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Exam 16: Working Capital

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Question 1

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Other things held constant, which of the following would tend to reduce the cash conversion cycle?

A) Carry a constant amount of receivables as sales decline.
B) Place larger orders for raw materials to take advantage of price breaks.
C) Take all discounts that are offered.
D) Continue to take all discounts that are offered and pay on the net date.
E) Offer longer payment terms to customers.

F) All of the above
G) A) and C)

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Question 2

Multiple Choice

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Which of the following statements is CORRECT?

A) Under normal conditions, a firm's expected ROE would probably be higher if it financed with short-term rather than with long-term debt, but using short-term debt would probably increase the firm's risk.
B) Conservative firms generally use no short-term debt and thus have zero current liabilities.
C) A short-term loan can usually be obtained more quickly than a long-term loan, but the cost of short-term debt is normally higher than that of long-term debt.
D) If a firm that can borrow from its bank at a 6% interest rate buys materials on terms of 2/10, net 30, and if it must pay by Day 30 or else be cut off, then we would expect to see zero accounts payable on its balance sheet.
E) If one of your firm's customers is "stretching" its accounts payable, this may be a nuisance but it will not have an adverse financial impact on your firm if the customer periodically pays off its entire balance.

F) B) and C)
G) B) and E)

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Question 3

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An increase in any current asset must be accompanied by an equal increase in some current liability.

As a rule, managers should try to always use the free component of trade credit but should use the costly component only if the cost of this credit is lower than the cost of credit from other sources.

The facts that (1) no explicit interest is paid on accruals and (2) the firm can vary the level of these accounts at will makes them an attractive source of funding to meet the firm's working capital needs.

Van Den Borsh Corp. has annual sales of $50,735,000, an average inventory level of $15,012,000, and average accounts receivable of $10,008,000. The firm's cost of goods sold is 85% of sales. The company makes all purchases on credit and has always paid on the 30th day. However, it now plans to take full advantage of trade credit and to pay its suppliers on the 40th day. The CFO also believes that sales can be maintained at the existing level but inventory can be lowered by $1,946,000 and accounts receivable by $1,946,000. What will be the net change in the cash conversion cycle, assuming a 365-day year?

Not taking cash discounts is costly, and as a result, firms that do not take them are usually those that are performing poorly and have inadequate cash balances.

Inmoo Company's average age of accounts receivable is 45 days, the average age of accounts payable is 40 days, and the average age of inventory is 69 days. Assuming a 365-day year, what is the length of its cash conversion cycle?

Net working capital is defined as current assets divided by current liabilities.

Which of the following statements is NOT CORRECT?

Ingram Office Supplies, Inc., buys on terms of 2/15, net 50 days. It does not take discounts, and it typically pays on time, 50 days after the invoice date. Net purchases amount to $450,000 per year. On average, what is the dollar amount of costly trade credit (total credit - free credit) the firm receives during the year? (Assume a 365-day year, and note that purchases are net of discounts.)

The concept of permanent current assets reflects the fact that some components of current assets do not shrink to zero even when a business is at its seasonal or cyclical low. Thus, permanent current assets represent a minimum level of current assets that must be financed.

The calculated cost of trade credit for a firm that buys on terms of 2/10, net 30, is lower (other things held constant) if the firm plans to pay in 40 days than in 30 days.

A firm's collection policy, i.e., the procedures it follows to collect accounts receivable, plays an important role in keeping its average collection period short, although too strict a collection policy can reduce profits due to lost sales.

Roton Inc. purchases merchandise on terms of 2/15, net 40, and its gross purchases (i.e., purchases before taking off the discount) are $800,000 per year. What is the maximum dollar amount of costly trade credit the firm could get, assuming it abides by the supplier's credit terms? (Assume a 365-day year.)

If a firm's suppliers stop offering discounts, then its use of trade credit is more likely to increase than to decrease other things held constant.

Which of the following statements is CORRECT?

Margetis Inc. carries an average inventory of $750,000. Its annual sales are $10 million, its cost of goods sold is 75% of annual sales, and its receivables collection period is twice as long as its inventory conversion period. The firm buys on terms of net 30 days, and it pays on time. Its new CFO wants to decrease the cash conversion cycle by 10 days, based on a 365-day year. He believes he can reduce the average inventory to $647,260 with no effect on sales. By how much must the firm also reduce its accounts receivable to meet its goal in the reduction of its cash conversion cycle?

Which of the following statements is CORRECT?

Atlanta Cement, Inc. buys on terms of 2/15, net 30. It does not take discounts, and it typically pays 60 days after the invoice date. Net purchases amount to $720,000 per year. What is the nominal annual percentage cost of its non-free trade credit, based on a 365-day year?