Question

1. If the future is not predictable, why should firms engage in financial forecasting?

2. Discuss the advantages and disadvantages associated with the use of short-term debt.

3. What are the risk-return trade-offs associated with adopting a more liberal trade credit policy?

4. What are some of the risks associated with direct foreign investments? How do they differ from those encountered in domestic investment?

Answer 1

(1): Despite the fact that future is unpredictable firms engage in financial forecasting for the simple reason that it helps organizations and companies to determine approximate future business conditions that will affect the company and how this will lead to shaping up of the financial conditions of the company. Financial forecasting involves forecasting of income statement, cash flow statement and balance sheet. This forecasting is based on various assumptions and some of the assumptions may go wrong in the future. Still financial forecasting is important as it helps a firm to determine the financial position that it will achieve or get to in future. Any changes in the external factors can be adjusted in the financial model as and when they occur.

(2): In terms of advantages use of short term debt allows faster funding. The process of obtaining short term debt is not as lengthy and elaborate as that in case of long term debts and hence funding can be availed quicker. Secondly young businesses and start-ups can also easily avail short term debt. Young businesses and start-ups will not have a strong credit rating history and hence their only funding option is use of short term debts.

In terms of disadvantages use of short term debt can lead to higher costs as short term debt carries a higher annual cost than use of longer term financing. Also the frequency of payments will be higher in case of short term debts.

(3): The risks associated with adopting a more liberal trade credit policy is that the collection costs and default costs may rise and also the possibility of losses from unpaid debt becomes real. On the other hand the returns that comes with having a liberal trade credit policy is that the quantum of sales will increase as more buyers will be attracted by the liberal credit policy. Also the level of customer loyalty will increase. A firm will have to implement liberal credit policy in such a way that its risk return payoff is optimized.

(4): The risks associated with foreign direct investment (FDI) arise due to interest rate risks and foreign exchange risks. When interest rate rises in other countries then foreign investors will park their capital in that country in which interest rate is higher. For example suppose that U.S. investors are parking their capital in Russia. When interest rates in U.S. will increase there will be flight of FDI from Russia to USA. Foreign exchange risks depend on the fluctuations in the exchange rates and a volatile exchange rate may dampen the flow of FDI. These risks are different from those encountered in a domestic investment as in case of a domestic investment the investors are more affected by the local macro and micro economic factors while in case of FDI the investors are affected by both the local factors as well as the global macro-economic scenario and conditions.