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Chapter 18

Working Capital Management and Short-Term Financing

True/False

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

Difficulty: Easy

Keywords: current assets

2. The minimum level of inventory the firm plans to hold for the foreseeable future is a temporary asset investment.

Difficulty: Easy

Keywords: permanent asset investment

3. The hedging principle involves matching the cash flow from an asset with the cash flow requirements of the financing used.

Difficulty: Moderate

Keywords: hedging principle

4. Current asset investments are always financed with temporary assets.

Difficulty: Moderate

Keywords: temporary financing

5. Working capital refers to investment in current assets, while net working capital is the difference between current assets and current liabilities.

Difficulty: Moderate

Keywords: working capital

6. The use of current assets subjects the firm to greater liquidity risk due to uncertainty.

Difficulty: Moderate

Keywords: liquidity risk

7. The use of short-term debt provides flexibility in financing since the firm is only paying interest when it is actually using the borrowed funds.

Difficulty: Moderate

Keywords: short-term debt

8. A firm can reduce net working capital by substituting long-term financing, such as bonds, with short-term financing, such as a one-year notes payable.

Difficulty: Moderate

Keywords: net working capital

9. Notes payable is a spontaneous source of financing.

Difficulty: Easy

Keywords: spontaneous financing

10. Investing in additional marketable securities and inventories creates higher profitability and lower liquidity.

Difficulty: Moderate

Keywords: investments in marketable securities and inventory

11. A firm that increases its investment in bonds increases its liquidity.

Difficulty: Easy

Keywords: liquidity

12. There is a risk-return trade-off involved in managing a firm’s liquidity.

Difficulty: Easy

Keywords: liquidity

13. Net working capital provides a very useful summary measure of a firm’s short-term financing decisions.

Difficulty: Easy

Keywords: net working capital

14. Increasing the use of short-term debt versus long-term debt financing will increase profit.

Difficulty: Moderate

Keywords: short-term versus long-term financing, profitability

15. Managing a firm’s liquidity is basically the same as managing a firm’s net working capital.

Difficulty: Moderate

Keywords: net working capital

16. Current liabilities have greater illiquidity risk due to the higher frequency that they have to be repaid or rolled over.

Difficulty: Moderate

Keywords: illiquidity

17. Trade credit is a source of spontaneous financing.

Difficulty: Easy

Keywords: trade credit

18. Short-term debt is frequently less expensive because it provides the borrower more security.

Difficulty: Moderate

Keywords: short-term debt

19. The hedging principle involves the matching of the cash flow of an asset with the maturity of a financing source.

Difficulty: Easy

Keywords: hedging principle

20. Holding all other variables constant, as accounts receivable increases, the cash conversion cycle decreases.

Difficulty: Moderate

Keywords: cash conversion cycle

21. A firm that continually finances part of its permanent asset needs from short-term financing is following a less-risky approach.

Difficulty: Moderate

Keywords: permanent financing

22. Sources of financing repaid in six months to one year are usually categorized as long-term.

Difficulty: Easy

Keywords: short-term financing

23. Major sources of secured credit include commercial banks, finance companies, and factors.

Difficulty: Moderate

Keywords: secured credit

24. Inventory loans are considered an unsecured source of financing.

Difficulty: Easy

Keywords: inventory loans

25. 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.

Difficulty: Moderate

Keywords: cost of trade credit

26. The continual practice of stretching on trade credit is potentially a very useful source of short-term credit for the firm.

Difficulty: Moderate

Keywords: stretching trade credit

27. The effective cost to the borrower of an unsecured bank loan is increased if a compensating balance is required.

Difficulty: Moderate

Keywords: compensating balance

28. Commercial banks often require that a firm clean up all short-term loans for some period of time to ensure that working capital needs are not being financed with short-term bank credit.

Difficulty: Moderate

Keywords: short-term bank credit

29. A major risk in using commercial paper for short-term financing is the inflexible repayment schedule.

Difficulty: Moderate

Keywords: commercial paper

30. To cover handling charges, accounts receivable loans have an interest rate that is about 0.5% higher than the prime rate.

Difficulty: Moderate

Keywords: accounts receivable loans

31. The amount that can be obtained on an inventory loan depends on both the marketability and perishability of the items in the inventory.

Difficulty: Moderate

Keywords: inventory loan

32. 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.

Difficulty: Moderate

Keywords: factoring

33. Minimizing working capital is accomplished by slowing down the cash conversion cycle.

Difficulty: Easy

Keywords: cash conversion cycle

34. The cost of a terminal warehouse agreement is usually higher than the cost for a field warehouse financing agreement.

Difficulty: Moderate

Keywords: terminal warehouse agreement

35. A commercial bank loan which must be repaid in two years is considered long-term financing.

Difficulty: Easy

Keywords: long-term financing, commercial bank loan

36. Trade credit appears on a company’s balance sheet as accounts payable.

Difficulty: Moderate

Keywords: trade credit

37. Security for long-term loans includes equipment.

Difficulty: Moderate

Keywords: secured loans

38. Multinational firms have assets valued in foreign currency and therefore have an added concern of exchange rate risk in dealing with working capital management.

Difficulty: Easy

Keywords: multinational firms, exchange rate risk

39. Issuers of commercial paper usually maintain lines of credit with banks to back up their short-term financing needs.

Difficulty: Moderate

Keywords: commercial paper

40. Accrued wages are considered an unsecured, non-spontaneous source of financing.

Difficulty: Moderate

Keywords: accrued wages, unsecured financing, spontaneous financing

41. The primary sources of collateral for short-term secured loans are accounts receivable and inventory.

Difficulty: Moderate

Keywords: collateral, short-term loans

42. When faced with a surplus of cash, most firms should stretch their trade accounts.

Difficulty: Easy

Keywords: stretching trade accounts

43. Prior to establishing trade credit, the firm is required to make extended formal agreements with the company.

Difficulty: Moderate

Keywords: trade credit

44. Lines of credit usually require that the borrower maintain a minimum balance in the bank throughout the loan period.

Difficulty: Moderate

Keywords: lines of credit

45. Trade credit provides one of the most flexible sources of short-term financing available to the firm.

Difficulty: Easy

Keywords: trade credit

46. Commercial paper is an unsecured form of credit.

Difficulty: Easy

Keywords: commercial paper

47. Trade credit is considered one of the most inflexible sources of financing available to a firm.

Difficulty: Moderate

Keywords: trade credit

48. In a chattel mortgage, specific items of inventory are identified in the security agreement.

Difficulty: Moderate

Keywords: chattel mortgage

49. Infrequent violation of trade terms offers a potential source of short-term credit.

Difficulty: Moderate

Keywords: stretching trade credit

50. Lines of credit involve fixed rates of interest.

Difficulty: Moderate

Keywords: line of credit

51. U.S. commercial bank holding companies are allowed to make limited equity investments in their clients despite the Glass-Stegall Act in 1933, which prohibits this activity for commercial banks.

Difficulty: Moderate

Keywords: commercial bank holding companies

52. The value of the billing and collection services for pledged assets the bank provides should be considered as a part of the cost of credit.

Difficulty: Moderate

Keywords: pledging assets, cost of credit

53. A firm can reduce its risk of illiquidity only by reducing its overall return on invested funds.

Difficulty: Moderate

Keywords: illiquidity

54. All other things remaining the same, the greater the firm’s reliance on short-term debt or current liabilities in financing its asset investments, the lower the risk of illiquidity.

Difficulty: Moderate

Keywords: illiquidity

55. As the firm increases its investment in working capital, there is a corresponding increase in its profits.

Difficulty: Moderate

Keywords: working capital

56. Current liabilities provide a flexible means of financing the firm’s fluctuating needs for assets.

Difficulty: Moderate

Keywords: current liabilities

57. Within the context of working capital management, the risk-return trade-off involves an increased risk of illiquidity versus increased profitability.

Difficulty: Moderate

Keywords: working capital management

58. When a firm follows the hedging principle of working capital management, the firm’s debt will “self-liquidate” because the assets being financed will generate sufficient cash to retire the debt as it comes due.

Difficulty: Moderate

Keywords: hedging principle

59. Secured loans are those that are secured by the lender’s faith in the ability of the borrower to repay the funds when due.

Difficulty: Moderate

Keywords: secured loans

60. Accrued wages and taxes provide sources of financing that rise and fall spontaneously with the level of the firm’s sales.

Difficulty: Moderate

Keywords: accrued wages and taxes

61. Trade credit provides one of the most flexible sources of short-term financing available to the firm.

Difficulty: Moderate

Keywords: trade credit

62. The cost of trade credit varies inversely with the size of the cash discount.

Difficulty: Moderate

Keywords: cost of trade credit

63. For short periods, and at infrequent intervals, stretching trade accounts offers an emergency source of short-term credit.

Difficulty: Moderate

Keywords: stretching trade accounts

64. In a revolving credit agreement, the bank has a legal obligation to provide the stated credit.

Difficulty: Moderate

Keywords: revolving credit agreements

65. The purpose of a clean-up requirement is to ensure that the borrower is not using short-term bank credit to finance a part of its permanent need for funds.

Difficulty: Moderate

Keywords: clean-up requirement

66. Commercial paper offers the borrower the same flexibility that exists when bank credit is used to meet financing needs.

Difficulty: Moderate

Keywords: commercial paper

67. A loan with a general line on a firm’s receivables is a loan for which all of the firm’s accounts are pledged as security.

Difficulty: Moderate

Keywords: pledging receivables

68. Factoring accounts receivable involves the purchase of accounts receivables from financial institutions.

Difficulty: Easy

Keywords: factoring accounts receivable

69. An inventory loan with a terminal warehouse agreement differs from an inventory loan with a field warehouse agreement in that under a field warehouse agreement, the pledged inventories are transported to a warehouse that is physically removed from the borrower’s premises.

Difficulty: Moderate

Keywords: inventory loan

Multiple Choice

70. The focus of current asset management is on:

a. property, plant, and equipment acquisition.

b. cash, accounts receivable, and inventory levels.

c. investments in marketable securities.

1. both a and c.
2. all of the above.

Difficulty: Easy

Keywords: current asset management

71. An increase in ___________ would increase net working capital.

a. plant and equipment

b. accounts payable

c. accounts receivable

d. both b and c

Difficulty: Easy

Keywords: net working capital

72. Spontaneous sources of financing include:

a. marketable securities.

b. accruals.

c. bonds.

1. both a and b.
2. all of the above.

Difficulty: Easy

Keywords: spontaneous financing

73. Accounts payable is considered a:

a. spontaneous liability.

b. temporary financing source.

c. permanent financing source.

d. both a and b.

e. both a and c.

Difficulty: Easy

Keywords: temporary financing, spontaneous liability

74. Which of the following is not considered a permanent source of financing?

a. Corporate bonds

b. Common stock

c. Preferred stock

d. Commercial paper

Difficulty: Easy

Keywords: permanent financing

75. A toy manufacturer following the hedging principle will generally finance seasonal inventory build-up prior to the Christmas season with:

a. common stock.

b. selling equipment.

c. trade credit.

d. preferred stock.

Difficulty: Moderate

Keywords: trade credit, hedging principle

76. Which of the following is considered to be a spontaneous source of financing?

a. Operating leases

b. Accounts receivable

c. Inventory

d. Accounts payable

Difficulty: Easy

Keywords: accounts payable, spontaneous financing

77. Disadvantages of using current liabilities as opposed to long-term debt include:

a. greater risk of illiquidity.

b. uncertainty of interest costs.

c. higher cash flow exposure.

1. both a and b.
2. all of the above.

Difficulty: Moderate

Keywords: disadvantages of current liabilities

78. According to the hedging principle, permanent assets should be financed with _______ liabilities.

a. permanent

b. spontaneous

c. current

d. fixed

Difficulty: Easy

Keywords: permanent liabilities, hedging principle

79. Which of the following is most consistent with the hedging principle in working capital management?

a. Fixed assets should be financed with short-term notes payable.

b. Inventory should be financed with preferred stock.

c. Accounts receivable should be financed with short-term lines of credit.

d. Borrow on a floating rate basis to finance investments in permanent assets.

Difficulty: Moderate

Keywords: hedging principle

80. With regard to the hedging principle, which of the following assets should be financed with permanent sources of financing?

a. Machinery

b. Expansion of inventory to meet seasonal demands

c. Machinery and expansion of inventory to meet seasonal demands

d. Minimum level of accounts receivable required year round, machinery, and minimum level of cash required for year-round operations

Difficulty: Moderate

Keywords: hedging principle

81. Which of the following is a spontaneous source of financing?

a. Accrued wages

b. Preferred stock

c. Trade credit

d. Both a and c

Difficulty: Easy

Keywords: spontaneous financing

82. Accounts receivable and inventory self-liquidate through the __________ cycle.

a. spontaneous account

b. net working capital

c. cash conversion

d. sales-to-receivables collection

Difficulty: Moderate

Keywords: accounts receivable, inventory

83. Which of the following is considered a source of spontaneous financing?

a. Trade credit

b. Inventories

c. Accounts payable

d. Both a and c

Difficulty: Easy

Keywords: spontaneous financing

84. 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 demands

c. Machinery used to produce a firm’s inventory

d. Both a and b

e. Both b and c

Difficulty: Moderate

Keywords: hedging principle

85. Trade credit is an example of which of the following sources of financing?

a. Spontaneous

b. Temporary

c. Permanent

d. Both a and b

Difficulty: Easy

Keywords: trade credit

86. Which of the following is a spontaneous source of financing?

a. Accounts payable

b. Accounts payable and wages and salaries payable

c. Accounts payable and inventories

d. Accounts payable, wages and salaries payable, and accrued interest

Difficulty: Moderate

Keywords: spontaneous financing

87. Which of the following types of financing offers the firm the greatest degree of flexibility?

a. Bonds

b. Preferred stock

c. Short-term lines of credit

d. Long-term notes payable

Difficulty: Moderate

Keywords: lines of credit

88. Which of the following actions would improve a firm’s liquidity?

a. Selling stock and reducing accounts payable

b. Selling stock to purchase equipment

c. Selling bonds and purchasing machinery

d. Both a and c

Difficulty: Moderate

Keywords: liquidity

89. An increase in ___________________ would increase a firm’s liquidity.

a. notes payable

b. inventories

c. cash

1. both b and c
2. all of the above

Difficulty: Moderate

Keywords: liquidity

90. A decrease in ______________________ would increase net working capital.

a. accounts payable

b. accounts receivable

c. cash

d. equipment

Difficulty: Easy

Keywords: net working capital

91. Advantages of current liabilities include:

a. lower risk of illiquidity.

b. higher flexibility.

c. greater certainty of interest costs.

1. both a and b.
2. all of the above.

Difficulty: Moderate

Keywords: advantages of current liabilities

92. A quite risky working capital management policy would have a high ratio of:

a. short-term debt to bonds and equity.

b. short-term debt to total debt.

c. bonds to property, plant, and equipment.

d. short-term debt to equity.

Difficulty: Moderate

Keywords: working capital management

93. In general, the greater a firm’s reliance upon short-term debt or current liabilities, the lower the:

a. liquidity.

b. flexibility.

c. certainty of interest costs.

d. both a and c.

Difficulty: Moderate

Keywords: short-term debt, liquidity

94. The risk of a firm not being able to pay its bills on time is called:

a. illiquidity.

b. hedging.

c. cash conversion.

d. float.

Difficulty: Easy

Keywords: illiquidity

95. Which of the following will reduce the liquidity of a firm? An increase in:

a. short-term debt.

b. current liabilities.

c. current assets.

d. both a & b.

Difficulty: Moderate

Keywords: liquidity

96. A firm might use current liabilities versus long-term debt for financing because:

a. it could improve a firm’s return on assets.

b. generally it is less costly than long-term debt.

c. it offers greater flexibility.

d. all of the above.

Difficulty: Moderate

Keywords: advantages of short-term debt

97. A _________________ is an agreement where the borrower gives the lender a lien against all its inventories.

a. floating lien

b. blanket lien

c. chattel lien

1. both a and b
2. both b and c

Difficulty: Moderate

Keywords: blanket lien, floating lien

98. Total assets must equal the sum of which sources of financing?

a. Spontaneous

b. Temporary

c. Permanent

1. Both b and c
2. All of the above

Difficulty: Moderate

Keywords: sources of financing

99. 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. All of the above

Difficulty: Easy

Keywords: commercial paper

100. A disadvantage involved in investing in marketable securities is that:

a. this reduces the risk of illiquidity.

b. this investment increases net working capital.

c. this investment offers a flexible means of financing.

d. these assets offer little or no return.

Difficulty: Moderate

Keywords: marketable securities

101. Which of the following is a primary disadvantage involved with financing with current liabilities?

a. Interest rates on short-term debt are generally higher than on long-term debt.

b. Short-term debt is less flexible because it must be repaid more often.

c. Short-term debt leads to an uncertainty of interest costs from year to year.

d. Short-term debt consists of spontaneous debt, which is very unreliable.

Difficulty: Moderate

Keywords: current liabilities, disadvantages

102. Which of the following could offset the higher risk exposure a company would face if it were to engage in heavy short-term borrowing?

a. Its inventory would need to be mostly highly liquid consumer impulse items.

b. Its accounts receivable collection policy could increase the average collection period.

c. It could offer no discounts for early payment by its customers.

d. It could buy back some of its shares in the open market in order to reduce its equity.

Difficulty: Moderate

Keywords: risk and short-term borrowing

103. Which of the following is not consistent with the hedging principle?

a. The time pattern of a financial liability should be set to match the time pattern of the cash flows generated by the asset being financed.

b. A seasonal expansion should be financed with either a spontaneous or temporary source of financing.

c. An example of spontaneous financing is a short-term bank note.

d. Preferred stock is an example of a permanent source of financing.

Difficulty: Moderate

Keywords: hedging principle

104. Short-term financing is a primary source of funds for small to medium-size companies because:

a. short-term loans have almost no credit quality standards that the company must meet.

b. short-term interest rates typically are easier to predict than long-term interest rates.

c. most firms of this size do not have ready access to the bond and equity markets.

d. the firms’ owners do not have to give personal guarantees of repayment.

Difficulty: Moderate

Keywords: short-term financing, small firms

105. What is the conventional method for financing permanent levels of accounts receivable and inventory?

a. Bonds and equity

b. Short-term loans

c. Accounts payable and accrued expenses

d. Equity only

Difficulty: Moderate

Keywords: financing accounts receivable and inventory

106. With respect to working capital policy, firms most often employ:

a. a cautious approach which finances short-term assets with long-term financing.

b. the hedging principle.

c. an aggressive approach which finances long-term assets with short-term financing.

d. a mixture of all of the above.

Difficulty: Moderate

Keywords: working capital policy

107. The correct equation for calculating the cost of short-term credit is:

a. rate = interest/(principal × time).

b. rate = (principal × time)/interest.

c. rate = principal/(time × interest).

d. rate = principal × interest × time.

Difficulty: Easy

Keywords: cost of short-term credit

108. Abbott Corp. has a debt ratio of 37.5%, a days sales outstanding ratio of 49, a return on equity of 22.6%, a cash turnover of 14%, days sales in inventory of 83, a times interest earned of 1.5, and a days payables outstanding ratio of 36. What is Abbott’s cash conversion cycle?

a. 66

b. 56

1. 46
2. 36

Difficulty: Moderate

Keywords: cash conversion cycle

109. Which of the following is not a type of collateral for a short-term secured loan?

a. Accounts receivable

b. Inventories

1. Commercial paper
2. Both a and c

Difficulty: Moderate

Keywords: commercial paper

110. Which of the following is not an advantage of trade credit?

a. The amount of extended credit expands and contracts with the needs of the firm.

b. The cost of foregoing the discount is less than the prime rate.

c. Generally, no formal agreements are involved in the extension of trade credit.

d. None of the above.

Difficulty: Moderate

Keywords: advantage of trade credit

111. Which of the following statements regarding a line of credit is true?

a. The purpose for which the money is being borrowed must be stated by the borrower.

b. A line of credit agreement usually fixes the interest rate that will be applied to any extensions of credit.

c. A line of credit agreement is a legal commitment on the part of the bank to provide the stated credit.

d. Such agreements usually cover the borrower’s fiscal year.

Difficulty: Moderate

Keywords: line of credit

112. A level production schedule leads to:

1. the concept of just-in-time inventory management.

b. seasonal bulges and sharp declines in accounts receivable and inventory.

c. more overtime costs than would be true with a seasonal production schedule.

d. manpower and equipment use that is efficient at a lower cost.

Difficulty: Moderate

Keywords: level production, accounts receivable, inventory

113. Which item would constitute poor collateral for an inventory loan?

a. Lumber

b. Vegetables

c. Grain

d. Chemicals

Difficulty: Moderate

Keywords: collateral, inventory loan

114. The inventory loan arrangement in which all of the borrower’s inventories are used as collateral is termed a:

a. terminal warehouse agreement.

b. floating lien agreement.

c. chattel mortgage agreement.

d. field warehouse financial agreement.

Difficulty: Moderate

Keywords: inventory loan

115. A chattel mortgage:

a. is a relatively inexpensive form of credit.

b. is an agreement where all items in an inventory are subject to the lien.

c. allows the borrower to retain title to the inventory.

d. allows the borrower full control over the inventory.

Difficulty: Moderate

Keywords: chattel mortgage

116. Which of the following is an advantage of using commercial paper for short-term credit?

a. The ability of some firms to obtain large amounts of credit.

b. A readily available source of credit for most firms.

c. It is a type of free credit.

d. It can be issued for very small amounts.

Difficulty: Moderate

Keywords: commercial paper

117. The prime rate of interest is the rate the bank charges for its:

a. most credit-worthy borrowers.

b. lenders.

c. average borrower.

d. home mortgages.

Difficulty: Moderate

Keywords: prime rate of interest

118. Terminal warehouse agreements:

a. are particularly useful where large, bulky items are used as collateral.

b. give the lender a lien against all inventories while only removing representative items.

c. remove control of the inventory from the borrower.

d. are less costly than field warehouse agreements.

Difficulty: Moderate

Keywords: terminal warehouse agreements

119. Under a field warehouse financing agreement:

a. collateral inventories are physically separated from other inventories of the borrower.

b. collateral inventories are placed under the control of a third party.

c. a warehouse receipt is issued which might or might not be negotiable.

d. all of the above.

Difficulty: Moderate

Keywords: field warehouse financing

120. A company which foregoes the discount when credit terms are 4/15 net 70 is essentially borrowing money from his supplier for an additional:

a. 40 days.

b. 55 days.

c. 70 days.

d. 85 days.

Difficulty: Moderate

Keywords: credit terms

121. Which of the following loans provides the least amount of security to the lender?

a. Chattel mortgage

b. Factoring

c. Floating lien

d. Terminal warehouse agreement

Difficulty: Moderate

Keywords: floating lien

122. If the firm provides the lender with a general line on its receivables then the loan amount ranges from a maximum of __________ of the face value of the accounts downward.

a. 95%

b. 85%

c. 75%

d. 65%

Difficulty: Moderate

Keywords: general line on receivables

123. What factors should we consider when selecting a source of short-term credit?

a. Effective cost and availability

b. Liquidity and profitability

c. Historical trend analysis and liquidity

d. None of the above

Difficulty: Moderate

Keywords: short-term credit

124. Which of the following is not a source of unsecured short-term credit?

a. Trade credit

b. A line of credit

c. Floating lien

d. Commercial paper

Difficulty: Moderate

Keywords: unsecured short-term credit

125. Once a cash discount period has passed:

a. one should pay immediately.

b. there is no financial incentive to pay before the final due date.

c. one should pay after the final due date.

d. cannot be determined from the information.

Difficulty: Moderate

Keywords: credit terms

126. Unsecured short-term credit is characterized by:

a. one year or less maturity.

b. low cost collateral.

1. a maturity of more than one year.

d. both a and b.

Difficulty: Moderate

Keywords: unsecured short-term credit

127. In a revolving credit obligation:

a. a legal commitment is involved.

b. there is no legal obligation.

c. legality is dependent upon the size of the transaction.

d. none of the above.

Difficulty: Moderate

Keywords: revolving credit

128. The Stant Shoe Company established a line of credit with a local bank. The maximum amount that can be borrowed under the terms of the agreement is $100,000 at an annual rate of 12%. A compensating balance averaging 10% of the amount borrowed is required. Prior to the agreement, Stant had no deposit with the bank. Shortly after signing the agreement, Stant needed $50,000 to pay off a note that was due. It borrowed the $50,000 from the bank by drawing on the line of credit. What is the effective annual cost of credit?

a. 13.2%

b. 13.3%

c. 13.6%

d. 13.9%

Difficulty: Moderate

Keywords: effective annual cost of credit

129. Smith Enterprises has a line of credit with Fidelity National Bank that allows Smith to borrow up to $350,000 at an interest rate of 15%. However, Smith must keep a compensating balance of 10% of any amount borrowed on deposit at Fidelity. Smith does not normally keep a cash balance account with Fidelity. What is the effective annual cost of credit (round to nearest .01 percent)?

a. 17.8%

b. 17.52%

c. 16.91

d. 16.67%

Difficulty: Moderate

Keywords: effective annual cost of credit

130. Georgia Peaches Corporation (GPC) has a line of credit with Trust Company Bank that allows GPC to borrow up to $300,000 at an annual interest rate of 11%. However, GPC must keep a compensating balance of 20% of any amount borrowed on deposit at the Trust Company Bank. GPC does not normally have a cash balance account with the Trust Company. What is the effective annual cost of credit?

a. 13.75%

b. 13.95%

c. 14.15%

d. 15.55%

Difficulty: Moderate

Keywords: effective annual cost of credit

131. Which of the following is an unsecured short-term bank loan made for a specific purpose?

a. Trade credit

b. Line of credit

c. Revolving credit agreement

d. Transaction loan

Difficulty: Moderate

Keywords: transaction loan

132. Which of the following comparisons between short-term bank loans is correct?

a. Commercial paper interest rates are usually slightly higher than rates on bank loans.

b. Commercial paper is only appropriate for firms requiring a limited amount of short-term financing, while banks can offer substantially larger amounts of funds.

c. Banks demand that borrowers meet exacting credit-worthiness tests, while the lenders that purchase commercial paper are less strict. Only the most credit-worthy borrowers have access to bank loans.

d. None of the above.

Difficulty: Moderate

Keywords: short-term bank loans

133. The Stoney River Pennant Company uses commercial paper to satisfy part of its short-term financing requirements. Next week, it intends to sell $50 million in 180-day maturity paper on which it expects to have to pay discounted interest at an annual rate of 19% per annum. In addition, Stoney River expects to incur a cost of approximately $100,000 in dealer placement fees and other expenses of issuing the paper. What is the effective annual cost of credit to Stoney River (round to the nearest .1 percent)?

a. 17.5%

b. 19.0%

c. 21.5%

d. 23.0%

Difficulty: Moderate

Keywords: effective annual cost of credit

134. The Dorle Manufacturing Company is going to issue 180-day commercial paper to raise $40 million. It anticipates a discounted interest rate of 13% and dealer placement costs of approximately $60,000. What is the effective annual cost of credit to Dorle (round to the nearest .01 percent)?

a. 14.25%

b. 13.90%

c. 12.75%

d. 11.60%

Difficulty: Moderate

Keywords: effective annual cost of credit

135. The effective annual cost of not taking advantage of the 3/10, net 30 terms offered by a supplier is (hint: use $1.00 as the invoice amount and a 360-day year):

a. 55.7%.

b. 45.4%.

c. 32.3%.

d. 28.2%.

Difficulty: Moderate

Keywords: effective annual cost of credit

136. Atlas Tire Irons, Inc. is considering borrowing $5,000 for a 90-day period. The firm will repay the $5,000 principal amount plus $150 in interest. What is the effective annual rate of interest (use a 360-day year)?

a. 9%

b. 12%

c. 15%

d. 18%

Difficulty: Moderate

Keywords: effective annual cost of credit

137. Which of the following apply to commercial paper?

a. It usually has a maturity of six months or less.

b. It generally carries an interest rate of slightly less than prime.

c. It is secured by a firm’s assets.

d. Both a and b.

e. Both a and c.

Difficulty: Moderate

Keywords: commercial paper

138. A floating lien, a chattel mortgage, and a terminal warehouse receipt have which of the following in common?

a. They all pledge accounts receivables as security.

b. They have nothing in common.

c. They are all unsecured forms of financing.

d. They all use inventory to secure a loan.

Difficulty: Moderate

Keywords: floating lien, chattel mortgage, terminal warehouse receipt

139. Which of the following would not be considered an unsecured loan?

a. Accrued tax payments

b. Line of credit

c. Transaction loans

d. Floating lien agreement

Difficulty: Moderate

Keywords: unsecured lien

140. The least likely factor to be considered when selecting a source of short-term credit is the:

a. financial market environment.

b. availability of credit in the amount needed.

c. influence of the use of a particular credit source on the cost of other sources of financing.

d. influence of the use of a particular credit source on the availability of other sources of financing.

Difficulty: Moderate

Keywords: short-term credit

141. The primary advantage that pledging accounts receivable provides is:

a. the flexibility it gives to the borrower.

b. that the financial institution bears the risk of collection.

c. the low cost as compared with other sources of short-term financing.

d. that the financial institution services the accounts.

Difficulty: Moderate

Keywords: pledging accounts receivable

142. The terminal warehouse agreement differs from the field warehouse agreement in that the:

a. cost of the terminal warehouse agreement is lower due to the lower degree of risk.

b. borrower of the field warehouse agreement can sell the collateral without the consent of the lender.

c. warehouse procedure differs for both agreements.

d. terminal agreement transports the collateral to a public warehouse.

Difficulty: Moderate

Keywords: terminal warehouse agreement

143. Within the context of working capital management:

a. as the firm increases its investment in working capital, there is a corresponding increase in its profits.

b. current liabilities provide a flexible means of financing the firm’s fluctuating needs for assets.

c. the use of current liabilities or short-term debt as opposed to long-term debt subjects the firm to less risk of illiquidity.

d. all of the above.

Difficulty: Moderate

Keywords: working capital management

144. The Omega Corp. plans to borrow $10,000 for a 60-day period. At maturity, Omega will repay the $10,000 principal plus interest at an annual rate of 12%. What is the effective rate of interest on this loan?

a. 12.62%

b. 12.13%

c. 11.47%

d. 11.22%

Difficulty: Moderate

Keywords: effective rate of interest

145. The cost of trade credit varies with the:

a. size of the cash discount.

b. length of time between the end of the discount period and the final due date.

c. length of time between the end of the discount period and when the firm purchased from the supplier.

d. both a and c.

Difficulty: Moderate

Keywords: cost of trade credit

146. Which of the following is an advantage of trade credit?

a. Trade credit is conveniently obtained as a normal part of the firm’s operations.

b. No formal agreements are generally involved in extending credit.

c. The amount of credit extended expands and contracts with the needs of the firm.

d. All of the above.

Difficulty: Moderate

Keywords: trade credit

Use the following information to answer questions 153-154. Quick Corp. makes its purchases under terms of 2/10 net 30.

147. If Quick Corp. foregoes the discount and pays for its purchases according to the terms of its trade credit, what is Quick’s effective cost of using this source of credit?

1. 26.67%
2. 31.48%

c. 36.73%

d. 51.32%

Difficulty: Moderate

Keywords: cost of trade credit

148. If Quick foregoes the discount but does not pay for its purchases until day 40, what is Quick’s effective cost of using this source of credit?

a. 38.37%

b. 36.73%

c. 26.67%

d. 24.49%

Difficulty: Moderate

Keywords: cost of trade credit

149. When a commercial bank extends short-term credit to a firm, it can provide a line of credit that involves:

a. a legal obligation on the part of the bank to provide the stated credit.

b. no legal obligation on the part of the bank to provide the stated credit.

c. the requirement that the borrower maintain a compensating balance with the bank throughout the loan period.

d. a fixed rate of interest.

Difficulty: Moderate

Keywords: line of credit

Use the following information to answer questions 156-157. ABC, Inc. requires $270,000 in short-term credit and is currently arranging a loan with its bank. ABC plans to use the funds for six months, the annual rate on the loan is 12%, and the bank will require a 10% compensating balance.

150. If ABC must have loan proceeds of $270,000, then it must borrow:

a. $270,000.

b. $300,000.

c. $410,000.

d. $500,000.

Difficulty: Moderate

Keywords: amount of borrowing, compensating balances

151. What is the effective annual cost of the loan?

a. 15.67%

b. 14.00%

1. 13.33%
2. 12.83%

Difficulty: Moderate

Keywords: effective annual cost of loan

152. A firm will borrow $1 million for six months on a discount basis. The annual interest rate on the loan is 12%. What is the effective annual cost of the loan?

a. 11.00%

b. 12.77%

c. 13.00%

d. 14.23%

Difficulty: Moderate

Keywords: effective annual cost of loan

a. are made for a specific purpose.

b. when unsecured, are very similar to a line of credit regarding cost, term to maturity, and compensating balance requirements.

c. often include clean-up requirements.

d. have all of the properties stated above.

Difficulty: Moderate

Keywords: transaction loans

154. Commercial paper:

a. rates are generally higher than rates on bank loans and comparable sources of short-term financing.

b. generally has a minimum compensating balance requirement.

c. offers the firm with very large credit needs a single source for all its short-term financing.

d. has all of the properties stated above.

Difficulty: Moderate

Keywords: commercial paper

155. Gamma, Inc. plans to sell $1 million in 270-day-maturity commercial paper on which it will pay discounted interest at an annual rate of 12%. In addition, Gamma expects to incur a cost of $1,000 in dealer placement fees and other expenses to issue the paper. What is the effective cost of the paper to Gamma?

a. 12.22%

b. 12.78%

c. 13.20%

d. 13.35%

Difficulty: Moderate

Keywords: effective cost, commercial paper

Use the following information to answer questions 162-163. Assume that your firm sells supplies to firms on terms of net 60 leading to an average accounts receivable balance of $400,000 for the 60-day period, and that your firm pledges all its receivables to a local bank. The bank in turn advances up to 70% of the face value of the receivables at 3% over prime and with an annual processing charge on all receivables pledged of $24,000. Your firm borrows the maximum amount possible, and currently prime is 10%.

156. What is the effective cost of this arrangement?

a. 21.57%

b. 19.10%

c. 17.32%

d. 15.40%

Difficulty: Moderate

Keywords: effective cost, pledging receivables

157. If, in addition to the terms stipulated above, your firm saves credit department expenses of $20,000 per year by pledging all of its receivables and letting the lender provide those services, then the effective cost is:

a. 12.86%.

b. 13.37%.

c. 14.43%.

d. 15.01%.

Difficulty: Moderate

Keywords: effective cost, pledging receivables

158. Pledging accounts receivable as a source of short-term credit:

a. has the primary advantage of flexibility.

b. provides financing that is available on a continuous basis.

c. has the primary disadvantage of a relatively high cost compared with other sources of short-term credit.

d. has all of the above characteristics.

Difficulty: Moderate

Keywords: pledging accounts receivable

159. Net working capital refers to which of the following?

a. Current assets

b. Current assets minus current liabilities

c. Current assets minus inventory

d. Current assets divided by current liabilities

e. Current assets minus inventory divided by current liabilities

Difficulty: Moderate

Keywords: net working capital

160. Which of the following is most likely to occur if a firm over-invests in net working capital?

a. The current ratio will be lower than it should be.

b. The quick ratio will be lower than it should be.

c. The return on investment will be lower than it should be.

d. The times interest earned ratio will be lower than it should be.

Difficulty: Moderate

Keywords: net working capital

161. Which of the following is most likely to occur if a firm under-invests in net working capital?

a. The firm might not have sufficient cash to pay its bill in a timely manner.

b. The firm might not have adequate inventory to meet the needs of its customers.

c. The firm could be losing sales because its terms of sale are too strict.

d. All of the above.

Difficulty: Moderate

Keywords: net working capital

162. Which of the following best illustrates the hedging principle as it applies to the management of working capital?

a. Don’t place all your eggs in one basket.

b. Temporary current assets of the firm should be financed with short-term sources of funds.

c. Permanent current assets of the firm should be financed with short-term sources of funds.

d. All current assets should be financed with short-term sources of funds.

Difficulty: Moderate

Keywords: working capital management

163. All else equal, which of the following is the most likely to occur if actual sales are much less than forecasted sales?

a. The company will be in a better position to pay down most of its debt.

b. The firm’s actual investment in inventory will be unchanged from the amount forecasted.

c. Accounts receivable will rise significantly above the forecast.

d. The company might face a cash flow crunch.

Difficulty: Moderate

Keywords: forecasted versus actual sales

164. Which of the following describes what will most likely occur if a firm uses a level production schedule when its sales are quite seasonal?

a. As sales decrease, accounts receivable remain level.

b. As sales decrease, inventory will decrease.

c. As sales decrease, inventory will increase.

d. As sales increase, accounts payable will remain constant.

Difficulty: Moderate

Keywords: seasonal sales

165. Which of the following is not an advantage for a company using cash budgeting procedures?

a. It makes forecasting short-term interest rates more accurate.

b. It makes managing inventory easier under a seasonal production approach.

c. It highlights the fluctuating levels of accounts receivable and inventory for a given production plan.

d. It helps the firm plan its current asset levels for a given production plan.

Difficulty: Moderate

Keywords: cash budgeting

166. Which of the following is considered to be a spontaneous source of financing?

a. Trade credit

b. Bonds

c. Common stock

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: spontaneous financing

167. Which of the following is considered to be a temporary source of financing?

a. Long-term debt

b. Accounts receivable

c. Short-term notes payable

d. All of the above

Difficulty: Moderate

Keywords: temporary financing

168. Which of the following is considered to be a permanent source of financing?

a. Trade credit

b. Long-term debt

c. Accounts receivable

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: permanent financing

169. A firm buys on terms of 3/10, net 30. What is the cost of trade credit under these terms?

a. 55.7%

b. 47.4%

c. 31.5%

d. 23.2%

Difficulty: Moderate

Keywords: cost of trade credit

170. Which of the following is a source of short-term funds?

a. Commercial paper

b. Bank loan

c. Accounts payable

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: short-term financing

171. Which of the following best describes commercial paper?

a. Long-term promissory notes of large corporations that maintain high credit ratings

b. Short-term promissory notes of large corporations that maintain high credit ratings

c. Preferred stock of large corporations that maintain high credit ratings

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: commercial paper

172. Which of the following best describes factoring?

a. The outright sale of a firm’s inventory to a financial institution

b. The outright sale of a firm’s notes payable to a financial institution

c. The outright sale of a firm’s accounts receivable to a financial institution

d. The outright sale of a firm’s factories to a financial institution

e. None of the above

Difficulty: Moderate

Keywords: factoring

173. Which of the following would be considered an issue that is related to the management of working capital?

a. How much inventory should the firm maintain?

b. How should a firm finance its current assets?

c. To whom should the firm grant trade credit?

d. All of the above.

e. None of the above.

Difficulty: Moderate

Keywords: working capital management

174. Which of the following is a method of pledging inventory in order to secure a loan?

a. Mortgage agreement

b. Field warehousing

c. Factoring

d. All of the above

e. None of the above

Difficulty: Moderate

Keywords: pledging inventory

175. A firm sells on terms of 2/10, net 30. What is the cost of trade credit under these terms?

a. 66.3%

b. 53.3%

c. 42.0%

d. 36.7%

Difficulty: Moderate

Keywords: trade credit

176. An index rate of interest charged by banks to their credit-worthy customers is referred to as the:

a. federal funds rate.

b. prime rate.

c. cost of funds.

d. risk-free rate.

Difficulty: Moderate

Keywords: prime rate

177. The result of a bank requiring compensating balances when extending a loan to a customer that would not otherwise carry account balances with the bank is to __________ the effective interest rate of the loan to the borrower.

a. increase

b. complicate

c. decrease

d. have no impact on

Difficulty: Moderate

Keywords: compensating balances

178. Your firm can borrow from its bank at a rate of 10.75% with a 15% compensating balance requirement. Assuming that your firm would not normally carry any deposits at the bank that is extending credit, what is the effective annual rate of interest on the line of credit?

a. 10.14%

b. 11.75%

c. 12.65%

d. 13.52%

Difficulty: Moderate

Keywords: effective rate of interest

179. Implementation of a just-in-time inventory control system accomplishes which of the following objectives?

a. Reduces a firm’s opportunity cost related to its investment in inventory

b. Reduces a firm’s inventory carrying costs

c. Improves a firm’s return on investment

d. All of the above

Difficulty: Moderate

Keywords: just-in-time inventory

180. Sargent Electric Acceptance Corporation regularly uses commercial paper in order to finance its current operations. The firm plans to sell $75 million in commercial paper, on which it expects to pay discounted interest at a rate of 7.5% ($5,625,000) per annum. In addition, Sargent Electric will incur a cost of $75,000 in fees related to the issuance of the commercial paper. What is the effective cost of credit to Sargent Electric?

a. 6.50%

b. 7.25%

c. 7.47%

d. 8.23%

e. 8.75%

Difficulty: Moderate

Keywords: effective cost of credit

181. Bank Two extends a $3 million revolving line of credit to Capital Corp. The rate of interest on the revolver is 9.5%. Bank Two requires Capital to maintain compensating balances equal to 10% of the amount of the line. In addition, Bank Two requires a loan fee of 1%, or $30,000. If you assume that Capital would not normally carry any deposits at the bank, what is the effective annual rate of interest on the loan?

a. 9.5%

b. 10.7%

c. 11.6%

d. 12.3%

Difficulty: Moderate

Keywords: effective annual rate of interest

Short Answer

182. Describe the differences between secured and unsecured short-term credit.

Difficulty: Easy

Keywords: secured versus unsecured short-term credit

183. Discuss the advantages of using commercial paper.

Difficulty: Moderate

Keywords: commercial paper

184. The balance sheet for Peterson Manufacturing Company is presented below.

Peterson Mfg. Co.

Balance Sheet

December 31, 1995

Cash $12,000 Current liabilities $72,000

Accounts receivable 60,000 Long-term liabilities 48,000

Inventories 48,000 Common equity 120,000

Total current assets $120,000

Net fixed assets 120,000

Total $240,000 Total $240,000

During 1995, the firm earned $28,000 after taxes based on net sales of $480,000.

a. Calculate Peterson’s current ratio, net working capital, and return on total assets.

b. Peterson is considering a plan to enhance the firm’s liquidity. The plan involves raising $24,000 in common equity and investing in marketable securities which will earn 8% before taxes and

4.8% after taxes. Calculate Peterson’s current ratio, net working capital, and return on total assets after the plan has been implemented.

c. Will the plan proposed in question (b) enhance the firm’s liquidity? Explain your answer.

d. What effect does the plan proposed in question (b) have on the firm’s profitability? Explain your answer.

a. Current ratio = ($120,000)/($72,000) = 1.67

Net working capital = $120,000 - $72,000 = $48,000

Return on total assets = ($28,000)/($240,000) = 11.67%.

b. Current ratio = ($145,152)/($72,000) = 2.02

Net working capital = $145,152 - $72,000 = $73,152

Return on total assets = ($29,152)/($265,152) = 10.99%.

c. Yes, the firm’s liquidity position as measured by the current ratio and the amount of net working capital has definitely improved.

However, the firm’s profitability has declined.

d. Peterson’s return on total assets declined from 11.67% to 10.99% as a result of the new financing plan. The firm was earning 11.67% after taxes on its investment of $240,000. It invested $24,000 in marketable securities earning only 4.8% after taxes. The result was a decline in firm profitability relative to its assets.

Difficulty: Moderate

Keywords: net working capital

185. The December 31, 1995 balance sheet for Spitco, Inc. is presented below.

Spitco, Inc. Balance Sheet

December 31, 1995

Current assets $40,000

Net fixed assets 20,000

Total $60,000

Accounts payable 11,000

Notes payable 12,000

Total $23,000

Long-term debt (10%) 12,000

Common equity 25,000

Total $60,000

Partial Income Statement for December 31, 1995

Net operating income $10,291

Less: interest income 1,200

Earnings before taxes $9,091

Less: taxes (34%) 3,091

Net income $ 6,000

a. Calculate Spitco’s current ratio, net working capital, and return on total assets.

b. Spitco feels that its current ratio is too far below the industry average of 2.40. To improve their liquidity, the treasurer of Spitco has devised a plan to issue $12,000 in long-term debt at 12%

and pay off its notes payable. The funds would be invested in marketable securities at 7% interest when not needed to finance the firm’s seasonal asset needs. The notes payable would remain outstanding through the year. Assume this plan had been implemented for 1993. The net income was $5,500. Calculate what the firm’s current ratio, net working capital, and return on total assets would have been.

c. Did Spitco improve their liquidity? What about their profitability?

a. Current ratio = (current assets)/(current liabilities) =

($40,000)/($23,000) = 1.74x

Net working capital = current assets - current liabilities =

$40,000 - $23,000 = $17,000

Return on total assets = ($6,000)/($60,000) = 10%.

b. Current ratio = ($40,000)/($11,000) = 3.64x

Net working capital = $40,000 - $11,000 = $29,000

Return on total assets = ($5,500)/($60,000) = 9.2%.

c. Yes, liquidity is now well above the industry average, but the firm’s profitability has fallen with this increase.

Difficulty: Moderate

Keywords: net working capital

186. Fybert Toy, Inc. is really making it big in Texas. Their sales predictions for next year are $9 million, and fixed assets will grow to $1,890,000. Projected earnings before interest and taxes are 22% of sales with a 34% tax rate. Fybert’s policies in the past have been carefully monitored. They have maintained an interest rate of 11% on all short- and long-term loans, which totals 32% of all assets. Fybert is now struggling over how their investment in current assets is affecting the return on common shareholders’ equity.

a. What is the company’s return on equity based upon a working capital strategy calling for a current asset-to-sales ratio of 35%?

b. Assuming the same information, answer (a) based upon a current-asset-to-sales ratio of 50%.

a. Fybert Toy, Inc.’s proforma balance sheet appears as follows:

Current assets $3.15m Debt $1.61m

Fixed assets 1.89m Equity 3.43m

Total $5.04m Total $5.04m

The firm’s proforma statement of earnings is the following:

Sales $9.000m

EBIT 1.9800m

Interest (.1771m)

EBT 1.8029m

Taxes (34%) (.6130m)

Net income $1.1899m

Thus, return on equity = $1.1899m/$3.43m = 34.7%

b.

Current assets $4.500m Debt $2.045m

Fixed assets 1.890m Equity 4.345m

Total assets $6.390m Total $6.390m

Sales $9.000m

EBIT 1.980m

Interest (.225m)

EBT 1.755m

Taxes (.597m)

Net income $1.158m

Return on equity =$1.158m/$4.345m = 26.7%

Difficulty: Moderate

Keywords: working capital, current-assets-to-sales ratio

187. On June 30, 19X1, the Alexander Bosh Coffee Co.’s balance sheet and income statement are as follows:

Balance Sheet Income Statement

June 30, 19X1 June 30, 19X1

Current assets $800,000 Net operating income $600,000

Net fixed assets 700,000 Less: interest expense (108,000)

Total assets $1,500,000 Earnings before taxes 492,000

Accounts payable $300,000 Less: taxes (34%) (167,280)

S-T notes payable (15%) 500,000 Net income $324,720

Total current liabilities $800,000

Long-term debt (11%) $300,000

Common equity 400,000

Total $1,500,000

a. Calculate the current ratio, net working capital, return on total assets, and return on common equity ratio for Alexander Bosh.

b. Recalculate the ratios from (a) and assess the change in the firm’s liquidity if the firm plans to issue $500,000 in common stock and use the proceeds to retire the firm’s notes payable.

a. Current ratio = $800,000/$800,000 = 1.0

Net working capital = $800,000 - $800,000 = 0.0

Return on total assets = $324,720/$1.5 million = 21.65%

Return on common equity = $324,720/$400,000 = 81.8%

b. Current ratio = $800,000/$300,000 = 2.667

Net working capital = $800,000 - $300,000 = $500,000

Return on total assets = $374,220/$1.5 million = 24.95%

Return on equity = $374,220/$900,000 = 41.58%

NOTE: Liquidity has improved with the current ratio, rising from 1.00 to 2.667 and net working capital from 0 to $500,000.

Difficulty: Moderate

Keywords: working capital, liquidity, net working capital, return on equity

188. Given your actions in part (b) in the previous problem, assume now that Alexander Bosh will finance a three-month seasonal need for $500,000 with a long-term bond issue that will carry an interest cost of 13%. In the nine months that the company will not need the funds, they can be reinvested in marketable securities to earn a rate of 11%. Recalculate the financial ratios in (a) of the previous problem. Analyze the results of the new proposal.

Finance three-month seasonal need for $500,000 with long-term bonds at 13% interest for three months inventories and receivable will increase by $500,000 for the other nine months, $500,000 can be invested in marketable securities earning 11%.

Current ratio = $1,300,000/300,000 = 4.33

Net working capital = $1,300,000 - $300,000 = $1,000,000

Return on total assets* = $358,545/2 million = 17.93%

Interest income on marketable securities = $500,000 × .11 × 9/12 = $41,250

Return on equity* = $358,545/$900,000 = 39.84%

Income Statement

*NOI $600,000

Less: interest expense (33,000 + 65,000) (98,000)

Plus: interest income $ 41,250

Earnings before taxes $543,250

Less: taxes (40%) (184,705)

Net income $358,545

Balance Sheet

Current assets $1,300,000 Current liabilities $300,000

Fixed assets $700,000 Long-term debt $800,000

Total $2,000,000 Common equity $900,000

Total $2,000,000

The liquidity position has steadily improved as the current ratio and net working capital are 9.00 and $800,000, respectively. However, profitability has steadily declined due to the cost of permanent financing sources (bonds) exceeding the earnings on marketable securities. Both total assets and common equity are generating less return.

Difficulty: Moderate

Keywords: working capital, liquidity, net working capital, return on equity

189. Canopy Cannery, Inc. estimates that its current assets are about 30% of sales. The firm’s current balance sheet is presented below.

Canopy Cannery, Inc.

Balance Sheet

December 31, 19X5

Current assets $2.7m Trade credit and accounts payable $1.35m

Fixed assets 1.3m Long-term debt 1.65m

Total $4m Common Equity 1.0m

Total $4m

Canopy Cannery, Inc. pays out all of its net income in cash dividends to its stockholders. Trade credit and accounts payable equal 15% of the firm’s sales. Based on the following five-year sales forecast, prepare five end-of-year pro forma balance sheets that indicate additional financing needed for each year as a balancing account. Fixed assets are expected to increase by $.5 million per year.

Year Predicted Sales

19X6 11

19X7 13

19X8 12

19X9 10

19X0 14

Canopy Cannery, Inc.

Forecast of Financial Needs

Trade Long- Added

Pred. Curr. Fixed Total Credit Term Comm. Fin.

Year Sales Assetsa Assetsb Assets &A/Pc Debtd Equityd Needede

19X6 $11m $3.3m $1.8m $5.1m $1.65m $1.65m $1m $0.80m

19X7 13m 3.9m 2.3m 6.2m 1.95m 1.65m 1m 1.60m

19X8 12m 3.6m 2.8m 6.4m 1.80m 1.65m 1m 1.95m

19X9 10m 3.0m 3.3m 6.3m 1.50m 1.65m 1m 2.15m

19X0 14m 4.2m 3.8m 8.0m 2.10m 1.65m 1m 3.25m

a. 0.30 × sales.

b. Growing by $.5 million each year.

c. (0.15) × (sales).

d. Assumed to remain unchanged.

e. Total assets - trade credit and accounts payable - long-term debt - common equity.

Difficulty: Moderate

Keywords: additional financing needed

190. Calculate the effective cost of the following trade credit terms if the discount is foregone and payment is made on the net due date.

a. 2/15 net 30

b. 2/15 net 45

c. 2/15 net 60

a. ($0.02/$0.98) × [1/(15/360)] = .4898

b. ($0.02/$0.98) × [1/(30/360)] = .2449

c. ($0.02/$0.98) × [1/(45/360)] = .1633

The cost of foregoing trade credit decreases as the length of time between the end of the discount period and the end of the net due period increases.

Difficulty: Moderate

Keywords: cost of foregoing trade credit

191. The U.R. Bloom Corporation established a line of credit with a local bank. The maximum amount that can be borrowed under the terms of the agreement is $125,000 at a rate of 14%. A compensating balance averaging 10% of the loan is required. Prior to the agreement, URB had maintained an account at the bank averaging $10,000. Any additional funds needed for the compensating balance will also have to be borrowed at the 14% rate. If the firm needs $100,000 for six months, what is the annual cost of the loan?

Borrowed funds = ($100,000/0.9) - $10,000

Borrowed funds = $101,111

Rate = [$101,111 × (.14/2)]/($100,000) × [1/(180/360)]

Rate = .1416 per year.

Difficulty: Moderate

Keywords: annual loan cost, compensating balance

192. Maximus, Inc. is planning to issue $2 million in 270-day maturity notes carrying a rate of 16% per annum. Due to the size of this firm, its commercial paper will be placed at a cost of $8,000. What is the effective cost of credit to Maximus?

Rate = ($240,000 + $8,000)/($2,000,000 - $8,000 - $240,000) × [1/(270/360)] = .1887

Difficulty: Moderate

Keywords: effective cost of credit, commercial paper

193. The Smith Corporation is a maker of fine stereo components and presently has finished goods inventories of $750,000. They need a short-term bank loan of $500,000 for three months. The bank has proposed two different financing arrangements. The first is a floating lien arrangement at a rate of 16%. The second proposal is for a terminal warehouse arrangement at 13%. Under the latter proposal, Smith will pay $3,000 a month plus round-trip shipping expense of $4,000. Which source of credit should be selected by the Smith Corporation? Explain your answer.

Floating lien arrangement:

Annual rate = 0.1600

Terminal warehouse arrangement:

Annual rate = ($16,250 + $9,000 + $4,000)/($500,000) × [1/(90/360)] = 0.2340

The additional expenses of the terminal warehouse arrangement make it more expensive than the floating lien arrangement.

Difficulty: Moderate

Keywords: floating lien

194. Rainbow Records is a producer and distributor of specialty recordings. It sells directly to large retail firms on terms of net 90 and has average monthly sales of $150,000. It has recently decided to pledge all of its accounts receivable to its bank. The bank advances up to 60% of the face value of these receivables at a rate of 2% over the prime rate, while charging 2% on all receivables pledged for processing to cover billing and collection services. Prior to this arrangement, Rainbow Records was spending $25,000 a year on its credit department. The prime rate is 15%.

a. What is the average level of accounts receivable?

b. What is the effective cost of using this short-term credit for one year?

a. 3 × $150,000 = $450,000

b. Rate = ($45,900 + $36,000 - $25,000)/(270,000) × [1/(360/360)] =0.2107

Annual interest expense = 0.17 × 0.60 × $450,000 = $45,900

Difficulty: Moderate

Keywords: effective cost of short-term credit

195. The effective interest rate on short-term loans from Bank A is 16% per year. Bank B claims that their interest rate is only 14.5% per year. However, Bank B charges interest on a discount basis. Which bank is charging the lowest effective rate of interest on a one-year loan?

Effective cost of loan from Bank A = .1600

Effective cost of loan from Bank B = .145/(1 - .145) = .1696

Bank A is charging the lowest effective rate of interest.

Difficulty: Moderate

Keywords: effective loan cost

196. AAC, Inc. is planning to issue $5 million in 180-day maturity notes earning a rate of 12% per annum. The company expects to incur costs of approximately $20,000 in dealer placement fees and other expenses of issuing the commercial paper. The company plans to back up their commercial paper offering with a line of credit from a bank for $5 million. The compensating balance requirement is 10% of the line of credit. The company normally maintains $450,000 in its accounts with the bank. What is the effective cost of the commercial paper offering?

Additional funds tied up with compensating balance requirements =

(.10)($5,000,000) - $450,000 = $50,000

Interest on commercial paper = (.12)($5,000,000)(180/360) = $300,000

Effective rate =

($300,000)/($5,000,000 - $20,000 - $300,000 - $50,000) × [1/(1/2)] =

($300,000/$4,630,000) × 2 = .1296

Difficulty: Moderate

Keywords: effective cost of commercial paper

197. Your company needs to pay $10,000 for the overhaul of five trucks. A bank offers you a loan at 18% per annum with a compensating balance requirement of 15% of the loan amount. You plan to borrow the money for nine months and currently do not have an account with this bank. What is the effective cost of the loan?

(.85)(loan amount) = $10,000

Loan amount = ($10,000/.85) = $11,765

Interest on loan = (.18)($11,765)(9/12) = $1,588

Rate = ($1,588/$10,000) × [1/(9/12)] = .2117

Difficulty: Moderate

Keywords: effective loan cost

198. Staplers, Inc. has a $400,000 line of credit with a local bank. The bank requires a compensating balance of 10% of the loan and extends credit to Staplers at 0.5% over the current prime rate. Staplers needs the use of $100,000 for a three-month period. They currently have no deposits with the lending bank.

a. What will be the effective annual cost of this credit? (Assume a 360-day year and a 10.5% prime rate.)

b. Using the above information, what would be the effective interest rate if the firm discounted the interest on the loan?

a. Loan amount to cover compensating balance

.90B = $100,000

B = $111,111

Interest paid on the $111,111:

$111,111 × .11 × 1/4 = $3055.56

Effective annual cost:

Rate = ($3055.56/$100,000) × [1/(90/360)] = 12.22%

b. Rate = [$3055.56/($100,000 - $3055.56)] × [1/(90/360)] = 12.61%

$35,000 × 0.13 = $4,550

$379/month interest

$5,250 compensating balance

Difficulty: Moderate

Keywords: effective annual cost of credit, effective annual interest rate

199. Dazzly Diamond Corp. called for credit at the Home Alone Bank of Paris, TX. The terms included a $35,000 maximum loan with interest of 1% over prime, and the agreement also requires a 15% compensating balance throughout the year. The prime rate is currently 12%.

a. If Dazzly Diamond Corp. maintains a balance in its account of $5,250 to $6,000, what is the effective cost of credit through the line of credit agreement where the maximum amount of the loan is used?

b. Recompute the effective cost of credit to Dazzly Diamond if it will have to borrow the compensating balance and the maximum amount possible under the agreement.

a. Rate = ($4,550/$35,000) × [1/(360/360)] = 0.13 or 13%

b. Rate = ($4,550/$29,750) × [1/(360/360)] = 0.1529 or 15.29%

Interest expense for the loan is ($35,000) (0.13) (360/360) = $4,550

However, the firm gets the use of only .85 × $35,000 = $29,750.

Difficulty: Moderate

Keywords: effective cost of credit

200. Quincy Fathows & Co. plans to issue commercial paper for the first time in its 85-year history. The firm plans to issue $400,000 in 120-day maturity notes. The paper will carry a 13% quarterly compounded rate with discounted interest and will cost Quincy Fathows $8,000 in advance to issue.

a. What is the effective cost of credit to Quincy Fathows?

b. What other factors should the firm consider in analyzing whether or not to issue the commercial paper?

a. Rate = (interest/principal) × (1/time)

Rate = ($17,333* + $8,000)/($400,000 - $8,000 - $17,333) ×

[1/(120/360)] = .203 = 20.3%

*Interest = 0.13 × $400,000 × 1/3

b. The risk involved with the issue of commercial paper should be considered. This risk relates to the fact that the commercial paper market is highly impersonal and denies even the most credit- worthy borrower any flexibility in terms of when repayment is made. In addition, commercial paper is a viable source of credit to only the most credit-worthy borrowers. Thus, it might simply not be available to the firm.

Difficulty: Moderate

Keywords: effective cost of credit

201. Richenstein Enterprises is in the business of selling dishwashers. The firm needs $192,000 to finance an anticipated expansion in receivables due to increased sales. Richenstein’s credit terms are net 40, and its average monthly credit sales are $180,000. In general, the firm’s customers pay within the credit period; thus, the firm’s average accounts receivable balance is $240,000.

The comptroller of Richenstein Enterprises, Mr. Gee, approached their bank for the needed capital, placing the accounts receivable as collateral. The bank offered to make the loan at a rate of 2% over prime plus a 1% processing charge on all receivables pledged. The bank agreed to loan up to 80% of the face value of the receivables pledged.

a. Estimate the cost of the receivables loan to Richenstein where the firm borrows the $192,000. The prime rate is currently 13%.

b. Gee also requested a line of credit for $192,000 from the bank. The bank agreed to grant the necessary line of credit at a rate of 4% over prime and required a 12% compensating balance. Gee currently maintains an average demand deposit of $40,000. Estimate the cost of the line of credit to Richenstein.

c. Which source of credit should Richenstein Enterprises select?

a. Rate = [($28,800* + $21,600**)/$192,000] × [1/(360/360)]= .2625 or

26.25%

*($240,000 × 0.15 × .8) = $28,800

bLs**($180,000 × .01 × 12) = $21,600

b. $192,000 × .12 = $23,040 (compensating balance)

Since Richenstein maintains a balance of $40,000 normally with the bank, the compensating balance requirement will not increase the effective cost of credit.

($32,640/$192,000) × [1/(360/360)] = 0.17 or 17%

Interest = $192,000 × .17 = $32,640

c. Choose the line of credit since the effective interest is considerably lower. Note, however, that the pledging arrangement might involve credit services to Richenstein which would reduce

Richenstein’s credit department expenses. If this were the case, then these savings would reduce the effective cost of that financing arrangement.

Difficulty: Moderate

Keywords: cost of receivables, cost of line of credit

202. Bonneau Sunglass Co. is considering the factoring of its receivables. The firm has credit sales of $500,000 per month and has an average receivables balance of $1 million with 60-day credit terms. The factor has offered to extend credit equal to 85% of the receivables factored less interest on the loan at a rate of 2% per month. The 15% difference in the advance and face value of all receivables factored consists of a 2% factoring fee plus a 13% reserve, which the factor maintains. In addition, if Bonneau decides to factor its receivables, it will sell them all, so that it can reduce its credit department costs by $2,000 a month.

a. What is the cost to Bonneau of borrowing the maximum amount of credit available through the factoring agreement?

b. What considerations other than cost should Bonneau account for in determining whether or not to enter the factoring agreement?

a. Maximum advance

Face value of receivables

(two months’ credit sales) $1,000,000

Less: factoring fee (2%) (20,000)

Reserve (13%)

Interest (2% per month for 60 days) *(34,000)

Loan advance (less discount interest) $ 816,000

Interest is calculated on the 85% of the factored accounts

that can be borrowed (.85 × $1,000,000 × .02 × 2 months) = $34,000

or ($1,000,000 - $20,000 - $130,000) × .02 × 2 months) = $34,000.

Thus, the effective cost of credit to Bonneau’s is calculated as follows:

Rate = [($34,000 + $20,000 - $4,000**)/$816,000] × [1/(60/360)] = .3676 or 36.76%

**Credit department savings for 60 days equals 2 × $2,000.

Calculated on an annual basis, the cost of credit would be:

Rate = [($204,000 + $120,000 - $24,000)/$816,000] × [1/(360/360)]

= .3676 or 36.76% where:

interest = .02 × $850,000 × 12 = $204,000

factoring fee = .02 × $500,000 × 12 = $120,000

credit department savings = 12 × $2,000 = $24,000.

b. Of particular concern here is the presence of any stigma associated with factoring. In some industries, factoring simply is not used unless the firm’s financial condition is critical. This would

appear to be the case here, given the relatively high effective rate of interest on borrowing.

Difficulty: Moderate

Keywords: effective cost of credit