a. SinceCarson Company has obtained substantial loans from finance companies andcommercial bank already, Carson’s debt level might be high and the company willnot have enough credit leverage to issue commercial paper. In addition,commercial papers are short-term, unsecured and generally very risky marketinstrument. Therefore, only large, credit worthy companies are qualified toissue commercial paper. Carson Company fell short on both requirements.
Therefore, Carson Company will not be able to issue commercial paper.b. If Carson Company needs to weigh betweenselling Treasury securities and issuing a credit line, selling Treasury securitieswill cost less. Since the Treasury securities rate is the risk-free rate, andevery credit line from financial institutions will have a premium on top of therisk-free rate. Therefore, forgoing the small return from the Treasurysecurities will have a lower cost.Chapter 7, Pg 186 Flow of Funds Exercisea. Considering50 percent expansion is quite an investment, Carson Company should considerusing short-term financing to increase the capacity by 10%. Doing this willensure a slower expansion and avoid the long-term debt burden that might notbring about enough revenue.
b. Eventhough the risk premium between the short and long-term debt markets aresimilar, there is normally an upward-sloping trend for the Treasury yieldcurve, thus increase the risk-free rate. As a result, Carson Company willobtain long-term financing at a higher interest rate than short-term financingc. Carsonshould not add a call provision to when it issues bonds.
Since Carson isexpecting that the Fed will increase interest rate to reduce inflation.Therefore, future bond will have a higher yield to maturity than the currentbonds that Carson is issuing. Therefore, if Carson can afford to pay intereston current bonds, it will likely be able to pay the same interest when the bondhas a lower value. Therefore, putting in a call provision is not necessaryd. Theprivate placement market is an option of selling bonds in large quantity to aninstitutional investor.
The potential investors include insurance companies orpension funds. Doing this may help Carson reduce the processing cost; however,Carson would have to pay a higher yield for those privately placed bonds, sinceliquidity resulting from lack of trading in the second market.e. Insurance companies increase revenue throughselling policies and receiving premium payments.
They would leave a decentamount for claim payments and using the rest to purchase bonds. They couldchoose to purchase bonds from companies like Carson. Therefore, premiums arechanneled through to corporations through bonds issuingPension funds receives contribution fromemployees monthly. Afterwards, they can use the available funds to invest inbonds and stocks, like Carson Company. The money is channeledChapter 8, Pgs 215 & 216 Flow of Funds Exercisea.
Ifthe CFO prediction about interest rate moving up is correct, it suggests thatthe money supply will be restricted, which will cause the economy to slow down.Slower economy will cause demand for Carson’s product to slow down and the needto issue bond to be subdued b. Aswe can see from the meeting, the view of the CEO and the CFO are different. Ifthe prediction from the CEO about the stable and strong economy is right,interest rate will likely remain low and Carson Company could pursue theexpansion. But if the CFO’s prediction about the rising interest rate iscorrect, issuing bonds right now would not be necessary. Therefore,straightening out the predictions is a must before doing anything else.c. Ifrising interest rate is part of the Fed’s monetary policy, it would suggest a smallermoney supply and a slower economy in the future.
As discussed above, slowereconomy would result in less demand for Carson’s product. Expansion would not beneeded and issuing bond will not, either. However, if the increase in interestrates are derived from demand for loanable funds, it suggests a strengthenedeconomy and a rising demand for Carson Company’s product. As a result,expansion is necessary and issuing bonds is reasonable Chapter 9, Pg 243 Flow of Funds Exercisea. Someeconomic factors that could affect interest rates include the current budgetdeficit. An indicator that suggests changing trajectory of the economy,inflation or employment level will do the same thing as well.
Changes ininterest rate will influence the mortgage refinancing decision.b. CarsonCompany should consider the minimum amount of down payment. Since with thecurrent size of the company, obtaining a large amount of money for the initialdown payment is difficult. In addition, since the long-term refinancing rate islower than issuing bonds, Carson should take the full advantage of mortgagerefinancing before considering other options that might incur higher interestexpense. Individual investors put their money into financial institutions.
Theseorganizations then pool the funds and issue mortgage loans to deficit unitslike Carson Company. In other words, individual depositors are indirectlyproviding the funds to Carso