Risk Return Trade Off in Short Term Source of Finance

RUNNING HEAD:RISK RETURN TRADE OFF IN SHORT TERM SOURCE OF FINANCE
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RISK RETURN TRADE OFF IN SHORT TERM SOURCE OF FINANCE
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Question 3 (15 marks)
AVER Ltd is considering short term financing for its working capital requirement. You are
invited to provide a discussion on the risk-return trade-off that the company should consider in
selecting different sources of short term financing. In your discussion, illustrate with an
appropriate example where possible. Write between 1,200 – 1,400 words for this question.
INTRODUCTION.
Decisions that involves working capital requirements of a particular company varies from company to
company across various industries and take various forms with various courses of actions. The risk
involved is such finances must be commensurate to with the level of returns it will bring to the entity.
For the company to be very effective in its operation, it must clearly manage its working capital well and
give specific goals to be attained. These main goals are to get optimal profits and ensure that it has
enough cash in order to meet its short term obligations as and when they fall due and for smooth
continuity in operation.
Profitability of an entity is in line with the theory of shareholder’s wealth maximization such that
investment should only be made by a firm if the return of such investment brings the required return to
the entity (Jones & Felps, 2013).
A company may also decide to have enough cash instead of investing for operational and speculative
motives
The correlation that exists between the return and the associated risks is expressed as follows:
Rate of return(required)=RISK FREE RATE+expected inflation+RISK PREMIUM
When the risk is high therefore, the return will be high in order to provide for equity or to cancel out its
effects.
TYPES OF SHORT-TERM SOURCES OF FINANCE
Bank loan-this either can be in cash credit or overdraft that involves withdrawing more than what you
have in the account. This provide a very short term funds to the entity.
Bank guarantee-this involves obtaining of letters or bank guarantee to acquires short term funds

RISK RETURN TRADE OFF IN SHORT TERM SOURCE OF FINANCE
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Deferred payment strategy-this involves delaying some payments of due debts and bills such as taxes,
rent, electricity in order to acquires funds for the short term use in the company. This pending bills can
therefore be paid in instalments thus providing interest free source of funds.
Discounting of bills. This is usually done through banks and it involves cashing out before elapse of a
credit time.
Commercial papers and factoring. Factoring involves sale of debts of the entity to a collection house at a
reduced value than what is actually due. This will provide funds to the company for working capital
requirements (Carbo, Rodriguez & Udell, 2016).
WORKING CAPITAL CONCEPT
This refers to the current assets less current liabilities. Every company should have liquid cash in order to
finance its daily operations like minimum stock required and maintain its account receivable. Working
capital therefore ties liquid cash in stock and accounts receivable even though these items are less
profitable. therefore, working capital comprises a trade-off between company’s liquidity and the
profitability (Ehlers, 2014).
RISK RETURN TRADE OFF
High levels of risks are associated with high chance of a higher levels of returns and the low risks levels
are associated with the great chance of minimal returns. The tradeoff that a potential investor faces while
making such investment decisions is what is referred to as risk return trade-off (Mathuva, 2015).
Short-term source of finance for a company normally involves getting funds for the operation of an entity
and do not exceed one year.
RISK AND RETURN RELATIONSHIP
The key fundamental concept in finance is the relationship that exist between the risk and return. Risk
return tradeoff is also known as iron stomach test in finance. This refers to a situation where an investor
tries to strike a balance between highest return and the lowest risk that is possible.in finance, situations of
low levels of uncertainties are normally associated with low levels of returns. The basic reason is that
investors who take additional risk must be compensated for such. This one therefore places an investor on
a point that he/she must make a decision on the amount of risk he has to take (Baños, García & Martínez,
2010).
Every manager makes decisions that are geared towards shareholder’s wealth maximization and prudent
working capital management.