Question

Bobo’s Jojoba Products Ltd. has $600,000 in current assets of which $200,000 are
considered to be permanent current assets. They also have $1,000,000 in capital
assets. Their tax rate is 40%. They want to finance all of their capital assets and
one-half of their permanent current assets with long-term financing at 12%. The
balance would be financed with short term financing at 10%.

They could reduce their interest expense by using more short-term financing.
Give two reasons why they might not want to do this.

Answer 1

Reason 1

High proportion of debt in capital structure would result in high risk and hence equity holder will demand higher returns. Which will result in higher WACC hence it is not good for company to raise debt beyond it's optimal capital structure though the cost of debt looks cheaper compared to cost of equity.

Reason 2

If company is not confident about the future earnings that means the future earnings are volatile, it is not advisable to have higher debts as debt service payments are fixed and company have to pay it no matter company earns profit or not. Hence in company which has volatile future earnings debt would add more burden in situations where company profit shrinks.