Question

Why is the debt maturity mix normally simplified to short- versus long-term debt? What, if anything, is lost in making this simplification?

What role does the debt maturity mix play in the firm's overall risk-return posture?

Answer 1

1. Answer:

a) This simplification is normally made to be consistent with the way assets and liabilities are categorized on the balance sheet. However, simplifying in this way hides the opportunity, and need, to consider a much finer hedging of assets and liabilities.

b) For example, an asset that will turn to cash in one month is generally not a good hedge for ten-month debt, yet both would appear on the balance sheet as current items. An asset with a 30-year life is generally not a good hedge for thirteen-month debt, yet both would appear on the balance sheet as long-term.

c) It is important to look beyond the simplicity of the balance sheet classification and examine the maturities of assets and liabilities in more detail.

2. Answer:

The debt maturity mix is an important input to a company's levels of risk and return. In general, short-term liabilities are less costly than long-term debt, since the yield curve is normally upward sloping. However, a firm with a high level of short-term liabilities has less liquidity than one whose debt is of longer maturities. In summary, a company which weights its debt financing toward the short-term increases both its return and risk, while a company which weights its debt financing toward the long-term decreases both its return and risk. By establishing its debt maturity mix, a company can add or subtract both risk and return to its risk-return position