AFB,Inc.purchases a new delivery van which is expected to increase cash flows for the next 10 years.AFB can finance the purchase with a standard 48-month vehicle loan,or by getting a 10-year loan from the bank.According to the hedging principle,AFB should
A) use the 10-year financing in order to match the cash flow stream from the asset with the financing repayments.
B) use the 48-month loan since it matches the type of asset with the type of loan.
C) use either type of financing, but hedge the risk in the options market.
D) avoid using either loan and finance the truck with current cash reserves to avoid interest expense.

Question

Quizplus · Accepted Answer

The hedging principle suggests that the cash flow stream from an asset should match the financing repayments. Since the delivery van is expected to increase cash flows for the next 10 years, AFB should finance the purchase with a 10-year loan from the bank to match the cash flows. The 48-month loan would require more frequent repayments that may not match the expected cash flows from the asset. Therefore, the best choice is to use the 10-year loan.

AFB,IncPurchases a New Delivery Van Which Is Expected to Increase