Question 1

Hardwig Inc.
Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 25%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.

-Refer to the data for Hardwig Inc.If the firm adopts a restricted policy, how much lower would its interest expense be than under the relaxed policy?

Accepted Answer

First, we need to calculate the company's total assets for both the restricted and relaxed policies.
Total assets under restricted policy = $3,600,000 / 2.5 = $1,440,000
Total assets under relaxed policy = $3,600,000 / 2.2 = $1,636,364

Next, we can calculate the interest expense for both policies. 
Interest expense under restricted policy = 0.10 * 0.5 * $1,440,000 = $72,000
Interest expense under relaxed policy = 0.10 * 0.5 * $1,636,364 = $81,818

The difference in interest expense between the two policies is:
$81,818 - $72,000 = $9,818

Therefore, the answer is D) $9,818.

Question 2

Which of the following will cause an increase in net working capital, other things held constant?

Accepted Answer

Selling merchandise on credit increases accounts receivable, which is a current asset and increases net working capital.

Question 3

Determining a firm's optimal investment in working capital and deciding how that investment should be financed are critical to working capital management.

Accepted Answer

This statement is true. Working capital management involves managing a company's short-term assets and liabilities to ensure that it has enough cash and resources to meet its operational needs. Determining the optimal investment in working capital and how to finance it are important decisions in this process.

Question 4

A firm that follows an aggressive current asset financing approach uses primarily short-term credit and thus is more exposed to an unexpected increase in interest rates than is a firm that uses long-term capital and thus follows a conservative financing policy.

Accepted Answer

A firm that relies on short-term credit for its current assets financing needs will be more vulnerable to fluctuations in interest rates than a firm that secures its financing through long-term debt, which has a fixed interest rate. As interest rates rise, the cost of borrowing increases, which put pressure on the firm's profitability and ability to meet its debt obligations. In contrast, a conservative financing approach that uses long-term capital is less exposed to interest rate risk as the cost of borrowing is fixed for a longer period, providing greater stability in the face of market volatility.

Question 5

Net working capital, defined as current assets minus the sum of payables and accruals, is equal to the current ratio minus the quick ratio.

Accepted Answer

The formula for net working capital is current assets minus current liabilities, not just payables and accruals. The current ratio minus the quick ratio does not give the same result as net working capital.

Question 6

Hardwig Inc.
Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 25%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.

-Refer to the data for Hardwig, Inc.Assume now that the company believes that if it adopts a restricted policy, its sales will fall by 15% and EBIT will fall by 10%, but its total assets turnover, debt ratio, interest rate, and tax rate will all remain the same.In this situation, what's the difference between the projected ROEs under the restricted and relaxed policies?

Accepted Answer

The answer of Hardwig Inc.
Hardwig Inc. is considering whether to...

Question 7

Net working capital is defined as current assets divided by current liabilities.

Accepted Answer

Net working capital is defined as current assets minus current liabilities.

Question 8

An increase in any current asset must be accompanied by an equal increase in some current liability.

Accepted Answer

An increase in current assets does not necessarily have to be accompanied by an increase in current liabilities. It is possible that the increase in current assets could be funded by long-term liabilities or equity investments. However, if the increase in current assets is funded by a loan or accounts payable, then there would be an increase in current liabilities as well.

Question 9

Although short-term interest rates have historically averaged less than long-term rates, the heavy use of short-term debt is considered to be an aggressive current operating asset financing strategy because of the inherent risks of using short-term financing.

Accepted Answer

Short-term debt carries a higher risk because it must constantly be refinanced and is vulnerable to changes in interest rates, whereas long-term debt provides a stable source of financing. Therefore, heavy use of short-term debt is considered aggressive financing.

Question 10

Which of the following statements is CORRECT?

Accepted Answer

The statement correctly highlights the risks associated with using short-term financing, despite the fact that short-term rates have historically been less than long-term rates. The other options contain incorrect or incomplete information.

Question 11

A conservative current operating asset financing approach will result in permanent current assets and some seasonal current assets being financed using long-term securities.

Accepted Answer

A conservative current operating asset financing approach aims to minimize the risk of short-term cash shortages by using long-term securities to finance permanent and seasonal current assets. This approach ensures that the company has sufficient funds to meet its operating needs even during periods of low cash flow.

Question 12

The concept of permanent current operating assets reflects the fact that some components of current assets do not shrink to zero even when a business is at its seasonal or cyclical low.Thus, permanent current operating assets represent a minimum level of current assets that must be financed.

Accepted Answer

The statement is true. Permanent current operating assets are the minimum level of current assets that a business must have even at its seasonal or cyclical low.

Question 13

Uncertainty about the exact lives of assets prevents precise maturity matching in an ex post (i.e., after the fact) sense even though it is possible to match maturities on an ex ante (expected) basis.

Accepted Answer

Uncertainty about the actual lives of assets can lead to variation in maturity dates, which makes it difficult to match maturities on an ex post basis. However, it is possible to match maturities on an ex ante basis based on expected lives of assets.

Question 14

Firms generally choose to finance temporary current operating assets with short-term debt because

Accepted Answer

Matching the maturities of assets and liabilities reduces risk under some circumstances, and also because short-term debt is often less expensive than long-term capital. This is the primary reason why firms choose to finance temporary current operating assets with short-term debt. Short-term debt can offer more flexibility and lower interest rates, making it a more attractive option for funding short-term needs. Additionally, using short-term debt can allow a company to adjust its financing needs as market conditions change.

Question 15

Short-term marketable securities are held for two separate and distinct purposes: (1) to provide liquidity as a substitute for cash and (2) as a non-operating investment.Marketable securities held while awaiting reinvestment are not available for liquidity purposes.

Accepted Answer

Marketable securities held while awaiting reinvestment are also considered a form of liquidity because they can be quickly converted into cash, thus serving the purpose of providing liquidity for the company.

Question 16

Net operating working capital is defined as operating current assets minus operating current liabilities..

Accepted Answer

Net operating working capital is calculated by subtracting operating current liabilities from operating current assets.

Question 17

The maturity matching, or "self-liquidating," approach to financing involves obtaining the funds for permanent current assets with a combination of long-term capital and short-term capital that varies depending on the level of interest rates.When short-term rates are relatively high, short-term assets will be financed with long-term debt to reduce costs.

Accepted Answer

The maturity matching, or "self-liquidating," approach to financing involves matching the maturity of the assets being financed with the maturity of the financing. So, short-term assets are financed with short-term debt, and long-term assets are financed with long-term debt, regardless of the level of interest rates.

Question 18

Buchholz Corporation follows a moderate current asset investment policy, but it is now considering a change, perhaps to a restricted or maybe to a relaxed policy.The firm's annual sales are $400,000; its fixed assets are $100,000; its target capital structure calls for 50% debt and 50% equity; its EBIT is $35,000; the interest rate on its debt is 10%; and its tax rate is 25%.With a restricted policy, current assets will be 15% of sales, while under a relaxed policy they will be 25% of sales.What is the difference in the projected ROEs between the restricted and relaxed policies?

Accepted Answer

The answer of Buchholz Corporation follows a moderate current asset...

Question 19

Hardwig Inc.
Hardwig Inc. is considering whether to pursue a restricted or relaxed current asset investment policy. The firm's annual sales are expected to total $3,600,000, its fixed assets turnover ratio equals 4.0, and its debt and common equity are each 50% of total assets. EBIT is $150,000, the interest rate on the firm's debt is 10%, and the tax rate is 25%. If the company follows a restricted policy, its total assets turnover will be 2.5. Under a relaxed policy its total assets turnover will be 2.2.

-Refer to the data for Hardwig, Inc.What's the difference in the projected ROEs under the restricted and relaxed policies?

Accepted Answer

First, we need to calculate the current assets and current liabilities under the two policies.

Restricted policy:
Current assets = $3,600,000 / 2.5 = $1,440,000
Current liabilities = $1,440,000 / 2 = $720,000

Relaxed policy:
Current assets = $3,600,000 / 2.2 = $1,636,363.64
Current liabilities = $1,636,363.64 / 2 = $818,181.82

Next, we can calculate the ROE under each policy:

Restricted policy:
ROE = [($150,000 - $72,000) x (1 - 0.25)] / [0.5 x $1,800,000] = 0.0425 or 4.25%

Relaxed policy:
ROE = [($150,000 - $81,818.18) x (1 - 0.25)] / [0.5 x $1,963,636.36] = 0.0613 or 6.13%

The difference in ROE between the two policies is 6.13% - 4.25% = 1.88%, so the answer is B.

To maximize shareholder wealth, the company should choose the policy with the higher ROE, which is the relaxed policy. This policy allows for more current assets to be invested in, which may lead to higher sales and profits. However, the company must balance this with the risk of holding too much inventory or receivables, which could lead to liquidity problems.

Question 20

The relative profitability of a firm that employs an aggressive current asset financing policy will improve if the yield curve changes from upward sloping to downward sloping.

Accepted Answer

An aggressive current asset financing policy involves financing short-term assets with short-term debt. When the yield curve is upward sloping, short-term interest rates are lower than long-term interest rates, making short-term borrowing cheaper than long-term borrowing. Therefore, an aggressive current asset financing policy may be more profitable in an upward-sloping yield curve environment. When the yield curve is downward sloping, short-term interest rates are higher than long-term interest rates, making short-term borrowing more expensive than long-term borrowing. Therefore, an aggressive current asset financing policy may be less profitable in a downward-sloping yield curve environment.

Quiz 17: Supply Chains and Working Capital Management