Question

Explain the “aggressive”, “conservative” and “moderate” approaches to financing fixed assets, permanent current assets and temporary current assets. What are the potential risks and rewards of each approach? Give an example of when a conservative approach is more appropriate. Give an example of when an aggressive approach might be more appropriate. Describe the Term Structure of Interest Rates and explain the following theories: Liquidity Premium Theory? Market Segmentation Theory? Expectations Hypothesis Theory?

Answer 1

Financing fixed assets

Aggressive approach – As per this approach long term funds are used to finance fixed assets.

Conservative approach – Long term funds are used to finance fixed assets

Moderate approach – Long term finance is used for financing fixed assets.

Financing permanent current assets

Aggressive approach – Some portion of permanent current assets are financed by long term and remaining by short term financing.

Conservative approach – Long term funds are used to finance permanent current assets

Moderate approach – Short term finance is used to finance permanent current assets

Financing temporary current assets

Aggressive approach – As per this approach short term funds are used to finance temporary current assets.

Conservative approach – Some portion of temporary current assets are financed by long term and remaining by short term financing..

Moderate approach – Short term finance is used to finance permanent current assets

Potential risks and rewards of each approach?

Aggressive approach – It has lower financing cost and gives higher profitability. But it is risky as funds will not be available to meet short term obligations. There is high refinancing risk as business will need short term funds frequently to finance both permanent and temporary assets.

Conservative approach – It has low liquidity risk because of availability of excess cash. It has the lowest interest rate risk. It also results in lowest profitability as long term financing has higher cost than short term financing. There is no insolvency risk. With this approach business will have smooth operations without any stoppage. It results in inefficient working capital management.

Moderate approach – It has lower profitability because of higher interest expense. It is less risky compared to aggressive approach. It balances between aggressive and conservative approach.

Give an example of when a conservative approach is more appropriate.

This approach is more appropriate for tourism, farming, construction companies which operate in volatile or seasonal industry.

Give an example of when an aggressive approach might be more appropriate.

It is appropriate when there is need of speeding up business cycle and to grow sales and revenue.

Describe the Term Structure of Interest Rates

It shows relationship between returns on securities having different maturity terms. It represents current state of economy and also shows market expectations about interest rates in future. It is also called as yield curve.

Liquidity Premium Theory

Liquidity premium theory means investors expect additional return on their investments for holding securities for longer period as compared to short term securities. Premium is extra return given to investors for investing in illiquid bonds which carries higher risk than liquid, short term bonds.

Market Segmentation Theory

It assumes that both short term and long term interest rates have no correlation. This theory explains how price is set on fixed income securities. Bonds of different maturities have different markets. Each of these markets have their own potential buyers and sellers and they have different characteristics and investment goals. This theory helps to identify potential buyers and to gain more sales.

Expectations Hypothesis Theory

It explains the relationship between short and long term interest rates. It helps to predict short term interest rates in future based on long term interest rates. It shows investor earns same amount from investing in sequence of short term bonds compared to investing in one two year bond today.