FINANCING CURRENT ASSETS

CHAPTER 16 FINANCING CURRENT ASSETS (Difficulty: E = Easy, M = Medium, and T = Tough)

Multiple Choice: Conceptual Easy: Current asset financing policy 1.

Answer: a

Diff: E

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

Current asset financing 2.

Answer: e

Diff: E

N

Which of the following statements is most correct? a. Permanent current assets are those current assets that must be increased when sales increase during an upswing. b. Temporary current assets are those current assets on hand at the low point of the business cycle. c. Maturity matching is considered an aggressive financing policy. d. An aggressive current asset financing policy uses a minimum amount of short-term debt. e. None of the statements above is correct.

Commercial paper 3.

Answer: d

Diff: E

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

Working capital financing 4.

Answer: e

Diff: E

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

Chapter 16 - Page 1

Working capital financing 5.

Answer: a

Diff: E

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

Medium: Working capital financing policy 6.

Answer: c

Diff: M

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

Peak $ 50 0 40 100 500 $690

Off-peak $ 30 20 20 50 500 $620

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

$ 30 50 300 310 $690

$ 10 0 300 310 $620

From this data we may conclude that a. Ski Lifts has a working capital financing policy of exactly matching asset and liability maturities. b. Ski Lifts’ working capital financing policy is relatively aggressive; that is, the company finances some of its permanent assets with short-term discretionary debt. c. Ski Lifts follows a relatively conservative approach to working capital financing; that is, some of its short-term needs are met by permanent capital. d. Without income statement data, we cannot determine the aggressiveness or conservatism of the company’s working capital financing policy. e. Statements a and c are correct. Working capital financing policy 7.

Answer: b

Diff: M

Which of the following statements is most correct? a. Net working capital may be defined as current assets minus current liabilities. Any increase in the current ratio will automatically lead to an increase in net working capital. b. Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive strategy because of the inherent risks of using short-term financing. c. If a company follows a policy of “matching maturities,” this means that it matches its use of common stock with its use of long-term debt as opposed to short-term debt.

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d. All of the statements above are correct. e. None of the statements above is correct. Working capital financing policy 8.

Answer: c

Which of the following statements is most correct? a. Accrued liabilities are an expensive way to b. A conservative financing policy is one in assets with long-term capital and part of term, nonspontaneous credit. c. If a company receives trade credit under company has 10 days of free trade credit. d. Statements a and b are correct. e. None of the answers above is correct.

finance working capital. which the firm finances all of its fixed its permanent current assets with shortthe terms 2/10 net 30, this implies the

Short-term financing 9.

Diff: M

Answer: a

Diff: M

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

Short-term versus long-term financing 10.

Answer: d

Diff: M

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

Choosing a bank 11.

Answer: e

Diff: M

Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank? a. Convenience of location. b. Competitive cost of services provided. Chapter 16 - Page 3

c. Size of the bank’s deposits. d. Experience of personnel. e. Loyalty and willingness to assume lending risks.

Multiple Choice: Problems Easy: Maturity matching 12.

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

Cost of trade credit

Diff: E

R

21.71% 22.07% 22.95% 23.48% 24.52%

Cost of trade credit

Answer: d

Diff: E

R

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

17.2% 23.6% 26.1% 37.2% 50.6%

Cost of trade credit 15.

Answer: a

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

14.

Diff: E

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

13.

Answer: e

Answer: b

Diff: E

R

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

Chapter 16 - Page 4

Free trade credit 16.

Diff: E

N

$25,293.45 $47,945.21 $68,651.33 $75,000.00 $95,890.42

Nominal interest rate

Answer: d

Diff: E

Coverall Carpets Inc. is planning to borrow $12,000 from the bank. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, 1-year installment loan, payable in 4 equal quarterly payments. What is the approximate (nominal) rate of interest on the 10.19 percent add-on loan? a. b. c. d. e.

5.10% 10.19% 12.00% 20.38% 30.57%

Discount interest face value

Answer: c

Diff: E

Picard Orchards requires a $100,000 annual loan in order to pay laborers to tend and harvest its fruit crop. Picard borrows on a discount interest basis at a nominal annual rate of 11 percent. If Picard must actually receive $100,000 net proceeds to finance its crop, then what must be the face value of the note? a. b. c. d. e.

$111,000 $100,000 $112,360 $ 89,000 $108,840

Discount interest face value 20.

Answer: b

HBC Inc. buys on terms of 2/10, net 30 days. It does not take discounts, and it typically pays 30 days after the invoice date. Net purchases amount to $1,750,000 per year. On average, how much “free” trade credit does HBC receive during the year? (Assume a 365-day year.) a. b. c. d. e.

19.

R

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

Free trade credit

18.

Diff: E

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

17.

Answer: a

Answer: a

Diff: E

Viking Farms harvests crops in roughly 90-day cycles based on a 360-day year. The firm receives payment from its harvests sometime after shipment. Due in part to the firm’s rapid growth, it has been borrowing to finance its harvests using 90-day bank notes on which the firm pays 12 percent discount interest. If the firm requires $60,000 in proceeds from each note, what must be the face value of each note? Chapter 16 - Page 5

a. b. c. d. e.

$61,856 $67,531 $60,000 $68,182 $67,423

Revolving credit agreement cost 21.

Answer: b

Diff: E

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

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

Medium: Accounts payable balance 22.

Diff: M

R

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

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

EAR cost of trade credit 23.

Answer: e

Answer: e

Diff: M

R

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

EAR cost of trade credit 24.

Answer: e

Diff: M

R

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

Chapter 16 - Page 6

trade credit? a. b. c. d. e.

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

(Assume a 365-day year.) 17.81% 17.54% 27.43% 17.54% 23.45%

EAR cost of trade credit 25.

Answer: d

Diff: M

R

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

21.63% 13.35% 14.90% 15.89% 18.70%

EAR discount loan

Answer: d

Diff: M

Coverall Carpets Inc. is planning to borrow $12,000 from the bank. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, 1-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 12 percent discount loan? a. b. c. d. e.

10.7% 12.0% 12.5% 13.6% 14.1%

EAR discount/compensating balance loan 28.

N

44.30% 32.25% 30.00% 37.39% 45.50%

EAR cost of trade credit

27.

Diff: M

A firm is offered trade credit terms of 3/15, net 30 days. The firm does not take the discount, and it pays after 50 days. What is the effective annual cost of not taking this discount? (Assume a 365-day year.) a. b. c. d. e.

26.

Answer: d

Answer: d

Diff: M

Suppose you borrow $2,000 from a bank for one year at a stated annual interest rate of 14 percent, with interest prepaid (a discounted loan). Also, assume that the bank requires you to maintain a compensating balance equal to 20 percent of the initial loan value. What effective annual interest rate are you being charged? a. b. c. d. e.

14.00% 8.57% 16.28% 21.21% 28.00%

EAR discount/compensating balance loan

Answer: b

Diff: M

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29.

Wentworth Greenery harvests its crop four times annually and receives payment 90 days after it is picked and shipped. However, the firm must plant, irrigate, and harvest on a near continual schedule. The firm uses 90-day bank notes to finance its operations. The firm arranges an 11 percent discount interest loan with a 20 percent compensating balance four times annually. What is the effective annual interest rate of these discount loans? a. b. c. d. e.

11.00% 15.94% 11.46% 13.75% 12.72%

EAR add-on installment loan 30.

9.50% 10.19% 15.22% 16.99% 22.05%

EAR add-on installment loan

Answer: c

Diff: M

XYZ Company needs to borrow $200,000 from its bank. The bank has offered the company a 12-month installment loan (monthly payments) with 9 percent add-on interest. What is the effective annual rate (EAR) of this loan? a. b. c. d. e.

16.22% 17.97% 17.48% 18.67% 18.00%

EAR monthly loan 32.

Diff: M

Matheson Manufacturing Inc. is planning to borrow $12,000 from the bank. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, 1-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 10.19 percent add-on loan? a. b. c. d. e.

31.

Answer: d

Answer: e

Diff: M

First National Bank of Micanopy has offered you the following loan alternatives in response to your request for a $75,000, 1-year loan. Alternative 1: 7 percent discount interest, with a 10 percent com-pensating balance. Alternative 2: 8 percent simple interest, with interest paid monthly. What is the effective annual rate on the cheaper loan? a. b. c. d. e.

8.00% 7.23% 7.67% 8.43% 8.30%

EAR short-term financing 33.

Answer: e

Diff: M

The Lasser Company needs to finance an increase in its working capital for the coming year. Lasser is reviewing the following three options: (1) The firm can borrow from its bank on a simple interest basis for one year at 13 percent. (2) It can borrow on a 3month, but renewable, loan at a 12 percent nominal rate. The loan is a simple interest

Chapter 16 - Page 8

loan, completely paid off at the end of each quarter, then renewed for another quarter. (3) The firm can increase its accounts payable by not taking discounts. Lasser buys on credit terms of 1/30, net 60 days. What is the effective annual cost (not the nominal cost) of the least expensive type of credit, assuming 360 days per year? a. b. c. d. e.

13.00% 12.82% 11.46% 12.12% 12.55%

EAR short-term financing 34.

1.12% 2.48% 3.60% 4.25% 5.00%

Costly trade credit

Diff: M

R

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

Stretching accounts payable

Answer: e

Diff: M

R

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

10.00% 11.11% 11.75% 12.29% 13.01%

Permanent assets financing 37.

Answer: a

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

36.

Diff: M

You need to borrow $25,000 for one year. Your bank offers to make the loan, and it offers you three choices: (1) 15 percent simple interest, annual compounding; (2) 13 percent nominal interest, daily compounding (360-day year); (3) 9 percent add-on interest, 12 end-of-month payments. The first two loans would require a single payment at the end of the year, the third would require 12 equal monthly payments beginning at the end of the first month. What is the difference between the highest and lowest effective annual rates? a. b. c. d. e.

35.

Answer: c

Answer: c

Diff: M

R

Wicker Corporation is determining whether to support $100,000 of its permanent current assets with a bank note or a short-term bond. The firm’s bank offers a two-year note for which the firm will receive $100,000 and repay $118,810 at the end of two years. The Chapter 16 - Page 9

firm has the option to renew the loan at market rates. Alternatively, Wicker can sell 8.5 percent annual coupon bonds with a 2-year maturity and $1,000 par value at a price of $973.97. How many percentage points lower is the interest rate on the less expensive debt instrument? a. b. c. d. e.

0.0% 1.2% 1.0% 1.8% 0.6%

Tough: Accounts payable balance 38.

N

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

Financial statements and trade credit

Answer: d

Diff: T

R

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

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

DSO and the cost of trade credit 40.

Diff: T

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

39.

Answer: d

Answer: e

Diff: T

Leiner Corp. is a retailer that finances its purchases with trade credit under the following terms: 1/10, net 30 days. The company plans to take advantage of the free trade credit that is offered. After all the free trade credit is used, the company can either finance the clothing purchases with a bank loan that has an effective rate of 10.1349 percent (on a 365-day year), or the firm can continue to use trade credit. The company has an understanding with its suppliers that within moderation, it is all right to “stretch out” its payments beyond 30 days without facing any additional financing costs. Therefore, the longer it takes the company to pay its suppliers, the lower the cost of trade credit. How many days would the firm wait to pay its suppliers in order for the cost of the trade credit to equal the cost of the bank loan? a. 30 days b. 36 days

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c. 40 days d. 46 days e. 48 days EAR short-term financing 41.

Answer: d

Diff: T

Judy’s Fashions Inc. purchases supplies from a single supplier on terms of 1/10, net 20. Currently, Judy takes the discount, but she believes she could extend the payment to 40 days without any adverse effects if she decided not to take the discount. Judy needs an additional $50,000 to support an expansion of fixed assets. This amount could be raised by making greater use of trade credit or by arranging a bank loan. The banker has offered to loan the money at 12 percent discount interest. Additionally, the bank requires an average compensating balance of 20 percent of the loan amount. Judy already has a commercial checking account at this bank that could be counted toward the compensating balance, but the required compensating balance amount is twice the amount that Judy would otherwise keep in the account. Which of the following statements is most correct? a. The nominal cost of using additional trade credit is 36 percent. b. Considering only the explicit costs, Judy should finance the expansion with the bank loan. c. The cost of expanding trade credit using the nominal formula is less than the cost of the bank loan. However, the true cost of the trade credit when compounding is considered is greater than the cost of the bank loan. d. The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent because Judy would hold a cash balance of one-half the compensating balance amount even if the loan were not taken. e. If Judy had transaction balances that exceeded the compensating balance requirement, the effective cost of the bank loan would be 12.00 percent.

Multiple Part: (The following data apply to the next two problems.) You have just taken out a loan for $75,000. The stated (simple) interest rate on this loan is 10 percent, and the bank requires you to maintain a compensating balance equal to 15 percent of the initial face amount of the loan. You currently have $20,000 in your checking account, and you plan to maintain this balance. The loan is an add-on installment loan that you will repay in 12 equal monthly installments, beginning at the end of the first month. Add-on loan payments 42.

Diff: E

Answer: d

Diff: E

How large are your monthly payments? a. b. c. d. e.

$6,250 $7,000 $7,500 $5,250 $6,875

Nominal add-on interest rate 43.

Answer: e

What is the nominal annual add-on interest rate on this loan? a. b. c. d. e.

10.00% 16.47% 18.83% 20.00% 24.00% Chapter 16 - Page 11

Chapter 16 - Page 12

CHAPTER 16 ANSWERS AND SOLUTIONS 1.

Current asset financing policy

2.

Current asset financing

Answer: a Answer: e

Diff: E

Diff: E

N

The correct answer is statement e. The definitions for permanent and temporary current assets have been reversed. Statement a is the definition of temporary current assets, while statement b is the definition of permanent current assets. Statement c is incorrect because maturity matching is considered a conservative financing policy. Statement d is also incorrect because an aggressive current asset financing policy uses the greatest amount of short-term debt. 3.

Commercial paper

Answer: d

Diff: E

4.

Working capital financing

Answer: e

Diff: E

5.

Working capital financing

Answer: a

Diff: E

Statement a is incorrect, and therefore the right answer. Commercial paper is a type of unsecured promissory note issued by large, strong firms. Statements b, c, d, and e are all accurate statements. 6.

Working capital financing policy

Answer: c

Diff: M

7.

Working capital financing policy

Answer: b

Diff: M

8.

Working capital financing policy

Answer: c

Diff: M

Statement b illustrates conservative one. 9.

an

aggressive

Short-term financing

financing

policy, Answer: a

not

a

Diff: M

Under normal conditions the yield curve is upward sloping, thus, shortterm interest rates are lower than long-term interest rates. Consequently, a firm financing with short-term debt will pay less interest than a firm financing with long-term debt--increasing its ROE. However, a firm increases its risk by financing with short-term debt because such debt must be “rolled over” frequently, and the firm is exposed to the volatility of short-term rates. The other statements are false. 10.

Short-term versus long-term financing

Answer: d

Diff: M

11.

Choosing a bank

Answer: e

Diff: M

Chapter 16 - Page 13

12.

Maturity matching

Answer: e

Diff: E

A maturity matching policy implies that fixed assets and permanent current assets are financed with long-term sources. Thus, since the minimum balance that total assets approach is $320,000, and $260,000 of that balance is fixed assets, permanent current assets equal $60,000. The likely level of long-term financing is $320,000. Long-term debt financing = Permanent cash assets + Fixed assets. Permanent cash assets = Low end of total assets - Fixed assets = $320,000 - $260,000 = $60,000. Long-term debt financing = $60,000 + $260,000 = $320,000. 13.

Cost of trade credit Nominal percentage cost =

14.

15.

Diff: E

R

Answer: d

Diff: E

R

Answer: b

Diff: E

R

Answer: a

Diff: E

R

Answer: b

Diff: E

N

365 3  = 21.71%. 97 52

Cost of trade credit Nominal percentage cost =

Answer: a

2 365  = 37.24%. 98 35 - 15

Cost of trade credit

 4   365     = 3.042 = 304.2%.  96   5 

Nominal percentage cost =  16.

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

Daily purchases =

17.

Free trade credit $1,750,000 = $4,794.52. 365 Free trade credit = $4,794.52  10 = $47,945.21.

Daily purchases =

18.

Nominal interest rate Total to be repaid = $12,000(1.1019) = $13,222.80. Interest = $13,222.80 - $12,000 = $1,222.80. $1,222.80 Approximate rateAdd-on = = 0.2038 = 20.38%. $12,000/ 2

Chapter 16 - Page 14

Answer: d

Diff: E

19.

Discount interest face value

Answer: c

Diff: E

Funds required 1.0 - Nominal rate (decimal) $100,000 $100,000 = = = $112,359.55  $112,360. 1.0 - 0.11 0.89

Face value =

20.

21.

Discount interest face value

Answer: a

Diff: E

Convert the annual rate to a periodic rate (quarterly) denominator of the face value formula: Funds required Face value = 1.0 - Nominal rate _ 90 / 360 $60,000 $60,000 = = = $61,855.67  $61,856. 0.97 1.0 - 0.12(0.25)

in

Revolving credit agreement cost

Diff: E

Answer: b

the

Interest rate on borrowed funds = 0.09 + 0.015 = 10.5%. Cost of unused portion: $4,000,000  0.005 = $ 20,000 Cost of used portion: $6,000,000  0.105 = 630,000 Total cost of loan agreement $650,000 22.

Accounts payable balance Approximate percentage cost = Accounts payable =

23.

Answer: e

Diff: M

R

Diff: M

R

365 2  = 0.212828. 98 35

$159,621 = $750,000. 0.212828

EAR cost of trade credit

Answer: e

Calculate the nominal percentage, which is the nominal annual cost: 2 365 days Nominal cost =  = 0.0204  36.5 = 0.7449  74.5%. 100  2 20  10 Calculate the effective annual rate (EAR): Numerical solution: EAR = (1.0204)36.5 - 1.0 = 2.0905 - 1.0 = 109.05%  109%. Financial calculator solution: (EAR) Inputs: P/YR = 36.5; NOM% = 74.49. Output: 24.

EAR cost of trade credit

EFF% = 109%. Answer: e

Diff: M

The company pays every 50 days or 365/50 = 7.3 times per year. the average accounts payable are $4,562,500/7.3 = $625,000. effective cost of trade credit can be found as follows:

R

Thus, The

Chapter 16 - Page 15

EAR = (1 + 2/98)365/35 - 1 = 1.2345 - 1 = 0.2345 = 23.45%. 25.

EAR cost of trade credit

Answer: d

Diff: M

N

Calculate the interest rate per period: Periodic rate = 3/97 = 3.093%. Calculate the number of compounding periods: Number of compounding periods = 365/35 = 10.4286. Use periodic rate and compounding periods to determine annual nominal rate: 3.093%  10.4286 = 32.25%. Calculate EAR: EAR = (1 + 3/97)365/35 - 1 = (1.03093)10.4286 - 1 = 1.37389 - 1 = 37.39%. 26.

EAR cost of trade credit

Answer: d

Diff: M

R

Calculate the interest rate per period: Periodic rate = 2/98 = 2.04%. Calculate the number of compounding periods: Number of compounding periods = 365/50 = 7.30. Use periodic rate and compounding periods to determine the annual nominal rate

2.04%  7.3 = 14.90%. Calculate EAR EAR = (1 + 2/98)365/50 – 1 = (1.0204)7.3 – 1 = 1.1589 – 1 = 0.1589 = 15.89%. 27.

EAR discount loan

Answer: d

Diff: M

Will receive $12,000. Face amount of loan = $12,000/(1 - 0.12) = $13,636.36. Discount interest = 0.12($13,636.36) = $1,636.36. 0

i = ?

13,636.36 - 1,636.36 discount interest 12,000.00

1 -13,636.36

With a financial calculator, enter N = 1; PV = 12000; PMT = 0; FV = -13636.36; and then solve for I/YR = 13.64%  13.6%. 28.

EAR discount/compensating balance loan

Answer: d

Will receive $2,000. Face amount of loan = $2,000/(1 - 0.14 - 0.20) = $3,030.30. Discount interest = 0.14($3,030.30) = $424.24.

Chapter 16 - Page 16

Diff: M

Compensating balance = 0.20($3,030.30) = $606.06.

0

i = ?

3,030.30 - 424.24 discount interest - 606.06 comp. balance 2,000.00

1 -3,030.30 + 606.06 -2,424.24

With a financial calculator, enter N = 1; PV = 2000; PMT = 0; FV = -2424.24; and then solve for I/YR = 21.21%. 29.

EAR discount/compensating balance loan

Answer: b

Diff: M

Assume firm needs $10,000. Face amount of loan = $10,000/(1 - 0.11 - 0.20) = $14,492.75. Discount interest = 0.11($14,492.75) = $1,594.20. Compensating balance = 0.20($14,492.75) = $2,898.55.

0

I = ?

14,492.75 - 1,594.20 discount interest - 2,898.55 comp. balance 10,000.00

1 -14,492.75 + 2,898.55 -11,594.20

With a financial calculator, enter N = 1; PV = 10000; PMT = 0; FV = -11594.20; and then solve for I/YR = 15.94%. 30.

EAR add-on installment loan

Answer: d

Diff: M

Calculate total to be repaid and quarterly payments: Total to be repaid = $12,000(1.1019) = $13,222.80. Quarterly payment = $13,222.80/4 = $3,305.70. Calculate the nominal interest rate per period: Inputs: N = 4; PV = -12000; PMT = 3305.71; FV = 0. Output: I = 4.0%. Calculate EAR using periodic rate and interest rate conversion feature: Nominal annual rate = NOM% = 4  4.0% = 16.0%. Inputs: NOM% = 16; P/YR = 4. Output: EFF% = 16.99%. 31.

EAR add-on installment loan

Answer: c

Diff: M

Interest is 9%($200,000) = $18,000. Thus, the face value of the loan is $200,000 + $18,000 = $218,000. Monthly payments are $218,000/12 = $18,166.67. Calculate the periodic rate as follows: N = 12; PV = 200000; FV = 0; PMT = -18166.67; and then solve for I/YR = 1.3514%. Convert this to an annual rate: 1.3514%  12 = 16.2168%. Applying the EAR formula, solve for EAR = (1 + 0.162168/12)12 - 1 = 17.48%.

Chapter 16 - Page 17

32.

EAR monthly loan

Answer: e

Diff: M

Alternative 1: Face amount of loan = $75,000/(1 - 0.07 - 0.10) = $90,361.45  $90,361.

0

1

i = ?

90,361 - 6,325 discount interest - 9,036 comp. balance 75,000

-90,361 + 9,036 -81,325

To solve for the loan’s effective rate enter N = 1; PV = 75000; PMT = 0; FV = -81325; and then solve for I/YR = 8.43%. Alternative 2: EAR = (1 + 0.08/12)12 - 1 = 8.30%. 33.

EAR short-term financing

Answer: e

Diff: M

(1) Simple interest: 13.0%. EAR = 13.0%. (2) Renewable loan: The rate on this loan is essentially a 12% nominal annual rate with quarterly compounding. Inputs: NOM% = 12; P/YR = 4. Output: EFF% = 12.55%. (3) Trade credit: Terms 1/30, net 60. Note that the nominal rate is really the rate per period multiplied by the number of periods, or a nominal annual rate. (1/99)(360/(60 - 30)) = (0.0101)(12) = 12.12% nominal rate. Inputs: NOM% = 12.12; P/YR = 12. Output: EFF% = 12.82%. The least expensive type of credit is the quarterly renewable loan at 12.55% effective annual rate. 34.

EAR short-term financing

Answer: c

Diff: M

Simple interest: EAR = 15%. Nominal interest, daily compounding: EAR = 1 + 

0.13  360 

360

-

1.

9% add-on, 12 mos. payments: a. Total amount to be repaid is $25,000 principal, plus 0.09($25,000) = $2,250 of interest, or $27,250. b. The monthly payment = $27,250/12 = $2,270.83. c. 0 i = ? 1 12 | |    | 25,000 -2,270.83 -2,270.83 With a financial calculator, enter N = 12; PV = 25000; PMT = -2270.83; and FV = 0 to solve for I = 1.3514%. However, this is a monthly rate. d. EARAdd-on = (1.013514)12 - 1 = 17.48%. Chapter 16 - Page 18

The difference between the highest and lowest EAR is 17.48% - 13.88% = 3.60%. 35.

Costly trade credit

Answer: a

Diff: M

R

Phranklin’s net purchases are $819,388  (1 - 0.02) = $803,000. Purchases per day are $803,000/365 = $2,200.00. Total trade credit is 40  $2,200 = $88,000. Free trade credit is 15  $2,200 = $33,000. Thus, costly trade credit, assuming discounts are taken, is $88,000 $33,000 = $55,000. If discounts are not taken, then the maximum amount of costly trade credit is $88,000. 36.

Stretching accounts payable

Answer: e

Accounts payable: (1/99)(365/(40 - 10)) = 12.29%. nominal rate. EAR is calculated as follows: EAR = (1 + 1/99)12.1667 - 1 = 13.01%. 37.

Permanent assets financing

Diff: M

R

However, this is a

Answer: c

Diff: M

R

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

1 |

2 Years | FV = -118,810

1 | -85

2 Years | -85 FV = -1,000

Note:

Inputs: Output:

N = 2; PV = 100000; PMT = 0; FV = -118810. I = 9.0%.

Bond:

Inputs: Output:

N = 2; PV = 973.97; PMT = -85; FV = -1000. I = 10.0%.

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

38.

Accounts payable balance Step 1:

Answer: d

Diff: T

N

Calculate the nominal annual cost of trade credit. 2 365  Nominal annual cost = 98 30  10 = 0.0204  18.25 Chapter 16 - Page 19

= 37.24%. Step 2:

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

Step 3:

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

Step 4:

Since accounts payable are shown net of discounts, determine daily sales based on net sales figure. Then multiply this amount by 30 days. $6,842,850 Daily net sales = 365 = $18,747.53. Accounts payable balance = $18,747.53  30 = $562,426.03  $562,426.

39.

Financial statements and trade credit

Answer: d

Diff: T

R

Calculate A/P with and without taking discounts: A/PNo discount = $11,760  30 days = $352,800. A/PDiscount = $11,760  10 days = $117,600. Calculate financing amount in notes payable and interest cost. firm will need to borrow the difference in notes payable. $352,800 - $117,600 = $235,200. The additional interest cost is $235,200  0.10 = $23,520.

The

Calculate total purchases and discounts lost: Total purchases = 365 days  12,000 gross purchases = $4,380,000. Discounts lost = $4,380,000  0.02 = $87,600. Construct comparative financial statements: I. Partial balance sheet: Take Discounts Don’t Take Discounts (Borrow N/P) (Use Max. Trade Cdt) Difference Accounts payable $117,600 $352,800 -$235,200 Chapter 16 - Page 20

Notes payable (10%) Total current liab.

235,200 $352,800

$352,800

+235,200 $ 0

II. Partial income statement: EBIT* $140,000 Less: Interest 23,520 Discounts lost 0 EBT $116,480 Less: Taxes (at 40%) 46,592 Net income $ 69,888

$140,000 0 87,600 $ 52,400 20,960 $ 31,440

$

*Any EBIT can be policies is zero. 40.

used,

since

DSO and the cost of trade credit

the

difference

in

0 +23,520 -87,600 +$ 64,080 +25,632 +$ 38,448

EBIT

from

Answer: e

the

two

Diff: T

Determine the number of days the firm would wait to pay its suppliers so that the cost of the trade credit equals the cost of the bank loan: I/YR = 10.1349; PV = -99; PMT = 0; FV = 100; and then solve for N = 0.1041. Multiply 0.1041 by 365 to convert it to the number of days per year: 0.1041(365) = 38 days. To get the final answer we must add back the initial 10 days of “free” financing. This gives 38 + 10 = 48 days. 41.

EAR short-term financing

Answer: d

Diff: T

Bank loan with account: Requires loan of $50,000. Face amount of loan = $50,000/(1 - 0.12 - 0.10) = $64,102.56. Discount interest = 0.12($64,102.56) = $7,692.30. Compensating balance = 0.10($64,102.56) = $6,410.26. 0

i = ?

64,102.56 - 7,692.30 discount interest - 6,410.26 comp. balance 50,000.00

1 -64,102.56 + 6,410.26 -57,692.30

With a financial calculator, enter N = 1; PV = 50000; PMT = 0; FV = -57692.30, and then solve for I/YR = 15.38%. Bank loan without account: Requires loan of $50,000. Face amount of loan = $50,000/(1 - 0.12 - 0.20) = $73,529.41. Discount interest = 0.12($73,529.41) = $8,823.53. Compensating balance = 0.20($73,529.41) = $14,705.88.

Chapter 16 - Page 21

0

1

i = ?

73,529.41 - 8,823.53 discount interest -14,705.88 comp. balance 50,000.00

-73,529.41 +14,705.88 -58,823.53

With a financial calculator, enter N = 1; PV = 50000; PMT = 0; FV = -58823.53; and then solve for I/YR = 17.65%. Trade credit: Nominal: (1/99)[360/(40 - 10)] = 12.12%. Effective rate: (1.0101)12 - 1.0 = 12.82%. Calculate the periodic rate and number of compounding periods and use to calculate annual nominal rate: Periodic rate = 1/99 = 1.01%. Number of compounding periods = [360/(40 - 10)] = 12. Annual nominal rate = (1.01%)(12) = 12.12%. Calculate EAR using interest rate conversion feature: Inputs: NOM% = 12.12; P/YR = 12. Output: EFF% = EAR = 12.82%. 42.

Add-on loan payments

Answer: e

Diff: E

Answer: d

Diff: E

Answer: c

Diff: E

The monthly payments would be: $75,000 + $7,500 Monthly payment = = $6,875. 12 43.

Nominal add-on interest rate Approximate rate =

$7,500 = 20%. $75,000/ 2

CHAPTER 15 MANAGING CURRENT ASSETS (Difficulty: E = Easy, M = Medium, and T = Tough) Multiple Choice: Conceptual Easy: Working capital 43.

Other things held constant, which of the following will cause an increase in working capital? a. b. c. d.

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

Chapter 16 - Page 22

Working capital 43.

Answer: d

Diff: E

N

Which of the following statements is most correct? a. The current ratio is calculated as net working capital divided by current liabilities. b. Gross working capital represents current assets used in operations. c. Net working capital is defined as current assets minus current liabilities. d. Statements b and c are correct. e. Statements a, b, and c are correct.

Cash conversion cycle 43.

Answer: b

Diff: E

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

Cash budget 43.

Diff: E

Which of the following is typically part of the cash budget?

a. Payments lag. b. Payment for plant construction. c. Cumulative cash. d. Statements a and c are correct. e. All of the above statements are correct. Cash budget 43.

Answer: e

Answer: a

Diff: E

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

Cash budget 43.

Answer: d

Diff: E

Which of the following items should a company explicitly include in its monthly cash budget? a. Its monthly depreciation expense. b. Its cash proceeds from selling one of its divisions. c. Interest paid on its bank loans.

Chapter 16 - Page 23

d. Statements b and c are correct. e. All of the statements above are correct. Cash management 43.

Answer: a

Diff: E

Which of the following statements is most correct? a. A cash management system that minimizes collections float and maximizes disbursement float is better than one with higher collections float and lower disbursement float. b. A cash management system that maximizes collections float and minimizes disbursement float is better than one with lower collections float and higher disbursement float. c. The use of a lockbox is designed to minimize cash theft losses. If the cost of the lockbox is less than theft losses saved, then the lockbox should be installed. d. Other things held constant, a firm will need a smaller line of credit if it can arrange to pay its bills by the 5th of each month than if its bills come due uniformly during the month. e. None of the statements above is correct.

Cash management 43.

Answer: d

Diff: E

Which of the following statements about current asset management is most correct? a. A positive net float means that a company has more cash available for its use than the amount shown in the company’s books. b. Use of a lockbox reduces the possibility that petty cash will be lost. c. Depreciation has an impact on the cash budget. d. Statements a and c are correct. e. All of the statements above are correct.

Cash management 43.

Answer: e

Diff: E

Which of the following statements is most correct? a. A good cash management system would minimize disbursement float and maximize collections float. b. If a firm begins to use a well-designed lockbox system, this will reduce its customers’ net float. c. In the early 1980s, the prime interest rate hit a high of 21 percent. In 2000 the prime rate was considerably lower. That sharp interest rate decline has increased firms’ concerns about the efficiency of their cash management programs. d. If a firm can get its customers to permit it to pay by wire transfers rather than having to write checks, this will increase its net float and thus reduce its required cash balances. e. A firm that has such an efficient cash management system that it has positive net float can have a negative checkbook balance at most times and still not have its checks bounce.

Lockbox

Chapter 16 - Page 24

Answer: d

Diff: E

43.

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

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

Marketable securities 43.

Answer: a

Diff: E

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

Monitoring receivables 43.

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

Credit policy

Answer: e

Diff: E

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

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

Credit policy 43.

Diff: E

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

43.

Answer: b

Answer: d

Diff: E

If easing a firm’s credit policy lengthens the collection period and results in a worsening of the aging schedule, then why do firms take such actions? a. It normally stimulates sales. b. To meet competitive pressures.

Chapter 16 - Page 25

c. To increase the firm’s deferral period for payables. d. Statements a and b are correct. e. All of the statements above are correct. Inventory management 43.

Answer: d

Diff: E

In the text, the “red-line method” refers to a. The policy of drawing a red line around certain neighborhoods on a map and then refusing to sell on credit to people who live within those areas. b. Restrictions imposed by companies that insure credit risks. c. The use in Dun & Bradstreet’s reports of a red line to show the maximum amount of credit that should be extended to a given customer; companies using this limit when they screen customers’ orders are said to be using the “red-line method.” d. A method of controlling inventories by drawing a red line on the inside of a bin. e. A method of controlling receivables by drawing a red line on invoices of companies that are expected to pay late.

Inventory management 43.

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

Answer: e following

might

be

attributed

efficient

inventory

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

Miscellaneous working capital concepts 43.

to

Diff: E

Answer: e

Diff: E

N

Which of the following statements is most correct? a. Working capital management involves both setting working capital policy and carrying out that policy in day-to-day operations. b. The aging schedule is the cycle in which a firm purchases inventory, sells goods on credit, and then collects accounts receivable. c. The best and most comprehensive picture of a firm’s liquidity position is shown by its cash budget, which forecasts cash inflows and outflows. d. Statements a, b, and c are correct. e. Statements a and c are correct.

Medium: Cash conversion cycle 43.

Answer: d

Diff: M

Ignoring cost and other effects on the firm, which of the following measures would tend to reduce the cash conversion cycle? a. Maintain the level of receivables as sales decrease. b. Buy more raw materials to take advantage of price breaks. c. Take discounts when offered.

Chapter 16 - Page 26

d. Forgo discounts that are currently being taken. e. Offer a longer deferral period to customers. Cash conversion cycle 43.

Answer: d

Diff: M

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

Cash balances 43.

Answer: c

Diff: M

Which of the following statements is most correct?

a. The cash balances of most firms consist of transactions, compensating, precautionary, and speculative balances. The total desired cash balance can be determined by calculating the amount needed for each purpose and then summing them together. b. The easier a firm’s access to borrowed funds the higher its precautionary balances will be, in order to protect against sudden increases in interest rates. c. For some firms, holding highly liquid marketable securities is a substitute for holding cash because the marketable securities accomplish the same objective as cash. d. Firms today are more likely to rely on cash than on reserve borrowing power or marketable securities for speculative purposes because of the need to move quickly. e. None of the statements above is correct. Cash budget Answer: e Diff: M 43.

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

Cash management

Answer: e

Diff: M

Chapter 16 - Page 27

43.

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

Send Have Have Hold Make

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

Marketable securities portfolio 43.

Diff: M

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

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

Float 43.

Answer: d

Answer: a

Diff: M

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

Compensating balances 43.

Answer: c

Diff: M

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

Chapter 16 - Page 28

Receivables management 43.

Answer: b

Diff: M

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

Credit policy and seasonal dating 43.

Answer: b

Diff: M

Which of the following statements is most correct? a. If credit sales as a percentage of a firm’s total sales increases, and the volume of credit sales also increases, then the firm’s accounts receivable will automatically increase. b. It is possible for a firm to overstate profits by offering very lenient credit terms that encourage additional sales to financially “weak” firms. A major disadvantage of such a policy is that it is likely to increase uncollectible accounts. c. A firm with excess production capacity and relatively low variable costs would not be inclined to extend more liberal credit terms to its customers than a firm with similar costs that is operating close to capacity. d. Firms use seasonal dating primarily to decrease their DSO. e. Seasonal dating with terms 2/15, net 30 days, with April 1 dating, means that if the original sale took place on February 1st, the customer can take the discount up until March 15th, but must pay the net invoice amount by April 1st.

DSO and aging schedule 43.

Answer: c

Diff: M

Which of the following statements is most correct? a. If a firm’s volume of credit sales declines then its DSO will also decline. b. If a firm changes its credit terms from 1/20, net 40 days, to 2/10, net 60 days, the impact on sales can’t be determined because the increase in the discount is offset by the longer net terms, which tends to reduce sales. c. The DSO of a firm with seasonal sales can vary. While the sales per day figure is usually based on the total annual sales, the accounts Chapter 16 - Page 29

receivable balance will be high or low depending on the season. d. An aging schedule is used to determine what portion of customers pay cash and what portion buy on credit. e. Aging schedules can be constructed from the summary data provided in the firm’s financial statements. Days sales outstanding (DSO) 43.

Answer: c

Diff: M

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

Working capital policy 43.

Answer: d

Diff: M

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

Miscellaneous concepts 43.

Answer: e

Diff: M

Which of the following statements is most correct? a. Depreciation is included in the estimate of cash flows (Cash flow = Net income + Depreciation), so depreciation is set forth on a separate line in the cash budget. b. If cash inflows and cash outflows occur on a regular basis, such as the situation where inflows from collections occur in equal amounts each day and most payments are made regularly on the 10th of each month, then it is not necessary to use a daily cash budget. A cash budget prepared at the end of the month will suffice. c. Lockboxes are more important for fast food retailers such as McDonald’s, which deal primarily with cash, than for manufacturers such as Xerox, which are generally paid by check. d. Statements b and c are correct.

Chapter 16 - Page 30

e. None of the statements above is correct.

Multiple Choice: Problems Easy: Sales collections 43.

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

Float

Answer: d

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

Accounts receivable balance

Answer: a

Diff: E

R

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

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

Inventory conversion period 43.

Diff: E

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

43.

Diff: E

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

43.

Answer: d

Answer: b

Diff: E

N

A firm has $5,000,000 of inventory on average and annual sales of $30,000,000. Assume there are 365 days per year. What is the firm’s inventory conversion period? a. 30.25 days Chapter 16 - Page 31

b. c. d. e.

60.83 45.00 72.44 55.25

days days days days

Payables deferral period 43.

Answer: c

N

Ammer Products has an average accounts payable balance of $850,000 and its annual cost of goods sold is $8,750,000. Assume there are 365 days per year. What is Ammer’s payables deferral period? a. b. c. d. e.

25.50 30.50 35.46 42.33 50.00

days days days days days

Cash conversion cycle 43.

Diff: E

Spartan accounts payables 30 days.

Answer: d

Diff: E

Sporting Goods has $5 million in inventory and $2 million in receivable. Its average daily sales are $100,000. The company’s deferral period (accounts payable divided by daily purchases) is What is the length of the company’s cash conversion cycle?

a. 100 days b. 60 days c. 50 days d. 40 days e. 33 days Cash conversion cycle 43.

Diff: E

R

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

87 90 65 48 66

days days days days days

Inventory turnover ratio and DSO 43.

Answer: a

Answer: a

Diff: E

N

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

5.84 4.25 3.33 2.75

Chapter 16 - Page 32

e. 7.25 Medium: Cash budget 43.

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

ROE and working capital policy

Answer: c

Diff: M

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

0.0% 6.2% 5.4% 1.6% 3.8%

Inventory conversion period 43.

Diff: M

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

43.

Answer: c

Answer: d

Diff: M

R

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

Chapter 16 - Page 33

Cash conversion cycle 43.

Answer: e

Diff: M

N

Biondi Manufacturing Company (BMC) has an average accounts receivable balance of $1,250,000, an average inventory balance of $1,750,000, and an average accounts payable balance of $800,000. Its annual sales are $12,000,000 and its cost of goods sold represents 80 percent of annual sales. Assume there are 365 days in a year. What is BMC’s cash conversion cycle? a. 84.15 days b. 53.23 days c. 72.28 days d. 100.55 days e. 60.83 days

Cash conversion cycle 43.

Answer: d

Diff: M

R

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

Cash conversion cycle 43.

Answer: e

Diff: M

R

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

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

a. 49 days b. 193 days c. 100 days d. 168 days Chapter 16 - Page 34

e. 144 days Cash conversion cycle 43.

Diff: M

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

-40 -22 -13 +22 +40

days days days days days

Cash conversion cycle 43.

Answer: e

Diff: M

R

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

-14.0 -18.8 -28.0 -25.6 -38.0

days days days days days

Lockbox 43.

Answer: b

Answer: e

Diff: M

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

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

Chapter 16 - Page 35

Changes in working capital and free cash flow 43.

Answer: b

Diff: M

N

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

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

The company forecasts that there will be no change in its cash and marketable securities, nor will there be any changes in notes payable or accrued liabilities. Which of the following will enable the company to achieve its goal of generating $180 million in free cash flow? a. Accounts receivable increase $470 million, inventory increases $230 million, and accounts payable increase $790 million. b. Accounts receivable increase $470 million, inventory increases $230 million, and accounts payable increase $610 million. c. Accounts receivable decrease by $500 million, inventory increases by $480 million, and accounts payable decline by $80 million. d. Accounts receivable decrease by $400 million, inventory increases by $480 million, and accounts payable increase by $80 million. e. Accounts receivable increase by $500 million, inventory increases by $100 million, and accounts payable decline by $480 million. Aging schedule 43.

Answer: b

Diff: M

N

Short Construction offers its customer’s credit terms of 2/10, net 30 days, while Fryman Construction offers its customer’s credit terms of 2/10, net 45 days. The aging schedules for each of the two companies’ accounts receivable are reported below: Short Construction Fryman Construction Age of Value of Percentage of Value of Percentage of Account (Days) Account Total Value Account Total Value 0-10 $58,800 60% $ 73,500 50% 11-30 19,600 20 29,400 20 31-45 14,700 15 29,400 20 46-60 2,940 3 10,290 7 Over 60 1,960 2 4,410 3 Total Receivables $98,000 $147,000 Which company has the greatest percentage of overdue accounts and what is their percentage of overdue accounts? a. b. c. d.

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

Chapter 16 - Page 36

e. Short; 40% overdue. Tough: Cash conversion cycle 43.

Answer: c

Diff: T

R

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

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

Multiple Part: (The following information applies to the next three problems.) Callison Airlines is deciding whether to pursue a restricted or relaxed current asset investment policy. Callison’s annual sales are expected to total $3.6 million, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50 percent of total assets. EBIT is $150,000, the interest rate on the firm’s debt is 10 percent, and the firm’s tax rate is 40 percent. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy, its total assets turnover will be 2.2. Current asset investment policy 43.

Diff: M

N

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

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

Current asset investment policy and ROE 43.

Answer: c

Answer: b

Diff: M

N

What is the difference in the projected ROEs between the restricted and relaxed policies? a. 2.24% b. 1.50% Chapter 16 - Page 37

c. 1.00% d. 0.50% e. 0.33% Current asset investment policy and ROE 43.

Answer: a

Diff: M

N

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

2.24% 1.50% 1.00% 0.50% 0.33%

Chapter 16 - Page 38