Question 1

Should credit be granted to a customer wishing to purchase a $2,000 item that has been marked up 50% over cost if the probability of collection is only 65%? Assume all cash flows are discounted to present value.

Accepted Answer

Expected profit = 0.65[$2,000 × (0.50/1.50)] - (1 - 0.65)[$2,000 × (1/1.50)] = -$33.33

Question 2

Which one of the following financial ratios is not used to develop Altman's Z score from multiple discriminant analysis?

Accepted Answer

Altman's Z score is a financial model used to predict the likelihood of bankruptcy within a two-year period. The formula includes several financial ratios, but Interest expense/Total assets is not one of them. The ratios used include Working capital/Total assets, Retained earnings/Total assets, Earnings before interest and tax (EBIT)/Total assets, Market value of equity/Total book debt, and Sales/Total assets.

Question 3

Assuming that a credit decision has been analyzed and credit refused due to a negative expected profit, which of the following changes, if of sufficient magnitude, might change the decision to one of approval?

Accepted Answer

Increasing the percentage of profit margin would result in a greater profit on the sale, potentially offsetting the initial negative expected profit and making the credit decision favorable. Decreasing the probability of payment, increasing the discount rate or reducing the selling price would further decrease the expected profit and not change the initial decision.

Question 4

You are buying goods worth $75,000 from a firm that offers credit terms of 2/10, net 30. What will be the actual payment needed to pay the account in full on Day 7?

Accepted Answer

Discounted payment = (1 - 0.02) × $75,000 = $73,500

Question 5

Which one of these changes to credit terms of 2/10, net 30 might encourage more purchasers to take the discount?

Accepted Answer

A shorter payment period would create a greater incentive for purchasers to take advantage of the discount to avoid paying the full amount sooner.

Question 6

Which one of the following assumptions is made when declaring that the break-even probability of collection is lower for customers with repeat orders?

Accepted Answer

Assuming that payment on the first order ensures payment on subsequent orders means that the risk of non-payment decreases with repeat customers. This lower risk results in a lower break-even probability of collection, as compared to first-time customers where the risk of non-payment is higher.

Question 7

What is the effective annual rate of trade credit if the credit terms are 1/10, net 30?

Accepted Answer

EAR = [1 + (0.01/(1 - 0.01))]^{365/(30 - 10)} - 1 = 0.2013, or 20.13%

Question 8

What is the minimum probability of collection that should be accepted by firms that have a 25% profit margin? Ignore the time value of money.

Accepted Answer

p = ($1 - 0.25)/$1 = 0.75, or 75%

Question 9

Which one of the following statements is correct for a firm that currently has total costs of carrying and ordering inventory that are 50% higher than total carrying costs?

Accepted Answer

If the total costs of carrying and ordering inventory are 50% higher than total carrying costs, it means that the ordering costs are too high compared to carrying costs. This suggests that the firm is ordering more frequently and in smaller quantities, which results in higher ordering costs. Therefore, the optimal order size is likely greater than the current order size, and the firm should increase its order size to reduce the frequency of orders and lower the ordering costs.

Question 10

Which one of the following financial ratios has the highest weight in Altman's Z-score estimation?

Accepted Answer

Altman's Z-score estimation uses five financial ratios, namely working capital/total assets, retained earnings/total assets, EBIT/total assets, sales/total assets, and market value of equity/book value of liabilities. Among these, EBIT/total assets has the highest weight (0.3) in the Z-score calculation, while working capital/total assets and retained earnings/total assets have weights of 0.1 each, and sales/total assets and market value of equity/book value of liabilities have weights of 0.05 each. Therefore, option C, i.e., EBIT/total assets, is the best choice.

Question 11

A firm with ______ profit margin is best situated to extend credit to customers with a high probability of default.

Accepted Answer

A firm with a high profit margin can better absorb the losses associated with extending credit to customers who may default, as it has a larger cushion of profitability to offset these losses.

Question 12

Check conversion is the process of:

Accepted Answer

Check conversion is the process where the amount on a check is electronically debited from a person's bank account at the point of sale, similar to a debit card transaction. This allows for faster processing times and reduces the risk of bounced checks.

Question 13

A break-down of accounts receivable according to the length of time outstanding is known as a(n):

Accepted Answer

An aging schedule is a breakdown of accounts receivable according to the length of time outstanding, typically in 30-day increments. This provides a snapshot of the company's accounts receivable and helps identify potential issues with collections or delinquent accounts. Option A is incorrect because an amortization schedule is a table showing the repayment amounts and interest due for a loan, such as a mortgage. Option B is incorrect because a sources of cash flow statement shows the inflows and outflows of cash during a particular period, but does not specifically address accounts receivable. Option C is incorrect as "receivables inventory" is not a commonly used term in accounting, nor does it relate specifically to the aging of accounts receivable.

Question 14

The five Cs of credit refer to the:

Accepted Answer

The five Cs of credit are character, capacity, capital, collateral, and conditions, which are attributes used to determine creditworthiness. These factors include a borrower's reputation, ability to repay debt, financial stability, available assets for collateral, and the economic environment in which the loan will be issued.

Question 15

A primary purpose of restricting the investment of idle cash balances to money market instruments is to:

Accepted Answer

The primary purpose of investing idle cash balances in money market instruments is to minimize interest rate risk. Money market instruments have a low maturity and are typically issued by creditworthy and stable institutions, reducing the risk of default. Additionally, these instruments are highly liquid, enabling the company to easily convert the investment into cash if necessary. By investing in short-term money market instruments, the company is protected from changes in interest rates, which could negatively impact longer-term investments.

Question 16

What is the break-even probability of collection when the present value of revenues from a sale is $100,000 and the present value of cost is $87,000?

Accepted Answer

p = $87,000/$100,000 = 0.87

Question 17

A firm is considering a one-time sale of $100,000 to a customer. The cost of goods sold for this sale is $90,000. If the probability of the customer paying is 0.8, what is the expected profit from this transaction?

Accepted Answer

Expected profit = 0.8($100,000 - 90,000) - (1 - 0.8)($90,000) = -$10,000

Question 18

Which one of the following credit decisions appears correct for a customer who intends to order $1,000 of goods annually that have a 20% profit margin if the probability of default is 20% and the discount rate is 10%?

Accepted Answer

Expected profit = (1 - 0.20) × [($1,000 × 0.20)/0.10] - 0.20 × [$1,000 × (1 - 0.20)] = $1,440

Question 19

In general, a firm's credit policy should grant credit whenever the expected:

Accepted Answer

The firm should grant credit only if the profit from granting credit exceeds the profit from refusing credit. This means that the expected revenue from selling the product on credit minus the expected bad debt expense should be greater than the expected revenue from selling the product for cash.

Question 20

What is the break-even probability in the following case? A customer wishes to purchase a $2,000 item that has been marked up 50% over cost and the probability of collection is only 65%. Assume all cash flows are discounted to present value.

Accepted Answer

p = [$2,000 × (1/1.50)]/$2,000 = 0.6667, or 66.67%

Quiz 20: Working Capital Management