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Pop Co is switching from using mainly long-term fixed rate finance to fund its working capital to using mainly short-term variable rate finance.
Which of the following statements about the change in Pop Co’s working capital financing policy is true?
A Finance costs will increase
B Re-financing risk will increase
C Interest rate risk will decrease
D Overcapitalisation risk will decreaseThe correct answer is B
Can you please explain that why re-financing risk will increase because the company has adopted aggressive financing policy. But why it results in increase in finance cost?
The answer is not saying that the finance cost will increase (although it might) it is saying that the risk of re-financing will increase.
The reason is that the lender of short-term finance (such as an overdraft) can demand repayment at any time which means there is risk about replacing the finance. With long-term finance there will be a fixed long-term agreement for the borrowing and so there is less risk in the short-term of having to replace it with more borrowing.
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