CHAPTER 28

ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL

Please see the preface for information on the AACSB letter indicators (F, M, etc.)
on the subject lines.

(Difficulty: E = Easy, M = Medium, and T = Tough)

True-False
Medium:
Target cash balance
FK
Answer: b Diff: M
1
.
The cash balances of most firms consist of transactions, compensating,
precautionary, and speculative balances. We can produce a total desired cash
balance by calculating the amount needed for each purpose and then summing
them together.
a. True
b. False
Precautionary balance
FK
Answer: b Diff: M
2
.
The easier a firm's access to borrowed funds the higher its precautionary
balances will be, in order to protect against sudden increases in interest
rates.
a. True
b. False
Cash balances
FK
Answer: a Diff: M
3
.
For some firms, holding highly liquid marketable securities is a substitute
for holding cash because a marketable securities portfolio can accomplish the
same objective as cash.
a. True
b. False
Inventory systems
FK
Answer: b Diff: M
4
.
A just-in-time system is designed to stretch accounts payable as long as
possible.
a. True
b. False

EOQ Extension
FK
Answer: b Diff: M
5
.
If a company increases its safety stock, then its EOQ will go up.
a. True
b. False

EOQ Extension
FK
Answer: a Diff: M
6
.
If a company increases its safety stock, then its average inventory will go
up.
a. True
b. False

Multiple Choice: Conceptual

Medium:
Average inventory
CK
Answer: d Diff: M
7
.
Which of the following would cause average inventory holdings to decrease,
other things held constant?
a.
b.
c.
d.
e.

Fixed order costs double.

The purchase price of inventory items decreases by 50 percent.
The carrying price of an item decreases (as a percent of purchase price).
The sales forecast is revised downward by 10 percent.
Interest rates fall.

Inventory accounting
CK
Answer: b Diff: M
8
.
During times of inflation, which of these inventory accounting methods is best
for cash flow?
a. FIFO, because the cheapest goods are recorded as being sold first,
resulting in lower cost of goods sold and higher reported net income.
b. LIFO, because the most expensive goods are recorded as being sold first,
resulting in a higher cost of goods sold and a lower reported net income.
c. Specific identification, because it correctly identifies the actual item
sold and so the actual cost is recorded on the income statement.
d. Weighted average, because it smoothes the reported cost of goods sold over
time.
e. It doesnt matter which you use since cash flow is unaffected by the choice
of inventory identification method.
Baumol model
CK
Answer: c Diff: M
9
.
Which of the following is true of the Baumol model?
Note that the optimal
cash transfer amount is C*?
a. If the fixed costs of selling securities or obtaining a loan (cost per
transaction) increase by 20%, then C* will increase by 20%
b. If the total amount of cash needed during the year increases by 20%, then
C* will increase by 20%.
c. If the average cash balance increases by 20%, then the total holding costs
will increase by 20%.
d. If the average cash balance increases by 20% the total transactions costs
will increase by 20%.
e. The optimal transfer amount is the same for all companies.

EOQ model
CK
10
.
Which of the following is true of the EOQ model?
quantity, Q, will be called EOQ.

Answer: c Diff: M
Note that the optimal order

a. If the fixed per order cost increases by 20%, then EOQ will increase by 20%
b. If the annual sales, in units, increases by 20%, then EOQ will increase by
20%.
c. If the average inventory increases by 20%, then the total carrying costs
will increase by 20%.
d. If the average inventory increases by 20% the total order costs will
increase by 20%.
e. The EOC is the same for all comppanies.

Multiple Choice: Problems

Medium:
Baumol model
CK
Answer: d Diff: M
11
.
Once each year, B. Smith Inc. receives a $2 million payment. Of this amount,
$700,000 is needed for cash payments made during the next year. Each time
Smith deposits money in its account, a charge of $2.00 is assessed to cover
clerical costs. If Smith can hold marketable securities which yield 5 percent,
and then convert these securities to cash at a cost of only the $2 deposit
charge, what is the total cost for one year of holding the minimum cost cash
balance according to the Baumol model?
a.
b.
c.
d.
e.

$7,483
$ 187
$3,741
$ 374
$ 748

Baumol model
CK
Answer: b Diff: M
12
.
Thoroughbred Industries has been practicing cash management for some time by
using the Baumol model for determining cash balances.
Some time ago, the
model called for an average balance (C*/2) of $500; at that time, the rate on
marketable securities was 4 percent. A rapid increase in interest rates has
driven the interest rate up to 9 percent.
What is the appropriate average
cash balance now?
a.
b.
c.
d.
e.

$200
$333
$414
$500
$666

Opportunity cost:

Baumol model

CK

Answer: e

Diff: M

13

.
Williams Companys optimal cash transfer amount, using the Baumol model, is
$60,000. The firms fixed cost per cash transfer of marketable securities to cash
is $180, and the total cash needed for transactions annually is $960,000.
In
addition, the total estimated cash costs (transfers and carrying cost) for the firm,
based on 16 transactions per year, are $5,760. On what opportunity cost of holding
cash was this analysis based?
a. 19.2%
b. 10.4%
c. 6.3%
d. 12.1%
e. 9.6%
Quantity discounts
CK
Answer: d Diff: M
14
.Suppose the Campus Bookstore purchases 50,000 boxes of writing tablets every year.
Ordering costs are $100 per order and carrying costs are $0.40 per box. Moreover,
management has determined that the EOQ is 5,000 boxes.
The vendor now offers a
quantity discount of $0.20 per box if the company buys tablets in order sizes of
10,000 boxes.
Determine the before-tax benefit or loss of accepting the quantity
discount.
(Assume the carrying cost remains at $0.40 per box whether or not the
discount is taken.)
a. $1,000 loss
b. $1,000 benefit
c. $ 500 loss
d. $ 500 benefit
e. $
0 (The change would not affect profits.)

Quantity discounts
CK
Answer: e Diff: M
15
.Crystal Clear Company purchases 50,000 gallons of distilled water each year.
Ordering costs are $100 per order, and the carrying cost, as a percentage of
inventory value, is 80 percent.
The purchase price to CCC is $0.50 per gallon.
Management currently orders the EOQ each time an order is placed. No safety stock
is carried. The supplier is now offering a quantity discount of $0.03 per gallon if
CCC orders 10,000 gallons at a time. Should CCC take the discount?
a. From a cost standpoint, CCC is indifferent.
b. No, the cost exceeds the benefit by $500.
c. No, the cost exceeds the benefit by $1,000.
d. Yes, the benefit exceeds the cost by $500.
e. Yes, the benefit exceeds the cost by $1,120.
Total inventory costs
CK
Answer: c Diff: M
16
.Fullerton Wine Company is a retailer which sells vintage wines. The company
established a policy of reordering inventory every 30 days. A recently employed
has considered Fullertons inventory problem from the EOQ model viewpoint. If
following constitute the relevant data, how does the current policy compare with
optimal policy?
Ordering cost
= $10 per order
Carrying cost
= 20% of purchase price
Purchase price
= $10 per unit
Total sales for year = 1,000 units
Safety stock
= 0
a. Total costs will be the same, since the current policy is optimal.

has
MBA
the
the

b. Total costs under the current policy will be less than total costs under
the EOQ by $10.
c. Total costs under the current policy exceed those under the EOQ by $3.
d. Total costs under the current policy exceed those under the EOQ by $10.
e. Cannot be determined due to insufficient information.
Multiple part:
(The following information applies to the next three problems.)
The Norris Company is trying to determine its optimal average cash balance.
The firm has determined that it will need $5,000,000 net new cash during the coming
year. The fixed transaction cost of converting securities to cash is $50, and the
firm earns 10 percent on its marketable securities investments.
Optimal transfer size

CK

Answer: c

Diff: E

17

.According to the Baumol model, what is the optimal transaction size for transfers
from marketable securities to cash?
a. $ 7,071
b. $ 38,357
c. $ 70,711
d. $102,956
e. $ 87,000
Average cash balance
CK
Answer: a Diff: E
18
.According to the Baumol model, what should be Norris average cash balance?
a. $35,356
b. $ 3,536
c. $22,157
d. $70,711
e. $42,918
Baumol model
CK
Answer: b Diff: M
19
.What will be the total cost to Norris of maintaining the optimal average cash
balance, as determined by the Baumol model?
a. $35,356
b. $ 7,071
c. $18,493
d. $70,711
e. $53,190

(The following information applies to the next six problems.)

Aberwald Corporation expects to order 126,000 memory chips for inventory during the
coming year, and it will use this inventory at a constant rate.
Fixed ordering
costs are $200 per order; the purchase price per chip is $25; and the firms
inventory carrying costs is equal to 20 percent of the purchase price. (Assume a
360-day year.)

EOQ
CK
20
.What is the economic ordering quantity for chips?
a. 12,088
b. 3,175
c. 6,243
d. 13,675
e. 8,124

Answer: b

Diff: E

Average inventory
CK
Answer: a Diff: E
21
.If Aberwald holds a safety stock equal to a 30-day supply of chips, what is its
average inventory level?
a. 12,088
b. 3,175
c. 15,750
d. 13,675
e. 8,124
Maximum inventory
CK
Answer: d Diff: E
22
.Assume that Aberwald holds a safety stock equal to a 30-day supply of chips. What
is the maximum amount of inventory that Aberwald will have on hand at any time, that
is, what will be the inventory level right after a delivery is made?
a. 9,216
b. 3,175
c. 6,243
d. 13,675
e. 8,124
Orders per year
CK
23
.How many orders should Aberwald place during the year?
a. 12
b. 25
c. 30
d. 40
e. 60

Ordering
24
.If the
equal to
placed?
a.
b.
c.
d.
e.

Answer: d

Diff: E

inventory
CK
Answer: c Diff: M
lead time for placing an order is 5 days, and Aberwald holds a safety stock
a 30-day supply of chips, then at what inventory level should an order be
15,570
3,175
12,250
13,675
8,124

Total inventory costs

CK
Answer: c Diff: M
25
.If Aberwald holds a safety stock equal to a 30-day supply of chips, what is
Aberwalds minimum cost of ordering and carrying inventory?
a. $28,500
b. $15,950
c. $68,440
d. $34,220
e. $47,693

(The following information applies to the next three problems.)

Assume that Fashion
Further, assume that
fixed ordering costs
the inventory value,
EOQ
26
.What is
a.
b.
c.
d.
e.

Clothiers Inc. uses 1,440,000 yards of material each year.

Fashion can order the material at a cost of $2 per yard, plus
of $100 per order. The firms carrying cost is 20 percent of
at cost.
CK

Answer: a

Diff: E

the firms EOQ?

26,833
30,040
43,987
13,563
21,456

Total inventory costs

CK
Answer: b Diff: E
27
.What is Fashion Clothiers minimum costs of ordering and holding inventory?
a. $ 6,254
b. $10,733
c. $11,560
d. $13,563
e. $19,825

Quantity discounts
CK
Answer: d Diff: M
28
.Now, suppose the manufacturer offers a discount of 0.5 percent for orders of a
least 40,000 yards. Should Fashion Clothiers increase its ordering quantity to take
the discount?
a. Yes; it will save $827 if it takes the discount.
b. No; it will lose $827 if it takes the discount.
c. Yes; it will save $14,400 if it takes the discount.
d. Yes; it will save $13,573 if it takes the discount.
e. No; it will lose $13,573 if it takes the discount.

CHAPTER 28
ANSWERS AND SOLUTIONS

1.Target cash balance

FK

2.Precautionary balance
3.Cash balances
4.Inventory systems
5.EOQ Extension
6.EOQ Extension
7.Average inventory
8.Inventory accounting
9.Baumol model
10.EOQ model
11.Baumol model

FK
FK
FK
FK
FK
CK
CK
CK
CK
CK

Answer: b
Answer:
Answer:
Answer:
Answer:
Answer:
Answer:
Answer:
Answer:
Answer:
Answer:

b
a
b
b
a
d
b
c
c
d

Diff:
Diff:
Diff:
Diff:
Diff:
Diff:
Diff:
Diff:
Diff:
Diff:

M
M
M
M
M
M
M
M
M
M

Diff: M

C* =

TC = (r)(C*/2) + (T/C*)(F)
= 0.05($3,741.50) + ($700,000/$7,483)($2.00) = $374.17 $374.
12.Baumol model
C*OLD =
$1,000 =
2FT =
2FT =
C*New =
C*/2 =

$500(2) = $1,000.

CK

Answer: b

Diff: M

0.04($1,000)2 = 0.04($1,000,000)
$40,000.
= $666.67.
$333.33 $333.

13.Opportunity cost: Baumol model

CK Answer: e Diff: M
Method 1:
Use the Baumol model and solve for r, the opportunity cost of holding cash.
Method 2:
Use the total cost formula to solve for the opportunity cost, r. Note that
transactions costs and holding costs are equal when C*/2 is the optimal
average cash balance.

Method 3:
Divide the total cost (TC) into the optimal cash transfer, C*, to yield the
opportunity cost.
Note that the holding costs equal transactions at C*.
Thus, total costs are twice holding or transactions costs, and C* is twice
the average cash balance held.
r = TC
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