Chapter 6
Working Capital and the Financing Decision
Discussion Questions
6-1. Explain how rapidly expanding sales can drain the cash resources of a firm.
Rapidly expanding sales will require a buildup in assets to support the growth.
In particular, more and more of the increase in current assets will be permanent
6-2. Discuss the relative volatility of short- and long-term interest rates.
6-3. What is the significance to working capital management of matching sales and
production?
If sales and production can be matched, the level of inventory and the amount
of current assets needed can be kept to a minimum; therefore, lower financing
costs will be incurred. Matching sales and production has the advantage of
6-4. How is a cash budget used to help manage current assets?
A cash budget helps minimize current assets by providing a forecast of inflows
and outflows of cash. It also encourages the development of a schedule as to
6-5. “The most appropriate financing pattern would be one in which asset buildup
and length of financing terms is perfectly matched.” Discuss the difficulty
involved in achieving this financing pattern.
Only a financial manager with unusual insight and timing could design a plan in
which asset buildup and the length of financing terms are perfectly matched.
6-6. By using long-term financing to finance part of temporary current assets, a firm
may have less risk but lower returns than a firm with a normal financing plan.
Explain the significance of this statement.
By establishing a long-term financing arrangement for temporary current assets,
a firm is assured of having necessary funding in good times as well as bad, thus
6-7. A firm that uses short-term financing methods for a portion of permanent
current assets is assuming more risk but expects higher returns than a firm with
a normal financing plan. Explain.
By financing a portion of permanent current assets on a short-term basis, we run
the risk of inadequate financing in tight money periods. However, since
6-8. What does the term structure of interest rates indicate?
The term structure of interest rates shows the relative level of short-term and
6-9. What are three theories for describing the shape of the term structure of interest
rates (the yield curve)? Briefly describe each theory.
Liquidity premium theory, the market segmentation theory, and the expectations
theory.
The expectations hypothesis maintains that the yields on long-term securities
are a function of short-term rates. The result of the hypothesis is that when
6-10. Since the mid-1960s, corporate liquidity has been declining. What reasons can
you give for this trend?
The decrease in liquidity can be traced in part to more efficient inventory
management such as just-in-time inventory and point of sales terminals that
Chapter 6
Problems
1. Expected value (LO6) Gary’s Pipe and Steel Company expects sales next year to be
$800,000 if the economy is strong, $500,000 if the economy is steady, and $350,000 if the
economy is weak. Gary believes there is a 20 percent probability the economy will be
strong, a 50 percent probability of a steady economy, and a 30 percent probability of a
weak economy. What is the expected level of sales for next year?
6-1. Solution:
Gary’s Pipe and Steel Company
State of
Econom
Sales Probability Expected
Outcome
y
2. Expected value (LO6) Sharpe Knife Company expects sales next year to be $1,550,000 if
the economy is strong, $825,000 if the economy is steady, and $550,000 if the economy is
weak. Mr. Sharpe believes there is a 30 percent probability the economy will be strong, a
40 percent probability of a steady economy, and a 30 percent probability of a weak
economy. What is the expected level of sales for the next year?
6-2. Solution:
Sharpe Knife Company
State of
Economy Sales Probability
Expected
Outcome
3. External financing (LO1) Tobin Supplies Company expects sales next year to be
$500,000. Inventory and accounts receivable will increase $90,000 to accommodate this
sales level. The company has a steady profit margin of 12 percent with a 40 percent
dividend payout. How much external financing will Tobin Supplies Company have to seek?
Assume there is no increase in liabilities other than that which will occur with the external
financing.
6-3. Solution:
Tobin Supplies Company
$500,000 Sales
0.12 Profit margin
60,000 Net income
4. External financing (LO1) Antivirus Inc. expects its sales next year to be $2,500,000.
Inventory and accounts receivable will increase $480,000 to accommodate this sales level.
The company has a steady profit margin of 15 percent with a 35 percent dividend payout.
How much external financing will the firm have to seek? Assume there is no increase in
liabilities other than that which will occur with the external financing.
6-4. Solution:
Antivirus Inc.
$2,500,000 Sales
.15 Profit margin
5. Level versus seasonal production (LO1) Antonio Banderos & Scarves makes headwear
that is very popular in the fall-winter season. Units sold are anticipated as:
October…………………………………………….. 1,250
November…………………………………………. 2,250
December…………………………………………. 4,500
January…………………………………………….. 3,500
11,500 units
If seasonal production is used, it is assumed that inventory will directly match sales for
each month and there will be no inventory buildup.
However, Antonio decides to go with level production to avoid being out of merchandise.
He will produce the 11,500 items over four months at a level of 2,875 per month.
a. What is the ending inventory at the end of each month? Compare the units sales to the
units produced and keep a running total.
b. If the inventory costs $8 per unit and will be financed at the bank at a cost of 12
percent, what is the monthly financing cost and the total for the four months? (Use 1
percent or the monthly rate.)
6-5. Solution:
Antonio Banderos and Scarves
a. Units
Sold
Units
Produced
Change in
Inventory
Ending
Inventory
b.
Ending
Inventory
Total Cost
per Unit
($8 per unit)
Inventory
Financing Cost
(at 1% per
month)
6. Level versus seasonal production (LO1) Bambino Sporting Goods makes baseball gloves
that are very popular in the spring and early summer season. Units sold are anticipated as
follows:
March………………………………………………. 3,250
April………………………………………………… 7,250
May…………………………………………………. 11,500
June…………………………………………………. 9,500
31,500
If seasonal production is used, it is assumed that inventory will directly match sales for
each month and there will be no inventory buildup.
The production manager thinks the preceding assumption is too optimistic and decides to
go with level production to avoid being out of merchandise. He will produce the 31,500
units over four months at a level of 7,875 per month.
a. What is the ending inventory at the end of each month? Compare the unit sales to the
units produced and keep a running total.
b. If the inventory costs $12 per unit and will be financed at the bank at a cost of 12
percent, what is the monthly financing cost and the total for the four months? (Use 0.01
as the monthly rate.)
6-6. Solution:
Bambino Sporting Goods
a. Units
Sold
Units
Produced
Change in
Inventory
Ending
Inventory
6-6. (Continued)
b.
Ending
Inventory
Total Cost
($12 per unit)
Inventory
Financing Cost
(at 1% per
month)
7. Short-term versus longer-term borrowing (LO3) Boatler Used Cadillac Co. requires
$850,000 in financing over the next two years. The firm can borrow the funds for two years
at 12 percent interest per year. Mr. Boatler decides to do forecasting and predicts that if he
utilizes short-term financing instead, he will pay 7.75 percent interest in the first year and
13.55 percent interest in the second year. Determine the total two-year interest cost under
each plan. Which plan is less costly?
6-7. Solution:
Boatler Used Cadillac Co.
Cost of Two-Year Fixed Cost Financing
cost
Cost of Two-Year Variable Short-Term Financing
The short-term plan is less costly.
8. Short-term versus longer-term borrowing (LO3) Biochemical Corp. requires $550,000
in financing over the next three years. The firm can borrow the funds for three years at
10.60 percent interest per year. The CEO decides to do a forecast and predicts that if she
utilizes short-term financing instead, she will pay 8.75 percent interest in the first year,
13.25 percent interest in the second year, and 10.15 percent interest in the third year.
Determine the total interest cost under each plan. Which plan is less costly?
6-8. Solution:
Biochemical Corp.
Cost of Three-Year Fixed Cost Financing
Cost of Three-Year Variable Short-Term Financing
The fixed cost plan is less costly.
9. Short-term versus longer-term borrowing (LO3) Sauer Food Company has decided to
buy a new computer system with an expected life of three years. The cost is $150,000. The
company can borrow $150,000 for three years at 10 percent annual interest or for one year
at 8 percent annual interest.
How much would Sauer Food Company save in interest over the three-year life of the
computer system if the one-year loan is utilized and the loan is rolled over (reborrowed)
each year at the same 8 percent rate? Compare this to the 10 percent three-year loan. What
if interest rates on the 8 percent loan go up to 13 percent in year 2 and 18 percent in year 3?
What would be the total interest cost compared to the 10 percent, three-year loan?
6-9. Solution:
Sauer Food Company
If Rates Are Constant
If Short-Term Rates Change
10. Optimal policy mix (LO5) Assume that Hogan Surgical Instruments Co. has $2,500,000 in
assets. If it goes with a low-liquidity plan for the assets, it can earn a return of 18 percent,
but with a high-liquidity plan, the return will be 14 percent. If the firm goes with a
short-term financing plan, the financing costs on the $2,500,000 will be 10 percent, and
with a long-term financing plan, the financing costs on the $2,500,000 will be 12 percent.
(Review Table 6-11 for parts a, b, and c of this problem.)
a. Compute the anticipated return after financing costs with the most aggressive asset
financing mix.
b. Compute the anticipated return after financing costs with the most conservative asset
financing mix.
c. Compute the anticipated return after financing costs with the two moderate approaches
to the asset financing mix.
d. Would you necessarily accept the plan with the highest return after financing costs?
Briefly explain.
6-10. Solution:
Hogan Surgical Instruments Company
a. Most aggressive
b. Most conservative
c. Moderate approach
OR
6-10. (Continued)
d. You may not necessarily select the plan with the highest
return. You must also consider the risk inherent in the plan.
11. Optimal policy mix (LO5) Assume that Atlas Sporting Goods Inc. has $840,000 in assets.
If it goes with a low-liquidity plan for the assets, it can earn a return of 15 percent, but with
a high-liquidity plan the return will be 12 percent. If the firm goes with a short-term
financing plan, the financing costs on the $840,000 will be 9 percent, and with a long-term
financing plan, the financing costs on the $840,000 will be 11 percent. (Review
Table 6-11 for parts a, b, and c of this problem.)
a. Compute the anticipated return after financing costs with the most aggressive
asset-financing mix.
b. Compute the anticipated return after financing costs with the most conservative
asset-financing mix.
c. Compute the anticipated return after financing costs with the two moderate approaches
to the asset-financing mix.
d. If the firm used the most aggressive asset-financing mix described in part a and had the
anticipated return you computed for part a, what would earnings per share be if the tax
rate on the anticipated return was 30 percent and there were 20,000 shares outstanding?
e. Now assume the most conservative asset-financing mix described in part b will be
utilized. The tax rate will be 30 percent. Also assume there will only be 5,000 shares
outstanding. What will earnings per share be? Would it be higher or lower than the
earnings per share computed for the most aggressive plan computed in part d?