From the point of view of a company‟s financial manager, outline the merits and demerits, to the company, of issuing floating rate debt as a means of raising capital

CPA-Financial-Management-Section-3 Revision kit

Merits to business organizations
• A company may be reluctant to pay a fixed rate of interest over a long period of time especially if the market interest rates are falling with time. Floating rate therefore reduces interest cost to firms.
• The further into the future the maturity of date of the loan, the greater is the interest that has to be offered the borrower in order to persuade the leader to part with his money. This is because the risk of default is deemed investors to be higher, the further into the future is the maturity date. This however need not to be the case when interest rate is floating because in this case, investors will view a long-term loan as several short-term loans, therefore with shorter maturities interest charged is thus smaller.
• It is easier to issue a floating rate bond with a longer maturity than negotiating short- term loans every so often to take care of falling short-term interest rates.
• Allows firms to obtain funds for long-term investments without committing a fixed rate of return over the loan‟s life i.e. the firm can take advantage of falling interest rates while at the same time obtaining a higher return on the funds obtained.

Demerits
• If interest rates are expected to rise with time, the firm is likely to end up paying a higher cost using floating rate bonds than it would if it is used a fixed rate bond. This is also accompanied with the cost of forecasting charges in the future rates of interest.
• The company may end up losing a lot of money in interest payment if the charges in the rate of interest in the future takes on forecast the financial manager.
• When the return on investment over time is not closely synchronized with changes in interest rate, the company may find itself unable to meet interest payments due a situation that may result in bankruptcy.

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