ACCA FM · Chapter 5
Cash management and working capital funding MCQs with Answers
10 multiple-choice questions on Cash management and working capital funding for ACCA FM Financial Management. Try each one before revealing the answer and explanation.
Practise this chapter interactivelyQuestion 1
A company needs $1.5m of cash for payments over the next year, spread evenly over the year. Each sale of short-term investments to raise cash costs $40, and the investments earn interest at 5% a year. Using the Baumol model, what is the optimal amount of investments to sell each time cash is needed (to the nearest $)?
- A) $4,899
- B) $24,495
- C) $34,641
- D) $48,990
Show answer & explanation
Answer: D) $48,990
Baumol optimal transfer Q = square root of (2 x C x S / i) = square root of (2 x 40 x 1,500,000 / 0.05) = square root of 2,400,000,000 = $48,990 (to the nearest $). The model applies EOQ logic to cash, where C is the transaction cost, S the annual cash requirement and i the interest rate earned on investments. $24,495 is the average cash balance (Q/2), not the transfer size.
Question 2
A company uses the Miller-Orr model. The minimum cash balance is $20,000, the cost of each transaction in securities is $50, the standard deviation of daily cash flows is $4,000 and the interest rate is 7.3% a year (365-day year). What is the upper limit for the cash balance (to the nearest $)?
- A) $22,726
- B) $34,422
- C) $43,267
- D) $63,267
Show answer & explanation
Answer: D) $63,267
Daily interest rate = 7.3% / 365 = 0.02%. Variance = 4,000^2 = 16,000,000. Spread = 3 x (0.75 x 50 x 16,000,000 / 0.0002)^(1/3) = 3 x (3,000,000,000,000)^(1/3) = 3 x 14,422.5 = $43,267. Upper limit = $20,000 + $43,267 = $63,267 (to the nearest $). A common error is to use the standard deviation instead of the variance.
Question 3
Using the Miller-Orr model, a company has set a lower cash limit of $10,000 and calculated a spread of $36,000. What is the return point?
- A) $12,000
- B) $22,000
- C) $28,000
- D) $46,000
Show answer & explanation
Answer: B) $22,000
Return point = lower limit + one third of the spread = $10,000 + $36,000/3 = $22,000. The upper limit would be $10,000 + $36,000 = $46,000. Cash is restored to the return point whenever it reaches either limit.
Question 4
Under the Miller-Orr cash management model, what action should a company take when its cash balance reaches the upper limit?
- A) Take no action until the cash balance returns to the lower limit
- B) Buy marketable securities so that the cash balance falls to the return point
- C) Buy marketable securities so that the cash balance falls to the lower limit
- D) Sell marketable securities so that the cash balance rises to the return point
Show answer & explanation
Answer: B) Buy marketable securities so that the cash balance falls to the return point
When the balance reaches the upper limit, excess cash is invested by buying securities, reducing the balance to the return point. When the balance falls to the lower limit, securities are sold to restore it to the return point. The return point is one third of the spread above the lower limit.
Question 5
Which of the following is the main purpose of preparing a cash budget?
- A) To value the company's shares
- B) To calculate the profit for each month
- C) To record actual cash receipts and payments for the audit
- D) To identify periods of expected cash surplus or shortfall so that action can be planned in advance
Show answer & explanation
Answer: D) To identify periods of expected cash surplus or shortfall so that action can be planned in advance
A cash budget forecasts cash receipts and payments period by period. It allows management to arrange finance in advance of a shortfall, or to plan the investment of surpluses. It is not a profit forecast, because it excludes non-cash items such as depreciation and includes capital and financing cash flows.
Question 6
Which of the following describes an aggressive working capital funding policy?
- A) Using short-term finance to fund all fluctuating current assets and some permanent current assets
- B) Using long-term finance to fund all non-current assets, all permanent current assets and some fluctuating current assets
- C) Using long-term finance to fund all non-current and permanent current assets and short-term finance for fluctuating current assets only
- D) Using only equity finance for all assets
Show answer & explanation
Answer: A) Using short-term finance to fund all fluctuating current assets and some permanent current assets
An aggressive policy relies heavily on short-term finance, which is usually cheaper but must be renewed frequently, increasing refinancing and interest rate risk. A conservative policy uses long-term finance for some fluctuating current assets as well, and a matching (moderate) policy funds permanent assets long term and fluctuating current assets short term.
Question 7
What is meant by 'permanent current assets'?
- A) Current assets that will never be converted into cash
- B) Seasonal increases in inventory before a peak sales period
- C) The minimum level of inventory, receivables and cash that a business needs to hold at all times to support its normal level of activity
- D) Non-current assets that are used for more than one year
Show answer & explanation
Answer: C) The minimum level of inventory, receivables and cash that a business needs to hold at all times to support its normal level of activity
Although individual items of inventory and receivables are continually turned over, a business always needs a core level of current assets to operate. This core level is permanent and should normally be financed long term. Seasonal or temporary increases above this level are fluctuating current assets.
Question 8
Compared with an aggressive policy, which of the following is a consequence of adopting a conservative working capital funding policy?
- A) Lower financing costs and higher profitability
- B) Lower risk of liquidity problems but higher financing costs and lower profitability
- C) Greater exposure to the risk of being unable to renew short-term borrowing
- D) Higher risk of liquidity problems and lower financing costs
Show answer & explanation
Answer: B) Lower risk of liquidity problems but higher financing costs and lower profitability
A conservative policy uses more long-term finance, which is more secure because it does not need frequent renewal, so liquidity risk is lower. However, long-term finance is usually more expensive than short-term finance, and some may be idle in periods of low activity, which reduces profitability.
Question 9
A company's sales are January $100k, February $120k and March $150k. Customers pay as follows: 20% in the month of sale, receiving a 2% discount; 50% in the following month; 28% two months after sale; 2% are bad debts. What are the expected cash receipts in March (in $000, to 1 decimal place)?
- A) $113.6k
- B) $117.4k
- C) $118.0k
- D) $119.4k
Show answer & explanation
Answer: B) $117.4k
March receipts: from March sales 150 x 20% x 98% = 29.4; from February sales 120 x 50% = 60.0; from January sales 100 x 28% = 28.0. Total = 117.4 ($000). Ignoring the discount gives 118.0, and including the 2% bad debts as a receipt gives 119.4.
Question 10
A company has a temporary cash surplus that will be needed to pay a tax liability in three months' time. Which of the following is the MOST appropriate investment?
- A) A ten-year government bond
- B) An unsecured loan to a customer
- C) A three-month bank deposit or certificate of deposit
- D) Ordinary shares in a listed company
Show answer & explanation
Answer: C) A three-month bank deposit or certificate of deposit
Surplus cash needed in the short term should be invested in low-risk, liquid instruments whose maturity matches the date the cash is needed. Shares and long-dated bonds expose the company to price risk (the value could fall before the tax is due), and an unsecured loan to a customer is risky and illiquid.