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. No, the firm needs to take the volatility of short-term rates into account. O No, an upward-sloping yield curve means that the firm will get a lower interest rate if it uses long-term financing 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 A company uses debt to buy another company. Such an event is called a leveraged buyout. A company's financial health improves. There is an increase in the perceived marketability of a7 company's bonds,so the liquidity premium decreases XYZ Co.'s credit rating was downgraded from AA to BBB. Less expensive More expensive

Explanation / Answer

1. (a) Upward slopping yield curve implies that rates will be higher for longer duration

So, firm should short term financing

2. Using debt to buy a company will increase the risk, which will have negetive impact on its credit rating. Decrease in credit rating implies that investors will required higher interest on their investment, so yield will increase. Also, cost of borrowing will also increase due to the risk involved.

3. Improve in company's financial health => company is safe for investment => credit rating improves => yield will decrease => cost of borrowing will decrease

4.  Increase in marketability of a company's bond => less market risk => credit rating improves => yield will decrease => cost of borrowing will decrease

5.  credit rating downgraded => company is not stable and risky => yield will decrease => cost of borrowing will decrease

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