Question

What is the risk–return trade-off that arises when a firm manages its working capital?

• How does a firm’s use of short-term debt as opposed to long-term debt subject the firm to a greater liquidity risk?

• explain how accounts receivable are created and managed, and calculate the cost of trade credit

Answer 1

Risk return trade off, that arises when the firm manages its working capital is that the firm should either be focusing at maintenance of the liquidity or the firm should try to be conservative in nature and it should be using debt to high extent so that it can help in managing its growth in the long run but that will always be having a cost of financial distress and the benefit of income tax shield on interest payment so those two benefit and cost should be traded off.

Formulas of short term debt subject the firm to a greater liquidity risk because the firm have to pay their debt repayment quickly in the short run and if the firm is unable to comply with the debt payment requirement, it will be having a lot of liquidity problem that can lead to the cost of financial distress as well on default.

Account receivables are created when credit is issued to consumers and those are having a time value of money because those trade credit cost is not just the cost of goods or services but also the time value of money associated with them due to late payments.