Case Analyses

Direction: Discuss the given cases thoroughly. (40 points: 8 items x 5 points)

1. Flow of Funds
Abraham Company has obtained substantial loans from finance companies and commercial banks. The interest
rate on the loans, which included a risk premium, is tied to the six-month Treasury bill rate and is adjusted every
six (6) months. Therefore, Abraham’s cost of obtaining funds is sensitive to interest rate movements. The
company expects that the Philippine economy will strengthen, so it plans to grow in the future by expanding its
business and by making acquisitions. Abraham 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.

Questions:

a. Assume that the market’s expectations for the economy are similar to Abraham’s expectations. Also,
assume that interest rate expectations primarily influence the yield curve. Would the yield curve be
upward sloping or downward sloping? Why?

 Market expects that economy would perform better over coming up. As a result, there would be
more demand for funds from various participants in the market. If there is more demand for firms,
interest rate would go up. Shape of yield curve is dependent on a host of factors. This includes
future expectations of interest rates, liquidity premium expected for holding long term
investments, investors preferences, demand and supply of funds and wider economic condition. All
these factors interact to give rise shape of the yield curve. If interest rate is expected to be higher
in future, people may refer o park their funds in short term investments. The prices of short-term
investment would rise and lead to fall in yield a short-term maturity. Yield curve would become
upward sloping and reverse situation would make the yield curve downward sloping.

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

 Floating interest rate loan would adjust the interest payable on the loan every six months. If the
interest rate is expected to go up, cost of financing would increase over a period of time. This is
more so if company Abraham takes out a 10 years floating rate loan. Fixed rate load would factor
in future expectation of interest rate anyway. But it would offer fixed and known interest rate
even when interest rate is going up in economy in future. This would tend to limit the cost of
financing for the company. When interest rates are going to go up in near futures, fixed rate loans
may offer better value to the company.

c. If Abraham 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 Abraham would pay on its 10-year bonds?

 Company Abraham is planning to issue a 10 years bond. The yield on the security would be
estimated based on various factors. Yield on any fixed income securities are driven by the
characteristic of the securities. Securities with high yields would have some characteristics that
are not favored by investors. Characteristics that determine the yields are default risk premium,
liquidity, tax status and term to maturity.
 d. If Abraham attempts to obtain funds by issuing loans with floating interest rates every six (6) 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 Abraham would pay over 10 years?

 If company Abraham plans to issue floating rate debt securities, yield would still be determined
based on the factors discussed above in previous part. But future expectation of interest rate
would play lesser role. This is because floating rate loan would adjust the rate based on new
interest rate level every six month. Changes in liquidity premium would also be automatically be
factored into new interest rate every sic=x months. Hence future expectations of interest rate
would play a less significant role in determining the rate. Credit risk, terms to maturity and tax
status would play a much larger role for floating interest rate securities.

2. Monitoring Yield Curve Adjustments

As an analyst of a bond rating agency, you have been asked to interpret the implications of the recent shift in the
yield curve. Six (6) months ago, the yield curve exhibited a slight downward slope. Over the past six
(6) months, long-term yields declined while short-term yields remained the same. Analysts said that the shift was
due to revised expectations of interest rates.

Questions:

a. Given the shift in the yield curve, does it appear that firms increased or decreased their demand for long-
term funds over the last six months?

 There is an inverse relationship between interest rate and demand for the fund. If the interest rate
decreases, the borrowing capacity of the firm increases and they can borrow more funds at low
cost. So, with the given downward sloping yield curve the demand for long-term funds should
increase.

b. Interpret what the shift in the yield curve suggests about the market’s changing expectations of future
interest rates.

 Based on the pure expectancy theory, the short-term rates are initially high. People will expect
the rates to come back down causing the long-term rates to fall below short-term rates because
the average of expected short-term rates would be lower than the current short-term rates.

c. Recently, an analyst argued that the underlying reason for the yield curve shift is that many large firms in
the country anticipate a recession due to the coronavirus disease. Explain why an anticipated recession
could force the yield curve to shift as it has.

 During the recession, people ted to hold money so demand for the bond will decrease. Demand
curve shift downward the price decrease and cause interest rate to increase. If real rate increase,
the inflation rate will decline. When the inflation rate decline it shows that now the economy had
a recession. From this we can conclude that anticipated recession could force the yield curve to
shift as it has.
d. What could the specific shift in the yield curve signal about the ratings of existing corporate bonds? What
types of corporations would be most likely to experience a change in their bond ratings as a result of this
shift in the yield curve?

 The downward shift in yield curve indicates a recession to happen. During recession, people are
less likely to borrow. Therefore, the credit worthiness of some corporation decline, which in turn,
results in a downgrade of bond ratings. As we move down the bond ratings, the bond get riskier as
a result of the higher default risk associated with the bonds. The shift in yield curve affects largely
on sensitive corporations.