FIN 466 – Winter 2015
Exam2 - Concept Questions
You MUST answer the first three questions. Then answer six of the remaining ten.
1. What is the appropriate level of working capital? Is working capital even needed? Argue your case in detail.
The extreme view is that the optimal level of NWC is zero. This is based on the premise that working capital is
an idle resource that provides little or no value to the stockholders. Research shows that there is a positive
relationship between a reduction in working capital and stockholder wealth. However, is it possible for a firm to
operate without any investment in working capital? It depends, probably not. Some investment in working
capital acts as a shock absorber and reduces the firm’s risk and the cost of capital.
2. Describe the three motives for holding cash.
Managers have a transactions motive to hold cash when expenses are unsynchronized with cash inflows. In this
case cash provides a medium to fulfill payments in lieu of liquidating long-term assets. Thus, cash can reduce
transaction costs and opportunity costs that stem from lost returns due to early liquidation. The transactions
motive for holding cash is important for firms with unsynchronized cash inflows and outflows.
Managers may hold cash for precautionary purposes because cash can buffer against unexpected contingencies
or cash flow shortages; realized cash inflows may be less than expected. Precautionary cash holdings provide
funding for purchases and repayment of debt, which are even more critical during tight credit periods when
external capital is more difficult to acquire.
Managers also have a speculative motive because cash holdings allow for the acquisition of positive net present
value investments, where examples include strategic mergers or acquisitions. In these specific instances cash
allows the buyer to move quickly, thereby avoiding a potential bidding war.
3. What are the five C’s of credit? Describe each.
Character, thought to be the most important criterion, refers to moral uprightness, integrity, trustworthiness, and
quality of management. Willingness to pay is tested when times are bad and there is pressure to compromise
one’s integrity. Past payment records and insights from a customer’s existing suppliers are often all the
information the credit analyst has on which to base an assessment.
Capital refers to net worth, or the difference between total assets and total liabilities. It measures the cushion
with which the business exists, or how much it has in assets over and above what is necessary to pay creditors.
The seller should not place too much confidence in this figure, however, because in a liquidation the assets would
generally be sold for less than the amount shown on the books.
Capacity is the ability to repay debts when due, as measured by the company’s ability to generate cash flows.
This often includes a subjective analysis of the borrower’s management and future outlook, both in normal and
pessimistic economic conditions. Critical evaluation of the borrower’s projected cash budget and most recent
statement of cash flows is instrumental here.
The general economy and industry environment, as well as the reason for the loan request, comprise the
conditions. Some of the specific issues that should be raised by the credit analyst involve economic analysis.
The last consideration, and least important for the trade credit situation, is collateral. Assets pledged as security
to back up a credit sale or loan are called collateral. The creditor holds claim to these assets in the event the
borrower does not pay.
4. What are the two major shortcomings of DSO and accounts receivable turnover? Which of these also plagues
the aging schedule?
DSO and receivables turnover are sensitive to recent sales patterns and are reliable measures of a changing
collection experience only if the credit sales patterns for current and preceding periods are identical. Second, the
measures give quite different readings depending on whether the measures are figured from monthly, quarterly, or
annual data. The aging schedule is likewise plagued with sensitivity to the sales pattern, even if collection rates
are stable.
5. Why shouldn’t a credit manager be overly aggressive when fi rst contacting a customer who has just missed a
payment due date?
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Customers that are delinquent in payments may be experiencing temporary problems or have simply overlooked
or misplaced the invoice. The credit manager can then indicate his understanding of the situation and make sure
an understanding is gained about when the payment will be forthcoming. If necessary, the seller could renegotiate
the terms, stressing that the revised terms must be met. The credit manager should not alienate the customer and
be understanding of any mailing problems or other circumstances.
When should firms take cash discounts?
If the annualized cash payment discount rate exceeds the firm’s opportunity rate, then paying early and taking the
discount is optimal.
What are the tangible costs related to late payments, and what are some of the intangible costs?
The tangible costs include the late payment fee. The intangible costs include the loss of goodwill with supplier.
Distinguish between a demand deposit account and a NOW account. Which one do businesses use, and why?
Traditional, non-interest-bearing checking accounts are termed demand deposit accounts. Since early 1981, banks
have offered checking with interest, or NOW accounts, to individuals and nonprofit organizations. By law,
businesses can only utilize non-interest-bearing demand deposit accounts (they can use MMDAs but with a very
limited number of transactions per month).
List and define the three major electronic-based payments, giving the usage occasions, advantages, and
disadvantages of each.
Electronic-based payments transfer value in a paperless, or electronic, form. The three major methods are wire
transfers, electronic depository transfer checks, and automated debits and credits. Wire transfers are
conducted through the Federal Reserve's FedWire system, whereas electronic DTCs and automated debits and
credits are processed through an automated clearing house. Wire transfers are bookkeeping entries that
simultaneously debit the payor's account and credit the payee's account. The only thing that is "wired" is the
encoded message requesting the transfer, which is sent via phone lines. Value is transferred immediately, which
is the distinguishing feature of wire transfers. FedWire is a linked network of the twelve Fed district banks which
transfers funds for banks (and by extension their customers) by debiting or crediting the banks' reserve accounts.
The main advantage is speed-the recipient of the payment gains faster availability and can credit the payor more
quickly than would be the case for checks. The main disadvantage is cost. Usage occasions are real estate
closings and (large) disputed payments (insisted upon by the seller). The other two electronic payment methods,
electronic depository transfers (EDTs) and electronic debits and credits, involve the automated clearing house
(ACH) system. ACH processing is ideal for payroll deposits, insurance premium collections, and corporate-tocorporate payments. Electronic depository transfers, or EDTs, are a common payment mechanism which uses the
ACH system. EDTs are not really checks, but are paperless, unsigned payments that transfer funds using the
ACH system. They are often communicated via a personal computer and usually are accompanied by an
electronic (paperless) message encoded in a specialized format. EDTs involve the payor's bank producing a
computer file of payees, which is sent to one of the ACH associations, for availability to the payee either the next
day or the day following. Direct debits and credits are used for corporate-to-corporate payments and collecting
periodic, small dollar payments such as insurance premiums. The advantage is relatively low cost, and
disadvantages are delayed settlement and limited access.
Explain Mail float, Processing float, and Availability float. What role does each play in the cash collection
process?
Mail float: the time delay from the time a check is mailed to the time it reaches its destination.
Processing float: the time delay from receipt of the check until the check is entered into the clearing process.
Availability float: the time delay from when the check is entered into the clearing process until good funds are
credited to the deposit account.
As the U.S. financial system moves to nationwide branch banking, how will this impact the collection systems
used by corporations?
It will definitely increase the efficiency of collection systems by reducing the number of banks that a company
will need to deal with. Increasing efficiency will reduce the costs associated with collections and it will also tend
to speed up the receipt of cash.
What are the two principal cash transfer tools and what are the main differences between them?
Depository transfer checks: a paper-based transfer item that clears exactly like a paper check. Electronic DTC
(EDT): an electronic equivalent to a paper DTC which clears through the ACH network in batch mode generally
in one day. Wire transfers clear electronically by banks debiting and crediting their reserve or correspondent
accounts. Clearing is instantaneous.
13. Briefly discuss the major complicating factors affecting cash transfer scheduling.
a.) No weekend transfers meaning that balances left at the end of Friday's business represent three days of idle
balances. b.) The availability of goods funds from deposits may be different from the clearing of the transfer
instrument and only good funds can be transferred. c.) Variability of daily deposits. d.) Timely deposit
notification.