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okmarks People Window Help xAplia: Student Question> courses.aplia.com/af/servlet/quiz?quiz action-takeQuiz&quiz;_probGuid-ONAPCOA8010100000041ca26100c0 9. Interest rates and decisions Aa Aa Which of the folilowing best explains why a firm that needs to borrow money would borrow at long-term rates when short-terms rates are lower than long-term rates? O A firm will only borrow at short-term rates when the yield curve is upward-sloping Firmas will always be better off when they borrow using long-term financing even if the yield curve is upward-sloping O Short-term interest rates are more volatile than long-term interest rates. 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 Previously, Ferro Co. had only used short-term debt financing. The company now finances its current assets such as inventories and reccivables with short-term debt, and it finances its fixed assets such as buildings and equipment with long-term debt Belgotts 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.

Explanation / Answer

Multiple Choice Question - Answer is Option 3.

Short term rates are more volatile than compared to the long term rates. Hence, financing at short term rates may create more voltility at company's liabilities side and hence add uncertainty about the amount of payment that need to be made for servicing of debt.

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. Use of short term financing and interest rates increased dramatically - This would create a risk for the ABC Real Estate as due to increase in interest rates, it would now have to borrow at a higher rate and its financial capacity may degrade significantly as a result. This would lead to decline in demand of company's bond - Price decreases - Yield increase - Cost of borrowoing from bond markets is more expensive

2. Company's financial capability improves as due to introduction of long term financing option, there is a lower chance of volatility in interest payments required to be made - Quality improves - demand rise - Price increases - Yield decline - Cost of borrowing money from bond markets is less expensive

3. Company's market share improvement without decline in its profit margin, which is higher than industry average would be viewed favorably by the market and investors as this would mean successful strategising at company - Quality improves - demand rise - Price increases - Yield decline - Cost of borrowing money from bond markets is less expensive

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

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