Introduction to Corporate Finance

(avery) #1
Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate Edition

VII. Short−Term Financial
Planning and Management


  1. Short−Term Finance
    and Planning


(^680) © The McGraw−Hill
Companies, 2002
cycled back down. This approach is the restrictive policy illustrated in Figure 19.5 as
Policy R.
In comparing the two strategies illustrated in Figure 19.5, notice that the chief dif-
ference is the way in which the seasonal variation in asset needs is financed. In the flex-
ible case, the firm finances internally, using its own cash and marketable securities. In
the restrictive case, the firm finances the variation externally, borrowing the needed
funds on a short-term basis. As we discussed previously, all else being the same, a firm
with a flexible policy will have a greater investment in net working capital.
Which Financing Policy Is Best?
What is the most appropriate amount of short-term borrowing? There is no definitive
answer. Several considerations must be included in a proper analysis:
1.Cash reserves.The flexible financing policy implies surplus cash and little short-
term borrowing. This policy reduces the probability that a firm will experience
financial distress. Firms may not have to worry as much about meeting recurring,
short-run obligations. However, investments in cash and marketable securities are
zero net present value investments at best.
2.Maturity hedging.Most firms attempt to match the maturities of assets and
liabilities. They finance inventories with short-term bank loans and fixed assets
with long-term financing. Firms tend to avoid financing long-lived assets with
short-term borrowing. This type of maturity mismatching would necessitate
frequent refinancing and is inherently risky because short-term interest rates are
more volatile than longer-term rates.
3.Relative interest rates.Short-term interest rates are usually lower than long-term
rates. This implies that it is, on the average, more costly to rely on long-term
borrowing as compared to short-term borrowing.
CHAPTER 19 Short-Term Finance and Planning 653


FIGURE 19.5


Dollars

Time

Long-term
Marketablesecurities financing

Total asset
requirement

Policy F
Dollars

Time

Long-term
financing

Total asset
requirement

Policy R

Short-term
financing

Policy F always implies a short-term cash surplus and
a large investment in cash and marketable securities.

Policy R uses long-term financing for permanent asset
requirements only and short-term borrowing for
seasonal variations.

Alternative Asset Financing Policies
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