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06 Chapter - Working Capital and the Financing Decision Chapter 06 Working Capital and the Financing Decision True / False Questions 1. The faster a firm's growth in sales, the more likely it is that an increasing percentage of financing will be internally generated. True False 2. Supply chain management has little impact on financial performance and is primarily a marketing and management concept. True False 3. Many companies such as McDonalds have embraced supply chain management using webbased procedures. True False 4. Working capital management is relatively unimportant for the small business. True False 5. The financial manager generally needs to devote little time to management of working capital. True False 6. Liquidating current assets are really fixed assets since they have lives greater than one year. True False 6-1 Chapter 06 - Working Capital and the Financing Decision 7. The key to current asset planning is the ability of management to forecast sales accurately and then match production schedules with the sales forecast. True False 8. One of the big benefits of implementing supply chain management, is a reduction in inventory on hand. True False 9. Permanent current assets are not similar to fixed assets because they are fully liquidated within the year. True False 10. Wal-Mart requires manufacturers to ship goods with RFID tags so that it can better track inventory and reduce the need for supply chain management. True False 11. When using level production, inventory will peak in the month where unit sales trend above the production level. True False 12. Cash, accounts receivables, and inventory all move monthly in the same direction under level production. True False 13. Level production methods smooth production schedules and utilize manpower and equipment more efficiently than seasonal production methods. True False 6-2 Chapter 06 - Working Capital and the Financing Decision 14. The use of point-of-sale terminals has made it easier for many retail store managers to manage their inventory. True False 15. The cash budget combines the cash receipts and cash payments schedules in determining cash flow. True False 16. Ideally, permanent current assets should be financed with short-term borrowings. True False 17. As a general rule, it is desirable to finance the permanent assets, including "permanent current assets", with long-term debt and equity. True False 18. Increased use of long-term financing is generally a more conservative approach to current asset financing. True False 19. A risky financial plan will use long-term financing for fixed assets, permanent current assets, and a portion of temporary current assets. True False 20. Short-term financing is risky because of the possibility of rising short-term rates and the inability of always being able to refund short-term debt. True False 6-3 Chapter 06 - Working Capital and the Financing Decision 21. Short-term interest rates are generally lower than long-term interest rates. True False 22. By using long-term capital to cover short-term needs, the firm is virtually assured of becoming technically insolvent. True False 23. Heavy use of long-term financing generally leads to lower financing costs. True False 24. During an economic "boom" period, a shortage of low-cost financing alternatives exists. True False 25. The "term structure of interest rates" refers to the relationship between yields on debt and their maturities. True False 26. The "term structure of interest rates" depicts the competitive cost of funds for the various short-term sources of funds such as Treasury bills, commercial paper, and bank CDs. True False 27. The "term structure of interest rates" is a schedule that tells when a company's bonds mature and shows how many dollars a firm must pay in interest payments. True False 28. Yield curves change very little in the short run (3 months). True False 6-4 Chapter 06 - Working Capital and the Financing Decision 29. If the liquidity premium theory was the only correct theory, yield curves would always be upward-sloping. True False 30. The ratio of long-term financing to short-term financing at any given time will be greatly influenced by the term structure of interest rates. True False 31. It is not necessary to understand interest rate movements when deciding the structure of short-term debt relative to long-term debt. True False 32. The behavior of various kinds of financial institutions determines the shape of the yield curve, according to the market segmentation theory. True False 33. Only the market segmentation theory has any significant impact on interest rates. True False 34. According to the expectations hypothesis, when long-term interest rates are higher than short-term interest rates, long-term rates are expected to decline. True False 35. According to the expectations hypothesis, when long-term interest rates are higher than short-term interest rates, short-term rates are expected to rise. True False 6-5 Chapter 06 - Working Capital and the Financing Decision 36. Short-term interest rates have historically been more volatile than long-term rates. True False 37. The successful financial manager is very interested in the term structure of interest rates but is not concerned with the relative volatility or historical level of interest rates. True False 38. Short-term interest rates are more dependent upon inflation than on current demand for money. True False 39. Interest rates and inflation are inversely related. True False 40. During tight money periods, short-term financing may be difficult to find. True False 41. The expected value is the sum of the probabilities of all expected events. True False 42. Expected value techniques allow consideration of more than one possible outcome. True False 43. In periods of tight money, long-term rates are often higher than short-term rates. True False 6-6 Chapter 06 - Working Capital and the Financing Decision 44. If we examine the ratio of working capital to sales, we can see that for the last several decades, firms' liquidity has been increasing. True False 45. Heavy risk exposure due to short-term borrowing can be compensated for by carrying illiquid assets. True False 46. Heavy use of long-term financing can generate more profit for the company during a tight money period. True False 47. Use of long-term financing and the carrying of highly liquid assets is a high-risk combination. True False 48. Firms with predictable cash-flow patterns should assume relatively low levels of risk. True False 49. Firms with highly volatile and perishable inventory should assume relatively low levels of risk. True False 50. The more short-term financing relative to long-term financing, the more risky the financial structure. True False 6-7 Chapter 06 - Working Capital and the Financing Decision 51. Immediate access to capital markets allows greater risk-taking capability. True False 52. Working capital management primarily involved long-term planning. True False 53. The aggressive financing plan involves utilizing long-term financing for permanent and temporary current assets. True False 54. Expected value analysis requires taking the difference between the actual projected outcome and the historic outcome times its' probability and summing these totals. True False 55. Long-term financing is usually less expensive than short-term financing because it is not as advantageous to the corporation as short-term financing. True False 56. The three most important factors when selecting a financing plan are risk, asset liquidity, and timing. True False 57. Generally a downward sloping yield curve indicates an eminent economic boom. True False Multiple Choice Questions 6-8 Chapter 06 - Working Capital and the Financing Decision 58. Pressure to increase current asset buildup often results from A. decline in sales growth. B. rapidly expanding sales. C. increased demands of short-term creditors. D. none of these. 59. Working capital management is primarily concerned with the management and financing of A. cash and inventory. B. current assets and current liabilities. C. current assets. D. receivables and payables. 60. A financial executive devotes the most time to A. Long-range planning. B. Capital budgeting. C. Short-term financing. D. Working capital management. 61. The term "permanent current assets" implies A. the same thing as fixed assets. B. nonmarketable assets. C. some minimum level of current assets that are not self-liquidating. D. inventory. 62. The concept of a self-liquidating asset implies that A. the working capital associated with a product will be liquidated within a one year period. B. all the product will be sold, receivables collected and bills paid over the time period specified. C. assets associated with the production of a product will be liquidated over the depreciable life of the assets. D. self-liquidating assets be financed by long-term sources of capital. 6-9 Chapter 06 - Working Capital and the Financing Decision 63. Well implemented web-based supply chain management has all of the following benefits except A. reduces inventory on hand. B. speeds up the ordering and delivery process. C. reduces the number of suppliers bidding for a company's business. D. decreases overall costs. 64. Permanent current assets are not a factor in a manager's decision making process when all current assets will be A. financed by short-term debt. B. long-term in nature. C. self-liquidating. D. internally financed. 65. RFID chips have been used to A. track livestock. B. track marathon runner's time. C. track inventory at retailers. D. all of these. 66. Frisch Fish Corp expects net income next year to be $750,000. Inventory and accounts receivable will have to be increased by $650,000 to accommodate this sales level. Frisch will pay dividends of $300,000. How much external financing will Frisch Fish need assuming no organically generated increase in liabilities? A. No external financing is required. B. $100,000 C. $200,000 D. $300,000 6-10 Chapter 06 - Working Capital and the Financing Decision 67. Tinbergen Cans expects sales next year to be $50,000,000. Inventory and accounts receivable (combined) will increase $8,000,000 to accommodate this sales level. The company has a profit margin of 6 percent and a 30 percent dividend payout. How much external financing will the firm have to seek? Assume there is no increase in liabilities other than that which will occur with the external financing. A. No external financing will be needed. B. Less than $1,000,000 of external financing is needed. C. Between $1,000,000 and $5,000,000 of external financing is needed. D. More than $5,000,000 of external financing is needed. 68. Samuelson will produce 20,000 units in January using level production. If each unit costs $500 to manufacture, what is the dollar value of ending inventory in January if beginning inventory is 10,000 units and January sales are 15,000?. A. Less than $5,000,000. B. Between $5,000,000 and $10,000,000. C. Greater than $10,000,000. D. There will be a shortage. 69. One advantage of level production is that A. manpower and equipment are used efficiently at lower cost. B. current assets fluctuate more than with seasonal production. C. seasonal bulges and sharp declines in current assets occur. D. None of these are advantageous. 70. Publishing companies are characterized by A. fluctuating production to match sales. B. seasonal sales. C. low inventories due to computer inventory management. D. a and b. 6-11 Chapter 06 - Working Capital and the Financing Decision 71. If a firm uses level production with seasonal sales A. as sales decline inventory will increase. B. as sales decline inventory will decrease. C. as sales decline accounts receivables will increase. D. a and c are correct. 72. Retail companies like Target and The Limited exhibit sales patterns that are mostly influenced by A. cyclical economic indicators. B. competitive prices. C. seasonality. D. sales promotions. 73. Retail companies like Target and Limited Brands are more likely to have A. stable sales and earnings per share. B. cyclical sales but less volatile earnings per share. C. cyclical sales and more volatile earnings per share. D. cyclical sales but stable accounts receivable and inventory. 74. The use of cash budgeting procedures A. helps the firm plan its current asset levels for a given production plan. B. makes managing inventory easier under seasonal production. C. illustrates fluctuating levels of current assets for a given production plan. D. all of these are correct. 75. Assuming level production throughout the year, and assuming receivables are collected in two equal installments over the two months subsequent to the sales period, developing the cash budget requires the following steps: A. calculate beginning accounts receivable balance B. calculate COGS C. estimate monthly net cash flow and bank borrowing or repayments D. calculate ending inventory 6-12 Chapter 06 - Working Capital and the Financing Decision 76. When actual sales are greater than forecasted sales A. inventory will decline. B. production schedules might have to be revised upward. C. accounts receivable will rise. D. all of these. 77. Normally, permanent current assets should be financed by A. long-term funds. B. short-term funds. C. borrowed funds. D. internally generated funds. 78. Ideally, which of the following type of assets should be financed with long-term financing? A. Fixed assets only B. Fixed assets and temporary current assets C. Fixed assets and permanent current assets D. Temporary and permanent current assets 79. A conservatively financed firm would A. use long-term financing for all fixed assets and short-term financing for all other assets. B. finance a portion of permanent assets and short-term assets with short-term debt. C. use equity to finance fixed assets, long-term debt to finance permanent assets, and shortterm debt to finance fluctuating current assets. D. use long-term financing for permanent current assets and fixed assets and a portion of the short-term fluctuating assets and use short-term financing for all other short-term assets. 80. Generally, more use is made of short-term financing because A. short-term interest rates are generally lower than long-term interest rates. B. most firms do not have Basic access to the capital markets. C. short-term financing is usually more predictable than long-term financing. D. a and b above. 6-13 Chapter 06 - Working Capital and the Financing Decision 81. The term structure of interest rates A. is an indication of investors' expectations about inflation and future interest rates. B. will be downward sloping if short-term interest rates are higher than long-term rates. C. will be upward sloping under normal conditions. D. all of these. 82. The term structure of interest rates A. changes daily to reflect current competitive conditions in the money and capital markets. B. plots returns for securities of different risk. C. shows the relative interest spread between bonds with different risk ratings such as AAA, AA, A, BBB, etc. D. depicts interest rates for T-bills over the last year. 83. The term structure of interest rates is influenced by A. inflation. B. money supply. C. Federal Reserve activities. D. all of these are true 84. The term structure of interest rates or the yield curve A. is normal when short-term rates are higher than long-term rates. B. is inverted when short-term rates are lower than long-term rates. C. shows the yield to maturity for securities of equal risk over time. D. all of these are true. 85. Financial managers can accurately predict future interest rates by A. calculating the anticipated inflation rate B. the Fed's decision regarding the target federal funds rate C. measuring investor sentiment and consumer confidence indices D. none of these 6-14 Chapter 06 - Working Capital and the Financing Decision 86. The belief that investors require a higher return to entice them into holding long-term securities is the viewpoint of the A. the expectations hypothesis. B. segmentation theory. C. the liquidity premium theory. D. market credit crunch theory. 87. The term structure of interest rates A. is often referred to as the yield curve. B. depicts the relative level of short and long-term interest rates. C. is usually constructed with U.S. government securities of varying maturities. D. all of these. 88. Yield curves change daily to reflect A. changing conditions in the money and capital markets. B. new inflation expectations. C. changing conditions in the overall economy. D. all of these. 89. U.S. government securities are used to construct yield curves because A. they are free of default risk. B. the large number of maturities form a continuous curve. C. both a and b. D. none of these. 90. As the economy moves through a business cycle, which of the following term structure of interest rate theories dominate the shape of the yield curve. A. The expectations theory B. The market segmentation theory C. The liquidity premium theory D. None of these dominate the shape of the yield curve 6-15 Chapter 06 - Working Capital and the Financing Decision 91. Some analysts believe that the term structure of interest rates is determined by the behavior of various types of financial institutions. This theory is called the A. expectations hypothesis. B. market segmentation theory. C. liquidity premium theory. D. theory of industry supply and demand for bonds. 92. The theory of the term structure of interest rates which suggests that long-term rates are determined by the average of short-term rates expected over the time that a long-term bond is outstanding is the A. expectations hypothesis. B. segmentation theory. C. liquidity premium theory. D. market average rate theory. 93. A "normal" term structure of interest rates would depict A. short-term rates higher than long-term rates. B. long-term rates higher than short-term rates. C. no general relationship between short- and long-term rates. D. Intermediate rates (1-5 years) lower than both short-term and long-term rates. 94. A firm will usually increase the ratio of short-term debt to long-term debt when A. short-term debt has a lower cost than long-term equity. B. the term structure is inverted and expected to shift down. C. the term structure is upward sloping and expected to shift up. D. the firm is undertaking a large capital budgeting project. 95. Which of the following yield curves would be characteristic during a period of high economic growth? A. Upward sloping B. Downward sloping C. Horizontal D. Humped 6-16 Chapter 06 - Working Capital and the Financing Decision 96. An inverted yield curve would suggest that A. interest rates are expected to rise. B. interest rates are expected to fall. C. inflation is expected to rise in the future. D. long-term rates are being pushed up by federal reserve policy. 97. When the term structure of interest rates is downward sloping and interest rates are expected to decline, the A. financial manager generally borrows short-term. B. financial manager borrows at the lower long-term rates. C. corporation's ratio of short-term to long-term debt is low. D. none of these. 98. During tight money periods A. long-term rates are higher than short-term rates. B. short-term rates are higher than long-term rates. C. short-term rates are equal to long-term rates. D. the relationship between short and long-term rates remains unchanged. 99. Which of the following techniques allows explicit consideration of more than one possible outcome? A. Operating leverage B. Present value C. Least-squares regression D. Expected value 100. Under normal conditions (60% probability), Financing Plan A will produce $30,000 higher return than Plan B. Under tight money conditions (40% probability), Plan A will produce $40,000 less than Plan B. What is the expected value of returns? A. $2800 B. $4,000 C. $4800 D. $2,000 6-17 Chapter 06 - Working Capital and the Financing Decision 101. Under normal conditions (70% probability), Plan A will produce $20,000 higher return than Plan B. Under tight money conditions (30% probability), Plan A will produce $100,000 less than Plan B. What is the expected value of returns? A. $28,000 B. ($16,000) C. $58,000 D. ($2,000) 102. Which of the following is a reason for diminishing liquidity in modern corporations? A. Just-in-time inventory programs. B. Better utilization of cash via computers. C. Increased use of point-of-sale terminals. D. All of these are reasons for diminishing liquidity. 103. Kuznets Rental Center requires $500,000 in financing over the next two years. Kuznets can borrow long-term at 8 percent interest per year for two years. Alternatively, Kuznets can borrow short-term and pay 6 percent interest in the first year. Then, Kuznets projects paying 9 percent interest in the second year. Assuming Kuznets pays off the accrued interest at the end of each year, which of the following statements is true? A. Kuznets will definitely end up paying more under the long-term financing plan. B. Kuznets will definitely end up paying less under the long-term financing plan. C. Kuznets will probably pay more under the short-term financing plan. D. Kuznets will probably pay less under the short-term financing plan. 104. Hicks Health Clubs, Inc., expects to generate an annual EBIT of $750,000 and needs to obtain financing for $1,200,000 of assets. Their tax bracket is 40%. If the firm goes with a short-term financing plan, their rate will be 7.5 percent, and with a long-term financing plan their rate will be 9 percent. By how much will their earnings after tax change if they choose the more conservative financing plan instead of the more aggressive plan? A. $10,000 B. ($10,800) C. ($6,000) D. $6,000 6-18 Chapter 06 - Working Capital and the Financing Decision 105. Hicks Health Clubs, Inc., expects to generate an annual EBIT of $750,000 and needs to obtain financing for $1,200,000 of assets. Their tax bracket is 40%. If the firm goes with a short-term financing plan, their rate will be 7.5 percent, and with a long-term financing plan their rate will be 9 percent. By how much will their earnings after tax change if they choose the more aggressive financing plan instead of the more conservative? A. $10,800 B. ($10,000) C. ($6,000) D. $6,000 106. An aggressive, risk-oriented firm will likely A. borrow long-term and carry low levels of liquidity. B. borrow short-term and carry low levels of liquidity. C. borrow long-term and carry high levels of liquidity. D. borrow short-term and carry high levels of liquidity. 107. Which of the following is not a condition under which a prudent manager would accept some risk in financing? A. Predictable cash-flow patterns B. Inventory is highly perishable C. Price of inventory is stable D. Basic access to capital markets 108. Risk exposure due to heavy short-term borrowing can be compensated for by A. carrying highly liquid assets. B. carrying illiquid assets. C. carrying longer term, more profitable current assets. D. carrying more receivables to increase cash flow. 6-19 Chapter 06 - Working Capital and the Financing Decision 109. Which of the following combinations of asset structures and financing patterns is likely to create the least volatile earnings? A. Illiquid assets and heavy short-term borrowing B. Illiquid assets and heavy long-term borrowing C. Liquid assets and heavy long-term borrowing D. Liquid assets and heavy short-term borrowing 110. Which of the following combinations of asset structures and financing patterns is likely to create the most volatile earnings? A. Illiquid assets and heavy short-term borrowing B. Illiquid assets and heavy long-term borrowing C. Liquid assets and heavy long-term borrowing D. Liquid assets and heavy short-term borrowing 111. An aggressive working capital policy would have which of following characteristics? A. A high ratio of long-term debt to fixed assets. B. A low ratio of short-term debt to fixed assets. C. A high ratio of short-term debt to long-term sources of funds. D. A short average collection period. 112. The following are the expected 1 year T-bill rates for the next 4 years: 3%, 4%, 5%, and 6%. What would you expect the rate for 3 year securities would be? A. 4% B. 4.5% C. 6% D. 3.75% 6-20 Chapter 06 - Working Capital and the Financing Decision 113. Riley Co. is considering a short-term or long-term financing plan for $4,000,000 in assets. They expect the following 1 year rates over the next 3 years: 6.5%, 7.75%, and 9%. Their long-term interest rate will be 7.5% for the 3 years. Assuming the rates follow their expectations, what will be the difference in interest costs over the 3 years? A. Long-term interest will be $30,000 more than short-term interest B. Long-term interest will be $30,000 less than short-term interest C. Long-term interest will be $140,000 less than short-term interest D. None of these 114. Genetech has $4,000,000 in assets, have decided to finance 30% with long-term financing (9% rate) and 70% with short-term financing (7%) rate. What will be their annual interest costs? A. $78,000 B. $126,000 C. $440,000 D. $304,000 115. When the yield curve is upward sloping, generally a financial manager should: A. utilize long-term financing B. utilize short-term financing C. wait for future financing D. lease 116. When the yield curve is downward sloping, generally a financial manager should A. expect an economic boom B. utilize long-term financing C. increase investment and level of financing overall D. utilize short-term financing Matching Questions 6-21 Chapter 06 - Working Capital and the Financing Decision 117. Match the following with the items below: Long-term interest rates reflect the average of expected short-term rates over the life of the longterm security. The financing and management of the current assets of the firm. Assets that are assumed to be long term in nature. Current assets that will not be reduced or 4. working capital converted to cash within the normal operating cycle management of the firm. Depicts in graphical form the relationship between interest rates and maturities for securities of equal 5. expected value risk. Financing provided by sellers or suppliers in the 6. trade credit normal course of business. Time periods in which financing may be difficult 7. market to find and interest rates may be quite high by normal segmentation theory standards. Equal monthly production used to smooth out 8. point of sales production schedules and employ manpower and terminals equipment more efficiently. A representative quantity from a probability distribution arrived at by multiplying each outcome 9. term structure of times the associated probability and summing up the interest rates products. 10. expectations Current assets that will be reduced or converted to hypothesis cash within the normal operating cycle of the firm. The relative convertibility of short-term assets to 11. tight money cash. Computer terminals in retail stores that may be 12. Liquidity used for inventory control or other purposes. 13. "permanent" Assets that are converted to cash within the current assets normal operating cycle of the firm. The relationship of short and long-term interest rates relies on the maturity preference of various 14. fixed assets financial institutions. 1. "temporary" current assets 2. self-liquidating assets 3. level production Essay Questions 6-22 ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ ____ Chapter 06 - Working Capital and the Financing Decision 118. King, Inc., a successful Midwest firm, is considering opening a branch office on the west coast. Under normal economic conditions, with a 45% probability of occurring, King can expect to earn a net income of $70,000 per year. In a mini-recession, at 25% probability, King will earn $20,000. In a severe recession, at a 20% probability, King will lose $15,000. There is also a slight probability (10%) that King will lose $300,000 if the expansion fails and the branch office must be closed. Should King open a branch office in California based on these assumptions? 119. Using the expectations hypothesis for the term structure of interest rates, calculate the expected yields for securities with maturities of two and three years on the basis of the following data: 120. Christensen & Assoc. is developing an asset financing plan. Christensen has $1,000,000 in current assets, of which 15% are permanent, and $700,000 in fixed assets. The current long-term rate is 9%, and the current short-term rate is 6.5%. Christensen's tax rate is 30%. a) Construct two financing plans-one conservative, with 80% of assets financed by long-term sources, and the other aggressive, with only 60% of assets financed by long-term sources. If Christensen's earnings before interest and taxes are $525,000, calculate net income under each alternative. b) What are some of the risks associated with each plan? c) If the yield curve is steeply inverted, which financing plan should Christensen choose? 6-23 Chapter 06 - Working Capital and the Financing Decision 121. McKinsee Inc. is developing a plan to finance its asset base. The firm has $3,000,000 in current assets, of which 20% are permanent, and $10,000,000 in fixed assets. Long-term rates are currently 8%, while short-term rates are at 6%. McKinsee's tax rate is 30%. a) Construct a conservative financing plan with 80% of assets financed by long-term sources. If McKinsee's earnings before interest and taxes are $4,500,000, what will their net income be? b) An alternative and more aggressive plan would be to finance 60% of total assets with longterm financing. Assuming that EBIT was again $4,500,000, what will net income be under this alternative? c) If the yield curve was steeply upward sloping, which plan would you recommend? Why? 6-24 Chapter 06 - Working Capital and the Financing Decision Chapter 06 Working Capital and the Financing Decision Answer Key True / False Questions 1. The faster a firm's growth in sales, the more likely it is that an increasing percentage of financing will be internally generated. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 2. Supply chain management has little impact on financial performance and is primarily a marketing and management concept. FALSE Bloom's: Remember Difficulty: Basic Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 3. Many companies such as McDonalds have embraced supply chain management using webbased procedures. TRUE Bloom's: Remember Difficulty: Basic Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 4. Working capital management is relatively unimportant for the small business. FALSE Bloom's: Understand Difficulty: Basic Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 6-25 Chapter 06 - Working Capital and the Financing Decision 5. The financial manager generally needs to devote little time to management of working capital. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 6. Liquidating current assets are really fixed assets since they have lives greater than one year. FALSE Difficulty: Basic Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Bloom's: Understand 7. The key to current asset planning is the ability of management to forecast sales accurately and then match production schedules with the sales forecast. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 8. One of the big benefits of implementing supply chain management, is a reduction in inventory on hand. TRUE Bloom's: Understand Difficulty: Basic Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 6-26 Chapter 06 - Working Capital and the Financing Decision 9. Permanent current assets are not similar to fixed assets because they are fully liquidated within the year. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. 10. Wal-Mart requires manufacturers to ship goods with RFID tags so that it can better track inventory and reduce the need for supply chain management. FALSE Bloom's: Understand Difficulty: Basic Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 11. When using level production, inventory will peak in the month where unit sales trend above the production level. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 12. Cash, accounts receivables, and inventory all move monthly in the same direction under level production. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 6-27 Chapter 06 - Working Capital and the Financing Decision 13. Level production methods smooth production schedules and utilize manpower and equipment more efficiently than seasonal production methods. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 14. The use of point-of-sale terminals has made it easier for many retail store managers to manage their inventory. TRUE AACSB: Analytic Bloom's: Evaluate Difficulty: Basic Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 15. The cash budget combines the cash receipts and cash payments schedules in determining cash flow. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 16. Ideally, permanent current assets should be financed with short-term borrowings. FALSE Bloom's: Understand Difficulty: Basic Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 6-28 Chapter 06 - Working Capital and the Financing Decision 17. As a general rule, it is desirable to finance the permanent assets, including "permanent current assets", with long-term debt and equity. TRUE Bloom's: Understand Difficulty: Basic Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 18. Increased use of long-term financing is generally a more conservative approach to current asset financing. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 19. A risky financial plan will use long-term financing for fixed assets, permanent current assets, and a portion of temporary current assets. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 20. Short-term financing is risky because of the possibility of rising short-term rates and the inability of always being able to refund short-term debt. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 6-29 Chapter 06 - Working Capital and the Financing Decision 21. Short-term interest rates are generally lower than long-term interest rates. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 22. By using long-term capital to cover short-term needs, the firm is virtually assured of becoming technically insolvent. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 23. Heavy use of long-term financing generally leads to lower financing costs. FALSE Bloom's: Understand Difficulty: Basic Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 24. During an economic "boom" period, a shortage of low-cost financing alternatives exists. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-30 Chapter 06 - Working Capital and the Financing Decision 25. The "term structure of interest rates" refers to the relationship between yields on debt and their maturities. TRUE Bloom's: Understand Difficulty: Basic Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 26. The "term structure of interest rates" depicts the competitive cost of funds for the various short-term sources of funds such as Treasury bills, commercial paper, and bank CDs. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 27. The "term structure of interest rates" is a schedule that tells when a company's bonds mature and shows how many dollars a firm must pay in interest payments. FALSE Bloom's: Remember Difficulty: Basic Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 28. Yield curves change very little in the short run (3 months). FALSE Bloom's: Understand Difficulty: Basic Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-31 Chapter 06 - Working Capital and the Financing Decision 29. If the liquidity premium theory was the only correct theory, yield curves would always be upward-sloping. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 30. The ratio of long-term financing to short-term financing at any given time will be greatly influenced by the term structure of interest rates. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 31. It is not necessary to understand interest rate movements when deciding the structure of short-term debt relative to long-term debt. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 32. The behavior of various kinds of financial institutions determines the shape of the yield curve, according to the market segmentation theory. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-32 Chapter 06 - Working Capital and the Financing Decision 33. Only the market segmentation theory has any significant impact on interest rates. FALSE Bloom's: Understand Difficulty: Basic Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 34. According to the expectations hypothesis, when long-term interest rates are higher than short-term interest rates, long-term rates are expected to decline. FALSE AACSB: Analytic Bloom's: Evaluate Difficulty: Challenge Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 35. According to the expectations hypothesis, when long-term interest rates are higher than short-term interest rates, short-term rates are expected to rise. TRUE AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 36. Short-term interest rates have historically been more volatile than long-term rates. TRUE Bloom's: Remember Difficulty: Basic Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 6-33 Chapter 06 - Working Capital and the Financing Decision 37. The successful financial manager is very interested in the term structure of interest rates but is not concerned with the relative volatility or historical level of interest rates. FALSE Bloom's: Understand Difficulty: Basic Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 38. Short-term interest rates are more dependent upon inflation than on current demand for money. FALSE AACSB: Analytic Bloom's: Evaluate Difficulty: Challenge Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 39. Interest rates and inflation are inversely related. FALSE Bloom's: Understand Difficulty: Objective: Intermediate Learning 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 40. During tight money periods, short-term financing may be difficult to find. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 6-34 Chapter 06 - Working Capital and the Financing Decision 41. The expected value is the sum of the probabilities of all expected events. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 42. Expected value techniques allow consideration of more than one possible outcome. TRUE Bloom's: Understand Difficulty: Basic Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 43. In periods of tight money, long-term rates are often higher than short-term rates. FALSE AACSB: Analytic Bloom's: Evaluate Difficulty: Challenge Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 44. If we examine the ratio of working capital to sales, we can see that for the last several decades, firms' liquidity has been increasing. FALSE Bloom's: Remember Difficulty: Basic Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 45. Heavy risk exposure due to short-term borrowing can be compensated for by carrying illiquid assets. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 6-35 Chapter 06 - Working Capital and the Financing Decision 46. Heavy use of long-term financing can generate more profit for the company during a tight money period. TRUE AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 47. Use of long-term financing and the carrying of highly liquid assets is a high-risk combination. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 48. Firms with predictable cash-flow patterns should assume relatively low levels of risk. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 49. Firms with highly volatile and perishable inventory should assume relatively low levels of risk. TRUE Bloom's: Understand Difficulty: Challenge Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 6-36 Chapter 06 - Working Capital and the Financing Decision 50. The more short-term financing relative to long-term financing, the more risky the financial structure. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 51. Immediate access to capital markets allows greater risk-taking capability. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 52. Working capital management primarily involved long-term planning. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 53. The aggressive financing plan involves utilizing long-term financing for permanent and temporary current assets. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 54. Expected value analysis requires taking the difference between the actual projected outcome and the historic outcome times its' probability and summing these totals. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 6-37 Chapter 06 - Working Capital and the Financing Decision 55. Long-term financing is usually less expensive than short-term financing because it is not as advantageous to the corporation as short-term financing. FALSE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 56. The three most important factors when selecting a financing plan are risk, asset liquidity, and timing. TRUE Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 57. Generally a downward sloping yield curve indicates an eminent economic boom. FALSE AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. Multiple Choice Questions 58. Pressure to increase current asset buildup often results from A. decline in sales growth. B. rapidly expanding sales. C. increased demands of short-term creditors. D. none of these. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Bloom's: Understand 6-38 Chapter 06 - Working Capital and the Financing Decision 59. Working capital management is primarily concerned with the management and financing of A. cash and inventory. B. current assets and current liabilities. C. current assets. D. receivables and payables. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 60. A financial executive devotes the most time to A. Long-range planning. B. Capital budgeting. C. Short-term financing. D. Working capital management. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 61. The term "permanent current assets" implies A. the same thing as fixed assets. B. nonmarketable assets. C. some minimum level of current assets that are not self-liquidating. D. inventory. Bloom's: Understand Difficulty: Basic Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Bloom's: Understand 6-39 Chapter 06 - Working Capital and the Financing Decision 62. The concept of a self-liquidating asset implies that A. the working capital associated with a product will be liquidated within a one year period. B. all the product will be sold, receivables collected and bills paid over the time period specified. C. assets associated with the production of a product will be liquidated over the depreciable life of the assets. D. self-liquidating assets be financed by long-term sources of capital. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Bloom's: Understand 63. Well implemented web-based supply chain management has all of the following benefits except A. reduces inventory on hand. B. speeds up the ordering and delivery process. C. reduces the number of suppliers bidding for a company's business. D. decreases overall costs. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 64. Permanent current assets are not a factor in a manager's decision making process when all current assets will be A. financed by short-term debt. B. long-term in nature. C. self-liquidating. D. internally financed. Bloom's: Understand Difficulty: Basic Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Bloom's: Understand 6-40 Chapter 06 - Working Capital and the Financing Decision 65. RFID chips have been used to A. track livestock. B. track marathon runner's time. C. track inventory at retailers. D. all of these. Bloom's: Remember Difficulty: Basic Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 66. Frisch Fish Corp expects net income next year to be $750,000. Inventory and accounts receivable will have to be increased by $650,000 to accommodate this sales level. Frisch will pay dividends of $300,000. How much external financing will Frisch Fish need assuming no organically generated increase in liabilities? A. No external financing is required. B. $100,000 C. $200,000 D. $300,000 AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 6-41 Chapter 06 - Working Capital and the Financing Decision 67. Tinbergen Cans expects sales next year to be $50,000,000. Inventory and accounts receivable (combined) will increase $8,000,000 to accommodate this sales level. The company has a profit margin of 6 percent and a 30 percent dividend payout. How much external financing will the firm have to seek? Assume there is no increase in liabilities other than that which will occur with the external financing. A. No external financing will be needed. B. Less than $1,000,000 of external financing is needed. C. Between $1,000,000 and $5,000,000 of external financing is needed. D. More than $5,000,000 of external financing is needed. AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 68. Samuelson will produce 20,000 units in January using level production. If each unit costs $500 to manufacture, what is the dollar value of ending inventory in January if beginning inventory is 10,000 units and January sales are 15,000?. A. Less than $5,000,000. B. Between $5,000,000 and $10,000,000. C. Greater than $10,000,000. D. There will be a shortage. Beginning Inv. + Production - Sales = Ending Inventory 10,000 + 20,000 - 15,000 = 15,000 units x $500 cost = $7,500,000 AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 6-42 Chapter 06 - Working Capital and the Financing Decision 69. One advantage of level production is that A. manpower and equipment are used efficiently at lower cost. B. current assets fluctuate more than with seasonal production. C. seasonal bulges and sharp declines in current assets occur. D. None of these are advantageous. Bloom's: Understand Difficulty: Basic Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Bloom's: Understand 70. Publishing companies are characterized by A. fluctuating production to match sales. B. seasonal sales. C. low inventories due to computer inventory management. D. a and b. AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Bloom's: Understand 71. If a firm uses level production with seasonal sales A. as sales decline inventory will increase. B. as sales decline inventory will decrease. C. as sales decline accounts receivables will increase. D. a and c are correct. AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Bloom's: Understand 6-43 Chapter 06 - Working Capital and the Financing Decision 72. Retail companies like Target and The Limited exhibit sales patterns that are mostly influenced by A. cyclical economic indicators. B. competitive prices. C. seasonality. D. sales promotions. Bloom's: Understand Difficulty: Basic Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Bloom's: Understand 73. Retail companies like Target and Limited Brands are more likely to have A. stable sales and earnings per share. B. cyclical sales but less volatile earnings per share. C. cyclical sales and more volatile earnings per share. D. cyclical sales but stable accounts receivable and inventory. Bloom's: Understand Difficulty: Basic Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Bloom's: Understand 74. The use of cash budgeting procedures A. helps the firm plan its current asset levels for a given production plan. B. makes managing inventory easier under seasonal production. C. illustrates fluctuating levels of current assets for a given production plan. D. all of these are correct. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 6-44 Chapter 06 - Working Capital and the Financing Decision 75. Assuming level production throughout the year, and assuming receivables are collected in two equal installments over the two months subsequent to the sales period, developing the cash budget requires the following steps: A. calculate beginning accounts receivable balance B. calculate COGS C. estimate monthly net cash flow and bank borrowing or repayments D. calculate ending inventory AACSB: Analytic Bloom's: Evaluate Difficulty: Challenge Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 76. When actual sales are greater than forecasted sales A. inventory will decline. B. production schedules might have to be revised upward. C. accounts receivable will rise. D. all of these. AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 77. Normally, permanent current assets should be financed by A. long-term funds. B. short-term funds. C. borrowed funds. D. internally generated funds. Bloom's: Understand Difficulty: Basic Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 6-45 Chapter 06 - Working Capital and the Financing Decision 78. Ideally, which of the following type of assets should be financed with long-term financing? A. Fixed assets only B. Fixed assets and temporary current assets C. Fixed assets and permanent current assets D. Temporary and permanent current assets Bloom's: Understand Difficulty: Basic Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. 79. A conservatively financed firm would A. use long-term financing for all fixed assets and short-term financing for all other assets. B. finance a portion of permanent assets and short-term assets with short-term debt. C. use equity to finance fixed assets, long-term debt to finance permanent assets, and shortterm debt to finance fluctuating current assets. D. use long-term financing for permanent current assets and fixed assets and a portion of the short-term fluctuating assets and use short-term financing for all other short-term assets. AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 80. Generally, more use is made of short-term financing because A. short-term interest rates are generally lower than long-term interest rates. B. most firms do not have Basic access to the capital markets. C. short-term financing is usually more predictable than long-term financing. D. a and b above. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-46 Chapter 06 - Working Capital and the Financing Decision 81. The term structure of interest rates A. is an indication of investors' expectations about inflation and future interest rates. B. will be downward sloping if short-term interest rates are higher than long-term rates. C. will be upward sloping under normal conditions. D. all of these. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 82. The term structure of interest rates A. changes daily to reflect current competitive conditions in the money and capital markets. B. plots returns for securities of different risk. C. shows the relative interest spread between bonds with different risk ratings such as AAA, AA, A, BBB, etc. D. depicts interest rates for T-bills over the last year. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 83. The term structure of interest rates is influenced by A. inflation. B. money supply. C. Federal Reserve activities. D. all of these are true Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-47 Chapter 06 - Working Capital and the Financing Decision 84. The term structure of interest rates or the yield curve A. is normal when short-term rates are higher than long-term rates. B. is inverted when short-term rates are lower than long-term rates. C. shows the yield to maturity for securities of equal risk over time. D. all of these are true. AACSB: Analytic Bloom's: Analyze Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 85. Financial managers can accurately predict future interest rates by A. calculating the anticipated inflation rate B. the Fed's decision regarding the target federal funds rate C. measuring investor sentiment and consumer confidence indices D. none of these AACSB: Analytic Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 86. The belief that investors require a higher return to entice them into holding long-term securities is the viewpoint of the A. the expectations hypothesis. B. segmentation theory. C. the liquidity premium theory. D. market credit crunch theory. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-48 Chapter 06 - Working Capital and the Financing Decision 87. The term structure of interest rates A. is often referred to as the yield curve. B. depicts the relative level of short and long-term interest rates. C. is usually constructed with U.S. government securities of varying maturities. D. all of these. Bloom's: Remember Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 88. Yield curves change daily to reflect A. changing conditions in the money and capital markets. B. new inflation expectations. C. changing conditions in the overall economy. D. all of these. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 89. U.S. government securities are used to construct yield curves because A. they are free of default risk. B. the large number of maturities form a continuous curve. C. both a and b. D. none of these. Bloom's: Understand Difficulty: Basic Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-49 Chapter 06 - Working Capital and the Financing Decision 90. As the economy moves through a business cycle, which of the following term structure of interest rate theories dominate the shape of the yield curve. A. The expectations theory B. The market segmentation theory C. The liquidity premium theory D. None of these dominate the shape of the yield curve AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 91. Some analysts believe that the term structure of interest rates is determined by the behavior of various types of financial institutions. This theory is called the A. expectations hypothesis. B. market segmentation theory. C. liquidity premium theory. D. theory of industry supply and demand for bonds. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 92. The theory of the term structure of interest rates which suggests that long-term rates are determined by the average of short-term rates expected over the time that a long-term bond is outstanding is the A. expectations hypothesis. B. segmentation theory. C. liquidity premium theory. D. market average rate theory. Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-50 Chapter 06 - Working Capital and the Financing Decision 93. A "normal" term structure of interest rates would depict A. short-term rates higher than long-term rates. B. long-term rates higher than short-term rates. C. no general relationship between short- and long-term rates. D. Intermediate rates (1-5 years) lower than both short-term and long-term rates. Bloom's: Remember Difficulty: Basic Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 94. A firm will usually increase the ratio of short-term debt to long-term debt when A. short-term debt has a lower cost than long-term equity. B. the term structure is inverted and expected to shift down. C. the term structure is upward sloping and expected to shift up. D. the firm is undertaking a large capital budgeting project. AACSB: Analytic Bloom's: Evaluate Difficulty: Challenge Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 95. Which of the following yield curves would be characteristic during a period of high economic growth? A. Upward sloping B. Downward sloping C. Horizontal D. Humped AACSB: Analytic Bloom's: Evaluate Difficulty: Challenge Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-51 Chapter 06 - Working Capital and the Financing Decision 96. An inverted yield curve would suggest that A. interest rates are expected to rise. B. interest rates are expected to fall. C. inflation is expected to rise in the future. D. long-term rates are being pushed up by federal reserve policy. AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 97. When the term structure of interest rates is downward sloping and interest rates are expected to decline, the A. financial manager generally borrows short-term. B. financial manager borrows at the lower long-term rates. C. corporation's ratio of short-term to long-term debt is low. D. none of these. AACSB: Analytic Bloom's: Evaluate Difficulty: Challenge Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 98. During tight money periods A. long-term rates are higher than short-term rates. B. short-term rates are higher than long-term rates. C. short-term rates are equal to long-term rates. D. the relationship between short and long-term rates remains unchanged. AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-52 Chapter 06 - Working Capital and the Financing Decision 99. Which of the following techniques allows explicit consideration of more than one possible outcome? A. Operating leverage B. Present value C. Least-squares regression D. Expected value Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 100. Under normal conditions (60% probability), Financing Plan A will produce $30,000 higher return than Plan B. Under tight money conditions (40% probability), Plan A will produce $40,000 less than Plan B. What is the expected value of returns? A. $2800 B. $4,000 C. $4800 D. $2,000 Expected value = ($30,000)(.6) - ($40,000)(.4) = $2,000 AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 101. Under normal conditions (70% probability), Plan A will produce $20,000 higher return than Plan B. Under tight money conditions (30% probability), Plan A will produce $100,000 less than Plan B. What is the expected value of returns? A. $28,000 B. ($16,000) C. $58,000 D. ($2,000) Expected value = ($20,000)(.7) - ($100,000)(.3) = ($16,000) AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 6-53 Chapter 06 - Working Capital and the Financing Decision 102. Which of the following is a reason for diminishing liquidity in modern corporations? A. Just-in-time inventory programs. B. Better utilization of cash via computers. C. Increased use of point-of-sale terminals. D. All of these are reasons for diminishing liquidity. Bloom's: Understand Difficulty: Challenge Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. 103. Kuznets Rental Center requires $500,000 in financing over the next two years. Kuznets can borrow long-term at 8 percent interest per year for two years. Alternatively, Kuznets can borrow short-term and pay 6 percent interest in the first year. Then, Kuznets projects paying 9 percent interest in the second year. Assuming Kuznets pays off the accrued interest at the end of each year, which of the following statements is true? A. Kuznets will definitely end up paying more under the long-term financing plan. B. Kuznets will definitely end up paying less under the long-term financing plan. C. Kuznets will probably pay more under the short-term financing plan. D. Kuznets will probably pay less under the short-term financing plan. AACSB: Analytic Bloom's: Analyze Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-54 Chapter 06 - Working Capital and the Financing Decision 104. Hicks Health Clubs, Inc., expects to generate an annual EBIT of $750,000 and needs to obtain financing for $1,200,000 of assets. Their tax bracket is 40%. If the firm goes with a short-term financing plan, their rate will be 7.5 percent, and with a long-term financing plan their rate will be 9 percent. By how much will their earnings after tax change if they choose the more conservative financing plan instead of the more aggressive plan? A. $10,000 B. ($10,800) C. ($6,000) D. $6,000 Feedback: Change in EAT = (difference in interest rates) x (assets) x (1-t) = .015 x $1,200,000 x (1..4) = $10,800 AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 105. Hicks Health Clubs, Inc., expects to generate an annual EBIT of $750,000 and needs to obtain financing for $1,200,000 of assets. Their tax bracket is 40%. If the firm goes with a short-term financing plan, their rate will be 7.5 percent, and with a long-term financing plan their rate will be 9 percent. By how much will their earnings after tax change if they choose the more aggressive financing plan instead of the more conservative? A. $10,800 B. ($10,000) C. ($6,000) D. $6,000 Feedback: Change in EAT = (difference in interest rates) x (assets) x (1-t) = .015 x $1,200,000 x (1..4) = $10,800 AACSB: Analytic Bloom's: Apply Difficulty: Challenge Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 6-55 Chapter 06 - Working Capital and the Financing Decision 106. An aggressive, risk-oriented firm will likely A. borrow long-term and carry low levels of liquidity. B. borrow short-term and carry low levels of liquidity. C. borrow long-term and carry high levels of liquidity. D. borrow short-term and carry high levels of liquidity. AACSB: Analytic Bloom's: Analyze Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 107. Which of the following is not a condition under which a prudent manager would accept some risk in financing? A. Predictable cash-flow patterns B. Inventory is highly perishable C. Price of inventory is stable D. Basic access to capital markets AACSB: Analytic Bloom's: Analyze Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 108. Risk exposure due to heavy short-term borrowing can be compensated for by A. carrying highly liquid assets. B. carrying illiquid assets. C. carrying longer term, more profitable current assets. D. carrying more receivables to increase cash flow. AACSB: Analytic Bloom's: Analyze Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 6-56 Chapter 06 - Working Capital and the Financing Decision 109. Which of the following combinations of asset structures and financing patterns is likely to create the least volatile earnings? A. Illiquid assets and heavy short-term borrowing B. Illiquid assets and heavy long-term borrowing C. Liquid assets and heavy long-term borrowing D. Liquid assets and heavy short-term borrowing AACSB: Analytic Bloom's: Analyze Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 110. Which of the following combinations of asset structures and financing patterns is likely to create the most volatile earnings? A. Illiquid assets and heavy short-term borrowing B. Illiquid assets and heavy long-term borrowing C. Liquid assets and heavy long-term borrowing D. Liquid assets and heavy short-term borrowing AACSB: Analytic Bloom's: Analyze Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 111. An aggressive working capital policy would have which of following characteristics? A. A high ratio of long-term debt to fixed assets. B. A low ratio of short-term debt to fixed assets. C. A high ratio of short-term debt to long-term sources of funds. D. A short average collection period. AACSB: Analytic Bloom's: Analyze Difficulty: Intermediate Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. 6-57 Chapter 06 - Working Capital and the Financing Decision 112. The following are the expected 1 year T-bill rates for the next 4 years: 3%, 4%, 5%, and 6%. What would you expect the rate for 3 year securities would be? A. 4% B. 4.5% C. 6% D. 3.75% Expected rate = (3% + 4% + 5%)/3 years = 4% AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 113. Riley Co. is considering a short-term or long-term financing plan for $4,000,000 in assets. They expect the following 1 year rates over the next 3 years: 6.5%, 7.75%, and 9%. Their long-term interest rate will be 7.5% for the 3 years. Assuming the rates follow their expectations, what will be the difference in interest costs over the 3 years? A. Long-term interest will be $30,000 more than short-term interest B. Long-term interest will be $30,000 less than short-term interest C. Long-term interest will be $140,000 less than short-term interest D. None of these AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-58 Chapter 06 - Working Capital and the Financing Decision 114. Genetech has $4,000,000 in assets, have decided to finance 30% with long-term financing (9% rate) and 70% with short-term financing (7%) rate. What will be their annual interest costs? A. $78,000 B. $126,000 C. $440,000 D. $304,000 Annual interest costs = ($4,000,000)(.3)(.09) + ($4,000,000)(.7)(.07) = $304,000 AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 115. When the yield curve is upward sloping, generally a financial manager should: A. utilize long-term financing B. utilize short-term financing C. wait for future financing D. lease AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 116. When the yield curve is downward sloping, generally a financial manager should A. expect an economic boom B. utilize long-term financing C. increase investment and level of financing overall D. utilize short-term financing AACSB: Analytic Bloom's: Evaluate Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. Matching Questions 6-59 Chapter 06 - Working Capital and the Financing Decision 117. Match the following with the items below: Long-term interest rates reflect the average of 1. "temporary" current expected short-term rates over the life of the long-term assets security. 2. self-liquidating The financing and management of the current assets assets of the firm. 3. level production Assets that are assumed to be long term in nature. 4. working capital Current assets that will not be reduced or converted management to cash within the normal operating cycle of the firm. Depicts in graphical form the relationship between 5. expected value interest rates and maturities for securities of equal risk. Financing provided by sellers or suppliers in the 6. trade credit normal course of business. Time periods in which financing may be difficult to 7. market find and interest rates may be quite high by normal segmentation theory standards. Equal monthly production used to smooth out 8. point of sales production schedules and employ manpower and terminals equipment more efficiently. A representative quantity from a probability distribution arrived at by multiplying each outcome 9. term structure of times the associated probability and summing up the interest rates products. 10. expectations Current assets that will be reduced or converted to hypothesis cash within the normal operating cycle of the firm. The relative convertibility of short-term assets to 11. tight money cash. Computer terminals in retail stores that may be used 12. Liquidity for inventory control or other purposes. 13. "permanent" Assets that are converted to cash within the normal current assets operating cycle of the firm. The relationship of short and long-term interest rates relies on the maturity preference of various financial 14. fixed assets institutions. 10 4 14 13 9 6 11 3 5 1 12 8 2 7 Bloom's: Understand Difficulty: Intermediate Learning Objective: 06-01 Working capital management involves financing and controlling the current assets of the firm. Learning Objective: 06-02 Management must distinguish between those current assets that are easily converted to cash and those that are more permanent. Learning Objective: 06-03 The financing of an asset should be tied to how long the asset is likely to be on the balance sheet. Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 6-60 Chapter 06 - Working Capital and the Financing Decision Essay Questions 118. King, Inc., a successful Midwest firm, is considering opening a branch office on the west coast. Under normal economic conditions, with a 45% probability of occurring, King can expect to earn a net income of $70,000 per year. In a mini-recession, at 25% probability, King will earn $20,000. In a severe recession, at a 20% probability, King will lose $15,000. There is also a slight probability (10%) that King will lose $300,000 if the expansion fails and the branch office must be closed. Should King open a branch office in California based on these assumptions? Yes, a branch office should be opened. AACSB: Analytic Bloom's: Apply and Evaluation Difficulty: Intermediate Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 6-61 Chapter 06 - Working Capital and the Financing Decision 119. Using the expectations hypothesis for the term structure of interest rates, calculate the expected yields for securities with maturities of two and three years on the basis of the following data: AACSB: Analytic Bloom's: Apply Difficulty: Intermediate Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. 6-62 Chapter 06 - Working Capital and the Financing Decision 120. Christensen & Assoc. is developing an asset financing plan. Christensen has $1,000,000 in current assets, of which 15% are permanent, and $700,000 in fixed assets. The current long-term rate is 9%, and the current short-term rate is 6.5%. Christensen's tax rate is 30%. a) Construct two financing plans-one conservative, with 80% of assets financed by long-term sources, and the other aggressive, with only 60% of assets financed by long-term sources. If Christensen's earnings before interest and taxes are $525,000, calculate net income under each alternative. b) What are some of the risks associated with each plan? c) If the yield curve is steeply inverted, which financing plan should Christensen choose? 6-63 Chapter 06 - Working Capital and the Financing Decision AACSB: Analytic Bloom's: Apply, Analysis, and Evaluation Difficulty: Challenge Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. Learning Objective: 06-05 Risk; as well as profitability; determines the financing plan for current assets. Learning Objective: 06-06 Expected value analysis may sometimes be employed in working capital management. 6-64 Chapter 06 - Working Capital and the Financing Decision 121. McKinsee Inc. is developing a plan to finance its asset base. The firm has $3,000,000 in current assets, of which 20% are permanent, and $10,000,000 in fixed assets. Long-term rates are currently 8%, while short-term rates are at 6%. McKinsee's tax rate is 30%. a) Construct a conservative financing plan with 80% of assets financed by long-term sources. If McKinsee's earnings before interest and taxes are $4,500,000, what will their net income be? b) An alternative and more aggressive plan would be to finance 60% of total assets with longterm financing. Assuming that EBIT was again $4,500,000, what will net income be under this alternative? c) If the yield curve was steeply upward sloping, which plan would you recommend? Why? c) Plan B produces slightly higher net income. However, since short-term rates are more volatile, a general increase in interest rates would probably raise the relative cost of shortterm financing significantly and possibly make short-term credit difficult to obtain. The firm's net income could be significantly reduced. Lock into long-term financing before rates increase and funds become difficult to obtain. 6-65 Chapter 06 - Working Capital and the Financing Decision AACSB: Analytic Bloom's: Apply, Analysis, and Evaluation Difficulty: Challenge Learning Objective: 06-04 Long-term financing is usually more expensive than short-term financing based on the theory of the term structure of interest rates. Learning Objective: 06-05 6-66 ... View Full Document

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