Chapter26

WorkingCapitalManagement

26.1 OverviewofWorkingCapital
1) Thedifferencebetweenafirmsoperatingcycleanditscashcycleis
A) thereisnodifferencebetweenthecashandoperatingcycles.
B) itsaccountreceivabledays.
C) itsaccountspayabledays.
D) itsinventorydays.
Answer: C
Diff:1
Skill:Definition

2) Thecashconversioncycle(CCC)isdefinedas
A) InventoryDays+AccountsReceivableDays- AccountsPayableDays.
B) InventoryDays-AccountsReceivableDays- AccountsPayableDays.
C) InventoryDays+AccountsReceivableDays+ AccountsPayableDays.
D) InventoryDays+AccountsPayableDays- AccountsReceivableDays.
Answer: A
Diff:1
Skill:Definition

3) Whichofthefollowingstatementsisfalse?
A) Themaincomponentsofnetworkingcapitalarecash,inventory,receivables,andpayables.
B) Thefirmscashcycleistheaveragelengthoftimebetweenwhenafirmoriginallypurchasesits
inventoryandwhenitreceivesthecashbackfromsellingitsproduct.
C) Workingcapitalincludesthecashthatisneededtorunthefirmonaday -to-daybasis.Itdoes
notincludeexcesscash,whichiscashthatisnotrequiredtorunthebusinessandcanbe
investedatamarketrate.
D) Ifthefirmpayscashforitsinventory,thefirmsoperatingcycleisidenticaltothefirmscash
cycle
Answer: B
Explanation:

Diff:2
Skill:Conceptual

B) Thefirmsoperatingcycle istheaveragelengthoftimebetweenwhenafirm
originallypurchasesitsinventoryandwhenitreceivesthecashbackfromsellingits
product.

Chapter26WorkingCapitalManagement657

4) Whichofthefollowingstatementsisfalse?
A) Afirmscashcycleisthelengthoftimebetweenwhenthefirmpayscashtopurchaseitsinitial
inventoryandwhenitreceivescashfromthesaleoftheoutputproducedfromthatinventory.
B) Thelongerafirmscashcycle,themoreworkingcapitalithas,andthemorecashitneedsto
carrytoconductitsdailyoperations.
C) Mostfirmsbuytheirinventoryoncredit,whichincreasestheamountoftimebetweenthecash
investmentandthereceiptofcashfromthatinvestment.
D) Anyreductioninworkingcapitalrequirementsgeneratesapositivefreecashflowthatthefirm
candistributeimmediatelytoshareholders.
Answer: C
Explanation:

C) Mostfirmsbuytheirinventoryoncredit,whichreducestheamountoftimebetween
thecashinvestmentandthereceiptofcashfromthatinvestment.

Diff:2
Skill:Conceptual

Usethetableforthequestion(s)below.
LutherIndustrieshadsalesof$980millionandacostofgoodssoldof$560millionin2006.Asimplifiedbalance
sheetforthefirmappearsbelow:
LutherIndustries
BalanceSheet
AsofDecember31,2006
(millionsofdollars)
Assets
Cash
Accountsreceivable
Inventory
Totalcurrentassets
Netplant,property,andequipment
Totalassets

25
85
90
200
6,100
6,300

LiabilitiesandEquity
Accountspayable
Notespayable
Accruals
Totalcurrentliabilities
Longtermdebt
Totalliabilities
Commonequity
Totalliabilitiesandequity

5) LuthersInventorydaysisclosestto:
A) 32days
B) 59days
C) 39days
D) 42days
Answer: B
Explanation:
Diff:1
Skill:Analytical

B) Inventorydays=

Inventory
$90
=
=58.66days
COGS/365 $560/365

60
425
45
530
2,725
3,255
3,045
6,300

658Berk/DeMarzoCorporateFinance

6) LuthersAccountsReceivabledaysisclosestto:
A) 42days
B) 39days
C) 32days
D) 59days
Answer: C
Explanation:

C) AccountsReceivabledays=

AccountsReceivable
$85
=
=31.66days
Sales/365
$980/365

Diff:1
Skill:Analytical

7) LuthersAccountsPayabledaysisclosestto:
A) 39days
B) 32days
C) 59days
D) 42days
Answer: A
Explanation:

A) AccountsPayablesdays=

AccountsPayable
$60
=
=39.11days
COGS/365
$560/365

Diff:1
Skill:Analytical

8) Lutherscashconversioncycleisclosestto:
A) 51days
B) 66days
C) 71days
D) 129days
Answer: A
Explanation:

A) Inventorydays=

Inventory
$90
=
=58.66days
COGS/365 $560/365

AccountsReceivabledays=
AccountsPayablesdays=

AccountsReceivable
$85
=
=31.66days
Sales/365
$980/365

AccountsPayable
$60
=
=39.11days
COGS/365
$560/365

CCC=Inventorydays+AccountsReceivabledays-AccountsPayabledays
CCC=58.66+31.66-39.11=51.21days
Diff:2
Skill:Analytical

Chapter26WorkingCapitalManagement659

9) CalculatethenumberofdaysinLuthersOperatingCycle.
Answer: Inventorydays=

$90
Inventory
=
=58.66days
COGS/365 $560/365

AccountsReceivabledays=

AccountsReceivable
$85
=
=31.66days
Sales/365
$980/365

OperatingCycle=Inventorydays+accountsreceivabledays=58.66+31.66=90.32days
Diff:2
Skill:Analytical

10) KTEnterpriseswouldliketoconstructandoperateanewiceskatingrink.Inadditiontothecapital
expendituresontherink,managementestimatesthattheprojectwillrequireaninvestmenttodayof
$220,000innetworkingcapital.Thefirmwillrecovertheinvestmentinnetworkingcapitalfifteen
yearsfromtoday,whenmanagementanticipatesclosingtherink.Thediscountrateforthistypeof
cashflowis8%peryear.Calculatethepresentvalueofthecostofworkingcapitalfortheiceskating
rink.
Answer: NPV=-$220,000+

$220,000
=-$150,646.82
(1.08) 15

Diff:1
Skill:Analytical

26.2 TradeCredit
1) Collectionfloatismadeupofallofthefollowingexcept
A) disbursementfloat.
B) processingfloat.
C) mailfloat.
D) availabilityfloat.
Answer: A
Diff:1
Skill:Conceptual

2) Whichofthefollowingstatementsisfalse?
A) UndertheModigliani-Millerassumptionsofperfectcapitalmarkets,theamountsofpayables
andreceivablesareirrelevant.
B) Onefactorthatcontributestothelengthofafirmsreceivablesandpayablesisthedelay
betweenthetimeabillispaidandthecashisactuallyreceived.
C) Collectionfloatistheamountoftimeittakesbeforepaymentstosuppliersactuallyresultina
cashoutflowforthefirm.
D) Thecreditthatthefirmisextendingtoitscustomerisknownastradecredit.
Answer: C
Explanation:
Diff:2
Skill:Conceptual

C) Disbursementfloat istheamountoftimeittakesbeforepaymentstosuppliers
actuallyresultinacashoutflowforthefirm.

660Berk/DeMarzoCorporateFinance

3) Whichofthefollowingstatementsisfalse?
A) TheCheckClearingforthe21stCenturyAct(Check21),whichbecameeffectiveonOctober28,
2004,eliminatedthedisbursementfloatduetothecheck-clearingprocess.
B) Tradecreditis,inessence,aloanfromthesellingfirmtoitscustomer.
C) Theaccountsreceivablebalancerepresentstheamountthatafirmowesitssuppliersforgoods
thatithasreceivedbutforwhichithasnotyetpaid.
D) Providingfinancingatbelow-marketratesisanindirectwaytolowerpricesforonlycertain
customers.
Answer: C
Explanation:

C) Theaccountspayablebalancerepresentstheamountthatafirmowesitssuppliersfor
goodsthatithasreceivedbutforwhichithasnotyetpaid.

Diff:2
Skill:Conceptual

4) Theterm2/10net30means?
A) Iftheinvoiceispaidwithin10daysa2%discountcanbetaken.Iftheinvoiceispaidbetween
11and29daysa1%discountcanbetaken.After30daysthefullinvoiceisdue.
B) Iftheinvoiceispaidwithin2daysa10%discountcanbetaken,otherwisethefullinvoiceisdue
in30days.
C) Iftheinvoiceispaidwithin2daysa10%discountcanbetaken,otherwisea2%discountcanbe
takeniftheinvoiceispaidin30days.
D) Iftheinvoiceispaidwithin10daysa2%discountcanbetaken,otherwisethefullinvoiceisdue
in30days.
Answer: D
Diff:1
Skill:Definition

5) Yourfirmpurchasesgoodsfromitssupplierontermsof1/10,net30.Theeffectiveannualcostto
yourfirmifitchoosesnottotakeadvantageofthetradediscountofferedisclosestto:
A) 16.8%
B) 44.6%
C) 20.1%
D) 13.0%
Answer: C
Explanation:

C) Thedifferenceindays= 30- 10= 20days.Youwilleitherpay$0.99onadollarof

Diff:1
Skill:Analytical

$1.00 20
-1=.201317or20.13%
$0.99

Chapter26WorkingCapitalManagement661

6) Yourfirmpurchasesgoodsfromitssupplierontermsof2/10,net45.Calculatetheeffectiveannual
costtoyourfirmifitchoosesnottotakeadvantageofthetradediscountoffered.
Answer: Thedifferenceindays= 45- 10= 35days.Youwilleitherpay$0.98onadollarofsalesin10
daysor$1.00onadollarofsalesin45days.
365

EAR=

$1.00 35
-1=.234524or23.45%
$0.98

Diff:1
Skill:Analytical

26.3 ReceivablesManagement
1) Whichoneofthefollowingisnotoneofthethreestepsinvolvedinestablishingacreditpolicy?
A) Establishingcreditpaymentpatterns
B) Establishingcreditstandards
C) Establishingacollectionpolicy
D) Establishingcreditterms
Answer: A
Diff:1
Skill:Conceptual

2) Whichofthefollowingstatementsisfalse?
A) Afterafirmdecidesonitscreditstandards,itmustnextestablishitscreditterms.
B) Thedecisionofhowmuchcreditrisktoassumeplaysalargeroleindetermininghowmuch
moneyafirmtiesupinitspayables.
C) Knowledgeofthepaymentspatternisalsousefulforforecastingthefirmsworkingcapital
requirements.
D) Anagingschedulecategorizesaccountsbythenumberofdaystheyhavebeenonthefirms
books.
Answer: B
Explanation:
Diff:2
Skill:Conceptual

B) Thedecisionofhowmuchcreditrisktoassumeplaysalargeroleindetermininghow
muchmoneyafirmtiesupinitsreceivables.

662Berk/DeMarzoCorporateFinance

3) Whichofthefollowingstatementsisfalse?
A) Theagingscheduleisalsosometimesaugmentedbyanalysisofthepaymentspattern,which
providesinformationonthepercentageofmonthlysalesthatthefirmcollectsineachmonth
afterthesale.
B) Becauseaccountsreceivabledayscanbecalculatedfromthefirmsfinancialstatement,outside
investorscommonlyusethismeasuretoevaluateafirmscreditmanagementpolicy.
C) Iftheagingschedulegetstop-heavythatis,ifthepercentagesintheupperhalfofthe
schedulebegintoincreasethefirmwilllikelyneedtorevisititscreditpolicy.
D) Seasonalsalespatternsmaycausethenumbercalculatedfortheaccountsreceivabledaysto
changedependingonwhenthecalculationtakesplace.
Answer: C
Explanation:

C) Iftheagingschedulegetsbottom-heavythatis,ifthepercentagesinthelowerhalf
oftheschedulebegintoincreasethefirmwilllikelyneedtorevisititscreditpolicy.

Diff:2
Skill:Conceptual

4) LutherIndustriesbillsitsaccountsontermsof2/10,net30.Thefirmsaccountsreceivableinclude
$250,000thathasbeenoutstandingfor10orfewerdays,$375,000outstandingfor11to30days,
$70,000outstandingfor31to40days,$35,000outstandingfor41to50days,$20,000outstandingfor
51to60days,and$8,000outstandingformorethan60days.PrepareanagingscheduleforLuther
Industries.
Answer: Days
Outstanding
1-10
11-30
31-40
41-50
51-60
60+
Total=
Diff:2
Skill:Analytical

Amount
Percentage
Outstanding($) Outstanding(%)
$250,000
33.0%
$375,000
49.5%
$70,000
9.2%
$35,000
4.6%
$20,000
2.6%
$8,000
1.1%
$758,000

Chapter26WorkingCapitalManagement663

26.4 PayablesManagement
1) Whichofthefollowingstatementsisfalse?
A) Thelowerthediscountpercentageoffered,thegreaterthecostofforgoingthediscountand
usingtradecredit.
B) Afirmshouldchoosetoborrowusingaccountspayableonlyiftradecreditisthecheapest
sourceoffunding.
C) Afirmshouldalwayspayonthelatestdayallowed.
D) Afirmshouldstrivetokeepitsmoneyworkingforitaslongaspossiblewithoutdevelopinga
badrelationshipwithitssuppliersorengaginginunethicalpractices.
Answer: A
Explanation:

A) Thehigherthediscountpercentageoffered,thegreaterthecostofforgoingthe
discountandusingtradecredit.

Diff:1
Skill:Conceptual

2) Whichofthefollowingstatementsisfalse?
A) Similartothesituationwithitsaccountsreceivable,afirmshouldmonitoritsaccountspayable
toensurethatitismakingitspaymentsatanoptimaltime.
B) Somefirmsignorethepaymentdueperiodandpaylater,inapracticereferredtoaspushingthe
accountspayable.
C) Suppliersmayreacttoafirmwhosepaymentsarealwayslatebyimposingtermsofcashon
delivery(COD)orcashbeforedelivery(CBD).
D) Iftheaccountspayableoutstandingis40daysandthetermsare2/10,net30,thefirmcan
concludethatitgenerallypayslateandmayberiskingsupplierdifficulties.
Answer: B
Explanation:
Diff:1
Skill:Conceptual

B) Somefirmsignorethepaymentdueperiodandpaylater,inapracticereferredtoas
stretchingtheaccountspayable.

664Berk/DeMarzoCorporateFinance

3) Yourfirmpurchasesgoodsfromitssupplierontermsof1/10,net30.Theeffectiveannualcostto
yourfirmifitchoosesnottotakeadvantageofthetradediscountofferedandstretchestheaccounts
payableto45daysisclosestto:
A) 13.0%
B) 11.1%
C) 15.9%
D) 20.1%
Answer: B
Explanation:

B) Thedifferenceindays= 45- 10= 35days.Youwilleitherpay$0.99onadollarof

$1.00 35
-1=.110500or11.05%
$0.99

Diff:2
Skill:Analytical

4) Yourfirmpurchasesgoodsfromitssupplierontermsof2/10,net40.Theeffectiveannualcostto
yourfirmifitchoosesnottotakeadvantageofthetradediscountofferedandstretchestheaccounts
payableto60daysisclosestto:
A) 20.1%
B) 15.9%
C) 13.0%
D) 11.1%
Answer: B
Explanation:

B) Thedifferenceindays= 60- 10= 50days.Youwilleitherpay$0.98onadollarof

$1.00 50
-1=.11589or15.89%
$0.98

Diff:2
Skill:Analytical

5) KinstonIndustrieshasanaverageaccountspayablebalanceof$220,000.Itsannualcostofgoodssold
is$5,475,000,anditreceivestermsof2/10,net30fromitssuppliers.Kinstonchoosestoforgothis
discount.IsKinstonmanagingitsaccountspayableswell?
Answer: Thefirmisnotmanagingitsaccountspayableswell.Kinstonsdayspayableoutstandingis
$220,000
=14.67days.IfKinstonmadethepaymentslessthanfivedaysearlier,they
$5,475,000/365
couldtakea2%discount.If,forsomereason,theychoosetoforgothediscount,thenthey
shouldnotbepayingthefullamountuntil30days.
Diff:2
Skill:Analytical

Chapter26WorkingCapitalManagement665

6) GoldsboroIndustrieshasanaverageaccountspayablebalanceof$680,000.Itsannualcostofgoods
soldis$4,500,000,anditreceivestermsof1/10,net40fromitssuppliers.Goldsborochoosestoforgo
thisdiscount.IsGoldsboromanagingitsaccountspayableswell?
Answer: Thefirmisnotmanagingitsaccountspayableswell.Goldsborosdayspayableoutstandingis
$680,000
=55.16days.Theyareoverthetermof40daysofferbytheirsuppliers.
$4,500,000/365
Goldsboroisstretchingthetermsofthecreditagreementandriskshavingproblemswiththeir
suppliersasaresult.
Diff:2
Skill:Analytical

26.5 InventoryManagement
1) Whichofthefollowingisnotadirectcostsassociatedwithinventory?
A) Acquisitioncosts
B) Ordercosts
C) Carryingcosts
D) Stockoutcosts
Answer: D
Diff:1
Skill:Definition

2) Whichofthefollowingstatementsisfalse?
A) UndertheModigliani-Millerassumptionsofperfectcapitalmarkets,theamountofinventoryis
irrelevant.
B) Unliketradecredit,inventoryrepresentsoneoftherequiredfactorsofproduction.
C) Itisthefirmsfinancialmanagerwhomustarrangeforthefinancingnecessarytosupportthe
firmsinventorypolicyandwhoisresponsibleforensuringthefirmsoverallprofitability.
D) Inventorymanagementreceivesextensivecoverageincoursesonoperationsmanagement.
Answer: A
Explanation:
Diff:2
Skill:Conceptual

A) EveninaperfectmarketssettinginwhichtheModigliani-Millerpropositionshold,
firmsstillneedinventory.

666Berk/DeMarzoCorporateFinance

3) Whichofthefollowingstatementsisfalse?
A) Firmsmayholdinventorybecausefactorssuchasseasonalityindemandmeanthatcustomer
purchasesdonotperfectlymatchthemostefficientproductioncycle.
B) Inventoryhelpsminimizetheriskthatthefirmwillnotbeabletoobtainaninputitneedsfor
production.
C) Ifafirmholdstoomuchinventory,stock-outs,thesituationwhenafirmrunsoutofproduct,
mayoccur,leadingtolostsales.
D) Becauseexcessiveinventoryusescash,efficientmanagementofinventoryincreasesfirmvalue.
Answer: C
Explanation:

C) Ifafirmholdstoolittleinventory,stock-outs,thesituationwhenafirmrunsoutof
product,mayoccur,leadingtolostsales.

Diff:2
Skill:Conceptual

4) Describejust-in-timeinventorymanagement.
Answer: Somefirmsseektoreducetheircarryingcostsasmuchaspossible.Withjust-intime(JIT)
inventorymanagement,afirmacquiresinventorypreciselywhenneededsothatitsinventory
balanceisalwayszero,orveryclosetoit.Thistechniquerequiresexceptionalcoordination
withsuppliersaswellasapredictabledemandforthefirmsproducts.Inaddition,theremay
beatrickle-downeffectwhenonefirminanindustryadoptsJIT.Forexample,in1999,ToysR
UsinstitutedJIT,whichcausedoneofitssuppliers,toymanufacturerHasbro,tomakechanges
initsproductionschedule.
Diff:2
Skill:Conceptual

26.6 CashManagement
1) Whichofthefollowingmoneymarketinvestmentsisashort-termdebtobligationsoftheU.S.
government?
A) TreasuryBill
B) RepurchaseAgreement
C) CommercialPaper
D) CertificatesofDeposit(CD)
E) BankersAcceptance
Answer: A
Diff:1
Skill:Definition

Chapter26WorkingCapitalManagement667

2) Whichofthefollowingmoneymarketinvestmentsisshort -termdebtissuedbyabankwitha
minimumdenominationof$100,000?
A) TreasuryBill
B) BankersAcceptance
C) RepurchaseAgreement
D) CommercialPaper
E) CertificatesofDeposit(CD)
Answer: E
Diff:1
Skill:Definition

3) Whichofthefollowingmoneymarketinvestmentsisessentiallyaloanarrangementwhereina
securitiesdealeristheborrowerandtheinvestoristhelender.Theinvestorbuyssecuritiesfrom
thesecuritiesdealer,withanagreementtosellthesecuritiesbacktothedealeratalaterdatefora
specifiedhigherprice?
A) CertificatesofDeposit(CD)
B) CommercialPaper
C) BankersAcceptance
D) RepurchaseAgreement
E) TreasuryBill
Answer: D
Diff:1
Skill:Definition

4) Whichofthefollowingmoneymarketinvestmentsisadraftwrittenbytheborrowerandguaranteed
bythebankonwhichthedraftisdrawn.Typicallyusedininternationaltradetransactions.The
borrowerisanimporterwhowritesthedraftinpaymentforgoods?
A) TreasuryBill
B) RepurchaseAgreement
C) CertificatesofDeposit(CD)
D) BankersAcceptance
E) CommercialPaper
Answer: D
Diff:1
Skill:Definition

668Berk/DeMarzoCorporateFinance

5) Whichofthefollowingmoneymarketinvestmentsisashort-term,unsecureddebtobligationissued
byalargecorporation.Theminimumdenominationis$25,000,butmosthaveafacevalueof$100,000
ormore?
A) BankersAcceptance
B) CommercialPaper
C) RepurchaseAgreement
D) CertificatesofDeposit(CD)
E) TreasuryBill
Answer: B
Diff:1
Skill:Definition

6) Theamountofcashafirmneedstobeabletopayitsbillsissometimesreferredtoasa(n)
A) operatingbalance
B) compensatingbalance.
C) transactionsbalance.
D) precautionarybalance.
Answer: C
Diff:1
Skill:Definition

7) Theamountofcashafirmholdstocountertheuncertaintysurroundingitsfuturecashneedsis
knownasa(n)
A) speculativebalance.
B) compensatingbalance.
C) operatingbalance
D) precautionarybalance.
Answer: D
Diff:1
Skill:Definition

8) Whatisacompensatingbalance?
Answer: Afirmsbankmayrequireittoholdacompensatingbalanceinanaccountatthebankas
compensationforservicesthatthebankperforms.Compensatingbalancesaretypically
depositedinaccountsthateitherearnnointerestorpayaverylowinterestrate.This
arrangementissimilartoabankofferingindividualsfreecheckingsolongastheirbalancesdo
notfallbelowacertainlevelsay,$1000.Essentially,thecustomerhas$1000cashthathecannot
useunlessheiswillingtopayaservicecharge.Similarly,thecashthatafirmhastiedupto
meetacompensatingbalancerequirementisunavailableforotheruses.
Diff:2
Skill:Conceptual