Question

Fly-by-night Corporation is in need of capital funds to expand its production capacity. It is selling short-term and long-term bonds and is also issuing shares. You are considering the prospect of helping finance its expansion.

1. If Standard and Poor lowered the credit worthiness of Fly-by-night, would this affect the rate of return you would demand when buying their bonds? Why?

2. If Fly-by-night is issuing both shares and bonds, from which would you expect to earn the higher rate of return over the long run? Why?

3. Which would be safer: putting all of your personal saving into Fly-by-night shares, or putting all of your personal saving into an investment fund that has some Fly-by-night shares in its portfolio? Why?

4. Use the saving and investment identities from the National Income Accounts to answer the following questions. Suppose the following values are from the national income accounts of a country with a closed economy (all values are in billions).

Answer 1

1. Credit Rating determines the rate of return the customer might receive while buying the bonds. Lower credit worthiness of Fly-by-night affects the rate of return when buying their bonds as the poor credit ratings indicate risky investments and indicates a larger probability that the company would not make the bond payments.

2. Shares would give the higher rate of return over the long run as bonds are debt instruments whereas shares are the ownership in the company. In the short run, bonds are good instruments whereas shares give higher rate of return in the long run.

3. It is always better not to keep all eggs in one basket. Similarly it is better putting all of your personal saving into an investment fund that has some Fly-by-night shares in its portfolio compared to putting all of your personal saving into Fly-by-night shares. If we put all our personal savings into Fly by night shares, it is quite risky as if the company shares go down, our entire savings would be at stake. Investing in a portfolio would divide our risk to several various options.