Question

Question 2

Financial Risk Management

A company has received a substantial loan from commercial banks. The interest rate on the loans is tied to market interest rates and is adjusted every six months. The company has obtained a credit line to satisfy temporary fund’s needs. Besides, in order to solve unexpected liquidity problems, it can sell short term government securities, which it has bought half a year ago. The economic forecasts are rather optimistic, thus in order to satisfy the rising demand, the company may be in need to increase its production capacity by about 40 percent over the next two years. However, the company is concerned about potential slowdown in the economy due to COVID 19. The company needs funding to cover payments to suppliers. It is also considering other possibilities of financing in the money market. The interest rate that the company is paying for its line of credit is less than the prevailing commercial paper interest rate of highly rated companies.

a) Should the company issue commercial paper on this prevailing interest rate?

b) Should the company sell its holding of government securities to cover the payments to suppliers?

Answer 1

Answer a= As the expected economic growth of the country is negative due to COVID 19, so with the reducing GDP or economic growth, the interest rates are expected to go down to boost the economic growth in the country. As commercial papers are issued with the fixed interest rates, thus the company should not issue the commercial paper with the current interest rates as it will harm the company in the long run as the company has to pay higher returns than the prevailing interest rate at the time of maturity.

Answer b= As the current interest rate is expected to be higher than in future, so it is better to sell the government holdings now to gain more funds from these.