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CHAPTER 21

WORKING CAPITAL MANAGEMENT


(Difficulty: E = Easy, M = Medium, and T = Tough)

True-False
Easy:
(21.2) Net working capital
Answer: b Diff: E
1
.
Net working capital may be defined as current assets minus current
liabilities. This also defines the current ratio.
a. True
b. False
(21.2) Net working capital
Answer: b Diff: E
2
.
Net working capital is defined as current assets divided by current
liabilities.
a. True
b. False
(21.2) Working capital
3
.
An increase in a current asset account must
corresponding increase in a liability account.

be

Answer: b Diff: E
accompanied by a

a. True
b. False
(21.2) Working capital policy
Answer: a Diff: E
4
.
Determination of a firm's investment in net operating working capital
and how that investment is financed are elements of working capital
policy.
a. True
b. False
(21.3) Goal of cash management
Answer: a Diff: E
5
.
Cash is often referred to as a "non-earning" asset. Thus, one goal of
cash management is to minimize the amount of cash necessary to conduct
business.
a. True
b. False

Chapter 21: Working Capital Management

Page 1

(21.3) Motives for holding cash


Answer: a Diff: E
6
.
Firms hold cash balances in order to complete transactions that are
necessary in business operations and as compensation to banks for
providing loans and services.
a. True
b. False
(21.4) Cash budget
Answer: a Diff: E
7
.
A firm's peak borrowing needs will probably be overstated if it bases
its monthly cash budget on uniform cash receipts and disbursements, but
actual receipts are concentrated at the beginning of each month.
a. True
b. False
(21.4) Cash budget
Answer: a Diff: E
8
.
Shorter-term cash budgets, in general, are used for actual cash control
while longer-term budgets are used primarily for planning purposes.
a. True
b. False
(21.5) Float
Answer: a Diff: E
9
.
For a firm that makes heavy use of float, being able to forecast its
collections and disbursement check clearings is essential.
a. True
b. False
(21.5) Lockbox
Answer: a Diff: E
10
.
Lockbox arrangements are one way for a firm to speed up its collection
of payments from customers.
a. True
b. False
(21.6) Goal of inventory management
Answer: b Diff: E
11
.
The central goal of inventory management is to provide sufficient
incentives to ensure that the firm never suffers a stock-out (i.e., runs
out of an inventory item).
a. True
b. False
(21.6) Goal of inventory management
Answer: a Diff: E
12
.
The principal goal of most inventory management systems is to balance
the costs of ordering, shipping, and receiving goods with the cost of
carrying those goods, while simultaneously meeting the firm's policy
with respect to avoiding running short of stock and disrupting
production schedules.

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Chapter 21: Working Capital Management

a. True
b. False
(21.6) Inventory management interaction
Answer: b Diff: E
13
.
Inventory management is largely self-contained, that is, only minimum
coordination among other departments such as sales, purchasing, and
production is required for successful inventory management.
a. True
b. False
(21.7) Receivables balance
Answer: b Diff: E
14
.
Since receivables and payables both result from sales transactions, a
firm with a high receivables-to-sales ratio will also have a high
payables-to-sales ratio.
a. True
b. False
(21.7) Receivables balance
Answer: a Diff: E
15
.
The average accounts receivables balance is determined jointly by the
volume of credit sales and the days sales outstanding.
a. True
b. False
(21.7) Receivables aging
Answer: b Diff: E
16
.
If a firm has a large percentage of accounts over 30 days old, it is a
sign that the firm's receivables management needs to be reviewed and
improved.
a. True
b. False
(21.7) Monitoring receivables
Answer: a Diff: E
17
.
The aging schedule is a commonly used method of monitoring receivables.
a. True
b. False
(21.7) Credit policy
Answer: a Diff: E
18
.
The four major elements in a firm's credit policy are (1) credit
standards, (2) discounts offered, (3) credit period, and (4) collection
policy.
a. True
b. False
(21.7) Cash discounts
Answer: b Diff: E
19
.
If you receive some goods on April 1 with the following terms; 3/20, net
30, June 1 dating, it means that you will receive a 3 percent discount
if the bill is paid on or before June 20 and that the full amount must
be paid 30 days after receipt of the goods.
Chapter 21: Working Capital Management

Page 3

a. True
b. False
(21.7) Trade discounts
Answer: b Diff: E
20
.
Offering trade credit discounts is costly to a firm and as a result,
firms that offer trade discounts are usually those that are performing
poorly and need cash quickly.
a. True
b. False
(21.7) Change in credit policy
Answer: a Diff: E
21
.
A firm changes its credit policy from 2/10, net 30, to 3/10, net 30. The
change is meant to meet competition, so no increase in sales is
expected. Average accounts receivable will probably decline as a result
of this change.
a. True
b. False
(21.8) Accruals
Answer: a Diff: E
22
.
Accruals are "free" financing in the sense that no explicit interest is
paid on accruals.
a. True
b. False
(21.8) Accruals
Answer: a Diff: E
23
.
Accruals are spontaneous, but, unfortunately, due to law and economic
forces, firms have little control over the level of these accounts.
a. True
b. False
(21.8) Accruals
Answer: b Diff: E
24
.
The fact that no explicit interest cost is paid on accruals, and that
the firm can exercise considerable control over their level, makes
accruals an attractive source of additional funding.
a. True
b. False
(21.8) Trade credit
Answer: b Diff: E
25
.
If a firm is offered credit terms of 2/10, net 30, it is in the firm's
financial interest to pay as early as possible during the discount
period.
a. True
b. False

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Chapter 21: Working Capital Management

(21.8) Trade credit


Answer: b Diff: E
26
.
Trade credit can be separated into two components: free trade credit,
which involves credit received after the discount period ends, and
costly trade credit, which is the cost of discounts not taken.
a. True
b. False
(21.8) Trade credit
Answer: a Diff: E
27
.
As a rule, managers should try to always use the free component of trade
credit but should use the costly component only after comparing its
costs to the costs of similar credit from other sources.
a. True
b. False
(21.8) Trade credit
Answer: a Diff: E
28
.
Trade credit is an inexpensive source of short-term financing if no
discounts are offered.
a. True
b. False
(21.8) Trade credit
Answer: a Diff: E
29
.
When deciding whether or not to take a trade discount, the cost of
borrowing funds should be compared to the cost of trade credit to
determine if the cash discount should be taken.
a. True
b. False
(21.8) Cost of trade credit
Answer: a
30
.
The calculated cost of trade credit is reduced by paying late.

Diff: E

a. True
b. False
(21.8) Cost of trade credit
Answer: a Diff: E
31
.
The calculated cost of trade credit for a firm that buys on terms of
2/10, net 30, is lower (other things held constant) if the firm pays in
40 days than if it pays in 30 days.
a. True
b. False

Chapter 21: Working Capital Management

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(21.8) Cost of trade credit


Answer: a Diff: E
32
.
One of the disadvantages of not taking trade credit discounts when
offered is that the firm's investment in accounts payable rises.
a. True
b. False
(21.8) Net trade credit
Answer: b Diff: E
33
.
A firm is said to be extending net trade credit when its accounts
receivable are less than its accounts payable.
a. True
b. False
(21.8) Net trade credit
Answer: a Diff: E
34
.
When a firm has accounts payable that are greater than the level of its
receivables, the firm is actually receiving net trade credit.
a. True
b. False
(21.8) Stretching accounts payable
35
.
"Stretching" accounts payable
financing technique.

is

widely

Answer: b Diff: E
accepted and costless

a. True
b. False
(21.9) Working capital financing
Answer: a Diff: E
36
.
Although short-term interest rates have historically averaged less than
long-term rates, the heavy use of short-term debt is considered to be an
aggressive working capital financing strategy because of the inherent
risks of using short-term financing.
a. True
b. False
(21.9) Short-term financing
Answer: a Diff: E
37
.
Short-term financing may be riskier than long-term financing since,
during periods of tight credit, the firm may not be able to rollover
(renew) its debt.
a. True
b. False

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Chapter 21: Working Capital Management

(21.9) Short-term financing


Answer: a Diff: E
38
.
One of the advantages of short-term debt financing is that firms can
expand or contract their short-term credit more easily than their longterm credit.
a. True
b. False
(21.9) Short-term financing
Answer: a Diff: E
39
.
Short-term loans generally are obtained faster than long-term loans
because when lenders consider long-term loans they insist on a more
thorough evaluation of the borrower's financial health and because the
loan agreement is more complex.
a. True
b. False
(21.12) Bank loans
Answer: b Diff: E
40
.
A line of credit and a revolving credit agreement are similar except
that a line of credit creates a legal obligation for the bank.
a. True
b. False
(21.12) Bank loans
Answer: a Diff: E
41
.
The maturity of most bank loans is short-term. Bank to business loans
are frequently 90-day notes which are often rolled over, or renewed, at
the end of their maturity.
a. True
b. False
(21.12) Promissory note
Answer: b Diff: E
42
.
A promissory note is the document signed when a bank loan is executed
and it specifies financial aspects of the loan. The separate indenture
note will specify items such as collateral and other terms and
conditions.
a. True
b. False
(21.12) Line of credit
Answer: a Diff: E
43
.
A line of credit can be either a formal or informal agreement between
borrower and bank regarding the maximum amount of credit the bank will
extend to the borrower subject to certain conditions.
a. True
b. False
(21.12) Revolving credit and risk
Answer: a Diff: E
44
.
Under a revolving credit agreement the risk to the firm of being unable
to obtain funds when needed is lower than with a line of credit.

Chapter 21: Working Capital Management

Page 7

a. True
b. False

Medium:
(21.4) Cash and capital budgets
Answer: b Diff: M
45
.
The cash budget and the capital budget are planned separately, and
although they are both important to the firm, they are independent of
each other.
a. True
b. False
(21.4) Cash budget and depreciation
Answer: b Diff: M
46
.
Since depreciation is a non-cash charge it does not appear nor have an
effect on the cash budget.
a. True
b. False
(21.4) Seasonal patterns and cash
Answer: b Diff: M
47
.
The target cash balance is set optimally such that it need not be
adjusted for seasonal patterns and unanticipated fluctuations although
it is changed to reflect long-term changes in the firm's operations.
a. True
b. False
(21.5) Synchronization of cash flows
Answer: a Diff: M
48
.
Synchronization of cash flows is an important cash management technique
and
effective
synchronization
can
actually
increase
a
firm's
profitability.
a. True
b. False
(21.5) Float
Answer: b Diff: M
49
.
Collections float offsets disbursement float. If a firm's collections
float is greater than its disbursement float then a firm is said to
operate with positive net float.
a. True
b. False
(21.5) Float
Answer: b Diff: M
50
.
A lockbox plan is one method of speeding up the check-clearing process
for customer payments and decreasing the firm's net float position.
a. True
b. False

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Chapter 21: Working Capital Management

(21.5) Lockbox
Answer: b Diff: M
51
.
A firm has a daily average collection of checks equal to $250,000. It
takes the firm approximately 4 days to convert the funds into usable
cash. Assume (1) a lockbox system could be employed which would reduce
the cash conversion procedure to 2 days and (2) the firm could invest
any additional cash received at 6 percent after taxes.
The lockbox
system would be a good buy if it costs only $23,000 annually.
a. True
b. False
(21.7) Receivables and growth
Answer: b Diff: M
52
.
A firm which makes 90 percent of its sales on credit and 10 percent for
cash is currently growing at a rate of 10 percent annually. If the firm
maintains stable growth it will also be able to maintain its accounts
receivable at its current level, since the 10 percent cash sales can be
used to manage the 10 percent growth rate.
a. True
b. False
(21.7) Receivables
53
.
In managing
credit sales
the firm can

and growth
Answer: a Diff: M
a firm's accounts receivable it is possible to increase
per day yet still keep accounts receivable fairly steady if
shorten the length of its collection period.

a. True
b. False
(21.7) Collection policy
Answer: b Diff: M
54
.
A firm's collection policy and the procedures it follows to collect
accounts receivable play an important role in keeping its deferrables
period short, although too strict a collection policy can result in
outright losses due to non-payment.
a. True
b. False
(21.7) Collection policy
Answer: a Diff: M
55
.
Changes in a firm's collection policy can affect sales, working capital
and even additional funds needed.
a. True
b. False
(21.7) Cash versus credit sales
56
.
In part because money has time value, cash
profitable and more valuable than credit sales.

sales

Answer: b Diff: M
are always more

a. True
b. False

Chapter 21: Working Capital Management

Page 9

(21.7) Days sales outstanding


Answer: a Diff: M
57
.
If a firm's sales and those of its customers are closely correlated with
economic conditions, it is certainly possible for a firm's total
investment in accounts receivable to decrease while its days sales
outstanding increases.
a. True
b. False
(21.7) Extending the credit period
Answer: a Diff: M
58
.
Generally, the longer the normal inventory holding period of a customer
the longer the credit period. One effect of extending the credit period
to match the customer's merchandise holding period is to increase the
deferrables period which actually serves to shorten the customer's cash
conversion cycle.
a. True
b. False
(21.7) DSO and past due accounts
Answer: b Diff: M
59
.
If a firm's terms are 2/10, net 30 days, and its DSO is 28 days, we can
be certain that the credit department is functioning efficiently and the
percentage of past due accounts is minimal.
a. True
b. False
(21.7) Aging schedule and credit policy
Answer: b Diff: M
60
.
If your firm's DSO or aging schedule deteriorates from the first quarter
of the year to the second quarter, this is a clear indication that your
firm's credit policy has weakened.
a. True
b. False
(21.8) Trade credit
Answer: b Diff: M
61
.
If a firm fails to take trade credit discounts it may cost the firm
money, but generally such a policy has a negligible effect on the firm's
income statement and no effect on the firm's balance sheet.
a. True
b. False
(21.8) Stretching accounts payable
Answer: a Diff: M
62
.
If a firm is involuntarily "stretching" its accounts payable then this
is one sign that it is undercapitalized, that is, that it needs more
working capital for operations.
a. True
b. False

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Chapter 21: Working Capital Management

(21.8) Stretching accounts payable


Answer: b Diff: M
63
.
A firm that "stretches" its accounts payable rather than paying on net
terms is actually increasing its calculated cost of credit given that it
already does not take discounts when offered, other things held
constant.
a. True
b. False
(21.8) Stretching accounts payable
Answer: b Diff: M
64
.
If one of your firm's customers is "stretching" its accounts payable,
this may be a nuisance but does not represent a real financial cost to
your firm as long as the firm periodically pays off its entire balance.
a. True
b. False
(21.9) Maturity matching
Answer: a Diff: M
65
.
Uncertainty about the exact lives of assets prevents precise maturity
matching in an ex post (i.e., after the fact) sense even though it is
possible to maturity match on an expected basis.
a. True
b. False
(21.9) Maturity matching
Answer: b Diff: M
66
.
The maturity matching or "self-liquidating" approach involves the
financing of permanent net operating working capital with combinations
of long-term capital and short-term capital depending on the level of
interest rates. When short-term rates are high, short-term assets will
be financed with long-term debt to reduce cost and risk.
a. True
b. False
(21.9) Aggressive financing approach
Answer: a Diff: M
67
.
A firm adopting an aggressive working capital financing approach is more
sensitive to unexpected changes in the term structure of interest rates
than is a firm with a conservative financing policy.
a. True
b. False
(21.9) Aggressive financing approach
Answer: b Diff: M
68
.
A firm that employs an aggressive working capital financing policy
stands to increase profitability when the yield curve changes from
upward sloping to downward sloping.
a. True
b. False

Chapter 21: Working Capital Management

Page 11

(21.9) Risk and short-term financing


Answer: a Diff: M
69
.
The risk to the firm of borrowing using short-term credit is usually
greater than with long-term debt.
Added risk stems from greater
variability of interest costs on short-term debt. Even if its long-term
prospects are good, the firm's lender may not renew a short-term loan if
the firm is even only temporarily unable to repay it.
a. True
b. False
(21.9) Short-term financing
Answer: b Diff: M
70
.
Long-term loan agreements always contain provisions, or covenants, which
constrain the firm's future actions. Short-term credit agreements are
just as restrictive in order to protect the interests of the lender.
a. True
b. False
(21.9) Short-term financing
Answer: a Diff: M
71
.
A firm constructing a new manufacturing plant and financing it with
short-term loans that are scheduled to be converted to first mortgage
bonds when the plant is completed, would want to separate the
construction loan from other current liabilities associated with working
capital management.
a. True
b. False
(21.12) Prime rate
Answer: b Diff: M
.
The prime rate charged by big money center banks can vary greatly (for
example, as much as 2 to 4 percentage points) across banks due to banks'
ability to differentiate themselves and because particular banks develop
particular clienteles, such as mainly making loans to small firms.

72

a. True
b. False
(21.12) Revolving credit agreement
Answer: a Diff: M
73
.
A revolving credit agreement is a formal line of credit usually used by
large firms.
The firm will pay a fee on the unused balance of the
committed funds to compensate the bank for the commitment to extend
those funds.
a. True
b. False

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Chapter 21: Working Capital Management

Multiple Choice: Conceptual


Easy:
(21.1) Cash conversion cycle
Answer: b Diff: E
74
.
Helena Furnishings wants to sharply reduce its cash conversion cycle.
Which of the following steps would reduce its cash conversion cycle?
a. The company increases its average inventory without increasing its
sales.
b. The company reduces its DSO.
c. The company starts paying its bills sooner, which reduces its average
accounts payable without reducing its sales.
d. Statements a and b are correct.
e. All of the statements above are correct.
(21.2) Working capital
75
.
Other things held constant,
increase in working capital?

which

of

the

Answer: c Diff: E
following will cause an

a.
b.
c.
d.

Cash is used to buy marketable securities.


A cash dividend is declared and paid.
Merchandise is sold at a profit, but the sale is on credit.
Long-term bonds are retired with the proceeds of a preferred stock
issue.
e. Missing inventory is written off against retained earnings.
(21.4) Cash budget
Answer: e
.
Which of the following is typically part of the cash budget?

76

a.
b.
c.
d.
e.

Diff: E

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

(21.4) Cash budget


Answer: a Diff: E
77
.
Which of the following statements concerning the cash budget is correct?
a. Depreciation expense is not explicitly included, but depreciation
effects are implicitly included in estimated tax payments.
b. Cash budgets do not include financial expenses such as interest and
dividend payments.
c. Cash budgets do not include cash inflows from long-term sources such
as bond issues.
d. Statements a and b are correct.
e. Statements a and c are correct.

Chapter 21: Working Capital Management

Page 13

(21.4) Cash budget


Answer: d Diff: E
78
.
Which of the following items should a company explicitly include in its
monthly cash budget?
a.
b.
c.
d.
e.

Its monthly depreciation expense.


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

(21.5) Cash management


79
.
Which of the following statements is most correct?

Answer: a

Diff: E

a. A cash management system which minimizes collections float and


maximizes disbursement float is better than one with higher
collections float and lower disbursement float.
b. A cash management system which maximizes collections float and
minimizes disbursement float is better than one with lower
collections float and higher disbursement float.
c. The use of a lockbox is designed to minimize cash theft losses. If
the cost of the lockbox is less than theft losses saved, then the
lockbox should be installed.
d. Other things held constant, a firm will need an identical line of
credit if it can arrange to pay its bills by the 5th of each month
than if its bills come due uniformly during the month.
e. The statements above are all false.
(21.5) Cash management
80
.
Which of the following statements is most correct?

Answer: e

Diff: E

a. A good cash management system would minimize disbursement float and


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

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Chapter 21: Working Capital Management

(21.5) Lockbox
81
.
A lockbox plan is
a.
b.
c.
d.
e.

Diff: E

A method for safe-keeping of marketable securities.


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

(21.6) Inventory management


82
.
Which of the following
management?
a.
b.
c.
d.
e.

Answer: d

might

be

attributed

to

Answer: e Diff: E
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.

(21.7) Monitoring receivables


Answer: b Diff: E
83
.
Analyzing days sales outstanding (DSO) and the aging schedule are two
common methods for monitoring receivables.
However, they can provide
erroneous signals to credit managers when
a.
b.
c.
d.
e.

Customers payments patterns are changing.


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

(21.7) Credit policy


Answer: e Diff: E
84
.
Which of the following is not commonly regarded as being a credit policy
variable?
a.
b.
c.
d.
e.

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

(21.7) Credit policy


Answer: d Diff: E
85
.
If easing a firms credit policy lengthens the collection period and
results in a worsening of the aging schedule, then why do firms take
such actions?
a.
b.
c.
d.
e.

It normally stimulates sales.


To meet competitive pressures.
To increase the firms deferral period for payables.
Statements a and b are correct.
All of the statements above are correct.

Chapter 21: Working Capital Management

Page 15

(21.9) Working capital financing policy


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

86

temporary

net

Answer: a
operating

Diff: E
working

a. Matching the maturities of assets and liabilities reduces risk.


b. Short-term interest rates have traditionally been more stable than
long-term interest rates.
c. A firm that borrows heavily long-term is more apt to be unable to
repay the debt than a firm that borrows heavily short-term.
d. The yield curve has traditionally been downward sloping.
e. Sales remain constant over the year, and financing requirements also
remain constant.
(21.9) Working capital financing
87
.
Which of the following statements is most correct?

Answer: e

Diff: E

a. Trade credit is provided to a business only when purchases are made.


b. Commercial paper is a form of short-term financing that is primarily
used by large, financially stable companies.
c. Short-term debt, while often cheaper than long-term debt, exposes a
firm to the potential problems associated with rolling over loans.
d. Statements b and c are correct.
e. All of the statements above are correct.
(21.9) Working capital financing
88
.
Which of the following statements is incorrect?

Answer: a

Diff: E

a. Commercial paper can be issued by virtually any firm so long as it is


willing to pay the going interest rate.
b. Accruals are free in the sense that no explicit interest is paid on
these funds.
c. A conservative approach to working capital will result in all
permanent assets being financed using long-term securities.
d. The risk to the firm of borrowing with short-term credit is usually
greater than with long-term debt. Added risk can stem from greater
variability of interest costs on short-term debt.
e. Bank loans have a lower interest rate than commercial paper.
(21.10) Marketable securities
Answer: a Diff: E
89
.
Which of the following is not a situation that might lead a firm to hold
marketable securities?
a. The firm has purchased a fixed asset that will require a large 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.)

Page 16

Chapter 21: Working Capital Management

(21.13) Commercial paper


90
.
Which of the following
incorrect?

statements

concerning

Answer: d Diff: E
commercial paper is

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

Medium:
(21.1) Cash conversion cycle
Answer: d Diff: M
91
.
Ignoring cost and other effects on the firm, which of the following
measures would tend to reduce the cash conversion cycle?
a.
b.
c.
d.
e.

Maintain the level of receivables as sales decrease.


Buy more raw materials to take advantage of price breaks.
Take discounts when offered.
Forgo discounts that are currently being taken.
Offer a longer deferral period to customers.

(21.1) Cash conversion cycle


Answer: d Diff: M
92
.
Which of the following actions are likely to reduce the length of a
companys cash conversion cycle?
a. Adopting a new inventory system that reduces the inventory conversion
period.
b. Reducing the average days sales outstanding (DSO) on its accounts
receivable.
c. Reducing the amount of time the company takes to pay its suppliers.
d. Statements a and b are correct.
e. All of the statements above are correct.

Chapter 21: Working Capital Management

Page 17

(21.2) Working capital policy


Answer: d Diff: M
93
.
Which of the following statements is incorrect about working capital
policy?
a. A company may hold a relatively large amount of cash if it
anticipates uncertain sales levels in the coming year.
b. Credit policy has an impact on working capital since it has the
potential to influence sales levels and the speed with which cash is
collected.
c. The cash budget is useful in determining future financing needs.
d. Holding minimal levels of inventory can reduce inventory carrying
costs and cannot lead to any adverse effects on profitability.
e. Managing working capital levels is important to the financial staff
since it influences financing decisions and overall profitability of
the firm.
(21.3) Cash balances
94
.
Which of the following statements is most correct?

Answer: c

Diff: M

a. The
cash
balances
of
most
firms
consist
of
transactions,
compensating, and precautionary balances. The total desired cash
balance can be determined by calculating the amount needed for each
purpose and then summing them together.
b. The easier a firms access to borrowed funds, the higher its
precautionary balances will be in order to protect against sudden
increases in interest rates.
c. For some firms holding highly liquid marketable securities is a
substitute for holding cash, because the marketable securities
accomplish the same objective as cash.
d. All companies hold the same amount of funds for a transaction
balance.
e. None of the statements above is correct.
(21.3) Compensating balances
95
.
Which of the following statements is most correct?

Answer: c

Diff: M

a. Compensating balance requirements apply only to businesses, not to


individuals.
b. Compensating balances are essentially costless to most firms, because
those firms would normally have such funds on hand to meet
transactions needs anyway.
c. If the required compensating balance is larger than the transactions
balance the firm would ordinarily hold, then the effective cost of
any loan requiring such a balance is increased.
d. Banks are prohibited from earning interest on the funds they force
businesses to keep as compensating balances.
e. None of the statements above is correct.

Page 18

Chapter 21: Working Capital Management

(21.4) Cash budget


96
.
Which of the following statements is most correct?

Answer: e

Diff: M

a. Shorter-term cash budgets, in general, are used primarily for


planning purposes, while longer-term budgets are used for actual cash
control.
b. The cash budget and the capital budget are planned separately and
although they are both important to the firm, they are independent of
each other.
c. Since depreciation is a non-cash charge, it does not appear on nor
have an effect on the cash budget.
d. The target cash balance is set optimally such that it need not be
adjusted for seasonal patterns and unanticipated fluctuations in
receipts, although it is changed to reflect long-term changes in the
firms operations.
e. The typical actual cash budget will reflect interest on loans and
income from investment of surplus cash. These numbers are expected
values and actual results might vary from budgeted results.
(21.5) Cash management
97
.
A lockbox plan is most beneficial to firms which
a.
b.
c.
d.
e.

Send
Have
Have
Hold
Make

Answer: e

Diff: M

payables over a wide geographic area.


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

(21.5) Float
98
.
Which of the following statements is most correct?

Answer: a

Diff: M

a. Poor synchronization of cash flows which results in high cash


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

Chapter 21: Working Capital Management

Page 19

(21.7) Receivables management


.
Which of the following statements is most correct?

99

Answer: b

Diff: M

a. A firm that makes 90 percent of its sales on credit and 10 percent


for cash is growing at a rate of 10 percent annually. If the firm
maintains stable growth it will also be able to maintain its accounts
receivable at its current level, since the 10 percent cash sales can
be used to manage the 10 percent growth rate.
b. In managing a firms accounts receivable it is possible to increase
credit sales per day yet still keep accounts receivable fairly steady
if the firm can shorten the length of its collection period.
c. If a firm has a large percentage of accounts over 30 days old, it is
a sign that the firms receivables management needs to be reviewed
and improved.
d. Since receivables and payables both result from sales transactions, a
firm with a high receivables-to-sales ratio should also have a high
payables-to-sales ratio.
e. None of the statements above is correct.
(21.7) DSO and aging schedule
100
.
Which of the following statements is most correct?

Answer: c

Diff: M

a. If a firms volume of credit sales declines then its DSO will also
decline.
b. If a firm changes its credit terms from 1/20, net 40 days, to 2/10,
net 60 days, the impact on sales cant be determined because the
increase in the discount is offset by the longer net terms, which
tends to reduce sales.
c. The DSO of a firm with seasonal sales can vary. While the sales per
day figure is usually based on the total annual sales, the accounts
receivable balance will be high or low depending on the season.
d. An aging schedule is used to determine what portion of customers pay
cash and what portion buy on credit.
e. Aging schedules can be constructed from the summary data provided in
the firms financial statements.
(21.7) Days sales outstanding (DSO)
101
.
Which of the following statements is most correct?

Answer: c

Diff: M

a. Other things held constant, the higher a firms days sales


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

Page 20

Chapter 21: Working Capital Management

(Comp.) Miscellaneous concepts


.
Which of the following statements is most correct?

102

Answer: e

Diff: M

a. Depreciation is included in the estimate of cash flows (Cash flow =


Net income + Depreciation), so depreciation is set forth on a
separate line in the cash budget.
b. If cash inflows and cash outflows occur on a regular basis, such as
the situation in which inflows from collections occur in equal
amounts each day and most payments are made regularly on the 10th of
each month, then it is not necessary to use a daily cash budget. A
cash budget prepared at the end of the month will suffice.
c. Sound working capital policy is designed to maximize the time between
cash expenditures on materials and the collection of cash on sales.
d. Statements b and c are correct.
e. None of the statements above is correct.
(21.9) Working capital financing policy
Answer: c Diff: M
103
.
Ski Lifts Inc. is a highly seasonal business.
The following summary
balance sheet provides data for peak and off-peak seasons (in thousands
of dollars):
Cash
Marketable securities
Accounts receivable
Inventories
Net fixed assets
Total assets

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 companys working capital financing policy.
e. Statements a and c are correct.

Chapter 21: Working Capital Management

Page 21

(21.9) Working capital financing policy


104
.
Which of the following statements is most correct?

Answer: b

Diff: M

a. Net working capital may be defined as current assets minus current


liabilities.
Any increase in the current ratio will automatically
lead to an increase in net working capital.
b. Although short-term interest rates have historically averaged less
than long-term rates, the heavy use of short-term debt is considered
to be an aggressive strategy because of the inherent risks of using
short-term financing.
c. If a company follows a policy of matching maturities, this means
that it matches its use of common stock with its use of long-term
debt as opposed to short-term debt.
d. All of the statements above are correct.
e. None of the statements above is correct.
(21.9) Working capital financing policy
105
.
Which of the following statements is most correct?

Answer: c

Diff: M

a. Accruals are an expensive way to finance working capital.


b. A conservative financing policy is one in which the firm finances all
of its fixed assets with long-term capital and part of its permanent
net operating working capital with short-term, nonspontaneous credit.
c. If a company receives trade credit under the terms 2/10, net 30 days,
this implies the company has 10 days of free trade credit.
d. Statements a and b are correct.
e. None of the answers above is correct.
(21.10) Marketable securities portfolio
Answer: d Diff: M
106
.
Which of the following statement completions is most correct? If the
yield curve is upward sloping, then a firms marketable securities
portfolio, assumed to be held for liquidity purposes, should be
a.
b.
c.
d.
e.

Weighted toward long-term securities because they pay higher rates.


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

(21.11) Short-term financing


107
.
Which of the following statements is most correct?

Answer: a

Diff: M

a. Under normal conditions, a firms expected ROE would probably be


higher if it financed with short-term rather than with long-term
debt, but the use of short-term debt would probably increase the
firms risk.
b. Conservative firms generally use no short-term debt and thus have
zero current liabilities.
c. A short-term loan can usually be obtained more quickly than a longterm loan, but the cost of short-term debt is likely to be higher
than that of long-term debt.
Page 22

Chapter 21: Working Capital Management

d. If a firm that can borrow from its bank buys on terms of 2/10, net 30
days, and if it must pay by Day 30 or else be cut off, then we would
expect to see zero accounts payable on its balance sheet.
e. If one of your firms customers is stretching its accounts payable,
this may be a nuisance but does not represent a real financial cost
to your firm as long as the firm periodically pays off its entire
balance.
(21.11) Short-term versus long-term financing
108
.
Which of the following statements is most correct?

Answer: d

Diff: M

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

Multiple Choice: Problems


Easy:
(21.1) Cash conversion cycle
Answer: d Diff: E
.
Spartan Sporting Goods has $5 million in inventory and $2 million in
accounts receivable.
Its average daily sales are $100,000.
The
companys payables deferral period (accounts payable divided by daily
purchases) is 30 days.
What is the length of the companys cash
conversion cycle?

109

a. 100 days
b. 60 days
c. 50 days
d. 40 days
e. 33 days

Chapter 21: Working Capital Management

Page 23

(21.1) Cash conversion cycle


Answer: a Diff: E
110
.
For the Cook County Company, the average age of accounts receivable is
60 days, the average age of accounts payable is 45 days, and the average
age of inventory is 72 days.
Assuming a 365-day year, what is the
length of the firms cash conversion cycle?
a.
b.
c.
d.
e.

87
90
65
48
66

days
days
days
days
days

(21.4) Sales collections


Answer: d Diff: E
111
.
The Danser Company expects to have sales of $30,000 in January, $33,000
in February, and $38,000 in March. If 20 percent of sales are for cash,
40 percent are credit sales paid in the month following the sale, and 40
percent are credit sales paid 2 months following the sale, what are the
cash receipts from sales in March?
a.
b.
c.
d.
e.

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

(21.5) Float
Answer: d Diff: E
112
.
Jumpdisk Company writes checks averaging $15,000 a day, and it takes 5
days for these checks to clear. The firm also receives checks in the
amount of $17,000 per day, but the firm loses three days while its
receipts are being deposited and cleared. What is the firm's net float
in dollars?
a.
b.
c.
d.
e.

Page 24

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

Chapter 21: Working Capital Management

(21.6) Inventory and NPV


Answer: d Diff: E
113
.
Rojas Computing is developing a new software system for one of its
clients. The system has an up-front cost of $75 million (at t = 0). The
client has forecasted its inventory levels for the next five years as
shown below:
Year
1
2
3
4
5

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

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

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

After Year 5, the software will become obsolete, so it will have no


further impact on the clients inventory levels.
Rojas client is
evaluating this software project as it would any other capital budgeting
project. The client estimates that the weighted average cost of capital
for the software system is 10 percent. What is the estimated NPV (in
millions of dollars) of the new software system?
a.
b.
c.
d.
e.

$233.56
$489.98
$625.12
$813.55
$956.43

(21.6) Inventory turnover ratio and DSO


Answer: a
114
.
Bowa Constructions days sales outstanding is 50 days (on a
basis).
The companys accounts receivable equal $100 million
balance sheet shows inventory equal to $125 million.
What
companys inventory turnover ratio?
a.
b.
c.
d.
e.

Diff: E
365-day
and its
is the

5.84
4.25
3.33
2.75
7.25

Chapter 21: Working Capital Management

Page 25

(21.8) Accounts receivable balance


Answer: a Diff: E
115
.
If Hot Tubs Inc. had sales of $2,027,773 per year (all credit) and its
days sales outstanding was equal to 35 days, what was its average amount
of accounts receivable outstanding? (Assume a 365-day year.)
a.
b.
c.
d.
e.

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

(21.8) Cost of trade credit


Answer: a Diff: E
116
.
A firm is offered trade credit terms of 3/15, net 45 days.
The firm
does not take the discount, and it pays after 67 days.
What is the
nominal annual cost of not taking the discount?
(Assume a 365-day
year.)
a.
b.
c.
d.
e.

21.71%
22.07%
22.95%
23.48%
24.52%

(21.8) Cost of trade credit


Answer: d Diff: E
117
.
Dixie Tours Inc. buys on terms of 2/15, net 30 days. It does not take
discounts, and it typically pays 35 days after the invoice date. Net
purchases amount to $720,000 per year. What is the nominal annual cost
of its non-free trade credit? (Assume a 365-day year.)
a.
b.
c.
d.
e.

17.2%
23.6%
26.1%
37.2%
50.6%

(21.8) Cost of trade credit


Answer: b Diff: E
118
.
Your company has been offered credit terms on its purchases of 4/30, net
90 days. What will be the nominal annual cost of trade credit if your
company pays on the 35th day after receiving the invoice? (Assume a 365day year.)
a. 30%
b. 304%
c.
3%
d. 87%
e. 156%

Page 26

Chapter 21: Working Capital Management

(21.8) Free trade credit


Answer: a Diff: E
119
.
Phillips Glass Company buys on terms of 2/15, net 30 days. It does not
take discounts, and it typically pays 30 days after the invoice date. Net
purchases amount to $730,000 per year. On average, how much free trade
credit does Phillips receive during the year? (Assume a 365-day year.)
a.
b.
c.
d.
e.

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

(21.9) Maturity matching


Answer: e Diff: E
120
.
Wildthing Amusement Companys total assets fluctuate between $320,000
and $410,000, while its fixed assets remain constant at $260,000.
If
the firm follows a maturity matching or moderate working capital
financing policy, what is the likely level of its long-term financing?
a.
b.
c.
d.
e.

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

(21.12) Revolving credit agreement cost


Answer: b Diff: E
121
.
Inland Oil arranged a $10,000,000 revolving credit agreement with a
group of small banks. The firm paid an annual commitment fee of onehalf of one percent of the unused balance of the loan commitment. On
the used portion of the loan, Inland paid 1.5 percent above prime for
the funds actually borrowed on an annual, simple interest basis.
The
prime rate was at 9 percent for the year. If Inland borrowed $6,000,000
immediately after the agreement was signed and repaid the loan at the
end of one year, what was the total dollar cost of the loan agreement
for one year?
a.
b.
c.
d.
e.

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

Chapter 21: Working Capital Management

Page 27

Medium:
(21.1) Inventory conversion period
Answer: d Diff: M
.
On average, a firm sells $2,000,000 in merchandise a month. It keeps
inventory equal to one-half of its monthly sales on hand at all times.
If the firm analyzes its accounts using a 365-day year, what is the
firms inventory conversion period?

122

a. 365.0 days
b. 182.5 days
c. 30.3 days
d. 15.2 days
e. 10.5 days
(21.1) Cash conversion cycle
Answer: d Diff: M
123
.
Porta Stadium Inc. has annual sales of $80,000,000 and keeps average
inventory of $20,000,000. On average, the firm has accounts receivable
of $16,000,000. The firm buys all raw materials on credit, its trade
credit terms are net 35 days, and it pays on time. The firms managers
are searching for ways to shorten the cash conversion cycle. If sales
can be maintained at existing levels but inventory can be lowered by
$4,000,000 and accounts receivable lowered by $2,000,000, what will be
the net change in the cash conversion cycle? Use a 365-day year. Round
to the closest whole day.
a. +105 days
b. -105 days
c. +27 days
d. -27 days
e.
-3 days
(21.1) Cash conversion cycle
Answer: e Diff: M
124
.
You have recently been hired to improve the performance of Multiplex
Corporation, which has been experiencing a severe cash shortage. As
one part of your analysis, you want to determine the firms cash
conversion cycle. Using the following information and a 365-day year,
what is your estimate of the firms current cash conversion cycle?

Page 28

Current inventory = $120,000.


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

a.
b.
c.
d.
e.

49
193
100
168
144

days
days
days
days
days
Chapter 21: Working Capital Management

(21.1) Cash conversion cycle


Answer: b Diff: M
125
.
Kolan Inc. has annual sales of $36,500,000 ($100,000 a day on a 365-day
basis).
On average, the company has $12,000,000 in inventory and
$8,000,000 in accounts receivable. The company is looking for ways to
shorten its cash conversion cycle, which is calculated on a 365-day
basis.
Its CFO has proposed new policies that would result in a 20
percent reduction in both average inventories and accounts receivables.
The company anticipates that these policies will also reduce sales by
10 percent. Accounts payable will remain unchanged. What effect would
these policies have on the companys cash conversion cycle? Round to
the nearest whole day.
a.
b.
c.
d.
e.

-40
-22
-13
+22
+40

days
days
days
days
days

(21.1) Cash conversion cycle


Answer: e Diff: M
126
.
Gaston Piston Corp. has annual sales of $50,735,000 and maintains an
average inventory level of $15,012,000.
The average accounts
receivable balance outstanding is $10,008,000. The company makes all
purchases on credit and has always paid on the 30th day. The company
is now going to take full advantage of trade credit and pay its
suppliers on the 40th day.
If sales can be maintained at existing
levels but inventory can be lowered by $1,946,000 and accounts
receivable lowered by $1,946,000, what will be the net change in the
cash conversion cycle? (Assume there are 365 days in the year.)
a.
b.
c.
d.
e.

-14.0
-18.8
-28.0
-25.6
-38.0

days
days
days
days
days

(21.2) ROE and working capital policy


Answer: c Diff: M
127
.
Jarrett Enterprises is considering whether to pursue a restricted or
relaxed current asset investment policy.
The firms annual sales are
$400,000; its fixed assets are $100,000; debt and equity are each 50
percent of total assets.
EBIT is $36,000, the interest rate on the
firms debt is 10 percent, and the firms tax rate is 40 percent. With
a restricted policy, current assets will be 15 percent of sales. Under
a relaxed policy, current assets will be 25 percent of sales. What is
the difference in the projected ROEs between the restricted and relaxed
policies?
a.
b.
c.
d.
e.

0.0%
6.2%
5.4%
1.6%
3.8%

Chapter 21: Working Capital Management

Page 29

(21.4) Cash budget


Answer: c Diff: M
128
.
Chadmark Corporations budgeted monthly sales are $3,000. Forty percent
of its customers pay in the first month and take the 2 percent discount.
The remaining 60 percent pay in the month following the sale and dont
receive a discount.
Chadmarks bad debts are very small and are
excluded from this analysis.
Purchases for next months sales are
constant each month at $1,500.
Other payments for wages, rent, and
taxes are constant at $700 per month. Construct a single months cash
budget with the information given.
What is the average cash gain or
(loss) during a typical month for Chadmark Corporation?
a.
b.
c.
d.
e.

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

(21.5) Lockbox
Answer: e Diff: M
129
.
Cross Collectibles currently fills mail orders from all over the U.S.
and receipts come in to headquarters in Little Rock, Arkansas.
The
firm's average accounts receivable (A/R) is $2.5 million and is financed
by a bank loan with 11 percent annual interest. Cross is considering a
regional lockbox system to speed up collections which it believes will
reduce A/R by 20 percent.
The annual cost of the system is $15,000.
What is the estimated net annual savings to the firm from implementing
the lockbox system?
a.
b.
c.
d.
e.

Page 30

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

Chapter 21: Working Capital Management

(21.7) Aging Schedule


Answer: b Diff: M
130
.
Short Construction offers its customers credit terms of 2/10, net 30
days, while Fryman Construction offers its customers credit terms of
2/10, net 45 days. The aging schedules for each of the two companies
accounts receivable are reported below:
Short Construction
Age of
Account (Days)
0-10
11-30
31-45
46-60
Over 60
Total Receivables

Fryman

Value of
Account

Percentage of
Total Value

Value of
Account

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

60%
20
15
3
2

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

Construction
Percentage of
Total Value
50%
20
20
7
3

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

Fryman; 50% overdue.


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

(21.8) Accounts payable balance


Answer: e Diff: M
131
.
Your firm buys on credit terms of 2/10, net 45 days, and it always pays
on Day 45.
If you calculate that this policy effectively costs your
firm $159,621 each year, what is the firms average accounts payable
balance?
(Hint:
Use the nominal cost of trade credit and carry its
cost out to 6 decimal places.)
a.
b.
c.
d.
e.

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

Chapter 21: Working Capital Management

Page 31

(21.8) EAR cost of trade credit


Answer: e Diff: M
132
.
Suppose the credit terms offered to your firm by your suppliers are
2/10, net 30 days.
Out of convenience, your firm is not taking
discounts, but is paying after 20 days, instead of waiting until Day 30.
You point out that the nominal cost of not taking the discount and
paying on Day 30 is approximately 37 percent. But since your firm is
not taking discounts and is paying on Day 20, what is the effective
annual cost of your firms current practice, using a 365-day year?
a. 36.7%
b. 105.4%
c. 73.4%
d. 43.6%
e. 109.0%
(21.8) EAR cost of trade credit
Answer: e Diff: M
133
.
Hayes Hypermarket purchases $4,562,500 in goods over a 1-year period
from its sole supplier.
The supplier offers trade credit under the
following terms: 2/15, net 50 days. If Hayes chooses to pay on time
but not to take the discount, what is the average level of the companys
accounts payable, and what is the effective annual cost of its trade
credit? (Assume a 365-day year.)
a.
b.
c.
d.
e.

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

(21.8) EAR cost


134
.
A firm is
not take
effective
year.)
a.
b.
c.
d.
e.

Page 32

17.81%
17.54%
27.43%
17.54%
23.45%

of trade credit
Answer: d Diff: M
offered trade credit terms of 2/8, net 45 days. The firm does
the discount, and it pays after 58 days.
What is the
annual cost of not taking this discount?
(Assume a 365-day

21.63%
13.35%
14.90%
15.89%
18.70%

Chapter 21: Working Capital Management

(21.8) Costly trade credit


Answer: a Diff: M
135
.
Phranklin Pharms Inc. purchases merchandise from a company that gives
sales terms of 2/15, net 40 days. Phranklin Pharms has gross purchases
of $819,388 per year. What is the maximum amount of costly trade credit
Phranklin could get, assuming it abides by the suppliers credit terms?
(Assume a 365-day year.)
a.
b.
c.
d.
e.

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

(21.8) Stretching accounts payable


Answer: e Diff: M
136
.
C+ Notes business is booming, and it needs to raise more capital. The
company purchases supplies from a single supplier on terms of 1/10, net
20 days, and it currently takes the discount. One way of getting the
needed funds would be to forgo the discount, and C+s owner believes she
could delay payment to 40 days without adverse effects.
What is the
effective annual rate of stretching the accounts payable?
a.
b.
c.
d.
e.

10.00%
11.11%
11.75%
12.29%
13.01%

Chapter 21: Working Capital Management

Page 33

(Comp.) Changes in working capital and free cash flow


Answer: b Diff: M
137
.
Allen Brothers is interested in increasing its free cash flow (which it
hopes will result in a higher EVA and stock price). The companys goal
is to generate $180 million of free cash flow over the upcoming year.
Allens CFO has made the following projections for the upcoming year:

EBIT is projected to be $850 million.


Gross capital expenditures are expected to total $360 million, and
its depreciation expense is expected to be $120 million. Thus, its
net capital expenditures are expected to total $240 million.
The firms tax rate is 40 percent.

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

Tough:
(21.1) Cash conversion cycle
Answer: c Diff: T
138
.
Jordan Air Inc. has average inventory of $1,000,000.
Its estimated
annual sales are $10 million and the firm estimates its receivables
conversion period to be twice as long as its inventory conversion
period. The firm pays its trade credit on time; its terms are net 30
days. The firm wants to decrease its cash conversion cycle by 10 days.
It believes that it can reduce its average inventory to $863,000.
Assume a 365-day year and that sales will not change. By how much must
the firm also reduce its accounts receivable to meet its goal of a 10day reduction in its cash conversion cycle?
a.
b.
c.
d.
e.

Page 34

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

Chapter 21: Working Capital Management

(21.7) Accounts payable balance


Answer: d Diff: T
139
.
Dalrymple Grocers buys on credit terms of 2/10, net 30 days, and it
always pays on the 30th day.
Dalrymple calculates that its annual
costly trade credit is $375,000.
What is the firms average accounts
payable balance? Assume a 365-day year.
a.
b.
c.
d.
e.

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

(21.8) Financial statements and trade credit


Answer: d Diff: T
140
.
Quickbow Company currently uses maximum trade credit by not taking
discounts on its purchases. Quickbow is considering borrowing from its
bank, using notes payable, in order to take trade discounts. The firm
wants to determine the effect of this policy change on its net income.
The standard industry credit terms offered by all its suppliers are 2/10,
net 30 days, and Quickbow pays in 30 days. Its net purchases are $11,760
per day, using a 365-day year. The interest rate on the notes payable is
10 percent and the firms tax rate is 40 percent. If the firm implements
the plan, what is the expected change in Quickbows net income?
a.
b.
c.
d.
e.

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

Chapter 21: Working Capital Management

Page 35

Multiple Part:
(The following information applies to the next three problems.)
Callison Airlines is deciding whether to pursue a restricted or relaxed working
capital investment policy. Callisons annual sales are expected to total $3.6
million, its fixed assets turnover ratio equals 4.0, and its debt and common
equity are each 50 percent of total assets. EBIT is $150,000, the interest rate
on the firms debt is 10 percent, and the firms tax rate is 40 percent. If the
company follows a restricted policy, its total assets turnover will be 2.5.
Under a relaxed policy, its total assets turnover will be 2.2.
(21.2) Working capital investment policy
Answer: c Diff: M
141
.
If the firm adopts a restricted policy, how much will it save in
interest expense (relative to what it would be if Callison were to adopt
a relaxed policy)?
a.
b.
c.
d.
e.

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

(21.2) Working capital investment policy and ROE


Answer: b Diff: M
142
.
What is the difference in the projected ROEs between the restricted and
relaxed policies?
a.
b.
c.
d.
e.

2.24%
1.50%
1.00%
0.50%
0.33%

(21.2) Working capital investment policy and ROE


Answer: a Diff: M
143
.
Assume now the company expects that if it adopts a restricted policy,
its sales will fall by 15 percent, EBIT will fall by 10 percent, but its
total assets turnover, debt ratio, interest rate, and tax rate will
remain the same.
In this situation, what is the difference in the
projected ROEs between the restricted and relaxed policies?
a.
b.
c.
d.
e.

Page 36

2.24%
1.50%
1.00%
0.50%
0.33%

Chapter 21: Working Capital Management

Financial Calculator Section


Multiple Choice: Problems
Medium:
(21.2) Permanent working capital financing
Answer: c Diff: M
144
.
Wicker Corporation is determining whether to support $100,000 of its
permanent working capital with a bank note or a short-term bond. The
firms bank offers a two-year note for which the firm will receive
$100,000 and repay $118,810 at the end of two years. The firm has the
option to renew the loan at market rates.
Alternatively, Wicker can
sell 8.5 percent annual coupon bonds with a 2-year maturity and $1,000
par value at a price of $973.97. How many percentage points lower is
the interest rate on the less expensive debt instrument?
a.
b.
c.
d.
e.

0.0%
1.2%
1.0%
1.8%
0.6%

Tough:
(21.8) DSO and the cost of trade credit
Answer: e Diff: T
145
.
Leiner Corp. is a retailer that finances its purchases with trade credit
under the following terms: 1/10, net 30 days. The company plans to take
advantage of the free trade credit that is offered. After all the free
trade credit is used, the company can either finance the clothing
purchases with a bank loan that has an effective rate of 10.1349 percent
(on a 365-day year), or the firm can continue to use trade credit.
The company has an understanding with its suppliers that within
moderation, it is all right to stretch out its payments beyond 30 days
without facing any additional financing costs. Therefore, the longer it
takes the company to pay its suppliers, the lower the cost of trade
credit. How many days would the firm wait to pay its suppliers in order
for the cost of the trade credit to equal the cost of the bank loan?
a.
b.
c.
d.
e.

30
36
40
46
48

days
days
days
days
days

Chapter 21: Working Capital Management

Page 37

CHAPTER 21
ANSWERS AND SOLUTIONS

Page 38

Chapter 21: Working Capital Management

1
.

(21.2) Net working capital

Answer: b

Diff: E

2.

(21.2) Net working capital

Answer: b

Diff: E

3.

(21.2) Working capital

Answer: b

Diff: E

4.

(21.2) Working capital policy

Answer: a

Diff: E

5.

(21.3) Goal of cash management

Answer: a

Diff: E

6.

(21.3) Motives for holding cash

Answer: a

Diff: E

7.

(21.4) Cash budget

Answer: a

Diff: E

8.

(21.4) Cash budget

Answer: a

Diff: E

9.

(21.5) Float

Answer: a

Diff: E

10.

(21.5) Lockbox

Answer: a

Diff: E

11.

(21.6) Goal of inventory management

Answer: b

Diff: E

12.

(21.6) Goal of inventory management

Answer: a

Diff: E

13.

(21.6) Inventory management interaction

Answer: b

Diff: E

14.

(21.7) Receivables balance

Answer: b

Diff: E

15.

(21.7) Receivables balance

Answer: a

Diff: E

16.

(21.7) Receivables aging

Answer: b

Diff: E

17.

(21.7) Monitoring receivables

Answer: a

Diff: E

18.

(21.7) Credit policy

Answer: a

Diff: E

19.

(21.7) Cash discounts

Answer: b

Diff: E

20.

(21.7) Trade discounts

Answer: b

Diff: E

21.

(21.7) Change in credit policy

Answer: a

Diff: E

22.

(21.8) Accruals

Answer: a

Diff: E

23.

(21.8) Accruals

Answer: a

Diff: E

24.

(21.8) Accruals

Answer: b

Diff: E

25.

(21.8) Trade credit

Answer: b

Diff: E

26.

(21.8) Trade credit

Answer: b

Diff: E

27.

(21.8) Trade credit

Answer: a

Diff: E

28.

(21.8) Trade credit

Answer: a

Diff: E

29.

(21.8) Trade credit

Answer: a

Diff: E

30.

(21.8) Cost of trade credit

Answer: a

Diff: E

31.

(21.8) Cost of trade credit

Answer: a

Diff: E

32.

(21.8) Cost of trade credit

Answer: a

Diff: E

33.

(21.8) Net trade credit

Answer: b

Diff: E

34.

(21.8) Net trade credit

Answer: a

Diff: E

35.

(21.8) Stretching accounts payable

Answer: b

Diff: E

36.

(21.9) Working capital policy

Answer: a

Diff: E

37.

(21.9) Short-term financing

Answer: a

Diff: E

38.

(21.9) Short-term financing

Answer: a

Diff: E

39.

(21.9) Short-term financing

Answer: a

Diff: E

40.

(21.12) Bank loans

Answer: b

Diff: E

41.

(21.12) Bank loans

Answer: a

Diff: E

42.

(21.12) Promissory note

Answer: b

Diff: E

43.

(21.12) Line of credit

Answer: a

Diff: E

44.

(21.12) Revolving credit and risk

Answer: a

Diff: E

45.

(21.4) Cash and capital budgets

Answer: b

Diff: M

46.

(21.4) Cash budget and depreciation

Answer: b

Diff: M

47.

(21.4) Seasonal patterns and cash

Answer: b

Diff: M

48.

(21.5) Synchronization of cash flows

Answer: a

Diff: M

49.

(21.5) Float

Answer: b

Diff: M

50.

(21.5) Float

Answer: b

Diff: M

51.

(21.5) Lockbox
Answer: b
Interest earned = $250,000(1.5)(0.06) = $22,500.
Thus, the cost ($23,000) exceeds the benefit ($22,500).

Diff: M

52.

(21.7) Receivables and growth

Answer: b

Diff: M

53.

(21.7) Receivables and growth

Answer: a

Diff: M

54.

(21.7) Collection policy

Answer: b

Diff: M

55.

(21.7) Collection policy

Answer: a

Diff: M

56.

(21.7) Cash versus credit sales

Answer: b

Diff: M

57.

(21.7) Days sales outstanding

Answer: a

Diff: M

58.

(21.7) Extending the credit period

Answer: a

Diff: M

59.

(21.7) DSO and past due accounts

Answer: b

Diff: M

60.

(21.7) Aging schedule and credit policy

Answer: b

Diff: M

61.

(21.8) Trade credit

Answer: b

Diff: M

62.

(21.8) Stretching accounts payable

Answer: a

Diff: M

63.

(21.8) Stretching accounts payable

Answer: b

Diff: M

64.

(21.8) Stretching accounts payable

Answer: b

Diff: M

65.

(21.9) Maturity matching

Answer: a

Diff: M

66.

(21.9) Maturity matching

Answer: b

Diff: M

67.

(21.9) Aggressive financing approach

Answer: a

Diff: M

68.

(21.9) Aggressive financing approach

Answer: b

Diff: M

69.

(21.9) Risk and short-term financing

Answer: a

Diff: M

70.

(21.9) Short-term financing

Answer: b

Diff: M

71.

(21.9) Short-term financing

Answer: a

Diff: M

72.

(21.12) Prime rate

Answer: b

Diff: M

73.

(21.12) Revolving credit agreement

Answer: a

Diff: M

74.

(21.1) Cash conversion cycle


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

75.

(21.2) Working capital

Answer: c

Diff: E

76.

(21.4) Cash budget

Answer: e

Diff: E

77.

(21.4) Cash budget

Answer: a

Diff: E

78.

(21.4) Cash budget


Answer: d Diff: E
Statement a is false because depreciation is not a cash item.
(Although
depreciation will affect taxes, depreciation itself will not be explicitly
included in the cash budget. The question asks explicitly.) Statement b
is true because this is a cash transaction, so it should be included in the
cash budget. Statement c is true because this is a cash transaction and
should be included in the cash budget. Since statements b and c are true,
statement d is the correct choice.

79.

(21.5) Cash management


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

80.

(21.5) Cash management


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

81
.

(21.5) Lockbox

Answer: d

Diff: E

82.

(21.6) Inventory management

Answer: e

Diff: E

83.

(21.7) Monitoring receivables

Answer: b

Diff: E

84.

(21.7) Credit policy

Answer: e

Diff: E

85.

(21.7) Credit policy

Answer: d

Diff: E

86.

(21.9) Working capital financing policy

Answer: a

Diff: E

87.

(21.9) Working capital financing

Answer: e

Diff: E

88.

(21.9) Working capital financing


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

89.

(21.10) Marketable securities

Answer: a

Diff: E

90.

(21.13) Commercial paper

Answer: d

Diff: E

91.

(21.1) Cash conversion cycle

Answer: d

Diff: M

92.

(21.1) Cash conversion cycle


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

93.

(21.2) Working capital policy


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

94.

(21.3) Cash balances

Answer: c

Diff: M

95.

(21.3) Compensating balances

Answer: c

Diff: M

96.

(21.4) Cash budget

Answer: e

Diff: M

97.

(21.5) Cash management

Answer: e

Diff: M

98.

(21.5) Float

Answer: a

Diff: M

99.

(21.7) Receivables management

Answer: b

Diff: M

100.

(21.7) DSO and aging schedule

Answer: c

Diff: M

101.

(21.7) Days sales outstanding (DSO)

Answer: c

Diff: M

102.

(Comp.) Miscellaneous concepts

Answer: e

Diff: M

103.

(21.9) Working capital financing policy

Answer: c

Diff: M

104.

(21.9) Working capital financing policy

Answer: b

Diff: M

105.

(21.9) Working capital financing policy


Answer: c Diff: M
Statement b illustrates an aggressive financing policy, not a conservative one.

106.

(21.10) Marketable securities portfolio

Answer: d

Diff: M

107.

(21.11) Short-term financing

Answer: a

Diff: M

108
.
109
.

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

Answer: d

Diff: M

(21.1) Cash conversion cycle


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

Cash conversion
Inv. conversion
Rec. collection
Pay. deferral
=
+

.
cycle
period
period
period

110.

Step 1:

Determine the inventory conversion period:


Inventory conversion period = Inventory/Daily sales
= $5,000,000/$100,000
= 50 days.

Step 2:

Determine the receivables collection period:


Receivables collection period = Receivables/Daily sales
= $2,000,000/$100,000
= 20 days.

Step 3:

Given data and information calculated above, determine the firms


cash conversion cycle:
Cash conversion cycle = 50 + 20 - 30
= 40 days.

(21.1) Cash conversion cycle

Cash conversion
cycle

Answer: a

Diff: E

Inv. conversion
Rec. collection
Pay. deferral
=
+

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

111.

(21.4) Sales collections

Answer: d

Diff: E

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

113.

(21.5) Float
Positive disbursement float = $15,000(5) = $75,000.
Negative collections float = $17,000(3) = $51,000.
Net float = $75,000 - $51,000 = $24,000.

Answer: d

Diff: E

(21.6) Inventory and NPV

Answer: d

Diff: E

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

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

114.

(21.6) Inventory turnover ratio and DSO


Step 1:

Diff: E

Determine sales level using the DSO equation.

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

DSO =
50 =
$100,000,000 =
$36,500,000,000 =
$730,000,000 =
Step 2:

Answer: a

Calculate inventory turnover ratio.

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

115
.
116
.

(21.8) Accounts receivable balance


Answer: a Diff: E
Accounts receivables = DSO Sales per day = 35($2,027,773/365) = $194,444.
(21.8) Cost of trade credit

Answer: a

Diff: E

Answer: d

Diff: E

Answer: b

Diff: E

365
3
Nominal percentage cost =

= 21.71%.
97
52
117
.

(21.8) Cost of trade credit

2
365
Nominal percentage cost =

= 37.24%.
98
35 - 15
118
.

(21.8) Cost of trade credit

4 365
Nominal percentage cost =

96 5
119
.

= 3.042 = 304.2%.

(21.8) Free trade credit

Answer: a

Diff: E

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

120.

(21.9) 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.
121.

(21.12) Revolving credit agreement cost


Answer: b
Interest rate on borrowed funds = 0.09 + 0.015 = 10.5%.

Diff: E

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
122.

Inventory conversion period

Answer: d

Diff: M

Answer: d
With Change

Diff: M

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

123.

(21.1) Cash conversion cycle


Old

365
ICP = $80

$20

365
=
4

91.25

365
365
$80 =
= 73.000
5
$16

+
DSO =
DP =

$16
$80 =
365

35 days
CCC =

73.00
-35.00
129.25 days

$14
$80 =
365
DP

63.875

New CCC =

-35.000
101.875 days

Change in CCC = 101.875 129.25 = -27.375 days -27 days.


Net change is 27 days (CCC is 27 days shorter).
124.

(21.1) Cash conversion cycle


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

125.

(21.1) Cash conversion cycle

Answer: b

Diff: M

Cash conversion
Inv. conversion
Rec. collection
Pay. deferral
=
+

.
cycle
period
period
period

For this problem we are only interested in the change in the CCC. We may
therefore ignore the Payables Deferral Period since it is assumed to
remain unchanged.
Old CCC (ignore payables) = $12,000,000/$100,000 + $8,000,000/$100,000
= 120 + 80 = 200 days.
New CCC = $9,600,000/$90,000 + $6,400,000/$90,000
= 106.67 + 71.11 = 177.78 days.
Change in CCC = New CCC Old CCC
= 177.78 200
= -22.22 days. Round to 22 days shorter.
126.

(21.1) Cash conversion cycle


Answer: e
First, calculate Sales/Day = $50,735,000/365 = $139,000.

Diff: M

Then, calculate the old inventory conversion period:


Inventory/Sales per day = $15,012,000/$139,000 = 108 days.
Then, find the new inventory conversion period:
$13,066,000/$139,000 = 94 days.
We have cut the inventory conversion period by 108 94 = 14 days.
Then, calculate the old DSO:
Accts. Rec./Sales per day = $10,008,000/$139,000 = 72 days.
Then, find the new DSO = $8,062,000/$139,000 = 58 days.
We have cut the DSO by 72 58 = 14 days.
Finally, find the total net change = -14 + (-14) 10
= -38 days.
127.

(21.2) ROE and working capital policy

Answer: c

Diff: M

Construct simplified comparative balance sheets and income statements for


the restricted and relaxed policies (In thousands of dollars):
15% of Sales
Restricted
$ 60.0
100.0
$160.0

25% of Sales
Relaxed
$100.0
100.0
$200.0

Debt
Equity
Total liabilities and equity

$ 80.0
80.0
$160.0

$100.0
100.0
$200.0

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

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

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

Balance sheet:
Current assets
Fixed assets
Total assets

ROE = NI/Equity
$16.8/$80 = 0.21
Difference in ROEs = 0.21 - 0.156 = 0.054 = 5.4%.
128.

(21.4) Cash budget


Construct a simplified cash budget:
Sales
Collections (same months sales)
Collections (last months sales)
Total collections

$15.6/$100 = 0.156.
Answer: c

$3,000
1,176
1,800
2,976

Diff: M

(0.98 0.40 $3,000)


(1.00 0.60 $3,000)

Purchases payments
Other payments
Total payments
Net cash gain (loss)
129
.

130.

1,500
700
2,200
$ 776

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

Diff: M

(21.7) Aging Schedule

Diff: M

Answer: b

Shorts credit policy is 2/10, net 30 days, so customers receivables are


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

($14,700 $2,940 $1,960)


= 20%.
$98,000
($10,290 $4,410)
Fryman:
= 10%.
$147,000
Short:

131.

(21.8) Accounts payable balance


Approximate percentage cost =
Accounts payable =

132
.

Answer: e

Diff: M

365
2

= 0.212828.
98
35

$159,621
= $750,000.
0.212828

(21.8) EAR cost of trade credit


Answer: e Diff: M
Calculate the nominal percentage, which is the nominal annual cost:
Nominal cost =

2
365 days

= 0.0204 36.5 = 0.7449 74.5%.


100 2
20 10

Calculate the effective annual rate (EAR):


Numerical solution:
EAR = (1.0204)36.5 - 1.0 = 2.0905 - 1.0 = 109.05% 109%.
Financial calculator solution: (EAR)
Inputs: P/YR = 36.5; NOM% = 74.49. Output:
133
.

134.

EFF% = 109%.

(21.8) EAR cost of trade credit


Answer: e Diff: M
The company pays every 50 days or 365/50 = 7.3 times per year. Thus, the
average accounts payable are $4,562,500/7.3 = $625,000.
The effective
cost of trade credit can be found as follows:
EAR = (1 + 2/98)365/35 - 1 = 1.2345 - 1 = 0.2345 = 23.45%.
(21.8) EAR cost of trade credit
Calculate the interest rate per period
Periodic rate = 2/98 = 2.04%.

Answer: d

Diff: M

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%.
135.

(21.8) Costly trade credit


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

136.

(21.8) Stretching accounts payable


Answer: e Diff: M
Accounts payable:
(1/99)(365/(40 - 10)) = 12.29%.
However, this is a
nominal rate. EAR is calculated as follows:
EAR = (1 + 1/99)12.1667 - 1 = 13.01%.

137.

(Comp.) Changes in working capital and free cash flow Answer: b


FCF
$180,000,000
$180,000,000
$180,000,000
-$90,000,000
NOWC

=
=
=
=
=
=

Diff: M

EBIT(1 T) + DEP CapExp - NOWC


$850,000,000(0.6) + $120,000,000 - $360,000,000 - NOWC
$510,000,000 + $120,000,000 - $360,000,000 - NOWC
$270,000,000 - NOWC
-NOWC
$90,000,000.

Net operating working capital needs to increase by $90 million, so we need


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

(21.1) Cash conversion cycle


ICP = 365 days/($10 million/$1 million) = 36.5 days.
DSO = 2.0 ICP = 73 days.

Answer: c

Diff: T

Solve for accounts receivable:


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

Reduction required in A/R = $2,000,000 - $1,863,014 = $136,986.


139
.

(21.7) Accounts payable balance


Step 1:

Answer: d

Diff: T

Calculate the nominal annual cost of trade credit.

2
365

98 30 10
= 0.0204 18.25
= 37.24%.

Nominal annual cost =

Step 2:

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

Step 3:

Determine gross and net sales.


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

Step 4:

Since accounts payable are shown net of discounts, determine


daily sales based on net sales figure. Then multiply this amount
by 30 days.

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

Daily net sales =

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


140.

(21.8) Financial statements and trade credit


Calculate A/P with and without taking discounts:
A/PNo discount = $11,760 30 days = $352,800.
A/PDiscount = $11,760 10 days = $117,600.

Answer: d

Calculate financing amount in notes payable and interest cost.


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.

Diff: T

The firm

Calculate total purchases and discounts lost:


Total purchases = 365 days 12,000 gross purchases = $4,380,000.
Discounts lost = $4,380,000 0.02 = $87,600.
Construct comparative financial statements:
I. Partial balance sheet:
Take Discounts
Dont Take Discounts
(Borrow N/P)
(Use Max. Trade Cdt) Difference
Accounts payable
$117,600
$352,800
-$235,200
Notes payable (10%)
235,200
+235,200
Total current liab.
$352,800
$352,800
$
0
II.

Partial income statement:

EBIT*
Less:

$140,000
$140,000
$
0
23,520
0
+23,520
0
87,600
-87,600
EBT
$116,480
$ 52,400
+$ 64,080
Less: Taxes (at 40%)
46,592
20,960
+25,632
Net income
$ 69,888
$ 31,440
+$ 38,448
*Any EBIT can be used, since the difference in EBIT from the two policies
is zero.
141.

Interest
Discounts lost

(21.2) Working capital investment policy


Step 1:

Answer: c

Diff: M

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

S
NFA
$3,600,000
4.0 =
NFA

FA turnover =

NFA = $900,000.
Step 2:

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

S
TA
$3,600,000
2.5 =
TA

Restricted:

Total assets turnover =

TA = $1,440,000.

Relaxed:

2.2 =

$3,600,000
TA

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

Develop balance sheets for each policy to determine the debt


level.
Restricted
Relaxed
Current assets
$ 540,000
$ 736,364
Fixed assets
900,000
900,000
Total assets
$1,440,000
$1,636,364
Debt
Equity
Total liabilities & equity

142.

720,000
720,000
$1,440,000

Step 4:

Determine interest under each policy:


Restricted: $720,000 0.10 = $72,000.
Relaxed: $818,182 0.10 = $81,818.

Step 5:

Calculate the difference in


between the 2 policies:
$81,818 - $72,000 = $9,818.

interest

(21.2) Working capital investment policy and ROE


Step 1:

818,182
818,182
$1,636,364

expense

(the

Answer: b

savings)

Diff: M

From the previous problem we can now set up an income statement


for each policy.
Restricted
Relaxed
EBIT
$150,000
$150,000
Interest (10%)
72,000
81,818
EBT
$ 78,000
$ 68,182
Taxes
31,200
27,273
Net income
$ 46,800
$ 40,909

143.

Step 2:

Calculate ROE using common equity as calculated in the prior


problem for each policy.
$46,800
$40,909
Restricted: ROE =
Relaxed: ROE =
$720,000
$818,182
= 6.5%.
= 5.0%.

Step 3:

Calculate the difference in ROEs.


ROE = 6.5% - 5.0% = 1.5%.

(21.2) Working capital investment policy and ROE

Answer: a

Diff: M

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

Calculate the new sales and EBIT levels.


New sales = $3,600,000 0.85 = $3,060,000.
New EBIT = $150,000 0.90 = $135,000.

Step 2:

Calculate the new level of assets under the restricted policy.


S/TA = 2.5
$3,060,000/2.5 = $1,224,000.

Step 3:

Develop the firms balance sheet under the restricted policy.

Step 4:

Total assets

$1,224,000

Debt
Equity
Total liabilities & equity

Develop the firms income statement under the restricted policy.


EBIT
Interest (10%)
EBT
Taxes (40%)
Net income

144.

612,000
612,000
$1,224,000

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

Step 5:

Calculate the firms ROE under the restricted policy.


ROE = NI/E = $44,280/$612,000
ROE = 7.24%.

Step 6:

Calculate the difference in ROEs between the 2 policies.


ROE = 7.24% - 5% = 2.24%.

(21.2) Permanent working capital financing


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

Inputs:
Output:

1
|

2 Years
|
FV = -118,810

1
|
-85

2 Years
|
-85
FV = -1,000

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


I = 9.0%.

Bond:

Inputs:
Output:

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


I = 10.0%.

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


145.

(21.8) DSO and the cost of trade credit


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