BUS 550 Module 3 Bonds and Interest Rates Example

Locking In or Floating: Bond Pricing, Credit Spreads and Interest Rate Risk in an RV Chassis Maker's Borrowing Decision

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MBA Program, Aspen University

BUS 550: Business Finance

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Month Day, Year

Locking In or Floating: Bond Pricing, Credit Spreads and Interest Rate Risk in an RV Chassis Maker's Borrowing Decision

Lakeland Chassis Corporation, a composite manufacturer in northern Indiana, builds the steel chassis on which motor homes are assembled. To add a second welding line and refinance existing short-term borrowing, it needs $25 million. Its investment bank has proposed a private placement of ten-year notes with institutional investors. Its commercial bank has offered instead to enlarge its floating-rate line of credit, priced at the prime rate plus 0.75 percentage point. The chief financial officer asked for an analysis of the two options. This paper applies bond valuation and interest rate concepts to the decision.

How Bonds Are Priced

A bond promises a series of coupon payments and the return of principal at maturity. Its price is the present value of those payments, discounted at the yield investors require for bonds of similar risk and maturity (Brigham & Ehrhardt, 2020). When a bond is issued, its coupon is usually set so that the price equals face value. After issue, the coupon is fixed, but the required yield changes with market conditions, so the price moves: if yields rise, the fixed payments are worth less and the price falls; if yields fall, the price rises.

Building the Company's Yield

The yield on Lakeland's notes would combine a risk-free rate and a credit spread. The Federal Reserve reports that the ten-year Treasury yield averaged 4.99% in September 2026 (Board of Governors of the Federal Reserve System, n.d.). Lakeland is unrated, mid-sized and exposed to the cyclical recreational vehicle market, so investors will require a substantial premium above Treasuries.

Fisher (1959) studied what determines the risk premiums on corporate bonds and found that they depend chiefly on two things: the risk of default, which he measured with the variability of a firm's earnings, its record of meeting obligations and its ratio of equity to debt; and the marketability of its bonds, measured by the value of bonds outstanding. Lakeland's earnings swing with RV sales, and its notes would be a small, privately placed issue that trades rarely. Both factors point to a wide spread. The investment bank estimates investors would require about 7.2%, a spread of about 2.2 percentage points above Treasuries, so the notes would carry a 7.2% coupon and sell at face value.

How Prices Move With Yields

Once issued, the notes' value to investors, and the cost to Lakeland of buying them back early, changes with yields. The table shows the price of a $1,000 note with a 7.2% coupon, paid semiannually, at different required yields with ten years remaining.

A one-point rise in yields cuts the price by about 6.7%; a one-point fall raises it by about 7.4%. The asymmetry, larger gains than losses for equal moves, reflects the curved relationship between bond prices and yields.

Duration

Duration summarizes this sensitivity in a single number. The notes' Macaulay duration, the weighted average time until their cash flows are received, is about 7.3 years, and their modified duration is about 7.0, meaning that a small change of one percentage point in yield changes the price by roughly 7%, consistent with the table. Longer maturities and lower coupons raise duration; for Lakeland, it means that fixed-rate notes lock in a cost that will look cheap if rates rise and expensive if they fall.

The Floating Alternative

The bank line would cost prime plus 0.75 point, currently about 8.5%, adjusting whenever the prime rate changes. Its cost today is higher than the notes', but it would fall if the Federal Reserve cut rates. Under three paths for short-term rates over the next five years, the average cost of the line would be about 7.1% if rates fall two points, 8.5% if they stay level and 9.6% if they rise a point and a half. The notes cost 7.2% under all three. Floating debt is cheaper only if rates fall substantially.

Covenants and Other Terms

Price is not the only difference between the options. Private placement notes usually carry covenants, promises such as keeping debt below three times operating earnings and maintaining minimum net worth, and breaking them can let investors demand early repayment. The bank line carries similar covenants but is easier to renegotiate with a single lender who knows the company. The notes would also require audited statements and annual reporting to several investors. These costs are real but modest for a company of Lakeland's size, and the CFO's review found the proposed covenants comfortably within the company's projected ratios even in a weak RV year.

What Investors Are Buying

From the investors' side, the notes are a claim on Lakeland's ability to pay over ten years. Insurance companies, the typical buyers of private placements, hold such notes to maturity to match their own long-term obligations, which is why they accept limited trading. Their required yield of about 7.2% reflects what they could earn on publicly traded bonds of similar risk plus a small premium for the notes' illiquidity, consistent with the marketability factor in Fisher's study.

Matching Debt to the Business

Lakeland's revenues fall in recessions, when the Federal Reserve often cuts rates, so floating debt offers a partial natural hedge: interest costs tend to fall when sales do. But the company's main use of the funds, a welding line that will operate for twenty years, is long-lived, and its lenders and owners value predictable costs. Fixed-rate notes match a long-lived asset with long-lived funding and remove the risk of a sharp rate increase during an RV boom.

Recommendation

Lakeland should issue $18 million of ten-year notes at about 7.2% to fund the welding line and refinance most short-term debt, and keep $7 million on the floating line for seasonal working capital. The notes should include a call provision allowing early repayment after five years, accepting a slightly higher coupon if necessary, so the company can refinance if rates fall significantly.

Conclusion

Bond valuation shows that a fixed-rate note's cost is set at issue while its market value moves with yields, and that the yield combines a Treasury rate with a spread reflecting the borrower's risk. For Lakeland, fixed notes cost slightly less than the floating line today and remove exposure to rising rates, while a modest floating balance keeps flexibility. The split matches the debt to the life of the assets it funds.

References

Board of Governors of the Federal Reserve System. (n.d.). Selected interest rates (daily): H.15. https://www.federalreserve.gov/releases/h15/

Brigham, E. F., & Ehrhardt, M. C. (2020). Financial management: Theory and practice (16th ed.). Cengage.

Fisher, L. (1959). Determinants of risk premiums on corporate bonds. Journal of Political Economy, 67(3), 217-237. https://doi.org/10.1086/258172