"CP 5-1 (Continued):One possible use of the funds might be to pay off part of thecurrent notes payable of $600,000. This might be acceptable ifthe firm can demonstrate the ability to meet its futureobligations. The banker should request to see pro formafinancial statements and projections of future cash flowgeneration. The loan might only be acceptable if the firm canbring its inventory position back in line and improve itsprofitability.AL d. Required new funds= ?S- ?S - PS 1- D( ) ( ) ( ) 2 SS $4,100,000 $1,900,000 RNF= $6,000,000×- 20% ( ) $6,000,000 $6,000,000 $6,000,000×- 20% .04% $7,200,000 1-.18 ( ) ( ) ( ) RNF = .683 $1,200,000-- .317 $1,200,000 $288,000 .82 ( ) ( ) ( ) =$819,600- $380,400- $236,160=$203,040 e. Required funds if selected industry ratios were applied to AspenReceivables = Sales/Receivable turnoverReceivables = $6,000,000/4.9Receivables = $1,224,489Inventory = Sales/inventory turnoverInventory = $6,000,000/4.4 = $1,363,636Profit Margin = 6.1%Revised A (assets)=$40,000+ $60,000+ $1, 224, 489+ $1,363,636 =$2,688,125 S5-48 CP 5-1 (Continued):AL RNF = ?S- ?S - PS 1- D( ) ( ) ( ) 2 SS $2,688,125 $1,900,000 RNF= $6,000,000×- 20% ( ) $6,000,000 $6,000,000 $6,000,000×- 20% .061 $7,200,000 1-.18 ( ) ( ) ( ) RNF= .448 $1,200,000-.317 $1,200,000- $439,200 .82 ( ) ( ) ( ) =$537,600-- $380,400 $360,144= - $202,944 Required new funds (RNF) is negative, indicating there willactually be an excess of funds equal to $202,944. This is due tothe much more rapid turnover of inventory and the higher profitmargin.f. (1) If Aspen Ski were at full capacity, more funds would beneeded to expand plant and equipment. (2) More funds would be needed to offset the larger payout ofearnings to dividends. (3) Fewer funds would be required as sales grow less rapidly.Fewer new assets would be needed to support salesgrowth. (4) As inflation increased so would the cost of new assets,especially inventory and plant and equipment. Even ifsales prices could be increased, more assets would berequired to support the same physical level of sales.Increased profits alone would not make up for the higherlevel of assets required and more funds would be needed. S5-49 Chapter 6Discussion Questions6-1. Explain how rapidly expanding sales can drain the cash resources of a firm.Rapidly expanding sales will require a buildup in assets to support the growth.In particular, more and more of the increase in current assets will be permanentin nature. A non-liquidating aggregate stock of current assets will be necessaryto allow for floor displays, multiple items for selection, and other purposes. Allof these “asset” investments can drain the cash resources of the firm. 6-2. Discuss the relative volatility of short- and long-term interest rates.Figure 6-10 shows the long-run view of short- and long-term interest rates.Normally, short-term rates are much more volatile than long-term rates. 6-3. What is the significance to working capital management of matching sales andproduction?If sales and production can be matched, the level of inventory and the amountof current assets needed can be kept to a minimum; therefore, lower financingcosts will be incurred. Matching sales and production has the advantage ofmaintaining smaller amounts of current assets than level production, andtherefore less financing costs are incurred. However, if sales are seasonal orcyclical, workers will be laid off in a declining sales climate and machinery(fixed assets) will be idle. Here lies the tradeoff between level and seasonalproduction: Full utilization of fixed assets with skilled workers and morefinancing of current assets versus unused capacity, training and retrainingworkers, with lower financing for current assets. 6-4. How is a cash budget used to help manage current assets?A cash budget helps minimize current assets by providing a forecast of inflowsand outflows of cash. It also encourages the development of a schedule as towhen inventory is produced and maintained for sales (production schedule), andaccounts receivables are collected. The cash budget allows us to forecast thelevel of each current asset and the timing of the buildup and reduction of each. 6-5. “The most appropriate financing pattern would be one in which asset buildupand length of financing terms is perfectly matched.” Discuss the difficultyinvolved in achieving this financing pattern.Only a financial manager with unusual insight and timing could design a plan inwhich asset buildup and the length of financing terms are perfectly matched.One would need to know exactly what current assets are temporary and whichones are permanent. Furthermore, one is never quite sure how much short-termS6-1 or long-term financing is available at all times. Even if this were known, itwould be difficult to change the financing mix on a continual basis. 6-6. By using long-term financing to finance part of temporary current assts, a firmmay have less risk but lower returns than a firm with a normal financing plan.Explain the significance of this statement.By establishing a long-term financing arrangement for temporary current assets,a firm is assured of having necessary funding in good times as well as bad, thuswe say there is low risk. However, long-term financing is generally moreexpensive than short-term financing and profits may be lower than those whichcould be achieved with a synchronized or normal financing arrangement fortemporary current assets. 6-7. A firm that uses short-term financing methods for a portion of permanentcurrent assets is assuming more risk but expects higher returns than a firm witha normal financing plan. Explain.By financing a portion of permanent current assets on a short-term basis, werun the risk of inadequate financing in tight money periods. However, sinceshort-term financing is less expensive than long-term funds, a firm tends toincrease its profitability over the long run (assuming it survives). In answer tothe preceding question, we stressed less risk and less return; here the emphasisis on risk and high return. 6-8. What does the term structure of interest rates indicate?The term structure of interest rates shows the relative level of short-term andlong-term interest rates at a point in time on U.S. treasury securities. It is oftenreferred to as a yield curve. 6-9. What are three theories for describing the shape of the term structure of interestrates (the yield curve)? Briefly describe each theory.Liquidity premium theory, the market segmentation theory, and theexpectations theory.The liquidity premium theory indicates that long-term rates should be higherthan short-term rates. This premium of long-term rates over short-term ratesexists because short-term securities have greater liquidity, and therefore higherrates have to be offered to potential long-term bond buyers to entice them tohold these less liquid and more price sensitive securities.The market segmentation theory states that Treasury securities are divided intomarket segments by the various financial institutions investing in the market.The changing needs, desires, and strategies of these investors tend to stronglyinfluence the nature and relationship of short- and long-term rates.S6-2 The expectations hypothesis maintains that the yields on long-term securitiesare a function of short-term rates. The result of the hypothesis is that whenlong-term rates are much higher than short-term rates, the market is saying thatit expects short-term rates to rise. Conversely, when long-term rates are lowerthan short-term rates, the market is expecting short-term rates to fall. 6-10. Since the middle 1960s, corporate liquidity has been declining. What reasonscan you give for this trend?The decrease is liquidity can be traced in part to more efficient inventorymanagement such as just-in-time inventory and point of sales terminals thatprovide better inventory control. The decline in working capital can also beattributed to electronic cash flow transfer systems, and the ability to sellaccounts receivables through securitization of assets (this is more fullyexplained in the next chapter). It might also be that management is simplywilling to take more liquidity risk as interest rates declined.S6-3 "