Question

Interest Rate Expectations, Economic Growth, and Bond Financing

Recall that if the economy continues to be strong, Carson Company may need to increase its production capacity by about 50 percent over the next few years to satisfy demand. It would need financing to expand and accommodate the increase in production. Recall that the yield curve is currently upward sloping. Also, recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. It needs funding to cover payments for supplies. It is also considering issuing stock or bonds to raise funds in the next year.

a. At a recent meeting, the chief executive officer (CEO) stated his view that the economy will remain strong, as the Fed’s monetary policy is not likely to have a major impact on interest rates. So he wants to expand the business to benefit from the expected increase in demand for Carson’s products. The next step would be to determine how to finance the expansion. The chief financial officer (CFO) stated that if Carson Company needs to obtain long-term funds, the issuance of fixed-rate bonds would be ideal at this point in time because she expects that the Fed’s monetary policy to reduce inflation will cause long-term interest rates to rise. If the CFO is correct about future interest rates, what does this suggest about future economic growth, the future demand for Carson’s products, and the need to issue bonds?

b. If you were involved in the meeting described here, what do you think needs to be resolved before deciding to expand the business?

c. At the meeting described here, the CEO stated: “The decision to expand should not be dictated by whether interest rates are going to increase or not. Bonds should be issued only if the potential increase in interest rates is attributed to a strong demand for loanable funds rather than the Fed’s reduction in the supply of loanable funds.” What does this statement mean?

Answer 1