what does each of the following yield curves reflect about interest rates: (a) downward-sloping; - 12843

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1. Now, let's think about debt.  Stock never mature versus debt securities which do.  To value the current value of debt, one must calculate the yield to maturity, or the annual rate of return earned on a debt security purchased on a given day and held to maturity. For a given class of similar-risk securities, what does each of the following yield curves reflect about interest rates: (a) downward-sloping; (b) upward-sloping; and (c) flat? Which form has been historically dominant?

 

2. In a situation where there is an escalating interest rate, should the consumer refinance the loan? How do the banks determine the interest rate they charge on loans?  We all understand the risk premium that is charged based on the credit score.  How is the rest of the interest rate determined?

 

3. What if you were able to quickly pay down a low interest credit card and then apply that cash to a higher interest rate card? How might you start out with a fixed amount you can apply towards debt and determine an effective strategy?

 

4. UPS is a historically conservative organization and this applies to their financials as well.  They tend to determine their discount rate based on opportunity cost versus their cost of debt or equity since both are relatively low. Let's consider their capital structure.  Why might a company choose to be highly leveraged versus being debt free like Cisco? UPS changed its capital structure when the current CEO, Scott Davis, took over the company.  The organization took on debt to finance buying out of a union pension plan.  Why would the organization choose to do this versus using cash from operations?

 

Solution Description

1. Now, let's think about debt.  Stock never mature versus debt securities which do.  To value the current value of debt, one must calculate the yield to maturity, or the annual rate of return earned on a debt security purchased on a given day and held to maturity. For a given class of similar-risk securities, what does each of the following yield curves reflect about interest rates: (a) downward-sloping; (b) upward-sloping; and (c) flat? Which form has been historically dominant?

A downward sloping yield curve means that long term debt is cheaper than the short term debt, i.e. the interest rate on debts with longer term to maturity is lower than on debt with shorter term to maturity. An upward sloping curve  means that the interest rates on debt instruments with  longer term to maturity are higher than on instruments with shorter term to maturity, i.e