INTEREST RATES AND BUSINESS DECISIONS

The yield curve for February 2005, shown earlier in Figure 6-4 in Section 6.4, indicates how much the U.S. government had to pay in February 2005 to borrow money for 1 year, 5 years, 10 years, and so on. A business borrower would have had to pay somewhat more, but assume for the moment that it is February 2005 and that the yield curve shown for that year applies to your company. Now suppose your company has decided to build a new plant with a 30-year life that will cost $1 million, and to raise the $1 million by borrowing rather than by issuing new stock. If you borrowed in February 2005 on a short-term basis—say, for one year—your interest cost would be only 3.1 percent, or $31,000. On the other hand, if you used long-term financing, your cost would be 4.6 percent, or $46,000. Therefore, at first glance, it would seem that you should use short-term debt.

However, this could prove to be a horrible mistake. If you use short-term debt, you will have to renew your loan every year, and the rate charged on each new loan will reflect the then-current short-term rate. Interest rates could return to their previous highs, in which case you would be paying 14 percent, or $140,000, per year. Those high interest payments would cut into and perhaps eliminate your profits. Your reduced profitability could increase your firm’s risk to the point where your bond rating was lowered, causing lenders to increase the risk premium built into your interest rate. That would further increase your inter- est payments, which would further reduce your profitability, worry lenders still more, and make them reluctant to even renew your loan. If your lenders refused to renew the loan and demanded its repayment, as they would have every right to do, you might have to sell assets at a loss, which could result in bankruptcy.

On the other hand, if you used long-term financing in 2005, your interest costs would remain constant at $46,000 per year, so an increase in interest rates in the economy would not hurt you. You might even be able to acquire some of your bankrupt competitors at bargain prices—bankruptcies increase dramatically when interest rates rise, primarily because many firms do use so much short-term debt.

Does all this suggest that firms should always avoid short-term debt? Not at all. If inflation falls over the next few years, so will interest rates. If you had borrowed on a long-term basis for 4.6 percent in February 2005, your company would be at a disadvantage if it were locked into 4.6 percent debt while its competitors (who used short-term debt in 2005) had a borrowing cost of only 3 percent or so.

Financing decisions would be easy if we could make accurate forecasts of future interest rates. Unfortunately, predicting interest rates with consistent accuracy is nearly impossible. However, even if it is difficult to predict future interest rate levels, it is easy to predict that interest rates will fluctuate—they always have, and they always will. This being the case, sound financial policy calls for using a mix of long- and short-term debt, as well as equity, to position the firm so that it can survive in any interest rate environment. Further, the optimal financial policy depends in an important way on the nature of the firm’s assets—the easier it is to sell off assets to generate cash, the more feasible it is to use more short-term debt. This makes it more feasible for a firm to finance cur-
rent assets like inventories and receivables with short-term debt than fixed assets like buildings. We will return to this issue later in the book, when we discuss working capital policy.

Changes in interest rates also have implications for savers. For example, if you had a 401(k) plan—and someday most of you will—you would probably want to invest some of your money in a bond mutual fund. You could choose a fund that had an average maturity of 25 years, 20 years, on down to only a few months (a money market fund). How would your choice affect your investment results, hence your retirement income? First, your annual interest income would be affected. For example, if the yield curve were upward sloping, as it normally is, you would earn more interest if you chose a fund that held long-term bonds. Note, though, that if you chose a long-term fund and interest rates then rose, the market value of the bonds in the fund would decline. For example, as we will see in Chapter 7, if you had $100,000 in a fund whose average bond had a maturity of 25 years and a coupon rate of 6 percent, and if interest rates then rose from 6 to 10 percent, the market value of your fund would decline from $100,000 to about $64,000. On the other hand, if rates declined, your fund would increase in value. In any event, your choice of maturity would have a major effect on your investment performance, hence on your future income.

  • If short-term interest rates are lower than long-term rates, why might a borrower still choose to finance with long-term debt?
  • Explain the following statement: “The optimal financial policy depends in an important way on the nature of the firm’s assets.”