Chapter 30 - Working Capital Management

Chapter 30 - Working Capital Management
Chapter 30
Working Capital Management

Multiple Choice Questions

1. The following are the types of inventories firms keep:

A. raw material
B. work in process
C. finished goods
D. all of the above
2. The costs of holding inventory are:

I) carrying cost
II) order cost
III) pilferage cost
A. I only
B. I and II only
C. III only
D. I and III only
3. The economic order quantity (EOQ) is calculated using:

A. Q = [(2  sales  cost per order)/(carrying cost)]
B. Q = [(2  sales  carrying cost)/(cost per order)]
C. Q = (2  sales  cost per order  carrying cost)
D. none of the above
4. High-Rise Building Company uses 400,000 tons of stone per year. The carrying costs are
$100/ton. The cost per order is $500. Calculate the economic order quantity per order.
A. 1,000 tons
B. 2,000 tons
C. 3,000 tons
30-1
$100/ton. The cost per order is $500. Calculate the optimal number of orders per year.
A. 400
B. 100
C. 200
$100/ton. The cost per order is $500. Calculate the optimal annual order costs.
A. $200,000
B. $100,000
C. $50,000
$100/ton. The cost per order is $500. Calculate the optimal carrying costs.
A. $200,000
B. $100,000
C. $50,000
$100/ton. The cost per order is $500. Calculate the total costs of optimal inventory.
A. $200,000
B. $100,000
C. $50,000
9. In the EOQ inventory model, the optimal order size is achieved when:
A. carrying costs > order costs
B. carrying costs < order costs
C. carrying costs = order costs
30-2
10. When credit is granted to another firm this gives rise to a(n):

I) Accounts receivable
II) COD
III) CBD
A. I only
B. II only
C. III only
D. II and III only
11. Accounts receivables include:

I) Trade credit
II) Consumer credit
III) Inventories
A. I only
B. II only
C. III only
D. I and II only
12. Which of the following transactions involve credit?

I) COD
II) 2/30, net 60
III) 2/10 EOM, net 60
IV) CBD
A. I only
B. I and IV only
C. IV only
D. II and III only
13. If a firm grants credit with terms of 3/10 net 30, the creditor:
A. Must pay a penalty of 3% when payment is made in more than 10 days after the sale
B. Must pay a penalty for 10% when payment is made in more than 3 days after the sale
C. Receives a discount of 3% when payment is made in less than 10 days after the sale
D. Receives a discount of 10% when payment is made in less than 3 days after the sale
30-3
14. The net credit period for a company with terms of 3/10 net 60 is:
A. 50 days
B. 60 days
C. 10 days
D. 57 days
15. Which of the following trade credit terms is not valid?

A. 3/10, net 50
B. 8/10 EOM, net 60
C. 2/10, net 30
D. All of the above are valid credit terms
16. Supposing you purchase goods on terms of 1/10, net 30. Taking compounding into
account, what annual rate of interest is implied by the cash discount? (Assume a year has 365
days.)
A. 9.6%
B. 9.2%
C. 20.1%
D. 44.6%
17. Suppose you purchase goods on terms of 3/10, net 60. Taking compounding into account,
what annual rate of interest is implied by the cash discount? (Assume a year has 365 days.)
A. 32%
B. 5%
C. 91%
D. 28.2%
A. 2%
B. 20.2%
C. 10.2%
D. 18.6%
30-4
19. When credit is offered with only the invoice as a formal instrument of credit, the credit
procedure is called an:
A. Invoice account
B. Open account
C. Unsecured account
D. Unsecured note
20. A trade acceptance, when immediate payment is not required, is a:

A. Sight draft
B. Time draft
C. Bill of lading
D. None of the above
21. Which of the following statements regarding "bankers' acceptances" is true?

I) Bankers' acceptances are used in overseas trading
II) Bankers' acceptances are bought and sold on a discount basis
III) Bankers' acceptances are guaranteed by the bank
A. I only
B. II only
C. III only
D. I, II, and III
22. A commercial draft can be

I) Sight draft
II) Time draft
III) Overdraft
A. I only
B. II only
C. III only
D. I and II only
30-5
23. Exporters who require guarantee of payment will ask for:

A. Trade acceptances
B. Bankers' acceptances
C. An irrevocable letter of credit
24. A letter of credit is issued by the:

A. Exporter's bank
B. Importer's bank
C. Dun & Bradstreet
D. Government
25. Companies frequently use information from the following sources when conducting their
credit analysis except:
I) Financial statement supplied by the customer
II) Payment history supplied by other firms
III) Payment history supplied by banks
A. I only
B. II only
C. II and III only
D. I, II, and III
26. A customer has ordered goods with a value of $800. The production cost is $600. Under
what conditions should you extend credit if there is no possibility of repeat orders?
A. If the probability of payment exceeds 0.67
B. If the probability of payment exceeds 0.80
C. If the probability of payment exceeds 0.75
D. If the probability of payment exceeds 0.90
30-6
29. Which of the following statements is true?

I) New companies must be prepared to incur more bad debts than established businesses as
part of the cost of building up a good customers list
II) Generally, repeat orders are profitable
III) Companies with high profit margins need to be particularly careful about extending credit
to high-risk customers
A. I only
B. II only
C. III only
D. I and II only
30. The default rate of Demurrage Associates' new customers has been running at 10%. The
average sale for each new customer amounts to $800, generating a profit of $100 and a 40%
chance of a repeat order next year. The default rate on repeat orders is only 2%. If the interest
rate is 9%, what is the expected profit from each new customer?
A. $88.70
B. $47.75
C. $43.25
D. $50.83
30-7
31. The default rate of Don's new customers has been running at 20%. The average sale for
each new customer amounts to $500, generating a profit of $200 and a 30% chance of a repeat
order next year. The default rate on repeat orders is only 5%. If the interest rate is 6%, what is
the expected profit from each new customer?
A. $152.50
B. $149.53
C. $275.00
D. $100.00
32. Terry's Place is currently experiencing a bad debt ratio of 4%. Terry is convinced that,
with looser credit controls, this ratio will increase to 8%; however, she expects sales to
increase by 10% as a result. The cost of goods sold is 80% of the selling price. Per $100 of
current sales, what is Terry's expected profit under the proposed credit standards?
A. $26.0
B. $15.4
C. $13.2
D. $25.6
33. Tom's Toys is currently experiencing a bad debt ratio of 6%. Tom is convinced that, with
tighter credit controls, he can reduce this ratio to 2%; however, he expects sales to drop by 8%
as a result. The cost of goods sold is 75% of the selling price. Per $100 of current sales, what
is Tom's expected profit under the proposed credit standards?
A. $15.2
B. $23.0
C. $19.0
D. $21.2
34. Factoring refers to:

A. Determining the aging schedule of the firm's accounts receivable
B. The sale of a firm's accounts receivable to another firm
C. The determination of the average collection period
D. Scoring a customer based on the 5 C's of credit
30-8
35. In the USA, export business is insured by:

A. Export-Import bank in association with Foreign Credit Insurance Association (FCIA)
B. Citibank
C. SBA
36. Determining the appropriate target cash balance involves assessing the trade-off between:
A. Income and diversification
B. The benefit and cost of liquidity
C. Balance sheet strength and transaction needs
D. All of the above
37. Which of the following countries is the heaviest user of checks:

A. USA
B. UK
C. France
D. Canada
38. The following are the main methods that firms use to send and receive money
electronically:
A. direct payments
B. direct deposits
C. wire transfers
D. all of the above
39. The following are electronic funds transfer systems available in the USA except:
A. Fedwire
B. CHIPS
C. SWIFT
D. ACH
30-9
40. In the United States large-value electronic payments are made through:
I) Fedwire
II) ACH
III) CHIPS
A. I only
B. II only
C. III only
D. I and III only
41. In the United States small-value electronic transfers are made through:
I) Fedwire
II) ACH
III) CHIPS
A. I only
B. II only
C. III only
D. I and III only
42. Which of the following is a real-time gross settlement system:

A. Fedwire
B. CHIPS
C. ACH
D. all of the above
43. The following are advantages of electronic payment systems except:

A. Easy record keeping
B. Marginal cost of transaction is low
C. Float is drastically reduced
D. Initial investment is high
30-10
44. Firms which receive a large volume of checks use the following to speed up availability of
funds:
A. Concentration banking
B. Retail banking
C. Money market deposit account
45. The most common cash management technique used to speed up collections is:
A. Wire transfers
B. Lockboxes
C. In house processing
D. SWIFT
46. The main advantage of using a netting system to settle foreign currency payments is:
A. drastically reduces the number of payments
B. increases the number of payments
C. reduces the number of foreign currencies
47. A large firm may hold substantial cash balances because:

A. These balances are required by the bank in the form of compensating balances
B. The company may have accounts in many different banks
C. The company may have a very decentralized organization
D. All of the above
48. The market for short-term investments is called:

A. Capital market
B. Stock market
C. Bond market
D. Money market
30-11
49. The discount on a 91-Treasury bill is 5.2%. What is the annually compounded rate of
return?
A. 4.8%
B. 5.2%
C. 5.4%
return?
A. 5.2%
B. 5.9%
C. 5.6%
D. 5.5%
51. "Eurodollars" or "international dollars" are:

A. Dollar deposits in banks outside the US
B. Dollars deposited in the US by foreigners
C. Dollars held by foreign governments
52. The following are money market instruments except:

A. T-bills
B. Federal agency discount notes
C. Commercial paper
D. Preferred stocks
30-12
53. A variable rate demand bond (VRDB):

I) Is a long-term security
II) Has interest payments linked to the level of short-term interest rates
III) May periodically be sold back to the issuer at face value
IV) Is tax-exempt
A. I only
B. I and II only
C. I, II, and III only
D. I, II, III, and IV
54. Negotiable CDs are issued by:

A. US Government
B. Federal agencies
C. Banks
D. Corporations
55. A repurchase agreement occurs when:

A. A company agrees to buy back its commercial paper before maturity
B. A bank depositor agrees, in advance, to re-invest money in a negotiable certificate of
deposit
C. An investor buys part of a government security dealer's inventory and simultaneously
agrees to sell it back
D. The federal government agrees to buy T-bills
56. Floating-rate preferred stock offers competitive rates of return with traditional money-
market instruments but:
A. Is not rated by Moody's or Standard & Poor's
B. Still provides the corporate investor with the tax exclusion on dividend income
C. Has a fixed rate of dividend income
D. Offers a highly competitive trading market
30-13
57. A tax-paying corporation would prefer to invest short-term money in:

A. Preferred stock
B. Floating-rate preferred stock
C. Common stock
D. Long-term bonds
E. None of the above
58. If the short-term commercial paper rate is 10% and the corporate tax rate is 35%, what
yield would a corporation require on an investment in floating-rate preferred stock? Assume
the default risk is the same as for commercial paper.
A. 15.2%
B. 10.0%
C. 7.3%
D. 6.6%
A. 6.0%
B. 39%
C. 9.2%
D. 4.4%
60. Which of the following have the most developed secondary market?

A. Treasury Bills
B. Commercial paper
C. Repurchase agreements
D. Bankers' acceptances
61. The most important source of short-term financing is:

A. Stretching payables
B. Issuing bonds
C. Bank loan
D. All of the above
30-14
62. The most common way to finance a temporary cash deficit is the use of:
A. Banker's acceptances
B. Call options
C. Commercial paper
D. Unsecured bank loans
63. Finance companies raise funds by

I) Attracting deposits
II) Issuing commercial paper
III) Issuing long-term securities
A. I only
B. II only
C. III only
D. II and III only
64. Generally, a line of credit is:

I) Less costly than stretching accounts payable
II) Provided by a bank
III) Unsecured bank borrowing
A. I only
B. I and II only
C. II only
D. I, II, and III
65. The maturity of most bank loans is:

A. A few months
B. One year
C. Three years
30-15
66. Short-term loans that are used for financing temporary increase in inventory are called:
A. Bridge loans
B. Self-liquidating loans
C. Term loans
67. One common arrangement that allows firms to borrow, repay, and re-borrow over a
specified period of time as their cash needs vary is called:
A. Bridge loans
B. Term loans
C. Revolving credit
68. The most common benchmarks used for pricing long-term bank loans are:
A. LIBOR
B. Federal funds rate
C. Prime rate
D. All of the above
69. The interest rate on a loan is set at "1% over LIBOR." If the LIBOR rate is 5% then the
interest rate on the loan is:
A. 5%
B. 4%
C. 6%
D. 7%
70. When banks have to make large loans, they form a group of banks for the purpose of
making the loan. The group is called a:
A. Bank holding company
B. Syndicate
C. Golden umbrella
D. Conglomerate
30-16
71. Loan sales can be in the form of:

I) Assignments
II) Participations
III) Securitizations
A. I only
B. II only
C. III only
D. I, II, and III
72. Credit lines, in addition to charging interest, also charge a fee on the unused loan amount
called:
A. commitment fee
B. registration fee
C. underwriting fee
73. What percent of syndicated loans are subsequently resold? (approximately)

A. 10%
B. 20%
C. 30%
74. When inventories are used as collateral, up to what percent of the value of the inventories
will banks lend?
A. 50%
B. 75%
C. 80%
30-17
75. Generally, banks lend up to the following amount when firms provide receivables as
collateral:
A. 50% of the value of the receivables
B. 60% of the value of the receivables
C. 80% of the value of the receivables
D. 100% of the value of the receivables
76. Commercial paper (CP) issued in the USA has a maximum maturity of nine months, most
CPs are sold with a maturity of
A. sixty days or less
B. thirty days or less
C. ninety days or less
D. one hundred and eighty days or less
77. Commercial paper (CP) rate is:

A. always greater than the prime rate
B. always equal to the prime rate
C. always less than the prime rate
D. always less than the T-bill rate
78. Which of the following are Moody's commercial paper (CP) ratings?

A. Aaa; Aa; A; Baa; etc
B. P-1 (Prime-1); P-2; P-3
C. AAA; AA; A; BBB; etc.
D. A-1; A-2; A-3
79. Which of the following Moody's rated commercial paper has the least risk?
A. P-1
B. P-2
C. P-3
30-18
80. Firms issuing commercial paper use the following as support to the issue:
I) a back-up line of credit which is generally 75% of amount of the issue in the case of a top-
tier issuers
II) a back-up line of credit which is generally 100% of amount of the issue in the case of a
lower-grade issuers
III) a back-up line of credit which is irrevocable which is 100% of the amount of the issue in
the case of low-rated issuers
A. I only
B. I and II only
C. I, II and III
81. Medium-term notes (MTNs) can be thought of as a hybrid between:

A. stocks and bonds
B. corporate bonds and commercial paper
C. corporate bonds and T-bills
D. stocks and T-bills

True / False Questions

82. Trade credit term 3/10, EOM, net 60, is not a valid one.
True False
83. If goods are sold on open account, the customer is asked to sign an IOU.
True False
84. If a firm sells goods on terms 2/30 net 60, customers who do not take the cash discount are
effectively borrowing money at approximately 2% per year.
True False
30-19
85. A commercial draft is simply an order to pay.

True False
86. If a commercial draft is an order to pay immediately, it is called a time draft.

True False
87. Bankers' acceptances are used in overseas trade.

True False
88. A factor buys the firm's receivables, and the customer then makes payments directly to the
factor.
True False
89. In the United States export credit insurance is provided by the Export-Import Bank in
association with a group of insurance companies known as the Foreign Credit Insurance
Association (FCIA).
True False
90. One good reason to hold cash is that cash provides more liquidity than securities.
True False
91. Concentration banking is used to slow down disbursements.

True False
92. Lock-box systems are used to speed up collections.

True False
30-20
93. Fedwire is a system that can be used to transfer money between banks.

True False
94. Direct deposits are processed through Automated Clearing House (ACH) system.
True False
95. The market for short-term investments is known as the capital market.

True False
96. LIBOR is the acronym for London Interbank Offered Rate.

True False

Short Answer Questions

97. What are the major objectives of credit management?

98. Briefly explain different terms of sale used in practice.

30-21
99. What is the effective cost of not taking a discount under terms 3/30 net 60?

100. Briefly describe the most widely used commercial credit instruments.

101. Discuss the general principles that should be used for credit decisions.

102. What is the main objective of a collection policy?

30-22
103. Briefly explain the process of factoring accounts receivables.

104. Briefly explain how firms can protect against bad debt?

105. Discuss the fundamental trade-off involved in cash management.

106. Discuss the two important ways of speeding up collection.

30-23
107. Briefly explain electronic funds transfer.

108. Briefly explain the additional complexities involved in international cash management.

109. What are Eurodollars (international dollars)?

110. Briefly explain different money-market instruments.

30-24
111. What are short-term tax-exempts?

112. What are Banker's Acceptances?

113. What is LIBOR?

114. What is a bridge loan? Briefly explain.

30-25
115. What is a self-liquidating loan? Briefly explain.

116. What is a syndicated loan?

117. What is a commercial paper?

118. Briefly describe the quality ratings for commercial paper.

30-26
119. What are medium-term notes (MTNs)?

30-27
Chapter 30 Working Capital Management Answer Key

Multiple Choice Questions

1. The following are the types of inventories firms keep:

A. raw material
B. work in process
C. finished goods
D. all of the above
Type: Easy

2. The costs of holding inventory are:

I) carrying cost
II) order cost
III) pilferage cost
A. I only
B. I and II only
C. III only
D. I and III only
Type: Medium

3. The economic order quantity (EOQ) is calculated using:

A. Q = [(2  sales  cost per order)/(carrying cost)]
B. Q = [(2  sales  carrying cost)/(cost per order)]
C. Q = (2  sales  cost per order  carrying cost)
Type: Difficult

30-28
$100/ton. The cost per order is $500. Calculate the economic order quantity per order.
A. 1,000 tons
B. 2,000 tons
C. 3,000 tons
Q = [(2  sales  cost per order)/(carrying cost)]

Q = [(2  400,000  500)/(100)] = 2,000 tons
Type: Difficult

$100/ton. The cost per order is $500. Calculate the optimal number of orders per year.
A. 400
B. 100
C. 200
Number of orders per year = 400,000/2000 = 200
Type: Medium

$100/ton. The cost per order is $500. Calculate the optimal annual order costs.
A. $200,000
B. $100,000
C. $50,000
Annual order costs = (200)  (500) = $100,000
Type: Medium

30-29
$100/ton. The cost per order is $500. Calculate the optimal carrying costs.
A. $200,000
B. $100,000
C. $50,000
Annual carrying costs = [(2000 + 0)/2]  (100) = $100,000
Type: Medium

$100/ton. The cost per order is $500. Calculate the total costs of optimal inventory.
A. $200,000
B. $100,000
C. $50,000
Total costs = order costs + carrying costs = $100,000 + $100,000 = $200,000
Type: Medium

9. In the EOQ inventory model, the optimal order size is achieved when:
A. carrying costs > order costs
B. carrying costs < order costs
C. carrying costs = order costs
Type: Medium

30-30
10. When credit is granted to another firm this gives rise to a(n):

I) Accounts receivable
II) COD
III) CBD
A. I only
B. II only
C. III only
D. II and III only
Type: Medium

11. Accounts receivables include:

I) Trade credit
II) Consumer credit
III) Inventories
A. I only
B. II only
C. III only
D. I and II only
Type: Medium

12. Which of the following transactions involve credit?

I) COD
II) 2/30, net 60
III) 2/10 EOM, net 60
IV) CBD
A. I only
B. I and IV only
C. IV only
D. II and III only
Type: Easy

30-31
13. If a firm grants credit with terms of 3/10 net 30, the creditor:
A. Must pay a penalty of 3% when payment is made in more than 10 days after the sale
B. Must pay a penalty for 10% when payment is made in more than 3 days after the sale
C. Receives a discount of 3% when payment is made in less than 10 days after the sale
D. Receives a discount of 10% when payment is made in less than 3 days after the sale
Type: Easy

14. The net credit period for a company with terms of 3/10 net 60 is:
A. 50 days
B. 60 days
C. 10 days
D. 57 days
60 - 10 = 50
Type: Easy

15. Which of the following trade credit terms is not valid?

A. 3/10, net 50
B. 8/10 EOM, net 60
C. 2/10, net 30
D. All of the above are valid credit terms
Type: Medium

30-32
16. Supposing you purchase goods on terms of 1/10, net 30. Taking compounding into
account, what annual rate of interest is implied by the cash discount? (Assume a year has 365
days.)
A. 9.6%
B. 9.2%
C. 20.1%
D. 44.6%
Implied interest rate = [(1 + (1/99))^(365/20)] - 1 = 1.201 - 1 = 0.201 = 20.1%
Type: Medium

A. 32%
B. 5%
C. 91%
D. 28.2%
Implied interest rate = [(1 + (3/97))^(365/40)] - 1 = 1.32 - 1 = 0.32 = 32%
Type: Medium

A. 2%
B. 20.2%
C. 10.2%
D. 18.6%
Implied interest rate = [(1 + (2/98))^(365/40)] - 1 = 0.202 = 20.2%
Type: Medium

30-33
19. When credit is offered with only the invoice as a formal instrument of credit, the credit
procedure is called an:
A. Invoice account
B. Open account
C. Unsecured account
D. Unsecured note
Type: Medium

20. A trade acceptance, when immediate payment is not required, is a:

A. Sight draft
B. Time draft
C. Bill of lading
Type: Medium

21. Which of the following statements regarding "bankers' acceptances" is true?

I) Bankers' acceptances are used in overseas trading
II) Bankers' acceptances are bought and sold on a discount basis
III) Bankers' acceptances are guaranteed by the bank
A. I only
B. II only
C. III only
D. I, II, and III
Type: Medium

30-34
22. A commercial draft can be

I) Sight draft
II) Time draft
III) Overdraft
A. I only
B. II only
C. III only
D. I and II only
Type: Medium

23. Exporters who require guarantee of payment will ask for:

A. Trade acceptances
B. Bankers' acceptances
C. An irrevocable letter of credit
Type: Medium

24. A letter of credit is issued by the:

A. Exporter's bank
B. Importer's bank
C. Dun & Bradstreet
D. Government
Type: Medium

30-35
25. Companies frequently use information from the following sources when conducting their
credit analysis except:
I) Financial statement supplied by the customer
II) Payment history supplied by other firms
III) Payment history supplied by banks
A. I only
B. II only
C. II and III only
D. I, II, and III
Type: Medium

p(800 - 600) - (1 - p)(600) = 0; 800p - 600p + 600p - 600 = 0; p = 600/800 = 0.75
Type: Medium

p(2000 - 1800) - (1 - p)(1800) = 0; p = 0.90
Type: Medium

30-36
p(1200 - 800) - (1 - p)(800) = 0; p = 0.67
Type: Medium

29. Which of the following statements is true?

I) New companies must be prepared to incur more bad debts than established businesses as
part of the cost of building up a good customers list
II) Generally, repeat orders are profitable
III) Companies with high profit margins need to be particularly careful about extending credit
to high-risk customers
A. I only
B. II only
C. III only
D. I and II only
Type: Easy

30. The default rate of Demurrage Associates' new customers has been running at 10%. The
average sale for each new customer amounts to $800, generating a profit of $100 and a 40%
chance of a repeat order next year. The default rate on repeat orders is only 2%. If the interest
rate is 9%, what is the expected profit from each new customer?
A. $88.70
B. $47.75
C. $43.25
D. $50.83
Expected profit first order: (0.9)(100) - (0.1)(700) = 90 - 70 = +20;

Repeat order: (0.98)(700) - (0.02)(700) = +84;
Expected profit: 20 + ((0.4)(84))/1.09 = 50.83
Type: Difficult

30-37
31. The default rate of Don's new customers has been running at 20%. The average sale for
each new customer amounts to $500, generating a profit of $200 and a 30% chance of a repeat
order next year. The default rate on repeat orders is only 5%. If the interest rate is 6%, what is
the expected profit from each new customer?
A. $152.50
B. $149.53
C. $275.00
D. $100.00
Expected profit first order: (0.8)(200) - (0.2)(300) = 100;

Repeat orders: (0.95)(200) (0.05)(300) = 175;
Expected profit: 100 + [((0.3)(175))/1.06] = $149.53
Type: Difficult

32. Terry's Place is currently experiencing a bad debt ratio of 4%. Terry is convinced that,
with looser credit controls, this ratio will increase to 8%; however, she expects sales to
increase by 10% as a result. The cost of goods sold is 80% of the selling price. Per $100 of
current sales, what is Terry's expected profit under the proposed credit standards?
A. $26.0
B. $15.4
C. $13.2
D. $25.6
Expected Profit: (0.92)(110 - 88) - (0.08)(88) = 13.2
Type: Difficult

30-38
33. Tom's Toys is currently experiencing a bad debt ratio of 6%. Tom is convinced that, with
tighter credit controls, he can reduce this ratio to 2%; however, he expects sales to drop by 8%
as a result. The cost of goods sold is 75% of the selling price. Per $100 of current sales, what
is Tom's expected profit under the proposed credit standards?
A. $15.2
B. $23.0
C. $19.0
D. $21.2
(0.98)(92 - 69) - 0.02(69) = $21.2
Type: Difficult

34. Factoring refers to:

A. Determining the aging schedule of the firm's accounts receivable
B. The sale of a firm's accounts receivable to another firm
C. The determination of the average collection period
D. Scoring a customer based on the 5 C's of credit
Type: Medium

35. In the USA, export business is insured by:

A. Export-Import bank in association with Foreign Credit Insurance Association (FCIA)
B. Citibank
C. SBA
Type: Medium

36. Determining the appropriate target cash balance involves assessing the trade-off between:
A. Income and diversification
B. The benefit and cost of liquidity
C. Balance sheet strength and transaction needs
D. All of the above
Type: Easy

30-39
37. Which of the following countries is the heaviest user of checks:

A. USA
B. UK
C. France
D. Canada
Type: Easy

38. The following are the main methods that firms use to send and receive money
electronically:
A. direct payments
B. direct deposits
C. wire transfers
D. all of the above
Type: Medium

39. The following are electronic funds transfer systems available in the USA except:
A. Fedwire
B. CHIPS
C. SWIFT
D. ACH
Type: Medium

40. In the United States large-value electronic payments are made through:
I) Fedwire
II) ACH
III) CHIPS
A. I only
B. II only
C. III only
D. I and III only
Type: Easy

30-40
41. In the United States small-value electronic transfers are made through:
I) Fedwire
II) ACH
III) CHIPS
A. I only
B. II only
C. III only
D. I and III only
Type: Easy

42. Which of the following is a real-time gross settlement system:

A. Fedwire
B. CHIPS
C. ACH
D. all of the above
Type: Medium

43. The following are advantages of electronic payment systems except:

A. Easy record keeping
B. Marginal cost of transaction is low
C. Float is drastically reduced
D. Initial investment is high
Type: Medium

44. Firms which receive a large volume of checks use the following to speed up availability of
funds:
A. Concentration banking
B. Retail banking
C. Money market deposit account
Type: Easy

30-41
45. The most common cash management technique used to speed up collections is:
A. Wire transfers
B. Lockboxes
C. In house processing
D. SWIFT
Type: Medium

46. The main advantage of using a netting system to settle foreign currency payments is:
A. drastically reduces the number of payments
B. increases the number of payments
C. reduces the number of foreign currencies
Type: Easy

47. A large firm may hold substantial cash balances because:

A. These balances are required by the bank in the form of compensating balances
B. The company may have accounts in many different banks
C. The company may have a very decentralized organization
D. All of the above
Type: Medium

48. The market for short-term investments is called:

A. Capital market
B. Stock market
C. Bond market
D. Money market
Type: Easy

30-42
return?
A. 4.8%
B. 5.2%
C. 5.4%
P = 100 - ((91/360)(5.2)) = 98.6855; 1 + Quarterly return = 100/98.6855 = 1.01332; Annual

return = (1.01332^4) - 1 = 5.4%
Type: Difficult

return?
A. 5.2%
B. 5.9%
C. 5.6%
D. 5.5%
P = 100 - ((91/360)(5.65)) = 98.5718; 1 + Quarterly return = 100/98.5718 = 1.01449; Annual

return = (1.01449^4) - 1 = 5.9%
Type: Difficult

51. "Eurodollars" or "international dollars" are:

A. Dollar deposits in banks outside the US
B. Dollars deposited in the US by foreigners
C. Dollars held by foreign governments
Type: Easy

30-43
52. The following are money market instruments except:

A. T-bills
B. Federal agency discount notes
C. Commercial paper
D. Preferred stocks
Type: Medium

53. A variable rate demand bond (VRDB):

I) Is a long-term security
II) Has interest payments linked to the level of short-term interest rates
III) May periodically be sold back to the issuer at face value
IV) Is tax-exempt
A. I only
B. I and II only
C. I, II, and III only
D. I, II, III, and IV
Type: Medium

54. Negotiable CDs are issued by:

A. US Government
B. Federal agencies
C. Banks
D. Corporations
Type: Medium

30-44
55. A repurchase agreement occurs when:

A. A company agrees to buy back its commercial paper before maturity
B. A bank depositor agrees, in advance, to re-invest money in a negotiable certificate of
deposit
C. An investor buys part of a government security dealer's inventory and simultaneously
agrees to sell it back
D. The federal government agrees to buy T-bills
Type: Medium

56. Floating-rate preferred stock offers competitive rates of return with traditional money-
market instruments but:
A. Is not rated by Moody's or Standard & Poor's
B. Still provides the corporate investor with the tax exclusion on dividend income
C. Has a fixed rate of dividend income
D. Offers a highly competitive trading market
Type: Medium

57. A tax-paying corporation would prefer to invest short-term money in:

A. Preferred stock
B. Floating-rate preferred stock
C. Common stock
D. Long-term bonds
E. None of the above
Type: Medium

30-45
A. 15.2%
B. 10.0%
C. 7.3%
D. 6.6%
After-tax yield on CP = 10(1 - 0.35) = 6.5; Effective tax rate on floating-rate preferred stock =
(0.3)(0.35) = 0.105 or 10.5%; Before tax equivalent yield = 6.5/0.895 = 7.3%
Type: Difficult

A. 6.0%
B. 39%
C. 9.2%
D. 4.4%
After-tax yield on CP = 6(1 - 0.35) = 3.9; Effective tax rate on floating-rate preferred stock =
(0.3)(0.35) = 0.105 or 10.5%; Before tax equivalent yield = 3.9/0.895 = 4.4%
Type: Difficult

60. Which of the following have the most developed secondary market?

A. Treasury Bills
B. Commercial paper
C. Repurchase agreements
D. Bankers' acceptances
Type: Easy

30-46
61. The most important source of short-term financing is:

A. Stretching payables
B. Issuing bonds
C. Bank loan
D. All of the above
Type: Difficult

62. The most common way to finance a temporary cash deficit is the use of:
A. Banker's acceptances
B. Call options
C. Commercial paper
D. Unsecured bank loans
Type: Medium

63. Finance companies raise funds by

I) Attracting deposits
II) Issuing commercial paper
III) Issuing long-term securities
A. I only
B. II only
C. III only
D. II and III only
Type: Difficult

30-47
64. Generally, a line of credit is:

I) Less costly than stretching accounts payable
II) Provided by a bank
III) Unsecured bank borrowing
A. I only
B. I and II only
C. II only
D. I, II, and III
Type: Easy

65. The maturity of most bank loans is:

A. A few months
B. One year
C. Three years
Type: Easy

66. Short-term loans that are used for financing temporary increase in inventory are called:
A. Bridge loans
B. Self-liquidating loans
C. Term loans
Type: Easy

67. One common arrangement that allows firms to borrow, repay, and re-borrow over a
specified period of time as their cash needs vary is called:
A. Bridge loans
B. Term loans
C. Revolving credit
Type: Medium

30-48
68. The most common benchmarks used for pricing long-term bank loans are:
A. LIBOR
B. Federal funds rate
C. Prime rate
D. All of the above
Type: Easy

69. The interest rate on a loan is set at "1% over LIBOR." If the LIBOR rate is 5% then the
interest rate on the loan is:
A. 5%
B. 4%
C. 6%
D. 7%
Type: Easy

70. When banks have to make large loans, they form a group of banks for the purpose of
making the loan. The group is called a:
A. Bank holding company
B. Syndicate
C. Golden umbrella
D. Conglomerate
Type: Medium

71. Loan sales can be in the form of:

I) Assignments
II) Participations
III) Securitizations
A. I only
B. II only
C. III only
D. I, II, and III
Type: Medium

30-49
72. Credit lines, in addition to charging interest, also charge a fee on the unused loan amount
called:
A. commitment fee
B. registration fee
C. underwriting fee
Type: Medium

73. What percent of syndicated loans are subsequently resold? (approximately)

A. 10%
B. 20%
C. 30%
Type: Easy

74. When inventories are used as collateral, up to what percent of the value of the inventories
will banks lend?
A. 50%
B. 75%
C. 80%
Type: Medium

75. Generally, banks lend up to the following amount when firms provide receivables as
collateral:
A. 50% of the value of the receivables
B. 60% of the value of the receivables
C. 80% of the value of the receivables
D. 100% of the value of the receivables
Type: Medium

30-50
76. Commercial paper (CP) issued in the USA has a maximum maturity of nine months, most
CPs are sold with a maturity of
A. sixty days or less
B. thirty days or less
C. ninety days or less
D. one hundred and eighty days or less
Type: Medium

77. Commercial paper (CP) rate is:

A. always greater than the prime rate
B. always equal to the prime rate
C. always less than the prime rate
D. always less than the T-bill rate
Type: Medium

78. Which of the following are Moody's commercial paper (CP) ratings?

A. Aaa; Aa; A; Baa; etc
B. P-1 (Prime-1); P-2; P-3
C. AAA; AA; A; BBB; etc.
D. A-1; A-2; A-3
Type: Medium

79. Which of the following Moody's rated commercial paper has the least risk?
A. P-1
B. P-2
C. P-3
Type: Medium

30-51
80. Firms issuing commercial paper use the following as support to the issue:
I) a back-up line of credit which is generally 75% of amount of the issue in the case of a top-
tier issuers
II) a back-up line of credit which is generally 100% of amount of the issue in the case of a
lower-grade issuers
III) a back-up line of credit which is irrevocable which is 100% of the amount of the issue in
the case of low-rated issuers
A. I only
B. I and II only
C. I, II and III
Type: Difficult

81. Medium-term notes (MTNs) can be thought of as a hybrid between:

A. stocks and bonds
B. corporate bonds and commercial paper
C. corporate bonds and T-bills
D. stocks and T-bills
Type: Medium

True / False Questions

82. Trade credit term 3/10, EOM, net 60, is not a valid one.
FALSE
Type: Medium

83. If goods are sold on open account, the customer is asked to sign an IOU.
FALSE
Type: Easy

30-52
84. If a firm sells goods on terms 2/30 net 60, customers who do not take the cash discount are
effectively borrowing money at approximately 2% per year.
FALSE
Type: Medium

85. A commercial draft is simply an order to pay.

TRUE
Type: Easy

86. If a commercial draft is an order to pay immediately, it is called a time draft.

FALSE
Type: Medium

87. Bankers' acceptances are used in overseas trade.

TRUE
Type: Medium

88. A factor buys the firm's receivables, and the customer then makes payments directly to the
factor.
TRUE
Type: Medium

30-53
89. In the United States export credit insurance is provided by the Export-Import Bank in
association with a group of insurance companies known as the Foreign Credit Insurance
Association (FCIA).
TRUE
Type: Medium

90. One good reason to hold cash is that cash provides more liquidity than securities.
TRUE
Type: Easy

91. Concentration banking is used to slow down disbursements.

FALSE
Type: Medium

92. Lock-box systems are used to speed up collections.

TRUE
Type: Easy

93. Fedwire is a system that can be used to transfer money between banks.

TRUE
Type: Medium

94. Direct deposits are processed through Automated Clearing House (ACH) system.
TRUE
Type: Medium

30-54
95. The market for short-term investments is known as the capital market.

FALSE
Type: Easy

96. LIBOR is the acronym for London Interbank Offered Rate.

TRUE
Type: Easy

Short Answer Questions

97. What are the major objectives of credit management?
The major objectives of credit management are:

 Establishing terms of sale
 Establishing firm's credit policies
 Evaluating customer creditworthiness
 Establishing customer credit lines
 Keeping up-to-date- records of accounts receivables and initiating collection procedure
when necessary
Type: Medium

98. Briefly explain different terms of sale used in practice.
Sale terms can be cash before delivery (CBD) or cash on delivery (COD) for customers with
special needs or irregular customers. Generally for regular customers firms offer credit terms.
Typical credit terms are 2/30 net 60 or 3/10, EOM, net 60 or 3/10, prox., net 60.
Type: Medium

30-55
99. What is the effective cost of not taking a discount under terms 3/30 net 60?
Annualized cost of trade credit = [Early Payment discount/(1 - Early Payment discount)] *
[365/(net payment period-Discount payment period] Annualized Cost of trade credit =
[0.03/(1 - 0.03)] * [365/(60 - 30)] = 0.3763 = 37.63%
Type: Medium

100. Briefly describe the most widely used commercial credit instruments.
There are several commercial credit instruments that are used commonly. They are:
Promissory note; commercial draft (sight draft & time draft); trade acceptance; bankers'
acceptance; irrevocable letter of credit.
Type: Medium

101. Discuss the general principles that should be used for credit decisions.
In general, there are three principles of credit management. First, the overall goal of the credit
decision is to maximize shareholders' wealth. Second, the credit manager must focus on the
dangerous accounts and large accounts. Third, the credit manager must have a long-term
strategy.
Type: Medium

102. What is the main objective of a collection policy?
The main objective of collection policy is to collect on overdue accounts using least offensive
methods. But it is not always possible to do so. Most companies use collection agencies to
collect on overdue accounts.
Type: Easy

30-56
103. Briefly explain the process of factoring accounts receivables.
Factoring is the sale of accounts receivables to a factor. Typically, a factor charges 1% to 2%

of the value of the invoice as a fee. Once the factor has purchased the accounts receivables,
the customers make payments directly to the factor.
Type: Medium

104. Briefly explain how firms can protect against bad debt?
Firms can get protection against bad debt by obtaining credit insurance. The insurance can be
claimed not only if the customer becomes insolvent but also if the account is overdue.
Generally, insurance companies establish maximum coverage for the accounts of a particular
credit rating. Also, most governments have established agencies to insure export credit. In the
United States export credit insurance is provided by the Export-Import Bank in association
with a group of insurance companies known as the Foreign Credit Insurance Association
(FCIA).
Type: Medium

105. Discuss the fundamental trade-off involved in cash management.
The trade-off is between holding cash, which provides liquidity but no interest, and holding
securities, which provide interest, but less liquidity. This trade-off is used to develop cash
management models.
Type: Medium

30-57
106. Discuss the two important ways of speeding up collection.
First many companies, in order to speed up collections, use concentration banking. In this
case customers send payment to the nearest branch office. The local branch office then
deposits the checks into a local bank account. Surplus funds are transferred to a concentration
account at one of the company's principal banks. Second, the lock-box system is used for
speeding up collection. The company rents a post office box in each region. Customers send
their payments to the post office box. The local bank empties the box and deposits checks in
the company's local account. Surplus funds are transferred to the company's principal banks.
Type: Medium

107. Briefly explain electronic funds transfer.
In the United States there are two systems for making large value electronic payments. They
are the Fedwire system and CHIPS. Fedwire is operated by the Federal Reserve System and is
a real-time gross settlement system. CHIPS is a privately owned system and is a net system.
CHIPS accumulate payment instructions throughout the day and at the end of each day net
payments are settled using Fedwire.
Type: Medium

108. Briefly explain the additional complexities involved in international cash management.
Large multinational corporations operating in many countries have to deal in different

systems and legal frameworks. They have dealt with these complexities by setting up regional
systems and managing cash through them.
Type: Medium

30-58
109. What are Eurodollars (international dollars)?
Eurodollars are dollar deposits in banks outside the US. These are not subject to Federal
Reserve regulations and hence the borrowing rates are slightly lower than in the US.
Type: Medium

110. Briefly explain different money-market instruments.
There are several money-market instruments available for investments. The most important
ones in the US are: US Treasury bills; Federal Agency Securities; Certificates of Deposit;
commercial paper; bankers' acceptances; repurchase agreements.
Type: Difficult

111. What are short-term tax-exempts?
These are short-term obligations issued by state and local governments and are exempt from
federal taxes.
Type: Medium

112. What are Banker's Acceptances?
Banker's Acceptance is an unconditional promise of a bank to make payment on a draft when

it matures. The acceptance is in the form of the bank's endorsement ("Acceptance") of a draft
drawn against that bank in accordance with the terms and conditions of a letter of credit
issued by the bank. These are traded at a discount. Banker's acceptances have their origin in
international trade transactions.
Type: Difficult

30-59
113. What is LIBOR?
The London Interbank Offered Rate (LIBOR) is the most commonly used benchmark for
borrowing.
Type: Easy

114. What is a bridge loan? Briefly explain.
A bridge loan is a short-term loan that is used, for example, to finance the purchase of new
equipment or acquisition of another firm. Here the loan serves as interim financing till the
purchase or acquisition is completed and long-term financing is arranged.
Type: Medium

115. What is a self-liquidating loan? Briefly explain.
A self-liquidating loan is a short-term loan that is used, for example, to finance a temporary
increase in inventory. Such a loan is described as self-liquidating because the sale of goods
provides the cash to repay the loan.
Type: Medium

116. What is a syndicated loan?
Sometimes bank loans are too large for a single bank to handle. Under these circumstances,
loans arranged by one or more lead banks and then shared among group of banks called a
syndicate. This reduces the risk exposure of banks to a single loan.
Type: Medium

30-60
117. What is a commercial paper?
Commercial paper is an unsecured promissory note issued by a firm to raise short-term funds.
They have maturities ranging from overnight to 270 days. Limiting the maturity of
commercial paper to 270 days avoids the SEC (Securities and Exchange Commission)
registration requirement. They are traded in the market on a discount basis.
Type: Medium

118. Briefly describe the quality ratings for commercial paper.
Moody's, Standard and Poor's, and Fitch publish quality ratings for commercial paper. For
Example, Moody's provides three ratings, from P-1 (Prime-1), the highest rating to P-3. Most
investors are reluctant to buy low rated commercial paper. For example, money-market Funds
are mostly limited to holding P-1 paper.
Type: Medium

119. What are medium-term notes (MTNs)?
Medium-term notes (MTNs) can be thought of as a hybrid between corporate bonds and
commercial paper. They are sold in maturities of nine months to thirty years. Many
companies are increasingly using MTNs to finance their needs because of its flexibility. They
are sold through dealers or sold directly to investors.
Type: Medium

30-61

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Multiple Choice Questions

1. The following are the types of inventories firms keep:

2. The costs of holding inventory are:

3. The economic order quantity (EOQ) is calculated using:

10. When credit is granted to another firm this gives rise to a(n):

11. Accounts receivables include:

12. Which of the following transactions involve credit?

15. Which of the following trade credit terms is not valid?

20. A trade acceptance, when immediate payment is not required, is a:

21. Which of the following statements regarding "bankers' acceptances" is true?

22. A commercial draft can be

23. Exporters who require guarantee of payment will ask for:

24. A letter of credit is issued by the:

29. Which of the following statements is true?

34. Factoring refers to:

35. In the USA, export business is insured by:

37. Which of the following countries is the heaviest user of checks:

42. Which of the following is a real-time gross settlement system:

43. The following are advantages of electronic payment systems except:

47. A large firm may hold substantial cash balances because:

48. The market for short-term investments is called:

51. "Eurodollars" or "international dollars" are:

52. The following are money market instruments except:

53. A variable rate demand bond (VRDB):

54. Negotiable CDs are issued by:

55. A repurchase agreement occurs when:

57. A tax-paying corporation would prefer to invest short-term money in:

60. Which of the following have the most developed secondary market?

61. The most important source of short-term financing is:

63. Finance companies raise funds by

64. Generally, a line of credit is:

65. The maturity of most bank loans is:

71. Loan sales can be in the form of:

73. What percent of syndicated loans are subsequently resold? (approximately)

77. Commercial paper (CP) rate is:

78. Which of the following are Moody's commercial paper (CP) ratings?

81. Medium-term notes (MTNs) can be thought of as a hybrid between:

True / False Questions

85. A commercial draft is simply an order to pay.

86. If a commercial draft is an order to pay immediately, it is called a time draft.

87. Bankers' acceptances are used in overseas trade.

91. Concentration banking is used to slow down disbursements.

92. Lock-box systems are used to speed up collections.

93. Fedwire is a system that can be used to transfer money between banks.

95. The market for short-term investments is known as the capital market.

96. LIBOR is the acronym for London Interbank Offered Rate.

Short Answer Questions

97. What are the major objectives of credit management?

98. Briefly explain different terms of sale used in practice.

100. Briefly describe the most widely used commercial credit instruments.

102. What is the main objective of a collection policy?

103. Briefly explain the process of factoring accounts receivables.

104. Briefly explain how firms can protect against bad debt?

105. Discuss the fundamental trade-off involved in cash management.

106. Discuss the two important ways of speeding up collection.

107. Briefly explain electronic funds transfer.

108. Briefly explain the additional complexities involved in international cash management.

109. What are Eurodollars (international dollars)?