Reference no: EM132679211

Problem - Influence of the Structure of Interest Rates

Recall that Carson Company has obtained substantial loans from finance companies and commercial banks. The interest rate on the loans is tied to the six-month Treasury bill rate (and includes a risk premium) and is adjusted every six months. Therefore, Carson's cost of obtaining funds is sensitive to interest rate movements. The company expects that the U.S. economy will strengthen, so it plans to grow in the future by expanding its business and by making acquisitions. Carson anticipates needing substantial long-term financing to pay for its growth and plans to borrow additional funds, either through loans or by issuing bonds; it is also considering issuing stock to raise funds in the next year.

a. Assume that the market's expectations for the economy are similar to Carson's expectations. Also assume that the yield curve is primarily influenced by interest rate expectations. Would the yield curve be upward sloping or downward sloping? Why?

b. If Carson could obtain more debt financing for 10-year projects, would it prefer to obtain credit at a long-term fixed interest rate or at a floating rate? Why?

c. If Carson attempts to obtain funds by issuing 10-year bonds, explain what information would help in estimating the yield it would have to pay on 10-year bonds. That is, what are the key factors that would influence the rate Carson would pay on its 10-year bonds?

d. If Carson attempts to obtain funds by issuing loans with floating interest rates every six months, explain what information would help in estimating the yield it would have to pay over the next 10 years. That is, what are the key factors that would influence the rate Carson would pay over the 10 -year period?

e. An upward-sloping yield curve suggests that the initial rate financial institutions could charge on a long-term loan to Carson would be higher than the initial rate they could charge on a loan that floats in accordance with short-term interest rates. Does this imply that creditors should prefer offering Carson a fixed-rate loan to offering it a floating-rate loan? Explain why Carson's expectations of future interest rates are not necessarily the same as those of some financial institutions.