Foundations of Finance, 7e (Keown/Martin/Petty)
Chapter 15 Working-Capital Management
15.1 Learning Objective 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.
2) Two advantages of financing with current liabilities are flexibility and lower interest cost.
3) Higher liquidity (holding larger cash and marketable securities balances) generally results in a
lower return on equity.
4) Long-term debt is generally less costly than short-term debt, but also results in more
illiquidity hence, the risk/return tradeoff.
5) Short-term debt provides a more flexible form of financing than long-term debt.
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.
7) Working capital refers to investment in current assets, while net working capital is the
difference between current assets and current liabilities.
8) A firm increases the risks of insolvency by keeping relatively large amounts of money tied up
in marketable securities.
9) A company decreases the risk of insolvency by financing long-term assets with short-term
debt.
10) Achieving a lower inventory balance through working capital management can result in
savings from both carrying costs and losses associated with obsolete inventory.
11) Working capital management involves managing a firm’s liquidity.
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.
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.
14) The risk of illiquidity is increased if either cash and marketable securities are decreased, or if
the firm relies more heavily of long-term debt.
15) In general, interest rates are 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.
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.
17) Current assets would usually not include
A) plant and equipment.
B) marketable securities.
C) accounts receivable.
D) inventories.
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.
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.
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) both A and B.
D) investors demand higher returns on short-term debt due to liquidity concerns.
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.
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.
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
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
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
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
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
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.
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.
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
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
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.
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
34) Working capital includes all of the following except:
A) cash.
B) accounts receivable.
C) accounts payable.
D) inventories.
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.
36) Discuss the risk-return tradeoff experienced in working-capital management.
15.2 Learning Objective 2
1) The hedging principle is also called the principle of self-liquidating inventory.
2) Accrued taxes and salaries payable are both sources of spontaneous financing.
3) The hedging principle involves the use of hedge funds to manage the firm’s working capital.
4) The hedging principle is used to address the issue of how much short-term financing a firm
should use.
5) One example of the hedging principle is to reduce a company’s foreign exchange risk by
purchasing futures contracts, which are called hedges.
6) Total assets must always equal the sum of temporary, permanent, and spontaneous sources of
financing.
7) Minimum levels of inventory and accounts receivable that will be maintained throughout the
year are current assets, and therefore considered temporary investments.
8) The hedging principle involves matching the cash flow from an asset with the cash flow
requirements of the financing used.
9) The firm’s total investment in current assets should be financed with temporary sources of
financing.
10) Notes payable is a spontaneous source of financing.
11) Trade credit is a source of spontaneous financing.
12) Commercial paper is an example of spontaneous financing because it is generated by the
day-to-day operations of a company.
13) Total debt must always be equal to the sum of temporary, permanent, and spontaneous
sources of financing.
14) Sources of spontaneous financing include trade credit, salaries payable, and accrued taxes.
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.
16) The primary source of spontaneous financing is accrued taxes.
17) JoLi Corp. purchases a new delivery van which is expected to increase cash flows for the
next 10 years. JoLi 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, JoLi 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.
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.
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.
20) Spontaneous sources of financing include
A) marketable securities.
B) wages payable.
C) accounts receivable.
D) common stock.
21) Permanent sources of financing include all but
A) corporate bonds.
B) common stock.
C) preferred stock.
D) commercial paper.
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.
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.
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
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
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
27) Trade credit is an example of which of the following sources of financing?
A) spontaneous
B) temporary
C) permanent
D) discretionary
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
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
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
15.3 Learning Objective 3
1) A cash conversion cycle of -5 days is better than a cash conversion cycle of 50 days.
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.
3) The cash conversion cycle is a measure of a firm’s effectiveness in managing its working
capital.
4) If a company’s inventory turnover increases from 8 to 10, then its cash conversion cycle will
also increase, i.e., get longer.
5) The cash conversion cycle cannot be negative.
6) One way to improve a company’s cash conversion cycle is to increase its days sales
outstanding.
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.
15.4 Learning Objective 4
1) Compounding effectively raises the cost of short-term credit.
2) Key Enterprises borrows $12,000 for a short-term purpose. The loan will be repaid after 120
days, with Key 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%
3) Key Enterprises borrows $12,000 for a short-term purpose. The loan will be repaid after 120
days, with Key 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%
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) Both rates are effectively the same, so your company should be indifferent between the two.
C) 112.75% annually because the annual percentage yield for 12% compounded monthly is
greater than 12.75%.
D) 12.75% annually, because even though the annual percentage yield is higher, interest if paid
only once per year at year end.
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%.
6) Bigtime 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%
7) Assume that Billings, 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%
8) Consolidated Industries borrows at prime plus 1.5% on its line of credit. The line requires a
15% compensating balance. If prime rate is 9%, what is the nominal APR of the line of credit?
A) 9.0%
B) 6.0%
C) 10.6%
D) 12.4%
15.5 Learning Objective 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.
2) A secured loan should have a higher interest rate because the lender has less risk and therefore
values the loan more highly.
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.
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.
5) Floating lien agreements are the least secure form of inventory collateral.
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.
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.
8) Major sources of secured credit include commercial banks, finance companies, and factors.
9) The cost of trade credit varies directly with the size of the cash discount and inversely with the
length of time between the end of the discount period and the final due date.
10) The effective cost to the borrower of an unsecured bank loan is increased if a compensating
balance is required.
11) A major risk in using commercial paper for short-term financing is the inflexible repayment
schedule.
12) The amount that can be obtained on an inventory loan depends on both the marketability and
perishability of the items in the inventory.
13) When the accounts receivable of a firm have been factored, bad debt losses remain the
responsibility of the borrowing firm and must be made good.
14) Under terms of a field warehouse financing agreement, the collateral inventories are
physically separated from the borrower’s other inventories but remain under the borrower’s
control.
15) Trade credit appears on a company’s balance sheet as accounts payable.
16) A revolving credit agreement is a legally binding agreement between a borrower and lender.
17) Issuers of commercial paper usually maintain lines of credit with banks to back up their
short-term financing needs.
18) The primary sources of collateral for secured loans are accounts receivable and inventory.
19) Commercial paper is an unsecured form of credit.
20) In a chattel mortgage, specific items of inventory are identified in the security agreement.
21) A bank is legally obligated to provide credit under a revolving credit agreement, but not
under a line of credit.
22) The inclusion of a compensating balance requirement in a line of credit will reduce the
effective annual cost of credit since the bank has additional collateral for the borrowing.
23) Both compensating balances and discounting interest increase the effective interest rate on a
loan.
24) Because only the largest and most creditworthy companies are able to use commercial paper,
the interest rate on commercial paper is generally lower than the prime rate.
25) Jones Company has a cash flow problem. The company owes its suppliers $300,000 on
credit terms of 2/10 net 40, but Jones doesn’t have the cash to pay during the discount period.
Jones, however, can borrow the $300,000 at annual rate of 24%. Should Jones borrow the
money to pay its accounts payable?
A) No, additional borrowing will cost more for interest ($60,000 per year) than the discount is
worth.
B) Yes, the effective cost of forgoing the discount is greater than 24%.
C) No, the effective cost of forgoing the discount is equal to 24%, and there are transactions
costs associated with borrowing.
D) It doesn’t matter because the present value of the cost of borrowing is exactly equal to the
amount of the discount for paying within 10 days.
26) Your company buys supplies on credit terms of 2/10 net 45. Suppose the company makes a
purchase of $20,000 today. Which of the following payment options makes the most sense as a
general rule?
A) Pay the bill as soon as possible to keep the supplier happy.
B) Pay the bill on day 45 due to the time value of money.
C) Pay the bill on day 10 to get the discount.
D) Either pay the bill on day 10 to get the discount, or wait until day 45.
27) As a company accounts payable manager, which of the following credit terms are most likely
to entice you to take the cash discount?
A) 1/10 net 45
B) 2/10 net 60
C) 1/10 net 30
D) 2/10 net 90
28) You are working on your company’s cash budget for the coming year and you believe there
may be short periods of time where financing is required. Which of the following sources of
short-term financing is most certain to be available when needed?
A) trade credit
B) line of credit with a bank
C) revolving credit agreement with a bank
D) accounts receivable
29) All of the following are likely to increase the cost of a company’s short-term financing
except:
A) an increase in the bank’s prime lending rate.
B) an increase in the compensating balance required.
C) taking a loan on a discount basis.
D) an increase in the company’s debt rating by Moody’s or Standard and Poors.
30) Penn Inc. needs to borrow $250,000 for the next 6 months. The company has a line of credit
with a bank that allows the company to borrow funds with an 8% interest rate subject to a 20%
of loan compensating balance. Currently, Penn Inc. has no funds on deposit with the bank and
will need the loan to cover the compensating balance as well as their other financing needs.
How much will Penn Inc. need to borrow?
A) $270,000
B) $300,000
C) $312,500
D) $347,222
31) Penn Inc. needs to borrow $250,000 for the next 6 months. The company has a line of credit
with a bank that allows the company to borrow funds with an 8% interest rate subject to a 20%
of loan compensating balance. Currently, Penn Inc. has no funds on deposit with the bank and
will need the loan to cover the compensating balance as well as their other financing needs.
What will be the annual percentage rate, or APR, for this financing?
A) 10.00%
B) 12.12%
C) 10.67%
D) 13.33%