Product Overview

On January 26, 2022, Dan Yu, treasurer for Integrated Circuits (IC), needed to decide between three financing options for a $200 million acquisition of Safe Technologies. The acquisition would significantly enhance IC’s capabilities and increase its chances of securing a major US Air Force contract that would accelerate company growth. Yu had to choose between a fixed-rate bullet loan, an amortizing loan, and a floating-rate loan. While interest rates were at a historically low level following the COVID-19 pandemic, the Federal Reserve was considering aggressive rate hikes, following a strong economy and rising inflation. Yu’s challenge was to select the best among the financing options, considering their borrowing costs, interest-rate risk, and rollover risk. This partially fictionalized case allows instructors to introduce interest-rate risk and the relationship between spot rates and forward rates. Students gain exposure to calculating Macaulay duration and modified duration as they balance market expectations of future interest rates with the risk profiles of each loan option. This case has been successfully taught at the University of Virginia Darden School of Business in the “Valuing a Company’s Options and Debt” module of “Valuation in Financial Markets,” an elective finance course in the MBA program. It is also suitable for core finance offerings that cover valuation of liabilities and interest-rate risks. To successfully complete this case, students are expected to have a modest understanding of interest rates and bond pricing math.

Learning Objectives

The case can be used to pursue the following objectives: (1) Explore how different loan types are exposed to interest-rate risk and cash-flow risk, and how these risks relate to maturity in complex ways. (2) Develop an intuitive understanding of Macaulay duration and modified duration as measures of interest-rate risk and learn how to calculate them for both amortizing and non-amortizing securities. (3) Cover the importance of interest-rate risk from a corporate perspective, highlighting how the interest-rate risk faced by the lender finds a mirror image in the risk held by the borrower. (4) Calculate spot implied forward rates using the law of one price, link them to expectations of future interest rates, and know how they inform corporate decisions. (5) Highlight the importance of the movement in risk-free interest rates in determining the cost of borrowing for companies and the value of their loans and of the bonds they issued.