Chapter 6: Working Capital and Financing Decision

Question 1

Current Assets can be

Answer 1

Self liquidating or permanent

Question 2

Nature of Asset Growth

Answer 2

Key: matching production schedules with accurate sales forecast.

Differences result in:
Unexpected buildup.
Reduction in inventory, affecting receivables and cash flow

Question 3

Purpose of working capital mgmt

Answer 3

Financing and management of current assets of firm.

Current assets change constantly, requiring decisions made by management.

Short-term decisions on working capital determines whether a firms gets to long term.

Requires immediate action.

Question 4

Fixed vs Current asset levels

Answer 4

Fixed grow slowly - increase productivity capacity, replace old equipment

Current assets fluctuate depening on - level of productions vs level sales

Question 5

What is level production?

Answer 5

Equal monthly production used to smooth out production schedules and employ manpower and equipment more efficiently and at a lower cost.

Consequence: current assets go up/down when sales/productions not equal

Question 6

Patterns of financing Ideal =

Answer 6

Assets buildup + length of financing perfect matched

all current assets financed by current/short term liabilities (ap, loans, commercial paper)

Permanent current + fixed asssets by long term (debt and equity)

Question 7

Why use an alternative financing plan?

Answer 7

Challenge of constructing financial plan is categorizing current assets into temporary and permanent.

Predicting exact timing of asset liquidation is difficult.

Difficult to determine amount of short-term and long-term financing available.

Question 8

Alternative Financing : Long term

Answer 8

Info: Can assure adequate capital at all times.

Long term used to finance - fixed assets, permanent assets, and part of temp/current assets

Short term for remainder of temp/current assets

Question 9

Alternative Financing : Short term

Answer 9

Info: Many small businesses do not have total access to long-term financing.
Rely on short-term bank and trade credit.
Advantage: Interest rates are lower.

Short term used for - temp current assets + part of perm working capital

Long term - fixed assets + remainder perm assets

Question 10

Term structure of interest rates: what is yield curve

Answer 10

Yield curve—shows relative level of short-term and long-term interest rates.

Normal = up

U.S. government securities used; free of default risks.

Corporate debt securities move in same direction as U.S. government securities.

Have higher interest rates due to more financial risk.

Question 11

Yield curves for both securities change daily to reflect.

Answer 11

Current competitive conditions.
Expected inflation.
Changes in economic conditions.

Question 12

3 theories describing yield curve shape

Answer 12

Liquidity premium theory: Long-term rates should be higher than short-term rates.
Incentive to hold less liquid and more price-sensitive securities.

Market segmentation theory: Treasury securities are divided into market segments by various financial institutions investing in market.

Expectations hypothesis: Yields on long-term securities are function of short-term rates.
avg of expected short term

Question 13

Short term financing is _____ during tight money periods

Answer 13

difficult to find, high rates

Question 14

Expected Value

Answer 14

A representative value from a probability distribution arrived at by multiplying each outcome by the associated probability and summing up the values.

Normal return * probability
+ Tight money return * probability = Expected value of return A vs B

Question 15

Types of time / liquidy = risk

Answer 15

Short + Low liquiud = high profit + risk

Long + High = low profit + risk

Long + low / Short + high = moderate

Question 16

Working capital management is primarily concerned with the management and financing of

Answer 16

current assets.

Question 17

Which of the following is a reason for diminishing liquidity in modern corporations?

Answer 17

Just-in-time inventory programs.

Better utilization of cash via computers.

Increased use of point-of-sale terminals.

Question 18

Retail companies like Target and Macy’s exhibit sales patterns that are most typically influenced by

Answer 18

seasonality

Question 19

Pressure to increase current asset buildup often results from

Answer 19

rapidly expanding sales.

Question 20

Revenue for all e-commerce has grown dramatically during 2020-2021 due to the COVID-19 pandemic. Which of the following include reasons for this growth?

Answer 20

Motivations by young consumers

Changing behavior of physical retailers

Consumer desire for independence from physical shopping

Question 21

When actual sales are greater than forecasted sales

Answer 21

inventory will decline.

production schedules might have to be revised upward.

accounts receivable will rise

Question 22

Samuelson will produce 20,000 units in January using level production. If each unit costs $500 to manufacture, what is the dollar value of ending inventory in January if beginning inventory is 10,000 units and January sales are 15,000?

Answer 22

Beginning Inventory + Production − Sales = Ending Inventory

10,000 + 20,000 − 15,000 = 15,000 units × $500 cost = $7,500,000

Question 23

A firm will usually increase the ratio of short-term debt to long-term debt when

Answer 23

the term structure is inverted and expected to shift down.

Question 23

An inverted yield curve would suggest that

Answer 23

interest rates are expected to fall.

Question 24

Riley Company is considering a short-term or long-term financing plan of $4,000,000 assets. It expects the following one-year interest rates over the next three years: 6.5%, 7.75%, and 9%. The long-term interest rate will be 7.5% during those three years. What will be the difference in interest costs over the three years?

Answer 24

long term 30,000 less costly

Question 25

A “normal” term structure of interest rates would depict

Answer 25

long-term rates are higher than short-term rates.

Question 26

The term structure of interest rates

Answer 26

changes daily to reflect current competitive conditions in the money and capital markets.

Question 27

Genetech has $4,000,000 in assets. It has decided to finance 30% with long-term financing (9% rate) and 70% with short-term financing (7%) rate. Assuming a 21% tax rate, what will its annual after-tax interest costs be?

Answer 27

Annual after−tax interest costs=($4,000,000)(0.3)(0.09)×(100%−21%)+($4,000,000)(0.7)(0.07)×(100%−21%)=$240,160

Question 28

The theory of the term structure of interest rates, which suggests that long-term rates are determined by the average of short-term rates expected over the time that a long-term bond is outstanding, is the

Answer 28

expectations hypothesis.

Question 29

An aggressive working capital policy would have which of the following characteristics?

Answer 29

A high ratio of short-term debt to long-term sources of funds

Question 30

Which of the following combinations of asset structures and financing patterns is likely to create the least volatile earnings?

Answer 30

Liquid assets and heavy long-term borrowing

Question 31

Hicks Health Clubs, Incorporated expects to generate an annual EBIT of $750,000 and needs to obtain financing for $1,200,000 of assets. Its tax bracket is 40%. If the firm uses short-term debt, its rate will be 7.5%, and if it uses long-term debt, its rate will be 9%. By how much will their earnings after taxes change if they choose the more aggressive financing plan instead of the more conservative plan?

Answer 31

Change in EAT=(difference in interest rates)×(assets)×(1−t)

=(0.015×$1,200,000×0.6)

= $10,800

Question 32

Which of the following techniques allows explicit consideration of more than one possible outcome?

Answer 32

expected value