Consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. • Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. • Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% • Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. Choosing strategy #1 will:[Fill in the blank]

Question

Consider these debt strategies being considered by a corporate borrower. Each is intended to provide $1,000,000 in financing for a three-year period. •  Strategy #1: Borrow $1,000,000 for three years at a fixed rate of interest of 7%. •  Strategy #2: Borrow $1,000,000 for three years at a floating rate of LIBOR + 2%, to be reset annually. The current LIBOR rate is 3.50% •  Strategy #3: Borrow $1,000,000 for one year at a fixed rate, and then renew the credit annually. The current one-year rate is 5%. Choosing strategy #1 will:[Fill in the blank]

BlackTom AI · Accepted Answer

Question restatement: A corporate borrower is evaluating three debt strategies, each aiming to provide $1,000,000 of financing for three years. Strategy #1: fixed 7% for three years. Strategy #2: floating at LIBOR + 2%, with annual resets; current LIBOR 3.50%. Strategy #3: one-year fixed rate now, then annual renewals; current one-year rate 5%. The prompt asks: Choosing strategy #1 will: [Fill in the blank].

Option A: guarantee the lowest average annual rate over the next three years.
- Why this is not correct: A fixed-rate loan at 7% does not guarantee the lowest average rate over the three-year horizon. If rates fall below 7% after purchase, the borrower would miss out on lower costs that could have been obtained via a floating or shorter-term/renewal strategy. The option assumes future rates will be higher or equal, which is not guaranteed, so this statement is inaccurate.

Option B: eliminate credit risk but retain repricing risk.
- Why this is not correct: No debt strategy fully eliminates credit risk; credit risk relates to the borrower’s ability to repay, which depends on the borrower’s own credit and covenants, not the instrument type alone. Also, repricing risk is typically associated with floating-rate or resetting instruments; a fixed-rate loan (Strategy #1) eliminates repricing risk for the term, but the claim here is that it eliminates credit risk while retaining repricing risk, which misstates the relationship: strategies don’t eliminate credit risk simply by instrument choice, and Strategy #1 does not retain repricing risk since the rate is fixed for the full term.

Option C: preclude the possibility of sharing in lower interest rates over the three-year period.
- Why this is correct: Locking in a fixed rate of 7% for three years means the borrower cannot benefit from any declines in market rates during that period. If LIBOR or other rates drop, the borrower would not be able to participate in lower costs; the financing cost remains stuck at 7% for the entire three-year horizon. This captures the core trade-off of fixed-rate financing: protection against rising rates but forfeiture of upside when rates fall. The statement accurately describes the consequence of committing to Strategy #1 for the full period.

Option D: maintain the possibility of lower interest costs, but maximizes the combined credit and repricing risks.
- Why this is not correct: Strategy #1 does not maximize combined credit and repricing risks. A fixed-rate loan removes repricing risk (no changes in rate during the term), and it does not maintain a pathway to lower costs if rates fall. Therefore, it does not keep the possibility of lower costs nor does it maximize the combined risk; in fact, it minimizes repricing risk and does not exploit potential rate declines. The description conflates risk exposure with potential rate movements and does not align with how fixed-rate debt behaves.

In summary, evaluating the implications of locking in a fixed rate for three years shows that only Option C accurately reflects the consequence of Strategy #1: it prevents benefiting from any possible future declines in interest rates during the three-year period, i.e., precludes sharing in lower rates over that horizon.

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