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, Carsons 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 markets expectations for the

economy are similar to Carsons 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 longterm 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 longterm 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

them a floating-rate loan? Explain why Carsons expectations of future interest rates are not necessarily the

same as those of some financial institutions.