Of the following, the working capital financing policy that would subject a firm to the greatest level of risk is the one where the firm finances
Answer (D) is correct. The maturity matching (self-liquidating) approach to financing of current assets minimizes the risk that the entity cannot pay its debts when they become due. It is based on the assumption that the firm can control when the assets are liquidated.
Accordingly, the riskiest approach is to finance permanent assets with short-term debt. Moreover, short-term financing subjects the firm to greater risks of interest rate increases and loan renewal problems.
Average daily cash outflows are $3 million for Evans, Inc. A new cash management system can add 2 days to the disbursement schedule. Assuming Evans earns 10% on excess funds, how much should the firm be willing to pay per year for this cash management system?
Answer (D) is correct. If cash outflows are $3 million per day, holding cash 2 extra days means that average balances should increase by $6 million. At a 10% interest rate, the additional $6 million would generate interest revenue of $600,000 per year. Thus, if the system can be acquired for $600,000 or less, it would be beneficial to do so.
According to John Maynard Keynes, the three major motives for holding cash are for
Answer (D) is correct. John Maynard Keynes, founder of Keynesian economics, concluded that there were three major motives for holding cash: for transactional purposes as a medium of exchange, precautionary purposes, and speculative purposes (but only during deflationary periods).
A consultant recommends that a company hold funds for the following two reasons:
1. Reason #1: Cash needs can fluctuate substantially throughout the year.
2. Reason #2: Opportunities for buying at a discount may appear during the year.
The cash balances used to address the reasons given above are correctly classified as
Answer (C) is correct. The three motives for holding cash are as a medium of exchange, as a precautionary measure, and for speculation. Reason #1 can be classified as a precautionary measure, and Reason #2 can be classified as holding cash for speculation.
All of the following are valid reasons for a business to hold cash and marketable securities except to
Answer (D) is correct. A company will hold cash and marketable securities to facilitate business transactions; cash is a medium of exchange. Cash and near-cash items are also held to meet future needs, to satisfy compensating balance requirements imposed by lenders, and to provide a precautionary balance for security purposes. Cash is usually not held in an attempt to earn maximum returns on investment because cash and marketable securities are not usually the highest paying investments.
Some managers express the opinion that their “cash management problems are nothing more than inventory problems.” They then proceed to use cash management models, such as the EOQ model, to determine the
Answer (D) is correct. Because cash and inventory are both nonearning assets, in principle they may be treated similarly. The alternative to holding cash, however, is to hold marketable securities that do earn interest or dividends. Thus, a cash management model would determine how much of a firm’s liquidity should be held as cash and how much in the form of marketable securities.
The economic order quantity (EOQ) formula can be adapted in order for a firm to determine the optimal split between cash and marketable securities. The EOQ model assumes all of the following except that
Answer (D) is correct. The EOQ formula is a deterministic model that requires a known demand for inventory or, in this case, the amount of cash needed. Thus, the cash flow requirements cannot be random. The model also assumes a given carrying (interest) cost and a flat transaction cost for converting marketable securities to cash, regardless of the amount withdrawn.
The most direct way to prepare a cash budget for a manufacturing firm is to include
Answer (D) is correct. The most direct way of preparing a cash budget requires incorporation of sales projections and credit terms, collection percentages, estimated purchases and payment terms, and other cash receipts and disbursements. In other words, preparation of the cash budget requires consideration of both inflows and outflows.
What is the benefit for a firm with daily cash receipts of $15,000 to be able to speed up collections by 2 days, assuming an 8% annual return on short-term investments and no cost to the company to speed up collections?
Answer (B) is correct. Speeding up collections by 2 days will raise the firm’s average cash balance by $30,000. At 8% interest, the benefit will be $2,400 annually [($15,000 × 2 days) × .08 .
DLF is a retail mail order firm that currently uses a central collection system that requires all checks to be sent to its Boston headquarters. An average of 6 days is required for mailed checks to be received, 3 days for DLF to process them, and 2 days for the checks to clear through its bank. A proposed lockbox system would reduce the mailing and processing time to 2 days and the check clearing time to 1 day. DLF has an average daily collection of $150,000. If DLF adopts the lockbox system, its average cash balance will increase by
Answer (A) is correct. Checks are currently tied up for 11 days (6 for mailing, 3 for processing, and 2 for clearing . If that period were reduced to 3 days, DLF’s cash balance would increase by $1,200,000 ($150,000 per day × 8 days).