8.5 Alternative Capital Structures The “Matching Principle” Illustrated

In general, companies will want to match up the duration of their assets and capital; this conservative strategy is referred to as the “matching principle” (and discussed above); this says that the (financially conservative) firm will use short-term financing sources for short-term assets, and long-term for long-term.

More aggressive managers will have an incentive increasingly to utilize short-term capital to finance long-term assets. Short-term capital is (usually) cheaper than long-term, as the yield curve normally is positively sloped. Even if the firm uses equity rather than debt, equity capital is still more expensive than long-term debt capital.

The following illustrates some possible manners in which managers may match or mis-match their firms’ assets and capital, depending on managements’ risk profiles. The chart should be taken with a grain of salt; it is not formulaic.

Here is another possible “horizontal” plan. Would you characterize it as conservative or aggressive?

Assets to be Financed Capital Financing Source 
Temporary Working Capital Spontaneous Current Liabilities and/or Short-term External Capital
Permanent Working Capital Long-term Debt and/or Equity
Long-term Assets

The above plan is notably conservative. The manager has not mismatched. In mismatching, a manager runs some risks. First, there may be no cash flow when the money comes due; s/he is relying on the firm’s ability to generate sufficient operating cash flow to service the debt. That is to say, there will be no asset that will “turn over” and provide cash flow at the required time.

The manager may re-finance the short-term borrowing by taking down another short-term loan to pay off the first one – if possible. The lender may not allow this. Secondly, he runs the risk that short-term rates, at some future point, will go higher – and even exceed the former long-term rate in which case mismatching may have been a poor strategic choice.

An aggressive manager may believe that the company will grow and hence, will experience increased future cash in-flows with which short-term financing sources may be paid off.


Icon for the Creative Commons Attribution 4.0 International License

Corporate Finance Copyright © 2023 by Kenneth S. Bigel is licensed under a Creative Commons Attribution 4.0 International License, except where otherwise noted.

Share This Book