BEC 6.5

Question 1

What are the advantaes and disadvantages of short-term financing?

Answer 1

Advantages:
- Increased liquidity
- Increased profitability
- Decreased financing costs

Disadvantages:
- Increased interest rate risk
- Increased credit risk

Question 2

What are the advantages and disadvantages of long-term financing?

Answer 2

Advantages:
- Decreased interest rate risk
- Decreased credit risk

Disadvantages:
- Decreased liquidity
- Decreased profitability
- Increased financing costs

Question 3

Differentiate between a line of credit and a letter of credit

Answer 3

Line of credit - revolves line of credit with a bank that is for a defined term and renewable prior to or upon expiration

Letter of credit - third party guarantee (usually by a bank) of obligations incurred by a company

Question 4

Compare an operating lease to a capital lease (as it pertains to a lessee)

Answer 4

In an operating lease, the lessee makes rent (expense) payments to a lessor in exchange for the use of an asset for an insignificant portion of its useful life

In a capital lease, the lessee essentially acquires the assets from the lessor either in substance or in legal form

Question 5

Define a debenture and a distinguishing characteristic of a subordinated debenture

Answer 5

Debenture - unsecured obligation of the issuing company

Subordinated debenture - bond issue that is unsecured and ranks behind senior creditors in a bankruptcy or liquidation scenario

Question 6

Why do creditors use debt covenants in lending agreements and how could this impact the issuer?

Answer 6

Debt covenants are stipulated in lending agreements ot protect the creditors’ interests by limiting or prohibiting certain actions of the debtors that may be harmful to the creditors’ interests (i.e., issuing more debt)

Debt covenants are disadvantageous to the issuer as they may restrict certain management activities (i.e., selling assets)