CFA Level 1 - Corporate Finance Session 11 - Reading 40

CFA Level 1 - Corporate Finance Session 11 - Reading 40 (Notes, Practice Questions, Sample Questions) 1. An example of a secondary source of liquidity is: A)negotiating debt contracts. B)cash flow management.C)trade credit and bank lines of credit {Explanation}: Secondary sources of liquidity include negotiating debt contracts, liquidating assets, and filing forbankruptcy protection and reorganization. Primary sourcesof liquidity include ready cash balances, short-term funds(e.g., trade credit and bank lines of credit), and cash flowmanagement 2. The condition that occurs when a company disburses cash too quickly, stretching the company’s cash reserves, is bestdescribed as a: A)pull on liquidity. B)drag on liquidity.C)liquidity premium {Explanation}: When cash payments are made too quickly, the condition is known as a pull on liquidity. A drag on liquidityoccurs when cash inflows lag

3. Which of the following is NOT a limitation to financial ratio analysis? A)The need to use judgment.B)Di erences in international accounting practices. C)A firm that operates in only one industry {Explanation}: If a firm operates in multiple industries, this would limit the value of financial ratio analysis by making itdi cult to find comparable industry ratios 4. Alton Industries will have better liquidity than its peer group of companies if its: A)average trade payables are lower. B)receivables turnover is higher. C)quick ratio is lower {Explanation}: Higher receivables turnover is an indicator of better receivables liquidity since receivables are converted tocash more rapidly. A lower quick ratio is an indication of lessliquidity. Lower trade payables could be related to betterliquidity, but could also be consistent with very poor liquidityand a requirement from its suppliers of cash payment 5. A firm has average days of receivables outstanding of 22 compared to an industry average of 29 days. An analystwould most likely conclude that the firm: A)has better credit controls than its peer companies. B)has a lower cash conversion cycle than its peer companies.C)may have credit policies that are too strict {Explanation}: The firm’s average days of receivables should be close to the industry average. A significantly lower averagedays receivables outstanding, compared to its peers, is an

indication that the firm’s credit policy may be too strict andthat sales are being lost to peers because of this. We can notassume that stricter credit controls than the average for theindustry are “better.” We cannot conclude that credit sales areless, they may be more, but just made on stricter terms. Theaverage days of receivables are only one component of thecash conversion cycle 6. The quick ratio is considered a more conservative measure of liquidity than the current ratio because the quick ratioexcludes: A)inventories, which are not necessarily liquid. B)short-term marketable securities, which may need to be soldat a significant loss.C)accounts receivable, which may not be collectible in theshort term {Explanation}: The quick ratio is usually defined as (current assets – inventory) / current liabilities. It is a more restrictivemeasure of liquidity than the current ratio, which equalscurrent assets / current liabilities. The numerator of the quickratio includes cash, receivables, and short-term marketablesecurities 7. An appropriate cash management strategy for a company that has a seasonally high need for cash prior to the holidayshopping season would least likely include: A)allowing short-term securities to mature withoutreinvestment. B)investing in U.S. Treasury notes at other times of the yearbecause they are highly liquid. C)borrowing funds though a bank line of credit.

{Explanation}: Treasury notes have maturities between 2 and 10 years and, thus, have maturities longer than those ofsecurities suitable for cash management. Allowing short-termsecurities to mature without reinvesting the cash generatedwould be one way to meet seasonal cash needs. Short-termbank borrowing or issuing commercial paper that can bepaid o when holiday sales generate cash would beappropriate strategies for dealing with a predictableshort-term need for cash 8. Which yield measure is the most appropriate for comparing a company’s investments in short-term securities? A)Bond equivalent yield. B)Money market yield.C)Discount basis yield. {Explanation}: When evaluating the performance of its short-term securities investments, a company shouldcompare them on a bond equivalent yield basis 9. A 30-day bank certificate of deposit has a holding period yield of 1%. What is the annual yield of this CD on abond-equivalent basis? A)11.83%. B)12.17%. C)12.00%. {Explanation}: The bond-equivalent yield is calculated as the holding period yield times (365 / number of days in theholding period). BEY = 1% × (365/30) = 12.17%

10. A 91-day Treasury bill has a holding period yield of 1.5%. What is the annual yield of this T-bill on a bond-equivalentbasis? A)6.02%. B)6.65%.C)6.24%. {Explanation}: BEY = 1.5% × (365/91) = 6.02% 11. An investment policy statement for a firm’s short-term cash management function would least appropriately include: A)a list of permissible securities. B)information on who is allowed to invest corporate cash.C)procedures to follow if the investment guidelines areviolated. {Explanation}: An investment policy statement typically begins with a statement of the purpose and objective of theinvestment portfolio, some general guidelines about thestrategy to be employed to achieve those objectives, and thetypes of securities that will be used. A list of permittedsecurities for investment would be limited and likely toorestrictive. A list of permitted security types is appropriateand can provide the necessary flexibility to increase yieldwithin the safety and liquidity constraints appropriate for thefirm 12. Assume that a 30-day commercial paper security has a holding period yield of 0.80%. The bond equivalent yield ofthis security is: A)9.60%. B)9.73%. C)10.12%

{Explanation}: BEY = HPY × (365/days) BEY = 0.80% × (365/30) = 9.73% 13. A banker’s acceptance that is priced at $99,145 and matures in 72 days at $100,000 has a(n): A)discount yield greater than its bond equivalent yield.B)bond equivalent yield greater than its e ective annual yield. C)money market yield greater than its discount yield. {Explanation}: The money market yield is the holding period yield times 360/72 and is always greater than the discountyield which is the actual discount from face value times360/72, since the holding period yield is always greater thanthe percentage discount from face value. A security’sdiscount yield and its money market yield are always less thanits bond equivalent yield, and its e ective annual yield isalways greater than its bond equivalent yield 14. A firm is choosing among three short-term investment securities: Security 1: A 30-day U.S. Treasury bill with a discount yield of3.6%.Security 2: A 30-day banker’s acceptance selling at 99.65% offace value.Security 3: A 30-day time deposit with a bond equivalent yieldof 3.65%.Based only on these securities’ yields, the firm would: A)prefer the banker’s acceptance. B)prefer the U.S. Treasury bill.C)prefer the time deposit

{Explanation}: We can compare the yields of these securities on any single basis. The preferred basis is the bondequivalent yield.Security 1 = discount is 3.6%(30 / 360) = 0.3%BEY = (0.3 / 99.7) (365 / 30) = 3.661% BEY of Security 2 = (0.35 /99.65) × (365 / 30) = 4.273%BEY of Security 3 = 3.65% 15. Which of the following strategies is most likely to be considered good payables management? A)Paying invoices on the last possible day to still get thesupplier’s discount for early payment. B)Taking trade discounts only if the firm’s annual return onshort-term investments is less than the discount percentage.C)Paying trade invoices on the day they arrive {Explanation}: Paying invoices on the last day to get a discount (for early payment) is often the most advantageousstrategy for a firm. If the annualized percentage cost of nottaking advantage of the discount is less than the firm’sshort-term cost of funds, it would be advantageous to pay onthe due date. However, the discount percentage is not anannualized rate, so it cannot be compared directly to thefirm's annual return on short-term investments. Paying priorto the discount cut-o date or prior to the due date sacrificesinterest income for no advantage 16. With respect to inventory management,: A)a firm with inventory turnover higher than the industryaverage can be expected to have better profitability as aresult.

B)a decrease in a firm’s days of inventory on hand indicatesbetter inventory management and can lead to increasedprofits. C)an increase in days of inventory on hand can be the resultof either good or poor inventory management {Explanation}: An increase in inventory could indicate poor sales and an accumulation of obsolete items or could be theresult of a conscious e ort to have adequate supplies toavoid losses from not having items to satisfy customer orders(stock outs). Higher-than-average inventory turnover couldindicate better inventory management or could indicate thata less than optimal inventory is being maintained by thecompany 17. A result that is most likely to give a financial manager concern that his firm’s credit policy may have become toolenient is: A)receivables turnover has increased significantly. B)weighted average collection period has increased. C)inventory turnover has decreased considerably. {Explanation}: The weighted average collection period is the average number of days it takes to collect a dollar ofreceivables. A decreased percentage of sales made on creditor an increase in the receivables turnover ratio might resultfrom more strict credit terms. Inventory turnover is notdirectly a ected by credit terms, only though the e ect ofcredit terms on overall sales 18. A large, creditworthy manufacturing firm would most likely get short-term financing by: A)factoring its receivables.

B)entering into an agreement for a committed line of credit. C)issuing commercial paper {Explanation}: Large, creditworthy firms can get the lowest cost of financing by issuing commercial paper. Sellingreceivables to a factor is a higher cost source of funds usedby firms with poor credit quality. A committed line of creditrequires payment of a fee and represents bank borrowing,which would be attractive to a firm that did not have the sizeor creditworthiness to issue commercial paper 19. Which of the following sources of credit would an analyst most likely associate with a borrower of the lowest creditquality? A)Uncommitted line of credit. B)Committed line of credit.C)Revolving line of credit. {Explanation}: Committed lines and revolving lines of credit all contain a commitment by a lender to lend up to a maximumamount, at the borrower’s option for some period of time. Afirm with lower credit quality may have an uncommitted line ofcredit which o ers no guarantee from the lender to provideany specific amount of funds in the future 20. Which of the following sources of short-term liquidity is considered reliable enough that it can be listed in thefootnotes to a firm’s financial statements as a source ofliquidity? A)Factoring agreement.B)Uncommitted line of credit. C)Revolving line of credit.

{Explanation}: With an uncommitted line of credit, the lender is not committed to make loans in any amount. A revolvingline of credit is typically for a longer period and involves anagreement to lend funds in the future up to some maximumamount. Factoring does not typically involve an agreementfor future receivables purchases 21. Which of the following sources of liquidity is the most reliable? A)Committed line of credit.B)Uncommitted line of credit. C)Revolving line of credit. {Explanation}: A revolving line of credit is typically for a longer term than an uncommitted or committed line of credit andthus is considered a more reliable source of liquidity. With anuncommitted line of credit, the issuing bank may refuse tolend if conditions of the firm change. An overdraft line ofcredit is similar to a committed line of credit agreementbetween banks and firms outside of the U.S. Both committedand revolving lines of credit can be verified and can be listedin the footnotes to a firm’s financial statements as sources ofliquidity