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Financial Management: Principles and Applications, 11e (Titman)
Chapter 18 Working Capital Management
1) An increase in ________ would increase net working capital.
A) plant and equipment
B) accounts payable
C) accounts receivable
D) both B and C
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
3) Total assets must equal the sum of which sources of financing?
A) Spontaneous
B) Temporary
C) Permanent
D) Spontaneous, temporary and permanent
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
1
Copyright © 2011 Pearson Education, Inc.
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.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
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
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
6) An increase in ________ would increase a firm's liquidity.
A) notes payable
B) inventories
C) cash
D) both B and C
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
7) A decrease in ________ would increase net working capital.
A) accounts payable
B) accounts receivable
C) cash
D) equipment
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
2
Copyright © 2011 Pearson Education, Inc.
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.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff
11) Within the context of working capital management:
A) as the firm increases its investment in working capital, there is a corresponding increase in its
profits.
B) current liabilities provide a flexible means of financing the firm's fluctuating needs for assets.
C) the use of current liabilities or short-term debt as opposed to long-term debt subjects the firm
to less risk of illiquidity.
D) all of the above.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
3
Copyright © 2011 Pearson Education, Inc.
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
E) Current assets minus inventory divided by current liabilities
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
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)
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
4
Copyright © 2011 Pearson Education, Inc.
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.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
17) Working capital refers to investment in current assets, while net working capital is the
difference between current assets and current liabilities.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
18) Net working capital provides a very useful summary measure of a firm's short-term financing
decisions.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: net working capital
Principles: Principle 2: There Is a Risk-Return Tradeoff
19) Within the context of working capital management, the risk-return trade-off involves an
increased risk of illiquidity versus increased profitability.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: risk-return tradeoff
Principles: Principle 2: There Is a Risk-Return Tradeoff
20) Managing a firm's liquidity is basically the same as managing a firm's net working capital.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff
5
Copyright © 2011 Pearson Education, Inc.
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.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff
6
Copyright © 2011 Pearson Education, Inc.
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?
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff
7
Copyright © 2011 Pearson Education, Inc.
23) On June 30, 19X1, the Alexander Bosh Coffee Co.'s balance sheet and income statement are
as follows:
Balance Sheet Income Statement
June 30, 19X1 June 30, 19X1
Current assets $800,000 Net operating income$600,000
Net fixed assets 700,000 Less: interest expense(108,000)
Total assets $1,500,000 Earnings before taxes492,000
Accounts payable $300,000 Less: taxes (34%) (167,280)
S-T notes payable (15%) 500,000 Net income $324,720
Total current liabilities $800,000
Long-term debt (11%) $300,000
Common equity 400,000
Total $1,500,000
a. Calculate the current ratio and net working capital for Alexander Bosh.
b. Recalculate the ratios from (a) and assess the change in the firm's liquidity if the firm
plans to issue $500,000 in common stock and use the proceeds to retire the firm's notes payable.
c. What effect would the change proposed in question b have on return on common equity
(net income/common equity)?
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: liquidity
Principles: Principle 2: There Is a Risk-Return Tradeoff
1) Accounts payable is considered a:
A) spontaneous liability.
B) temporary financing source.
C) permanent financing source.
D) both A and B.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: spontaneous sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
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Copyright © 2011 Pearson Education, Inc.
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
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: permanent sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
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
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
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
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: permanent investments
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
9
Copyright © 2011 Pearson Education, Inc.
6) Gamma, Inc. plans to sell $1 million in 270-day-maturity commercial paper on which it will
pay discounted interest at an annual rate of 12%. In addition, Gamma expects to incur a cost of
$1,000 in dealer placement fees and other expenses to issue the paper. What is the effective cost
of the paper to Gamma?
A) 12.22%
B) 12.78%
C) 13.20%
D) 13.35%
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: temporary sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
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.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: self-liquidating debt
Principles: Principle 2: There Is a Risk-Return Tradeoff
8) A toy manufacturer following the self-liquidating debt. principle will generally finance
seasonal inventory build-up prior to the Christmas season with:
A) common stock.
B) selling equipment.
C) trade credit.
D) preferred stock.
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: self-liquidating debt
Principles: Principle 2: There Is a Risk-Return Tradeoff
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
Topic: 18.1 Working Capital Management and the Risk-Return Tradeoff
Keywords: spontaneous sources of financing
Principles: Principle 2: There Is a Risk-Return Tradeoff
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