The three possible financing
policies described above were distinguished by the relative amounts of
short-term debt used under each policy. The aggressive policy called for the
greatest use of short-term debt, while the conservative policy called for the
least. Maturity matching fell in between. Although short-term credit is
generally riskier than long-term credit, using short-term funds does have some
significant advantages. The pros and cons of short-term financing are
considered in this section.
Speed
A short-term loan can be obtained
much faster than long-term credit. lenders will insist on a more thorough
financial examination before extending long-term credit and the loan agreement
will have to be spelled out in considerable detail because a lot can happen
during the life of a 10 to 20 year loan. Therefore if funds are needed in a
hurry the firm should look to the short-term markets.
Flexibility
If its needs for funds are
seasonal or cyclical, a firm may not want to commit itself to long-term debt
for three reasons: (1) Flotation costs are higher for long-term debt than for
short-term credit. (2) Although long-term debt can be repaid early, provided
the loan agreement includes a prepayment provision, prepayment penalties can be
expensive. Accordingly, if a firm thinks its need for funds will diminish in
the near future, it should choose short-term debt. (3) Long-term loan
agreements always contain provisions, or covenants, which constrain the firm’s
future actions. Short-term credit agreements are generally less restrictive.
Cost of Long-Term Versus Short-Term
Debt
The yield curve is normally
upward sloping, indicating that interest rates are generally lower on
short-term debt. Thus, under normal conditions, interest costs at the time the
funds are obtained will be lower if the firm borrows on a short-term rather
than a long-term basis.
Risks of Long-Term Versus Short-Term
Debt
Even though short-term rates are
often lower than long-term rates, short-term credit is riskier for two reasons:
(1) If a firm borrows on a long-term basis, its interest costs will be
relatively stable over time, but if it uses short-term credit, its interest
expense will fluctuate widely, at times going quite high. For example, the rate
banks charge large corporations for short-term debt more than tripled over a
two-year period in the 1980s, rising from 6.25 to 21 percent. Many firms that
had borrowed heavily on a short-term basis simply could not meet their rising
interest costs and as a result, bankruptcies hit record levels during that
period. (2) If a firm borrows heavily on a short-term basis, a temporary
recession may render it unable to repay this debt. If the borrower is in a weak
financial position, the lender may not extend the loan, which could force the
firm into bankruptcy. Braniff Airlines, which failed during a credit crunch in
the 1980s, is an example. Another good example of the riskiness of short-term
debt is provided by Transamerica Corporation, a major financial services
company. Transamerica’s chairman, Mr. Beckett, described how his company was
moving to reduce its dependency on short-term loans whose costs vary with
short-term interest rates. According to Beckett, Transamerica had reduced its
variable-rate (short-term) loans by about $450 million over a two-year period.
We aren’t going to go through the enormous increase in debt expense again that
had such a serious impact on earnings, he said. The company’s earnings fell
sharply because money rates rose to record highs. We were almost entirely in
variable rate debt, he said, but currently about 65 percent is fixed rate and
35 percent variable, We’ve come a long way, and we’ll keep plugging away at it.
Transamerica’s earnings were badly depressed by the increase in short-term
rates, but other companies were even less fortunate they simply could not pay
the rising interest charges and this forced them into bankruptcy.
