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Here are the answers to your questions:
1. The two principal reasons for holding cash are for "transactions" and for "compensating balances". No, the target cash balance is not equal to the sum of the holdings for each reason because the same money can often partially satisfy both motives.
2. From the standpoint of the borrower, short-term credit is riskier because short-term interest rates fluctuate more than long-term rates, and the company may be unable to repay the debt. If the lender will not extend the loan, the company could possibly be forced into bankruptcy.
A company might borrow on a short-term basis if the company thought that interest rates would fall, and thus, the long-term rate would go even lower. A company might also want to borrow on a short-term basis if the company was only going to need the money for a short while and the higher interest would be offset by lower administration costs and no prepayment penalty. Therefore, companies do consider factors other than interest rates when deciding on the maturity/terms of their debt.
3. Stockholders can eliminate the risk of volatile cash flows by diversifying their portfolios. However, if a company decided to hedge away the risks associated with the volatility of its cash flows, the company would have to pass on the costs of hedging to the investors. More educated investors can hedge risks themselves and thus they are indifferent as to who actually does the hedging. More volatile cash flows will generally be able to produce more growth options due to the greater liquid asset requirements and higher liquidity needed by a company with more volatile cash flows. However, a more stable cash flow may not have the same growth options or have the opportunity to grow as quickly due to the lower liquidity level of a company with a stable cash flow. Firms with high cash flow volatility maintain higher levels of financial slack than those firms with more stable cash flow volatility. Companies with more stable cash flows however, are generally safer to by stock in overall. Thus, these are a few reasons why stockholders might be indifferent between owning the stock of a firm with volatile cash flows and that of a firm with stable cash flows.
4. While there are not any studies that prove that risk management either adds or does not add value, there are 6 reasons why risk management may increase the value of a firm. Risk management allows corporations to:
1) Increase their use of debt
2) Maintain their capital budget over time.
3) Avoid costs associated with financial distress
4) Utilize their comparative advantages in hedging relative to the hedging ability of individual investors
5) Reduce both the risks and costs of borrowing by using swaps
6) Reduce the higher taxes that result from fluctuating earnings.
5. There are a few ways to reduce a company's risk exposure and here they are below:
1) A company can transfer its risk to an insurance company that requires periodic premium payments that are established by the insurance company based on its notion of the company's risk exposure.
2) A company can transfer risk-producing functions to a third party.
3) A company can purchase derivatives contracts to reduce input and financial risks.
4) A company can take specific actions to reduce the probability of occurrence of adverse events. This would include things such as the replacing of old electrical wiring or using fire resistant materials in areas with the greatest fire potential.
5) A company can take actions to reduce the magnitude of the loss associated with adverse events, such as installing an automatic sprinkler system to hinder potential fires.
6) Finally, a company can totally avoid the activity that gives rise to the risk.
6. Creditors usually accept a plan for financial rehabilitation rather than demand liquidation of the business because a financial rehabilitation is a voluntary settlement that is simply a contract between the debtor and the creditors that settles their claims to maximize the return for the creditors while minimizing the financial distress of the debtor. A financial rehabilitation keeps the customer in business and avoids the unnecessary court costs. While the creditors could end up taking a temporary loss, the creditors will expect the debtor to emerge stable and solvent again.
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