Credit 5

CHAPTER 14WORKING CAPITAL POLICY
TRUE/FALSE
1. The fact that no explicit interest cost is paid on accruals and that the firm can exercise considerable control over
their level makes accruals an attractive source of additional funding.
ANS: F DIF: Easy TOP: Accruals
2. Due to advanced technology and the similarity of general procedures, working capital management for
multinational firms is no more complex than it is for domestic firms.
ANS: F DIF: Easy TOP: International working capital management
3. Working capital management is not important for new firms since they will be able to generate positive cash flows
at some time in the future.
ANS: F DIF: Easy TOP: Working capital policy
4. The best and most comprehensive picture of a firm's liquidity position is obtained by examining its cash budget.
ANS: T DIF: Easy TOP: Working capital policy
5. A high current ratio insures that a firm will have the cash required to meet its needs.
ANS: F DIF: Easy TOP: Working capital policy
6. The inventory conversion period is calculated by dividing inventory by the cost of goods sold per day.
ANS: T DIF: Easy TOP: Cash conversion cycle
7. The cash conversion cycle is the sum of the inventory conversion period, the receivables collection period, and
the payables deferral period.
ANS: F DIF: Easy TOP: Cash conversion cycle
8. A firm with a current ratio equal to four will have its current ratio increase if both current assets and current
liabilities increase by the same amount.
ANS: F DIF: Medium TOP: Working capital policy
9. The sale of inventory at cost for cash will increase the current assets for a firm.
ANS: F DIF: Medium TOP: Current assets
10. The sale of common stock for cash will increase the current assets for a firm.
ANS: T DIF: Medium TOP: Current assets
11. A firm's goal should be to lengthen the cash conversion cycle since shorter cash conversion cycles leads firms to
increase their dependence on costly external financing.
ANS: F DIF: Medium TOP: Cash conversion cycle
12. In terms of the cash conversion cycle, a restricted investment policy would tend to reduce the inventory
conversion and receivables collection periods, which would result in a relatively short cash conversion cycle.
ANS: T DIF: Medium TOP: Restricted current asset investment policy
Chapter 14 Working Capital Policy 310
MULTIPLE CHOICE
1 Net working capital is
a. current liabilities.
b. current assets.
c. current liabilities plus current assets.
d. current assets minus current liabilities.
e. current liabilities minus current assets.
ANS: D DIF: Easy OBJ: TYPE: Conceptual
TOP: Net working capital
13. Which of the following current liabilities are considered when calculating net working capital?
a. Use of short-term debt to finance fixed assets.
b. Commercial paper issued to finance inventory.
c. Current maturities of long term debt.
d. Accounts receivable generated by sales on credit.
e. Inventory purchased with cash.
ANS: B DIF: Easy OBJ: TYPE: Conceptual
TOP: Net working capital
14. The cash conversion cycle is the length of time from the __________ raw materials to manufacture a product until
the __________ of accounts receivable associated with the sale of the product.
a. ordering of; creation
b. ordering of; collection
c. payment for; creation
d. payment for; collection
e. none of the above
TOP: Cash conversion cycle
15. The average length of time required to convert materials into finished products and sell that product is called the
__________.
a. cash conversion cycle
b. inventory conversion period
c. receivables collection period
d. payables deferral period
e. days sales outstanding
16. The average length of time required to convert a firm's receivables into cash is called the __________.
ANS: C DIF: Easy OBJ: TYPE: Conceptual
17. The average length of time between the purchase of raw material and labor and the payment of cash for them is
called the __________.
18. Firms following a restricted current asset policy are likely to __________ holdings of cash and have a
__________ credit policy on sales.
a. have large; conservative
b. minimize the; conservative
c. have large; liberal
d. minimize the; liberal
e. have zero; liberal
TOP: Working capital policy
19. Firms following a relaxed current asset policy are likely to __________ holdings of cash and have a __________
credit policy on sales.
a. have large; conservative
b. minimize the; conservative
c. have large; liberal
d. minimize the; liberal
e. have zero; liberal
20. A firm following an aggressive approach to working capital policy will finance all of the fixed assets with
__________, and some of the firm's permanent current assets will be financed with __________.
a. short-term nonspontaneous sources of funds; long term capital
b. commercial paper; long term capital
c. long term capital; short-term nonspontaneous sources of funds
d. long term capital; corporate bonds
e. short-term nonspontaneous sources of funds; corporate bonds
21. A firm following a conservative approach to working capital policy will finance __________ of the fixed assets,
__________ of the permanent current assets, and __________ of temporary current assets are financed with long
term capital.
a. all; some; none
b. none; all; all
c. all; none; none
d. all; all; some
e. some; all; all
312 Chapter 14 Working Capital Policy
22. The aggressive approach towards working capital policy requires the __________ use of short-term debt, whereas
the conservative approach of working capital policy requires the __________ use of short-term debt.
a. greatest; least
b. least; greatest
c. limited; total
d. lack of; heavy
e. heavy; heavy
ANS: A DIF: Easy OBJ: TYPE: Conceptual
23. The average cash conversion cycle of European firms is __________ as long as the average cash conversion cycle
of American firms.
a. equally
b. one-half
c. twice
d. one-fourth
e. four times
TOP: Multinational working capital policy
24. Golden Fritter Corporation has a current ratio equal to three. If Golden Fritter issues $1,000,000 in long term
bonds and uses the proceeds to purchase inventory, what will happen to the current ratio?
a. Increase
b. Decrease
c. Stay the same
d. Change, but more information is required to determine the direction of the change.
e. None of the above.
ANS: B DIF: Medium OBJ: TYPE: Conceptual TOP: Working capital
25. Sea Sport Boat Corporation currently has a current ratio of two. If Sea Sport Boat Corporation increases current
assets and current liabilities by the same amount, what will happen to their current ratio?
a. Increase
b. Decrease
c. Stay the same
ANS: B DIF: Medium OBJ: TYPE: Conceptual TOP: Working capital
26. Gator Corporation currently has a current ratio equal to 0.65. If Gator Corporation increases current assets and
current liabilities by the same amount, what will happen to their current ratio?
a. Increase
b. Decrease
c. Stay the same
ANS: A DIF: Medium OBJ: TYPE: Conceptual TOP: Working capital
27. On average, a firm sells $2,500,000 in merchandise a month. Its cost of goods sold equals 80 percent of sales, and
it keeps inventory equal to one-half of its monthly cost of goods on hand at all times. If the firm analyzes its
accounts using a 360-day year, what is the firm's inventory conversion period?
a. 360 days
b. 180 days
c. 30 days
d. 15 days
e. 10 days
ANS: D
360 days
Inventory Conversion Period =
Cost of goods sold/ Inventory
Annual cost of goods = [$2,500,000(0.8)] 12 months = $24,000,000.
Inventory = 0.5 $2,500,000(0.8) = $1,000,000.
360
ICP = = 15 days.
$ 24 /$ 1
DIF: Easy OBJ: TYPE: Problem TOP: Inventory conversion period
28. The accounts of Weston Inc. indicate the following changes in long-term assets and capital for the past year:
(1) Fifty thousand (50,000) shares of common stock were sold at $25 per
share.
(2) Two million dollars ($2 million) in bonds matured and were retired.
(3) Dividends of $1 million were paid.
(4) Net fixed assets declined by $200,000.
(5) Net income was calculated to be $2 million.
(6) Depreciation expense was $1.5 million.
What was the increase or decrease in net working capital? (Hint: Changes in net fixed assets incorporate changes
in both gross fixed assets and accumulated depreciation.)
a. +$450,000
b. -$250,000
c. -$1,950,000
d. +$1,950,000
e. +$3,300,000
ANS: A
Sources of funds (In millions):
Net income $2.00

Depreciation 1.50
Sale of stock 1.25
Total sources $4.75
Uses of funds (In millions):
Purchase of assets $1.30

Dividend paid 1.00
Retirement of bond 2.00
Increase in NWC 0.45 (Forced figure)
314 Chapter 14 Working Capital Policy
Total uses $4.75

Increase in net working capital = 0.45 $1,000,000 = $450,000.
DIF: Medium OBJ: TYPE: Problem TOP: Change in net working capital
29. You have recently been hired to improve the performance of Multiplex Corporation which has been experiencing
a severe cash shortage. As one part of your analysis, you want to determine the firm's cash conversion cycle.
Using the following information and a 360-day year, what is your estimate of the firm's current cash conversion
cycle?
Current inventory = $120,000
Annual sales = $600,000
Accounts receivable = $160,000
Accounts payable = $25,000
Total annual purchases = $360,000
Purchases credit terms: net 30 days
Receivables credit terms: net 50 days
a. 49 days
b. 143 days
c. 100 days
d. 168 days
e. 191 days
ANS: E
Calculate each of the three main components of the cash conversion cycle:
Inventory conversion period (ICP):
$ 120,000 $ 120,000
ICP = = =120 days
$ 360,000/360 $ 1,000
Receivables collection period (RCP):
$ 160,000 $ 160,000
RCP = = =96 days
$ 600,000 /360 $ 1,666.67
Payables deferral period (PDP):
$ 25,000 $ 25,000
ICP = = =25 days
$ 360,000/360 $ 1,000
Cash conversion cycle (CCC):

CCC = ICP + RCP - PDP = 120 + 96 - 25 = 191 days.
DIF: Medium OBJ: TYPE: Problem TOP: Cash conversion cycle
30. Jordan Air Inc. has average inventory of $1,000,000. Its estimated annual sales are 15 million and the firm
estimates its receivables collection period to be twice as long as its inventory conversion period. The firm pays its
trade credit on time; its terms are net 30. The firm wants to decrease its cash conversion cycle by 10 days. It
believes that it can reduce its average inventory to $900,000. Assume a 360-day year and that sales will not
change. Cost of goods sold equal 80 percent of sales. By how much must the firm also reduce its accounts
receivable to meet its goal of a 10-day reduction?
a. $101,900
b. $1,000,000
c. $291,667
d. $333,520
e. $0
ANS: C
ICP = 360 days/ [($15 million 0.80)/$1 million)] = 30 days.
DSO = 2.0 ICP = 60 days.
Solve for accounts receivable:

DSO = 60 = Receivable accounts/Sales per day
= (A/R)/($15/360) = $2.5 million.
Calculate new ICP, change in CCC, and new DSO required to meet goal:
New ICP = 360/($12/0.9) = 360/13.333 = 27 days.
Net change in ICP = -3 days.
Total change in CCC required = 10 days.
Reduction in DSO needed = 10 - 3 = 7 days.
New DSO required = 60 - 7 = 53 days.
Solve for new receivables level:
DSO = 53 = [(A/R)/($15,000,000/360)]
A/R = 53 $41,666.67 = $2,208,333.
Old A/R = $2,500,000. New A/R = $2,208,333.
Reduction required in A/R = $2,500,000 - $2,208,333 = $291,667.
DIF: Tough OBJ: TYPE: Problem TOP: Cash conversion cycle

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CHAPTER 14WORKING CAPITAL POLICY

TOP: Working capital policy

Inventory = 0.5 $2,500,000(0.8) = $1,000,000.

Net income $2.00

Purchase of assets $1.30

Total uses $4.75

Receivables collection period (RCP):

Payables deferral period (PDP):

Cash conversion cycle (CCC):

Solve for accounts receivable:

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