Suppose that a firm is facing an upward-sloping yield curve and needs to borrow

Question

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? O No, the firm needs to take the volatility of short-term rates into account. O Yes, using short-term financing will give the firm the lowest possible interest rate over the life of the project No, an upward-sloping yield curve means that the firm will get a lower interest rate if it uses long-term finanding 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 Cost of Borrowing Money from Bond Markets Scenario Impact on Yield XYZ Co.'s credit rating was downgraded from AA to BB8 A company's financial health improves. There is an increase in the perceived marketability of a company's bonds, so the liquidity premium decreases. A company uses debt to buy another company. Such an event is called a leveraged buyout

Explanation / Answer

Multiple Choice Question - Answer is Option 2.

Upward sloping yield curve means the long term interest rates are higher than short term interest rates. Long term bonds/debt if raised would need to pay back interest at higher yields. This means long term financing would be more expensive than the short term debt. Hence, company should go for short term debt when there is an upward sloping yield curve.

Scenarios:

We will understand this a basic concept - when the quality of bond declines, its demand decreases. A decrease in demand (by basics of economics) means lower price. Price has an inverse relationship with yield, which would mean higher yield. Higher yield would mean higher cost of financing

1. Credit rating downgraded - Quality decline - demand falls - Price falls - Yield increases - Cost of borrowing money from bond markets is more expensive

2. Company's financial health improves - Quality improves - demand rise - Price increases - Yield decline - Cost of borrowing money from bond markets is less expensive

3. Decrease in liquidity premium - Liquidity risk premium is added to the yield (by bond plus risk premium approach). Now, when this premium declines - yield declines - cost of borrowing money from bond markets is less expensive

4. Levereaged buyout - This is generally seen as very risky - higher risk demands higher returns - hence the yield increases - cost of borrowing money from bond markets is more expensive.

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