PRACTICE EXERCISES

1) Management of a firm's liquidity involves management of the firm's investment in current assets as
well as its mix of long-term capital. (False)

2) Two advantages of financing with current liabilities are flexibility and lower interest cost.
True
3) Higher liquidity (holding larger cash and marketable securities balances) generally results in a lower
return on equity. True

4) Long-term debt is generally less costly than short-term debt, but also results in more illiquidity—hence,
the risk-return trade-off. False

5) Short-term debt provides a more flexible form of financing than long-term debt.true

6) Short-term debt has a greater risk of illiquidity than long-term debt because it must be rolled over more
frequently and its use creates more uncertainty concerning future interest rates. True

7) Working capital refers to investment in current assets, while net working capital is the difference
between current assets and current liabilities. True

8) A firm increases the risks of insolvency by keeping relatively large amounts of money tied up in
marketable securities. False

9) A company decreases the risk of insolvency by financing long-term assets with short-term debt.False

10) Achieving a lower inventory balance through working capital management can result in savings from
both carrying costs and losses associated with obsolete inventory. True

11) Working capital management involves managing a firm's liquidity. True

12) Three basic factors that determine which sources of short-term financing a firm uses are the effective
cost of financing, the availability of credit, and the influence of the use of a particular credit source on the
cost and availability of other sources of financing. True

13) The trade-off associated with holding large amounts of cash and marketable securities is increased
liquidity offset by a reduction in the overall rate of return. True

14) Accounts receivable is an asset representing sales made on credit. True

15) For many industries, accounts receivable comprise as much as 25 percent of total assets. True

16) Accounts receivable variables under control of the financial manager include the terms of credit sales
and the quality of credit customers. True

17) Accrued wages and taxes are secured sources of financing because companies are obligated to make
these payments before they make payments on any other loans or pay dividends. False
18) Credit terms of 2/10, net 30 have a lower effective cost than credit terms of 2/10, net 60 because in the
first case the loan will be repaid sooner.
False

19) Near-cash assets consist of marketable securities and accounts receivable. False

20) Marketable securities are purchased when excess cash is temporarily available and sold when cash is
needed. True

21) Transaction balances are used to meet the regular cash needs of the firm, not irregular outflows that
will be handled with speculative balances. False

22) The most important reasons firms hold cash balances are the transaction and precautionary
motives.True

23) The goal of cash management is to hold the minimum amount of cash necessary to meet the firm's
obligations in a timely manner. True

24) All of the following are potential disadvantages of short-term debt EXCEPT
A) short-term debt must be paid back more quickly than long-term debt.
B) uncertainty of interest costs because short-term debt must be replaced often.
C) a greater risk of illiquidity than long-term debt.
D) short-term debt generally has a higher interest cost than long-term debt.

25) Which of the following is NOT true regarding the use of short-term debt?
A) It must be rolled over more often than long-term debt.
B) There is uncertainty connected with interest costs on short-term debt from year to year.
C) The firm is subjected to greater liquidity risk when using short-term credit.
D) Interest rates are usually higher on short-term debt.

26) Which of the following is a disadvantage of the use of current liabilities to finance assets?
A) greater risk of illiquidity
B) less flexibility
C) higher interest costs
D) the hedging principle

27) Which of the following is an advantage of the use of current liabilities to finance assets?
A) less risk of illiquidity
B) more flexibility
C) lower interest costs
D) both B and C

28) Which of the following actions would improve a firm's liquidity?

A) repurchasing stock
B) selling bonds and increasing cash
C) buying bonds
D) increasing the company's dividend payments
29) Which of the following actions would improve a firm's liquidity?
A) purchasing inventories for cash
B) purchasing inventory on trade credit
C) purchasing inventory with long-term debt
D) buying machinery with long-term debt

30) Which of the following actions would decrease a firm's liquidity?

A) selling stock and reducing accounts payable
B) selling machinery and using proceeds to retire bonds
C) reducing accounts receivable and buying bonds
D) selling bonds and holding proceeds in the cash account

31) In general, the greater a firm's reliance upon short-term debt or current liabilities,
A) the lower will be its liquidity.
B) the greater will be its liquidity.
C) liquidity will remain constant.
D) there will be no effect on liquidity.

32) If a firm relies on short-term debt or current liabilities in financing its asset investments, and all other
things remain the same, what can be said about the firm's liquidity?
A) The firm will be relatively more liquid.
B) The firm will be relatively less liquid.
C) The liquidity of the firm will be unchanged.
D) The firm will be more liquid only if interest rates are below the company's weighted average cost of
capital.

33) Which of the following would normally occur if a firm increases its investment in current assets?
A) The firm's liquidity would be improved.
B) The firm's net working capital would decline.
C) The firm's liquidity would be worsened.
D) The firm's profit margin would improve.

34) The risk-return trade-off in managing a firm's working capital involves which of the following?
A) a trade-off between liquidity and activity
B) a trade-off between debt and equity
C) a trade-off between the firm's liquidity and its profitability
D) none of the above

35) A company that has an unpredictable cash flow, and is holding cash because of things that might
happen due to this uncertainty, is holding a larger minimum cash balance due to which type of motive?
A) transaction
B) precautionary
C) speculative
D) common sense

36) Which of the following would be an example of the "transactions motive" for a firm holding cash
balances?
A) investing "excess cash balances"
B) anticipating a downturn in the economy
C) purchase of inventory
D) take advantage of an anticipated decline in the price of raw materials

37) A company is technically insolvent when

A) cash outflows in a given period are greater than cash inflows.
B) earnings before interest payments are less than the interest payments.
C) it lacks the necessary liquidity to promptly pay its current debt obligations.
D) current ratio is less than 1.0.

38) Premium Seed Sales, Inc. expects to generate sales of $22,000,000 in the coming year. All sales are
done on a credit basis, net 45 days. Premium Seed has estimated that it takes an average of three days for
payments to reach their central office and an additional two days to process the payments. What is the
opportunity cost of the funds tied up in the mail and processing? Premium Seed uses a 360-day year in all
calculations and can invest free funds at 6.5%.

39) The Bike Store orders $2000 worth of supplies every 30 days. If they take advantage of the 3/10 net 30
discount offered by their supplier, how much would they save over the year? Assume a 360-day year.

40) Mountain Snow Sports, Inc. is trying to determine the optimal order quantity for snow boards for the
next twelve months. Annual sales are expected to be 1,000,000 units at a retail price of $400 each. The cost
of carrying snow boards is $80 per year. Studies show that it costs Mountain Snow $250 to prepare and
receive an order. What is the EOQ?

41) Fiesta Taco Company purchases 30,000 boxes of ground beef each year. It costs $50 to place each order
and $10.00 per year for each box held as inventory.
a. What is the average inventory held during the year?

b. What is the economic order quantity for the ground beef?

c. How many orders will be made each year?

42) A textile manufacturer has cloth that has a $14 per yard carrying cost per year. This cloth is used at a
rate of 25,000 yards per year, and ordering costs are $10 per order.

a. What is the economic order quantity for this cloth?

b. What are the annual inventory costs for this firm if it orders in this quantity?

43) A local lamp store expects to sell 2000 lamps in the coming year. It costs the store $1.00 in carrying
costs for each lamp and $10.00 for each order placed.

a. What is the economic order quantity for the lamps?

b. How many orders will be placed each year?

44) Discuss the risk-return trade-off experienced in working-capital management.

45) What are some examples of permanent and temporary investments in current assets?
46) What are the three motives for holding cash?

47) Describe the relationship between the firm's cash management program and the firm's risk of
insolvency.