Page 16 - DCOM505_WORKING_CAPITAL_MANAGEMENT

Unit 1: Introduction to Working Capital Management

Proportions of Short-term Financing Notes

Not only a firm have to be concerned about the level of current assets; it also has to determine
the proportions of short-and long-term debt to use in financing use in these assets. The decision
also involves trade-offs between profitability and risk.
Sources of debt financing are classified according to their maturities. Specifically, they can be
categorized as being either short-term or long-term, with short-term sources having maturities
of one year or less and long-term sources having maturities of greater than one year.

Cost of Short-term versus Long-term Debt

Historically long-term interest rates normally exceeds short-term rate because of the reduce
flexibility of long-term borrowing relative to short-term borrowing. In fact, the effective cost of
long-term debt, even went short-term interest rates are equal to or greater than long-term rates.
With long-term debt, a firm incurs the interest expense even during times went it has no immediate
need for the funds, such as during seasonal or cyclical downturns. With short-term debt, in
contrast, the firm can avoid the interest costs on unneeded funds by playing of (or not renewing)
the debt. Therefore, the long-term debt generally is higher than the cost of short-term debt.

Risk of Long-term versus Short-term Debt

Borrowing companies have different attitudes toward the relative risk of long-term versus
short-term debt then lenders. Whereas lenders normally feel that risk increases with maturity,
borrowers feel that there is more risk associated with short-term debt. The reasons for this are
two fold.

First, there is always the chance that a firm will not be able to refund its short-term debt. When
a firm’s debt matures, it either pays off the debt as part of a debt reduction program or arranges
new financing. At the time of maturity, however, the firm could faced with financial problems
resulting from such events as strikes, natural disasters, or recessions that cause sales and cash
inflows to decline. Under these circumstances the firm may find it very difficult or even impossible
to obtain the needed funds. This could lead to operating and financial difficulties.

Notes The more frequently affirm must refinance debt, the greater is the risk of its not
being able to obtain the necessary financing.
Second, short-term interest rates tend to fluctuate more over time than long-term interest rates.
As a result, a firm’s interest expenses and expected earnings after interest and taxes are subject to
more variation (risk) over time with short-term debt than with long-term debt.

Self Assessment

Fill in the blanks:
15. Short-term interest rates tend to fluctuate ......................... over time than long-term interest
rates.
16. The ......................... level of working capital investment is the level expected to maximize
shareholder’s wealth.
17. ......................... single working capital investment policy is necessarily optimal for all
firms.

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