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Unformatted text preview: R. 1. >R. 2. R. 3. R. 4. R. 5. R. 6. R. 7. R. 8. CHAPTER 17 REVIEW QUESTIONS Working capital is defined as a firm’s investment in current assets. Net
working capital is defined as current assets minus current liabilities where
current refers to assets or liabilities with lifetimes of less than one year. The three tasks that underlie working capital management are (1) speeding up receipts of cash, (2) delaying payments of cash, and (3) investing excess
cash. The liquidity of an asset refers to the speed that the asset is able to
be converted into cash at a reasonable price. The ranking of current assets from most to least liquid would be (1) cash, (2) marketable securities, (3)
accounts receivable, and (4) inventory. Cash management is the process of determining the optimal level of cash to be
held inside the firm, and the techniques required to maintain this optimal
level. The concept that drives cash management is that while cash is
necessary, too much cash is wasteful. A corporation’s capital is a valuable
commodity which could be better put to work to earn rates of return higher
than what it earns as interest in a bank’s checking account. The objective of the cash management model known as the EOQ model is to find
the correct balance between having enough cash on hand to conduct business
while not having too much cash on hand such that the firm’s assets are not
best utilized. The EOQ model states this tradeoff in terms of order costs
(turning non—cash assets into cash) and storage costs (the cost of having too
much cash). The EOQ model finds the level of cash that minimizes the total of
order and storage costs. The Miller—Orr model is a cash management model that allows the firm’s cash
balance to rise or fall randomly as the firm’s operations either produce cash
inflows or require cash outﬂows on a continuous basis. The Miller—Orr model
sets an upper and lower cash limit as well as an optimal cash balance that is
reset anytime the cash balance reaches either the upper or lower limit. The money market refers not to a physical market place such as a stock
exchange but to types of securities characterized by short term maturities and
low default risk. Examples of money market securities include US. Treasury
bills, commercial paper, certificates of deposit, and repurchase agreements. Marketable securities are held as corporate assets in order to provide funds
to meet expenses that are planned at specific points of time in the future or
to meet unexpected expenses. Cash managers must consider three aspects of
marketable securities when determining which securities to include in the 129 portfolio; (1) the maturity of the security, (2) the security’s credit risk,
and (3) the taxes owed on the income of the security. R. 9. The term structure of interest rates describes the relationship between
interest rates and term to maturity of’identical securities such as United States
Government securities. R. 10.Credit risk is the potential for the issuer of the marketable security to
default and be unable to pay back some or all of the investor’s principal and
interest. In the United States, securities backed by the US. government are
considered free of default risk. Although other types of money market
securities contain default risk, the extent of the risk is usually low when compared
to common stocks and many long term corporate bonds. R. 11.The potential benefit of extending credit through accounts receivable is not
just the hope for profit on the one transaction but rather the potential value
of the customer for a long term relationship. The potential cost of extending
credit is the cost of the goods sold, not the sale price. R. 12.Credit terms given by 2/10 net/30 need to be broken up into pairs; the first
pair is 2 and 10 and the second pair is net and 30. The first item in each
pair denotes the cost. The cost is listed either as a percentage discount or
the word net that means no discount. Thus, the 2 in this example indicates
that the customer can receive a 2 percent discount meaning that the seller
will accept 98 percent of the billed price as payment in full. The second
number in each pair is the number of days that the stated discount or net
price will be available. In this example the 2 percent discount will only be
available if the discounted price is paid within 10 days. Net 30 offers the
buyer the terms in the event that the buyer does not pay within the time
period‘for the first payment option. R. l3.Lock boxes are payment collection locations spread geographically so as to
reduce the amounts of time taken for checks mailed to the firm to be deposited
and cleared. Lock boxes are typically post office box addresses that go
directly to a bank for deposit on the same day. R. 14.Accounts payable are short term liabilities that the firm has incurred as a
result of buying products on credit from other corporations. This is the
other side of the transaction previously detailed under accounts receivables. The
accounts payable decision is rather straightforward. If a firm is offered
several payment alternatives, the goal of accounts payable management is to
select the payment alternative that maximizes shareholder wealth. The goal of
accounts payable management is to accept an extension of credit whenever the
interest rate implied by the credit is less than the benchmark rate, and to
reject other extensions of credit. 130 #5920.de CHAPTER 17 PROBLEMS $135,092.56 from formula 17.3 in text. . Annual Cash / EOQ = 365 x $10,000/$135,092.56 = 27.02 $6,754.63 or $6,750 rounded. . $67,546.28 (half of the E00) $6,754.63 (the average inventory times 10%) $78,240.74. Found by subtracting optimal costs from costs using $10,000:
Total Costs = (# Orders per year x Order Cost) + (Avg. Inv. x Int. Rate)
Optimal Costs = (27.02 x $250) + ($67,546.28 X 10%) = $13,509.26. . $125,000. In the Miller—Orr Model, the target cash balance is one—third of the distance from the lower cash balance towards the upper cash balance. . The firm would invest all excess cash (the amount over $75,000) so that $75,000 was the only remaining cash balance.
The firm would replenish the cash balance until the cash balance was $75,000 . Plug the known values into the Miller—Orr Model as given in the text: Target = Lower + (3*TCOST*VAR/4*r) to the power 1/3
Target = $10,000 + (3*$500*$50,000/4*0.0003) to the power 1/3
Target = $10,000 + $3,969 = $13,969 . Upper = (3*Target) — (2*Lower) Upper = $41,907 — $20,000 $21,907 4. Repeat problem #3 using 0.0004 for the daily interest rate rather than 0.0003: Target = Lower + (3*TCOST*VAR/4*r) to the power 1/3
Target = $10,000 + (3*$500*$50,000/4*0.0004) to the power 1/3
Target = $10,000 + $3,606 = $13,606 Upper = (3*Target) — (2*Lower)
Upper = $40,818 — $20,000 = $20,818 Note that with higher interest rates, target and upper cash limits fall. . Target = Lower + (3*TCOST*VAR/4*r) to the power 1/3 Target = $50,000 + (3*$100*$100,000/4*0.0003) to the power 1/3
Target = $50,000 + $2,924 = $52,924 . Target = Lower + (3*TCOST*VAR/4*r) to the power 1/3 Target = $75,000 + (3*$100*$100,000/4*0.0003) to the power 1/3
Target = $75,000 + $2,924 = $77,924 131 c. Target = Lower + (3*TCOST*VAR/4*r) to the power 1/3
Target = $50,000 + (3*$800*$200,000/4*0.0004) to the power 1/3
Target = $50,000 + $6,694 = $56,694 d. Target = Lower + (3*TCOST*VAR/4*r) to the power 1/3
Target = $50,000 + (3*$600*$400,000/4*0.0005) to the power 1/3
Target = $50,000 + $7,114 = $57,114 6. a. $11,881.00 using the future value concepts of Chapter 4.
$10,800.00 using the future value concepts of Chapter 4.
10.01% found by using the answer to 5a. as the future value, or FV, the
answer to 5b. as the present value, or PV, one year as the length of time, or N,
and then computing the missing interest rate, or %I. 0.6 Note that the answer is approximately the same rate (10%) that would make the average rates of the one year rates (8% & 10%) equal to the two year rate (9%).
The very small difference is attributable to a cross—product term. a. $9,259.26 found with the present value techniques of Chapter 4.
b. $8,573.39 found with the present value techniques of Chapter 4.
c $9,174.31 found with the present value techniques of Chapter 4.
d $8,416.80 found with the present value techniques of Chapter 4. 8. The price fell from $9,259.26 to $9,174.31, which is $84.95 or 0.92%
found by dividing the prie change by the inital price.
9. The price fell from $8,573.39 to $8,416.80, which is $156.59 or 1.86%
found by dividing the prie change by the inital price.
10. Maturity Price at 8% Price at 9% Price Chnge Percent Change
One—Half 050 $9,622.50 $9,578.26 $44.24 0.46%
Three Year 3.00 $7,938.32 $7,721.83 $216.49 2.73%
Five Year 5.00 $6,805.83 $6,499.31 $306.52 4.50% Note that the percent price declines are always slightly less than the maturities. This
confirms that zero coupon bonds rise and fall by percentages slightly less than the
bond’s maturity in years for each percentage point that interest rates fall or rise.
Remember that bond prices and interest rates move in opposite directions. 11.21. $108,000.00 found with the future value techniques of Chapter 4.
b $110, 000. 00 found with the future value techniques of Chapter 4.
(3. Expected Value— — Sum of (Probabilities * Outcomes)
Expected Value (97%*$110, 000) + (3%*$0) =$106, 700.00
d. Expected Value Sum of (Probabilities * Outcomes)
Expected Value = (90%*$115,000) + (5%*$50,000) + (5%*$0) = $106,000 132 12a. 5.94% — it’s lower. Found by subtracting out 34% taxes (multiply by 0.66). b. 9.90% — it’s still lower. The municipal offers a higher after—tax return.
13a. 7.00% The pre—tax return equals the after—tax return. b. 6.60% Found by subtracting out 34% taxes (multiply by 0.66) c. 6.60% Found by subtracting out 40% taxes (the two rates summed) 14.All financial analyses should compare expected benefits with expected costs. The
cost of the decision is straightforward: the company must spend $30,000 producing
the goods. Note that the firm is not risking $50,000, the purchase price, as long
as the company has sufficient production to fill all orders. The expected benefit is that there is a 50% chance of being paid. Ignoring time value, the expected
benefits is found by multiplying all potential payoffs times their probabilities. Expected Cost vs. Expected Benefit
$30,000 vs. (0.50 * $50,000)
$30,000 vs. $25,000 The credit should not be extended. 15.The potential financial benefit to the firm now must incorporate the present value
of the future potential profits from the relationship. The $500,000 of future orders
could be assumed to offer $200,000 of potential future profit. Using a discount rate
of, say 20%, the potential value to this customer is $166,667 Expected Cost vs. Expected Benefit
$30,000 vs. ( 0.50 * ($50,000 + $166,667) )
$30,000 vs. $95,834 The credit should be extended. 16.The key to these problems is to recognize the cash ﬂows and timings of the two
payment choices and then compute an interest rate using the techniques of Chap. 4.
Assume a $100 amount for simplicity, although all amounts would give the same rate Early Pay’t Late Pay’t Gap— days Rate
a. $98.00 $100.00 15 63.49%
b. $98.00 $100.00 30 27.86%
c. $98.00 $100.00 60 13.08%
(1. $98.00 $100.00 80 9.66% The financial calculator can solve these using the first column as PV, the second as
FV, the days divided by 365 as the number of periods (N) and then computing %1.
The gap in days for 15c. depends upon the number of days in the month. 133 CHAPTER 17 DISCUSSION QUESTIONS 1. The costs to liquidity are that generally speaking, the more liquid an asset is, the
lower is its expected return. Thus, high liquidity usually produces less interest
income. The advantage to liquidity is that it permits a firm to exploit opportunities
and avoid penalties (such as for late payment). No liquidity almost always is a poor
performer since the firm will lose positive NPV opportunities and pay penalties and
so forth. However, extremely high liquidity hurts shareholder wealth by producing
a lower average rate of return. Thus, there is almost always an optimal level of
liquidity somewhere in between. 2. Many firms experience cyclical cash flows due to the much greater retail sales during
and before the December holidays. Other firms have products that sell more in
particular types of weather. Some firms experience slumps during the summer
months because their customers are corporations and many corporate managers take summer vacations. Obviously, agricultural operations can be directly affected by
the growing seasons. 3. Many firms appear willing to take large risks in some endeavors and little or no risk
in other endeavors. Often, the logic is that the firm should take risks only in those
areas that it has a superior expertise. Sometimes, the varying degrees of risk aversion
appears illogical. In pension management, long term securities can actually be of
significantly less risk than short term securities because the pension is attempting
to meet long term liabilities. General interest rate theory demonstrates that often
long term liabilities such as a corporation’s fixed pension obligations can be met
with less risk by investing in long term securities. 4. A corporation or any other investor who purchases municipal bonds receives a much
lower pre—tax return than if they had purchased fully taxed bonds of similar risk and
maturity. Thus, a municipal bond might pay only 7% interest while an otherwise
fully taxed bond might pay 10%. The proper way to view municipal bonds is to view
the Federal government as ”giving up" its taxes so that a municipality can pay a
lower rate. Thus the investor "pays" money to the municipality in the form of a much
lower pre—tax rate of return rather than collecting a higher rate of return and then
turning some of the money over to the Federal government in the form of higher
income taxes. An investor in fully taxed bonds earns a higher pre—tax return and
then directly and explicitly pays taxes from the interest income. An investor in
municipal bonds pays taxes implicitly — — by receiving a much lower pre—tax rate of
return. The only true difference is which level of government is receiving the benefit 5. Poor credit risks. Although the text demonstrates that there can be significant
economic advantages to extending small amounts of credit to customers of poor
credit due to the potenital advantage of having the customer return in the future,
it is important to note that if a firm hands out credit too loosely, it will attact a
customer base with poor credit. 134 6. False. An optimal inventory level is almost always somewhere between always having
items in stock and never having items in stock. A good example arises in the area
of public transportation. We are all familiar with the decision of when to try to
arrive at an airport, bus station or train station. If you arrive too early, you waste
your time waiting. If you arrive too late, you miss your transportation and waste
your time waiting for another departure. Note that there is an optimal time to try
to arrive — — early anough to avoid missing too many departures, but late enough to
avoid wasting too much time waiting for the departure. Now consider this: if
you have never missed an airplane, train or bus, you are almost certainly trying
to arrive too early and are wasting your valuable time. In short, you have a less than
optimal procedure! Everyone would agree that arriving many hours before every
scheduled departure is a waste of time. Similarly, in most cases, if there is never an
inventory shortage, it means that too much time, money and space is being wasted
by holding too large of an inventory. Optimal inventory policy usualy involves having
to "say that you are sorry" an optimal number of times. A similar agrument can be made for people who hold large balances in their checking account and never bounce
a check. 7. Yes. A target cash balance half way between the upper and lower bounds would
minimize the expected expenses from adjusting the cash balance under the model’s
assumptions. However, a target cash balance half way between would cause a higher
average cash balance and therefore would increase the "storage costs", or in other
words, the lost interest income. The Miller—Orr model finds that having the target
balance one — third of the way from the lower balance to the upper balance minimizes
the sum of the two costs. 135 ...
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 Spring '10
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