Short-Term and Long-Term Financing Instruments: Understanding and Benefits

QUESTION

Select three short-term financing instruments and three long-term financing instruments. Please explain them and describe how they work.  When explaining the long-term financing instruments, address the concept of tax savings in terms of how they are achieved and why they occur when using one instrument and not another

ANSWER

Short-Term and Long-Term Financing Instruments: Understanding and Benefits

Introduction

In the world of finance, businesses often rely on various instruments to meet their funding requirements. Two broad categories of financing instruments are short-term and long-term financing options. Short-term financing instruments help companies manage their immediate cash flow needs, while long-term financing options are designed to support significant investments or expansions over an extended period. In this essay, we will explore three short-term and three long-term financing instruments, explain how they work, and discuss the concept of tax savings associated with long-term instruments.

Short-Term Financing Instruments

Trade Credit

Trade credit is one of the most common short-term financing instruments used by businesses. It involves buying goods or services from suppliers on credit with a specified payment period, usually ranging from 30 to 90 days. This allows the purchasing company to use the goods or services immediately and pay for them later, helping to improve their cash flow in the short term. Trade credit is typically interest-free, making it an attractive option for companies looking to maintain liquidity without incurring additional costs.

 Commercial Paper

Commercial paper is an unsecured promissory note issued by creditworthy corporations to raise short-term funds. It has a maturity period ranging from a few days to 270 days. Investors purchase commercial paper at a discount to its face value, and the difference between the purchase price and the face value represents the interest earned. As a widely accepted money market instrument, commercial paper offers a lower cost of borrowing compared to traditional bank loans.

 Bank Overdrafts

Bank overdrafts provide businesses with a short-term line of credit through their bank accounts. It allows companies to withdraw more money than their account balance, up to an agreed limit. The interest is charged only on the overdrawn amount and for the period it is utilized. Bank overdrafts offer flexibility and are particularly useful for managing temporary cash shortages or unexpected expenses.

Long-Term Financing Instruments

Bonds

Bonds are long-term debt instruments issued by corporations or governments to raise capital. Investors who purchase bonds are essentially lending money to the issuer in exchange for periodic interest payments (coupon) and the return of the principal amount upon maturity. Bonds typically have maturities ranging from 5 to 30 years, making them suitable for financing large projects or capital-intensive ventures. One of the primary advantages of bonds is their fixed interest rate, which provides certainty to both the issuer and the investor.

 Preferred Stock

Preferred stock is a hybrid instrument that combines features of equity and debt. It represents ownership in a company but usually does not carry voting rights. Instead, preferred shareholders are entitled to receive fixed dividend payments, which take precedence over common stock dividends. Preferred stock has no maturity date, making it a permanent source of financing for the issuing company. Though it does not offer tax savings directly, using preferred stock can help a company optimize its capital structure by reducing the reliance on debt and benefiting from lower interest expenses.

 Equity Financing

Equity financing involves raising capital by selling shares of ownership in the company. This can be done through private placements or by going public and issuing shares on a stock exchange. Equity financing provides a long-term source of funds without requiring periodic interest payments or fixed repayment schedules. Unlike debt, equity does not create a legal obligation to repay the investment, but shareholders are entitled to a share in the company’s profits through dividends. From a tax perspective, equity financing can lead to tax savings compared to debt financing. Interest on debt is tax-deductible, whereas dividends paid to shareholders are typically not tax-deductible. Therefore, using equity can reduce a company’s tax burden and improve its overall financial position.

Conclusion

In conclusion, short-term financing instruments such as trade credit, commercial paper, and bank overdrafts offer businesses the flexibility to manage their immediate cash flow needs. On the other hand, long-term financing instruments like bonds, preferred stock, and equity financing support larger investments and expansion plans over an extended period. While each instrument has its unique benefits, long-term financing options like equity financing can provide tax savings by reducing the tax burden compared to interest expenses on debt. Companies must carefully evaluate their financing needs, risk tolerance, and tax implications to choose the most suitable financing instruments that align with their long-term financial goals.