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Chapter 14 - Working Capital Management and Policies
CHAPTER 14– WORKING CAPITAL MANAGEMENT AND POLICIES
Questions
LG 1 1. Is it possible for a firm to have negative net working capital? How?
LG1 2. Would it be possible for a decision to deny credit to your customers be value maximizing?
How?
LG2 3. Which of the following will result in an increase in net working capital?
a. An increase in cash.
LG3 4. Would it be possible for a firm to have a negative cash cycle? How?
14-1
LG3 5. If a firm’s inventory turnover ratio increases, what will happen to the firm’s operating cycle?
LG3 6. If a firm’s inventory turnover ratio increases, what will happen to the firm’s cash cycle
LG4 7. Everything else held constant, will an increase in the amount of inventory on hand
LG5 8. Would a firm ever use short-term debt to finance permanent current assets? Why or why
LG5 9. Suppose that short-term borrowing actually becomes more expensive than long-term
borrowing. How would this affect the firm’s choice between a flexible financing policy
and a restrictive policy? (
LG6 10. If asset-backed loans are cheaper than unsecured loans, what is the disadvantage to the
LG7 11. Is an increase in the cash account a source of funds or a use of funds?
LG7 12. What will be the carrying cost associated with a compensating balance requirement?
LG7 13. What will be the shortage cost associated with a compensating balance requirement?
14-2
LG7 14. What would be the shortage costs associated with a restaurant not having enough cash
on hand to make change?
LG8 15. If a firm needs to keep a minimum cash balance on hand and faces both cash inflows and
outflows, which of the cash management models discussed in this chapter would be more
appropriate for them to use?
LG8 16. What effect will increasing the trading costs associated with selling marketable
securities have on the optimal replenishment level in the Baumol model? Why?
LG8 17. What effect will an increase in the standard deviation of daily cash flows have on the return
LG9 18. Could a firm ever have negative collection float? Why or why not?
LG9 19. Could a firm ever have negative disbursement float? Why or why not?
LG9 20. Would a draft have availability float? Why or why not?
LG9 21. From our discussion of capital markets elsewhere in this book, why would you expect
a firm to have a time delay between raising funds to finance a project and the expenditure
of those funds on that project?
LG9 22. What purpose does a discount on credit terms serve? What is the cost of such a
discount to the offering firm?
14-3
Education.
Chapter 14 - Working Capital Management and Policies
problems
basic problems
LG2 14-1 Net Working Capital Requirements JohnBoy Industries has a cash balance of $45,000,
accounts payable of $125,000, inventory of $175,000, accounts receivable of $210,000, notes
payable of $120,000, and accrued wages and taxes of $37,000. How much net working capital
does the firm need to fund?
LG2 14-2 Net Working Capital Requirements Dandee Lions, Inc., has a cash balance of
$105,000, accounts payable of $220,000, inventory of $203,000, accounts receivable of
$319,000, notes payable of $65,000, and accrued wages and taxes of $75,000. How much net
working capital does the firm need to fund?
LG3 14-3 Days’ Sales in Inventory Dabble, Inc., has sales of $980,000 and cost of goods sold of
$640,000. The firm had a beginning inventory of $36,000 and an ending inventory of $46,000.
LG3 14-4 Days’ Sales in Inventory Sow Tire, Inc., has sales of $1,450,000 and cost of goods sold
of $980,000. The firm had a beginning inventory of $97,000 and an ending inventory of $82,000.
LG3 14-5 Average Payment Period If a firm has a cash cycle of 67 days and an operating cycle of
104 days, what is its average payment period?
Using equation 14-2:
-
-
104 days 67 days 37 days
Cash Cycle Operating Cycle Average Payment Period
Operating Cycle Cash Cycle Average Payment Period
=
=
- =
14-4
LG3 14-6 Average Payment Period If a firm has a cash cycle of 45 days and an operating cycle of
77 days, what is its average payment period?
Using equation 14-2:
-
-
77 days 45 days 32 days
Cash cycle Operating cycle Average payment period
Operating cycle Cash cycle Average payment period
=
=
- =
LG3 14-7 Payables Turnover If a firm has a cash cycle of 73 days and an operating cycle of 127
days, what is its payables turnover?
Using equation 14-2:
-
-
127 days 73 days 54 days
Cash cycle Operating cycle Average payment period
Operating cycle Cash cycle Average payment period
=
=
- =
Payables turnover will be 365 days / 54 days = 6.76 times
LG3 14-8 Payables Turnover If a firm has a cash cycle of 54 days and an operating cycle of 77
days, what is its payables turnover?
Using equation 14-2:
-
-
77 days 54 days 23 days
Cash cycle Operating cycle Average payment period
Operating cycle Cash cycle Average payment period
=
=
- =
Payables turnover will be 365 days / 23 days = 15.87 times
LG7 14-9 Compensating Balance Would it be worth it to incur a compensating balance of $10,000
in order to get a 1-percent-lower interest rate on a one-year, pure discount loan of $225,000?
It depends upon whether $225,000 × (1 + i) or $235,000 × (1 + [i – 0.01]) is larger. The
LG7 14-10 Compensating Balance Would it be worth it to incur a compensating balance of $7,500
in order to get a 0.65-percent-lower interest rate on a two-year, pure discount loan of $150,000?
It depends upon whether $150,000 × (1 + i) or $157,500 × (1 + [i – 0.0065]) is larger. The
Chapter 14 - Working Capital Management and Policies
Operating cycle Days' sales in inventory Average collection period
Inventory 365 days Accounts receivable 365 days
=Cost of goods sold Credit sales
$1,116,000 365 days $750,000 365 days
=$1,650,000 $2,30
= +
´ ´
+
´ ´
+0,000
365.89 days=
LG3 14-14 Operating Cycle Suppose that LilyMac Photography has annual sales of $230,000, cost
of goods sold of $165,000, average inventories of $4,500, and average accounts receivable of
$25,000. Assuming that all of LilyMac’s sales are on credit, what will be the firm’s operating
cycle?
Using equation 14-1:
Operating cycle Days' sales in inventory Average collection period
Inventory 365 days Accounts receivable 365 days
=Cost of goods sold Credit sales
$4,500 365 days $25,000 365 days
=$165,000 $230,000
49.
= +
´ ´
+
´ ´
+
=63 days
LG3 14-15 Cash Cycle Suppose that LilyMac Photography has annual sales of $230,000, cost of
goods sold of $165,000, average inventories of $4,500, average accounts receivable of $25,000,
and an average accounts payable balance of $7,000. Assuming that all of LilyMac’s sales are on
credit, what will be the firm’s cash cycle?
Using equation 14-1:
Operating cycle Days' sales in inventory Average collection period
Inventory 365 days Accounts receivable 365 days
=Cost of goods sold Credit sales
$4,500 365 days $25,000 365 days
=$165,000 $230,000
49.
= +
´ ´
+
´ ´
+
=6285 days
Using this, in turn, in equation 14-2:
-
365 days
-
$7,000 365 days
49.6285 - $165,000
34.14 days
Cash cycle Operating cycle Average payment period
Accounts payable
Operating cycle Cost of goods sold
=
´
=
´
=
=
LG3 14-16 Cash Cycle Suppose that the Ken-Z Art Gallery has annual sales of $870,000, cost of
goods sold of $560,000, average inventories of $244,500, average accounts receivable of
$265,000, and an average accounts payable balance of $79,000. Assuming that all of Ken-Z’s
sales are on credit, what will be the firm’s cash cycle?
Using equation 14-1:
Operating cycle Days' sales in inventory Average collection period
Inventory 365 days Accounts receivable 365 days
=Cost of goods sold Credit sales
$244,500 365 days $265,000 365 days
=$560,000 $870,000
= +
´ ´
+
´ ´
+
=270.5398 days
Using this, in turn, in equation 14-2:
-
365 days
-
$79, 000 365 days
270.5398 days - $560,000
219.05 days
Cash cycle Operating cycle Average payment period
Accounts payable
Operating cycle Cost of goods sold
=
´
=
´
=
=
LG4 14-17 Compensating Balance Interest Rate Suppose your firm is seeking an eight-year,
amortizing $800,000 loan with annual payments and your bank is offering you the choice
between an $850,000 loan with a $50,000 compensating balance and an $800,000 loan without a
compensating balance. If the interest rate on the $800,000 loan is 8.5 percent, how low would
the interest rate on the loan with the compensating balance have to be in order for you to choose
it?
The payments on the $800,000 loan would be $141,864.52:
( )
( )
8
1
11
.085
$800, 000 1
11 .085
N
N
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14-10
