Matching Liabilities to Assets

The first step every firm should take towards making the right financing choices is to understand how cash flows on its assets vary over time. In this section, we consider five aspects of financing choices, and how they are guided by the nature of the cash flows generated by assets. We begin by looking at the question of financing maturity, i.e, the choice between long term, medium term and short term debt, and argue that this choice will be determined by how long term asset cash flows are. Next, we examine the choice between fixed and floating rate debt, and how this choice will be affected by the way inflation affects the cash flows on the assets financed by the debt. Third, we look at the currency of in which the debt is to be denominated and link it to the currency in which asset cash flows are generated. Fourth, we evaluate when firms should use convertible debt instead of straight rate debt, and how this determination should be linked to how much growth there is in asset cash flows. Finally, we analyze other features that can be attached to debt, and how these options can be used to insulate a firm against specific factors that affect cash flows on assets, either positively or negatively.

A. Financing Maturity

Firms can issue debt of varying maturities, ranging from very short term to very long term. In making this choice, they should first be guided by how long term the cash flows on their assets are. For instance, firms should not finance assets that generate cash flows over the short term (say 2 to 3 years) using 20-year debt. In this section, we begin by examining how best to assess the life of assets and liabilities, and then we consider alternative strategies to matching financing with asset cash flows. Measuring the Cashflow Lives of Liabilities and Assets

When we talk about projects as having a 10-year life or a bond as having a 30-year maturity, we are referring to the time when the project ends or the bond comes due. The cash flows on the project, however, occur over the 10-year period, and there are usually interest payments on the bond every six months until maturity. The duration of an asset or liability_is a weighted maturity of all the cash flows on that asset or liability, where the weights are based upon both the timing and the magnitude of the cash flows. In general, larger and earlier cash flows are weighted more than are smaller and later cash flows. The duration of a 30-year bond, with coupons every six months, will be lower than 30 years, and the duration of a 10-year project, with cash flows each year, will generally be lower than 10 years.

A simple measure11 of duration for a bond, for instance, can be computed as follows:

Duration of Bond =

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