Chpt 2 Financial Management Environment

Question 1

Disintermediation

Answer 1

Describes a decline in the traditional deposit and lending relationship between banks and their customers and an increase in direct relationships between the ultimate suppliers and users of financing.

Question 2

Eurobond

Answer 2

A bond denominated in a currency which often differs from that of the country of issue.

Question 3

Exchange rate

Answer 3

The rate at which one country’s currency can be traded in exchange for another country’s currency.

Question 4

Financial intermediary

Answer 4

An institution bringing together providers of finance and users of finance.

Question 5

Fiscal policy

Answer 5

Action by the government to spend money, or to collect money in taxes, with the purpose of influencing the condition of the national economy.

Question 6

Macroeconomics

Answer 6

Concerned with issues affecting the economy as a whole eg economic growth, inflation, unemployment.

Question 7

Market failure

Answer 7

said to occur when the market mechanism fails to work efficiently and therefore the outcome is sub-optimal.

Question 8

Monetary policy

Answer 8

The regulation of the economy through control of the monetary system by operating on such variables as the money supply, the level of interest rates and the conditions for availability of credit.

Question 9

Controlling the flow of money in the economy by raising taxes is

Answer 9

Fiscal Policy

“A fiscal policy is the means by which governments adjust spending levels by controlling tax rates. It is closely associated with the monetary policy which controls the money supply in the economy.”

Question 10

When a government is attempting to control the economy by adjusting interest rates, this policy is called a:

Answer 10

Monetary Policy

Question 11

ABC Inc has a loan of $1 million at 5% fixed interest rate. ABC Inc believes that they would save interest payments if they switched to a variable interest rate. They formally agree to pay the loan of QTZ Inc variable rate loan and QTZ Inc will pay ABC’s fixed rate loan. Which of the following statement(s) is/are true? (select all that apply)

Answer 11

This is a swap agreement

Question 12

Increase in interest rates can cause:

Answer 12

Expensive Borrowings

Increase in interest rates can cause a fall in sales, decrease in disposable income, and expensive borrowings leading to expensive investments.

Question 13

What is a CD

Answer 13

A CD is an interest yielding money market instrument

Question 14

An example of controlling the supply of money in the economy through a monetary policy is:

Answer 14

Issuing government treasury bills

Issuing government treasury bills to control the supply of money in the economy is an example of a monetary policy. This is usually performed through the central bank. This drains the cash from the economy and traps the funds in treasury bills. This reduces demand, which in turn reduces inflation.

Question 15

The economy in its simplest form can be defined as: “households supply labour to the firms, which in turn allows firms to manufacture goods which they supply to _______”:

Answer 15

Households

Question 16

Heli Inc has funds on deposit that are earning no interest. They must have access to these funds to in eighteen months’ time but the board are eager for them to earn a return. Which should they invest in?

Answer 16

Treasury Notes

Question 17

What advantages does securitisation offer to financial institutions?

Answer 17

They can create liquid securities from illiquid assets

Banks and other financial institutions can also convert their illiquid assets into marketable securities and sold on. These are usually attached to an underlying asset. This is advantageous for the financial institution, they can convert illiquid assets into liquidity. This conversion of illiquid assets like long-term debt to a marketable security is called securitisation.

Question 18

Which of these are financial intermediaries

Answer 18

A Merchant bank

Financial intermediaries bring investors and those needing investment together. Examples of financial intermediaries are: (1) Banks; (2) Building societies; (3) Finance Companies; (4) Pension Funds; (5) Insurance Companies; (6) Investment Trusts.

Question 19

What benefits does a financial intermediary offer?

Answer 19

Risk Transformation
Maturity transformation
Aggregating small investors deposits together to supply large borrowers

Question 20

Which of the following statements is true

Answer 20

Bonds can be traded on the stock market

Capital markets are where debt and equity are traded. They are markets where longer term investments are sold. The organisations who seek finance from these markets are seeking long term finance. A bond is a form of debt financing issued by a company directly to an investor that offers a rate of return. They are liabilities or debt for the sellers and assets for the buyers. Corporate and government bonds are issued on a specific market, the bond market. This is a primary financial market where companies and governments can issue the new debt. Once issued they can be traded on a secondary market like the stock market. Eurobonds also called international bonds – these are bonds that are in a currency that is not the national currency of the issuing company. So, a US company could issue an international Stirling bond.

Question 21

Heli Inc wants to raise funds through the money markets. However, they do not have a good credit rating. Their bank has offered to guarantee them for a fee. This makes the investment more secure for investors. What will they issue to the money market?

Answer 21

Banker’s Acceptance -

These are issued by companies like commercial paper but a bank guarantees them. They are guaranteed because the organisation may not have a good enough credit rating to offer a commercial paper. The guarantee makes them more secure. So, the return offered will be low, but the organisation must pay a fee to the bank for that guarantee. These can be traded on the money market before maturity.

Question 22

The longer the firm’s accounts payable period, the:

Answer 22

Less the firm must invest in working capital
Working capital cycle in days is calculated as follows: Receivables days + inventory days - Payables days. Therefore, increase in payables days adversely affect the amount necessary to be invested in working capital.

Question 23

A manufacturing company buys materials from its suppliers, and is allowed a credit of 3 months. On average, the material is kept in inventory for 1.5 months and production takes another 2 months. Assuming goods are sold immediately after production and customers are allowed 2 months to pay their debts, what is the cash operating cycle of the company? Answer: Operating Cycle is

Answer 23

2.5 months
(1) “The operating cycle is the time between when the supplier is paid and when the cash is received from customers. The suppliers are paid after 3 months. The goods are prepared in 1.5 + 2 = 3.5 months and are sold immediately. After that it takes 2 months to get the cash back. The cash is received in 3.5 + 2 = 5.5 months. So the operating cycle is 5.5 - 3 = 2.5.”

Question 24

Given the data, find the number of orders that need to be placed every year and the inventory cycle if inventory costs are to be minimized. Demand = 10,000 units. Holding costs = 2.5/unit. Order cost = 500/order.

Answer 24

5 orders and 10.4 weeks
EOQ =√[2C0D/Ch] = √[(2 x 500 x 10,000)/2.5] = 2,000 units. Number of orders = 10,000/2,000 = 5. Inventory cycle = 52/5 = 10.4 weeks.

Question 25

Which of the following actions will increase quick ratio?

Answer 25

Sell inventory on credit term.

Question 26

Given the following information about a company, find its buffer safety inventory (assume 50-week year)

Reorder level 10,000 units
Reorder size 30,000 units
Demand for coming year 300,000 units
Average lead time 1 week

Answer 26

4000
Buffer safety = Re-order level – (average usage x average lead time). Average usage per week = 300,000 / 50 = 6,000 units/week. Buffer safety = 10,000 - (6,000 x 1) = 4,000 units.

Question 27

Which one of the following actions should be made by manager to decrease cash operating cycle?

Answer 27

Decrease the period of time for which credit is granted to customers;
Working capital cycle in days is calculated as follows: Receivables days + inventory days - Payables days. Therefore, decrease in receivables days directly affect the amount necessary to be invested in working capital.

Question 28

The time period between paying for raw materials and collecting receivables on sales of finished goods is known as:

Answer 28

Cash operating cycle
Working capital cycle or cash operating cycle is the period of time that a company is deprived of cash during a normal business operating cycle and can be used to measure the level of money tied up and the associated cost to the company.

Question 29

If the inventory re-order level for a company is 5,000, what is the number (in units) of expected stock- outs if the probability of the actual demand during the lead time being 5,500 is 0.1 and that of it being 6,000 is 0.05?

Answer 29

The number of expected stocks outs will be = [(5,500 - 5,000) x 0.1] + [(6,000 - 5,000) x 0.05] = 100

Question 30

A supplier offers a client a 5% discount if it orders at least 5,000 units at a time. Given the following information about the client, what would be the difference in the costs for the client of taking up the discount offer? Price per unit = $23. Demand = 10,000 units per year. Ordering cost = $600. Holding cost = $1.92 per unit. Answer: $ (round the answer to nearest $

Answer 30

10,300
First find the EOQ = √(2 x order cost x demand/holding cost) = √(2 x 600 x 10,000/1.92) = 2,500. The without discount the annual costs will be: Cost of purchases = 23 x 10,000 = 230,000. Ordering costs will be = 600 x (10,000/2,500) = 2,400. Holding costs will be = 1.92 x (2500/2) = 2,400. Total costs = 230,000 + 2,400 + 2,400 = 234,800. With discount the costs will be: Cost of purchases = 23 x 10,000 x 0.95 = 218,500. Ordering costs will be = 600 x (10,000/5,000) = 1,200. Holding costs will be = 1.92 x (5,000/2) = 4,800. Total costs = 218,500 + 1,200 + 4,800 = 224,500. So the savings are = 234,800 – 224,500 = 10,300

Question 31

Calculate the EOQ and the total inventory costs (excluding purchase price) given the following data: Demand = 4,900 units. Order cost = 100/order. Holding costs = 2/unit.

Answer 31

700 units and $ 1,400

Question 32

Which of the following are inventory holding costs? (select all that apply)

Answer 32

Insurance
Obsolescence
Cost of capital

When a company holds inventory it ties up the capital used to procure the inventory. It also insures its inventory and this is a holding cost. Moreover there is always the danger that goods will become obsolete while held in inventory. Extra cost for emergency inventory on the other hand is a cost that results due to shortage of inventory.

Question 33

Given the following information about a company, calculate its inventory turnover ratio.

Sales revenue 600,000
Gross profit 200,000
Net profit 40,000
Average inventory 50,000
Ending inventory 80,000

Answer 33

8

Inventory turnover = Cost of sales/Average inventory. Cost of sales = Sales revenue – Gross profit. Cost of sales = 600,000 – 200,000 = 400,000. Inventory turnover = 400,000/50,000 = 8

Question 34

Working capital can be best described as:

Answer 34

Net current assets or current assets minus current liabilities;
Working capital is short term investment that companies make in a day-to-day operating infrastructure and can be calculated as current assets minus current liabilities.

Question 35

Given the following information about a company, find its average safety inventory (assume 50-week year)

Reorder level 15,000 units
Reorder size 35,000 units
Demand for coming year 300,000 units
Average lead time 2 weeks

Answer 35

20,500
First calculate the buffer safety inventory = Reorder level – (average usage x average lead time). Buffer safety = 15,000 - (300,000 / 50) x 2 = 15,000 - 12,000 = 3,000. Average inventory = buffer safety + re-order amount / 2 = 3,000 + (35,000 / 2) = 20,500 units.

Question 36

Given the following information about a company, find its average inventory (assume a 50-week year). Reorder level = 9,000 units. Re-order size = 32,000 units. Demand for coming year = 200,000 units. Average lead time = 2 weeks.

Answer 36

17,000 units

First calculate the buffer safety inventory = reorder level – (average usage x average lead time). Buffer safety = 9,000 – (200,000/50 x 2) = 9,000 – 8,000 = 1,000. Average inventory = buffer safety + (re-order amount/2) = 1,000 + (32,000/2) = 17,000

Question 37

As a firm’s cash operating cycle increases, the firm:

Answer 37

Increases its investment in working capital;

Working capital cycle or cash operating cycle is the period of time that a company is deprived of cash during a normal business operating cycle and can be used to measure the level of money tied up and the associated cost to the company. It can be measured in absolute terms and equals to net current assets or current assets - current liabilities. If net current assets increase the cash operating cycle also increases. Other options will lead to decrease in cash operating cycle.

Question 38

Which of the following are objectives of working capital? (select from the list)

Answer 38

Liquidity
Profitability

The objective of working capital management is finding the right balance between profitability and liquidity.

Question 39

Given the following information about a company, find its buffer safety inventory (assume a 50-week year). Reorder level = 5,000 units. Re-order size = 25,000 units. Demand for coming year = 150,000 units. Average lead time = 1 week.

Answer 39

2000 units

Buffer safety = re-order level – (average usage x average lead time). Average usage per week = 150,000/50 = 3,000 units/week. Buffer safety = 5,000 – (3,000 x 1) = 2,000 units

Question 40

The following are extracts from company Green accounts for the year ended 30 June 2016: Investments in subsidiaries - $310,000; Trade receivables - $150,000; Raw materials - $25,000; Finished goods - $40,000; Bank loan (maturity on 31 December 2017) - $200,000; Trade payables - $95,000; Sales for the year ended 30 June 2016 - $1,140,000; Cost of sales for the year ended 30 June 2016 - $730,000. Inventory amounts didn’t fluctuate much during the year. Which of the following statement is TRUE?

Answer 40

Each $1 invested in working capital by Green generates $9.5 of revenue

Question 41

A manufacturing company requires rubber as a raw material for its products. Placing an order to acquire rubber costs the company $22.05/order and holding costs are $ 0.1 per unit per year. If the company has a demand of 20,000 units per year and every unit uses 2 units of rubber, find the economic order quantity for the company. Answer: EOQ is

Answer 41

4200 units

“EOQ = √[2CoD/Ch] = √[(2 x 22.05 x 20,000 x 2)/0.1] = 4,200”

Question 42

Which of these statements about economic order quantity (EOQ) of inventory is true?

Answer 42

The higher the EOQ level the higher is the inventory cycle

Question 43

What is the difference between the current ratio and the quick ratio?

Answer 43

The current ratio includes inventories and the quick ratio does not;