Question

(Hedging

principle​)

A popular theory for managing risk to the firm that arises out of its management of working capital​ (that is, current assets and current​ liabilities) involves following something called the principle of​ self-liquidating debt. How would this principle be applied in each of the following​ situations? Explain your responses to each alternative.

a. Longleaf Homes owns a chain of senior housing complexes in the​ Seattle, Washington, area. The firm is presently debating whether it should borrow short or long term to raise​ $10 million in needed funds. The funds are to be used to expand the​ firm's care​ facilities, which are expected to last 20 years.

b. Arrow Chemicals needs​ $5 million to purchase inventory to support its growing sales volume. Arrow does not expect the need for additional inventory to diminish in the future.

c. Blocker Building​ Materials, Inc. is reviewing its plans for the coming year and expects that during the months of November through January it will need an additional​ $5 million to finance the seasonal expansion in inventories and receivables.

a. Longleaf Homes owns a chain of senior housing complexes in the​ Seattle, Washington, area. The firm is presently debating whether it should borrow short or long term to raise​ $10 million in needed funds. The funds are to be used to expand the​ firm's care​ facilities, which are expected to last 20 years.

In this​ case, Longleaf Homes should use

▼

Short-term (temporary)

Long-term

Permanent

source of financing for its expansion.  ​(Select from the​ drop-down menu.)

b. Arrow Chemicals needs​ $5 million to purchase inventory to support its growing sales volume. Arrow does not expect the need for additional inventory to diminish in the future.

In this​ case, Arrow Chemicals should use

▼

short-term (temporary)

permanent

long-term

source of financing for its expansion.  ​(Select from the​ drop-down menu.)

c. Blocker Building​ Materials, Inc. is reviewing its plans for the coming year and expects that during the months of November through January it will need an additional​ $5 million to finance the seasonal expansion in inventories and receivables.

In this​ case, Blocker Building Materials should use

▼

long-term

permanent

short-term (temporary)

source of financing for its expansion.  ​(Select from the​ drop-down menu.)

Answer 1

There are mainly three different types of working capital based on its nature of use. The first one is Temporary working capital, which is mostly used for the purpose of meeting out the short term funding requirements of the business like a need for increase in inventories etc. The second one is long term working capital which is used for meeting out the long term funds requirements like construction of building etc. while the third one is permanent working capital which is used in cases where the funds are going to be tied for a prolonged period of time, and hence it is better to fund the same through sources of permanent working capital like Equity or Long term debt. The answer to the above questions are as follows:

a. Under this case, since the funds are going to be used for the purpose of expansion of firm's care facilities which is going to last for more than 20 years, the same can be funded through permanent sources of working capital like equity or long term debt.

b. In this case, Arrow Chemicals need funds for the purpose of increasing its inventory which is a temporary measure and hence temporary working capital like short term loans can be raised for the said purpose.

c. Seasonal expansion plan of receivables and inventory by Blocker Building Material, Inc. is a short term measure and thus the same should be funded through temporary working capital or temporary working capital.