Firms generally choose to finance temporary current operating assets with short-

Question

Firms generally choose to finance temporary current operating assets with short-term debt because ...
A) matching the maturities of assets and liabilities reduces risk under some circumstances, and also because short-term debt is often less expensive than long-term capital.
B) short-term interest rates have traditionally been more stable than long-term interest rates.
C) a firm that borrows heavily on a long-term basis is more apt to be unable to repay the debt than a firm that borrows short term.
D) the yield curve is normally downward sloping.
E) short-term debt has a higher cost than equity capital.

Explanation / Answer

Matching the maturities of assets and liabilities reduces risk explanation: Choice "a" is correct. Matching the maturities of current assets with liabilities as they come due is designed to ensure liquidity and reduce risk of cash shortages. Temporary assets (such as inventories, generally, and seasonal inventories, specifically) might be financed with short term debt such that the earnings from the sales of those temporary assets could be used to liquidate the related obligations as they come due and ensure that cash is available to meet cash flow requirements. Choice "b" is incorrect. Interest rate risks would likely motivate a firm to use longer term financing than short-term financing. Choice "c" is incorrect. Matching cash inflows with cash outflows are more influential in determining a firm's ability to repay debt rather than the length of the obligation. Choice "d" is incorrect. Long-term rather than short-term debt promotes consistent finance charges. The requirements for financing itself are driven by business practice, not by the maturity of financial instruments used.

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