Financial Management (Chapter 18: Working Capital Management)

18.1   Working Capital Management and the Risk-Return Tradeoff

1) An increase in ________ would increase net working capital.

A) plant and equipment
B) accounts payable
C) accounts receivable
D) both B and C

2) P. Noel's Inc.'s current ratio is 2. Current liabilities are $500,000. P. Noel's current assets
equal ________ and net working capital is ________.
A) $500,000 and $1,000,000
B) $500,000 and $250,000
C) $1,000,000 and $500,000
D) $500,000 and $500,000

3) Current assets include

A) all assets that have not been fully depreciated.
B) accounts payable, accounts receivable and short-term notes.
C) cash, accounts receivable and leased equipment.
D) cash, accounts receivable and inventory.

4) Which of the following could offset the higher risk exposure a company would face if it s
current ratio and net working capital were relatively low?
A) Its current assets would need to be highly liquid.
B) Its accounts receivable collection policy could increase the average collection period.
C) It could offer no discounts for early payment by its customers.
D) It could buy back some of its shares in the open market in order to reduce its equity.

5) Which of the following would be considered an issue that is related to the management of
working capital?
A) How much inventory should the firm maintain?
B) How should a firm finance its current assets?
C) To whom should the firm grant trade credit?
D) All of the above

6) An increase in ________ would increase a firm's current ratio and net working capital.
A) notes payable
B) inventories
C) cash
D) both B and C
7) A decrease in ________ would increase net working capital.
A) accounts payable
B) accounts receivable
C) cash
D) equipment

8) In general, the greater a firm's reliance upon short-term debt or current liabilities, the lower
the
A) liquidity.
B) flexibility.
C) certainty of interest costs.
D) both A and C.

9) The risk of a firm not being able to pay its bills on time is called
A) illiquidity.
B) insolvency.
C) capital inadequacy.
D) float.

10) Which of the following will reduce the liquidity of a firm? An increase in
A) short-term notes payable.
B) accounts payable.
C) current assets.
D) both A and B.

11) Which of the following policies will reduce a retailer's investment in working capital?
A) Using cash rather than trade credit for inventory purchases
B) Accepting major credit cards rather than offering store credit
C) Keeping unsold seasonal merchandise in storage so that it can be offered again the following
year
D) All of the above

12) Net working capital refers to which of the following?

A) Current assets
B) Current assets minus current liabilities
C) Current assets minus inventory
D) Current assets divided by current liabilities

13) Which of the following is most likely to occur if a firm over-invests in net working capital?
A) The current ratio will be lower than it should be.
B) The quick ratio will be lower than it should be.
C) The return on investment will be lower than it should be.
D) The times interest earned ratio will be lower than it should be.

14) Which of the following is most likely to occur if a firm under-invests in net working capital?
A) The firm might not have sufficient cash to pay its bill in a timely manner.
B) The firm might not have adequate inventory to meet the needs of its customers.
C) The firm could be losing sales because its terms of sale are too strict.
D) All of the above.

15) Solstice Corporation has current assets of $10 million and current liabilities of $8 million.
Solstice's current ratio is ________ and its net working capital is ________.
A) 1.25, $10 million
B) 1.25, $2 million
C) 2, $1.25 million
D) .8, ($2 million)

16) J.B. 's Wholesale Club has current assets of $12.25 million and current liabilities of $14
million. Which of the following is possible?
A) J.B. makes efficient use of its current assets.
B) J.B. may be at some risk of being unable to pay its bills.
C) J.B. appears to be overinvesting in current assets.
D) Either or both A and B may be true.

17) Working capital refers to investment in current assets, while net working capital is the
difference between current assets and current liabilities.
Answer:  TRUE

18) Net working capital provides a very useful summary measure of a firm's short-term financing
decisions.
Answer:  TRUE

19) Within the context of working capital management, the risk-return trade-off involves an
increased risk of illiquidity versus increased profitability.
Answer:  TRUE

20) A company with a current ratio less than one or negative net working capital would not be
able to pay its bills on time.
Answer:  FALSE
21) The balance sheet for Peterson Manufacturing Company is presented below.

                                                      Peterson Mfg. Co.

                                                         Balance Sheet
                                                    December 31, 1995
        Cash                                $32,000        Current liabilities              $72,000
        Accounts receivable      40,000        Long-term liabilities           48,000
        Inventories                       48,000        Common equity                 120,000
        Total current assets  $120,000
        Net fixed assets            120,000
        Total                              $240,000        Total                                    $240,000

During 2009, the firm earned $28,000 after taxes based on net sales of $480,000.
a.    Calculate Peterson's current ratio and net working capital.
b.    Assume that Peterson's uses $20,000 of its cash to reduce current liabilities. Recompute
the current ratio and net working capital.
c.     What effect, if any, does the change proposed in question b have on Peterson's liquidity.

Answer: 
a.    Current ratio = ($120,000)/($72,000) = 1.67
        Net working capital = $120,000 - $72,000 = $48,000
b.    Current ratio = ($100,000)/($52,000) = 1.92
        Net working capital = $100,000 - $52,000 = $48,000
c.     Yes, the firm's liquidity position as measured by the current ratio improves slightly but the
amount of net working capital is less. The composition of Peterson's current assets is less liquid
than before because cash is the most liquid asset.

22) The December 31, 1995 balance sheet for Spitco, Inc. is presented below.

                                      Spitco, Inc.

                                   Balance Sheet
                              December 31, 2010
        Current assets                                     $40,000
        Net fixed assets                                     20,000
        Total                                                       $60,000
        Accounts payable                                 11,000
        Notes payable                                        12,000
        Total                                                       $23,000
        Long-term debt (10%)                          12,000
        Common equity                                    25,000
        Total                                                       $60,000       

a.    Calculate Spitco's current ratio, and net working capital.

b.    Spitco feels that its current ratio is too far below the industry average of 2.40. To improve
their liquidity, the treasurer of Spitco has devised a plan to issue $12,000 in long-term debt at
12% and pay off its notes payable. The funds would be invested in marketable securities at 7%
interest when not needed to finance the firm's seasonal asset needs. The notes payable would
remain outstanding through the year. Assume this plan had been implemented for 2010.
Calculate what the firm's current ratio, and net working capital would have been.
c.     Did Spitco improve their liquidity? What do you think happened to Spitco's return on
investment?

Answer: 
a.     Current ratio = (current assets)/(current liabilities) = ($40,000)/($23,000) = 1.74x
        Net working capital = current assets - current liabilities = $40,000 - $23,000 = $17,000
b.     Current ratio = ($40,000)/($11,000) = 3.64x
        Net working capital = $40,000 - $11,000 = $29,000
c.     Yes, liquidity is now well above the industry average. The firm's return on investment has
probably fallen.

23) The current ratio and net working capital are good predictors of a firm's ability to meet its
short term obligations.  Agree or disagree.

Answer:  A firm may have a high current ratio and high net working capital because its
customers are slow to pay or because the company is slow to write off delinquent accounts. 
Both actions would increase accounts receivable, but not it's ability to pay current liabilities in a
timely manner.  Likewise, it may have slow-moving or obsolete inventory.  

Poor management of receivables and inventory, along with cash balances larger than what are
needed for transactions, can create a kind of false liquidity which disguises the fact the
company has trouble turning current assets into cash. 

As the Dell text box illustrates, firms that manage receivables and inventory efficiently and
maximize the use of trade credit may have low liquidity measures, but still generate plenty of
cash to meet their current obligations.

18.2   Working Capital Policy

1) Accounts payable is considered a

A) spontaneous liability.
B) temporary financing source.
C) permanent financing source.
D) both A and B.

2) Which of the following is NOT considered a permanent source of financing?

A) Corporate bonds
B) Common stock
C) Preferred stock
D) Commercial paper

3) Which of the following is most likely to be a temporary source of financing?

A) Commercial paper
B) Preferred stock
C) Long-term debt
D) All of the above

4) What is the conventional method for financing permanent levels of accounts receivable and
inventory?
A) Bonds and equity
B) Short-term loans
C) Accounts payable and accrued expenses
D) Equity only

5) Commercial paper
A) rates are generally higher than rates on bank loans and comparable sources of short-term
financing.
B) generally has a minimum compensating balance requirement.
C) offers the firm with very large credit needs a single source for all its short-term financing.
D) has all of the properties stated above.

6) A "pop-up" store wants to use vacated space at a shopping mall to sell seasonal
merchandise during the months of October, November and December. The rent is $10,000 per
month, but the mall's owners are requiring a payment of $100,000 on September 1.  If the space
is vacated in good condition at the end of December, the owners will return $70,000 to the
lessees.  How should the $100,000 be financed?
A) Space is a permanent asset and should be financed with equity or long-term debt.
B) Because the lessee may rent the same or similar space in future years, they should use long-
term debt or equity.
C) The space is a temporary asset and should be financed with short-term loans.
D) The space is a temporary asset and should be financed with trade credit.

7) With respect to working capital policy, firms most often employ

A) a cautious approach which finances short-term assets with long-term financing.
B) the principle of self-liquidating debt.
C) an aggressive approach which finances long-term assets with short-term financing.
D) the principle of liquidity optimization.

8) A toy manufacturer following the self-liquidating debt. principle will generally finance seasonal
inventory build-up prior to the Holiday season with:
A) common stock.
B) selling equipment.
C) trade credit.
D) preferred stock.

9) Which of the following is considered to be a spontaneous source of financing?

A) Operating leases
B) Accounts receivable
C) Inventory
D) Accounts payable

10) Current assets of NorthPole.com at the end of each quarter were: 1st quarter $1.3 million,
2nd quarter $1.7 million, 3rd quarter $1.5 million and 4th quarter $2.2 million. The best estimate
for North Pole's permanent current assets is
A) $2.2 million.
B) $1.675 million.
C) $1.3 million.
D) $0.9 million.

11) Disadvantages of using current liabilities as opposed to long-term debt include

A) greater risk of illiquidity.
B) uncertainty of interest costs.
C) higher cash flow exposure.
D) both A and B.

12) According to the self-liquidating debt principle permanent assets should be financed with
________ liabilities.
A) permanent
B) spontaneous
C) current
D) fixed

13) Which of the following is most consistent with the self-liquidating debt principle in working
capital management?
A) Fixed assets should be financed with short-term notes payable.
B) Inventory should be financed with preferred stock.
C) Accounts receivable should be financed with short-term lines of credit.
D) Borrow on a floating rate basis to finance investments in permanent assets.

14) The principle of maturity matching suggests that

A) machinery with a 5 year economic life be financed with debt that will be paid off in five years
or less.
B) seasonal peaks in inventory be financed with traded credit.
C) the minimum level of current assets required for the firm's year around operations be
financed with permanent sources.
D) all of the above.

15) Spontaneous sources of financing include

A) marketable securities.
B) accruals.
C) bonds.
D) commercial paper.

16) Which of the following is NOT a spontaneous source of financing?

A) Accrued salaries payable
B) Loans secured by accounts receivable
C) Accrued taxes payable
D) Accounts payable

17) A quite risky working capital management policy would have a high ratio of
A) short-term debt to bonds and equity.
B) short-term debt to total debt.
C) bonds to property, plant, and equipment.
D) short-term debt to equity.

18) Which of the following is a spontaneous source of financing?

A) Accrued wages
B) Preferred stock
C) Trade credit
D) Both A and C

19) Trade credit is an example of which of the following sources of financing?

A) Spontaneous
B) Temporary
C) Permanent
D) Both A and B

20) If management expects interest rates to rise and credit to tighten in the near future, it should
consider
A) increasing its use of commercial paper and loans secured by current assets.
B) decreasing the use of spontaneous financing.
C) decreasing the level of permanent financing.
D) increasing the level of permanent financing.

21) All else equal, which of the following is the most likely to occur if actual sales are much less
than forecasted sales?
A) The company will be in a better position to pay down most of its debt.
B) The firm's actual investment in inventory will be unchanged from the amount forecasted.
C) Accounts receivable will rise significantly above the forecast.
D) The company might face a cash flow crunch.
22) Potential risks of using short-term bank loans for permanent assets include
A) higher costs.
B) a loss of flexibility.
C) inability to renew the loans on favorable terms.
D) falling interest rates.

23) The use of short-term debt provides flexibility in financing since the firm is only paying
interest when it is actually using the borrowed funds.
Answer:  TRUE

24) Unlike spontaneous sources of financing, discretionary financing requires a managerial

decision.
Answer:  TRUE

25) Within the context of working capital management, the risk-return trade-off involves an
increased risk of illiquidity versus increased profitability.
Answer:  TRUE

26) Accrued wages are considered an unsecured, non-spontaneous source of financing.

Answer:  FALSE

27) The primary sources of collateral for short-term secured loans are accounts receivable and
inventory.
Answer:  TRUE

28) Trade credit appears on a company's balance sheet as accounts payable.

Answer:  TRUE

29) A firm can reduce net working capital by substituting long-term financing, such as bonds,
with short-term financing, such as a one-year notes payable.
Answer:  TRUE

30) Increasing the use of short-term debt versus long-term debt financing will increase profit.
Answer:  TRUE

31)  Spontaneous sources of financing may be either short-term or long-term.

Answer:  FALSE
32) Short-term debt is frequently less expensive because it provides the borrower more security.
Answer:  FALSE

33) Trade credit is a source of spontaneous financing.

Answer:  TRUE

34) Summary data from the quarterly balance sheets of ACH Air Conditioners are shown below.

Quarter 1 Quarter 2 Quarter 3 Quarter 4

Current Assets    $50,000 $90,000 $75,000 $30,000
Fixed Assets $60,000 $60,000 $60,000 $60,000
Liabilities $70,000 $110,00 $95,000 $50,000
Equity $40,000 $40,000 $40,000 $40,000
.
a. If ACH follows the self liquidating debt principle, how much long-term debt will be used to
finance current assets? Explain your answer briefly.
b. What would be the highest and lowest levels of temporary debt?

Answer: 
a. It would appear from the quarterly balance sheets that current assets do not fall below
$30,000, so that part of the current assets should be financed with long-term funds.
b. Temporary debt should peak at ($90,000 - $30,000) = $60,000 in the 2nd quarter. At the end
of the fourth quarter, ACH should have no temporary debt.

35) L. Stevens Inc. uses permanent sources of financing to cover its peak level of current
assets. When it does not need the money to finance inventories and accounts receivable, it
invests the excess funds in short-term certificates of deposit. What are the advantages and
disadvantages of this policy?

Answer:  By financing all of its temporary needs with long-term funds, L. Stevens avoids the
inconvenience of arranging for short-term loans on a frequent basis. The company also
insulates itself from the risks of rising interest rates and tight credit. On the other hand, the cost
of long-term debt and equity is considerably higher than on short-term debt and L. Stevens will
have to pay interest on the full year rather than just for the period when it needs the funds. It is
very unlikely that the rate earned on short-term investments will equal the rate paid on the long-
term debt, so this policy will reduce the company's profits.

18.3   Operating and Cash Conversion Cycles

1) King Co.'s inventory turnover ratio is 12. Its inventory conversion period is
A) 12 days.
B) 30.4 days.
C) 2.5 days.
D) There is not enough information.

2) Prince Co.'s inventory turnover ratio is 30.4. Its inventory conversion period is
A) 12 days.
B) 30.4 days.
C) 2.5 days.
D) There is not enough information.

3) Queen Co.'s balance in accounts receivable is $240,000. Annual credit sales are $2,880,000.
Queen's average collection period is
A) 12 days.
B) 30.4 days.
C) 2.5 days.
D) There is not enough information.

4) Frosty's Frozen Food Inc.'s inventory balance is $1.22 million. Frosty's Cost of Good's Sold is
$30.4 million. Its inventory conversion period is
A) 12 days.
B) 24.92 days.
C) 14.65 days.
D) 299.2 days.

5) Currier & Ive's Lithography has a Cost of Goods Sold of $60.8 million. The company's
accounts payable balance is $7.5 million. Its accounts payable deferral period is
A) 81 days.
B) 45 days.
C) 8.11 days.
D) 48.7 days.

6) Abbot Corporation has an average collection period of 49 days, an inventory conversion

period of 83 days, and a payables deferral period of 36 days. What is Abbott's cash conversion
cycle?
A) 96 days
B) 70 days
C) 85 days
D) 132 days

7) Abbot Corporation has an average collection period of 49 days, an inventory conversion

period of 83 days, and a payables deferrable period of 36 days. What is Abbott's operating
cycle?
A) 96 days
B) 70 days
C) 85 days
D) 132 days

8) Clark Corporation has an average collection period of 7 days, an inventory conversion period
of 30 days, and a payables deferrable period of 60 days. What is Clark's operating cycle?
A) 97 days
B) 37 days
C) 23 days
D) -23 days

9) Clark Corporation has an average collection period of 7 days, an inventory conversion period
of 30 days, and a payables deferrable period of 60 days. What is Clark's cash conversion cycle?
A) 97 days
B) 37 days
C) 23 days
D) -23 days

10) Becker.com has an inventory turnover ratio of 52, an accounts receivable balance of
$365,000, average daily credit sales of $36,500, accounts payable of $182,500 and cost of
goods sold of $7,993,500. What is Becker's operating cycle to the nearest day?
A) 17 days
B) 61 days
C) 27 days
D) -27 days

11) Becker.com has an inventory turnover ratio of 52, an accounts receivable balance of
$365,000, average daily credit sales of $36,500, accounts payable of $182,500 and cost of
goods sold of $7,993,500. What is Becker's cash conversion cycle to the nearest day?
A) 17 days
B) 9 days
C) 27 days
D) -27 days

12) ViteS Equipment Company has increased its inventory turnover ratio from 12 to 18. By how
many days has it reduced the operating cycle?
A) 20 days
B) 6 days
C) 10 days
D) 1.5 days
13) It is not possible to have a negative cash conversion cycle.
Answer:  FALSE

14) The operating cycle can never be longer than the cash conversion cycle.
Answer:  FALSE

15) As the inventory turnover ratio decreases, the inventory conversion cycle increases.
Answer:  TRUE

16) Increasing the accounts payable deferral period also increases the cash conversion cycle.
Answer:  FALSE

17) Cash Conversion Cycle = Operating Cycle - Accounts Payable Deferral Period.
Answer:  TRUE

18) A& B Global's annual credit sales are $18 million; the accounts receivable balance is $1.5
million; the cost of goods sold is $12.6 million; the inventory balance is $350,000, and the
balance in accounts payable is $700,000.
a. Compute A&B's operating cycle.
b. Compute A&B's cash conversion cycle.

Answer:  Average collection period = $1,500,00/($18,000,000/365) = 30.42 days. Inventory

conversion period = $350,000/($12,600,000/365) = 10.14 days. The accounts payable deferral
period is 365/($12,600,000/$700,000 ) = 20.28 days.
a. Operating cycle = 30.42 + 10.14 = 40.56 days.
b. Cash conversion cycle = 40.56 - 20.28 = 20.28 days.

18.4   Managing Current Liabilities

1) A firm buys on terms of 3/10, net 30. What is the cost of trade credit under these terms?
A) 55.7%
B) 47.4%
C) 31.5%
D) 23.2%

2) The correct equation for calculating the cost of short-term credit is

A) rate = interest/(principal × time).
B) rate = (principal × time)/interest.
C) rate = principal/(time × interest).
D) rate = principal × interest × time.
3) Which item would constitute poor collateral for an inventory loan?
A) Lumber
B) Vegetables
C) Copper
D) Chemicals

4) Which of the following statements regarding a line of credit is true?

A) The purpose for which the money is being borrowed must be stated by the borrower.
B) A line of credit agreement usually fixes the interest rate that will be applied to any extensions
of credit.
C) A line of credit agreement is a legal commitment on the part of the bank to provide the stated
credit.
D) Such agreements usually cover the borrower's fiscal year.

5) Which of the following is an advantage of using commercial paper for short-term credit?
A) The interest rate is usually lower than for equivalent bank loans.
B) It is a readily available source of credit for most firms
C) It is a type of free credit.
D) It can be issued for very small amounts.

6) The First Webster Bank requires borrowers to maintain a balance of 10% of the line of credit
in a non-interest paying account as compensation for providing the line of credit. If the borrower
would not normally have deposits in such an account
A) the amount borrowed will be higher than the amount needed.
B) the APR will be less than the stated rate.
C) the amount borrowed will be lower than the amount needed.
D) neither the amount borrowed nor the APR will be affected by the required balance.

7) A company which foregoes the discount when credit terms are 4/15 net 70 is essentially
borrowing money from his supplier for an additional
A) 40 days.
B) 55 days.
C) 70 days.
D) 85 days.

8) A company that foregoes a discount of 1/7 net 30 is essentially borrowing money from the
vendor at
A) 1%.
B) 12.29%.
C) 16.03%.
D) 52.7%.
9) What factors should we consider when selecting a source of short-term credit?
A) Effective cost and availability
B) Liquidity and profitability
C) Historical trend analysis and liquidity
D) None of the above

10) Once a cash discount period has passed

A) one should pay immediately.
B) there is no financial incentive to pay before the final due date.
C) one should pay after the final due date.
D) cannot be determined from the information.

11) Bank Two extends a $3 million line of credit to Capital Corp. The stated rate of interest is
9.5%. Bank Two requires Capital to maintain compensating balances equal to 10% of the
amount of the line. Assuming that Capital would not normally carry any deposits at the bank,
what is the effective annual rate of interest on the loan?
A) 9.5%
B) 10.6%
C) 11.6%
D) 12.3%

12) The Stant Shoe Company established a line of credit with a local bank. The maximum
amount that can be borrowed under the terms of the agreement is $100,000 at an annual rate of
5%. A compensating balance of 10% of the amount borrowed is required. What is the largest
amount of money Stant will actually be able to use from the line of credit?
A) $90,909
B) $90,000
C) $111,111
D) $100,000

13) Smith Enterprises has a line of credit with Fidelity National Bank that allows Smith to borrow
up to $350,000 at an interest rate of 5%. However, Smith must keep a compensating balance of
10% of any amount borrowed on deposit at Fidelity. Smith does not normally keep a cash
balance account with Fidelity. What is the effective annual cost of credit (round to nearest .01
percent)?
A) 5.93%
B) 5.84%
C) 5.64%
D) 5.56%
14) Georgia Peaches Corporation (GPC) has a line of credit with Trust Company Bank that
allows GPC to borrow up to $300,000 at an annual interest rate of 5.5%. However, GPC must
keep a compensating balance of 20% of any amount borrowed on deposit at the Trust Company
Bank. GPC does not normally have a cash balance account with the Trust Company. What is
the effective annual cost of credit?
A) 6.875%
B) 6.975%
C) 7.075%
D) 7.775%

15) Which of the following comparisons between short-term bank loans is correct?
A) Commercial paper interest rates are usually slightly higher than rates on bank loans.
B) Commercial paper is only appropriate for firms requiring a limited amount of short-term
financing, while banks can offer substantially larger amounts of funds.
C) Banks demand that borrowers meet exacting credit-worthiness tests, while the lenders that
purchase commercial paper are less strict. Only the most credit-worthy borrowers have access
to bank loans.
D) Commercial paper is less flexible than a line of credit, but the interest rate is lower.

16) The Stoney River Textiles Company will borrow $50 million for 180 days from Merrimac
Bank. The bank will charge Stoney River 4.5 % on a discounted basis. What is the annual
percentage rate (APR) to Stoney River (round to the nearest .1 percent)?
A) 2.25%
B) 2.36%
C) 4.71%
D) 4.5%

17) The Stoney River Textiles Company will borrow $50 million for 180 days from Merrimac
Bank. The bank will charge Stoney River 4.5 % on a discounted basis. What is the dollar
amount of interest Stoney River will need to pay? Assume a 360 day year.
A) $1,125,000
B) $1,099,688
C) $2,250,000
D) 41,074,375

18) Fibercom Inc. needs $500,000 for one year.  If the loan takes the form of a discounted note
at a stated rate of 4%, how much will Fibercom actually need to borrow?
A) $480,000
B) $500,000
C) $520,833
D) $520,000

19) Atlas Tire Irons, Inc. is considering borrowing $5,000 for a 3 month period. The firm will
repay the $5,000 principal amount plus $150 in interest. What is the annual percentage rate
(APR) rate of interest (use a 360-day year)?
A) 3%
B) 12%
C) 15%
D) 18%

20) Which of the following would NOT be considered an unsecured loan?

A) Accrued tax payments
B) Line of credit
C) Transaction loans
D) Factored accounts receivable

21) The primary advantage that factoring accounts receivable provides is

A) the flexibility it gives to the borrower.
B) that the financial institution bears the risk of collection.
C) the low cost as compared with other sources of short-term financing.
D) that the financial institution services the accounts.

22) The Omega Corp. plans to borrow $10,000 for a 2 months. At maturity, Omega will repay
the $10,000 principal plus $100 interest. What is the annual percentage rate (APR) rate of
interest on this loan?
A) 6%
B) 1%
C) 4%
D) 6.4%

23) The cost of trade credit varies with the

A) size of the cash discount.
B) length of time between the end of the discount period and the final due date.
C) length of time between the end of the discount period and when the firm purchased from the
supplier.
D) both A and C.

24) Which of the following is an advantage of trade credit?

A) Trade credit is conveniently obtained as a normal part of the firm's operations.
B) No formal agreements are generally involved in extending credit.
C) The amount of credit extended expands and contracts with the needs of the firm.
D) All of the above.

Use the following information to answer the following question(s).

Quick Corp. makes its purchases under terms of 2/10 net 30.
25) If Quick Corp. foregoes the discount and pays for its purchases according to the terms of its
trade credit, what is Quick's effective cost of using this source of credit?
A) 26.67%
B) 31.48%
C) 36.73%
D) 51.32%

26) If Quick foregoes the discount but does not pay for its purchases until day 40, what is
Quick's effective cost of using this source of credit? Assume that no penalty is incurred for late
payment.
A) 38.37%
B) 36.73%
C) 26.67%
D) 24.49%

27) When a commercial bank extends short-term credit to a firm, it can provide a line of credit
that involves
A) a legal obligation on the part of the bank to provide the stated credit.
B) no legal obligation on the part of the bank to provide the stated credit.
C) the requirement that the borrower maintain a compensating balance with the bank
throughout the loan period.
D) a fixed rate of interest.

Use the following information to answer the following question(s).

DEF, Inc. requires $540,000 in short-term credit and is currently arranging a loan with its bank.
ABC plans to use the funds for six months; the annual rate on the loan is 5%, and the bank will
require a 10% compensating balance.

28) If ABC must have loan proceeds of $540,000, then it must borrow
A) $540,000.
B) $600,000.
C) $486,000.
D) $660,000.

29) What is the annual percentage cost of the loan, to the nearest .01%?
A) 5.00%
B) 4.50%
C) 5.56%
D) 2.5%

30) A firm will borrow $1 million for six months on a discount basis. The annual interest rate on
the loan is 6%. What is the annual percentage cost of the loan?
A) 5.64%
B) 6.38%
C) 3.19%
D) 6.00%

31) Pledging accounts receivable as a source of short-term credit

A) is a type of loan secured by accounts receivable.
B) is a form of spontaneous credit.
C) involves the outright sale of accounts receivable to a financial institution.
D) is an inexpensive but risky source of short-term financing.

32) The effective cost to the borrower of an unsecured bank loan is increased if a compensating
balance is required.
Answer:  TRUE

33) Commercial paper is a source of credit available to large firms with healthy balance sheets.
Answer:  TRUE

34) A major risk in using commercial paper for short-term financing is the inflexible repayment
schedule.
Answer:  TRUE

35) Prior to establishing trade credit, the firm is required to make extended formal agreements
with the company.
Answer:  FALSE

36) Lines of credit often require that the borrower maintain a minimum balance in the bank
throughout the loan period.
Answer:  TRUE

37) Compensating balances increase the APR because the firm must borrow more than it would
otherwise need.
Answer:  TRUE

38) Commercial paper is an unsecured form of credit.

Answer:  TRUE

39) Lines of credit involve fixed rates of interest.

Answer:  FALSE
40) Secured loans are those that are secured by the lender's faith in the ability of the borrower
to repay the funds when due.
Answer:  FALSE

41) Accrued wages and taxes provide sources of financing that rise and fall spontaneously with
the level of the firm's sales.
Answer:  TRUE

42) Commercial paper offers the borrower the same flexibility that exists when bank credit is
used to meet financing needs.
Answer:  FALSE

43) Describe the differences between secured and unsecured short-term credit.

Answer:  Secured loans are backed by the pledge of specific assets. Examples of secured loans
include accounts receivable and inventory loans. Unsecured loans are only backed by the
promise of the borrower to honor the loan commitment. If loans are unsecured, and not paid, the
creditor would have to obtain a judgment then legally execute on assets of the borrower.

44) Discuss the advantages of using commercial paper.

Answer:  There are four advantages of using commercial paper. First, commercial paper rates
are generally lower than rates on bank loans and comparable sources of short-term financing.
Second, commercial paper does not require a minimum balance. 

However, issuing firms usually maintain lines of credit agreements to back their short-term
financing needs just in case the issue of commercial paper cannot be sold. Third, commercial
paper offers the firm with very large credit needs a single source for all its short-term financing.
Fourth, the use of commercial paper is a sign of prestige for the issuing company.

45) Calculate the effective cost of the following trade credit terms if the discount is foregone and
payment is made on the net due date.
a.     2/15 net 30
b.     2/15 net 45
c.     2/15 net 60

Answer: 
a.    ($0.02/$0.98) × [1/(15/360)] = .4898
b.    ($0.02/$0.98) × [1/(30/360)] = .2449
c.     ($0.02/$0.98) × [1/(45/360)] = .1633
The cost of foregoing trade credit decreases as the length of time between the end of the
discount period and the end of the net due period increases.
46) The U.R. Bloom Corporation established a line of credit with a local bank. The maximum
amount that can be borrowed under the terms of the agreement is $125,000 at a rate of 5%. A
compensating balance averaging 10% of the loan is required. If the firm needs $100,000 for six
months, what is the dollar cost of the loan and the annual percentage rate (APR)?

Answer: 
Borrowed funds = ($100,000/0.9) = $111,111
Dollar cost = $111,111 × .05/2 = $2,777.78
APR = .05/.9 = 5.56%

47) Maximus, Inc. is planning to borrow $2 million for 9 months at a discounted interest rate of
4.5%. What is the annual percentage rate on the loan?

Answer: 
Interest = $2,000,000 × .045 × 9/12 = $67,500
Rate = 67,500/(2,000,000 - 67,500) × 12/9 = 4.66%

48) The Smith Corporation has purchased $500,000 worth of inventory. The vendor offers terms
of 1/15 net 45. Unfortunately, Smith does not have enough cash available to take advantage of
the discount. It can borrow $500,000 from Wesson National Bank for 30 days at an annual
percentage rate of 6%. Should Smith forego the discount or pay within the discount period with
money borrowed from the bank?

Answer:  In either case, Smith will effectively be borrowing the money for 30 days. The APR
implied by the discount is 1/99 × 365/30 = 12.29% so Smith should clearly borrow from the
bank.

49) Lightbulbs.com sells industrial and institutional lighting supplies through its website. It sells
directly to businesses and organizations such as universities and hospitals on terms of net 90.
To finance its rather large investments in receivables and inventory, the firm has an average
need for $2,000,000 in short-term loans. It is choosing between 3 alternative arrangements:
Converse Bank offers a 4.75% APR with interest and principal paid at the end of the year.
Guaranty Bank offers a rate of 4.5% with interest discounted at the time of the loan.
County Bank offers 4.25% with a 10% compensating balance.

Which bank offers the APR when all terms of the loan are considered? You may assume that
required amounts are borrowed for the full year.

Answer: 
Converse Bank's rate is simply 4.75%.
Guaranty Bank's APR =.045(2,000,000)/(2,000,000 - 90,000) = .045/.955 = 4.71%
County Bank's APR = .0425/ .90 = 4.72%
There is very little real difference between the three banks but Guaranty offers the lowest APR
by a slight margin.
50) The annual percentage rate (APR) on short-term loans from Bank A is 5.75% per year.
Bank B claims that their interest rate is only 5.44% per year. However, Bank B charges interest
on a discount basis. Which bank is charging the lowest APR on a one-year loan?

Answer: 
APR from Bank A = 5.75%
APR from Bank B = 5.44/(1 - .0544) = 5.753
Bank A is charging the lowest rate of interest by a very small amount.

18.5   Managing the Firm's Investment in Current Assets

1) Which of the following is NOT a typical characteristic of money-market securities?

A) Little or no default risk
B) Liquid, easily bought and sold
C) Interest is not taxable at federal level
D) Maturities less than 1 year

2) A disadvantage involved in investing in marketable securities is that

A) this reduces the risk of illiquidity.
B) this investment increases net working capital.
C) this investment offers a flexible means of financing.
D) these assets offer low rates of return, commensurate with their risk.

3) "Float" is the term given to

A) differences between the cash balance and the balance of cash plus marketable securities.
B) differences between the cash balance in the ledger and the funds available in the firm's
checking account.
C) the period between the date an invoice is received and the date on which it must be paid.
D) the practice of deliberately delaying payments beyond the due date.

4) Typical securities in which firms invest their temporary cash surpluses include all of the
following EXCEPT
A) U. S. Treasury Bills.
B) commercial paper.
C) high quality corporate bonds.
D) Money Market Mutual Funds.

5) Which of the following would NOT typically be used for assessing customer quality for
purposes of granting trade credit?
A) Ratio analysis
B) Aging of accounts receivable
C) Credit scoring
D) Credit rating services

6) Accounts receivable typically comprise ________ of a firm's assets.

A) 25%
B) 50%
C) less than 1%
D) 10%

7) Which of the following terms would tend to minimize a firm's investment in accounts
receivable?
A) Net 15
B) Net 30
C) 1/15 net 45
D) 2/10 net 30

8) Which of the following money market instruments may not be subject to state and local
taxes?
A) Bankers' acceptances.
B) Repurchase agreements
C) U. S. Treasury bills
D) Federal agency securities

9) Which of the following factors influence the size of the firm's investments in accounts
receivable?
A) Terms of sale
B) Required minimum balance
C) Customer quality
D) A and C

10) Which of the following factors does not have a major influence on credit ratings?
A) Amount owed as a percent of credit limit
B) Zip code
C) Length of credit history
D) Applications for new credit

11) Management of a firm's liquidity involves management of the firm's investment in current
assets.
Answer:  TRUE

12) When faced with a surplus of cash, most firms should stretch their trade accounts.
Answer:  FALSE
13) T-bills and Treasury bonds are guaranteed by the full faith and credit of the United States
and are therefore default-free.
Answer:  TRUE

14) A banker's acceptance is a draft drawn on a specific bank by an exporter in order to obtain
payment for goods that he has shipped to a customer who maintains an account with that
specific bank.
Answer:  TRUE

15) A negotiable certificate of deposit (CD) is a marketable receipt for funds deposited in a
bank.
Answer:  TRUE

16) Although CDs are slightly more risky than Treasury bills, the yield is usually slightly less.
Answer:  FALSE

17) If revenues can be forecast to fall within a tight range of outcomes, then the ratio of cash
and near-cash to total assets will be greater for the firm than if the prospective cash inflows
might be expected to vary over a wide range.
Answer:  FALSE

18) Electronic funds transfer (EFT) could eventually eliminate the use of most checks and
minimize float.
Answer:  TRUE

19) Treasury bills are a safer choice than bank deposits for very large sums.
Answer:  TRUE

20) One of the attractive features of commercial paper is an active secondary market.
Answer:  FALSE

21) Marketable securities are near-cash assets because they can be converted into cash
quickly.
Answer:  TRUE

22) Investing in additional marketable securities and inventories creates higher profitability and
lower liquidity.
Answer:  FALSE
23) Firms should hold the minimum amounts of inventories that will not jeopardize productions
schedules or the satisfaction of customer expectations.
Answer:  TRUE

24) Briefly describe at least three useful tools for maintaining control over accounts receivable.

Answer:  Ratio analysis: by tracking the average collection period the firm knows whether
customers are taking longer to pay their bills.

Aging the accounts receivable allows the firm to determine what percentage of accounts are
past due, how long past due they are, and whether the situation is getting better or worse.

It is useful to track the ratio of bad debts to sales over time to determine whether the firm should
pursue stricter or more liberal credit policies.