Introduction to Corporate Finance

16: Financial Planning

to make Hershey shareholders rich.^5 Furthermore, because the term structure of interest rates (the yield

curve) is typically upward-sloping, Hershey will generally pay higher interest rates on its long-term debt

than it would pay if it were willing to borrow on a short-term basis.

The second strategy that Hershey might adopt is much more aggressive. In this aggressive strategy,

Hershey relies heavily on short-term borrowing not only to meet the seasonal peaks each year but also

to finance a portion of the long-term growth in total current assets. In Panel B of Figure 16.2, the

purple line represents the aggressive strategy. The difference between that line and the one representing

Hershey’s total current assets indicates how much short-term debt Hershey has outstanding at any

moment in time. During peak quarters, Hershey increases its short-term borrowings. But even during

the first and second quarters, when business is relatively slow, Hershey continues to finance at least part

of its operations with short-term debt. Thus, Hershey uses short-term financing to fund a portion of its

long-term, or permanent, growth in total current assets. With this strategy, the company takes advantage

of short-term interest rates, which are usually lower than long-term rates. However, if short-term rates

rise, Hershey will face increased interest expense. The company also faces a significant refinancing risk

in this strategy. That is, if Hershey’s financial condition weakens, it may not be able to roll over short-

term debt as it had in the past.

A third strategy is the matching strategy. Companies that follow the matching strategy finance the

permanent component of current assets with long-term financing, and finance the temporary or seasonal

portion of current assets with short-term debt. The matching strategy is represented by the red solid line

in Panel B of Figure 16.2. In the figure, notice that Hershey will increase short-term borrowing during

peak periods. It will repay those loans as it reduces its investment in total current assets during slow

periods.

The matching strategy is a middle-of-the-road approach. If Hershey finances its short-term assets with

short-term debt, then it will have smaller cash surpluses than under the conservative approach, but its

borrowing costs will be lower, on average (because short-term debt is usually lower-cost than long-term

debt), Hershey’s interest costs will be higher under the matching strategy than with the aggressive strategy,

but it will face less exposure to refinancing risk, and its interest costs will not fluctuate as much from

quarter to quarter.

Regardless of which strategy Hershey decides to pursue, the company will pay careful attention to short-

term inflows and outflows of cash. Doing so will allow the company to invest unanticipated cash surpluses

and cover unexpected deficits. The primary tool for managing cash flow on a short-term basis is the cash

budget.

16-3b THE CASH BUDGET

Managers use the tools described in the section on planning for growth (16-2) to make financial

projections over horizons of a year or more. However, they also need to monitor the company’s financial

performance over shorter horizons. Because it takes cash to operate on a day-to-day basis, companies

monitor their cash inflows and outflows very closely, and the primary tool they use for this purpose is the

cash budget.

5 Companies sometimes argue that a large cash reserve is a strategic asset because it enables the company to make acquisitions quickly as

opportunities arise. We agree that, in principle, a cash reserve could have strategic value, but it also enables managers to make value-

reducing investments without facing the discipline that comes with raising money in the capital markets. As you will see in the online

Chapter 21, research evidence suggests that managers of acquiring firms generally do not create wealth for their shareholders.

aggressive strategy

Financing strategy in which

a company relies heavily on

short-term borrowing, not only

to meet the seasonal peaks

each year but also to finance

a portion of the long-term

growth in sales and assets

matching strategy

Financing strategy in which a

company finances permanent

assets (fixed assets plus the

permanent component of

current assets) with long-term

funding sources and finances

its temporary or seasonal

asset requirements with short-

term debt

LO 16.6

What are the risks of financing

a long-term need with a short-

term line of credit?

thinking cap

question

See the concept explained

step by step on the

CourseMate website.

SMART

CONCEPTS