One would need to know exactly what part of current assets are temporary and what part are permanent. Furthermore, one is never quite sure how much short term or long-term financing is available at all times. Even if this were known, it would be difficult to change the financing mix on a continual basis By using long-term financing to finance part of temporary current assts, a firm may have less risk but lower returns than a firm with a normal financing plan Explain the significance of this statement By establishing a long-term financing arrangement for temporary current assets, a firm is assured of having necessary fund ing in good times as well as bad, thus we say there is low risk. However, long-term financing is genera ally more expensive than short-term financing and profits may be lower than those which could be achieved with a synchronized or normal financing arrangement for temporary current assets 6-7 A firm that uses short-term financing methods for a portion of permanent current assets is assuming more risk but expects higher returns than a firm with a normal financing plan. Explain By financing a portion of permanent current assets on a short-term basis, we run the risk of inadequate financing in tight money periods. However, since short-term financing is less expensive than long-term funds, a firm tends to increase its profitability over the long run(assuming it survives). In answer to the preceding question, we stressed less risk and less return; here the emphasis is on risk and high return 6-8 What does the term structure of interest rates indicate? The term structure of interest rates shows the relative level of short -term and long-term interest rates at a point in time. It is often referred to as a yield curve 6-9 What are three theories for describing the shape of the term structure of interest rates( the yield curve)? Briefly describe each theory Liquid ity premium theory, the market segmentation theory, and the pectations theory The liquid ity premium theory indicates that long-term rates should be higher than short-term rates. This premium of long-term rates over short-term rates exists because short-term securities have greater liquidity, and therefore higher rates have to be offered to potential long-term bond buyer to entice them to hold these less liquid and more price sensitive securities CopyrightC 2005 by The McGray-Hill Companies, Inc. S-212Copyright © 2005 by The McGraw-Hill Companies, Inc. S-212 One would need to know exactly what part of current assets are temporary and what part are permanent. Furthermore, one is never quite sure how much short￾term or long-term financing is available at all times. Even if this were known, it would be difficult to change the financing mix on a continual basis. 6-6. By using long-term financing to finance part of temporary current assts, a firm may have less risk but lower returns than a firm with a normal financing plan. Explain the significance of this statement. By establishing a long-term financing arrangement for temporary current assets, a firm is assured of having necessary funding in good times as well as bad, thus we say there is low risk. However, long-term financing is generally more expensive than short-term financing and profits may be lower than those which could be achieved with a synchronized or normal financing arrangement for temporary current assets. 6-7. A firm that uses short-term financing methods for a portion of permanent current assets is assuming more risk but expects higher returns than a firm with a normal financing plan. Explain. By financing a portion of permanent current assets on a short-term basis, we run the risk of inadequate financing in tight money periods. However, since short-term financing is less expensive than long-term funds, a firm tends to increase its profitability over the long run (assuming it survives). In answer to the preceding question, we stressed less risk and less return; here the emphasis is on risk and high return. 6-8. What does the term structure of interest rates indicate? The term structure of interest rates shows the relative level of short-term and long-term interest rates at a point in time. It is often referred to as a yield curve. 6-9. What are three theories for describing the shape of the term structure of interest rates (the yield curve)? Briefly describe each theory. Liquidity premium theory, the market segmentation theory, and the expectations theory. The liquidity premium theory indicates that long-term rates should be higher than short-term rates. This premium of long-term rates over short-term rates exists because short-term securities have greater liquidity, and therefore higher rates have to be offered to potential long-term bond buyer to entice them to hold these less liquid and more price sensitive securities