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 Yes, using short-term financing will give the firm the lowest possible interest rate over the life of the project. O No, an upward-sloping yield curve means that the firm will get a lower interest rate if it uses long-term financing O No, the firm needs to take the volatility of short-term rates into account. 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 Scenarid Impact on Yield A start-up company is struggling with finances for its [ projects A company's credit rating was upgraded from AA to A company's interest coverage ratio improves. A car manufacturing company loses 40% of its market share and has a declining investment in new product development.

Explanation / Answer

(a) An upward sloping yield curve implies that required interest rates go up as the time to maturity increases. Therefore, long-term interest rates will be higher than short-term interest rates, thereby implying that short-term borrowings would reduce the overall level of interest rates over the project lifetime.

(b) A struggling startup will have an extremely high risk of default, thereby commanding higher yields and borrowing costs from the bond market.

A credit rating upgrade implies lower default risk, thereby lowering yields and reducing borrowing costs.

An increase in a firm's interest coverage ratio indicates increased ability to pay off a firm's debt burden, thereby lowering yields and reducing borrowing costs.

A significant loss of market share and declining investment in new product development indicates lower free cash flows being generated by the firm, thereby lowering yields and reducing borrowing costs.

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