Question

Compare long-term instruments and short-term risks, in terms of the various types of risk to which investors are exposed. Justify your answer.

Answer 1

Financing is a very important part of every business. Firms often need financing to pay for their assets, equipment, and other important items. Financing can be either long-term or short-term. As is obvious, long-term financing is more expensive as compared to short-term financing.

There are different vehicles through which long-term and short-term financing is made available. This chapter deals with the major vehicles of both types of financing.

The common sources of financing are capital that is generated by the firm itself and sometimes, it is capital from external funders, which is usually obtained after issuance of new debt and equity.

A firm’s management is responsible for matching the long-term or short-term financing mix. This mix is applicable to the assets that are to be financed as closely as possible, regarding timing and cash flows.

Long-Term Financing
Long-term financing is usually needed for acquiring new equipment, R&D, cash flow enhancement, and company expansion. Some of the major methods for long-term financing are discussed below.

Equity Financing
Equity financing includes preferred stocks and common stocks. This method is less risky in respect to cash flow commitments. However, equity financing often results in dissolution of share ownership and it also decreases earnings.

The cost associated with equity is generally higher than the cost associated with debt, which is again a deductible expense. Therefore, equity financing can also result in an enhanced hurdle rate that may cancel any reduction in the cash flow risk.

Corporate Bond
A corporate bond is a special kind of bond issued by any corporation to collect money effectively in an aim to expand its business. This tern is usually used for long-term debt instruments that generally have a maturity date after one year after their issue date at the minimum.

Some corporate bonds may have an associated call option that permits the issuer to redeem it before it reaches the maturity. All other types of bonds that are known as convertible bonds that offer investors the option to convert the bond to equity.

Capital Notes
Capital notes are a type of convertible security that are exercisable into shares. They are one type of equity vehicle. Capital notes resemble warrants, except the fact that they usually don’t have the expiry date or an exercise price. That is why the entire consideration the company aims to receive, for the future issuance of the shares, is generally paid at the time of issuance of capital notes.

Many times, capital notes are issued with a debt-for-equity swap restructuring. Instead of offering the shares (that replace debt) in the present, the company provides its creditors with convertible securities – the capital notes – and hence the dilution occurs later.

Short-Term Financing
Short-term financing with a time duration of up to one year is used to help corporations increase inventory orders, payrolls, and daily supplies. Short-term financing can be done using the following financial instruments −

Commercial Paper
Commercial Paper is an unsecured promissory note with a pre-noted maturity time of 1 to 364 days in the global money market. Originally, it is issued by large corporations to raise money to meet the short-term debt obligations.

It is backed by the bank that issues it or by the corporation that promises to pay the face value on maturity. Firms with excellent credit ratings can sell their commercial papers at a good price.

Asset-backed commercial paper (ABCP) is collateralized by other financial assets. ABCP is a very short-term instrument with 1 and 180 days’ maturity from issuance. ACBCP is typically issued by a bank or other financial institution.

Promissory Note
It is a negotiable instrument where the maker or issuer makes an issue-less promise in writing to pay back a pre-decided sum of money to the payee at a fixed maturity date or on demand of the payee, under specific terms.

Asset-based Loan
It is a type of loan, which is often short term, and is secured by a company's assets. Real estate, accounts receivable (A/R), inventory and equipment are the most common assets used to back the loan. The given loan is either backed by a single category of assets or by a combination of assets.

Repurchase Agreements
Repurchase agreements are extremely short-term loans. They usually have a maturity of less than two weeks and most frequently they have a maturity of just one day! Repurchase agreements are arranged by selling securities with an agreement to purchase them back at a fixed cost on a given date.

Letter of Credit
A financial institution or a similar party issues this document to a seller of goods or services. The seller provides that the issuer will definitely pay the seller for goods or services delivered to a third-party buyer.

The issuer then seeks reimbursement to be met by the buyer or by the buyer's bank. The document is in fact a guarantee offered to the seller that it will be paid on time by the issuer of the letter of credit, even if the buyer fails to pay.

All else being equal, a bond with a longer maturity usually will pay a higher interest rate than a shorter-term bond. For example, 30-year Treasury bonds often pay a full percentage point or two more interest than five-year Treasury notes.

The reason: A longer-term bond carries greater risk that higher inflation could reduce the value of payments, as well as greater risk that higher overall interest rates could cause the bond's price to fall.

Bonds with maturities of one to 10 years are sufficient for most long-term investors. They yield more than shorter-term bonds and are less volatile than longer-term issues.

Long-term finance can be defined as any financial instrument with maturity exceeding one year (such as bank loans, bonds, leasing and other forms of debt finance), and public and private equity instruments. Maturity refers to the length of time between origination of a financial claim (loan, bond, or other financial instrument) and the final payment date, at which point the remaining principal and interest are due to be paid. Equity, which has no final repayment date of a principal, can be seen as an instrument with nonfinite maturity. The one year cut-off maturity corresponds to the definition of fixed investment in national accounts. The Group of 20, by comparison, uses a maturity of five years more adapted to investment horizons in financial markets (G-20 2013). Depending on data availability and the focus, the report uses one of these two definitions to characterize the extent of long-term finance. Moreover, because there is no consensus on the precise definition of long-term finance, wherever possible, rather than use a specific definition of long-term finance, the report provides granular data showing as many maturity buckets and comparisons as possible.

The term of the financing reflects the risk-sharing contract between providers and users of finance. Long-term finance shifts risk to the providers because they have to bear the fluctuations in the probability of default and other changing conditions in financial markets, such as interest rate risk. Often providers require a premium as part of the compensation for the higher risk this type of financing implies. On the other hand, short-term finance shifts risk to users as it forces them to roll over financing constantly.

The amount of long-term finance that is optimal for the economy as a whole is not clear. In well-functioning markets, borrowers and lenders will enter short- or long-term contracts depending on their financing needs and how they agree to share the risk involved at different maturities. What matters for the economic efficiency of the financing arrangements is that borrowers have access to financial instruments that allow them to match the time horizons of their investment opportunities with the time horizons of their financing, conditional on economic risks and volatility in the economy (for which long-term financing may provide a partial insurance mechanism). At the same time, savers would need to be compensated for the extra risk they might take.

Where it exists, the bulk of long-term finance is provided by banks; use of equity, including private equity, is limited for firms of all sizes. As financial systems develop, the maturity of external finance also lengthens. Banks’ share of lending that is long term increases with a country’s income and the development of banking, capital markets, and institutional investors. Long-term finance for firms through issuances of equity, bonds, and syndicated loans has also grown significantly over the past decades, but only very few large firms access long-term finance through equity or bond markets.