186 Part 3 Financial Assets
However, this could prove to be a horrible mistake. If you use short-term
debt, you will have to renew your loan every 6 months; and the rate charged on
each new loan will re" ect the then-current short-term rate. Interest rates could
return to their previous highs, in which case you would be paying 14%, or
$140,000, per year. Those high interest payments would cut into and perhaps
eliminate your pro! ts. Your reduced pro! tability could increase your! rm’s risk
to the point where your bond rating was lowered, causing lenders to increase
the risk premium built into your interest rate. That would further increase your
interest payments, which would further reduce your pro! tability, worry lend-
ers still more, and make them reluctant to renew your loan. If your lenders re-
fused to renew the loan and demanded its repayment, as they would have every
right to do, you might have to sell assets at a loss, which could result in
bankruptcy.
On the other hand, if you used long-term! nancing in 2008, your interest costs
would remain constant at $43,000 per year; so an increase in interest rates in the
economy would not hurt you. You might even be able to acquire some of your
bankrupt competitors at bargain prices—bankruptcies increase dramatically when
interest rates rise, primarily because many! rms use so much short-term debt.
Does all of this suggest that! rms should avoid short-term debt? Not at all. If
in" ation falls over the next few years, so will interest rates. If you had borrowed
on a long-term basis for 4.3% in January 2008, your company would be at a disad-
vantage if it was locked into 4.3% debt while its competitors (who used short-term
debt in 2008) had a borrowing cost of only 2.7%.
Financing decisions would be easy if we could make accurate forecasts of
future interest rates. Unfortunately, predicting interest rates with consistent ac-
curacy is nearly impossible. However, although it is dif! cult to predict future
interest rate levels, it is easy to predict that interest rates will! uctuate—they al-
ways have, and they always will. That being the case, sound! nancial policy
calls for using a mix of long- and short-term debt as well as equity to position
the! rm so that it can survive in any interest rate environment. Further, the op-
timal! nancial policy depends in an important way on the nature of the! rm’s
assets—the easier it is to sell off assets to generate cash, the more feasible it is to
use more short-term debt. This makes it logical for a! rm to! nance current as-
sets such as inventories and receivables with short-term debt and to! nance
! xed assets such as buildings and equipment with long-term debt. We will re-
turn to this issue later in the book when we discuss capital structure and! nanc-
ing policy.
Changes in interest rates also have implications for savers. For example, if
you had a 401(k) plan—and someday most of you will—you would probably
want to invest some of your money in a bond mutual fund. You could choose a
fund that had an average maturity of 25 years, 20 years, on down to only a few
months (a money market fund). How would your choice affect your investment
results and hence your retirement income? First, your decision would affect
your annual interest income. For example, if the yield curve was upward-
sloping, as it normally is, you would earn more interest if you chose a fund that
held long-term bonds. Note, though, that if you chose a long-term fund and
interest rates then rose, the market value of your fund would decline. For exam-
ple, as we will see in Chapter 7, if you had $100,000 in a fund whose average
bond had a maturity of 25 years and a coupon rate of 6% and if interest rates
then rose from 6% to 10%, the market value of your fund would decline from
$100,000 to about $63,500. On the other hand, if rates declined, your fund would
increase in value. If you invested in a short-term fund, its value would be stable,
but it would probably provide less interest per year. In any event, your choice
of maturity would have a major effect on your investment performance and
hence on your future income.