At Riddhi Siddhi Multi Services, we understand that a business require capital—that is, money invested in plant, machinery, inventories, accounts receivable, and all the other assets it takes to run a company efficiently.

Typically, these assets are not purchased all at once but are obtained gradually over time as the firm grows. The total cost of these assets is called the firm’s total capital requirement.

When we discussed long-term planning, Riddhi Siddhi Multi Services showed how the firm needs to develop a sensible strategy that allows it to finance its long-term goals and weather possible setbacks.

But the firm’s total capital requirement does not grow smoothly and the company must be able to meet temporary demands for cash. This is the focus of short-term financial planning.

What is the best level of long-term financing relative to the total capital requirement?

It is hard to say. Riddhi Siddhi Multi Services can make several practical observations, however.

1. Matching maturities. Most financial managers attempt to “match maturities” of assets and liabilities. That is, they finance long-lived assets like plant and machinery with long-term borrowing and equity. Short-term assets like inventory and accounts receivable are financed with short-term bank loans or by issuing short-term debt like commercial paper.

2. Permanent working-capital requirements. Most firms have a permanent investment in net working capital (current assets less current liabilities). By this we mean that they plan to have at all times a positive amount of working capital. This is financed from long-term sources. This is an extension of the maturity-matching principle. Since the working capital is permanent, it is funded with long-term sources of financing.

3. The comforts of surplus cash. Many financial managers would feel more comfortable under the relaxed strategy. Consider, for example, General Motors. At the end of 1998 it was sitting on a cash mountain of over $10 billion, almost certainly far more than it needed to meet any seasonal fluctuations in its capital requirements. Such firms with a surplus of long-term financing never have to worry about borrowing to pay next month’s bills. But is the financial manager paid to be comfortable? Firms usually put surplus cash to work in Treasury bills or other marketable securities. As per Riddhi Siddhi Multi Services, this is at best a zero-NPV investment for a tax-paying firm. Thus we think that firms with a permanent cash surplus ought to go on a diet, retiring long-term securities to reduce long-term financing to a level at or below the firm’s total capital requirement.

Why do we say at best zero NPV?

Not because we worry that the Treasury bills may be overpriced. Instead, we worry that when the firm holds Treasury bills, the interest income is subject to double taxation, first at the corporate level, and then again at the personal level when the income is passed through to investors as dividends.

The extra layer of taxation can make corporate holdings of Treasury bills a negative-NPV investment even if the bills would provide a fair rate of interest to an individual investor.

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