Q. Benefits of the proposed policy change?
Short-term sources of debt finance comprise overdrafts and short-term loans. An overdraft offers elasticity but since it is technically repayable on demand it is a moderately risky source of finance and a company could experience liquidity problems if an overdraft were called in until an alternative source of finance was found. The danger with a short-term loan as a source of funding is that it may be renewed on less favourable terms if economic circumstances have deteriorated at its maturity leaving the company vulnerable to short-term interest rate changes.
Short-term funding will be cheaper than long-term finance although this is based on the assumption of a normal shape to the yield curve. Economic situations could invert the yield curve for example if short-term interest rates have been increased in order to curb economic growth or to dampen inflationary pressures.
Long-term sources of debt finance comprise loan stock debentures and long-term loans. These are comparatively safer forms of finance: for instance if a company meets its contractual obligations on debentures in terms of interest payments and loan covenants it will not have to repay the finance until maturity. The risk for the company is thus lower if it finances working capital from a long-term source.
Nevertheless long-term finance is more expensive than short-term finance. The form of the normal yield curve for example, indicates that providers of debt finance will expect compensation for deferred consumption and default risk as well as protection against expected inflation.
The choice among short-term and long-term debt for the financing of working capital is hence a choice between cheaper but riskier short-term finance and more expensive but less risky long-term debt.