©2012 McGraw-Hill Ryerson Limited1 of 39

Learning Objectives

5. Explain financing of assets in terms of hedging. (LO5)

6. Describe the term structure of interest rates, explain the theories that suggest its shape, and identify how it may be of use to a financial manager. (LO6)

7. Identify risk and profitability in determining the financing plan for current assets. (LO7)

©2012 McGraw-Hill Ryerson Limited2 of 39

The Financing Decision: An Example

The Edwards Corporation needs to finance $500,000 of working capital (current

assets). It has identified two alternative financing plans.

Plan A, which they deem “risky” and a more conservative Plan B.

LO7

©2012 McGraw-Hill Ryerson Limited3 of 39

Table 6-7Alternative financing plans

LO7

©2012 McGraw-Hill Ryerson Limited4 of 39

Table 6-8Impact of financing plans on earnings

LO7

©2012 McGraw-Hill Ryerson Limited5 of 39

Table 6-9Expected returns underdifferent economic conditions

LO7

©2012 McGraw-Hill Ryerson Limited6 of 39

Table 6-10Expected returns forhigh-risk firm

LO7

©2012 McGraw-Hill Ryerson Limited7 of 39

An Optimal Policy

• The combination of financing patterns (short-term versus long-term) and asset liquidity produces 4 possible working capital alternatives:

1. the aggressive firm borrows short term and maintains relatively low levels of liquidity

2. the more moderate firm compensates for short-term financing with highly liquid assets

3. the more moderate firm balances low liquidity with long-term Financing

4. the more conservative firm utilizes long-term financing and maintains a high degree of liquidity

• Each alternative represents a trade-off between risk and return.

• An appropriate strategy is selected based on the company’s tolerance for risk.

LO7

©2012 McGraw-Hill Ryerson Limited8 of 39

Table 6-11Current asset liquidity and asset financing plan

LO7