Question

Interest rates and decisions

Suppose that a firm is facing an upward-sloping yield curve and needs to borrow money to invest in production. Does this mean that the firm should consider borrowing only at short-term rates?
a. No, the firm needs to take the volatility of short-term rates into account.
b. No, an upward-sloping yield curve means that the firm will get a lower interest rate if it uses long-term financing
c. Yes, using short-term financing will give the firm the lowest possible interest rate over the life of the project.
Credit ratings affect the yields on bonds. Based on the scenario described in the following table, determine whether yields will increase or decrease and whether it will be more expensive or less expensive, as compared to other players in the market, for a company to borrow money from the bond market.
Scenario Impact on Yield Cost of Borrowing Money
from Bond Markets
ABC Real Estate is a commercial real estate firm that primarily uses short-term financing, while its competitors primarily use long-term financing. Interest rates have recently increased dramatically. Decrease More expensive Ziffy Corp.’s credit rating was downgraded from AAA to A. Bellgotts Inc. has increased its market share from 15% to 37% over the last year while maintaining a profit margin greater than the industry average. Previously, Ferro Co. had only used short-term debt financing. The company now finances its current assets such as inventories and receivables with short-term debt, and it finances its fixed assets such as buildings and equipment with long-term debt.

Answer 1

a. No, the firm needs to take the volatility of short-term rates into account.

Step-by-step explanation:

Short term interest rates are more volatile than the long term interest rates. If the company chooses to finance its operations solely from short term financing than it will need to incorporate the affect of volatility in the short term interest rates to identify the net returns. The volatility should be calculated with the risk factor and required rate of return of the funds.