Interest rates and decisions Suppose that a firm is facing an upward-sloping yie
ID: 2612394 • Letter: I
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? No, an upward-sloping yield curve means that the firm will get a lower interest rate if the uses long-term financing. No, the firm needs to take the volatility of short-term rates into account. 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.Explanation / Answer
8. i.
Ferro Co. Case:
Impact on Yield: It will increase; Cost of borrowing money from Bond Market= more expensive than what it will cost to its competitors. This is because, it is only from now onwards that Ferro Co. has started tapping Bond Market for access to long-term borrowed funds; Previously it had used only short-term debt for its financing requirements; Hence, its long-term credit rating would be comparatively lower than its competitors if not bad. Thus, it will face an upward yield curve with steep slope; thus impact on yield will be that it will increase. AND Cost of borrowing money from Bond Market= more expensive than what it will cost to its competitors..
8.ii.
ABC Real Estate case:
In this case, interest rates have recently increased dramatically, thus causing the value and hence pricing of existing bonds in the Bond Market to fall, which in turn will cause the Yield on these bonds to increase.
Cost of borrowing money from Bond Market= more expensive than what it will cost to its competitors
8. iii.
Ziffy Corp's credit rating was downgraded from AAA to A; Thus Impact on Yield= Yield will increase because with downgrade in credit rating the bond market players [investors] will react by selling off the company's bonds in the bond market thereby causing company's bond price to fall which in turn will cause the Yield on its bond to increase..
Cost of borrowing money from Bond Market= more expensive than what it will cost to its competitors due to downgrade in its credit rating
8. iv.
Bellgotts Inc. Case:
Impact on Yield: It will decrease; because with substantial increase in market share of its products while maintaining a profit margin greater than industry average, company's cash-inflows plus its Operating Profits plus its debt-service coverage including repayment cpacity of debt's principal amount; all of these will substantially improve thereby causing its credit rating to considerably get upgraded to which the Bond Market will react by increased demand for company's existing bonds; this will cause its bond prices to rise and hence its bond yield will fall considerably in the bond market.
AND; Cost of borrowing money from Bond Market= less expensive than what it will cost to its competitors due to upgrade in its credit ratings
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