You work as a financial analyst at a large automobile corporation

Read the scenario below, and answer the following questions.

You work as a financial analyst at a large automobile corporation that occasionally makes acquisitions of smaller companies that specialize in the production and assembly of small component parts. In order to achieve vertical integration of its newest sports sedan model, the company is evaluating a few manufacturing companies that have experienced strong financial performance in the past few years. These companies would make excellent acquisitions due to the nature and quality of the product and the anticipated ease of transition. You have been tasked to evaluate these companies from a financial perspective and choose one. To do this, you need to brush up on a few concepts by addressing the following topics:

1. Describe what a crediting rate/score is. Should this be a factor in evaluating companies?
2. The firm will need to raise funds immediately for the acquisition, and debt will be used. Should the firm borrow on a long-term or short-term basis? Why?
3. Explain the effect, if any, inflation rates will have on the purchase? How significant is this factor?
4. Define the relationship between yield curves and the term structure of interest rates.
5. Explain what would happen to interest rates if a new process was developed that allowed automobiles to run off oil that was formulated based on lemonade? The technology used to convert this liquid to gas would be pricey but well worth it. What impact would this technology have on interest rates?
6. Discuss what ratios should be used to assess the financial health of the potential acquisition?

Your completed case study must be at least two pages in length, and you must use at least your textbook as a reference. Other references may be used as needed. Any information from a source used must be cited and referenced in APA format.

Components of Market Interest Rates

In addition to supply-and-demand relationships, interest rates are determined by a number of specific factors or components. The market interest rate is the interest rate observed in the marketplace for a debt instrument. A market, or nominal, interest rate contains at least two components—a real rate of interest and an inflation premium. The real rate of interest is the interest rate on a risk-free financial debt instrument when no inflation is expected. It is generally believed that investors must expect a minimum level of return in order to get them to invest in debt instruments instead of holding cash. The inflation premium is the additional expected return to compensate for anticipated inflation over the life of a debt instrument. In its simplest form, the observed market interest rate (r) can be expressed as, (8-1) r = RR + IP r=RR+IP where RR is the real rate of interest and IP is an inflation premium. For debt instruments that have no additional risk components, this interest rate is called the risk-free interest rate. In practice, it is difficult to identify a debt instrument that trades in the market based only on a risk-free interest rate. In the next section we will discuss the possibility of using observed interest rates on U.S. Treasury securities as proxies for the risk-free interest rate. Most debt instruments will also have a default risk premium. Equation 8-1 can be expanded to include expected compensation for this additional risk: (8-2) r = RR + IP + DRP r=RR+IP+DRP where DRP is the default risk premium. The default risk premium is the additional expected return to compensate for the possibility that the borrower will not pay interest and/or repay principal when due according to the debt instrument's contractual arrangements. The DRP reflects the application of the risk-return principle of finance presented in Chapter 1. In essence, “higher returns are expected for taking on more risk.” This is a higher “expected” return because the issuer may default on some of the contractual returns. Of course, the actual “realized” return on a default risky debt investment could be substantially less than the expected return. At the extreme, the debt security investor could lose all of his or her investment. The DRP is discussed further in the last section of this chapter. The risk-return finance principle is extended to stock investments and to portfolios of securities in Chapter 12. Instead of a default risk premium, the concentration is on “stock risk premiums” and “market risk premiums.” Two additional premiums are added to Equation 8-2 to explain market interest rates for debt instruments with varying maturities and liquidity. This expanded version can be expressed as, (8-3) r = RR + IP + DRP + MRP + LP r=RR+IP+DRP+MRP+LP where MRP is the maturity risk premium and LP is the liquidity premium on a debt instrument. The maturity risk premium is the additional expected return to compensate interest rate risk on debt instruments with longer maturities. Interest rate risk is the risk of changes in the price or value of fixed-rate debt instruments resulting from changes in market interest rates. There is an inverse relationship in the marketplace between debt instrument values or prices and market interest rates. For example, if market interest rates rise from, say, 4 percent to 5 percent because of the expectation of higher inflation rates, the values of outstanding debt instruments will decline. Furthermore, the longer the remaining life until maturity, the greater the reductions in a fixed-rate debt instrument's value to a specific market interest rate increase. These concepts with numerical calculations are explored in Chapter 10. The liquidity premium is the additional expected return to compensate for debt instruments that cannot be easily converted to cash at prices close to their estimated fair market values. For example, a corporation's low-quality bond may be traded very infrequently. As a consequence, a bondholder who wishes to sell tomorrow may find it difficult to sell except at a very large discount in price. Possibly, this should be called an illiquidity premium since the premium is compensation for a lack of liquidity. However, it is common practice to use the term liquidity premium. The factors that influence the market interest rate are discussed throughout the remainder of this chapter, beginning with the concept of a risk-free interest rate and a discussion of why U.S. Treasury securities are used as the best estimate of the risk-free rate. Other sections focus on the term or maturity structure of interest rates, inflation expectations and associated premiums, and default risk and liquidity premium considerations.

Norton, R.W.M.E. A. (2016). Introduction to Finance: Markets, Investments, and Financial Management, Enhanced eText. [VitalSource Bookshelf]. Retrieved from https://online.vitalsource.com/#/books