Answer to Qus.

No – 1

1(a)

It expects that it will need substantial long-term financing and plans to borrow additional funds either through loans
or by issuing bonds. Commercial banks can provide loans to Carson so that Carson can expand its operations.

1(b)

Carson might use the primary market to facilitate its expansion  by issuing stock or bond in the future to raise
funds. If financial markets were perfect, it might allow Carson to avoid financial institutions by being able to avoid
the help of investment banks when it issued stocks and they can also sell its holding of Treasury securities in the
secondary market.

1(c)

Carson might have limited access to additional debt financing during its growth phase  because it
could have already borrowed the maximum amount allowed by the financial institutions or may reach it.

1(d)

The purpose is to prevent Carson from using the funds in a manner that would be very risky, as Carson may default
on its loans if it takes excessive risk when using the fund to expand its business. The owner of the firm may prefer to
take more risk than the lender will allow, because owners would benefit directly from the risky ventures that
generate large returns. Conversely, the lenders simply hope to receive the repayment of the loan that they provided,
and do not receive a share in the profit. They would prefer that the funds be used in a conservative manner so that
Carson will definitely generate sufficient cash flow to repay the loan.

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2(a)

The demand for loanable funds will decline because of the stagnant economic growth over the next year and also
because of the major cut in government spending. The supply of loanable funds will remain the same because the
overall savings of households is not expected to change and the Fed is not expected to affect the existing supply of
loanable funds. Since there will be a decline in demand for loanable funds and no change in the supply of loanable
funds, the interest rate will decline.

2(b)

The floating-rate loan would be the best choice because interest rates will go down.

2(c)

It would put pressure on the U.S. interest rates because investors might withdraw their money from the U.S. market
and put it into the Canadian market to get a higher rate. Since the economic growth and budget deficit will put
pressure on interest rates, I will still say that the interest rate will decline.
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 3(a)

The yield curve would be upward sloping to reflect the expectations or rising interest rates along
with a liquidity premium for debt securities with longer maturities.

3(b)

The prevailing interest rate would be lower on loans than on the bonds, but the interest rate on
loans would increase over time if market interest rate rise. Therefore, Carson may be willing to
lock in the cost of debt by issuing bond rather than be subjected to the uncertainty if it obtain
floating-rate loans.

3(c)

The key factors are the risk-free rate on 10 years bonds, the risk premium, and any especial
provision on the bond. They yield to be offered is equal to risk free rate on ten-years bonds plus a
risk premium to reflect the possibility of Carson’s default, plus an adjustment for any especial
features of the bond.

3(d)

The key factors are the risk free rate on six-month Treasury Bills, and risk premium. The cost of
dent in this case changes over time, and dependent on how Treasury Bills rates move over time.

3(e)

In an upward sloping yield curve, future interest rate at longer maturity is expected to be higher.
This results in financial institution offering fixed rate loans to charge a higher interest rate than
what is prevailing now on long term fixed interest rate loans. The higher rate is intended in part
to cover the higher future interest rate and higher cost of liabilities for the financial institutions.

But this does not necessarily means that financial institution would prefer to issue fixed rate
loans. Preference of financial institution for fixed rate loan or floating rate loans is dependent on
the nature of its assets and liabilities in their portfolio and how it is managing interest rate risk.

A financial institution which is being funded by short term liabilities like fixed deposits from
retail investors may prefer to offer floating rate loans. This is because they have to adjust their
rates on fixed deposits and would like to be able to adjust their rates on assets also in response to
changing interest rate scenario.
Similarly, if a financial institution relies more on long term liabilities to finance its asset creation
may be more willing to offer fixed rate loans. Hence, the consideration that applies to financial
institutions is different than what applies to company.
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