You have elected to fund additional needs for the next year with an increase in long-term debt. What, if any, problems might be associated with this decision?
Long-term debt refers to the amount of debt holding with a maturity of more than 1 year. Usually, long-term debt is used to finance long-term projects or fixed asset purchases since a significant period is needed to recover the initial cost, which is spread out as payments until maturity. When taking a long-term debt for a specific project, the borrower should evaluate the feasibility of that project. If it is not profitable, the borrower might incur interest burden in the long-term.
Answer and Explanation:
The additional needs for funds for next year should be considered as the lack of working capital in the short-term. The need for this additional fund could be for the immediate future like the next year of operations, but it might not be necessary two years from now. Therefore, taking a long-term debt to fund this need will not be ideal since the business would have to pay the lender more due to the long period of maturity. For instance, if we need extra fund for less than 12 months, but the lender only offers the loan with a 3-year maturity. That means we will have to pay interest for two additional years. Long-term debt would be suitable only if we can estimate the additional income for the long-term (e.g. 3 or 5 years and more).
Moreover, interest rates should be the main factor to be taken into consideration since the long-term and short-term interest rates are different. Floating or fixed interest rates are also a concern. If the company is not taking a bank loan, then they could issue bonds for financing the need for additional funds. However, the coupon rate should be considered since it is different for short and long-term maturity. The long-term coupon rate would be higher since a lower rate will not attract investors.
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from Financial Accounting: Help and ReviewChapter 8 / Lesson 7