[nalratoss]

Can anyone help me clarify the following concepts?

“1) The interest rate on long-term debt is higher than the interest rate on short-term debt. Consequently, long-term financing is more expensive.

2) However, the shorter the maturity schedule of a firm’s debt obligations, the greater the risk that the firm will be unable to make principal and interest payments.

In general, short-term financing is more risky and less expensive than long term financing.”

So I understand 1), makes sense. Higher interest rate for LT financing, you borrow money for a longer period, the lender is afraid that you can’t repay principal so the lender charges a higher interest rate.

But 2)? short maturity schedule is riskier? If I borrow for 1 hour and return it, I haven’t got the time to invest the money I borrowed, where is the risk?

FAR-80

AUD-77

REG-75

BEC-82

 

I'm done done!

[RB]

I think there are 2 core concepts to understand here, one seems explicit in the problem and the other one may not be.

The explicit piece – I take a loan out and have to repay it in FULL in 3 months. Well in 3 months you better have that cash to repay it, instead of say paying interest only each year and principle in 10 years.

The other big element of the risk here is the firm's own “credit risk,” they're assuming the firm needs cash to operate, otherwise whats the point of requesting a loan for 1 hour? If you do short term debt, they're assuming you'll need to find a new loan after that one matures in order to keep operating capital. The risk is that you have to request financing again each time, so maybe a lender says no, or charges higher rates, etc.

AUD - 95
BEC - 98
FAR - 98
REG - 91

Justin - reach out for more help

[Author]

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