44: Financial Management
108. A firm with a higher degree of operating leverage when compared to the industry average implies that the a. Firm has higher variable costs. b. Firm's profits are more sensitive to changes in sales volume. c. Firm is more profitable. d. Firm is less risky.
Correct Answer: B) Firm's profits are more sensitive to changes in sales volume. Higher operating leverage involves more fixed costs, which results in more operating variability and more risk. Answer (b) is correct because a firm's profits are more sensitive to changes in sales volume when the firm is more leveraged. Answer (a) is incorrect because higher leveraged firms have less variable costs. Answer (c) is incorrect because the firm may or may not be more profitable. Answer (d) is incorrect because a highly leveraged firm is more risky.
103. The following information is available for Rothenberg, Inc.: Balance Sheet Information: Current assets: $500,000 PP&E: $4,000,000 Total Assets: $4,500,000 Current Liabilities: $30,000 Long-term debt: $2,500,000 Common Stock: $200,000 Retained earnings: $1,770,000 Total Liabilities & SHE: $4,500,000 Budget Income Information: @100,000 units: Sales: $3,000,000 Expenses: ($2,800,000) Operating Income (EBIT): $200,000 Earnings per Share (EPS): $0.20 @105,000 units: Sales: $3,150,000 Expenses: ($2,850,000) Operating Income (EBIT): $300,000 Earnings per Share (EPS): $1.20 What is the degree of financial leverage for Rothenberg, Inc.? a. 10 b. 5 c. 1/6 d. 1/10
Correct Answer: A) 10 The formula for degree of financial leverage is DFL = % change in EPS / % change in EBIT In this case, the percent change in EPS is equal to 500% [($1.20 - $0.20) ÷ $0.20], and the percent change in EBIT is equal to 50% [($300,000 - $200,000) ÷ $200,000]. Therefore, the DFL is equal to 10 (500% ÷ 50%), and answer (a) is correct.
73. A company obtained a short-term bank loan of $250,000 at an annual interest rate of 6%. As a condition of the loan, the company is required to maintain a compensating balance of $50,000 in its checking account. The company's checking account earns interest at an annual rate of 2%. Ordinarily, the company maintains a balance of $25,000 in its checking account for transaction purposes. What is the effective interest rate of the loan? a. 6.44% b. 7.11% c. 5.80% d. 6.66%
Correct Answer: A) 6.44% Answer (a) is correct because the effective interest is 6.44%. The effective interest rate is determined by calculating the net interest expense, which is $15,000 ($250,000 × 6%) minus the interest income from the compensating balance $500 ($25,000 × 2%) equals $14,500. Then, this amount is divided by the amount of money that the firm has available, $250,000 - $25,000 compensating balance. Thus, the effective interest rate is 6.44% ($14,500/$225,000).
6. Which of the following actions is likely to reduce the length of a firm's cash conversion cycle? a. Adopting a new inventory system that reduces the inventory conversion period. b. Adopting a new inventory system that increases the inventory conversion period. c. Increasing the average days sales outstanding on its accounts receivable. d. Reducing the amount of time the firm takes to pay its suppliers.
Correct Answer: A) Adopting a new inventory system that reduces the inventory conversion period. Notes (a) The requirement is to identify the impact of decisions on the cash conversion cycle. The cash conversion cycle is equal to the Inventory conversion period + Receivables collection period - Payables deferral period. Answer (a) is correct because the impact of a decreased inventory conversion period is a reduction in the cash conversion cycle. Answers (b), (c), and (d) are incorrect because these actions would increase the length of a firm's cash conversion cycle.
2. The inventory conversion period is calculated as follows: a. Average inventory / Cost of sales per day b. Year-end inventory / Cost of sales per day c. Average inventory / Accounts receivable d. Year-end inventory / Cost of sales
Correct Answer: A) Average inventory / Cost of sales per day Notes (a) The requirement is to identify the formula for the inventory conversion period. Answer (a) is correct because the inventory conversion period describes the average time required to convert materials into fi nished goods and sell those goods. Answers (b), (c), and (d) are all incorrect versions of the formula.
38. Firms that maintain very low or no inventory levels a. Have higher ordering costs. b. Have higher carrying costs. c. Have higher ordering and carrying costs. d. Have lower ordering and carrying costs.
Correct Answer: A) Have higher ordering costs. Maintaining a low level of inventory requires that many smaller orders of inventory be made in order to satisfy customer demand. Answer (a) is correct because each order incurs ordering cost and as the quantity of orders increases the ordering costs will also increase. Answer (b) is incorrect because carrying costs are higher with a higher level of inventory. Answer (c) is incorrect because although the ordering costs are higher the carrying costs are lower. Answer (d) is incorrect because the ordering costs would be higher.
94. Nerco has a bond issue that matures in fifteen years. Recently, the company's bond rating has gone from B to Baa. How would this affect the market price of the bonds? a. Increase. b. Decrease. c. Remain the same. d. The effect cannot be predicted.
Correct Answer: A) Increase. Answer (a) is correct because going from a B rating to a Baa rating is an increase in the bond rating indicative of lower risk. Therefore, the market value of the bonds should increase. Answers (b), (c), and (d) are incorrect because the bond value should increase.
45. An appropriate technique for planning and controlling manufacturing inventories, such as raw materials, components, and subassemblies, whose demand depends on the level of production, is a. Materials requirements planning. b. Regression analysis. c. Capital budgeting. d. Linear programming.
Correct Answer: A) Materials requirements planning. Notes (a) The requirement is to identify the technique used to plan and control manufacturing inventories. Answer (a) is correct because materials requirements planning is an inventory planning technique. Answer (b) is incorrect because regression analysis is a technique used to estimate the relationship between variables. Answer (c) is incorrect because capital budgeting is a technique used to evaluate investments in capital assets. Answer (d) is incorrect because linear programming is a technique used to determine the optimal decision when resources are constrained.
74. A manufacturing firm wants to obtain a short-term loan and has approached several lending institutions. All of the potential lenders are offering the same nominal interest rate, but the terms of the loans vary. Which of the following combinations of loan terms will be most attractive for the borrowing firm? a. Simple interest, no compensating balance. b. Discount interest, no compensating balance. c. Simple interest, 20% compensating balance required. d. Discount interest, 20% compensating balance required.
Correct Answer: A) Simple interest, no compensating balance. Answer (a) is correct because simple interest with no compensating balance is the most favorable terms from an effective interest basis. Answers (b), (c), and (d) are incorrect because discount interest and/or a compensating balance increase the effective interest rate on the loan.
52. A company plans to tighten its credit policy. The new policy will decrease the average number of days in collection from 75 to 50 days and reduce the ratio of credit sales to total revenue from 70 to 60%. The company estimates that projected sales would be 5% less if the proposed new credit policy were implemented. The firm's short-term interest cost is 10%. What effect would the implementation of this new credit policy have on income before taxes? a. $2,500,000 decrease. b. $2,166,667 decrease. c. $ 83,334 increase. d. $ 33,334 increase.
Correct Answer: B) $2,166,667 decrease. Answer (b) is correct because the decrease in operating income is equal to $2,166,667 [$2,500,000 loss in sales - ($3,333,334 × 10%) interest savings]. Answer (a) is incorrect because it only considers the loss in sales. Answer (c) is incorrect because it treats the entire $3,333,334 change in average receivables as a benefit.
102. The following information is available for Rothenberg, Inc.: Balance Sheet Information: Current assets: $500,000 PP&E: $4,000,000 Total Assets: $4,500,000 Current Liabilities: $30,000 Long-term debt: $2,500,000 Common Stock: $200,000 Retained earnings: $1,770,000 Total Liabilities & SHE: $4,500,000 Budget Income Information: @100,000 units: Sales: $3,000,000 Expenses: ($2,800,000) Operating Income (EBIT): $200,000 Earnings per Share (EPS): $0.20 @105,000 units: Sales: $3,150,000 Expenses: ($2,850,000) Operating Income (EBIT): $300,000 Earnings per Share (EPS): $1.20 What is Rothenberg's degree of operating leverage? a. 1/5 b. 10 c. 5 d. 2/3
Correct Answer: B) 10 The formula for degree of operating leverage is DOL = % Change in operating income / % change in unit volume In this case, the percent change in operating income is equal to 50% [($300,000 - $200,000) ÷ $200,000], and the percent change in unit volume is equal to 5% [(105,000 - 100,000 units) ÷ 100,000 units]. Therefore, the correct answer is (b) because DOL is equal to 10 (50% ÷ 5%).
116. Management of Terra Corp. is attempting to estimate the firm's cost of equity capital. Assuming that the firm has a constant growth rate of 5%, a forecasted dividend of $2.11, and a stock price of $23.12, what is the estimated cost of common equity using the dividend-yield-plus-growth approach? a. 9.1% b. 14.1% c. 15.6% d. 12.3%
Correct Answer: B) 14.1% The formula for estimated cost of common equity is equal to the expected dividend divided by the stock price plus the growth rate. Therefore, the correct answer is (b) because the estimated cost of equity is 14.1% [(2.11/23.13) + 5%].
57. Newton Corporation is offered trade credit terms of 3/15, net 45. The firm does not take advantage of the discount, and it pays the account after 67 days. Using a 365-day year, what is the nominal annual cost of not taking the discount? a. 18.2% b. 21.71% c. 23.48% d. 26.45%
Correct Answer: B) 21.71%
36. Ral Co. sells 20,000 radios evenly throughout the year. The cost of carrying one unit in inventory for one year is $8, and the purchase order cost per order is $32. What is the economic order quantity? a. 625 b. 400 c. 283 d. 200
Correct Answer: B) 400
8. Jones Company has $5,000,000 of average inventory and cost of sales of $30,000,000. Using a 365-day year, calculate the firm's inventory conversion period. a. 30.25 days. b. 60.83 days. c. 45.00 days. d. 72.44 days.
Correct Answer: B) 60.83 days. Notes (b) The requirement is to calculate the inventory conversion period. The inventory conversion period is calculated as average inventory/(cost of sales per day). Answer (b) is correct because $5,000,000/($30,000,000/365) = 60.83 days.
90. DQZ Telecom is considering a project for the coming year that will cost $50 million. DQZ plans to use the following combination of debt and equity to finance the investment: -Issue $15 million of 20-year bonds at a price of 101, with a coupon rate of 8%, and flotation costs of 2% of par. -Use $35 million of funds generated from earnings. The equity market is expected to earn 12%. US Treasury bonds are currently yielding 5%. The beta coefficient for DQZ is estimated to be .60. DQZ is subject to an effective corporate income tax rate of 40%. The before-tax cost of DQZ's planned debt financing, net of flotation costs, in the first year is a. 11.80% b. 8.08% c. 10.00% d. 7.92%
Correct Answer: B) 8.08% (b) The requirement is to calculate the first-year, before-tax cost of the planned debt financing, net of floatation costs. The first year cost would be calculated by dividing the interest rate by the amount of funds received after floatation costs. Therefore, the interest cost before tax is equal to 8% ÷ (101% issue price - 2% floatation costs) = 8.08%. Therefore, the correct answer is (b).
133. Which of the following methods of valuation provides the most reliable measure of fair value? a. Use of a discounted cash flow method. b. Market values obtained from active markets. c. Combination of valuation models and active markets. d. Sophisticated valuation models.
Correct Answer: B) Market values obtained from active markets. Answer (b) is correct because the most reliable valuation comes from market values obtained from active markets.
137. A soft drink producer acquiring a bottle manufacturer is an example of a a. Horizontal merger. b. Vertical merger. c. Congeneric merger. d. Conglomerate merger.
Correct Answer: B) Vertical merger. Answer (b) is correct because a vertical merger is a merger between a firm and one of its suppliers or customers. A bottle manufacturer can supply bottles to be used by a soft drink producer. Answer (a) is incorrect because a horizontal merger is a combination of two firms producing the same type of good or service. Answer (c) is incorrect because a congeneric merger is a merger of firms in the same industry, but the two firms do not have a customer or supplier relationship (as in vertical merger). Answer (d) is incorrect because a conglomerate merger is a merger of companies in totally different industries.
51. A company plans to tighten its credit policy. The new policy will decrease the average number of days in collection from 75 to 50 days and reduce the ratio of credit sales to total revenue from 70 to 60%. The company estimates that projected sales would be 5% less if the proposed new credit policy were implemented. The firm's short-term interest cost is 10%. Projected sales for the coming year are $50 million. Calculate the dollar impact on accounts receivable of this proposed change in credit policy. Assume a 360-day year. a. $ 3,819,445 decrease. b. $ 6,500,000 decrease. c. $ 3,333,334 decrease. d. $18,749,778 increase.
Correct Answer: C) $ 3,333,334 decrease. Under the existing policy, sales are equal to $50,000,000, 70% of which are on credit. Therefore, the average accounts receivable balance is equal to $7,291,667 [($35,000,000 credit sales ÷ 360 days) × 75 days]. Under the new policy credit sales are estimated to be $28,500,000 [($50,000,000 × 95%) × 60%]. Accordingly, the average accounts receivable balance under the new policy is estimated to be $3,958,333 [($28,500,000 credit sales ÷ 360) × 50 days]. Answer (c) is correct because the change in accounts receivable balance is estimated to be a decrease of $3,333,334 ($7,291,667 - $3,958,333).
43. Ethan, Inc. has seasonal demand for its products and management is considering whether level production or seasonal production should be implemented. The firms' short-term interest cost is 8%, and management has developed the following information to make the decision: Alternative 1 (Level production): Average inventory: $2,000,000 Production Costs: $6,000,000 Alternative 2 (Seasonal production): Average inventory: $1,500,000 Production Costs: $6,050,000 At what rate of short-term interest rate would the two alternatives have the same cost? a. 6% b. 9% c. 10% d. 12%
Correct Answer: C) 10% The cost of implementing Alternative 2 is the $50,000 in additional production costs. When the inventory holding costs related to Alternative 1 equals that amount the costs are equal. By dividing the $50,000 by the $500,000 in additional average inventory, we get 10% ($50,000 ÷ $500,000). Therefore, the correct answer is (c) because at a 10% interest rate the cost of holding the additional inventory under Alternative 1 is equal to the additional production costs under Alternative 2.
120. Assume a firm is expected to pay a dividend of $5.00 per share this year. The firm along with the dividend is expected to grow at a rate of 6%. If the current market price of the stock is $60 per share, what is the estimated cost of equity? a. 8.3% b. 6.0% c. 14.3% d. 12.0%
Correct Answer: C) 14.3% Notes (c) The requirement is to use the dividend-yield-plus-growth-rate approach to calculate the estimated cost of equity. The estimated cost of equity is equal to the dividend divided by the price of the stock + the growth rate. Accordingly, answer (c) is correct because the estimated cost of equity is equal to 14.3% [($5 ÷ $60) + 6%].
11. An organization offers its customers credit terms of 5/10 net 20. One-third of the customers take the cash discount and the remaining customers pay on day 20. On average, 20 units are sold per day, priced at $10,000 each. The rate of sales is uniform throughout the year. Using a 360-day year, the organization has days' sales outstanding in accounts receivable, to the nearest full day, of a. 13 days. b. 15 days. c. 17 days. d. 20 days.
Correct Answer: C) 17 days. Notes (c) The requirement is to calculate the number of days' sales outstanding. Answer (c) is correct. One-third of the customers take advantage of the 5% cash discount and pay on day ten. The remaining two-thirds of the customers pay on day 20. Average days' sales outstanding is calculated as Days' sales outstanding = (1/3) (10 days) + (2/3) (20 days) = 17 days Answer (a) is incorrect because this inappropriately weights the two different types of customers. Answer (b) is incorrect because this uses a simple average of days rather than a weighted-average. Answer (d) is incorrect because this solution uses the 20-day collection period for customers not taking the cash discount as the days' sales outstanding, rather than the average days for payment by all customers.
123. Martin Corporation Balance Sheet: (Dollars in millions) Assets Current assets &75 Plant and equipment $250 Total assets $325 Liabilities and shareholders' equity Current liabilities $46 Long-term debt (12%) $64 Common stock, $1 par $10 Additional paid in capital $100 Retained earnings $105 Total liabilities and shareholders' equity $325 Additional data: The long-term debt was originally issued at par ($1,000/ bond) and is currently trading at $1,250 per bond. Martin Corporation can now issue debt at 150 basis points over US Treasury bonds. The current risk-free rate (US Treasury bonds) is 7%. Martin's common stock is currently selling at $32 per share. The expected market return is currently 15%. The beta value for Martin is 1.25. Martin's effective corporate income tax rate is 40%. Martin Corporation's current net cost of debt is a. 5.5% b. 7.0% c. 5.1% d. 8.5%
Correct Answer: C) 5.1% The current cost of debt before tax is 8.5% (7% Treasury bond rate + 1.5%), and the cost of debt after tax is 5.1% [8.5% × (1 - 40% tax rate)]. Therefore, the correct answer is (c).
129. Hi-Tech Inc. has determined that it can minimize its weighted-average cost of capital (WACC) by using a debt/equity ratio of 2:3. If the firm's cost of debt is 9% before taxes, the cost of equity is estimated to be 12% before taxes, and the tax rate is 40%, what is the firm's WACC? a. 6.48% b. 7.92% c. 9.36% d. 10.80%
Correct Answer: C) 9.36% Answer (c) is correct because the WACC is calculated as 9.36% {2/5 × [9% × (1 - 40%)]} + (3/5 × 12%).
30. To determine the inventory reorder point, calculations normally include the a. Ordering cost. b. Carrying cost. c. Average daily usage. d. Economic order quantity.
Correct Answer: C) Average daily usage. Notes (c) Calculation of the reorder point includes consideration of the average daily usage, average delivery time, and stock-out costs. Answer (a) is incorrect because ordering costs are included in determining the economic order quantity but not the reorder point. Answer (b) is incorrect because carrying cost is considered in determining the economic order quantity but not the reorder point. Answer (d) is incorrect because the economic order quantity is not considered in determining the reorder point.
3. The payables deferral period is calculated as follows: a. Average payables / Sales per day b. Beginning payables / Sales per day c. Average payables / Purchases per day d. Average payables / Cost of goods sold
Correct Answer: C) Average payables / Purchases per day Notes (c) The requirement is to identify the formula for the calculation of the payables deferral period. Answer (c) is correct because the payables deferral period is equal to the average length of time between the purchase of materials and the payment of cash for them. Answers (a), (b), and (d) are all incorrect because they illustrate inaccurate versions of the formula.
10. If everything else remains constant and a firm increases its cash conversion cycle, its profitability will likely a. Increase. b. Increase if earnings are positive. c. Decrease. d. Not be affected.
Correct Answer: C) Decrease. Answer (c) is correct because the longer the cash conversion cycle the greater the amount of time from when a firm pays its suppliers to the time it ultimately collects receivables. The greater the time frame the more likely the firm will have to borrow funds and incur interest expense which reduces profitability. Answers (a), (b), and (d) are incorrect because the incurrence of interest will reduce profitability.
100. Which of the following is usually not a feature of cumulative preferred stock? a. Has priority over common stock with regard to earnings. b. Has priority over common stock with regard to assets. c. Has voting rights. d. Has the right to receive dividends in arrears before common stock dividends can be paid.
Correct Answer: C) Has voting rights. Notes (c) The requirement is to identify the characteristic that is not usually a feature of cumulative preferred stock. Answer (c) is correct because preferred stock usually does not have voting rights. Preferred shareholders are generally given the right to vote for directors of the company only if the company has not paid the preferred dividend for a specified period of time, such as ten quarters. Answer (a) is incorrect because preferred stock does have priority over common stock with regard to earnings, so dividends must be paid on preferred stock before they can be paid on common stock. Answer (b) is incorrect because preferred stock does have priority over common stock with regard to assets, so in the event of bankruptcy, the claims of preferred shareholders must be satisfied in full before the common shareholders receive anything. Answer (d) is incorrect because cumulative preferred stock does have the right to receive any dividends in arrears before common stock dividends are paid.
1. Which of the following is not a function of financial management? a. Financing. b. Risk-management. c. Internal control. d. Capital budgeting.
Correct Answer: C) Internal control. Notes (c) The requirement is to identify the function that is not related to financial management. The correct answer is (c) because internal control is a function of the controller's office. Answers (a), (b), and (d) are incorrect because the functions of financial management include: financing, capital, budgeting, financial management, corporate governance, and risk management.
13. Which of the following is true about electronic funds transfer from a cash flow standpoint? a. It is always beneficial from a cash flow standpoint. b. It is never beneficial from a cash flow standpoint. c. It is beneficial from a cash receipts standpoint but not from a cash disbursements standpoint. d. It is beneficial from a cash disbursements standpoint but not from a cash receipts standpoint.
Correct Answer: C) It is beneficial from a cash receipts standpoint but not from a cash disbursements standpoint. Answer (c) is correct because electronic funds transfer takes the float out of both the cash receipts and disbursements processes. It is beneficial to take the float out of the cash receipts process but not the cash disbursements process.
21. A firm has daily cash receipts of $100,000. A bank has offered to reduce the collection time on the firm's deposits by two days for a monthly fee of $500. If money market rates are expected to average 6% during the year, the net annual benefit (loss) from having this service is a. $ 3,000 b. $12,000 c. $0 d. $ 6,000
Correct Answer: D) $ 6,000 (d) The requirement is to calculate the annual benefit from accepting the bank's proposal. Answer (d) is correct because the net benefit from the reduction of the cash receipts float is $12,000 [($100,000 × 2) × 6%] minus the annual service fee, $6,000 ($500 × 12 months), which is equal to $6,000. Answer (b) is incorrect because it ignores the bank service charge. Answer (c) is incorrect because it assumes only a one-day reduction in float.
55. A company with $4.8 million in credit sales per year plans to relax its credit standards, projecting that this will increase credit sales by $720,000. The company's average collection period for new customers is expected to be 75 days, and the payment behavior of the existing customers is not expected to change. Variable costs are 80% of sales. The firm's opportunity cost is 20% before taxes. Assuming a 360-day year, what is the company's benefit (loss) from the planned change in credit terms? a. $0 b. $ 28,800 c. $144,000 d. $120,000
Correct Answer: D) $120,000 Answer (d) is correct because the benefit is equal to the contribution margin received from the additional sales minus the cost of having incremental funds tied up in accounts receivable. The benefit from an increase in sales is equal to $144,000 ($720,000 sales × 20% contribution margin (1-80% VC)). The interest opportunity cost is equal to 75 days' interest on the variable portion of sales, or ($720,000 × 80%)/360 × 75 × 20% interest = $24,000. Therefore, the net benefit is equal to $120,000 ($144,000 - $24,000).
80. On January 1, Scott Corporation received a $300,000 line of credit at an interest rate of 12% from Main Street Bank and drew down the entire amount on February 1. The line of credit agreement requires that an amount equal to 15% of the loan be deposited into a compensating balance account. What is the effective annual cost of credit for this loan arrangement? a. 11.00% b. 12.00% c. 12.94% d. 14.12%
Correct Answer: D) 14.12% Notes (d) The requirement is to calculate the effective annual interest rate of the credit arrangement. Answer (d) is correct because the effective interest rate is equal to the interest cost divided by the available funds. The interest cost is $36,000 ($300,000 × 12%), and the available funds is equal to $255,000 [$300,000 - (15% × $300,000)]. Therefore, the effective interest rate is 14.12% ($36,000/$255,000).
124. Martin Corporation Balance Sheet: (Dollars in millions) Assets Current assets &75 Plant and equipment $250 Total assets $325 Liabilities and shareholders' equity Current liabilities $46 Long-term debt (12%) $64 Common stock, $1 par $10 Additional paid in capital $100 Retained earnings $105 Total liabilities and shareholders' equity $325 Additional data: The long-term debt was originally issued at par ($1,000/ bond) and is currently trading at $1,250 per bond. Martin Corporation can now issue debt at 150 basis points over US Treasury bonds. The current risk-free rate (US Treasury bonds) is 7%. Martin's common stock is currently selling at $32 per share. The expected market return is currently 15%. The beta value for Martin is 1.25. Martin's effective corporate income tax rate is 40%. Using the Capital Asset Pricing Model (CAPM), Martin Corporation's current cost of common equity is a. 8.75% b. 10.00% c. 15.00% d. 17.00%
Correct Answer: D) 17.00% The CAPM formula is Cost of capital = Risk - free rate + (Market rate - Risk-free rate) × Beta. In this case, the estimated cost of equity is equal to 17% [7% + (15% - 7%) × 1.25]. Thus, the answer is (d).
37. The following information pertains to material X that is used by Sage Co.: Annual usage in units: 20,000 Working days per year: 250 Safety stock in units: 800 Normal lead time in working days: 30 Units of material X will be required evenly throughout the year. The order point is a. 800 b. 1,600 c. 2,400 d. 3,200
Correct Answer: D) 3,200 Notes (d) The requirement is to determine the order point for material X. When safety stock is maintained, the order point is computed as follows: Reorder point = (# of units sold per day X Purchase lead time in days) + Safety Stock Daily demand is eighty units (20,000 units / 250 days). Therefore, the order point is 3,200 units [(80 × 30) + 800].
7. Eagle Sporting Goods has $2.5 million in inventory and $2 million in accounts receivable. Its average daily sales are $100,000. The firm's payables deferral period is 30 days and average daily cost of sales are $50,000. What is the length of the firm's cash conversion period? a. 100 days. b. 60 days. c. 50 days. d. 40 days.
Correct Answer: D) 40 days. The cash conversion period is calculated as the Inventory conversion period + Receivables collection period - Payables deferral period. Answer (d) is correct because the inventory conversion period is $2,500,000/$50,000 = 50 days, and the receivable conversion period is $2,000,000/$100,000 = 20 days. Therefore, the cash conversion cycle is equal to 50 days + 20 days - 30 days = 40 days. Answer (a) is incorrect because is erroneously adds the payable deferral period.
75. Elan Corporation is considering borrowing $100,000 from a bank for one year at a stated interest rate of 9%. What is the effective interest rate to Elan if this borrowing is in the form of a discount note? a. 8.10% b. 9.00% c. 9.81% d. 9.89%
Correct Answer: D) 9.89% When a note is on a discounted basis, the interest is withheld from the proceeds. Answer (d) is correct because the effective interest rate is calculated by dividing the total amount of interest by the amount of funds available. In this case, the interest is equal to $9,000 ($100,000 × 9%) and the funds available are $91,000 ($100,000 - $9,000). Thus the interest rate is 9.89% ($9,000/$91,000). Answer (b) is incorrect because it represents the stated rate, not the effective rate.
9. The length of time between the acquisition of inventory and payment for it is called the a. Operating cycle. b. Inventory conversion period. c. Accounts receivable period. d. Accounts payable deferral period.
Correct Answer: D) Accounts payable deferral period. Notes (d) The requirement is to identify the definition of the payables deferral period. Answer (d) is correct because the payables deferral period is the average length of time between the purchase of materials and the payment of cash for them. Answer (a) is incorrect because the operating cycle is the period of time elapsing between the acquisition of goods and services involved in the manufacturing process and the final collection of cash from sale of the products. Answer (b) is incorrect because the inventory cycle is the average time required to convert materials into finished goods and sell those goods. Answer (c) is incorrect because the accounts receivable period is the length of time required to collect accounts receivable.
42. Ethan, Inc. has seasonal demand for its products and management is considering whether level production or seasonal production should be implemented. The firms' short-term interest cost is 8%, and management has developed the following information to make the decision: Alternative 1 (Level production): Average inventory: $2,000,000 Production Costs: $6,000,000 Alternative 2 (Seasonal production): Average inventory: $1,500,000 Production Costs: $6,050,000 Which alternative should be accepted and how much is saved over the other alternative? a. Alternative 1 with $500,000 in savings. b. Alternative 2 with $50,000 in savings. c. Alternative 2 with $10,000 in savings. d. Alternative 1 with $10,000 in savings.
Correct Answer: D) Alternative 1 with $10,000 in savings. Under the level production alternative, the firm would incur an additional $40,000 [($1,500,000 - $2,000,000) × 8%] in inventory holding costs but it would save $50,000 in production costs. Therefore, answer (d) is the correct answer. Alternative 1 results in $10,000 ($50,000 - $40,000) in savings over Alternative 2.
12. Troy Toys is a retailer operating in several cities. The individual store managers deposit daily collections at a local bank in a noninterest-bearing checking account. Twice per week, the local bank issues a depository transfer check (DTC) to the central bank at headquarters. The controller of the company is considering using a wire transfer instead. The additional cost of each transfer would be $25; collections would be accelerated by two days; and the annual interest rate paid by the central bank is 7.2% (0.02% per day). At what amount of dollars transferred would it be economically feasible to use a wire transfer instead of the DTC? Assume a 360-day year. a. It would never be economically feasible. b. $125,000 or above. c. Any amount greater than $173. d. Any amount greater than $62,500.
Correct Answer: D) Any amount greater than $62,500. Notes (d) The requirement is to determine the effect of changing from using a depository transfer check to using a wire transfer. The change is feasible if the interest savings offsets the increased costs. For a fee of $25, the firm gets two extra days' interest on the average transfer amount. By dividing the $25 fee by the interest rate for two days, .04% (2 days × .02%), we get $62,500. Therefore, management should make the change if the average transfer is expected to be greater than $62,500. Answer (a) is incorrect because it is a calculating assuming there is only a one-day decrease in float.
4. All of the following statements in regard to working capital are correct except: a. Current liabilities are an important source of financing for many small firms. b. Profitability varies inversely with liquidity. c. The hedging approach to financing involves matching maturities of debt with specific financing needs. d. Financing permanent inventory buildup with longterm debt is an example of an aggressive working capital policy.
Correct Answer: D) Financing permanent inventory buildup with longterm debt is an example of an aggressive working capital policy. Notes (d) The requirement is to determine the false statement regarding working capital management. Answer (d) is correct because financing permanent inventory buildup with long-term debt is an example of a conservative working capital policy. Answers (a), (b), and (c) are all accurate statements about working capital management.
5. Determining the appropriate level of working capital for a firm requires a. Evaluating the risks associated with various levels of fixed assets and the types of debt used to finance these assets. b. Changing the capital structure and dividend policy of the firm. c. Maintaining short-term debt at the lowest possible level because it is generally more expensive than long-term debt. d. Offsetting the benefit of current assets and current liabilities against the probability of technical insolvency.
Correct Answer: D) Offsetting the benefit of current assets and current liabilities against the probability of technical insolvency. (d) The requirement is to identify the factor considered in determining the appropriate level of working capital. Answer (d) is correct because the main reason to retain working capital is to meet the firm's financial obligations. Therefore, the amount is determined by offsetting the benefit of current assets and current liabilities against the probability of technical insolvency. Answer (a) is incorrect because it is a consideration regarding long-term financing. Answer (b) is incorrect because it is a consideration regarding capital structure. Answer (c) is incorrect because short-term debt is generally less expensive than long-term debt.
109. When a company increases its degree of financial leverage a. The equity beta of the company falls. b. The systematic risk of the company falls. c. The unsystematic risk of the company falls. d. The standard deviation of returns on the equity of the company rises.
Correct Answer: D) The standard deviation of returns on the equity of the company rises. Answer (d) is correct because when the degree of financial leverage rises, fixed interest charges rise. This causes the standard deviation of returns to equity holders to increase. Answers (a) and (b) are incorrect because an increase in the degree of financial leverage is associated with an increase in equity beta and an increase in the systematic risk of the company. Equity beta is a measure of systematic risk of the company. Answer (c) is incorrect because unsystematic risk of the company does not fall.
