Question

A firm is contemplating how to finance the purchase of a new piece of equipment that is replace 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

Solution:

The given situation is a classic example of the capital decision every business faces wherein they have to evaluate the interest rate risks associated with their choices.

As given, the current long-term interest rates (30-year) are higher than the short-term interest rates (2-year and 5-year) which means that instead of taking a 30-year loan at higher interest rates, the company can rather take a short-term loan at lower interest rates and later pay off the short-term debt at its maturity using the proceeds from new debt. This way, the company is planning to lower its interest cost during the overall debt liability term of 30-years.

While there is no doubt that the above plan would result in reduction of interest costs in short-term but it would come at the expense of few additional risks and costs. Following are the strengths and weaknesses of the idea:

Strengths

• The company keeps itself open to benefits from possible reductions in interest rates in the future. For e.g.- it is possible that the interest rates in the economy go down in the next 2 years and hence the company may get even more attractive rates of interest when they are looking to refinance debt after 2 years. Similarly, as long as it keeps choosing to take short-term finance instead of long-term finance, it keeps open the possibilities of benefits from lowered interest rates in future if they go down.
• Lowered cost of capital as the company enjoys benefits of lower short term interest rates as compared to long term rates
• As long as company chooses short-term finance over long-term debt, it will not have risk of paying pre-payment charges in case it wants to pay off its debts completely in the interim period without holding it for full 30 years
• As the company grows in future, gains in size and reduces its operating risk, the lenders may be willing to offer debt at the time of refinancing at a much lower rate due to reduction in default risks

Weaknesses

• The company will have to incur refinancing expenses every time it looks to roll over debt. The expenses include processing fee, investment banker fee, advisory expenses, etc.
• The company exposes itself to the interest rate risk, i.e. the risk of rise in interest rates in the future. For e.g.- it is a possibility that both long-term and short-term interest rates go up in the next few years, in which case it will have the interest cost increased when it refinances the debt
• The company takes on refinancing risk with this strategy, i.e. the risk of not being able to refinance its debt after two years. This may happen due to various reasons such as deterioration in economic situation, increase in operating risk of the business or industry, deterioration in fundamentals of the business, etc