Capital Management, Including Working Capital

Question 1

Capital investments require balancing risk and return. Managers have a responsibility to ensure that the investments that they make in their own firms increase shareholder value. Managers have met that responsibility if the return on the capital investment:

a. Is less than the rate of return associated with the firm’s beta factor.
b. Is greater than the prime rate of return.
c. Is less than the prime rate of return.
d. Exceeds the rate of return associated with the firm’s beta factor.

Answer 1

Choice “d” is correct. A capital investment whose rate of return exceeds the rate of return associated with the firm’s beta factor will increase the value of the firm.

Question 2

Which of the following transactions would increase the current ratio and decrease net profit?

a. A dividend is distributed.
b. A long-term bond is retired before maturity at a discount.
c. Vacant land is sold for less than the net book value.
d. A federal income tax payment due from the previous year is paid.

Answer 2

Choice “c” is correct. The current ratio is current assets divided by current liabilities. The sale of land would increase cash and therefore current assets without increasing current liabilities. This would increase the current ratio. Furthermore, the sale of land at a loss would decrease net profit.

Question 3

The amount of inventory that a company would tend to hold in stock would increase as the:

a. Cost of running out of stock decreases.
b. Length of time that goods are in transit decreases.
c. Variability of sales decreases.
d. Cost of carrying inventory decreases.

Answer 3

Choice “d” is correct. The amount of inventory that a company would tend to hold in stock would increase as the cost of carrying inventory decreases.

Question 4

The Stewart Co. uses the Economic Order Quantity (EOQ) model for inventory management. A decrease in which one of the following variables would increase the EOQ?

a. Quantity demanded.
b. Carrying costs.
c. Safety stock level.
d. Cost per order.

Answer 4

Choice “b” is correct. A decrease in carrying costs would increase the Economic Order Quantity (EOQ).

Question 5

A working capital technique, which delays the outflow of cash, is:

a. A draft.
b. A lock-box system.
c. Factoring.
d. Compensating balances.

Answer 5

Choice “a” is correct. The use of a draft delays a cash disbursement and increases payable float.

Question 6

The optimal level of inventory would be affected by all of the following, except the:

a. Cost of placing an order for merchandise.
b. Current level of inventory.
c. Cost per unit of inventory.
d. Lead time to receive merchandise ordered.

Answer 6

Choice “b” is correct. The current level of inventory has no impact on the optimal level of inventory.

Question 7

Which one of the following would increase the working capital of a firm?

a. Payment of a thirty-year mortgage payable with cash.
b. Refinancing of accounts payable with a two-year note payable.
c. Cash collection of accounts receivable.
d. Cash payment of accounts payable.

Answer 7

Choice “b” is correct. Working capital (WC) increases only if current assets are increased or current liabilities are decreased. Exchanging accounts payable (current liability) for a two-year note payable (long-term liability) would decrease current liabilities and increase working capital.

Question 8

As a company becomes more conservative with respect to working capital policy, it would tend to have a (n):

a. Decrease in the operating cycle.
b. Increase in the ratio of current assets to noncurrent assets.
c. Increase in the ratio of current liabilities to noncurrent liabilities.
d. Decrease in the quick ratio.

Answer 8

RULE: Working capital policy is deemed to be more conservative as an increasing portion of an organization’s long-term assets, permanent current assets, and temporary current assets are funded by long-term financing.

Choice “b” is correct. An increase in the ratio of current assets to non-current assets would be indicative of an increasingly conservative working capital policy. With no other information, an increase in current assets would indicate that a growing percentage of current assets are financed by non current liabilities and that, nominally, the absolute amount of working capital and the current ratio is improving.

Question 9

In inventory management, the safety stock will tend to increase if the:

a. Variability of lead-time increases.
b. Fixed order cost decreases.
c. Carrying cost increases.
d. Cost of running out of stock decreases.

Answer 9

Choice “a” is correct. If lead times became more variable, the amount of safety stock needed to reduce the risk of stock outs will increase.

Question 10

Which of the following inventory management approaches orders at the point where carrying costs equate nearest to restocking costs in order to minimize total inventory cost?

a. Economic order quantity.
b. Just-in-time.
c. Kanban inventory control.
d. Materials requirements planning.

Answer 10

Choice “a” is correct. The economic order quantity (EOQ) method of inventory control anticipates orders at the point where carrying costs are nearest to restocking costs. The objective of EOQ is to minimize total inventory costs.

Question 11

Which of the following ratios is appropriate for the evaluation of accounts receivable?

a. Return on total assets.
b. Days sales outstanding.
c. Current ratio.
d. Collection to debt ratio.

Answer 11

Choice “b” is correct. Among the ratios listed, the ratio that is appropriate for the evaluation of accounts receivable is the number of days sales are outstanding. Sales are related to accounts receivable, so the more days the sales are outstanding, the longer the receivables are outstanding.

Question 12

Why would a firm generally choose to finance temporary assets with short-term debt?

a. Financing requirements remain constant.
b. Matching the maturities of assets and liabilities reduces risk.
c. A firm that borrows heavily long term is more apt to be unable to repay the debt than a firm that borrows heavily short term.
d. Short-term interest rates have traditionally been more stable than long-term interest rates.

Answer 12

Choice “b” is correct. Matching the maturities of current assets with liabilities as they come due is designed to ensure liquidity and reduce risk of cash shortages. Temporary assets (such as inventories, generally, and seasonal inventories, specifically) might be financed with short term debt such that the earnings from the sales of those temporary assets could be used to liquidate the related obligations as they come due and ensure that cash is available to meet cash flow requirements.

Question 13

The CFO of a company is concerned about the company’s accounts receivable turnover ratio. The company currently offers customers terms of 3/10, net 30. Which of the following strategies would most likely improve the company’s accounts receivable turnover ratio?

a. Pledging the accounts receivable to a finance company.
b. Entering into a factoring agreement with a finance company.
c. Changing customer terms to 3/20, net 30.
d. Changing customer terms to 1/10, net 30.

Answer 13

Choice “b” is correct. The accounts receivable turnover ratio is expressed as Sales ÷ Accounts Receivable. A reduction in accounts receivable would serve to improve (increase) the turnover ratio. Factoring (selling) receivables would serve to reduce the amount of accounts receivable (indicating more rapid collections) thereby increasing (improving) the company’s accounts receivable turnover ratio.

Question 14

Which of the following effects would a lockbox most likely provide for receivables management?

a. Maximized collection float.
b. Minimized disbursement float.
c. Maximized disbursement float.
d. Minimized collection float.

Answer 14

Choice “d” is correct. A lockbox system expedites cash inflows (minimizes collection float) by having a bank receive payments from a company’s customers directly, via mailboxes to which the bank has access. Payments that arrive in these mailboxes are deposited into the company’s account immediately.

Question 15

Which of the following assumptions is associated with the economic order quantity formula?

a. Periodic demand is known.
b. The cost of placing an order will vary with quantity ordered.
c. The purchase cost per unit will vary based on quantity discounts.
d. The carrying cost per unit will vary with quantity ordered.

Answer 15

Choice “a” is correct. The economic order quantity formula (EOQ) assumes that periodic demand is known. Annual sales volume is a crucial variable in the EOQ formula.

Question 16

The working capital financing policy that subjects the firm to the greatest risk of being unable to meet the firm’s maturing obligations is the policy that finances:

a. Permanent current assets with short-term debt.
b. Fluctuating current assets with short-term debt.
c. Permanent current assets with long-term debt.
d. Fluctuating current assets with long-term debt.

Answer 16

Choice “a” is correct. The working capital financing policy that finances permanent current assets with short-term debt subjects the firm to the greatest risk of being unable to meet the firm’s maturing obligations.

Question 17

Cash Co. is seeking to establish better controls over its cash receipts. As part of its strategy, the company establishes a single bank as its central depository. This technique is known as:

a. Concentration banking.
b. Lockbox banking.
c. Zero balance account banking.
d. Compensating balances.

Answer 17

Choice “a” is correct. Concentration banking is the method by which a single bank is designated as a central bank as a means of controlling receipts.

Question 18

Which one of the following factors might cause a firm to increase the debt in its financial structure?

a. Increased economic uncertainty.
b. An increase in the price/earnings ratio.
c. An increase in the corporate income tax rate.
d. A decrease in the times interest earned ratio.

Answer 18

Choice “c” is correct. An increase in the corporate income tax rate might cause a firm to increase the debt in its financial structure because interest is tax deductible, while dividends are not tax deductible.

Question 19

The overall cost of capital is the:

a. Maximum rate of return on assets.
b. Minimum rate a firm must earn on high-risk projects.
c. Rate of return on assets that covers the costs associated with the funds employed.
d. Cost of the firm’s equity capital at which the market value of the firm will remain unchanged.

Answer 19

Choice “c” is correct. Firms must at least earn a return rate on investments equal to their cost of capital, or the investments are losing money and, therefore, decreasing the value of the firm.

Question 20

If Brewer Corporation’s bonds are currently yielding 8 percent in the marketplace, why would the firm’s cost of debt be lower?

a. Market interest rates have increased.
b. There is a mixture of old and new debt.
c. Additional debt can be issued more cheaply that the original debt.
d. Interest is deductible for tax purposes.

Answer 20

Choice “d” is correct. Because interest expense is a tax deduction, the cost to Brewer is lower than the market yield rate on debt.

Question 21

The theory underlying the cost of capital is primarily concerned with the cost of:

a. Short-term funds and new funds.
b. Any combination of old or new, short-term or long-term funds.
c. Long-term funds and old funds.
d. Long-term funds and new funds.

Answer 21

Choice “b” is correct. The cost of capital considers the cost of all funds, whether they are short-term, long-term, new or old.

Question 22

Which one of a firm’s sources of new capital usually has the lowest after tax cost?

a. Preferred stock.
b. Common stock.
c. Retained earnings.
d. Bonds.

Answer 22

Choice “d” is correct. Because debt is a cheaper source of financing than equity, bonds will be the cheapest form of financing. In addition, the company issuing bonds receives a tax deduction for interest paid. This further reduces the cost of bond financing.

Question 23

Residual income is a better measure for performance evaluation of an investment center manager than return on investment because:

a. Only the gross book value of assets needs to be calculated.
b. The problems associated with measuring the asset base are eliminated.
c. Issues related to the implicit cost of interest are eliminated.
d. Desirable investment decisions will not be neglected by high-return divisions.

Answer 23

Choice “d” is correct. Residual income measures actual dollars that an investment earns over its required return rate. Performance evaluation on this basis will mean that desirable investment decisions will not be rejected by high-return divisions.

Question 24

The segment margin of an investment center after deducting the imputed interest on the assets used by the investment center is known as:

a. Residual income.
b. Operating income.
c. Return on assets.
d. Return on investment.

Answer 24

Choice “a” is correct. Residual income is the segment margin of an investment center after deducting the imputed interest (hurdle rate) on the assets used by the investment center.

Question 25

Which one of the following statements pertaining to the return on investment (ROI) as a performance measurement is incorrect?

a. The use of ROI may lead managers to reject capital investment projects that can be justified by using discounted cash flow models.
b. ROI relies on financial measures that are capable of being independently verified while other forms of performance measures are subject to manipulation.
c. The use of ROI can make it undesirable for a skillful manager to take on trouble-shooting assignments such as those involving turning around unprofitable divisions.
d. When the average age of assets differs substantially across segments of a business, the use of ROI may not be appropriate.

Answer 25

Choice “b” is correct. ROI is no more and no less capable of being independently verified or manipulated than other performance measures.

Question 26

The basic objective of the residual income approach of performance measurement and evaluation is to have a division maximize its:

a. Income in excess of a desired minimum amount.
b. Imputed interest rate charge.
c. Cash flows in excess of a desired minimum amount.
d. Return on investment rate.

Answer 26

Choice “a” is correct. Residual income is defined as income in excess of a desired minimum return.

Question 27

The imputed interest rate used in the residual income approach for performance measurement and evaluation can best be characterized as the:

a. Historical weighted average cost of capital for the company.
b. Average prime lending rate for the year being evaluated.
c. Average return on assets employed over a particular time period.
d. Average return on investment that has been earned by the company over a particular time period.

Answer 27

Choice “a” is correct. Historical weighted average cost of capital is usually used as the target or hurdle rate in the residual income approach.

Question 28

What is the primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers?

a. ROI is a percentage, while RI is a dollar amount.
b. ROI may lead to rejecting projects that yield positive cash flows.
c. ROI does not necessarily reflect the company’s cost of capital.
d. ROI does not reflect all economic gains.

Answer 28

Choice “b” is correct. The primary disadvantage of using return on investment (ROI) rather than residual income (RI) to evaluate the performance of investment center managers is that ROI may lead to rejecting projects that yield positive cash flows. Profitable investment center managers might be reluctant to invest in projects that might lower their ROI (especially if their bonuses are based only on their investment center’s ROI), even though those projects might generate positive cash flows for the company as a whole. This characteristic is often known as the “disincentive to invest.”

Question 29

The benefits of debt financing over equity financing are likely to be highest in which of the following situations?

a. Low marginal tax rates and few noninterest tax benefits.
b. High marginal tax rates and few noninterest tax benefits.
c. High marginal tax rates and many noninterest tax benefits.
d. Low marginal tax rates and many noninterest tax benefits.

Answer 29

Choice “b” is correct. The benefits of debt financing over equity financing are likely to be highest if marginal tax rates are high (because interest on debt is deductible for tax purposes) and if there are few noninterest tax benefits (because there is little or no reason to depart from debt financing).

Question 30

The optimal capitalization for an organization usually can be determined by the:

a. Intersection of the marginal cost of capital and the marginal efficiency of investment.
b. Maximum degree of financial leverage (DFL).
c. Maximum degree of total leverage (DTL).
d. Lowest total weighted-average cost of capital (WACC).

Answer 30

Choice “d” is correct. The optimal capitalization for an organization usually can be determined by the lowest total weighted-average cost of capital (WACC). Capitalization at WACC serves to maximize shareholder’s equity.

Question 31

Which of the following rates is most commonly compared to the internal rate of return to evaluate whether to make an investment?

a. Short-term rate on U.S. Treasury bonds.
b. Weighted-average cost of capital.
c. Prime rate of interest.
d. Long-term rate on U.S. Treasury bonds.

Answer 31

Choice “b” is correct. The weighted-average cost of capital is frequently used as the hurdle rate within capital budgeting techniques. Investments that provide a return that exceeds the weighted-average cost of capital should continuously add to the value of the firm.

Question 32

Which of the following statements is correct regarding the weighted-average cost of capital (WACC)?

a. A company with a high WACC is attractive to potential shareholders.
b. WACC is always equal to the company’s borrowing rate.
c. One of a company’s objectives is to minimize the WACC.
d. An increase in the WACC increases the value of the company.

Answer 32

Choice “c” is correct. The optimal capital structure is the mix of financing instruments that produces the lowest WACC.

Question 33

An increase in which of the following should cause management to reduce the average inventory?

a. The annual demand for the product.
b. The lead time needed to acquire inventory.
c. The cost of placing an order.
d. The cost of carrying inventory.

Answer 33

Choice “d” is correct. An increase in the cost of carrying inventory would lead to a reduction in average inventory. Suppose item A is required to be refrigerated so that it will not spoil. If electricity prices are rising, management would prefer to have a lower inventory of item A on hand because of the electricity (i.e., carrying) cost of that item.

Question 34

Which of the following ratios would most likely be used by management to evaluate short-term liquidity?

a. Acid test (quick) ratio.
b. Accounts receivable turnover.
c. Return on total assets.
d. Sales to cash.

Answer 34

Choice “a” is correct. The acid test ratio evaluates short-term liquidity.

Question 35

Which of the following ratios would be used to evaluate a company’s profitability?

a. Current ratio.
b. Inventory turnover ratio.
c. Gross margin ratio.
d. Debt to total assets ratio.

Answer 35

Choice “c” is correct. The gross margin ratio describes the ratio of gross margin to sales and serves to evaluate a company’s profitability.

Question 36

Larson Corp. issued $20 million of long-term debt in the current year. What is a major advantage to Larson with the debt issuance?

a. The increased financial risk resulting from the use of the debt.
b. The reduced earnings per share possible through financial leverage.
c. The reduction of Larson’s control over the company.
d. The relatively low after-tax cost due to the interest deduction.

Answer 36

Choice “d” is correct. Debt is generally the least expensive component of a company’s capital structure. Debt typically commands a lower return than equity since debt contemplates a full return of principal over a specific period compared to equity that has no such guarantee and exposes the investor/creditor to lower risks. In addition, interest payments on debt are tax deductible, creating a tax shield for the debtor company. Lower rates reduced further by a tax shield give debt an advantage over equity financing.

Question 37

Green, Inc., a financial investment-consulting firm, was engaged by Maple Corp. to provide technical support for making investment decisions. Maple, a manufacturer of ceramic tiles, was in the process of buying Bay, Inc., its prime competitor. Green’s financial analyst made an independent detailed analysis of Bay’s average collection period to determine which of the following?

a. Operating profitability.
b. Financing.
c. Liquidity.
d. Return on equity.

Answer 37

Choice “c” is correct. A company’s average collection period is used to evaluate the liquidity of the firm through the calculation of the cash conversion cycle. Liquidity measurements focus on the ability of the company to meet obligations as they come due.

Question 38

Farrow Co. is applying for a loan in which the bank requires a quick ratio of at least 1. Farrow’s quick ratio is 0.8. Which of the following actions would increase Farrow’s quick ratio?

a. Selling obsolete inventory at a loss.
b. Implementing stronger procedures to collect accounts receivable at a faster rate.
c. Paying an existing account payable.
d. Purchasing inventory through the issuance of a long-term note.

Answer 38

Choice “a” is correct. Selling obsolete inventory at a loss would increase the quick ratio. The reduction of inventory values and recording of a loss would have no impact on quick assets. The addition of cash, however, would increase cash with no impact on current liabilities. The quick ratio would improve.

Question 39

All of the following statements about Return on Investment (ROI) are correct, except:

a. ROI is expressed as a percentage of profit to investment.
b. ROI is an outstanding performance measure since it motivates managers to delay or avoid investing in new plant, property, & equipment (PP&E).
c. Delayed investment in new plant, property, & equipment (PP&E) generally makes achievement of ROI targets easier.
d. ROI targets are designed to motivate managers to achieve target levels of net earnings on company resources.

Answer 39

Choice “b” is correct. While it is true that ROI can motivate managers to delay or avoid investing in new PP&E, this is often an inappropriate business decision. The company with very old PP&E may have very high ROI measures but could be more profitable with newer, more efficient PP&E.

Question 40

Each of the following items is included when computing a firm’s target cash conversion cycle, except the:

a. Payables deferral period.
b. Inventory conversion period.
c. Average collection period.
d. Cash discount period.

Answer 40

Choice “d” is correct. The cash conversion cycle does not include the cash discount period. Cash discounts would be considered as a component of receivables collections and payables deferrals. The cash conversion cycle is the sum of the inventory conversion and receivable collection periods minus the payables deferral period shown as follows:

Cash
Conversion
Cycle
=
Inventory
Conversion
Period
\+
Receivables
Collection
Period
−
Payables
Deferral
Period

Question 41

Return on investment (ROI) is criticized as a performance measure since it is not a well balanced measure. What characteristic of effective performance measures does the ROI lack?

a. ROI does not balance long and short-term issues.
b. ROI is not easily measured.
c. ROI is not understood.
d. ROI is not controlled or influenced by the manager.

Answer 41

Choice “a” is correct. ROI encourages shortsighted behavior that defers or avoids investment for the sake of current ROI performance. Short-term benefits are emphasized over long-term commitments.

Question 42

The three elements needed to estimate the cost of equity capital for use in determining a firm’s weighted-average cost of capital are:

a. Current dividends per share, expected growth rate in dividends per share, and current market price per share of common stock.
b. Current dividends per share, expected growth rate in earnings per share, and current market price per share of common stock.
c. Current earnings per share, expected growth rate in dividends per share, and current market price per share of common stock.
d. Current earnings per share, expected growth rate in earnings per share, and current book value per share of common stock.

Answer 42

Choice “a” is correct. The three elements needed to estimate the cost of equity capital are:
Current dividends per share (D)
Expected growth rate in dividends (G) and
Current market price per share of common stock (P)

The question asks the candidate to identify the three elements needed to estimate the cost of equity capital for use in determining a firm’s weighted average cost of capital. The cost of equity capital is defined by the following mathematical expression where the cost of capital or return (R) is:
R = D1 / (P + G)

Note that to obtain D1 in the above formula, multiply D0 by (1 + G).

Question 43

Which of the following terms represents the residual income that remains after the cost of all capital, including equity capital, has been deducted?

a. Economic value-added.
b. Net operating capital.
c. Free cash flow.
d. Market value-added.

Answer 43

Choice “a” is correct. Economic value-added is a residual income technique used for capital budgeting and performance evaluation. It represents the residual (excess) income of project earnings in excess of the cost of capital (including cost of equity) associated with invested capital.

Question 44

A firm that designs its cost structure to include a higher degree of operating fixed costs than variable costs by electing to pay salaries instead of commissions, is magnifying the impact of each additional sales dollar using the concept of:

a. Combined leverage.
b. Financial leverage.
c. Operating leverage.
d. Fixed leverage.

Answer 44

Choice “c” is correct. Operating leverage is defined as the degree to which a firm uses fixed operating costs, as opposed to variable operating costs. A firm that has high operating leverage has high fixed operating costs and relatively low variable operating costs and uses this cost structure to magnify the financial results of each additional dollar in sales.

Question 45

A company uses its company-wide cost of capital to evaluate new capital investments. What is the implication of this policy when the company has multiple operating divisions, each having unique risk attributes and capital costs?

a. High-risk divisions will over-invest in new projects and low risk divisions will under-invest in new projects.
b. Low-risk divisions will over-invest in low-risk projects.
c. Low-risk divisions will over-invest in new projects and high risk divisions will under-invest in new projects.
d. High-risk divisions will under-invest in high-risk projects.

Answer 45

Choice “a” is correct. A company-wide cost of capital averages risks to arrive at required return for investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of multiple divisions with unique risk characteristics, higher risk divisions will automatically beat the threshold for investments and invest in higher risk projects that beat the company wide average. Meanwhile, their lower risk counterparts will find it hard to achieve the risk return that beats the average (artificially inflated) returns that are driven by higher risk divisions and will under invest in new projects.

Question 46

Which of the following inventory management techniques focuses on a set of procedures to determine inventory levels for demand-dependent inventory types such as work-in-process and raw materials?

a. Safety stock reorder point.
b. Cycle counting.
c. Economic order quantity.
d. Materials requirements planning.

Answer 46

Choice “d” is correct. Materials requirements planning (MRP) is an inventory management technique that projects and plans inventory levels in order to control the usage of raw materials in the production process. MRP primarily applies to work in process and raw materials.

Question 47

The cost of debt most frequently is measured as:

a. Actual interest rate.
b. Actual interest rate minus tax savings.
c. Actual interest rate plus a risk premium.
d. Actual interest rate adjusted for inflation.

Answer 47

Choice “b” is correct. Actual interest rates minus tax savings is the most frequently used measure for cost of debt (kdt). After-tax interest fully considers both the costs and tax shield advantages of financing charges which reduce the cost of debt to its most relevant amount.

Question 48

Which of the following performance measures may lead a manager of an investment center to forgo investments that could benefit the company as a whole?

a. Profitability index.
b. Economic value added.
c. Residual income.
d. Return on investment.

Answer 48

Choice “d” is correct. Return on investment (ROI) measures may discourage mangers from avoiding investments that could benefit the company as a whole. Use of the ROI exclusively as a measure of performance can inadvertently focus managers purely on maximizing short-term returns. Profitable units are reluctant to invest in additional productive resources because their short-term result will be to reduce ROI.