Common equity Total claims 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 companys working capital financing policy. e. Statements a and c are correct. Peak $ 50 0 40 100 500 $690 $ 30 50 300 310 $690 Off-peak $ 30 20 20 50 500 $620 $ 10 0 300 310 $620 Chapter 21: Working Capital Management Page 21 (21.9) Working capital financing policy 104 . Which of the following statements is most correct? Register to View Answer Diff: M 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. (21.9) Working capital financing policy 105 . Which of the following statements is most correct? Register to View AnswerDiff: M 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. (21.10) Marketable securities portfolio Register to View AnswerDiff: M 106 . Which of the following statement completions is most correct? If the yield curve is upward sloping, then a firms 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. Register to View AnswerDiff: M (21.11) Short-term financing 107 . Which of the following statements is most correct? a. Under normal conditions, a firms 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 firms 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 Page 22 Chapter 21: Working Capital Management 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 firms 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. (21.11) Short-term versus long-term financing 108 . Which of the following statements is most correct? Register to View AnswerDiff: M a. Under normal conditions the shape of the yield curve implies that the interest cost of short-term debt is greater than that of longterm 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. Multiple Choice: Problems Easy: 109 (21.1) Cash conversion cycle Register to View AnswerDiff: E . Spartan Sporting Goods has $5 million in inventory and $2 million in accounts receivable. Its average daily sales are $100,000. The companys payables deferral period (accounts payable divided by daily purchases) is 30 days. What is the length of the companys cash conversion cycle? a. 100 days b. 60 days c. 50 days d. 40 days e. 33 days Chapter 21: Working Capital Management Page 23 (21.1) Cash conversion cycle Register to View AnswerDiff: E 110 . 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 firms cash conversion cycle? a. b. c. d. e. 87 90 65 48 66 days days days days days (21.4) Sales collections Register to View AnswerDiff: E 111 . 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. $55,000 $47,400 $38,000 $32,800 $30,000 (21.5) Float Register to View AnswerDiff: E 112 . 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 Page 24 Chapter 21: Working Capital Management (21.6) Inventory and NPV Register to View AnswerDiff: E 113 . 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 clients 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 Diff: E 365-day and its is the (21.6) Inventory turnover ratio and DSO Register to View Answer114 . Bowa Constructions days sales outstanding is 50 days (on a basis). The companys accounts receivable equal $100 million balance sheet shows inventory equal to $125 million. What companys inventory turnover a. ratio? b. c. d. e. 5.84 4.25 3.33 2.75 7.25 Chapter 21: Working Capital Management Page 25 (21.8) Accounts receivable balance Register to View AnswerDiff: E 115 . 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. $194,444 $ 57,143 $ 5,556 $ 97,222 $212,541 (21.8) Cost of trade credit Register to View AnswerDiff: E 116 . 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. 21.71% 22.07% 22.95% 23.48% 24.52% (21.8) Cost of trade credit Register to View AnswerDiff: E 117 . 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% (21.8) Cost of trade credit Register to View AnswerDiff: E 118 . 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% Page 26 Chapter 21: Working Capital Management (21.8) Free trade credit Register to View AnswerDiff: E 119 . 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. $30,000 $40,000 $50,000 $60,000 $70,000 (21.9) Maturity matching Register to View AnswerDiff: E 120 . Wildthing Amusement Companys 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. $ 90,000 $260,000 $350,000 $410,000 $320,000 (21.12) Revolving credit agreement cost Register to View AnswerDiff: E 121 . 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 Chapter 21: Working Capital Management Page 27 Medium: 122 (21.1) Inventory conversion period Register to View AnswerDiff: 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 firms inventory conversion period? a. 365.0 days b. 182.5 days c. 30.3 days d. 15.2 days e. 10.5 days (21.1) Cash conversion cycle Register to View AnswerDiff: M 123 . 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 firms 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 (21.1) Cash conversion cycle Register to View AnswerDiff: M 124 . 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 firms cash conversion cycle. Using the following information and a 365-day year, what is your estimate of the firms current cash conversion cycle? a. b. c. d. e. Page 28 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. days days days days days Chapter 21: Working Capital Management 49 193 100 168 144 (21.1) Cash conversion cycle Register to View AnswerDiff: M 125 . 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 companys cash conversion cycle? Round to the nearest whole day. a. b. c. d. e. -40 -22 -13 +22 +40 days days days days days (21.1) Cash conversion cycle Register to View AnswerDiff: M 126 . 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. -14.0 -18.8 -28.0 -25.6 -38.0 days days days days days (21.2) ROE and working capital policy Register to View AnswerDiff: M 127 . Jarrett Enterprises is considering whether to pursue a restricted or relaxed current asset investment policy. The firms 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 firms debt is 10 percent, and the firms 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% Chapter 21: Working Capital Management Page 29 (21.4) Cash budget Register to View AnswerDiff: M 128 . Chadmark Corporations 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 dont receive a discount. Chadmarks bad debts are very small and are excluded from this analysis. Purchases for next months sales are constant each month at $1,500. Other payments for wages, rent, and taxes are constant at $700 per month. Construct a single months 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. $2,600 $ 800 $ 776 $ 740 $ 728 (21.5) Lockbox Register to View AnswerDiff: M 129 . 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 Page 30 Chapter 21: Working Capital Management (21.7) Aging Schedule Register to View AnswerDiff: M 130 . Short Construction offers its customers credit terms of 2/10, net 30 days, while Fryman Construction offers its customers 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 Value of Account $58,800 19,600 14,700 2,940 1,960 $98,000 Percentage of Total Value 60% 20 15 3 2 Fryman Value of Account $ 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. (21.8) Accounts payable balance Register to View AnswerDiff: M 131 . 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 firms 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 Chapter 21: Working Capital Management Page 31 (21.8) EAR cost of trade credit Register to View AnswerDiff: M 132 . 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 firms current practice, using a 365-day year? a. 36.7% b. 105.4% c. 73.4% d. 43.6% e. 109.0% (21.8) EAR cost of trade credit Register to View AnswerDiff: M 133 . 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 companys accounts payable, and what is the effective annual cost of its trade credit? (Assume a 365-day year.) a. b. c. d. e. $208,333; $416,667; $416,667; $625,000; $625,000; 17.81% 17.54% 27.43% 17.54% 23.45% (21.8) EAR cost of trade credit Register to View AnswerDiff: M 134 . 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% Page 32 Chapter 21: Working Capital Management (21.8) Costly trade credit Register to View AnswerDiff: M 135 . 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 suppliers credit terms? (Assume a 365-day year.) a. b. c. d. e. $88,000 $33,000 $55,000 $50,000 $44,000 (21.8) Stretching accounts payable Register to View AnswerDiff: M 136 . C+ Notes business is booming, and it needs to raise more capital. The company purchases supplies from a single supplier on terms of 1/10, net 20 days, and it currently takes the discount. One way of getting the needed funds would be to forgo the discount, and C+s owner believes she could delay payment to 40 days without adverse effects. What is the effective annual rate of stretching the accounts payable? a. b. c. d. e. 10.00% 11.11% 11.75% 12.29% 13.01% Chapter 21: Working Capital Management Page 33 (Comp.) Changes in working capital and free cash flow Register to View AnswerDiff: M 137 . Allen Brothers is interested in increasing its free cash flow (which it hopes will result in a higher EVA and stock price). The companys goal is to generate $180 million of free cash flow over the upcoming year. Allens 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 firms tax rate is 40 percent. that there will be no change in its cash and nor will there be any changes in notes payable the following will enable the company to achieve $180 million in free cash flow? The company forecasts marketable securities, or accruals. Which of its goal of generating b. Accounts receivable increase $470 million, inventory increases $230 million, and accounts payable increase $790 million. c. Accounts receivable increase $470 million, inventory increases $230 million, and accounts payable increase $610 million. d. Accounts receivable decrease by $500 million, inventory increases by $480 million, and accounts payable decline by $80 million. e. Accounts receivable decrease by $400 million, inventory increases by $480 million, and accounts payable increase by $80 million. f. Accounts receivable increase by $500 million, inventory increases by $100 million, and accounts payable decline by $480 million. Tough: (21.1) Cash conversion cycle Register to View AnswerDiff: T 138 . 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. $ 101,900 $1,000,000 $ 136,986 $ 333,520 $ 0 Page 34 Chapter 21: Working Capital Management (21.7) Accounts payable balance Register to View AnswerDiff: T 139 . 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 firms average accounts payable balance? Assume a 365-day year. a. b. c. d. e. $187,475 $374,951 $223,333 $562,426 $457,443 (21.8) Financial statements and trade credit Register to View AnswerDiff: T 140 . 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 firms tax rate is 40 percent. If the firm implements the plan, what is the expected change in Quickbows net income? a. b. c. d. e. -$23,520 -$31,440 +$23,520 +$38,448 +$69,888 Chapter 21: Working Capital Management Page 35 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. Callisons 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 firms debt is 10 percent, and the firms 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. (21.2) Working capital investment policy Register to View AnswerDiff: M 141 . 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. $ 3,233 $ 6,175 $ 9,818 $ 7,200 $10,136 (21.2) Working capital investment policy and ROE Register to View AnswerDiff: M 142 . 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% (21.2) Working capital investment policy and ROE Register to View AnswerDiff: M 143 . 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% Page 36 Chapter 21: Working Capital Management Financial Calculator Section Multiple Choice: Problems Medium: (21.2) Permanent working capital financing Register to View AnswerDiff: M 144 . Wicker Corporation is determining whether to support $100,000 of its permanent working capital with a bank note or a short-term bond. The firms 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: (21.8) DSO and the cost of trade credit Register to View AnswerDiff: T 145 . 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 days days days days days Chapter 21: Working Capital Management Page 37 CHAPTER 21 ANSWERS AND SOLUTIONS Page 38 Chapter 21: Working Capital Management 1 . 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. (21.2) Net working capital (21.2) Net working capital (21.2) Working capital (21.2) Working capital policy (21.3) Goal of cash management (21.3) Motives for holding cash (21.4) Cash budget (21.4) Cash budget (21.5) Float (21.5) Lockbox (21.6) Goal of inventory management (21.6) Goal of inventory management (21.6) Inventory management interaction (21.7) Receivables balance (21.7) Receivables balance (21.7) Receivables aging (21.7) Monitoring receivables (21.7) Credit policy (21.7) Cash discounts (21.7) Trade discounts (21.7) Change in credit policy (21.8) Accruals (21.8) Accruals (21.8) Accruals (21.8) Trade credit (21.8) Trade credit (21.8) Trade credit (21.8) Trade credit (21.8) Trade credit Register to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View Answer Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E 30. 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. 44. 45. 46. 47. 48. 49. 50. 51. (21.8) Cost of trade credit (21.8) Cost of trade credit (21.8) Cost of trade credit (21.8) Net trade credit (21.8) Net trade credit (21.8) Stretching accounts payable (21.9) Working capital policy (21.9) Short-term financing (21.9) Short-term financing (21.9) Short-term financing (21.12) Bank loans (21.12) Bank loans (21.12) Promissory note (21.12) Line of credit (21.12) Revolving credit and risk (21.4) Cash and capital budgets (21.4) Cash budget and depreciation (21.4) Seasonal patterns and cash (21.5) Synchronization of cash flows (21.5) Float (21.5) Float Register to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View Answer Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M (21.5) Lockbox Register to View AnswerInterest earned = $250,000(1.5)(0.06) = $22,500. Thus, the cost ($23,000) exceeds the benefit ($22,500). (21.7) Receivables and growth (21.7) Receivables and growth (21.7) Collection policy (21.7) Collection policy (21.7) Cash versus credit sales (21.7) Days sales outstanding (21.7) Extending the credit period Register to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View Answer 52. 53. 54. 55. 56. 57. 58. Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M 59. 60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70. 71. 72. 73. 74. (21.7) DSO and past due accounts (21.7) Aging schedule and credit policy (21.8) Trade credit (21.8) Stretching accounts payable (21.8) Stretching accounts payable (21.8) Stretching accounts payable (21.9) Maturity matching (21.9) Maturity matching (21.9) Aggressive financing approach (21.9) Aggressive financing approach (21.9) Risk and short-term financing (21.9) Short-term financing (21.9) Short-term financing (21.12) Prime rate (21.12) Revolving credit agreement Register to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View Answer Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M Diff: M (21.1) Cash conversion cycle Register to View AnswerDiff: 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. (21.2) Working capital (21.4) Cash budget (21.4) Cash budget Register to View AnswerRegister to View AnswerRegister to View AnswerDiff: E Diff: E Diff: E 75. 76. 77. 78. (21.4) Cash budget Register to View AnswerDiff: 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. Since statements b and c are true, statement d is the correct choice. (21.5) Cash management Register to View AnswerDiff: 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 79. necessitate a large line of credit. 80. (21.5) Cash management Register to View AnswerDiff: 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. (21.5) Lockbox (21.6) Inventory management (21.7) Monitoring receivables (21.7) Credit policy (21.7) Credit policy (21.9) Working capital financing policy (21.9) Working capital financing Register to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerDiff: E Diff: E Diff: E Diff: E Diff: E Diff: E Diff: E 8 81 . 82. 83. 84. 85. 86. 87. 88. (21.9) Working capital financing Register to View AnswerDiff: 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. (21.10) Marketable securities (21.13) Commercial paper (21.1) Cash conversion cycle Register to View AnswerRegister to View AnswerRegister to View AnswerDiff: E Diff: E Diff: M 89. 90. 91. 92. (21.1) Cash conversion cycle Register to View AnswerDiff: 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. (21.2) Working capital policy Register to View AnswerDiff: 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. (21.3) Cash balances (21.3) Compensating balances (21.4) Cash budget (21.5) Cash management (21.5) Float (21.7) Receivables management Register to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerDiff: M Diff: M Diff: M Diff: M Diff: M Diff: M 93. 94. 95. 96. 97. 98. 99. 100. 101. 102. 103. 104. 105. (21.7) DSO and aging schedule (21.7) Days sales outstanding (DSO) (Comp.) Miscellaneous concepts (21.9) Working capital financing policy (21.9) Working capital financing policy Register to View AnswerRegister to View AnswerRegister to View AnswerRegister to View AnswerRegister to View Answer Diff: M Diff: M Diff: M Diff: M Diff: M (21.9) Working capital financing policy Register to View AnswerDiff: M Statement b illustrates an aggressive financing policy, not a conser-vative one. (21.10) Marketable securities portfolio Register to View AnswerDiff: M 106. 107. 1 108 . 1 109 . (21.11) Short-term financing Register to View AnswerDiff: 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. (21.11) Short-term versus long-term financing Register to View AnswerDiff: M (21.1) Cash conversion cycle Register to View AnswerDiff: 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 Step 1: Determine the inventory conversion period: Inventory conversion period = Inventory/Daily sales = $5,000,000/$100,000 = 50 days. Determine the receivables collection period: Receivables collection period = Receivables/Daily sales = $2,000,000/$100,000 = 20 days. Given data and information calculated above, determine the firms cash conversion cycle: Cash conversion cycle = 50 + 20 - 30 = 40 days. Step 2: Step 3: 110. (21.1) Cash conversion cycle Register to View AnswerDiff: E Cash conversion Inv. conversion Rec. collection Pay. deferral = + cycle period period period = 72 + 60 - 45 = 87 days. (21.4) Sales collections Register to View AnswerDiff: E 111. March receipts = (0.20)($38,000) + (0.40)($33,000) + (0.40)($30,000) = $32,800. 1 112 . (21.5) Float Positive disbursement float = $15,000(5) = $75,000. Negative collections float = $17,000(3) = $51,000. Net float = $75,000 - $51,000 = $24,000. (21.6) Inventory and NPV Register to View AnswerDiff: E 113. Register to View Answer Diff: E We are given the up-front cost. The new software systems 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 3 (1.1) (1.1) (1.1) $300, , 000 000 $300, , 000 000 + + 4 5 (1.1) (1.1) 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 + 114. (21.6) Inventory turnover ratio and DSO Step 1: Determine sales level using the DSO equation. Receivables DSO = Sales/365 $100, , 000 000 50 = Sales/365 50(Sales) $100,000,000 = 365 $36,500,000,000 = 50(Sales) $730,000,000 = Sales. Calculate inventory turnover ratio. Sales Inv. turnover = Inv. $730 000, , 000 Inv. turnover = $125, , 00 000 0 Inv. turnover = 5.84. Register to View AnswerDiff: E Step 2: 1 115 . 1 116 . (21.8) Accounts receivable balance Register to View AnswerDiff: E Accounts receivables = DSO Sales per day = 35($2,027,773/365) = $194,444. (21.8) Cost of trade credit 3 Nominal percentage cost = 97 (21.8) Cost of trade credit 2 Nominal percentage cost = 98 Register to View Answer365 = 21.71%. 52 Register to View Answer365 = 37.24%. 35 - 15 Diff: E Diff: E 1 117 . 118 . (21.8) Cost of trade credit 4 365 Nominal percentage cost = = 3.042 = 304.2%. 96 5 Register to View Answer Diff: E 1 119 . (21.8) Free trade credit $730, 000 Daily purchases = = $2,000. 365 Free trade credit = $2,000 15 = $30,000. Register to View Answer Diff: E 120. (21.9) Maturity matching Register to View AnswerDiff: 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. Long-term debt financing = $60,000 + $260,000 = $320,000. 121. (21.12) Revolving credit agreement cost Register to View AnswerInterest 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 Diff: E 122. Inventory conversion period 365 days Inventory conversion period (ICP) = . Sales/Inventory Annual sales = 12 $2 million = $24 million. Inventory = 0.5 $2 million = $1 million. 365 ICP = = 15.2 days. $24/$1 Register to View Answer Diff: M 123. (21.1) Cash conversion cycle Old 365 365 ICP = $80 = = 91.25 4 $20 + $16 DSO = $80 = 73.00 365 DP = 35 days -35.00 CCC = 129.25 days Register to View AnswerWith Change 365 365 $80 = = 5 $16 $14 $80 = 365 DP New CCC = 73.000 + 63.875 Diff: M -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). 124. (21.1) Cash conversion cycle Register to View AnswerDiff: 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. 125. (21.1) Cash conversion cycle Register to View AnswerDiff: 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. 126. (21.1) Cash conversion cycle Register to View AnswerFirst, 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. 127. (21.2) ROE and working capital policy Register to View AnswerDiff: M Diff: M Construct simplified comparative balance sheets and income statements for the restricted and relaxed policies (In thousands of dollars): 15% of Sales 25% of Sales Balance sheet: Current assets Fixed assets Total assets Debt Equity Total liabilities and equity Income statement: EBIT Interest (10%) EBT Taxes (40%) Net income Restricted $ 60.0 100.0 $160.0 $ 80.0 80.0 $160.0 Relaxed $100.0 100.0 $200.0 $100.0 100.0 $200.0 $ 36.0 (8.0) $ 28.0 (11.2) $ 16.8 $ 36.0 (10.0) $ 26.0 (10.4) $ 15.6 $15.6/$100 = 0.156. Register to View AnswerDiff: M ROE = NI/Equity $16.8/$80 = 0.21 Difference in ROEs = 0.21 - 0.156 = 0.054 = 5.4%. 128. (21.4) Cash budget Construct a simplified cash budget: Sales Collections (same months sales) Collections (last months sales) Total collections Purchases payments Other payments Total payments Net cash gain (loss) 1 129 . $3,000 1,176 1,800 2,976 1,500 700 2,200 $ 776 (0.98 0.40 $3,000) (1.00 0.60 $3,000) (21.5) Lockbox Register to View AnswerCalculate 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. (21.7) Aging Schedule Register to View Answer Diff: M 130. Diff: M Shorts 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%. Frymans 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, 00 + $2, 40 + $1, ) 7 9 960 Short: = 20%. $98 000 , ($10, 90 + $4, ) 2 410 Fryman: = 10%. $147 000 , 131. (21.8) Accounts payable balance 2 365 Approximate percentage cost = = 0.212828. 98 35 $159, 621 Accounts payable = = $750,000. 0.212828 Register to View Answer Diff: M 1 132 . (21.8) EAR cost of trade credit Register to View AnswerDiff: M Calculate the nominal percentage, which is the nominal annual cost: 2 365 days Nominal cost = = 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%. Financial calculator solution: (EAR) Inputs: P/YR = 36.5; NOM% = 74.49. Output: EFF% = 109%. 1 133 . (21.8) EAR cost of trade credit Register to View AnswerDiff: 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%. (21.8) EAR cost of trade credit Calculate the interest rate per period Periodic rate = 2/98 = 2.04%. Calculate the number of compounding periods Number of compounding periods = 365/50 = 7.30. Use periodic rate and compounding periods to determine the annual nominal rate 134. Register to View Answer Diff: M 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. (21.8) Costly trade credit Register to View AnswerDiff: M Phranklins 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. (21.8) Stretching accounts payable Register to View AnswerDiff: M Accounts payable: (1/99)(365/(40 - 10)) = 12.29%. However, this is a nominal rate. EAR is calculated as follows: EAR = (1 + 1/99)12.1667 - 1 = 13.01%. (Comp.) Changes in working capital and free cash flow Register to View AnswerDiff: M 136. 137. FCF = EBIT(1 T) + DEP CapExp - NOWC $180,000,000 = $850,000,000(0.6) + $120,000,000 - $360,000,000 - NOWC $180,000,000 = $510,000,000 + $120,000,000 - $360,000,000 - NOWC $180,000,000 = $270,000,000 - NOWC -$90,000,000 = - 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. (21.1) Cash conversion cycle 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. 1 139 . (21.7) Accounts payable balance Step 1: Register to View AnswerDiff: T Register to View AnswerDiff: T Calculate the nominal annual cost of trade credit. 2 365 Nominal annual cost = 98 30 10 = 0.0204 18.25 = 37.24%. 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, 00 0 Free trade credit = $139,650. Determine gross and net sales. $139,650 = Discount, which represents 2% of sales. Step 2: Step 3: .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 Daily net sales = 365 = $18,747.53. Accounts payable balance = $18,747.53 30 = $562,426.03 $562,426. 140. (21.8) Financial statements and trade credit Calculate A/P with and without taking discounts: A/PNo discount = $11,760 30 days = $352,800. A/PDiscount = $11,760 10 days = $117,600. Register to View AnswerDiff: T 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 Dont 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. 141. (21.2) Working capital investment policy Step 1: Register to View AnswerDiff: M Calculate net fixed assets, which will be the same under either policy. S FA turnover = NFA $3, , 600 000 4.0 = NFA NFA = $900,000. Step 2: Determine total assets under each policy, given the total assets turnover ratio for each one. S Restricted: Total assets turnover = TA $3, , 600 000 2.5 = TA 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 Total liabilities & equity $ 720,000 720,000 $1,440,000 $ 818,182 818,182 $1,636,364 Step 4: Determine interest under each policy: Restricted: $720,000 0.10 = $72,000. Relaxed: $818,182 0.10 = $81,818. Calculate the difference in interest expense (the savings) between the 2 policies: $81,818 - $72,000 = $9,818. Register to View AnswerDiff: M Step 5: 142. (21.2) Working capital investment policy and ROE 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 Calculate ROE using common equity as calculated in the prior problem for each policy. $46, 800 $40, 909 Restricted: ROE = Relaxed: ROE = $720, 00 0 $818 182 , = 6.5%. = 5.0%. Calculate the difference in ROEs. ROE = 6.5% - 5.0% = 1.5%. Register to View AnswerDiff: M Step 2: Step 3: 143. (21.2) Working capital investment policy and ROE 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. Develop the firms balance sheet under the restricted policy. Total assets Debt Equity Total liabilities & equity Step 4: $1,224,000 $ 612,000 612,000 $1,224,000 Step 3: Develop the firms income statement under the restricted policy. EBIT Interest (10%) EBT Taxes (40%) Net income $135,000 61,200 $ 73,800 29,520 $ 44,280 Step 5: Calculate the firms ROE under the restricted policy. ROE = NI/E = $44,280/$612,000 ROE = 7.24%. Calculate the difference in ROEs between the 2 policies. ROE = 7.24% - 5% = 2.24%. Step 6: 144. (21.2) Permanent working capital financing Register to View AnswerDiff: M Time lines: Note that the cash flows viewed from the firms 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: 0i=? | +973.97 Note: Bond: Inputs: Output: Inputs: Output: 1 | 2 Years | FV = -118,810 2 Years | -85 FV = -1,000 1 | -85 N = 2; PV = 100,000; PMT = 0; FV = -118,810. I = 9.0%. N = 2; PV = 973.97; PMT = -85; FV = -1,000. I = 10.0%. The difference is 10.0% - 9.0% = 1.0%. 145. (21.8) DSO and the cost of trade credit Register to View AnswerDiff: 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. ... View Full Document

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