Anticipating Fed Actions Recall that Carson Company has obtained substantial loa

Question

Anticipating Fed Actions
Recall that Carson Company has obtained substantial
loans from finance companies and commercial banks.
The interest rate on the loans is tied to market interest
rates and is adjusted every six months. Because of its
expectations of a strong U.S. economy, Carson plans to
grow in the future by expanding the business and by making acquisitions. It expects that it will need substantial
long-term financing and plans to borrow additional
funds either through loans or by issuing bonds. The company may also issue stock to raise funds in the next year.
An economic report recently highlighted the strong
growth in the economy, which has led to nearly full
employment. In addition, the report estimated that
the annualized inflation rate increased to 5 percent,
up from 2 percent last month. The factors that caused
the higher inflation (shortages of products and
shortages of labor) are expected to continue.
a. How will the Fed’s monetary policy change based
on the report?
b. How will the likely change in the Fed’s monetary
policy affect Carson’s future performance? Could it
affect Carson’s plans for future expansion?
c. Explain how a tight monetary policy could affect
the amount of funds borrowed at financial institutions
by deficit units such as Carson Company. How might it
affect the credit risk of these deficit units? How might it
affect the performance of financial institutions that
provide credit to such deficit units as Carson
Company?

Explanation / Answer

a. How will the Fed’s monetary policy change based on the report?

Answer:

As on date the Fed’s monetary policy is expansionary monetary policy in which the interest rates were on the lower side. This was done by US Federal Reserve by lowering the benchmark Federal Reserve rate and also by increasing the money supply in the market by purchasing the Treasury bonds in the open markets. The real cause for this notion was to boost aspects of the economy which is going through a rough patch and being slow on its business cycle.

Now On the basis of the report that says the economic indicators like employment rate has moved up and the inflation is also increased from 2% to 5%, Fed may change its Base rate in future to come and increase it to tackle increase rate of inflation and putting off the support which is not needed now.

The impact of this base rate increase would be on the interest rates and they will increase.

b. How will the likely change in the Fed’s monetary policy affect Carson’s future performance? Could it affect Carson’s plans for future expansion?
Answer: As Carson has taken substantial loans for its expansion of business when the rates were lower any increase in the interest rate in the market would affect his business profitability. Increase in base rate by Fed in future means increase in interest rate in the market and then the Carson’s debt interest will also be revised after 6 months and then the business would have to shell out more money in terms of interest payments. Thus the fund will become costlier for Carson business and the business cost of capital will increase, decreasing the value of the business.

c. Explain how a tight monetary policy could affect the amount of funds borrowed at financial institutions by deficit units such as Carson Company. How might it affect the credit risk of these deficit units? How might it affect the performance of financial institutions that provide credit to such deficit units as Carson Company?

Answer:

Tight monetary policy means that Fed Reserve has increased the interest rate in the market and because of this now the market has less liquidity and the financial institutions would get funds at higher rate of interest. That means costlier funds would now be available with the financial institutions and the new takers of funds will have to shell out more money to get funds.

As Carson company has taken loans in the past, these loans interest rate will get revised and thus making them costlier for the company in future.

Also this tight monetary policy would increase the credit risk for the company, reason being rise in the interest rate and fall in the interest coverage ratio.

Interest coverage ratio = EBIT / interest expense

As the interest expense for the company will increase the interest coverage ratio will also get reduced, increasing the chances of default by the company.

As a financial institution increase in credit risk means increased chances of default by the company and thus higher chances of conversion of assets to non performing assets.

A non performing asset is that in which bank fails to get interest by the company for substantial number of periods.

So banks profitability will also be under scanner in case company default on their loans.

Related Questions

Navigate

• Browse (All)
• Browse A
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.