Question

AVER Ltd is considering short term financing for its working capital requirement. You are invited to provide a discussion on the risk-return trade-off that the company should consider in selecting different sources of short term financing. In your discussion, illustrate with an appropriate example where possible. Write between 1,200 – 1,400 words for this question.

Answer 1

Almost all the financial decisions has alternative courses of action. The higher the risk on any decision, the higher the required return to compensate for this risk. The relationship between Return and Risk can be expressed as follows: Required Rate of Return = Risk-free rate + Risk premium

Types of short term sources of short term finance

1. Bank borrowing like cash credit or over drafts

This facility can be availed as this will provide liquidity to the business.

2. Use of Non fund facility such as Letters of credit and bank guarantee etc.

3. Deferred payment facilities. Means temporary postponement of the payment of an outstanding bill or debt, usually involving repayment by instalments. These payments can be used at lower cost from the known vendors or creditors

4. Bills discounting which can be done through banks. Bills discounting means bank provides the funds to the party before ending credit period

5. Commercial papers and factoring are also available options to the company to get short term sources for working capital requirements.