Which of the following best explains why a firm that needs to borrow money would

Question

Which of the following best explains why a firm that needs to borrow money would borrow at long-term rates whern short-terms rates are lower than long-term rates? O The use of short-term financing over long-term financing for a long-term project will increase the risk of the firm O The firm's interest payments will be the same whether it uses short-term or long-term financing, so it is essentially indifferent to which type of financing it uses A firm will only borrow at short-term rates when the yield curve is downward-sloping. 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 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. 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. Ziffy Corp. 's credit rating was downgraded from AAA to A. 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.

Explanation / Answer

Part 1: Answer is “A firm will borrow at short-term rates when the yield curve is downward-sloping”

Short-term rates add to the uncertainty of finance cost that the company may face. In an upward yield curve, interest rates are expected to increase over the period of time. Therefore, company would prefer a long term financing option, even though it may be higher than short term rates, in order to hedge itself from the rising finance cost in future.

When the yield curve is downward sloping, interest rates are expected to fall. Company would like to then borrow at short term rates, since they will be able to borrow at a lower price in future as expected by downward yield curve.

Part 2:

Before we answer this, let me take a step back to explain you the bond economics. Demand and supply forces work in bond markets as well. A bond, with higher demand (lower supply), will see its price rising and a bond witrh lower demand (higher supply) will see its price falling.

Price and yield have an inverse relation. If price rises, yields fall and vice versa. This relation also stands true in opposite way. If yield rises, price falls and vice versa.

Now, let us begin answer:

1. "ABC real estate......": Increase in interest rates will have a negative impact on ABC's financials compared to its competitors. This is because competitors have long term financing in place and hence lower volatility of finance cost. So, the risk associated with the company would increase and their demand would decline. Decline in demand implies their price will fall and yield would increase. Increase in yield implies their cost of borrowing from bond markets would also increase as they will now have to offer higher returns to compensate the investors for higher risk that they would take by investing company's bonds.

2. "Bellgots Inc......": Now, the statement signifies clearly that the financials and business profile of the company has improved significantly. This implies the bonds of this company carry lower risk and will see increase in demand which implies price rise and hence yield will decrease. Also, given the company is stronger than the competitors in idustry, it would have lower risk and hence have lower cost of borrowing from market.

3. "Ziffy Corp.....": Clearly, the bond has been downgraded that means probability of default has increased. This implies it now carries higher risk and hence lower demand. So price will fall and yield would increase. Cost of borrowing from bond market would also be higher as the higher risk would be compensated by higher yield offering.

4. "Ferro Co.....": Ferro Co has improved its financing structure and hence reduced the risk by matching the term of financing with the maturity of asset. Lower risk implies higher demand and price and hence yield will decline. This implies the cost of borrowing from bond market would also decline.

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