Chapter 17 Working Capital Management AND Short TERM

Financing
Finance 2 (FMGT 4510)

Name Clas Dat

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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING

1. An increase in the holding of marketable securities must be accompanied by a corresponding increase in the net
operating working capital.
a. True
b. Fals
e
ANSWER: Fals
e

2. If a firm takes actions that reduce its DSO, then, other things held constant, this will lengthen its CCC.
a. True
b. Fals
e
ANSWER: Fals
e

3. Other things held constant, if a firm stretches its accounts payable, this will lengthen its CCC.
a. True
b. Fals
e
ANSWER: Fals
e

4. Minimizing cash holdings, inventories, or receivables, and maximizing payables or accruals are the aims of relaxed
working capital policies.
a. True
b. Fals
e
ANSWER: Fals
e

5. The firm’s total capital requirement grows over time with amounts including the base level of fixed assets and current
assets. There exists seasonal variation around the trend showing the required temporary working capital.
a. True
b. Fals
e
ANSWER: True

6. Determining a firm’s optimal investment in net operating working capital and how that investment is financed are
elements of working capital policy.
a. True
b. Fals
e
ANSWER: True

7. Permanent net operating working capital reflects the fact that net operating working capital does not shrink to zero even
when a business is at its seasonal or cyclical low. Thus, permanent net operating working capital represents a minimum
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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING

level of net operating working capital that must be financed.
a. True
b. Fals
e
ANSWER: True

8. A conservative financing approach to working capital will result in most of the permanent net operating working capital
being financed by long-term securities.
a. True
b. Fals
e
ANSWER: True

9. A firm’s peak borrowing needs will probably be overstated if it bases its monthly cash budget on the assumption of
uniform daily cash receipts and disbursements, but actual receipts are concentrated at the beginning of each month.
a. True
b. Fals
e
ANSWER: True

10. Shorter-term cash budgets, in general, are used for actual cash control, while longer-term cash budgets are used for
planning purposes.
a. True
b. Fals
e
ANSWER: True

11. 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. Fals
e
ANSWER: True

12. Short-term financing is riskier than long-term financing since, during periods of tight credit, the firm may not be able
to rollover (renew) its debt. This is especially true if the funds are used to finance long-term rather than short-term assets.
a. True
b. Fals
e
ANSWER: True

13. Funds from short-term loans can generally be obtained faster than from long-term loans for two reasons: (1) when
lenders consider long-term loans they must make a more thorough evaluation of the borrower’s financial health, and (2)
long-term loan agreements are more complex.
a. True
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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING

b. Fals
e
ANSWER: True

14. You receive some goods on April 1 with the following terms: 3/20, net 30, June 1 dating. This means that you will
receive a 3% discount if the bill is paid on or before June 20 and also that the full amount must be paid 30 days after
receipt of the goods.
a. True
b. Fals
e
ANSWER: Fals
e

15. Offering trade credit discounts is costly and, as a result, firms that offer trade discounts are usually those that are
performing poorly and need cash quickly.
a. True
b. Fals
e
ANSWER: Fals
e

16. Trade credit can be separated into two components: free trade credit, which is credit received after the discount period
ends, and costly trade credit, which is the cost of discounts not taken.
a. True
b. Fals
e
ANSWER: Fals
e

17. As a rule, managers should try to always use the free component of trade credit but should use the costly component
only if the cost of this credit is lower than the costs of credit from other sources.
a. True
b. Fals
e
ANSWER: True

18. One of the effects of not taking trade credit discounts when offered is that the firm’s use of accounts payable rises.
a. True
b. Fals
e
ANSWER: True

19. The trade credit that a firm receives during the discount period is referred to as free trade credit.
a. True
b. Fals
e
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ANSWER: True

20. Stretching accounts payable is a widely accepted and costless financing technique.
a. True
b. Fals
e
ANSWER: Fals
e

21. Accruals are “free” capital in the sense that no explicit interest must be paid on accruals.
a. True
b. Fals
e
ANSWER: True

22. Accruals are spontaneous, but, unfortunately, due to law and economic forces, firms have little control over the level
of these accounts.
a. True
b. Fals
e
ANSWER: True

23. An informal 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. Fals
e
ANSWER: Fals
e

24. While the maturity of most bank loans is short term, they are frequently repaid on demand rather than on a specific
maturity date.
a. True
b. Fals
e
ANSWER: True

25. A line of credit can be either a formal or an informal agreement between a borrower and a bank regarding the
maximum amount of credit the bank will extend to the borrower subject to certain conditions, including the borrower’s
maintaining its financial strength.
a. True
b. Fals
e
ANSWER: True

26. Under a revolving credit agreement, the risk to the firm of being unable to obtain funds when needed is lower than
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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING

with an informal line of credit.
a. True
b. Fals
e
ANSWER: True

27. The effect of compensating balances is to decrease the effective interest rate of a loan.
a. True
b. Fals
e
ANSWER: Fals
e

28. Interest rates charged on loans vary depending on the risk of borrower, and the size of the loan, but not the economic
conditions.
a. True
b. Fals
e
ANSWER: Fals
e

29. Pledging of receivables involves the sale of accounts receivable.

a. True
b. Fals
e
ANSWER: Fals
e

30. Under a public warehouse agreement, the inventory used as collateral for the loan is stored on the premises of a third
party.
a. True
b. Fals
e
ANSWER: True

31. Due to the complexity of factoring procedures, factoring is rarely used as a source of short-term financing in Canada
today.
a. True
b. Fals
e
ANSWER: Fals
e

32. Generally, the longer the normal inventory holding period of customers, the longer the credit period. One effect of
lengthening the credit period to match the customer’s merchandise holding period is to increase the payables deferral
period, which shortens the customer’s cash conversion cycle.
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a. True
b. Fals
e
ANSWER: True

33. The inventory conversion period of the operating cycle terminates when the inventory is paid for with cash.
a. True
b. Fals
e
ANSWER: Fals
e

34. When the accounts receivable turnover and payables deferral period are decreased, a firm’s cash conversion cycle will
be lengthened.
a. True
b. Fals
e
ANSWER: True

35. 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 match maturities on an expected basis.
a. True
b. Fals
e
ANSWER: True

36. 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 that vary depending on the level of interest rates.
When short-term rates are relatively high, short-term assets will be financed with long-term debt to reduce costs and risk.
a. True
b. Fals
e
ANSWER: Fals
e

37. A firm that follows an aggressive working capital financing approach is more exposed to unexpected changes in the
term structure of interest rates than is a firm that follows a conservative financing policy.
a. True
b. Fals
e
ANSWER: True

38. The relative profitability of a firm that employs an aggressive working capital financing policy will improve when the
yield curve changes from upward sloping to downward sloping.
a. True
b. Fals
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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING

e
ANSWER: Fals
e

39. The cash budget and the capital budget are handled separately and, although they are both important, they are
developed independently of one another.
a. True
b. Fals
e
ANSWER: Fals
e

40. Since depreciation is a noncash charge, it neither appears on, nor has any effect on, the cash budget.
a. True
b. Fals
e
ANSWER: Fals
e

41. The risk to the firm of borrowing using short-term credit is usually greater than if it used 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 temporarily unable to repay it.
a. True
b. Fals
e
ANSWER: True

42. Long-term loan agreements always contain provisions, or covenants, that 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. Fals
e
ANSWER: Fals
e

43. 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 its other
current liabilities associated with working capital management.
a. True
b. Fals
e
ANSWER: True

44. Because money has time value, cash sales are always more profitable than credit sales.
a. True
b. Fals
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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING

e
ANSWER: Fals
e

45. If a firm is offered credit terms of 2/10, net 30, on its purchases, it is in the firm’s financial interest to pay as early as
possible during the discount period.
a. True
b. Fals
e
ANSWER: Fals
e

46. If a firm fails to take trade credit discounts, then it may cost the firm some money, but generally such a policy has a
negligible effect on the firm’s income statement and no effect on its balance sheet.
a. True
b. Fals
e
ANSWER: Fals
e

47. A firm is said to be using costly trade credit when its accounts payable are extended beyond the discount period and an
explicit cost is shown on the foregone discounts.
a. True
b. Fals
e
ANSWER: Fals
e

48. If a firm’s suppliers stop offering discounts, then its use of trade credit is more likely to increase than to decrease.
a. True
b. Fals
e
ANSWER: True

49. When deciding whether or not to take a trade discount, the cost of borrowing from a bank should be compared to the
cost of trade credit to determine if the cash discount should be taken.
a. True
b. Fals
e
ANSWER: True

50. The calculated cost of trade credit can be reduced by paying late.
a. True
b. Fals
e
ANSWER: True
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51. 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 in 30 days.
a. True
b. Fals
e
ANSWER: True

52. The fact that no explicit interest is paid on accruals, and that the firm can vary the level of these accounts, makes
accruals an attractive and flexible source of funding to meet increased working capital needs.
a. True
b. Fals
e
ANSWER: Fals
e

53. If a firm is involuntarily stretching its accounts payable, then this is probably a sign that it is undercapitalized, that is,
that it needs more working capital to support its operations.
a. True
b. Fals
e
ANSWER: True

54. If a firm’s customers is stretching its accounts payable, this may be a nuisance, but it does not represent a real financial
cost to the firm as long as the customer periodically pays off its entire balance.
a. True
b. Fals
e
ANSWER: Fals
e

55. The prime rate charged can vary greatly (e.g., 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 making loans to specialty
retailers.
a. True
b. Fals
e
ANSWER: Fals
e

56. A revolving credit agreement is a formal line of credit often used by large firms. The firm generally must 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. Fals
e
ANSWER: True
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57. Firms must have high credit quality in order to issue commercial paper; therefore, all commercial papers are equally
risky.
a. True
b. Fals
e
ANSWER: Fals
e

58. The cost of an installment loan is always slightly less than twice the stated annual rate.
a. True
b. Fals
e
ANSWER: True

59. Discount loans are usually provided for terms of only 1 year or less. Their interest is paid together with the principal at
the end of the loan.
a. True
b. Fals
e
ANSWER: Fals
e

60. The factoring of receivables involves the specific use of receivables as collateral for the loan.
a. True
b. Fals
e
ANSWER: Fals
e

61. The blanket inventory lien gives the lender a lien against all inventories of the borrower. However, the borrower is free
to sell them.
a. True
b. Fals
e
ANSWER: True

62. Helena Furnishings wants to reduce its cash conversion cycle sharply. Which action should it take?
a. The company should increase its average inventory without increasing its sales.
b.The company should reduce its DSO.
c. The company should start paying its bills sooner, which reduces its average accounts
payable without reducing its sales.
d.The company should increase its DSO.
ANSWER: b

63. Other things held constant, which strategy would tend to reduce the cash conversion cycle?
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a. maintaining the same level of receivables as sales decline
b. placing larger orders for raw materials to take advantage of price breaks
c. taking all discounts that are offered
d. not taking all discounts that are offered to get more trade credit
ANSWER: d

64. Which action would NOT be likely to shorten the length of the cash conversion cycle?
a. adopting a new inventory system that reduces the inventory conversion
period
b. reducing the average DSO on its accounts receivable
c. reducing the amount of time the company takes to pay its suppliers
d. increasing sales while maintaining the same level of receivables
ANSWER: c

65. Why do firms generally choose to finance temporary net operating working capital with short-term debt?
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 on a long-term basis is more apt to be unable to repay the
debt than a firm that borrows short term.
d.The yield curve has traditionally been downward sloping.
ANSWER: a

66. Ski Lifts Inc. is in a highly seasonal business, and the following summary balance sheet data show its assets and
liabilities at peak and off-peak seasons (in thousands of dollars):
Peak Off-Peak
Cash $ 50 $ 30
Market
able
0 20
securiti
es
Accoun
ts
40 20
receiva
ble
Invento
100 50
ries
Net
fixed 500 500
assets
Total
$690 $620
assets

Spontan $ 30 $ 10
eous
liabiliti
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es
Short-
term
50 0
bank
debt
Long-
term 300 300
debt
Commo
310 310
n equity
Total
$690 $620
claims

What can we conclude from this data?

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

67. Which statement best describes working capital financing policy?

a. Net working capital may be defined as current assets minus current liabilities, and an
increase in the current ratio automatically indicates that net working capital has
increased.
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 shares with its use of long-term debt as opposed to short-term debt.
ANSWER: b

68. Which of the following statements best describes alternatives to short-term financing policies?
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 terms 2/10, net 30, this implies the company
has 10 days of free trade credit.
d.A firm following an aggressive financing policy would finance all its permanent
NOWC with long-term capital.
ANSWER: c

69. Which factor is typically NOT considered when constructing a cash budget?
a. payments lag
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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING

b. payment for plant
construction
c. cumulative cash
d. writing off bad debts
ANSWER: d

70. Which statement best describes cash budgets?

a. Depreciation expense is not explicitly included, but depreciation effects are reflected
in the 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.Changes that affect the DSO do not affect the cash budget.
ANSWER: a

71. Which item should a company report directly in its monthly cash budget?
a. its monthly depreciation expense
b. cash proceeds from selling one of its divisions
c. accrued interest on zero coupon bonds that it
issued
d. new shares issued in a stock split
ANSWER: b

72. Which statement best describes cash budgets?

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 noncash charge, it does not appear on nor have an effect on the
cash budget.
d.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.
ANSWER: d

73. Which of the following statements is NOT true?

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 with long-term capital.
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 the greater variability of interest costs on
short-term debt.
ANSWER: a
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74. Which statement best describes short-term financing?

a. Under normal conditions, a firm’s expected ROE would probably be higher if it
financed with short-term rather than with long-term debt, but the use of short-term
debt would probably increase the firm’s risk.
b.Conservative firms generally use no short-term debt and thus have zero current
liabilities.
c. A short-term loan can usually be obtained more quickly than a long-term loan, but the
cost of short-term debt is normally higher than that of long-term debt.
d.If a firm that can borrow from its bank buys materials on terms of 2/10, net 30, and if
it must pay by Day 30 or else be cut off, then we would expect to see zero accounts
payable on its balance sheet.
ANSWER: a

75. Which of the following borrowers benefits the most from a revolving line of credit?
a. a local grocery retailer located in downtown Toronto
b. an owner of a gift shop with the majority of its annual sales during Christmas season
c. an ice cream seller whose business is located in a Niagara Falls resort
d. a manufacturer of hand tools whose sales are generally evenly distributed throughout
the year
ANSWER: b

76. Which statement best describes compensating balances?

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 compensating balances they hold.
ANSWER: c

77. Which statement concerning commercial paper is NOT true?

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

78. Which of the following statements is NOT true?

a. Bankers’ acceptances are more popular than commercial paper used in Canada as a
short-term financing source.
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b.Banks are the ultimate guarantors for payments of bankers’ acceptances.
c. Bankers’ acceptances can be traded in the secondary markets prior to their maturities.
d.Bankers’ acceptances are commonly used to finance goods sold with short payment
terms.
ANSWER: d

79. A large, well-established, highly rated firm needs to borrow money for the next 3 months. How would it likely get the
best interest rate?
a. by issuing commercial paper
b. by obtaining a loan secured by its
inventory
c. by factoring its receivables
d. by obtaining a discounted loan
ANSWER: a

80. A firm has a serious cash shortage due to the growing investment in accounts receivable. If this firm is incapable of
dealing with such a high level of receivables, how would it likely benefit most?
a. by securing any short-term credit with a blanket inventory lien
b. by factoring its receivables
c. by applying for a line of credit
d. by pledging its receivables on a short-term loan
ANSWER: b

81. Which of the following methods CANNOT be employed by lenders to control inventory that has been used as
security for a loan?
a. blanket liens
b. trust receipts
c. warehousing
d. compensating balance
ANSWER: d

82. Which of the following is NOT a characteristic of factoring accounts receivable?

a. A firm sells its accounts receivable to a finance company.
b. Receivables are sold without recourse.
c. The firm incurs any losses from nonpayment.
d. Maturity factoring and advance factoring are the two basic ways of
financing.
ANSWER: c

83. Which of the following statements best describes cash flows that would be shown on a cash budget?
a. Depreciation is included in the estimate of cash flows (Cash flow = Net income +
Depreciation); hence, depreciation is set forth on a separate line in the cash budget.
b.If cash inflows from collections occur in equal daily amounts but most payments are
made regularly on the 10th of each month, then it is not necessary to use a daily cash
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budget. A cash budget focused on 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.The cash flows shown on the cash budget are the actual cash inflows and outflows and
thus different from the firm’s free cash flows, because FCF reflects after-tax operating
income and the investments required to maintain future operations.
ANSWER: d

84. Which statement best describes short-term versus long-term financing?

a. Flexibility is an advantage of short-term credit, but this is somewhat offset by the high
flotation costs associated with the need to repeatedly renew short-term credit.
b.A short-term loan can usually be obtained more quickly than a long-term loan, but the
penalty for early repayment of a short-term loan is normally significantly higher than
that for a long-term loan.
c. The flexibility, cost, and riskiness of short-term versus long-term credit are dependent
on the type of credit that is actually used.
d.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.
ANSWER: c

85. Carroll & King Corporation has $5 million of inventory and $2 million of accounts receivable. Its average daily sales
are $120,000. The company’s payables deferral period (accounts payable divided by daily purchases) is 30 days. What is
C&K’s cash conversion cycle?
a. 24
b. 26
c. 27
d. 28
ANSWER: d

86. Westley Company’s average age of accounts receivable is 50 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 its cash conversion cycle?
a. 66
b. 69
c. 73
d. 77
ANSWER: d

87. Miletkov Company’s total assets fluctuate between $320,000 and $410,000, while its fixed assets remain constant at
$260,000. If the firm follows a maturity matching, or moderate, working capital financing policy, what is the likely level
of its long-term debt and equity financing?
a. $274,360
b. $288,800
c. $304,000
d. $320,000
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ANSWER: d

88. Schoof Inc. expects to have sales of $30,000 in January, $35,000 in February, and $40,000 in March. If 20% of sales
are for cash, 40% are credit sales paid in the month following the sale, and another 40% are credit sales paid 2 months
following the sale, what are the cash receipts for the firm in March?
a. $29,151
b. $30,685
c. $32,300
d. $34,000
ANSWER: d

89. A firm buys on terms of 3/15, net 45 days. It does not take the discount, and it generally pays after 65 days. What is
the nominal annual cost of its non-free trade credit, based on a 365-day year?
a. 22.58
%
b. 23.71
%
c. 24.89
%
d. 26.14
%
ANSWER: a

90. Durham Cement, Inc. buys on terms of 2/15, net 30 days. It does not take discounts, and it typically pays 60 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. 15.73
%
b. 16.55
%
c. 17.38
%
d. 18.25
%
ANSWER: b

91. Your company has been offered credit terms of 4/30, net 90 days. What will be the nominal annual cost of trade credit
if you pay 100 days after the purchase? (Assume a 365-day year.)
a. 20.64
%
b. 21.73
%
c. 22.81
%
d. 23.95
%
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ANSWER: b

92. Filbeck 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 $500,000 per year. On average, how much free trade credit does the firm receive
during a 365-day year?
a. $20,548
b. $21,575
c. $22,654
d. $23,787
ANSWER: a

93. On average, Bragg Inc. has sales of $2,000,000 per month. It keeps inventory equal to 50% of its monthly sales on
hand at all times. Based on using a 365-day year, what is the inventory conversion period?
a. 11.7
b. 13.0
c. 14.4
d. 15.2
ANSWER: d

94. Cyree Inc. has annual sales of $80,000,000, its average inventory is $20,000,000, and its average accounts receivable
is $16,000,000. The firm buys all raw materials on terms of net 35 days, and it pays on time. The firm is searching for
ways to shorten the cash conversion cycle. If sales can be maintained at existing levels while lowering inventory by
$4,000,000 and accounts receivable by $2,000,000, by how many days would the cash conversion cycle be changed? Use
a 365-day year.
a. –27.4
b. –28.7
c. –30.2
d. –31.7
ANSWER: a

95. You were recently hired as CFO to improve the performance of Dennis Systems, which is highly profitable but has
been experiencing cash shortages due to its high rate of growth. As one part of your analysis, you want to determine the
firm’s cash conversion cycle. Using the following information and a 365-day year, what is your estimate of the firm’s
present cash conversion cycle?

Average inventory: $120,000

Annual sales: $600,000
Average accounts receivable: $160,000
Average accounts payable: $25,000
Total annual purchases: $365,000
Buy on net 30 days, no discounts: 30
Sell on net 50 days, no discounts: 50
a. 118.4
b. 124.6
c. 131.2
d. 145.3
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ANSWER: d

96. Ferson Inc. has annual sales of $36,500,000, or $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 firm 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%
reduction in both average inventories and accounts receivables. She also anticipates that these policies would reduce sales
by 10%, while accounts payable would remain unchanged. What effect would these policies have on the company’s cash
conversion cycle? Round to the nearest whole day.
a. –40 days
b. –22 days
c. +22
days
d. +40
days
ANSWER: b

97. Bello Corp. has annual sales of $50,735,000, an average inventory level of $15,012,000, and average accounts
receivable of $10,008,000. The company makes all purchases on credit and has always paid on the 30th day. However, it
now plans to take full advantage of trade credit and pay its suppliers on the 40th day. The CFO also believes that sales can
be maintained at the existing level but inventory can be lowered by $1,946,000 and accounts receivable by $1,946,000.
What will be the net change in the cash conversion cycle, assuming a 365-day year?
a. –14.0
days
b. –18.8
days
c. –25.6
days
d. –38.0
days
ANSWER: d

98. Shahrokhi Enterprises follows a moderate current asset investment policy, but it is now considering whether to shift to
a restricted or perhaps to a relaxed policy. The firm’s annual sales are $400,000, its fixed assets are $100,000, its target
capital structure calls for 50% debt and 50% equity, its EBIT is $35,000, the interest rate on its debt is 10%, and its tax
rate is 40%. With a restricted policy, current assets will be 15% of sales, while under a relaxed policy they will be 25% of
sales. What is the difference in the projected ROEs between the restricted and relaxed policies?
a. 4.3
%
b. 4.7
%
c. 5.3
%
d. 5.8
%
ANSWER: c

99. Nagel Corporation’s budgeted monthly sales are $5,000, and they are constant from month to month. Its customers
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pay as follows: 40% pay in the first month and take the 2% discount, while the remaining 60% pay in the month following
the sale and do not receive a discount. The firm has no bad debts. Purchases for next month’s sales are constant at 50% of
projected sales for the next month. “Other payments,” which include payments for wages, rent, and taxes, are 25% of
sales for the month. Construct a cash budget for a typical month. What is the average cash gain or loss during the month?
a. $1,092
b. $1,150
c. $1,210
d. $1,271
ANSWER: c

100. 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 25 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%. But since your firm is not taking discounts and is
paying on Day 25, what is the effective annual cost (NOT the nominal cost) of your firm’s current practice, using a 365-
day year?
a. 60.3
%
b. 63.5
%
c. 66.7
%
d. 70.0
%
ANSWER: b

101. Viale Enterprises purchases $4,562,500 in goods per year from its sole supplier on terms of 2/15, net 50. If the firm
chooses to pay on time but does not take the discount, what is the effective annual cost of its trade credit? (Assume a 365-
day year.)
a. 17.81
%
b. 19.66
%
c. 23.45
%
d. 27.43
%
ANSWER: c

102. A firm is offered trade credit terms of 2/8, net 45 days. The firm does not take the discount, and it pays after 58 days.
What is the effective annual cost of not taking this discount? (Assume a 365-day year.)
a. 13.35
%
b. 14.70
%
c. 15.89
%
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d. 18.70
%
ANSWER: c

103. Shanklin Inc. purchases merchandise on terms of 2/15, net 40, and its total gross purchases (i.e., purchases before
taking off the discount) are $800,000 per year. What is the maximum amount of costly trade credit Shanklin could get,
assuming it abides by the supplier’s credit terms? (Assume a 365-day year.)
a. $53,699
b. $56,384
c. $59,203
d. $62,163
ANSWER: a

104. Hefner Inc.’s business is booming, and it needs to raise more capital. The company purchases supplies on terms of
1/10, net 20, and it currently takes the discount. One way of getting the needed funds would be to forego the discount, and
the firm’s owner believes she could delay payment to 40 days without adverse effects. What would be the effective annual
rate of funds raised by this action? (Assume a 365-day year.)
a. 10.00
%
b. 11.75%
c. 12.29
%
d. 13.01
%
ANSWER: d

105. Gorman Inc. arranged a $10,000,000 revolving credit agreement with a group of banks. The firm paid an annual
commitment fee of 0.5% of the unused balance of the loan commitment. On the used portion of the revolver, it paid 1.5%
above prime for the funds actually borrowed on a simple interest basis. The prime rate was 9% during the year. If the firm
borrowed $6,000,000 immediately after the agreement was signed and repaid the loan at the end of 1 year, what was its
total dollar cost for the year?
a. $617,500
b. $650,000
c. $682,500
d. $716,625
ANSWER: b

106. A firm needs $45,000 to purchase inventory. The bank requires a 5% compensating balance. With a stated interest
rate of 15%, what is the effective interest rate?
a. 14.25
%
b. 15.00
%
c. 15.79
%

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d. 16.67
%
ANSWER: c

107. Your firm needs $630 for one quarter to finance a deficit. Interest charges are 2% per quarter. Your bank requires a
10% compensating balance. How much must your firm borrow in order to obtain the needed funds?
a. $693.00
b. $700.00
c. $705.60
d. $715.91
ANSWER: b

108. XYZ Inc. is planning a $200,000 90-day commercial paper issue. The issue is sold for $193,500. There is a flotation
cost of $1,500. The corporate tax rate is 35%. (Assume a 365-day year.) Which of the following statements is correct?
a. The before-tax cost is
16.77%.
b. The before-tax cost is
15.71%.
c. The after-tax cost is 10.21%.
d. The after-tax cost is 10.06%.
ANSWER: a

109. LMN Co. plans to enter into a secured term loan by assigning its receivables of $600,000 with an average maturity
date of 30 days. The finance company will loan 75% of the receivables value at 11% interest plus a service fee of 0.05%
of the total receivables pledged. What is the total cost of this financing arrangement?
a. $3,039
b. $3,872
c. $4,049
d. $4,368
ANSWER: d

110. Tareque Inc. wants to increase its free cash flow by $180 million during the coming year, which should result in a
higher EVA and share price. The CFO has made these projections for the upcoming year:

– EBIT is projected to be $850 million.

– Gross capital expenditures are expected to total $360 million versus depreciation of $120 million, so its net capital
expenditures should total $240 million.
– The tax rate is 40%.
– There will be no changes in cash or marketable securities, nor will there be any changes in notes payable or accruals.

Which of the following actions would enable the company to achieve its goal of generating $180 million in free cash
flow?
a. accounts receivable increase by $470 million, inventory increases by $230 million, and
accounts payable increase by $790 million
b.accounts receivable increase by $470 million, inventory increases by $230 million, and
accounts payable increase by $610 million
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c. accounts receivable decrease by $500 million, inventory increases by $480 million,
and accounts payable decline by $80 million
d.accounts receivable decrease by $400 million, inventory increases by $480 million,
and accounts payable increase by $80 million
ANSWER: b

111. Margetis Inc. carries an average inventory of $1,000,000. Its annual sales are $10 million, and its receivables
conversion period is twice as long as its inventory conversion period. The firm buys on terms of net 30 days, and it pays
on time. Its new CFO wants to decrease the cash conversion cycle by 10 days, based on a 365-day year. He believes he
can reduce the average inventory to $863,000 with no effect on sales. By how much must the firm also reduce its accounts
receivable to meet its goal of a 10-day reduction in the cash conversion cycle?
a. $0
b. $101,900
c. $136,986
d. $333,520
ANSWER: c

112. Gonzales Company currently uses maximum trade credit by not taking discounts on its purchases. The standard
industry credit terms offered by all its suppliers are 2/10, net 30 days, and the firm pays in 30 days. The new CFO is
considering borrowing from its bank, using short-term notes payable, and then taking discounts. The firm wants to
determine the effect of this policy change on its net income. Its net purchases are $11,760 per day, using a 365-day year.
The interest rate on the notes payable is 10%, and the tax rate is 40%. If the firm implements the plan, what is the
expected change in net income after taxes?
a. –$31,440
b. –$23,520
c. $23,520
d. $38,448
ANSWER: d

113. Aggarwal Inc. buys on terms of 2/10, net 30, and it always pays on the 30th day. The CFO calculates that the average
amount of costly trade credit carried is $375,000. What is the firm’s average accounts payable balance? (Assume a 365-
day year.)
a. $223,333
b. $374,951
c. $457,443
d. $562,500
ANSWER: d

114. If the firm adopts a restricted policy, how much lower would its interest expense be than under the relaxed policy?
a. $3,233
b. $6,175
c. $7,200
d. $9,818
ANSWER: d

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115. What’s the difference in the projected ROEs under the restricted and relaxed policies?
a. 2.24
%
b. 1.50
%
c. 1.00
%
d. 0.50
%
ANSWER: b

116. Assume now that the company believes that if it adopts a restricted policy, its sales will fall by 15% and EBIT will
fall by 10%, but its total assets turnover, debt ratio, interest rate, and tax rate will all remain the same. In this situation,
what’s the difference between the projected ROEs under the restricted and relaxed policies?
a. 2.24
%
b. 1.50
%
c. 1.00
%
d. 0.50
%
ANSWER: a

117. Which of the following best describes gross working capital?

a. current assets used in operations
b. fixed assets and retained earnings used in
operation.
c. long-term assets used in operations
d. current liabilities and inventory used in operation.
ANSWER: a

118. Which of the following describes net working capital?

a. current assets minus current
liabilities
b. current assets minus inventory
c. current assets minus cash
d. long –term minus current liabilities
ANSWER: a

119. Which of the following are included in the cash conversion cycle?
a. inventory conversion period, the receivables collection period, and the payables
deferral period
b. inventory conversion period, the receivables collection period, and the long-term
assets cycle
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c. acid test period, the receivables collection period, and the payables deferral period
d. the inventory conversion period and the payables deferral period
ANSWER: a

120. What is the purpose of the cash conversion cycle (CCC)?

a. It shows how long a firm must finance its long-term capital.
b. It shows how long a firm must finance its operating working
capital.
c. It shows how long a firm must finance its mortgage capital.
d. It shows how long is must finance its inventories.
ANSWER: b

121. Other things held constant, what happens with a short CCC?
a. The firm’s working capital management is more effective.
b. The firm’s working capital management is less effective.
c. The firm’s inventory management is more effective..
d. The firm’s administrative costs are more effective.
ANSWER: a

122. What is one of the advantages of short-term debt financing.

a. Firms can obtain short-term credit more quickly than long-term credit.
b. Firms can obtain long-term more quickly than short-term credit.
c. Firms can obtain short-term credit to pay preferred dividends in the short-run.
d. Firms can obtain short-term credit to from accounts receivable in the short-run at
cheaper rates.
ANSWER: a

123. Canada Corp., needs $16,000 for one quarter to finance a deficit. Interest charges are 4% per quarter. Your bank
requires an 8% compensating balance. How much must your firm borrow in order to obtain the needed funds?
a. $16,320
b. $17,392
c. $17,270
d. $19,900
ANSWER: b

124. BC Corp., needs $10,000 for one quarter to finance a deficit. Interest charges are 2% per quarter. Your bank requires
a 10% compensating balance. How much must your firm borrow in order to obtain the needed funds?
a. $11,111
b. $8,888
c. $15,270
d. $11,000
ANSWER: b

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