978-0134083285 Chapter 15 Part 2

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13) Total debt must always be equal to 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

14) Sources of spontaneous financing include trade credit, salaries payable, and accrued taxes.

Keywords: Spontaneous Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

15) The hedging principle implies that permanent asset investments not financed by spontaneous sources

should be financed with permanent sources, and temporary investments not financed by spontaneous

sources should be financed with temporary sources.

Keywords: Hedging Principle, Permanent Financing, Temporary Financing, Spontaneous Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

16) The primary source of spontaneous financing is accrued taxes.

Keywords: Spontaneous Financing, Accrued Taxes, Trade Credit

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

17) AFB, Inc. purchases a new delivery van which is expected to increase cash flows for the next 10 years.

AFB can finance the purchase with a standard 48-month vehicle loan, or by getting a 10-year loan from

the bank. According to the hedging principle, AFB should

A) use the 10-year financing in order to match the cash flow stream from the asset with the financing

repayments.

B) use the 48-month loan since it matches the type of asset with the type of loan.

C) use either type of financing, but hedge the risk in the options market.

D) avoid using either loan and finance the truck with current cash reserves to avoid interest expense.

Keywords: Hedging Principle

Learning Obj.: L.O. 15.2

AACSB: Analytical Thinking

18) According to the hedging principle, fixed assets should NOT be financed with

A) permanent financing.

B) temporary financing.

C) permanent plus spontaneous financing.

D) equity financing.

Keywords: Hedging Principle, Temporary Financing, Permanent Financing, Spontaneous Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

19) Accrued wages and accrued taxes are considered to be

A) permanent sources of financing because companies must always pay wages and taxes.

B) spontaneous sources of unsecured short-term financing.

C) secured sources of short-term financing.

D) current assets.

Keywords: Spontaneous Financing, Unsecured Sources of Short-term Credit, Accrued Wages, Accrued Taxes

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

20) Spontaneous sources of financing include

A) marketable securities.

B) wages payable.

C) accounts receivable.

D) common stock.

Keywords: Spontaneous Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

21) Permanent sources of financing include all but

A) corporate bonds.

B) common stock.

C) preferred stock.

D) commercial paper.

Keywords: Permanent Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

22) According to the hedging principle, plant and equipment should be financed with

A) commercial paper.

B) long-term funds.

C) short-term bank loans.

D) spontaneous financing.

Keywords: Hedging Principle

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

23) A toy manufacturer following the hedging principle will generally finance seasonal inventory build–

up prior to the Christmas season with

A) common equity to avoid interest on a recurring annual need.

B) selling equipment.

C) trade credit.

D) long-term bonds since this is a recurring financing need.

Keywords: Hedging Principle, Seasonal Inventory

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

24) According to the hedging principle, which of the following assets should be financed with permanent

sources of financing?

A) seasonal expansions of inventory

B) seasonal increases in accounts receivable

C) levels of inventory and accounts receivable the firm maintains throughout the year

D) none of the above

Keywords: Hedging Principle, Permanent Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

25) With regard to the hedging principle, which of the following would be an appropriate method to

finance a minimum level of current assets required for year round operations?

A) short-term notes payable

B) trade credit

C) common stock

D) revolving credit agreements that must be repaid in a period less than 1 year

Keywords: Hedging Principle, Permanent Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

26) With regard to the hedging principle, which of the following assets should be financed with current

liabilities?

A) minimum level of cash required for year round operations

B) expansion of accounts receivable to meet seasonal demand

C) machinery

D) buildings

Keywords: Hedging Principle

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

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

A) spontaneous

B) temporary

C) permanent

D) discretionary

Keywords: Trade Credit, Spontaneous Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

28) 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) common stock

Keywords: Temporary Financing, Commercial Paper

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

29) In the context of managing working capital, the hedging principle refers to which of the following?

A) speculation regarding the direction of short-term interest rates

B) the usage of interest rate swaps

C) matching the maturity of the source of financing to the cash flow generating characteristics of the asset

being financed

D) protecting the firm against the risk of rising interest rates

Keywords: Hedging Principle

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

30) Which of the following is considered a spontaneous source of financing?

A) short-term notes payable

B) accounts payable

C) long-term notes payable

D) preferred stock

Keywords: Spontaneous Financing, Accounts Payable

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

31) What is the hedging principle or principle of self-liquidating debt?

Keywords: Hedging Principle, Permanent Financing, Temporary Financing, Spontaneous Financing

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

32) What are some examples of permanent and temporary investments in current assets?

Keywords: Temporary Investments, Inventory, Accounts Receivable

Learning Obj.: L.O. 15.2

AACSB: Reflective Thinking

Learning Objective 15.3

1) A cash conversion cycle of –5 days is better than a cash conversion cycle of 50 days.

Keywords: Cash Conversion Cycle

Learning Obj.: L.O. 15.3

AACSB: Reflective Thinking

2) The cash conversion cycle is equal to the days of sales outstanding plus the days of sales in inventory

plus the days of payables outstanding.

Keywords: Cash Conversion Cycle

Learning Obj.: L.O. 15.3

AACSB: Reflective Thinking

3) The cash conversion cycle is a measure of a firm’s effectiveness in managing its working capital.

Keywords: Cash Conversion Cycle, Working Capital

Learning Obj.: L.O. 15.3

AACSB: Reflective Thinking

4) If a company‘s inventory turnover increases from 8 to 10, then its cash conversion cycle will also

increase, i.e., get longer.

Keywords: Inventory Turnover, Cash Conversion Cycle

Learning Obj.: L.O. 15.3

AACSB: Analytical Thinking

5) The cash conversion cycle cannot be negative.

Keywords: Cash Conversion Cycle

Learning Obj.: L.O. 15.3

AACSB: Reflective Thinking

6) One way to improve a company‘s cash conversion cycle is to increase its days sales outstanding.

Keywords: Cash Conversion Cycle, Days Sales Outstanding

Learning Obj.: L.O. 15.3

AACSB: Analytical Thinking

7) If a company offers a cash discount for early payment, this will most likely increase its cash conversion

cycle since it will have to pay out more cash to its customers.

Keywords: Cash Conversion Cycle, Credit Terms

Learning Obj.: L.O. 15.3

AACSB: Analytical Thinking

8) What three actions can a firm take to minimize its net working capital?

Keywords: Net Working Capital

Learning Obj.: L.O. 15.3

AACSB: Reflective Thinking

Learning Objective 15.4

1) Compounding effectively raises the cost of short-term credit.

Keywords: Compounding, Short-term Credit

Learning Obj.: L.O. 15.4

AACSB: Reflective Thinking

2) Simpson Conglomerates borrows $12,000 for a short-term purpose. The loan will be repaid after 120

days, with Simpson paying a total of $12,400. What is the approximate cost of credit using the APR, or

annual percentage rate, calculation?

A) 3.33%

B) 4.00%

C) 10.00%

D) 11.75%

Keywords: Annual Percentage Rate, APR

Learning Obj.: L.O. 15.4

AACSB: Analytical Thinking

3) Simpson Conglomerates borrows $12,000 for a short-term purpose. The loan will be repaid after 120

days, with Simpson paying a total of $12,400. What is the approximate cost of credit using the APY, or

annual percentage yield, calculation?

A) 4.33%

B) 10.34%

C) 12.25%

D) 12.46%

Keywords: Annual Percentage Yield, APY

Learning Obj.: L.O. 15.4

AACSB: Analytical Thinking

4) Your company is able to arrange financing at either a rate of 12.75% annually, or at a rate of 12%

compounded monthly. Assuming financing is needed for one year, which rate is the best?

A) 12% compounded monthly, because the annual percentage yield is 12.68%.

B) 12.75% annually, because the annual percentage yield for 12% compounded monthly is greater than

12.75%.

C) 12.75% annually, because even though the annual percentage yield is higher, interest if paid only once

per year at year end.

D) Both rates are effectively the same, so your company should be indifferent between the two.

Keywords: Annual Percentage Yield, APY

Learning Obj.: L.O. 15.4

AACSB: Analytical Thinking

5) A company that forgoes the discount when credit terms are 2/10 net 60 due to insufficient cash flow

would be better off to borrow funds and take the discount as long the company could borrow the funds

at any rate

A) less than 16.33%.

B) less than 15.47%.

C) less than 14.69%.

D) less than 12.00%.

Keywords: Annual Percentage Rate, Cash Discount

Learning Obj.: L.O. 15.4

AACSB: Analytical Thinking

6) Blastdale Corp. is considering borrowing $15,000 for a 60-day period. The firm will repay the $15,000

principal amount plus $200 in interest. What is the effective annual rate of interest? Use a 360-day year.

A) 7.2%

B) 8.0%

C) 8.2%

D) 10.5%

Keywords: Effective Annual Rate of Interest

Learning Obj.: L.O. 15.4

AACSB: Analytical Thinking

7) Assume that Montana Mining, Inc. borrows $5,000,000 for 120 days. The total interest paid is $150,000.

What is the APY, or Effective Annual Rate of interest that Billings pays?

A) 3.00%

B) 9.00%

C) 9.27%

D) 9.77%

Keywords: Annual Percentage Yield, APY

Learning Obj.: L.O. 15.4

AACSB: Analytical Thinking

8) Idaho Mining, Inc. borrows at prime plus 1.5% on its line of credit. The line requires a 15%

compensating balance. If the prime rate is 9% and Idaho Mining plans on borrowing for a period of one

year, what is the nominal APR of the line of credit?

A) 9.0%

B) 6.0%

C) 10.6%

D) 12.4%

Keywords: Annual Percentage Rate, APR

Learning Obj.: L.O. 15.4

AACSB: Analytical Thinking

Learning Objective 15.5

1) To ensure that a borrower is not using short-term bank credit to finance a part of its permanent needs

for funds, banks often require borrowers to clean up their short-term loans for a 30-45 day period during

the year.

Keywords: Transaction Loans, Clean Up, Permanent Needs

Learning Obj.: L.O. 15.5

AACSB: Reflective Thinking

2) A secured loan should have a higher interest rate because the lender has less risk and therefore values

the loan more highly.

Keywords: Secured Loan, Risk

Learning Obj.: L.O. 15.5

AACSB: Analytical Thinking

3) Accrued wages and taxes are secured sources of financing because companies are obligated to make

these payments before they make payments on any other loans or pay dividends.

Keywords: Accruals, Secured Sources of Financing

Learning Obj.: L.O. 15.5

AACSB: Reflective Thinking

4) Credit terms of 2/10, net 30 have a lower effective cost than credit terms of 2/10, net 60 because in the

first case the loan will be repaid sooner.

Keywords: Credit Terms, Effective Rate

Learning Obj.: L.O. 15.5

AACSB: Analytical Thinking

5) Floating lien agreements are the least secure form of inventory collateral.

Keywords: Floating Lien Agreement

Learning Obj.: L.O. 15.5

AACSB: Reflective Thinking

6) Factoring accounts receivable is the sale of a firm’s receivables while pledging accounts receivable is

the use of accounts receivable as collateral for a loan.

Keywords: Factoring Accounts Receivable, Pledging Accounts Receivable

Learning Obj.: L.O. 15.5

AACSB: Reflective Thinking

7) Credit terms of 1/10 net 30 means that the buyer may take a 10% discount (1/10)if the bill in paid within

30 days.

Keywords: Credit Terms, Cash Discount

Learning Obj.: L.O. 15.5

AACSB: Analytical Thinking