Question 1

When the term structure of interest rates is downward sloping and interest rates are expected to decline, the

Accepted Answer

When the term structure of interest rates is downward sloping and interest rates are expected to decline, the financial manager generally borrows short-term to take advantage of the lower short-term rates.

Question 2

Risk exposure due to heavy short-term borrowing can be compensated for by

Accepted Answer

Carrying highly liquid assets can help offset the risk exposure of heavy short-term borrowing, as these assets can be sold quickly to raise funds in the event of a cash shortfall. This provides a buffer against the risk of default. Carrying many illiquid assets can actually increase risk exposure, as these assets may be difficult to sell quickly if funds are needed urgently. Increasing receivables to increase cash flow may also increase risk exposure if customers are unable to pay their debts. Carrying longer term, more profitable current assets may help to increase overall profitability, but will not necessarily offset the risk exposure of heavy short-term borrowing.

Question 3

Under normal conditions (70% probability), Plan A will produce a $20,000 higher return than Plan B. Under tight money conditions (30% probability), Plan A will produce $100,000 less than Plan B. What is the expected value of return?

Accepted Answer

Expected value = ($+20,000)(0.7) + (−$100,000)(0.3) = ($16,000)

Question 4

Which of the following combinations of asset structures and financing patterns is likely to create the least volatile earnings?

Accepted Answer

Liquid assets are easier to convert into cash and therefore less likely to experience volatility. Heavy long-term borrowing ensures a stable and predictable stream of debt payments over time, reducing the likelihood of sudden changes in financial obligations. This combination creates the least volatile earnings.

Question 5

A firm will usually increase the ratio of long-term debt to short-term debt when

Accepted Answer

Firms prefer to lock in current lower interest rates with long-term debt if they expect future interest rates to increase, to avoid higher costs in the future.

Question 6

The theory of the term structure of interest rates, which suggests that long-term rates are determined by the average of short-term rates expected over the time that a long-term bond is outstanding, is the

Accepted Answer

The description given matches with the expectations hypothesis. It states that long-term interest rates are determined by the market's expectation of future short-term rates over the long-term bond's life.

Question 7

Hicks Health Clubs, Inc., expects to generate an annual EBIT of $750,000 and needs to obtain financing for $1,200,000 of assets. The company's tax bracket is 40%. If the firm uses short-term debt, its rate will be 7.5%, and if it uses long-term debt, its rate will be 9%. By how much will earnings after taxes change if the company chooses the more conservative financing plan instead of the more aggressive plan?

Accepted Answer

Change in EAT = (difference in interest rates) × (assets) × (1 − t)
= −(0.015 × $1,200,000 × 0.6)
= ($10,800)

Question 8

A manager can be aggressive if the firm has all of the following EXCEPT

Accepted Answer

High amounts of permanent current assets can tie up a significant portion of a firm's resources and limit its flexibility. Without this constraint, a manager may feel more comfortable being aggressive in pursuing growth opportunities. The other options (predictable cash-flow patterns, stable inventory price, and basic access to capital markets) can all contribute to a firm's stability and ability to take calculated risks.

Question 9

Which of the following techniques allows explicit consideration of more than one possible outcome?

Accepted Answer

Expected value is the only technique that explicitly considers more than one possible outcome by weighting each outcome by its probability of occurrence. Operating leverage, present value, and least-squares regression all focus on a single outcome or calculation without explicitly considering multiple possible outcomes.

Question 10

During tight money periods, generally

Accepted Answer

During tight money periods, central banks aim to reduce inflation by raising the cost of borrowing. This often results in higher short-term rates relative to long-term rates as the demand for short-term credit increases while long-term borrowing slows down. Therefore, option B is correct.

Question 11

Which of the following yield curves would be present during a period of high economic growth?

Accepted Answer

During a period of high economic growth, there is a higher demand for credit, leading to an increase in short-term interest rates. This results in an upward sloping yield curve, where long-term interest rates are higher than short-term interest rates. This indicates that investors expect higher inflation and higher growth in the future.

Question 12

A firm will usually increase the ratio of short-term debt to long-term debt when

Accepted Answer

When the term structure is inverted (short-term interest rates are higher than long-term rates) and is expected to shift down (meaning that short-term rates are expected to decrease), it makes sense for a firm to increase its ratio of short-term debt to long-term debt. This strategy allows the firm to take advantage of lower borrowing costs in the near future as short-term rates decline.

Question 13

Hicks Health Clubs, Inc., expects to generate an annual EBIT of $750,000 and needs to obtain financing for $1,200,000 of assets. Its tax bracket is 40%. If the firm uses short-term debt, its rate will be 7.5%, and if it uses long-term debt, its rate will be 9%. By how much will their earnings after taxes change if they choose the more aggressive financing plan instead of the more conservative plan?

Accepted Answer

Change in EAT = (difference in interest rates) × (assets) × (1 − t)
= (0.015 × $1,200,000 × 0.6)
= $10,800

Question 14

Kuznets Rental Center requires $500,000 in financing over the next two years. Kuznets can borrow long-term debt at 8 percent interest per year for two years. Alternatively, Kuznets can borrow short-term debt at 6 percent interest in the first year and 9 percent interest in the second year. Assuming Kuznets pays off the interest at the end of each year, which of the following statements is true?

Accepted Answer

The answer of Kuznets Rental Center requires $500,000 in financing...

Question 15

Which of the following is a reason for diminishing liquidity in modern corporations?

Accepted Answer

All of the options listed contribute to diminishing liquidity in modern corporations. Just-in-time inventory programs reduce the need to hold large amounts of inventory, thereby reducing cash tied up in stock. Better utilization of cash via computers allows for more efficient cash management, reducing the need for large cash reserves. Increased use of point-of-sale terminals improves the speed and efficiency of transactions, further reducing the need for holding cash.

Question 16

Hicks Health Clubs, Inc., expects to generate an annual EBIT of $750,000 and needs to obtain financing for $1,200,000 of assets. The company's tax bracket is 40%. If the firm uses short-term debt, its rate will be 7.5%, and if it uses long-term debt, its rate will be 9%. By how much will earnings after taxes change if the company chooses to use short-term debt financing for the first year?

Accepted Answer

Change in EAT = (difference in interest rates) × (assets) × (1 − t)
= (0.015 × $1,200,000 × 0.6)
= $10,800

Question 17

Under normal conditions (60% probability), Financing Plan A will produce a $30,000 higher return than Plan B. Under tight money conditions (40% probability), Plan A will produce $40,000 less than Plan B. What is the expected value of return?

Accepted Answer

Expected value = (+$30,000)(0.6) + (−$40,000)(0.4) = $2,000

Question 18

An inverted yield curve would suggest that

Accepted Answer

An inverted yield curve occurs when short-term interest rates are higher than long-term interest rates. This suggests that investors are anticipating a decrease in economic growth and that interest rates will fall in the future. This is because long-term investments are more uncertain, and investors require a higher return to compensate for that risk. Therefore, an inverted yield curve is often seen as a sign of an upcoming recession or economic slowdown.

Question 19

A "normal" term structure of interest rates would depict

Accepted Answer

A "normal" term structure of interest rates is one where long-term rates are higher than short-term rates. This is because investors demand higher compensation for lending money over a longer period of time, due to the increased risk of inflation and default. This pattern is often referred to as an upward-sloping yield curve.

Question 20

An aggressive, risk-oriented firm will likely

Accepted Answer

An aggressive, risk-oriented firm will likely borrow short-term and carry low levels of liquidity. The firm is willing to take on more risk and may therefore prefer to borrow at a lower cost with shorter maturity to take advantage of potential opportunities. Low levels of liquidity allow the firm to invest in higher risk, higher return projects.

Quiz 6: Working Capital and the Financing Decision