Question

A firm will borrow long-term:

A. if the extra interest cost of borrowing long-term is less than the expected cost of rising interest rates before it retires its debt.
B. if long-term interest rates are expected to decline during the term of the debt.
C. if short-term interest rates are expected to decline during the term of the debt.
D. if the extra interest cost of borrowing short-term due to rising interest rates does not exceed the expected premium that is paid for borrowing long-term.

Answer 1

Answer: A. if the extra interest cost of borrowing long-term is less than the expected cost of rising interest rates before it retires its debt.

Step-by-step explanation:

Borrowing long term usually attracts a MATURITY PREMIUM. It is part of the computation of the REQUIRED RETURN and is meant to account for the extra interest rate risk that could come about as a result of the duration of time till maturity.

If this EXTRA cost is LESS than the amount that the company believes interest rates will increase by in future, then they will borrow long term because it means that they are paying less than they should.

For instance, if rates are due to rise by 1% every year but the maturity premium on a long term bond puts it at 0.5% a year, they will take that long term bond.