Chapter 17 - Working Capital Management And Short Term Financing PDF

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: s: e:CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING 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 eANSWER:  Fals e If a firm takes actions that reduce its DSO, th...

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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 Copyright Cengage Learning. Powered by Cognero.

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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 Copyright Cengage Learning. Powered by Cognero.

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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 Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING 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 Copyright Cengage Learning. Powered by Cognero.

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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. Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING 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 Copyright Cengage Learning. Powered by Cognero.

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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. Shortterm 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 Copyright Cengage Learning. Powered by Cognero.

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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 Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING 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 Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING 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? Copyright Cengage Learning. Powered by Cognero.

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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING 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): Cash Market able securiti es Accoun ts receiva ble Invento ries Net fixed assets Total assets Spontan eous liabiliti Copyright Cengage Learning. Powered by Cognero.

Peak $ 50

Off-Peak $ 30

0

20

40

20

100

50

500

500

$690

$620

$ 30

$ 10

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CHAPTER 17 - WORKING CAPITAL MANAGEMENT AND SHORT-TERM FINANCING es Shortterm bank debt Longterm debt Commo n equity Total claims

50

0

300

300

310

310

$690

$620

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 Copyright Cengage Learning. Powered by Cognero.

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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 ...