Chapter 13 - Working Capital Management and Financing Decisions 795 ‘MULTIPLE CHoIce: ; 1. Which of the following statements is correct? a. The stockholders’. equity is a major component. of working capital, ; b. Net working capital is the difference between quick assets and current liabilities, c. Working capital is a measure of long-term solvency. d._Net working capital is the difference between current assets and current liabilities. 2. The primary objective of working capital management is to ‘a. maximize the company’s total current assets. b. minimize the company’s total current liabilities. . balance the amount of current assets and current liabilities. 4d. achieve a balance between risk and return. 3, Ina conservative or relaxed working capital financing policy, ‘a. operations are conducted on @ minimum amount of working capital b. operations are operated with too much working capital. ¢. short-term liabilities are used to finance not only temporary ‘current assets, but also part or all of the permanent current asset requirements. d.. the company is exposed to tisk of iliquidity because of tow ‘working capital position. 4. Financing inventory build-up with long-term debt is an example of ‘a, a conservative working capital policy. b. matching policy, ‘can aggressive working capital policy. hedging policy. 5. The hedging approach to financing involves aa. the use of long-term debt to finance current assets, b.. the use of short-term debt to finance non-current assets. . matching maturities of debt with specific financing needs. a neue 2. ‘common stocks to raise funds for working capital796 PART 3 - FINANCIAL MANAGEMENT RELATED SERVICES 6. Which of the following is incorrect? a. Profitability varies directly with liquidity. The greater the risk, the greater is the potential for larger return. . Longrterm financing has less tiquidity risk than short-term financing, but has.a higher explicit cost, hence lower return d. More current assets lead to greater liquidity, but yield lower returns, 7. Which of the following statements is true? a. Short-term debt is usually more expensive than long-term debt. b. Liquid assets do not ordinarily earn higher retums relative to long-term assets, so holding the former will maximize the return on total assets, ©. A conservative working capital policy is characterized by higher current ratio and acid-test ratio. 4. Determining the appropriate level of working capital for a firm requires changing the firm's capital structure and dividend policy. 8. The length of time it takes for the initial cash outflows for goods and services to be realized as cash inflows from sales is called ‘a. product life cycle. vicious cycle. b. manufacturing cycle, d. cash conversion cycle. 9. If the average age of accounts payable is 15 days, the average ‘age of accounts receivables is 60 days, and the average age of inventory is 10 days, the number of days in the operating cash conversion cycle is, a. 70 days. c. 55 days. b. 85 days. d. 60 days. 10. The following data are taken from the records of Apple Corporation for the year ended December 31, 2008: Net credit sales 576,000 Average materials inventory 8,000 Average finished goods inventory 12,000 Average accounts receivable 80,000 Average accounts payable 5,000 Net credit purchases 120,000 Raw materials used 96,000 Gross profit rate 25%Chapter 13 - Working Capital Management and Financing Decisions = 797 ‘What is the average number. of days in the company’s operating cash conversion cycle? (Use a 360-day year) a. 50 days c, 105 days b. 75 days d. 45 days 11, An objective of cash management is to ‘a. maximize the cash balance to avoid the risk of illiquidity, b. minimize the cash balance to maximize the return from idle ‘cash. invest cash for a return while retaining sufficient liquidity to satisfy future needs. d.. reserve as much cash as possible for potential investment opportunities. 12, In-cash management, the difference between the bank balance for a firm’s account and the cash balance that the firm shows on its ‘own books is called a. float. c. interest income. b. bank charges. d. reconciling item. 13. Banks sometimes require its borrowers to maintain a certain percentage of the face amount of a loan which the bank requires, its borrowers to keep in a non-interest bearing current account, This is called compensating balance, which ‘a. decreases the effective rate of interest paid by the borrower, 'b. compensates the bank for services rendered by providing it with deposits of funds, c._ represents prepaid interest on’a loan. 4. cannot be used for disbursements by both the borrower and the bank. 14! A working capital technique that increases the’ payable float and therefore delays the outflow of cash is. a. electronic data interchange (EDI). bb. automatic fund transfer (AFT). c. adraft. d. Baumol Cash Management Model. 15, Company A grants credit terms of 30 days to Company B. The ‘operating cycle of Company B is 20 days. In this cese, Company A798 PART 3 — FINANCIAL MANAGEMENT RELATED SERVICES: 2._ i n effect, financing more than Company B's inventory needs, b._ is, in effect, financing less than Company B's inventory needs, c. will have a lower level of accounts receivable than those companies granting shorter credit terms. d. can be sure that Company B will be able to convert its inventories into cash before payment is due. 16. A change in a seller’s credit policy as caused the following: 7. 18, © Sales decreased ‘*__ Discounts taken decreaced "Investment in accounts receivable increased * The number of doubtful accounts increased Based on this information, we can say that a, the company increased the rate of discount offered. b. net profit has decreased. €. gF0ss profit has increased. d._ the average collection period has increased. For a manufacturing firm,,the most direct way of preparing a cash budget requires incorporation of the following, except a. sales projections and credit terms, bi collection percentages and other cash receipts. estimated purchases and payment terms and other cash disbursements, d. projected net income and depreciation expenses. Belle Company's average monthly cash receipts is P1,500,000. Its average collection period is ten (10) days. A collection agency has offered to be the company’s collector and shorten collection period to four (4) days-for a monthly fee of P1,500. The company can invest its excess funds in money market placement at a rate of 8%. If the collection agency's éffer is accepted, Belle Company's net annual benefit (loss) is a. 6,000. c. 270,000. b. (P6,000). d. 500.Chapter 13 — Working Capital Management and Financing Decisions 799 19. 20. 21. ‘Onor Corporaition had income before tax of P100,000 for the year. Included in this amount was depreciation expense of P20,000, bond: discount amortization of P18,000, and the amount paid for salaries and wages of P30,000. ‘The estimated cash flow for the year is a. 100,000. cP 138,000, b. .P 62,000. d. P120,000. ‘Annabelle Corporation is engaged in a multi-level marketing business: that presently requires all sales agents to mail checks to its Manila office. An average of three days is requited for mailed checks to be received, one day for Annabelle Corporation to process them and three days to clear through its banks. “Thie companys treasurer proposed a change in'the system, where the checks will no longer be mailed to Manila office. Instead, checks collected will be deposited on-line in any branch of the ‘company’s depository bank, and the deposit slips, as well as the other pertinent documents will be sent by fax or e-mail to the Manila office on the same day.. The original deposit slips and other documents will be submitted by the sales agents to Manila when they attend the Salés Agents’ Monthly Meeting. “The new system will eliminate the mailing float and the’ processing time. Annabelle Corporation has an. average daily collection of 50,000. If the new system is implemented, Annabelle. Corporation's average cash balance will increase by a. -P 50,000. cc. P350,000. b, P150,000. d. 200,000. Majority of Aning Company's customers are farmers from remote rural areas. Farmers Bank has offered to provide Aning Company a lockbox system at a fixed fee of P300 per month and a variable fee of P2 for each payment processed by the bank. ‘Aning Company receives 30 payments per day, averaging P5,000 ‘per payment. With the lockbox system, the company’s collection float Wwill decrease by 3 days. Money market securities earn 5% per annum,8oc fagraacy \AGEMENT RELATED SERVICES Should ning y accept Farmers Bank's offer to provide a + fockbox system? (Use 360 days in a yea.) Yes, because: Ft would ear additional income of P22,500 per b. Yes, because it would earn net benefit of P2,700 from the tockbox syctem, c. Mo, because the than the of th: lockbox system Is P2,700 more cir return on money market placements. because the fockbax system would require the company tm spend P25,200 per year. ITEMS 22 and 22 ARE BASED ON THE FOLLOWING INFORMATION: Ben Corporation uses the Baumol Cash Management Model to determine its optimal cash balance. For the coming year, the expecked cash disburseanents total P432,000, ‘The interest rate on marketable securities is 5% per annum, The fired cost of selling marketable Securities is PS per transaction, 22. Using the Baumol Cash Management Model, the company’s coptimnal cash balance is ‘a. PLL,757.55. <. P142,000.00. b. P 5,878.78. dP 1,175.76. 23. Using the Baumol Cash Management Model, the average cash balance is, a. PLL757.55. . P142,000.00. b. P 5,876.78. dP 1,175.76. 24. Which of the following items is not a marketable security? a. Treasury Bills b. Commercial Papers c. Central Bank Certificate of Indebtedness (CBCIs) d. Convertible Bonds: 25. When managing cash and short-term investments in markstable securities, the treasurer of a corporation is primarily concemed wit 2. liquidity and safety. cc. maximizing risk. b. maximizing the rate of return. d, tax avoidance.Chapter 13 - Working Capital Management and Financing Decisions 801 26, An objective of accounts receivable management is to have both the optimal amounts of receivables outstanding and bad debts. This balance requires the trade-off between the benefit of more credit sales and a, the cost of sales. . b, more bad debts. c. the cost of accounts receivables, such as collection, interest and cost of bad debts. d._ a high accounts receivable turnover. 27. Following are ways of accelerating collection of accounts receivables, except ‘a, shorten credit terms. 'b.minimiz= negative float. ©. age accuunts receivables. d._ offer special discounts to those who pay promptiy. 28. The average collection period for a firm. measures the number of days after a typical credit sale is made until the firm receives the payment. It should be related to the firm’s credit terms. For ‘example, a firm that allows terms of 2/10, net 30 should have an average collection period of a. thirty days.” cc. twenty days “b. ten days. d.. somewhere between 10 days and 30 days. 29. Which of the following represents a firm's average gross receivables balance? 1. Average age in days of receivables x average daily sales IL, Average dally sales x average collection period IIL, Annual credit sales + accounts receivable turnoyer a, Lonly Monly b.' Tand If only d. 1,0, and I ‘A change in credit policy accelerated the collection of accounts recelvable, As a resut, the company experienced the following, except a. an increase in discounts taken by customers, '. an increase in the average collection period. ¢. a-decrease in:the receivables balance.802 PART 3 ~ FINANCIAL MANAGEMENT RELATED SERVICES. d. a decrease in bad debts. ITEMS 31 and 32 ARE BASED ON THE FOLLOWING INFORMATION: 31. 32. 3. Elaine Corporation is planning to introduce changes in its collection procedures. The new procedures are expected to make the collection -period longer by 10 days, although there will be no change in bad debts, For the coming year, Elaine Corporation's budgeted sales is 32,400,000 or P90,000 per day. Short-term interest rates are expected to average at 9% per annum. ‘As a result of the changes in colléction procedures, Elaine Corporation's average accounts receivable balance will increase (decrease) by a. P900,000. cc. (P_ 900,000). b. P 90,000. d. P32,400,000. ‘To make the changes in collection procedures cost beneficial, the minimum savings in collection costs for the coming year should be a. 900,000, cP 8,100. b. P 81,000, d. P90,000. ‘A company’s president requested the credit and collection ‘manager to submit proposals on how to change the company’s credit policy. The credit and collection manager submitted two proposals. In both proposals, sales, profits, and collection periods will change although by different figures. Bad debts experience will remain the same despite the proposed changes. ‘In making @ decision on which proposal should be implemented, the president should consider the following factors, except a. the impact of the proposed changes on the current customers of the company. b. the cost of short-term credit. the company’s current bad debts experience. 4. the change in credit terms to be imposed by banks which provide short-term financing to the company.Chapter 13 - Working Capital Management and Financing Decisions 803. ITEMS 34 and 35 ARE BASED ON THE FOLLOWING INFORMATION: ‘Che-Che Corporation is planning to change its credit policy. The proposed change is expected to: +. shorten the collection period from 50 days to 30-days. '* increase the ratio of cash sales to total. sales from 20% to 30%. © decrease.total sales by 10%. 34, If projected sales for the coming year is P40M, what is the peso impact on the average accounts receivable balance of the proposed change in credit policy?. (Use 360 days in a year.) a. P2,344,444 decrease .P 6,800,000 decrease b. ' P2,100,000 decrease 4d. P18,889 decrease 35. What is the impact of the proposed credit policy on the company's accounts receivable turnover? : i a, Decrease by 7.2 ' Decrease by 20 days b. "Increase by 4.8 d, Increase to 4.8 times 36. Donny Traders sells on credit terms of 2/10, net 30. Average daily credit sales is P50,000. On the average, 70% of the customers avail of the discount and pay on the 10th day after purchase, while the rest pays on the last day of the credit term. “How much is the ‘company's accounts receivable balance? ‘a, P1,500,000 c. P. 800,000 b. P 450,000 d._ 1,050,000 37. Flint Company's average collection period is 20 days. The average dally sales is P5,000. All of the company's customers pay by credit card. How much is the company’s average accounts receivable balance? a. PO . P50,000. b. P1000 d. 5,000 May Corporation's average daily sales is P6;400,000, 10% of which is cash sales. The variable cost ratio is 60%. Starting next year, May Corporation will relax its credit standards,’ The relaxation in credit standards is expected to cause the following changes: ‘+ Total credit sales will ncreasé by 20%,©The collection petiod for incremental sales i8 60 days. (The payment behavior of the existing customers will not change.) The variable cost ratio, even for the incremental sales, will be the seme as it the past. The cost of borrowing is estimated at 25% per ‘year. The company uses 360 days in a year in all ts computations. what is May Comporation’s expected benefit (loss) from the planned relaxation in credit policy? a, .P1,152,000 . (P 27,520) ~ b. P 460,800 : dd. P432,000 39. Sisa Corporation has the following data: . Selling price per unit P70 Variable cost per unit P45 Annual credit sales - units 50,400 Collection period 30 days Rate of return 20% Sisa Corporation is considering easing its credit standards. If it does, sales will increase by 25%; collection period will increase to 45 days; bad debts {usses are anticipated to be % of the incremental sales; and collection costs will increase by P3i,649. IF the proposed relaxation in credit standards is implemented, the net benefit (loss) for Sisa Corporation is a. P215,000, c. (33,075). b. 315,000. d. (P100,000). 40. Inventory management is the formulation and administration of plans 2nd polices to efficiently and satisfactorily meet production and merchandising requirements and minimize costs relative to iniventories. One of its objectives is to. . ‘2, maximize the units in inventory. b. maximize sales. €. minimize,production costs. G,miaintain inventory at a level that best balances the estimates of actual savings, the cost of carrying additional inventory, and the efficiency of inventory control.Chapter 13 - Working Capital Management and Financing Decisions ~=—-- BOS 41. Inventory costs, in addition to'the costs of the purchased items, have been traditionally classified as follows, except j a. order costs. cc. stockout costs. b. carrying costs. d. order-filing costs. 42. Inventory management requires the firm to balance the quantity of inventory on hand for operations with the investment in inventory. “Two cost categories in inventory management are order costs and carrying costs. 2. The carying costs include handling costs, interest on captal invested, and obsolescence. b. The order costs incude quantity discounts lest, handling costs, and setup costs for a production run. c. The carrying costs include purchasing costs, shipping costs, uantity discounts lost, and setup costs. d, The order. costs include insurance costs, shipping costs, and obsolescence. 43. The following data are taken from the fecords of Chikoy Corporation for year 200A: Sales 25,200,000 Cost of sales 14,400,000 Inventory turnover 9 times per year For 2008, budgeted sales and cost of sales are the same as in 200A actual data, although the company will try to increase its inventory turnover to-12 times per year. If short-term interest rates are expected to average at 8%, what is the company’s ‘expected savings due to the increase in inventory turnover? a. 400,000 . P32,000 b. P700,000 d. P56,000 44. Which inventory costing system will result in a high inventory * turnover ratio in a period of rising prices? a. FIFO Perpetual b. LIFO d._ Periodic 45. In inventory management, a decrease in the frequency of ordering will normally a. increase total carrying costs.”806 PART 3 - FINANCIAL MANAGEMENT RELATED SERVICES b. increase the total ordering costs. have no effect on total carrying costs. d. have no effect on total ordering costs. 46. A company would be willing to have a low inventory turnover ratio if the 2. inventory order costs is low. b. carrying cost of inventory is high. cost of stock out is high. d._ lead time is short. 47. The EOQ model is a deterministic model that calculates the ideal order quantity (or production lot) given specified periodic demand, the cost per order or production run, and the periodic carrying cost per unit. The E0Q model imizes the sum of inventory carrying costs and either ordering or production setup costs. b. minimizes the sum of ordering costs and production setup costs. minimizes the sum of carrying costs and handling costs. d. minimizes the level of average inventory in units. 48, The Economic Order Quantity (E0Q) wade! cen be we 41> establish inventory policy:.In the case of a manufacturer, the EOQ is called the Economic “ot Size (ELS) or Economic Production Quantity (EPQ). Which of she following statements about the ELS is incorrect? 1a, The objective of the ELS model is to minimize the sum of inventory carrying costs and the costs of production runs or sebep costs. b. In “ne ELS model, the production rate is deemed to be .instentaneous. c. ‘In te ELS model, the demand is assumed to-occur at a con-‘ant rate over some period of time. d. The ELS model is used to maximize contiibution margin or miniaize costs given resource constraints, 49. Which of the following is not an element in the EQ formula? ‘a. yearly demand c._ safety stock b. varial\e cost per order d. periodic carrying cdst per un‘Chapter 13 Working Capital Management and Financing Decisions 807 ‘50. Which of the following statements is False? ‘a, The cost of inventory itself, as well as any quantity discounts lost ‘on inventory purchases, is directly reflected in the EOQ model. b. A decrease in inventory order costs will decrease the £0Q. ¢.__ An ingrease in inventory cafrying costs will decrease the EOQ. ._ An increase in the variable cost of placing and receiving, an ‘order will increase the E0Q. 51. The Economic Order Quantity (E0Q) formula does not assume that ‘a. demand is known. b, “usage is uniform. ._ the cost of placing an order is constant. di the cost of inventory itself is constant. 52. In the EOQ model, the return on capital that is foregone when it is invested in inventory is a(an) ‘a. order-cost. b. carrying cost. cc... exclision in the E0Q computation. 4. relevant cost. ITEMS.53 to 55 ARE BASED ON THE FOLLOWING INFORMATION: Emil Traders, Inc. sells cellphone cases which it buys from a local ranvfacturer, Emil Traders sells 24,000 cases evenly throughout the year. The cost of carrying one unit in inventory for one year is 11,52 and the order cost per order is P38.40. '53. What is the economic order quantity? a, 400 cc. 200 b, 283 d. 625 54, If Emil Traders would buy in economic order quantities, the total order costs is a, 921,600. cP 76,800. b. P 2,304, d. P460,800. 5. If Emil Traders would buy in economic order quantities, the total inventory carrying costs per year Is808 56. PART 3 - FINANCIAL MANAGEMENT RELATED SERVICES, a. 276,480. b. P 2,304, cP 23,040, d. P138,240, The basic EOQ model equals the square root of the (1) product of twice the demand times the cost per order, (2) divided by the periodic carrying cost per unit. If the annual demand increases by 44%, the EOQ will increase (decrease) by a. 6.63%. c. 9.38%, b. 20%, d. 12%. ITEMS 57 and 58 ARE BASED ON THE FOLLOWING INFORMATION: 57. 58, The following information is available for Edgar Corporation's Material X Annual usage 12,600 units Working days per year 360 days, Normal lead time 20 days ‘The units of Material X are required evenly throughout the year. What is the reorder point? a. 35 units 700 units b. 20th day d. 630 units Assuming that occasionally, the company experiences delay in the delivery of Material X, such that the lead time reaches a maximum of 30 days, how many” units of safety stock should the company Maintain and what is the reorder point? Safety Stock Reorder Point a 350 1,050 b. 350 700 © 0 1,050 d. 1,050 700 ‘The following information pertains to Annie Corporation's Material X: Annual usage 25,200 units Working days per year 360 days Normal lead time in working days 30 days Safety stock 1,050 unitsChaptor 13.- Working Capital Management and Financing Decisions 809 ‘The maximum lead time In working days and the reorder point for Material X are ‘Maximum Lead Time ‘Reorder Point a. 30 days 2,100 b. Sdays 1,050 ee 45 days 3,150 dS days 2,100 60. Using the EOQ model, Ram Corporation determined the economic “order. quantity for a merchandise item to be 800.units. To avoid stockout costs, it maintains 200 units in safety stock. What is Ram Corporation's average inventory of such merchandise iter? a. 400 units c. — 500.units 'b, 600 units d. 1,000 units ITEMS 6, and 62 ARE BASED ON THE FOLLOWING INFORMATION: Using. the EOQ model,” Apple Baby Corporation computed. the ‘economic order quantity for one of the products it sells to be 4,000 ‘units, Apple Baby. Corporation maintains safety stock of 300 units. ‘The quarterly demand for the product is 10,000 units. The order ‘cost is P200 per order. The purchase price of the product is P2.40. ‘The company. sells at a 100% markup. The annual inventory ‘carrying cost is equal to 25% of the average inventory level. 61. The annual inventory carrying costs is a, P 2,300. ¢,. P4,300. b. P2,000. d. P4,000. “The total inventory order cost per year is “a P2300. c. P2,000, 'b. 800,000. d. -P5,520. [ITEMS 63 to 66 ARE BASED ON THE FOLLOWING INFORMATION: “The following information pertains to Emy Manufacturing Corporation's Product X: ‘Annual demand 33,750 units ‘Annual cost to hold one unit of inventory PIS ‘Setup cost (or the cost to initiate a production run) P500810 PART 3 FINANCIAL MANAGEMENT RELATED SERVICES Beginning inventory of product X 0 ‘At present, the company produces 2,250 units of Product X per production un, for a total of 15 production runs per year. The company iS considering to use the EQ model to determine the economic lot size and the number of production runs that will minimize the total inventory camrying cost and setup cost for Product X. 63. At present, the company’s total annual inventory costs is a, P 7,500. c. P24,375, b. P16,875. d. 22,500. 64. Ifthe EOQ mode! is used, the economic lot size is a, 2,250 units. 2,250,000 units, b. 1,500 units. 4: PA,500. 665. Ifthe EOQ model is used, the number of production runs should be a, 15 runs. 67.5 runs. b. 1,500 units. d. 22.5 runs, 66. If the EOQ model is used, the total annual inventory costs, compared with that under the present system, will increase (decrease) by a. (P1875). cc (P5,625) b.. P3750. dé, P11,250 67. Which of the following is not a source of short-term credit? a. purchases on account —_¢. deferred income b. accruals: 4 common stock ‘68. Which of the following is incorrect? ‘a. When a firm purchases goods or services on credit from a supplier, it automatically obtains short-term financing. b, Trade credit usually bears no interest, so itis costless, Accruals or accrued expenses is a form of spontaneous financing which represents labilies for services that have been provided to the company but have not been paid for. d. Pledging of receivables is an example of secured short-term credit.Chapter 18-Woring Capa Management andFancing Decisions 81T 69. Which of the following forms of short-term borrowing is a secured credit? a. commercial paper ¢, chattel mortgage b._ line of credit banker's acceptances 70. A company obtained a short-term loan from a bank. Information about Suc loan is as follows: Principal of loan 5,000,000 Stated interest rate 10% Terms © ‘year \ \ If the Joan is discounted, the effective interest rate is a, 10%. 1c. 9.09%. b. 11.11%. d. 8.89%. 71, A company. received a P500,000 line of credit from its bank. Some information about the credit line’is as follows: “Stated interest rate 10% Compensating balance requirement 20% ‘Assuming that the’ company drew down the entire amount at the ‘beginning of the:year;‘and that the Joan is discounted, what-is the effective interest rate on the loan? ‘a, 10% 30% b. 20% d 14.29% 72. A company received a line of credit from its bank. The stated interestorate: is: 12% deducted in advance.’ THe: line of credit ‘agreementirequités'that-an amount equat to 20% ‘of the’ loan be ‘depesited:inta-acomperisating balance acount, ‘On Match’, the. company: drewdawtthe entire usable-amount of the'loan and received: the: proceeds ‘of P340,000. « Howe much 1s: the principal amount of the loan? a. :P340}000:: c, P231,200 b, P300,000 dd. P448,800 73. A company purchases merchandise form its supplier on credit equivalent annuakntefest rate812 PART 3- FINANCIAL MANAGEMENT RELATED SERVICES (use a 360-day year) if the company foregoes the discount and pays on the 30th day? a. 55.67% 60% b. 3% d. 3.09% 74. What is the current price of a P100,000 treasury bill due in 180 days on an 8% discount basis? ‘a. P100,000 cc. P104,000 b. P 96,000 4. P $2,000 7. Jun Traders, a merchandising firm, purchases merchandise from its suppliers on credit terms of 2/10, net 30. Jun Traders needs ‘cash, 50 it is considering two alternatives: Alternative 1 ~ Obtain a short-term loan from a bank at an - effective interest rate of 12%. Alternative 2 Forego the discount on its credit purchases and pay on the 30th day of the term. Jun Traders should choose (Use a 360-day year.) ‘a. Alternative 2 because this is a costless credit financing. b. Alternative 2 because its cost is cheaper by 10%. c._ Alternative 1 because its cost is cheaper by 24.73%. d. Alternative 1 because its cost is cheaper by 1%. 76._ A company's policy is to maintain a current ratio of at least 2:1. At present, its current ratio is 2.5 is to 1. If current liabilities at present amounts to P250,000, what is the maximum amount of short-term commercial loan that can be obtained by the firm to finance inventory expansion without violating its current ratio policy? a. P125,000 P62,500 b. PO d. 50,000 77. & company obtained a short-term bank loan of 500,000 at an annual interest rate of 10%. The bank requires that a ‘compensating balance of 20% be maintained in the borrower's, account. The compensating balance will earn interest of 2% per ‘annum, payable on the maturity of the loan,Chapter 13-Werkne Ceptal Management and FancigDeckions 813 Even .béfore thé approval of the loan, the company has been ‘maintaining a balance of P50,000-in’ the account, Thus, in ‘compliance with the bank’s condition, the company will just ‘deposit from the loan principal an amount of 50,000. What is the effective interest rate of the loan? a. 10% 1.11% b. 10.89% d. 12.5% ITEMS 78 to 80 ARE BASED ON THE FOLLOWING INFORMATION: “The expected boom in business in the coming period led the Baby ‘Apple Company to decide to expand its operations. The expansion requires an increase of P500,000 in working capital, which the ‘company is considering to finance through any of the following alternatives: 1, Pledge the accounts receivable ‘The company’s average accounts receivable is P625,000 per month. A financier will lend 80% of the face value of the receivables at 10% interest per annium, payable on the maturity of the loan. 2. Issue P515,000. of 3-month commercial. paper to. net. 500,000. New paper will be issued every 3 months. 3. Borrow from a commercial bank an amount that will net 500,000 after deducting @ compensating balance of 15% and interest of 5%. Use’a 360-day year in all your calculations. 78. The cost of Alternative 1 is a. 10%. c+ 8%. b. 12.5%. de 120%, 79. The annual cost of Alternative’ 2 is : a 11.65%. ce 12%: b, 1%. a, 0.97%. ‘80. The annual cost of Alternative 3 is” a 5%. c 25%, b. 20%. 2d 6.25%.814 PART 3 - FINANCIAL MANAGEMENT RELATED SERVICES ITEMS 81 to 84 ARE BASED ON THE FOLLOWING INFORMATION: Lei Company enters into an agreement with a firm that will buy Let Company's accounts teceivable and assume the risk of collection. Detalls about the agreement are as follows: ‘Average amount of receivable to be factored each month 500,000, ‘Average collection period 60 days ‘Amount to be advanced by the factor 80% of the face amount of the receivables Interest rate, deductible in : advance 10% pa. Factors fee, deductible in advance 2% Annual savings of Lei Company in collection expenses 60,000 81. How much is the monthly net proceeds from factoring the receivables? ‘a. 500,000 c, P383,333, b. 400,000 d. 350,000 82. What is the annual net cost of factoring? ‘a. 120,000 .P160,000 b. P100,000 d. (P 10,000) 83, What is the effective annual cost rate of financing? a, 26.09% 20% b. 25% d. 29.41% 84. If the interest charge and factor’s fee is not deducted in advance, the effective annual cost rate is a 26.09%. 20%. b. 25%. d. 29.41%. 85. Loi often factors its accounts receivable. The factor requires 2 10% reserve and charges 2% commission on the amount of receivables factored. The remaining amount (after deducting the reserve and commission) i further reduced by an annual interest charge of 12%.Chapter 18--Workng Capa Management and Financing Decisions 815 ‘At the beginning of the month, the company factored P500,000 of accounts receivable due in 60'days and received net’ proceeds of (Use 4 360-day year) a. 440,000. aed P431,200, b. P387,200. , 380,000. ITEMS 86 to 89 ARE BASED ON THE FOLLOWING INFORMATION: Jem Traders, Inc. needs, P100,000 to. pay a supplier's invoice for merchandise purchased with terms of 2/10, net 30. Jem Traders wants to pay on the 10th day of the credit term so it can avail of the 2% discount. ‘The funds needed can be raised by obtaining @ short-term loan from a, bank which agrees to grant a 30-day loan at 12% discounted interest per annum. . The bank requires that a compensating balance of 10% bbe maintained in the borrowers norrnterest eaming deposit account. 86, The amount needed by Jem Traders to pay the invoice within the discount period is a. P 98,000, cP 9,000. , 100,000. d._P 102,000. 87. The principat amount of the loan that must be obtained from the bank to raise'the needed fund is, a. PL10,112. cc. P112,360. b. 108,780. . de 125,640. 88, What is the effective interest rate of the loan? a 12% 10% b. 22% d. 13.48% 89, If Jem Traders fails to pay the-discount and pays the account on the 30th day of the term, what is the annual cost of this non-free trade credit? a. 2%, © 24% by 36.73% ao ‘90. : Which of the following is,not a source of long-term financing? ‘a. ' Common stocks. c._ Preferred stocks b. Bonds d. Floating lien816 PART 3- FINANCIAL MANAGEMENT RELATED SERVICES 91.° One of the sources of long-term financing is the issuance of common stocks. The advantages (to the issuer) of issuing common stocks are as follows, except a. the sale of common stocks increases credit worthiness of the firm by providing more equity. . common stock cash dividends are not tax deductible as expense, common stock is frequently more attractive to investors than. debt because it grows in value with the success of the firm. 4. common stock dividends are not fixed ~ they are paid from profits when available. 92._ It is a hybrid of debt and equity. It has a fixed charge and increases leverage, but payment of dividends is not a legal obligation. a. Preferred stock Bonds b. Common stock d, Commercial paper 93. Bonds, @ source of long-term financing, are long-term debt instruments. They are similar to term loans, except that they are usually offered to the public and sold to many investors. Among the advantages (to the issuer) of issuing bonds are as follows, except ‘cost of debt is limited ~ bondholders usually do not participate in the superior earnings of the firm. b._ interest paid on debt (bonds) is tax deductible. Cc. debt adds risk to a firm. basic control ofthe firm is not shared with the debt holders. 94. Leasing has become a major means of financing because it offers a variety of tax and other benefits. The three principal forms of lease are sale-leaseback, operating lease, and capital lease. The operating lease involves the sale of property by the owner and a lease of the property back to the seller. . is non-cancelable and fully amortizes the cost of the leased asset over the term of the basic lease contract. transfers substantially all of: the benefits and risks of ‘ownership of property to the lessee. 4. is a form of off-balance-sheet financing,‘Chapter 13 Working Capital Management and Financing Decisions = 817 ‘95. Jammy. Corporation presently has 200,000 shares, P10 par value ‘common stocks issued and outstanding, The common stockholders of Jammy Corporation have preemptive rights. If Jammy Corporation issues 100,000. additional shares of common stock at P15 per share, a current holder of 30,000 shares of Jammy Corporation's common stocks must be given the option to buy ‘a. 15,000 additional shares. c. 45,000 additional shares. 'b. 30,000 additional shares. d. 60,000 additional shares. 196. Which of the following brings in additional capital to the firm? ‘a. Issuance of stock dividend © b. Two-for-one stock spit c. Exercise of warrants d. Conversion of convertible bonds to common stocks 97. Warrants are long-term options that give holders the right to buy ‘common stocks in the future at a specified price.” Issuers of debt sometimes attach stock purchase warrants to debt instrument as an inducement to investors, A major use of warrants in financing isto ‘a, increase the return on debt. b. “lower the cost of debt. avoid dilution in earnings per share, d, maintain managerial control. 98, To acquire additional capital while attempting’ to. maximize ‘earnings per share, a company should normally ‘a. select debt over equity intially. . select equity over debt intially. issue both bonds and stocks in equal proportion, . discontinue paying dividends and. use current cash flows to ralse capital funds. ‘99. If a firm's degree of operating leverage is higher than the industry average, such firm 2. is more profitable. bi is less risky. . has profits that are“more sensitive to changes in sales volume. 4. has higher sales.818 PART 3 FINANCIAL MANAGEMENT RELATED SERVICES ITEMS 100 to 102 ARE BASED ON THE FOLLOWING INFORMATION: Following is the income statement of Annabelle Corporation for the year ended December 31, 200A: ANNABELLE CORPORATION Income Statement For the year ended December 31, 2008 Sales (500,000 units at P100 each) 50,000,000 Less variable cost (500,000 at P80 each) 40,000,000 Contribution margin 10,000,000 Less fixed costs 6,000,000 Operating income (or EBIT) P- 4,000,000 Less interest expense 1,000,000 Income before tax P 3,000,000 Less income tax (30%) ‘900,000 Income after tax P.2.100,000 100. What is Annabelle Corporation's degree of operating leverage (DOL)? a. 2.50 < 4.90 b. 3.33 7.35 101. What is Annabelle Corporation's degree of financial leverage (DFL)? a 172 2.00 b. 2.50 4. 1.33 102. What is Annabelle Corporation's degree of total leverage (DTL)? a. 4.00 © 125 b. 3.325 4. 0.80 103. The weighted average cost of capital approach to decision making is not directly affected by the a, cost of debt outstanding .__value of the common stocks current budget for capital expansion 4d. proposed mix of debt, equity, and existing funds used to implement the project 104, Which of the following statements about cost of capital is false? ‘a. Cost of capital is based on what the company pays for its capital, not the return earned on the capital employed.Chapter 13 working Captal Management and Financing Desisions 819 b. The overall cost of capital is the minimum rate a firm must earn on all investments to cover capital costs. .. The overall cost of capital is the cost of. the firm's equity capital at which the, market value of the firm will remain unchanged. d. The overall cost of capital is the’ weighted average cost of the various debt and equity components in a firm's capital structure. 105. Ideally, a firm's optimal capital structure is the one that balances the cost of debt and equity capital and their associated risk levels. ‘The optimal capital structure minimizes the firms ‘a. weighted average cost of capital. - b. cost of debt. c._ cost of equity capital. earnings per share. 106, . Which of the following statements is incorrect? a. Capital structure is the mix of the long term sources of funds used by the firm. b. Capital structure consists of the firms long-term financing, ice, long-term debt and stockholders’ equity. ‘c.. The optimum capital structure is a combination of long-term debt and equity that minimizes the cost of capital and value of the firm. d. Debt {s ‘cheaper than equity, but excessive use of debt increases the firm’s risk and drives up the weighted average cost of capital. : 107. Which of the following statements is incorrect? ‘a, An increase in the. corporate “income. tax. rate might ° fencourage a firm to increase the amount of debt in. its capital structure. b. An Increase in economic uncertainty encourages equity financing. . In general, debt financing is'more expensive than equity financing, d. When ‘calculating the: cost of capita the cost assigned to retained earings should be lower than the cost of external ‘common equity.820 PART 3 FINANCIAL MANAGEMENT RELATED SERVICES 108. At present, Jerry Corporation's capital structure is composed of 200,000 shares of common stocks outstanding with a market price (of P20 per share, It also has P4 milion in 8% bonds and P2 milion in 10%, P10 par value preferred stocks, both currently selling at par. The company is considering a P3-million expansion program which can be financed with: 1. all common stocks at P20 per share. 2. all bonds at 10% interest rate, 3. all preferred stocks. If the expansion rogram is undertaken, the company estimates that it can eam EBIT (earnings before interests and taxes) of 2,000,000. The income tax rate is 30%. If the expansion program is implemented, the expected earnings per share under each alternative source of financing are: ‘All Common Stocks All Bonds All Preferred Stocks a Part 3.69 P3.21 b. 3.26 4,69 Sat « 2.69 428 571 d 278 3.83 3.38 109. Jervi Corporation is planning to issue P20M bonds at an effective interest rate of 10%. The company pays income tax at a rate of 30%, What is the cost of debt capital? a. 10% 3% b. 7% d. 13% 110. Sam Corporation is planning to issue 100,000 shares of 10%, P50 par value preferred stocks for P8O per share. The company pays income taxat a rate of 30%. What is the cost of capita (preferred stocks)? a. 10% 6.25% b. PS d. 4.25% 111. Tanya Corporation issued preferred stocks for P120 per share. ‘The issue price is P20 more than the stock’s par value. The company incurred underwriting fees-of P10 per share. The stocks will earn annual dividends of P12 per share. If the tax rate is 30%, the cost of capital (preferred stocks) Is(Chapter 13 ~ Working Capital Management and Financing Decisions. «= 827 2. 10% © 742% b. 12% d. 10.91% 4142. Vicky Corporation has preferred stocks that pay dividends of P6.72 pper share. If the cost of funds (capital) coming from preferred stocks is 12% and the income tax rate is 30%, what is the price of -~ the preferred stocks? s a. P56.00 - cP 179 bP OBL 5 d. 38,08: ITEMS 113 to 116 ARE BASED ON THE FOLLOWING INFORMATION: Hector Corporation's capital structure is as follows: ‘Bonds payable, 10 years, 10% 1,000,000 10% preferred stocks, P200 par value, 10,000 shares issued and outstanding 2,000,000 ‘Common stocks, P50 per share, 30,000 shares issued and outstanding 41,500,000 Retained earings 500,000 Total, 5.000.000 ‘The company’s earnings per common share (EPS) is P12. The ‘common shares’ current market price is P6O, while that of preferred shares is P250. The income tax rates 30%. 4113. For purposes of computing the company's ‘overall cost of capital, the cost of common stocks and retained earings is a 24%, c. 20%. b. 16.32%, d. 13.6%. 114.. The cost of debt is, a 7%. © 14.71%: b. 10%, : d. 7.58%. 115. The cost of preferred stocks is a. 10%. b. 6.8%. 8%. 5.44%. nO822 PART 3 FINANCIAL MANAGEMENT RELATED SERVICES, 116., What is the weighted average cost of capital? a. 34.80% c. 8.54% b. 23.66% d. 12.60% 117. Harry Corporation's common stocks currently sell for P40. per share. The estimated dividend payment at the end of this year is 4 per share. The expected growth rate is 12%. Using the dividend growth model, the cost of capital is a 22%. 12%, b. 10%. d, 23%, ITEMS 118 and 119 ARE BASED ON THE FOLLOWING INFORMATION: Harold Corporation's common stocks currently sell for P50 per share. Flotation cost is 596. In the past, the company paid dividends of 4.50 per share, The expected dividend growth rate is 10%. 118. Using the dividend growth model, the cost of capital is a. 19.47%. ©. 20.42%. b. 19.90%. d. 10.42%. 119. What is the cost of retained earings? a. 19.47% &. ‘20.42% b. 19.90% d. 10.42% 120. Pinky Corporation expects to pay dividends of PS per sare at the end of this year. The expected growth rate is 10%. Using the dividend growth model, what is the stock’s market price if the cost of capital (common stocks) is 25%? a. 14.29 P20 b. P50 d. P33.33 ITEMS 121 and 122 ARE BASED ON THE FOLLOWING INFORMATION: The return on market portfolio is 12% and the risk-free rate is 5%, ‘The beta coefficient is 1.4,Chapter 13 Working Capital MariagementandFinanciog Decisions. 823. 121. Using the capital asset pricing model, what is the cost of capital (or required rate of return)? a. 14.8% c. 9.8% be 12% de 14.0% 122.. If the beta coefficient increases to 1.6, the required rate of return will increase (decrease) by a 0.2%: 1.4%. b. (0.2%). d. (1.4%). 123. Chelsea Corporation. is planning to invest in project. Two investment opportunities are being considered: ‘Atemative ——Costof investment Expected Retum on Investment 1 P10 M 11% 2 P100 M 15% ‘Chelsea Corporation can invest in only one of the alternatives. The investment project will be financed by issuing common stocks. The ‘company uses the capital asset pricing model (CAPM) in computing ‘the cost of capital (common stocks). At present, the market rate is 12% and the risk-ree rate is 8%. ‘The beta coeffidentis 1.3, Which investment alternative should the company choose? ‘a. Altemative 1 only “Alternatives 1 and 2 . Alternative 2 only 4. None ITEMS 124 to 126 ARE BASED ON THE FOLLOWING INFORMATION: Following are some financial data pertaining to Kyle Corporation: Capital structure (in millions): Long-term debt (12% interest rate) P 140 ‘Stockholders’ equity: ‘Common stocks, P10 par value. P40 ‘Additional paid-in capital 400 Retained earings 420 | _960 Total P1000 Kyle Corporation's common stock iS currently selling at par. The current market return is 14% and the risk-free rate is 10%. The824 PART 3- FINANCIAL MANAGEMENT RELATED SERVICES beta value for Kyle Corporation is 1.20, Tt pays income tax at the rate of 30% of taxable income. 124. The after-tax cost of debt is a, 12%, 8.40%. b. 3.84%, d. 17.64%. 125. Using the capital asset pricing model, the cost of common equity is a. 14.8%. c. 18.8%. b.- 12.0%. d. 4.8%. 126. , The weighted average cost of capital is, a. 22.96%. c. 14.80%. b, 11.48%. d. 13.91%. 127, Charmaine Corporation has P50M bonds in its capital structure, The corporation issued the bonds at par, P1,000 per bond, with 10% interest rate, The bonds will mature in 10 years. At present, such bonds can be sold at P1,300 per bond and can be issued at 140 basis points over Philippine treasury bonds. Charmaine Corporation's income tax rate is 30%. The interest rate for Philippine treasury bonds is 8%. ‘What is Charmaine Corporation’s current cost of debt? a. 7.84% c. 11.20% b. 8% d. 9.52% ITEMS 128 to 131 ARE BASED ON THE FOLLOWING INFORMATION: Apple Corporation is engaged in the call center business. A boom jn this type of business has caused Apple Corporation's management to consider expanding its operations by opening more call centers in key cities all over the country. The planned expansion project requires an investment of P240M, a 100% increase in the corporation's present capital structure, Management is considering three financing alternatives: Alternative 1 - Debt and Equity Financing > Float bonds with 10% interest rate, expected proceeds of P72M, net of flotation costs.Chapter 13 —Working Capital Management and Financing Decisions 825 > Issue 8% preferred ‘stocks, expected proceeds of PASM, Tet of P2M flotation costs, > Issue common stocks, expected proceeds of P120M, net of (6% flotation costs. ‘Altemative 2- Debt Financing > Float bonds with 12% interest rate. Expected proceeds, P240M, net of flotation costs. Alternative 3 Equity Financing > Issue common stocks, expected proceeds, P240M, net of 5% flotation costs, ‘The company's capital structure is composed of 30% bonds, 20% preferred stocks, and 50% common stocks. ‘The common stocks currently sell for PSO per share. For the past 2 years, common stock dividends amounted to PS per share. The expected dividend growth rate is 4%. Apple Corporation pays income tax at the rate of 30% 128. What is the’ weighted average cost of capital for Apple Corporation's first financing alternative? a. 11.30% 1G 15.06% b. 30.19% a 6.80% 129. What is the weighted average cost. of capital for Apple Corporation's second financing alternative, assuming that the costs Of preferred stocks and common stocks are 8.5% and 15%, a. 31.66% & 10.06% bd. 8.16% d, 11.65% 130. What is the. weighted average cost of capital for Apple Corporation's alternative 3, assuming ‘that costs of bonds and preferred stocks are 6.8% and 8.33%, respectively? a, 30.08% 11.21% b. 13.06% d. 11.19% 131, What is the after-tax weighted marginal cost of capital for Apple Corporation's financing alternative 2, consisting solely of bonds?826 PART 3 - FINANCIAL MANAGEMENT RELATED SERVICES a 8.40% c 3.84% b. 12.00% d. 17.65% ITEMS 132 to 135 ARE BASED ON THE FOLLOWING INFORMATION: ‘Ayie Corporation is considering a project for the coming year that will require an investment cost of PIOOM. the company plans to finance the project by a combination of debt and equity, as follows: > Issue P20M of 10-year bonds at a price of 102, with an interest rate of 10%, and flotation cost of 3% of par. > Use P8OM of funds generated from earnings retained in the business. ‘The expected market rate of return is 14%. The current rate of ‘Treasury Bills is 8%. The beta coefficient for Ayie Corporation is 1.2. The corporate income tax rate is 30%. 132, What is the effective rate of interest of the bonds? a. 10% 10.20% b. 9.89% d. 10.10% 133. What is the after-tax effective cost of bonds? a. 6.80% c. 6.73% be 7.07% d. 6.94% 134, Using the capital asset pricing model (CAPM), what is the cost of equity capital for Ayie Corporation? a. 9.6% 15.20% b. 10.34% d. 7.2% 135. Assume that the after-tax cost of debt is 7% and the cost of equity capital is 15%, what is the weighted average cost of capital for Ayie Corporation's project? - a. 13.40% c. 13.53% b. 22% d. 14.96% ITEMS 136 to 138 ARE BASED ON THE FOLLOWING INFORMATION: ‘Oneng Corporation's present capital structure consists of 30% debt, 10% preferred equity, and 60% common equity. This capital structure is considered optimal and Oneng Corporation wishes toChapter 13'-Working Capital Management and Financing Decisions == 27 ‘maintain it. For the coming year; Oneng Corporation is planning to Invest in an PEOM project that will be financed according to the desired capital structure. Currently, Oneng Corporation has P20M cash available for the,project. - 136. ‘The percentage of P8OM that will come from long-term debt is a. 30% PRAM, b. 225% d.. PI8M. 137, The percentage of P8OM that will come from a new issuance of ‘common stock is ‘ 2. 60% & 30.6%. b, 40.8% d. 45%. 138. If the company will maintain the optimal capital structure to finance the projet, ae prefered sors re en, the proceeds should be 10%. ®. Pat. d. 7.5%. 139, Butchoy Corporations present capital structure, at book value, is shown below: Bonds P 9,800,000 Preferred stocks (140,000 shares) 1,400,006 ‘Common stocks (280,000 shares) 2,800,000 Total P21.000.000 ‘Additional data pertaining to the capital structure were- gathered and they are as follows: Prefered ~ Common Bonds Stocks ‘Stocks Curent sing price 80% ofpar P10 per share P4Oper share Interest rate 9% Expected dividend payments 6% 4 20lshare Dividend growth rate etkivear Income taxrete 30% What is Butchoy Corporation's weighted average cost of capital if its new financing will be in proportion to the market value of its present financing? : a 8.39% © 11.00% b. 23.12% d. 8.86%828 PART 3 FINANCIAL MANAGEMENT RELATED SERVICES 140. Unye Corporation expects to pay dividends of P4.80 per share at the end of the current year. The dividend growth rate is 10% and the cost of common equity capital is 14% : If the dividend growth mode! is used to appraise Unye Corporation’s shares of stocks, the price of the stocks to the public is a. 120.00 per share. c. 14.00%. b. P 5.28 per share. d. 15.40%. 141, Danise Corporation believes that it can sell long-term bonds with ‘an 8% coupon rate, although the effective rate is 10%. If such bonds are part of Danise Corporation's financing plans for next year, what is the after-tax (30% tax rate) cost of bonds for purposes of calculating the corporation's cost of capital? a. 5.44% c 8% b. 7% 4. 10% ITEMS 142 to 148 ARE BASED ON THE FOLLOWING INFORMATION: ‘At the end of 200A, Tanya Corporation had the following capital structure considered to be optimal (in millions of pesos): Amount 9% Debt (10% coupon bonds) P 42.00 25% 16% Preferred stocks, P100 par value 25.20 15% ‘Common stocks and retained earnings 100.80 60% ‘The management of Tanya Corporation is planning to increase its productive capacity. This pian will require acquisition of additional facilities that calls for a substantial amount of capital expenditures. ‘Tanya is considering four investment alternatives: “Amount of Investment Required Rate of Retum Alternative A 300M 14.80% Alternative B 300M 15.20% + Aternative C 300M 15.50% Alternative D 300M 16.00% Preferred stocks may be issued at par.Chapter 13-Werking Capt Management andFhnanchgDecions 829 Common stock has a. par value of P10 and is selling for P42 per share, net of P3:per share flotation cost. The company-has had {8% dividend yield and a growth rate of 9% per year, Retained earnings as of the end of 200A amount to P58.8M. “The 10% yield on bonds is applicable to a maximum of P70M bond8. Additional debt will require a 4% premium and be sold to © yield 14%. : ‘The corporate tax rate is 40% 142. The cost of retained earnings and common stocks are Retained Earnings Common Stocks a 8% 9% . b. 5.44% 25% i c 17.72% 18.34%. 4. 18.34% 172% 143. What is the cost of preferred stocks? a. 10.88% c 16% b. 5.12% d. P16 144, The weighted-average cost of capital as of the end of 200A is a. 14.78% q cc. 17.72% db. 18.34% d. 15.15% 145. What is the retained earnings breakpoint? a. P58.8M cc. P100.8M: » 'b. P98.0M d. P35.28M. 146. Wiat is the weighted-average cost of capital beyond the retained. earnings breakpoint? a. 14.78% 17.72%. bd. 18.34% d. 15.15%. 147. Whats the debt breakpoint? : a. P70M c. P280M b. P42M d. P.28M830 PART 3 - FINANCIAL MANAGEMENT RELATED SERVICES 148. If the additional facilities require an investment of P300M, which investment alternative should be chosen? a. Alternative A c. Alternative C b. Alternative B d. Alternative D ITEMS 149 and 150 ARE BASED ON THE FOLLOWING INFORMATION: Neo Corporation is a closely held corporation owned by Rivera Family. Tt currently earns PEM profit after tax and has 300,000 shares outstanding. Next year, Neo Corporation will go public for the first time. Its intial public offering of 100,000 shares will be priced at P60 per share, with a 5% spread on the offering price, In ‘addition, Neo Corporation will incur P200,000 in out-of-pocket costs. 149, If all the shares will be issued, the net proceeds will be a. P6.OM. PSM. b. PSSM, d, P5.8M. 150. What rate of return must be eared on the net proceeds from the TPO so that there will be no dilution in earnings per share during the year of going public? a. 35.09% 34.48% b, 33.33% d. 36.36% 151. Bea Recreation Corporation is a publicly listed corporation. In 200C, it decided to go private by buying all its 5M outstanding shares at P5.80 per share. In 2000, it restructured the company by selling its low margin facilities (bowling and billiard centers) for P20M and concentrated in operating its golf course, tennis, and badminton centers. Within cone year, the restructuring improved the company’s earnings per share to P1.50. This made the company's management consider expanding its golf and tennis operations. Funds for the planned expansion can be raised by going public again and issue the 5M shares that it previously reacquired. The company’s investment bankers said that the shares can be offered to the public at a P/E ratio of 4 times t#é present earninas ner share of Pi.50. ‘At what pricgawill the SM shares be offered to the public?Chapter 13 -Working Capital Management and Financing Decisions 83 a. P6.00 c PLSO bi P4.00 de P2.67 ITEMS 152 to 155 ARE BASED ON THE FOLLOWING INFORMATION: a Jess Corporation is planning to go public for the first time. To determine some relevant information pertaining to the planned 1PO, Ka Jess Corporation submitted the following operating and financial data for the most recent year to its investment bankers: KA JESS CORPORATION Balance Sheet December 31, 2000 Assets Gash P__ 240,000 ‘Accounts receivable 3,360,000 Inventory 6,080,000 Plant and equipment, net 10,800,000 Total assets P20,480,000 abilities: ‘Accounts and notes payable 3,520,000 Long-term liabilities 3,808,000 Total Liabilities 2,328,000 ‘Stockholders’ Equity: ‘Common stocks (480,000 shares @ P4 par value) P1, 920,000 ‘Additidnal paid-in capital 4,480,000 Retained earnings 6,752,000 Total stockholders’ equity 13,152,000 Total labilties and stockholders’ equity 20,480,000 KA JESS CORPORATION Income Statement For the Year Ended December 31, 200D Sales 35,884,800 Cost of goods sold 25,964,800 Gross income P 9,920,000 Less operating expenses —4255,040 Income from operations P 5,664,960832 PART 3- FINANCIAL MANAGEMENT RELATED SERVICES Income from, operations P 5,664,960 Less interest expense * "592,960 Income before tax P 5,072,000 Less provision for income tax 2,028,800 ‘Net income 23,043,200 The investment bankers estimate that the new public offering will bbe at 5 times the earings per share. The company will issue 120,000 new common shares to the public. 152. What will be the inital price of the new shares? a. P31.50 cP 0.99 b, P 1.01 d. P25.35 153. If an underwriter spread of 6% and out-of-pocket costs of 159,480 will be incurred, how much will the net proceeds from the new issuance be? a. 3,042,000 c. P2,859,480 . P2,700,000 dd, 2,882,520 154. What return must the corporation earn on the net proceeds from the issuance of new shares to equal the earnings per share before the offering? a. 25% 25.35% b. 31.10% d. 28.18% 155, Assume that the price-earnings ratio after the distribution of new shares is 5, and that of the 120,000-share distribution, 30,000 shares belong to the current stockholders and 90,000 are new corporate shares and these will be added to the 480,000 shares currently outstanding, At how much should the stocks be priced to the public? a. P25.35 cP 26.70 b. P3170 4. P126.80833 (Chapter 13 - Working Capital Management and Financing Decisions Kev ANSWERS: 131A 132, 105. A 106. c 79, 80. A 63, 27. 133. B Cc 107. 108, 134, at. 56. 135. A 136. 137. D 109. B 110. ¢ A B 83, “4, o< BS 11.0 c A A 85. 86, 87. ° 33. 198. A 112. A 60. 139. D 113.6 61. 140. A 114. A D B o B A 88. ES 90. 91 36, 62. 37. 10. 1 141. B 116. © 142. ¢ 116. D D 38. 2A 143. C 17. A 66, 39, 40, a 13.8 118.0 144. A 92, 93, 94 96, 96. o 14..C 16, 16. 17. 18. 19, 145. B 119. B c D A c B A 67. 148. D 120. D 63. 2 A 147 70. 43, 148. D 122, C 97. 13.8 143.8 160. nm 45, D 124.6 98. 99, 46. 72. 20. 151. A 162, 125.8 126. c 100. A 24. D B 74, 153. B 154. 7A D 101 102° B 23, 24. D 128. A A 76. 77. 78. 50. 51 129. 185. C 103.16 25. 26. 130. 8 104. Cc: Bt834 PART 3 - FINANCIAL MANAGEMENT RELATED SERVICES. EXPLANATIONS: 1. D_ Net working capital is the difference between current assets and current liabilities. > The stockholders’ equity is not a component of working capital > Quick assets do not include all the current assets. > Working capital is a measure of short-term solvency. 2. D Working capital management is the administration of the company’s working capital, The primary objective is to achieve a balance between risk and return (profitability). 3. B_ Ina conservative working capital financing policy, operations are operated with too much working capital. ‘It involves financing almost all asset investments with long-term capital Although it reduces the company's isk of iliquidty and eliminates the firm's exposure to fluctuating loan rates, it is less profitable because it requires higher financing costs. > The other choices (A, C, and D) refer to Aggressive or Restricted Policy, 4. A Ina conservative (relaxed or moderate) working capital policy, operations, are conducted with too much working capital. It uses long-term liabilities to finance almost all asset investments . Financing inventory with long-term debt increases the current ratio. Although the borrowing costs is higher, liquidity is greater and risk is lower. 5. C The hedging (selfiquidating or matching) policy matches matures of debt with specific financing needs. Short-term assets are financed with short-term liabilities, long-term assets are funded by long-term financing sources. 6. A The statements are’ about risk-retun tradeoff, Proftabilty (return) varies inversely with liquidity. Higher iquidity leads to lower risk and lower return. 7. © A conservative working capital policy minimizes the risk ofChapter 13 - Working Capa! Management and Financing Decisions. 835 10. iliquidity by increasing working capital. It is characterized by @ higher current rato (current assets + current labiities) and acid- test ratio (quick assets + current libiliies) because assets are financed using long-term or permanent funds rather than short- term sources, > Short-term debt is usually fess expensive than long-term debt. > Liquid assets do not ordinarily eam higher returns relative to long-term assets, so holding the former will not maximize the return on total assets. > Capital structure and dividends relate to capital structure finance, not working capital structure. Cash conversion cycle (or operating cash conversion cycle or ‘cash flow cycle) is the length of time it takes for the initial Cash outflows for goods and services to be realized as cash inflows from sales. 4. ‘Average age of inventories» 10 days ‘Average age of accounts receivable 60 ‘Average age of accounts payable (15) Number of days in the cash flow cycle ‘5B days : Tumover ‘Average (TO) Age RM Inventory P96,000_ 360. To = — eg = 2s 0 days FG inventory _ _P576.000x75% _ ee es 4 36 times 5 10 days 2 P7600 360, ARTO = Pang — = 72iimes “> S0days = P2000 0" NPTO. =A = Mines “Sp (1S ‘Average number of dysin the operatngcashcomesoncyce 75 dave > (960 days + Turnover)836 1 13. 14, 16. 16. PART 3 FINANCIAL MANAGEMENT RELATED SERVICES Cash management involves the maintenance of the appropriate levels of cash and investment in marketable securities to meet the firm's cash requirements and to maximize income on idle funds. One of its objectives is to invest excess cash for a retum while- retaining sufficient liquidity to satisty future needs. ‘A compensating balance is a certain percentage of the face ‘amount of a loan which the bank requires its borrowers to keep in a non-interest bearing current account. This amount ‘compensates the bank for the services rendered to the borrower. It increases the effective rate of interest paid by the borrower. it can be used by the bank to satisfy its reserve requirement. It can be relent to other borrowers, thereby resulting in greater proftabilty of the bank. Payment by draft is a means of slowing cash outflows. > A draft is a three-party instrument in which the drawer orders the drawee to pay money to the payee. A check is the most common draft. When payment is made by check, a check float or clearing float arises, which slows ‘down the actual outflow of cash. > Electronic Data Interchange (EDI) and Automated Fund Transfer (AFT) are techniques used to accelerate cash receipts, > The Baumol Cash Management Mode! is an EOQ4ype model which can be used to determine the optimal cash balance, where the costs of obtaining and maintaining cash are at the minimum. ‘When the credit term granted by the seller is longer than the buyer's operating cycle, the seller is, in effect, financing more than the company's inventory needs. > A seller that grants longer credit terms will have a higher level of accounts receivables than those companies granting shorter credit terms. > Asseller cannot be sure if its buyer will be able to convert its inventories into cash. The average collection period is computed by dividing the average accounts receivable by the average sales per day.‘Chapter 18-Working Capital Management and Financing Decisions. O37 ‘Accordingly, the change in credit policy caused an increase in the investment in accounts receivable and a decrease in sales. Both of these. changes increased the average collection period. > Discounts taken decreased. So, the rate of discount offered couldn't have increased. > Changes in gross profit and net profit cannot be determined because no cost data are given in his case. 17. D. Projected net income includes non-cash items in its ‘computation. Depreciation expense is.a non-cash item. A cash budget prepared in the most direct way should include only cash items, both cash inflows and outiows. 18. A Average daily cash receipts (1,500,000 + 30 days) P 50,000 x Decrease in collection period (10 days - 4 days) 6 days Increase in average cash balanoe 300,000 x Interest rate on money market placement 8% Interest income from money market placement 24,000 Less service fee — collection agency (P1,500x 12 months) — 18,000 ‘Net annual benefit P 6,000 19. Income before tax 100,000 ‘Add non-cash items: Depreciation 20,000 ‘Amortization 18,000 38,000 Net cash flow ‘138,000 20. D Average daily collection es P 50,000 x Float reduction (3 days mailing float +1 day processing time) days Increase in average cash balance ‘200.000 21. © Lockbox system.cost per year: Fixed fee (P300 x 12 months) P 3,600 Variable fee (30 paymentsiday x 360 x P2) 21,600 ‘Total annual cost of the lockbox system 25.200838 23, 24, PART 3— FINANCIAL MANAGEMENT RELATED SERVICES Expected income from money market placement: Increase in average cash balance if the lockbox system is used (P5,000 x 30 payments x 3 days) 450,000 x Money market placement rate 5% Expected income from money market placement B.22.500 ‘The lockbox system offer should be rejected because its cost is 2,700 more (P25,200 — P22,500) than the expected income it the increase in cash balance arising from the system is invested in money market placements. Optimal Cash Balance = [21D ‘As in EOQ model, where average inventory is equal to EOQ + 2, the average cash balance when the optimal cash balance is known equals Optimal Cash Balance + 2 or P5,878.78 (P11,757 55 +2) Marketable securities are short-term money _ market instruments that can easily be converted to cash. They are nnear-cash items that are “used primarily for short-term investment. Examples are’ > TREASURY BILLS ~ debt instruments representing obligations of the National Goverment issued by the Central Bank and sold at a discount through competitive bidding > CB BILLS OR CENTRAL BANK CERTIFICATES OF INDEBTEDNESS (CBCIs) - represent indebtedness by the Central Bank > COMMERCIAL PAPERS ~ short-term, unsecured promissory Notes issued by corporations with very high credit standingGhapter 13 Working Coptal Managementand Fiancing Decisions. 839 ‘A convertible bond is not a marketable security. It is not @ short-term investment because its maturity is usually longer than one year. 25, A. Cash and marketable securties are held because of their ability to facltate routine operations of the company, not for purposes of ‘achieving investment returns, In dealing wth these highly liquid assets, the corporate treasurer is primarily concemed with the firm's liquidity and safety. 26. C Accounts receivables management involves the formulation and ‘administration of plané and policies related to sales on account ‘and erisuring the maintenance of receivables at a predetermined Jevel and their colletiblity as planned. Its objective is to have. tooth the optimal amount of receivables Outstanding and the ‘optimal amount of bad debts. This balance requires the trade-off between: ‘a. the’benefit of more credit sales, and .. the costs of accounts receivable such as collection, interest, and bad debts cost 27. C Ageing of accounts receivable is an aid in analyzing receivables: ‘which, in itself, does not accelerate collection. 28, B. Customers who will avail of the discount will pay within’ 10 ‘days, most probably on the tenth day, Those who will not avail of the discount will pay within 30 days. Thus, the average Collection period is somewhere between 10 days and 30 days. 29. D. All the given formulas can be used to calculate the average accounts receivable balance. 30. B- If the collection of accounts receivable is’ accelerated, the average collection period will decrease. 31. A. Averade sales per day P 90,000 x Increase in collection period 40 days Increase in average A/R balance ‘P300,000 32. B_ Increase in average AVR balance 900,000 x Short-term interest rate 9% Increase in the company's interest cost.» 251000840 33, 34, 36. 36. PART 3 FINANCIAL MANAGEMENT RELATED SERVICES ‘The company should be able to save P81,000 in collection cost to offset the additional interest cost due to the increase in the balance of average accounts receivable. {n analyzing the data for decision-making purposes, only the relevant factors must be considered, The current bad debts experience is irelevant because, accordingly, it will not change despite the changes in the ‘company’s credit policy. Present Policy. Proposed Policy Total sales 40,000.000 {(P40M x 90%) P36,000,000 x Credit sales ratio (100% — cash sales ratio) 80% 70% Credit sales 132,000,000 25,200,000 + Number of days in a year 360 days 360 days Average ced sles pr doy Pamaeess — P 7oot0 x Collection period SO days _30.days ‘Average accounts receivable balance §=—P 4.444.444 =P 2,100,000 Deseasein average AR blanca (P4,444,444 — P2,100,000) P2344,446 222,000.00, 380 days ARTO, presnt icy (— py aggaas © “sndays) 728TeS 25,200,000 360 days ARO, propose poley (~“Ep‘qq90 % “aDdays) 1208nes Increase in AIR TO 48 times Average daily sales P: _ 50,000 Total credit sales during the 30-day credit term Credit sales to be collected after day 10: (P1,500,000 x 30%) - ‘450,000 (P1,500,000 x 70% x 1/3) 350,000 ‘Average accounts receivable balance 90,000Chapter 13 Working Capt Management and FinancingDecisione 841 7. 38. WrrHout Discount: 1,500,000 x 30%, o be paid on day 30 = P450,000 day 7 day 10 day 30 Wink Discount: 1,500,000 x 70% = Pt 050000 tt day day 10 day 21 day 30 Sale ce cata Ec ee eee pee 28 of 1,050,000. ‘1 ofP',050,000 collected stl oustanding ‘Average daily credit sales 5,000 x Average collection period # 20 days. Average accounts receivable balance 190.000 ‘The company coliects the accounts from the credit card companies. Incremental credit sales (P6 400,000 x 90% x 20%) 1,152,000 Contribution margin ratio (100% ~ 60%) 40% Incremental contribution mergin P 460,800 Less incremental costs: : Funds required for adltional sales = variable cost (P1, 152,000 x 60%) P_ 691,200 2360.days: Funds required fr variable cost per day. P1920 x Collectio period “60 days ‘Average fund requirement for incremental variable cost P 115,200 Borrowing costrate 25% __28,800 ‘Benefit fom the relaxation in credit policy Faz842 39. A 41.0 aK PART 3 FINANCIAL MANAGEMENT RELATED SERVICES, Incremental contibulon margin (60,400 x 25% x P70 - Pas) 315,000 Less incremental costs Bad debs (5,400 x25% x70 x 4%) P6280, Collection costs 31S Opportunity cos on funds forthe increase investment in receivables Average cost of receivables, present policy (60,400 + 360} 30 days x P45) 89000 ‘Average costo receivables, proposed paliy (60,400 x 125%} + 360) 45 days x P45) 354.975 Increase in funds equed for investment in receivables Pres a75 x Rate of run 20% 33075 _109,000 Net benefit fm th retxation of credit ploy Em Order-flling cost is not an inventory cost. It refers to the costs Necessary to prepare and ship the customer's order, including the resulting payment process. The inventory costs are: ‘* ORDER costs ~ include all costs associated with preparing purchase order ‘© CARRYING costs — include avoidable labor cost, rent, taxes, security, insurance, and opportunity cost (the cost incurred by investing in inventory rather than on. income- eaming investment) * Srockour costs — include the costs incurred when an item is (out of stock, such as the lost contribution margin on sales, ‘Production interruptions, and customer i wl Carrying costs include handling storage costs, handling costs, interest on capital invested, insurance costs, and obsolescence. Order costs include purchasing costs, shipping costs, setup Costs for @ production run, and quantity discounts lost.‘Chaptet 13 Working Capital Management and Financing Decision ac Cost of Goods Sold ‘Average Inventxy 5 ination Tumover Ave, inventory, 2008 ( —P*4400,000 ), Pr800.000 14,400,000 ‘Ave. inventory, 2008 aes: ) 4,200,000 Decrease in ave. inventory P 400,000 x Short-term interest rate. Cost savings B_32.000 843 45. Funds tied up with inventory would be released if the turnover increases, thereby reducing the average inventory balanice. If short-term ‘borrowings are used to finance inventory, the company could save the interest expehse of P32,000 on such borrowings. Cost of goods sold Inventory Turnover Ratio = ‘Average inventory “The ratio increases when the average inventory decreases, and the cost of goods sold increases. In a period of rising prices, LIFO gles lower average inventory values and higher cost of ‘goods sold. Thus, in'a period of rising prices, LIFO results in a high inventory turnover rato If the frequency of ordering is reduced, the purchaser has to buy more units per order. This will reduce the ordering costs but will ‘normally increase the total carrying costs, as the purchaser has to cary more units in inventory. A low inventory tumover ratio. results from a high level of average inventory. A firm would be willing to maintain a high level of average inventory if the cost of stockout, or the cost of running out of stock, is very high. Low order costs, high carrying costs, and short lead time encourage more frequent orders which result in higher levels ‘of average inventory and a higher turnover ratio.844 47. 48, 49, 60. 54 62. 53, PART 3 FINANCIAL MANAGEMENT RELATED SERVICES ‘The EOQ model minimizes the sum of inventory carrying (or holding) costs and either ordering or production setup costs, In the EOQ model, the costs, not the units, are t> be minimized Linear programming (not the ELS model) is used to maximize profits ‘or minirize costs given resource constraints, c0q= [22D where: a= ordering costs k D= yearly demand k= periodic carrying ‘cost per unit ‘The safety stock is not an element in the EOQ formula, The cost of inventory itself is not a component of the EOQ model, and neither is any quantity discounts lost on inventory purchases. The cost of inventory itself is not an element in the EOQ formula, In the EOQ model, carrying costs include storage costs, handling costs, obsolescence, property taxes, insurance, and the opportunity cost of investing capital in inventory that is, the return on capital that is foregone when it (capital) is invested in inventory =/ 220. | 2(P38.4024,000) _ hl ag Pi1.52 ‘Annual demand +E00 Frequency of orders x Order cost per order Total order cost ‘Average inventory (EOQ + 2 = 400 + 2) x Carrying cost per unit “etal im ntory carrying cost per yearChapter 43 --Working Capital Management and Financing Decisions = 845, When a firm orders at economic order quantities, the total order cost is equal tothe total carrying cost. 56. 8 £0q= [22 PAD = fa Se )- 23 cin The EOQ will increase by 20% (from 1 or 169% to 1.2 or 120%). 57. C_ Average dally usage (12,600* 360) z 35 units x Normal lead time 20 days Reorder point (the normal lead time usage) ‘ZOOunits 58. A Maximum lead time 30 days Less normal lead time 20 days ‘Maximum days of delay 10 days x Average dally usage (12,600 +360) 35 units Safety stock 30units _ Average daily usage (12,600 * 360) 35 units x Maximum lead time 30 days Reorder point 1050 units : So gOR S: Reorder point = Normal lead time usage + Safety stock 700 + 350 = 1,050 units 59. C. Safety stock 41,050 units * Average daily usage (25,200 units = 360 days) 70 units Maximum days of delay in delivery 16 days ‘Add normal lead time 30 days ‘Maximum lead time ASdays ‘Average daily usage 70 units x Maximum lead time 45 days = Reorder point » Zi50.units846 60. 6 62. 63, PART 3 - FINANCIAL MANAGEMENT RELATED SERVICES, OR Normal lead time usage (70 units x 30 days) 2,100 units ‘Add safety stock . 4,050 units Reorder point 3.150units When the EOQ is known, the average inventory is equal to E0Q = 2. Ifa safety stock level is maintained, the units in safety stock is included in the average inventory. Average Inventory ‘Annual Demand (4) (10,000 units per quarter x 4) 40.000 units ‘Carrying cost per unit (P2.40 x 25%) PL ‘Average inventory [(EOQ = 2) + safety stock] {(4,000 units + 2) + 300 units) 2,300 units x Carrying cost per unit Pt Total annual inventory carrying cost P2300 ‘Annual demand (10,000 per quarter x 4) 40,000 +E0Q 4,000 Frequency of orders iDtimes x Order cost per order P_200 Total order cost 2.000 ‘Setup costs (15 setups x P500) P 7,500 Carrying costs ([2,250 + 2) x P15) 16.875 Total annual inventory costs E eo. 8 as=[ tad _[ 2RONCE TED [Pat [ESO oo usChapter 13 —Working Capital Management and Financing Decisions. = 847 where: ELS = economic lot size ‘a= setup cost d= annual demand = carrying cost per unit per year 65. D Annual demand 33,750 units + Economic lot size : (units per production run) 41,500 units Number of production runs: 2Scuns 66. A. Setup costs (22.5 runs x P500) 11,250 Carrying costs ((1,500 + 2] x P15) 11,250, Total annual inventory costs, using the EOQ model 22,500 Less total annual inventory costs, present system (refer to tem #63) 4375 Decrease in annual inventory cost B1g75 67. D Common stock is a source of long-term financing. 68. B Trade credit (purchases on account) usually bears no interest, but itis not costless. Its cost is implicit in the terms of credit ‘agreed upon, such as the discount policy and the discount period. , For example, purchases on credit with no trade discount are usually priced higher than cash purchases. The difference between the credit selling price and the cash selling price is the implicit cost of credit. n 69. C A chattel mortgage is a loan secured by personal. property (movable property such as equipment and vehicles) s848 PART 3 + FINANCIAL MANAGEMENT RELATED SERVICES, erst 10% xP5M 70. B Efe Rete = 7-5 amount or proceeds” PEM —(10% x PEM) = —Ps00,000 4.500000 = 11% OR = Ilerestrate 10 1086 = Obie =inerest ale ~~ T00%- 10%” 80% = tte or 71. Interest for one year (P500,000x 10%) =P $0,000 Compensating balance (PS00,000x20%) = 100,000 = —lterest__. _P50,000___ fectve Rate = —[epie amount * ~P5O0 G00 P50. 000 P100,000 = 14.20% oR = Werestrte 10% = “FOG = interest rale= ~~ 100% = 10% 20% compensating blance% 10% Princigal amount ofthe loan 70% = AZ 72. B Let Proceeds= Principal — interest - Compensating balance 340,000 = x ~ 0.12x -0.20x 340,000 = 0.68x x= 340,000 + 0.68 = P500,000 = 3, —_360 days __ 73, A Annual interest Rate = ~56°3~x ay gays 1 days -3 eon i 74, B Face amount of treasury bill 100,000 Less interest for 180 days (P100,000 x 8% x [180 + 360)) 4,000 Purchase price P.96,000‘Chapter 13 - Working Capital Management and Financing Decisions 75. © pnmuaintrestrate- 2, _ 360 days ‘Atemative 2 * 7 3-10 ‘Annual interest rate ~ ‘Atematve 1 76. 78, 79, A ‘Savings initerest costf Alternative 11s chosen Current assets ) 849 s ag & BB Current Ratio = erent ibilties Present: _2.5 _ Current Assots 1 250,000 Current assets = P250,000 x2.5 = P625.000 Ix = the proceeds from the short-term commercial Joan that will bbe used to finance acquisition of additional inventories and the ‘current ratio is maintained at 2.0 to 1, 2 __P625,000+ x _ 1 ~~ P250,000+x 2 (250,000 + x) = 625,000 + x '500,000 + 2x = 625,000 + x X= P426,000 Interest expense (P500,000 x 10%) Less incremental interest income from additional deposit in compensating balance (P50,000 x 2%) Net interest expense + Net loan proceeds (P500,000 ~ P50,000) Effective interest rate Proceeds of loan (P625,000 x 80%) Interest expense (P500,000 x 10%) Effective interest rate (P50,000 + P500,000) = Total interest expense (P15,000 per 3 months x 4 quarters) + Usable amount of the loan Effective interest rate P 50,000 4,000 P 49,000850 PART 3- FINANCIAL MANAGEMENT RELATED SERVICES ‘Since a new commercial paper will be issued every three ‘months, the loan will always have an outstanding balance of 500,000. 80. D Let x= Principal of the loan 500,000 = x -0.16x ~0.05x 500,000 = 0.80x Principal = 600,000 + 0.80 ‘625.000 Interest expense (625,000 x 5%) P 31,250 + Usable amount of the loan 800,000 Effective interest rate 6.25% 81. C Face value of receivables to be factored 500,000 Less: 20% reserve (only 80% will be advanced) 100,000 2% factor’s fee (P500,000 x.2%%) 10,000 interest for 60 days 6667" _116,667 Net proceeds per month 383.333 * ({P500,000 - 100,000} x 10% x [60 + 360)) 82. B Factors fee (P500,000 x 2% per mo. x 12 mos.) 120,000 Interest (P400,000 x 10%) 40,000 Total cost 160,000 Less savings in collection expenses 60,000 Net cost of factoring the receivables per year 00.090 83. A. Net cost of financing 100,000 + Average usable balance of the loan 383,333 Effective annual cost rate 26.08% 84, B_ Net cost of financing 100,000 + Average amount of the loan 400,000 Effective annual cost rate 25%(Chapter 13 - Working Capital Management and Financing Decisions = 85] 85. C_ Face value of receivables factored 'P500,000 Less: reserve (10%) 50,000, ‘commission (2%) 40.000 _ 60,000 Balance : Paao,000 Less interest for 60 days (P440,000 x 12% x 60/360) 8,800 Net proceeds 431.200 86. A Invoice amount 100,000 Less 2% discount 2,000 ‘Net amount of funds needed 298.000 a7. 89, 90, 91. 93, ‘The proceeds of the loan must be P98,000 (from ltern #86). Letx = principal amount of the loan 198,000 = x-0.10x -0.01x ‘Annual interest expense (P110,112x 12%), 13,213.44 + Usable loan amount 98,000.00 Effective annual interest rate 13.48% : 2 360 Arinual Cost Rate = 95x 394 = 96.2806 Floating lien is @ source of short-term financing which is secured by property, such as inventory, the composition of which may be constantly changing. ‘One of the disadvantages of issuing comman stocks is that ‘common stock cash dividends are not deductible as expense for tax purposes. Issuance of bonds create long-term debt to the issuer. This ‘adds risk to the firm. Debt originally appearing to be profitable may become a burden and drive the firm into bankruptcy. Under an operating lease; the lessee records no liability ‘except for rental expense accrued at the end of an accounting period. Rent is recorded as an expense by the lessee and852 95, 97 98, PART 3 FINANCIAL MANAGEMENT RELATED SERVICES income by the lessor. Thus, an operating lease is a form of off-balance sheet financing, > A saleteaseback involves the sale of property by the ‘owner and a lease of the property back to the seller. > A capital lease is non-cancelable and fully amortizes the cost of the leased asset cver the term of the basic lease contract. Capital lease transfers substantially all of the benefits and risks of ownership of property to the lessee. ‘Common stockholders with preemptive rights have the right to purchase any new issues of common stock in proportion to their current ownership percentages. ‘A current holder of 30,000 shares has 15% ownership in Jammy Corporation (30,000 + 200,000 = 15%). Thus, such holder has the right to buy 15,000 shares from the new issuance (100,000 x 15%). ‘The exercise of warrants results in inflows and the issuance of the stock. In the issuance of stock dividends, two-for-one stock spit, and conversion of convertible bond to common stocks, no inflow is received by the firm, If warrants are attached, bonds can sell at an interest rate slightly lower than the market rate. Warrants, therefore, lower the cost of debt. > Warrants dilute earings per share. They are included in. the EPS calculation even if they have not been exercised. > ‘Warrants can, if exercised, result in dilution of ‘management's holdings and control Eamings per share will be higher if debt, instead of equity, is used to raise funds for capital requirements. The cost of debt is lower than the cost of equity. Interest expense on-debt is tax deductible. ‘One way of computing DOL is: = 564 in Income DOL = "SGA in SalesChapter 13 Working Cantal Managementand nancingDeckions 853. 100. 101. 102. 104. 105. 106. 107. ‘Thus, profits become more sensitive to changes in sales volume as the DOL increases. jn__ _P 10,000,000 __ 5 ixed costs 'P4,000,000 FL EBIT 2 4,000,000 a ae aioe 'P4,000,000 — 1,000,000 = 133 ‘The overall cost of capital is based on both debt and equity ‘components. ‘The optimal capital structure minimizes the. firm's weighted average cost of capital. It balances the cost of debt and equity capital and their associated risk level. : ‘The optimum capital structure is a combination of long-term debt and equity that minimizes the cost of capital and thus, maximizes the value of the frm. In general, equity financing is more expensive than debt financing because investors are exposed to greater risk with ‘equity ‘capital since the firm is not obligated to pay them a retum, unlike in debt where investors are pald a fixed rate of interest per period. Moreover, in liquidation, equity investors are given the least priority in distribution of assets. Thus, ‘equity investors require a higher retum: to compénsate the (greater tisk assumed. > An increase in the corporate income tax rate might encourage a firm to increase the amount of debt in its capital structure. An increase in tax rate reduces the after- tax cost of debt. :854 108. D 109. B 110. c 14. D PART 3 FINANCIAL MANAGEMENT RELATED SERVICES > An increase in economic uncertainty. encourages equity financing. In bad years, the fim does not have to pay dividends. In debt financing, interest on debt is a fixed charge, regardless of the economic conditions. > When caloulating the cost of capital, the cost assigned to ‘etained earnings should be lower than the cost of external ‘common equity. The company incurs issuance costs when raising new, outside funds. These costs are not incurred when retained eamings is used as a financing source. 2 ‘AlCommen ——_All_—AllPrefered Stocks Bonds Stocks = ear P2goqa00 —Penno.oo0 — P2.000,000 Les interest 0.000" __ezo.g00@ 320.000 Earrings belo tat Pyjes0000 Pi.3e0000 880.000 Less tax (30%) soho 414,000 504,000 Eamings afer tx P7750 P9650 ©. 176000 Less prefered cvdends mun mon soe Income fox common stockholders P876.000 P 766,000 + Coenen shares em an “ane _Eamings per share © PAN 8% 1 200,00 «(Pam + P20) 2 PPA XBR POM x 10% PMX 10% The cost of devi is equal to the after-tax rate of interest. Cost of debt = 10% x (1 - 0.30) = 2% ‘The cost of preferred stocks equals dividends per share (DPS) divided by the net issuance price. Costot Ps = 10% x P50 Prefered Sots” “Heleumcepice peo SAB Preferred stocks dividend is not tax deductible, hence, the tax rate is irrelevant in this case. Cost of OPS P12 Prefered Sots ~ ~Vethevancapice “Pran—pTo” AEChapter 13.-Working Captal Manogoment and Financing Decisions 885, pps: 412.8 Cost of Prefered Stocks = —yersshance price 7 672 12% = —Neatissuance price = 872 Net Issuance Price = —F>¢-— = BS 413. © ~ Costof Common” __. Eamings per-share, P12 ‘Stocks and Curent market price Retained Eamings 144. A Cost of debt = (1 - THR) = 10%(1 ~0.30) = 7% 415. C Costof Preferred. _ DPS. Stocks Net issuance price or Current Market price 10% x P200 : = "paso Ae 116. D Cost of Proportion Weighted ‘Sources of Funds Capital” of Funds Cost Bonds 7.0% 15 0.20 1.40% Preferred Stocks 8.00% m5 0.40 3.20% ‘Common stocks and Retained Eamings 20.00% 25 0.40: 8.00% ‘Weighted average cost of capital 12.80%: 417. A Usirig the dividend’ growth model, the formula to compute the cost of capital (R) is: pee ae . R= —poi Flotation Cost *© a : ‘ = pron = 2h 06 UTE soe Nae gE856 PART 3 - FINANCIAL MANAGEMENT RELATED SERVICES, where: R = cost of canital _ 860 PART 3- FINANCIAL MANAGEMENT RELATED SERVICES 133. B After-tak effective cost of bonds = 10.10% (1 = 0,30) = 07%. 134. .C Cost of capital = Re + B(Rw - Re) = B% + 1.2(14% ~ 8%) = 15.20% 135. A Source of Funds Cost of Capital Proportion of Funds Weighted Cost Bonds Th 2000 20% 1.40% Equity 18h 80100 60% 12.00% Weighted average cost of capital B40 196. B Total project cost P8oM Less cash available 20M Required financing - om x Proportion of debt tothe optimal . capital structure 20% Required financing from long-term debt Piem + Total projact cost 80M Percentage of P80M that will come from long-term debt . 22.50% 137. D_ Total project cost * PBOM Less cash available “20M Required financing 60m x Proportion of common equity to the optimal capital structure 80% Required financing from common equity P3em + Total project cost 230M Percentage of PBOM that will come from ‘a new issuance of common stocks 45% 198. A Total project cost PeOM Less cash available 20M Financing required PeoM x Proportion of preferred equity to the ‘optimal capital structure 1% Required proceeds from issuance of preferred stocks PoemChaptor 18 Working Capital Management end Financing eciins 861 438. D Sours Cost of Proportion Weighted of Funds Capital of Funds Cost Bonds 820%0B7.84MO) 36.36% 242% Preferedstocks «6.00% = 140M. 685% O4N% Common stocks 11.00% “_11,20M 64.70% 6.00% Pada f Weighted average cost of capital 380 1) Ot -0.30] (9 POBMx80% @ [eW xP10]+ P10 & sP=PV 0 [1.204 40) +8% (280,000 rs, xP40 440. A The dividend grown model is used to determine the cost of common equity capital (R) The formula is D: 6 ee R= —5y (= Flotation costs) * where: Dy =next dividend Pa = issue price: G = growth rate ‘Assuming no flotation ,cost, Po or the issue price can be ‘calculated as follows: ‘ : ao Di 400 Por Rig" ram 10%” Pladper share 141. 'B _Costofbonds = Effective rate x (1 ~ Tax Rate) = f0%(1~0.30) = 10% 442, © Cost of retained earings = ay ‘ 1 [(8.60" x 1.09) + 45] + 0% = 47.720 Dividend yield =” _Dividend per share_ ‘ Price per share 8%. = — _Dividend per share . P42 + PS Dividend per share = 896 x 45 = P3.60 per share,862 PART 3- FINANCIAL MANAGEMENT RELATED SERVICES Cost of Preferred ___ Dividends per share Rane ‘Stocks = Net issue price , P100 x 16% P10 = 16% 144. A Proportion Weighted ‘Source of Funds Costof Capital of Funds. ——cost Bonds (10% x 70%) 10% 25% 175% Prefered stocks 18.00% 15% 2.40% CIS & RE {177% BO 10.63% Weighted average costo capital , Mae * the cost of retained earings was used asthe cost of common equi 145. B Retained eamings breakpoint represents the total amount of financing that can be raised before the corporation is forced to sell new common stocks, The retained earings baiance as of the end of 200A is P58.8M. Therefore, the retained earings: breakpoint is P98M = (P58.8M + 60%), 146. D Proportion Weightad Source of Funds CastofCapitel of Funds cast Bonds (10% x 70%) 70% 25% 175% Prefered stocks 16.00% 15% 240% CIS8RE 1eatK 60% 11.00% Weighted average ens of capital : 615% * Beyond the RE Breakpaint, the cost of common stocks is used as thé cost of common ent P70M 147. © Debt breakpoint oe E200(Chapter 13 Working Capt Management and Financing Decisions §— 863. 148. D 149. B 150. 151. A Debt breakpoint - the capital structure size beyond which there wil be a change in the cost of debt. ‘The additional invesfment required is P300M, an amount . that is beyond both the retained eamings and debt breakpoints, The weighted average cost of capital will be: ‘Proportion. Weighed Source ofFunds Costof Capital of Funds cost Bonds (14% x 70%) 9.80% 25% 245% Prefered stocks 16.00% 18 240% ‘Common stocks and Retained earrings 18% 60% 11.00% Weighted average costo capital 15854 ‘Alternative D should be chosen because its return of 16% is higher than the weighted average cost of capital of 15.85% Total sales (100,000 x P60) ‘6,000,000 Less: 5% spread 300,000 Other out-of-pocket costs 200,000 500,000 Net proceeds 5.500.000 Present earnings per share (P6M + 300,000) P20 x Total shares outstanding! including the IPO shares (300,000 + 100,000) as 400,000 Total earnings desired 8,000,000 Less earnings before issuance of new shares i 6,000,000 Desired incremental earnings P2,000,000 + Net proceeds from the new issuance of shares (from Item #149) -5,500,000 Rate of return on the net proceeds 26.36% ci Price per share ~~ Barnings per share’ Price per share P4150 Price per share = 4x P1.50 = P6,00864 152. D 153. B 14. 0 185. C PART 3- FINANCIAL MANAGEMENT RELATED SERVICES Net income 3,043,200 + Number of common shares: Present number of shares 480,000 ‘Add new shares to be issued 120,000 __600,000 Earnings per share 5.07 x Price-earnings ratio 5 Price of new shares to be issued P2635 Total value of new shares (120,000 shares x P25.35) 3,042,000 Less: Underwriter’s spread (6% x,P3,042,000) 182,520 Out-of-pocket costs: 159.480 _342,000 Net proceeds 2,700,000 Eamings per share before the issuance of new shares (P3,043,200 + 480,000) P64 Total number of shares, including the new Issuance (480,000 + 120,000) 600,000, Desired total earings 504,000, Less earings before the issuance of new shares -31043.200 Required increase in earnings 780,800 + Net proceeds from the new issuance of shares : (fom tam #183) 2.700.000 Required return on the net proceeds from new ‘issuance 8.18% Net income 3,043,200 + Number of shares Present number of shares 480,000 ‘Add new issuance 90,000 __70,000 Earnings per share 5.34 x Price-samings ratio 5.00 New issue price P2620