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Dear Sir,
By answering below questions I found that the answer were contradictory. Below the questions which the answers provided
Question 1
Which of the following is a benefit to the borrower of a loan as apposed to to an overdraftLower interest
Explanation:Short terms loans are subject to a loan agreement giving the bank security and a define repayment schedule. This lowers the risk from their perspective, hence the interest rate charged i lower..
Question 2
Are the following statements about the working capital management is true or false?
A conservative working capital finance approach is low risk but expensive
Good working capital management adds to the wealth of shareholdersAnswer both true
(No problem with option 2)
Why is the loan more expensive if it has lower interest rate than the overdraft?
The book’s answer gives this additional information: the short term finance is low risk from an investor’s prospective.
So, it means that when comparing the source of finance do we need consider the economic effect of the borrowing (interest rate) whereas when considering the working capital financial policy, the cost of debt is ignore and we need to consider the shareholder’s prospective?
Thanks a lot for your help
Gabriella
What is happening is this:
Taking out a loan means that you are borrowing a fixed amount and paying interest whether or not you need the money from day to day. (Working capital goes up and down from day to day and so sometimes you will need all the money and sometimes you won’t).
On the other hand, with overdrafts you pay interest from day to day on the money being borrowed each day. So although the rate of interest itself may be higher, on days when you don’t need the money you are not borrowing and do not pay interest. So overall, an overdraft can work out cheaper in $’s (even though the interest rate itself might be higher).
Dear Sir,
That’s perfectly clear. With your explanation everything makes sense
Best Regards
Gabriella
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