978-0134083285 Chapter 15 Part 1

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Foundations of Finance, 9e (Keown/Martin/Petty)

Chapter 15 Working-Capital Management

Learning Objective 15.1

1) Management of a firm’s liquidity involves management of the firm’s investment in current assets as

well as its mix of long-term capital.

Keywords: Liquidity, Current Assets

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

2) Two advantages of financing with current liabilities are flexibility and lower interest cost.

Keywords: Current Liabilities, Flexibility, Interest Cost

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

3) Higher liquidity (holding larger cash and marketable securities balances) generally results in a lower

return on equity.

Keywords: Liquidity, Return on Equity, Risk-Return Tradeoff

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

4) Long-term debt is generally less costly than short-term debt, but also results in more illiquidity—hence,

the risk-return trade-off.

Keywords: Long-term Debt, Illiquidity, Short-term Debt, Risk-Return Tradeoff

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

5) Short-term debt provides a more flexible form of financing than long-term debt.

Keywords: Short-term Debt

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

6) Short-term debt has a greater risk of illiquidity than long-term debt because it must be rolled over more

frequently and its use creates more uncertainty concerning future interest rates.

Keywords: Short-term Debt, Illiquidity, Long-term Debt

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

7) Working capital refers to investment in current assets, while net working capital is the difference

between current assets and current liabilities.

Keywords: Working Capital, Net Working Capital

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

8) A firm increases the risks of insolvency by keeping relatively large amounts of money tied up in

marketable securities.

Keywords: Insolvency Risk, Marketable Securities

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

9) A company decreases the risk of insolvency by financing long-term assets with short-term debt.

Keywords: Insolvency Risk, Short-term Debt

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

10) Achieving a lower inventory balance through working capital management can result in savings from

both carrying costs and losses associated with obsolete inventory.

Keywords: Inventory, Carrying Costs, Obsolete Inventory

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

11) Working capital management involves managing a firm’s liquidity.

Keywords: Liquidity, Working Capital Management

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

12) Three basic factors that determine which sources of short-term financing a firm uses are the effective

cost of financing, the availability of credit, and the influence of the use of a particular credit source on the

cost and availability of other sources of financing.

Keywords: Sources of Short-term Financing, Effective Cost of Financing, Availability of Credit

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

13) The trade-off associated with holding large amounts of cash and marketable securities is increased

liquidity offset by a reduction in the overall rate of return.

Keywords: Trade-Off, Liquidity, Return

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

14) The risk of illiquidity is increased if either cash and marketable securities are decreased, or if the firm

relies more heavily on long-term debt.

Keywords: Risk of Illiquidity

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

15) In general, interest rates on short-term debt are higher than interest rates on long-term debt because

the borrower has less time to repay the loans, and hence the risk to the lender is higher.

Keywords: Level of Interest Rates, Short-term vs. Long-term Debt

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

16) Although interest rates are generally higher on long-term debt, using more long-term debt rather than

short-term debt can reduce the risk of illiquidity and decrease uncertainty related to interest rate changes.

Keywords: Risk of Illiquidity, Long-term Debt vs. Short-term Debt

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

17) Current assets would usually NOT include

A) plant and equipment.

B) marketable securities.

C) accounts receivable.

D) inventories.

Keywords: Current Assets

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

18) A company that increases its liquidity by holding more cash and marketable securities is

A) likely to achieve a higher return on equity because of higher interest income.

B) likely to achieve a lower return on equity because of the smaller rates of return earned on cash and

marketable securities compared to the firm‘s other investments.

C) going to maximize firm value because risk is decreased.

D) going to have to sell common stock to raise the cash to become more liquid.

Keywords: Liquidity, Risk-Return Tradeoff

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

19) Which of the following statements concerning liquidity and debt is true?

A) The greater the use of short-term debt, the lower the risk of illiquidity.

B) Long-term debt is generally less costly than short-term debt.

C) A firm can reduce its risk for illiquidity by shifting from short-term debt to long-term debt.

D) The risk of illiquidity does not depend on the mix of short-term versus long-term debt.

Keywords: Illiquidity, Short-term Debt, Long-term Debt

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

20) Interest costs for short-term debt are generally lower than interest costs for long-term debt because

A) the term structure of interest rates generally reflects an upward sloping yield curve.

B) short-term debt is more flexible, allowing a match of short-term needs with short-term financing.

C) investors demand higher returns on short-term debt due to liquidity concerns.

D) both A and B.

Keywords: Short-term Debt, Long-term Debt, Interest Costs

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

21) All of the following are potential disadvantages of short-term debt EXCEPT

A) short-term debt must be paid back more quickly than long-term debt.

B) uncertainty of interest costs because short-term debt must be replaced often.

C) a greater risk of illiquidity than long-term debt.

D) short-term debt generally has a higher interest cost than long-term debt.

Keywords: Short-term Debt, Long-term Debt, Illiquidity, Interest Cost

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

22) Which of the following is NOT true regarding the use of short–term debt?

A) It must be rolled over more often than long-term debt.

B) There is uncertainty connected with interest costs on short-term debt from year to year.

C) The firm is subjected to greater liquidity risk when using short-term credit.

D) Interest rates are usually higher on short-term debt.

Keywords: Short-term Debt

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

23) Which of the following is a disadvantage of the use of current liabilities to finance assets?

A) greater risk of illiquidity

B) less flexibility

C) higher interest costs

D) the hedging principle

Keywords: Current Liabilities, Illiquidity

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

24) Which of the following is an advantage of the use of current liabilities to finance assets?

A) less risk of illiquidity

B) more flexibility

C) lower interest costs

D) both B and C

Keywords: Current Liabilities, Flexibility, Interest Cost

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

25) Which of the following actions would improve a firm’s liquidity?

A) repurchasing stock

B) selling bonds and increasing cash

C) buying bonds

D) increasing the company‘s dividend payments

Keywords: Liquidity

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

26) Which of the following actions would improve a firm’s liquidity?

A) purchasing inventories for cash

B) purchasing inventory on trade credit

C) purchasing inventory with long-term debt

D) buying machinery with long-term debt

Keywords: Liquidity

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

27) Which of the following actions would decrease a firm’s liquidity?

A) selling stock and reducing accounts payable

B) selling machinery and using proceeds to retire bonds

C) reducing accounts receivable and buying bonds

D) selling bonds and holding proceeds in the cash account

Keywords: Liquidity

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

28) In general, the greater a firm’s reliance upon short-term debt or current liabilities,

A) the lower will be its liquidity.

B) the greater will be its liquidity.

C) liquidity will remain constant.

D) there will be no effect on liquidity.

Keywords: Liquidity, Current Liabilities

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

29) If a firm relies on short-term debt or current liabilities in financing its asset investments, and all other

things remain the same, what can be said about the firm’s liquidity?

A) The firm will be relatively more liquid.

B) The firm will be relatively less liquid.

C) The liquidity of the firm will be unchanged.

D) The firm will be more liquid only if interest rates are below the company‘s weighted average cost of

capital.

Keywords: Liquidity, Short-term Debt

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

30) Which of the following would normally occur if a firm increases its investment in current assets?

A) The firm’s liquidity would be improved.

B) The firm’s net working capital would decline.

C) The firm’s liquidity would be worsened.

D) The firm‘s profit margin would improve.

Keywords: Liquidity, Current Assets

Learning Obj.: L.O. 15.1

AACSB: Analytical Thinking

31) The risk-return trade-off in managing a firm’s working capital involves which of the following?

A) a trade-off between liquidity and activity

B) a trade-off between debt and equity

C) a trade-off between the firm’s liquidity and its profitability

D) none of the above

Keywords: Risk-Return Trade-off, Liquidity, Profitability

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

32) Which of the following is an advantage of utilizing short-term debt to finance the acquisition of short-

term assets?

A) Interest rates on short-term debt are usually lower than interest-rates on long-term debt.

B) It exposes the firm to less risk than if the firm were to use long-term debt.

C) It improves the firm‘s debt ratio.

D) It increases the firm’s sustainable growth rate.

Keywords: Short-term Debt

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

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

A) cash, accounts receivable, and inventory

B) notes payable, accruals, and accounts payable

C) current assets plus current liabilities

D) current assets divided by current liabilities

E) current assets minus current liabilities

Keywords: Net Working Capital

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

34) Working capital includes all of the following EXCEPT

A) cash.

B) accounts receivable.

C) accounts payable.

D) inventories.

Keywords: Working Capital

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

35) Selection of a source of short-term financing should include all of the following EXCEPT

A) the effective cost of credit.

B) the availability of financing in the amount and for the time needed.

C) the floatation costs for debentures.

D) the effect of the use of credit from a particular source on the cost and availability of other sources of

credit.

Keywords: Short-term Financing

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

36) Discuss the risk-return trade-off experienced in working-capital management.

Keywords: Risk-Return Trade-off, Working Capital Management

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

37) How does the use of current liabilities enhance profitability and also increase the firm’s risk of default

on its financial obligations?

Keywords: Current Liabilities, Illiquidity

Learning Obj.: L.O. 15.1

AACSB: Reflective Thinking

Learning Objective 15.2

1) The hedging principle is also called the principle of self-liquidating inventory.

Keywords: Hedging Principle, Principle of Self-Liquidating Debt

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

2) Accrued taxes and salaries payable are both sources of spontaneous financing.

Keywords: Spontaneous Financing, Accruals

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

3) The hedging principle involves the use of hedge funds to manage the firm‘s working capital.

Keywords: Hedging Principle, Working Capital

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

4) The hedging principle is used to address the issue of how much short-term financing a firm should

use.

Keywords: Hedging Principle, Short-term Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

5) One example of the hedging principle is to reduce a company‘s foreign exchange risk by purchasing

futures contracts, which are called hedges.

Keywords: Hedging Principle

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

6) Total assets must always equal the sum of temporary, permanent, and spontaneous sources of

financing.

Keywords: Temporary Financing, Permanent Financing, Spontaneous Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

7) Minimum levels of inventory and accounts receivable that will be maintained throughout the year are

current assets, and therefore considered temporary investments.

Keywords: Temporary Investments, Inventory, Accounts Receivable

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

8) The hedging principle involves matching the cash flow from an asset with the cash flow requirements

of the financing used.

Keywords: Hedging Principle

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

9) The firm’s total investment in current assets should be financed with temporary sources of financing.

Keywords: Current Assets, Temporary Sources of Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

10) Notes payable is a spontaneous source of financing.

Keywords: Notes Payable, Spontaneous Liabilities

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

11) Trade credit is a source of spontaneous financing.

Keywords: Trade Credit, Spontaneous Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

12) Commercial paper is an example of spontaneous financing because it is generated by the day-to-day

operations of a company.

Keywords: Commercial Paper, Spontaneous Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking