A firm\'s asset or capital requirements grow over time and usually exhibit tempo

Question

A firm's asset or capital requirements grow over time and usually exhibit temporal (seasonal) variation. Firms must solve the challenge of how to finance their assets with a combination of short- and long-term financing. The following graph exhibits this relationship for a particular firm. DOLLARS Asset Requirements Long-term Financing TIME Which of the following best characterizes this firm's policy of financing assets? O Moderate policy Conservative policy O Aggressive policy Note the shaded region on the preceding graph. Which of the following statements best describes the firm's situation during this time? O The firm has excess capital to invest in cash or marketable securities. O The firm must rely on short-term borrowing.

Explanation / Answer

Conservative policy involves financing long-term assets with long-term funds and short-term assets with short-term/long-term funds. An aggressive policy, on the other hand, tries to finance assets predominantly with short-term funds as these funds have lower costs than long-term funds, thereby improving the firm's profitability. This approach, however, is fraught with risks owing to the unreliability of short-term funding and their shorter repayment tenures.

The graph shows that all levels of capital/asset requirements are above the long-term financing straight line, thereby implying that long-term financing is inadequate at all time for all levels of asset requirements and the deficit needs to be financed by riskier short-term financing at all levels. Therefore, the firm's financing policy is Aggressive in nature.

In the shaded portion, the firm's asset requirement is way above the available long-term financing, thereby implying that the excess capital requirement is funded through short-term borrowing.

NOTE: Please raise a separate query for the solution to the second unrelated question.

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