Given the following levels of permanent assets and temporary assets are for each
ID: 2655239 • Letter: G
Question
Given the following levels of permanent assets and temporary assets are for each month.
A flexible policy would finance $80,000 with long-term debt and have excess cash of $10,000 to invest in marketable securities in January, March, and April. Overall, the interest expense on the extra $10,000 borrowed long-term will outweigh the interest received from the marketable securities.
A restrictive policy would finance $70,000 with long-term debt. In February, the firm would borrow $10,000 on a short-term basis to cover the cost of temporary assets in that month. The short-term loan would be repaid in March.
Which policy would be most effective for this firm- the flexible or restrictive? Post an answer, justifying it with what evidence you believe would be the most convincing.
January February March April Current Assets 20,000 30,000 20,000 20,000 Fixed Assets 50,000 50,000 50,000 50,000 Permanent Assets 70,000 70,000 70,000 70,000 Temporary Assets 0 10,000 0 0Explanation / Answer
It is a policy of funding capital requirement. The company has employed a part of its fund in fixed asset and balance in current asset. Fixed asset is permanent nature. If you employ fund there, it will remain blocked for many years to come. Hence fund collected for investment in fixed asset must be from permanent or long term source.
Next consider current asset. It is a fund required for working capital. It is fluctuating in nature. However if you make an analysis you will observe that a major portion of this investent is also permanent in nature. In this problem, you will observe that $20,000 is always required to fund working capital. So it is permanent in nature. Only in February $10,000 extra is required.
For safe funding you have to collect permanent portion of current asset from long term source. Thus $20,000 will be required from long term source. Only 10,000 temporary requirement can be taken from short term source.
In this problem, company has collected entire fund from long term source. Total long term debt is $80,000. Out of this $10,000 will be used only in February. For remaining three month it will remain idle. as you have to pay interest on such idle fund, you can invest it for short period to earn some interest. It will reduce the effective interest pais on such idle fund.
Now the question is whether this strategy is better. As you know that alternatively you can borrow temporary $10,000 working capital requirement from short term source. The interest on short term source will be less than interest on long term source.
Here second option i.e. borrowing from short term source is always beneficial. In this case you will borrow money for one month only. you have to pay interest for one month. Also interrst rate will be lower than long term interest. If you borrow it from long term source, then you will pay interest for Febuuary at higher rate. also you have to pay some interest on this fund for remaining three idle months. altough you have earned some interest by investing the idle fund yet the investment interest rate cannot be equal or higher than borrowed rate. Hence some interest must be paid.
Answer: restrictive policy is better. you collect $70,000 fund from long term source. Balance $10,000 can be borrowed from short term source. This policy will lower total interest payable.
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