Question

A firm is contemplating how to finance the purchase of a new piece of equipment that is replaces an old piece that can no longer be repaired. The new equipment is critical to operations and is expected to last 30 years or more. You had initially planned to finance the purchase of the equipment using a 30-year amortizing loan. However, the new Treasurer notes that the interest rates on two and five-year loans are much lower than current 30-year rates and therefore advocates for initially financing the purchase with a two-year loan, and then "rolling" the debt in a few years (rolling debt means issuing new debt to pay off the face value of maturing debt). Carefully articulate the strengths and weaknesses of this idea.

Answer 1

The strengths of this idea is that if the short term interest rates continue to remain low in the future also, the firm may save significant costs due to lower interests outlay. Moreover, due to various factors such as liquidity premium and maturity risk premium, the shorter tenure interest rates would be lower than the longer tenure ones. Hence, the firm can save significant costs through this technique.

The disadvantage of "rolling the debt" is that the firm is exposed to significant interest rate risks. For example, by opting for a 30 year loan, the interest rate for the entire tenure is locked into. On the other hand, by rolling over debt, if the interest rate rises after 2 or 5 years, then the firm will be exposed to that risk and this is a significant pitfall.