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Hi,
I was wondering why financing of working capital using short term would be any cheaper. let’s say this can be done through either delaying payables or borrowing overdraft.
suppose we are delaying payments from suppliers- this is effectively running the risk of missing discount offered by suppliers and most importantly lead to lose of supplies in the long term. this is double tragedy.
suppose it was overdraft borrowing- there is the interest payment at varying rate as the financing might be done frequently. so the cost of interest subject to change in interest rates is a huge bet (yes it might change in our favour but it has equal chance of going against us too!).But if we were to use long term borrowing the cost of interest is inevitably the cost of equity/debt- the capital. Amazingly this is fixed. on top of this, another risk might be the risk of foregoing purchase of plant. Here we are not imparting attached stakeholders like we will do in payables or neither will we be on the fate of changing interest rates like we are in the case of overdraft. For this reasons i feel the long term option is cheaper.
thanks,john.There is no definitive answer.
Using long-term finance is less risky because the borrowing is for a fixed term, whereas with short-term borrowing (overdraft) the bank can demand repayment whenever they want.
Using short-term finance (i.e. overdraft finance)is likely to be cheaper because at any point in time we are only borrowing what is actually needed (and interest is charged on a day-to-day basis). Using long-term finance means interest is being paid on a fixed amount whether the money is actually needed all the time.
That is why (as I state in my lectures) it would be sensible to finance ‘permanent’ working capital (i.e. the long term basic level needed for working capital) using long-term finance, and on days when more was needed to borrow the extra (the ‘temporary’ working capital) using short-term finance.
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