2) What are the two principal reasons for holding cash? Can a firm estimate its

Question

2) What are the two principal reasons for holding cash? Can a firm estimate its target cash balance by summing the cash held to satisfy each of the two reasons?

4) What are the four elements of a firm's credit policy? To what extent can firms set their own credit policies as opposed to accepting policies that are dictated by their competitors?

5) what are the advantages of matching the maturities of assets and liabilities? What are the disadvantages?

6) From the standpoint of the borrower, is long-term or short term credit riskier? Explain, would it ever make sense to borrow on a short-term basis if short-term basis rates were above long-term rates?

Explanation / Answer

What are the two principal reasons for holding cash? Can a firm estimate its target cash balance by summing the cash held to satisfy each of the two reasons?

The two principal reasons for holding cash are for transac­tions and compensating balances. The target cash balance is not equal to the sum of the holdings for each reason because the same money can often partially satisfy both motives.

What are the four elements of a firm's credit policy? To what extent can firms set their own credit policies as opposed to accepting policies that are dictated by their competitors?

The four elements in a firm’s credit policy are (1) credit standards, (2) credit period, (3) discount policy, and (4) collection policy. The firm is not required to accept the credit policies employed by its competition, but the optimal credit policy cannot be determined without considering com­petitors’ credit policies. A firm’s credit policy has an important influence on its volume of sales, and thus on its profitability.

what are the advantages of matching the maturities of assets and liabilities? What are the disadvantages?

The principal advantage of matching asset and liability maturities is that most assets provide cash flows over their lives, and matching maturities permits the borrower to service the loan with the asset’s cash flows. A real problem would arise if a firm borrowed to build and use a building with a 20-year life on a 1-year loan, because the building would be unlikely to provide enough cash in the one year to pay off the loan. Similarly, lenders would balk at providing a 20-year loan to finance an asset with a 1-year life, because the collateral for the loan would be gone after only one year. So, financing charges are likely to be “most reasonable” if there is a reasonable correspondence between asset and liability lives.

                        It is feasible to match some assets’ lives with the lives of the liabilities used to finance those liabilities. For example, a power company might build a new generating plant and finance the cost with a loan whose maturity matched the expected life of the plant. Similarly, a bank might lend a retailer money on a 3-month basis to finance inventory the retailer wanted to stock in the fall and sell prior to Christmas. However, firms normally must have some equity capital, and it has no stated maturity, but few assets have infinite expected lives. Also, lenders like to maintain some margin of safety, hence will make say a 10-year loan on an asset with an expected life of 15 years. So, for firms as a whole, we would not expect to find exactly matching asset and liability maturities.

                        The primary reason for deliberately mismatching maturities is to obtain financing at a lower cost. For example, if the yield curve is sharply upward sloping, then a firm might borrow to buy long-term assets on a short-term basis in order to get a lower interest rate. This is risky, because interest rates might rise and also because the lender might refuse to renew the loan. Also, a firm might choose to obtain long-term capital to finance current assets on the theory that the current assets will be replaced, and the long-term capital will enable the firm to carry permanent current assets.

From the standpoint of the borrower, is long-term or short term credit riskier? Explain, would it ever make sense to borrow on a short-term basis if short-term basis rates were above long-term rates?

From the standpoint of the borrower, short-term credit is riskier because short-term interest rates fluctuate more than long-term rates, and the firm may be unable to repay the debt. If the lender will not extend the loan, the firm could be forced into bankruptcy.

A firm might borrow short-term if it thought that interest rates were going to fall and, therefore, that the long-term rate would go even lower. A firm might also borrow short-term if it were only going to need the money for a short while and the higher interest would be offset by lower administration costs and no prepayment penalty. Thus, firms do consider factors other than interest rates when deciding on the maturity of their debt.

Related Questions

Navigate

• Browse (All)
• Browse 2
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.