This strategy would be less expensive but more risky

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Unformatted text preview: Fixed Assets Fixed Long-Term Debt Preferred Stock Preferred Common Stock Common Suppose we use current liabilities to Suppose current finance some of our fixed assets. fixed Balance Sheet Balance Current Assets Current Liabilities Current Fixed Assets Fixed Long-Term Debt Preferred Stock Preferred Common Stock Common Suppose we use current liabilities to Suppose current liabilities finance some of our fixed assets. fixed assets Balance Sheet Balance Current Assets Current Liabilities Current Fixed Assets Fixed Long-Term Debt Preferred Stock Preferred Common Stock Common Suppose we use current liabilities to Suppose current finance some of our fixed assets. fixed This strategy would be less expensive, but less but more risky! more The Hedging Principle s Permanent Assets (those held > 1 year) Assets x should be financed with permanent and should spontaneous sources of financing. spontaneous s Temporary Assets (those held < 1 year) Assets x should be financed with temporary should sources of financing. sources The Hedging Principle: Example s s Purchase a new machine for $250,000, which will be used Purchase for 20 years and generate $25,000 cost savings every year. for How should we finance the purchase of this machine? x If we use current liabilities (i.e. issue a 1-year note of If $250,000) then we won’t be able to repay this loan from the $25,000 cash flow generated by the asset in one year! the x Similarly if we use a 50 year long term bond to finance Similarly this asset, we will have excess liquidity, because the cash flow savings from this machine will amortize the cost of the machine in less than 50 years. s We should finance the asset with a source of We financing that matches the expected life and cash flow generating characteristics of the asset. flow x In this c...
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