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(Chapter 8)
(Chapter 6 – pages 151 – 155)
Short-Term Vs. Long-Term Financing
Approaches to Financing Policy
Trade Credit
Simple Interest
Discount Interest
Compensating Balance
Add-On Interest
Commercial Paper
Use of Collateral
Short-Term Vs. Long-Term Financing
Short-term financing tends to be riskier than long-
term financing:
Uncertainty concerning future rates.
May not be able to renew.
Use of short-term financing, however, may lead to
higher returns:
Most frequently, short-term rates are lower than
long-term rates (i.e., the term structure is
normally upward sloping)
Flexibility: When financing is not required, short-
term debt can be paid off.
Approaches to Financing Policy
Maturity Matching Approach
A general rule of thumb is to use short-
term financing for temporary asset needs,
and long-term financing for permanent
asset requirements.
Aggressive Approach
Use more short-term financing.
Conservative Approach
Use less short-term financing
Maturity Matching
(A Moderate Financing Approach)
Millions of Dollars
16
Temporary Current Assets
14 Short-Term Financing
12
10
8
6
Permanent Long-Term Financing
Current Assets
4
2
Fixed Assets
0
12
15
18
21
0
Time Period
Aggressive Financing
(Higher Risk - Higher Expected Return)
Millions of Dollars
16
Temporary Current Assets
14
Short-Term Financing
12
10
8 Permanent
6 Current Assets Long-Term Financing
4
2 Fixed Assets
0
12
15
18
21
0
Time Period
Conservative Financing
(Lower Risk - Lower Expected Return)
Millions of Dollars
16
14
Marketable Securities Short-Term Financing
12
10
8
Permanent Long-Term Financing
6 Current Assets
4
2
Fixed Assets
0
12
15
18
21
0
Time Period
Trade Credit
A very large source of short-term credit
Example of terms: 2/10, net 60
Free Trade Credit: Credit received during the
discount period. Always use (i.e., Do not pay
early).
Costly Trade Credit: Loss of discount if you do
not pay within the discount period. Compare
the % cost with the cost of funds from other
sources.
Trade Credit (Continued)
Disc % 360
% cost
100% - Disc % Total Credit Period - Disc Period
(Interest Rate Per Period)(Nu mber of Interest Periods)
2 360
= .1469 14.69%
98 60 - 10
Interest 360
Effective Annual Rate
Principal Days Loan is Outstandin g
(Interest Per Period)(Nu mber of Interest Periods)
Discount Interest
A single payment is made on the maturity date of
loan. The interest charge, however, is paid in
advance.
One-year loan:
Interest
Effective Annual Rate
Principal - Interest