Pault Co is currently undertaking a major programme of product development. Pault Co has made a significant investment in plant and machinery for this programme. Over the next couple of years, Pault Co has also budgeted for significant development and launch costs for a number of new products, although its finance director believes there is some uncertainty with these budgeted figures, as they will depend upon competitor activity amongst other matters.
Pault Co issued floating rate loan notes, with a face value of $400 million, to fund the investment in plant and machinery. The loan notes are redeemable in ten years’ time. The interest on the loan notes is payable annually and is based on the spot yield curve, plus 50 basis points.
Pault Co’s finance director has recently completed a review of the company’s overall financing strategy. His review has highlighted expectations that interest rates will increase over the next few years, although the predictions of financial experts in the media differ significantly.
The finance director is concerned about the exposure Pault Co has to increases in interest rates through the loan notes. He has therefore discussed with Millbridge Bank the possibility of taking out a four-year interest rate swap. The proposed terms are that Pault Co would pay Millbridge Bank interest based on an equivalent fixed annual rate of 4·847%. In return, Pault Co would receive from Millbridge Bank a variable amount based on the forward rates calculated from the annual spot yield curve rate at the time of payment minus 20 basis points. Payments and receipts would be made annually, with the first one in a year’s time. Millbridge Bank would charge an annual fee of 25 basis points if Pault Co enters the swap.
(i) Using the current annual spot yield curve rates as the basis for estimating forward rates, calculate the amounts Pault Co expects to pay or receive each year under the swap (excluding the fee of 25 basis points). (6 marks)
(ii) Calculate Pault Co’s interest payment liability for Year 1 if the yield curve rate is 4·5% or 2·9%, and comment on your results. (6 marks)
(i) Gross amount of annual interest paid by Pault Co to Millbridge Bank = 4·847% x $400m = $19·39m.
Gross amounts of annual interest receivable by Pault Co from Millbridge Bank, based on Year 1 spot rates and Years 2–4 forward rates:
(ii) Interest payment liability
Advise the chairman on the current value of the swap to Pault Co and the factors which would change the value of the swap.
At the start of the contract, the value of the swap will be zero. The terms offered by Millbridge Bank equate the discounted value of the fixed rate payments by Pault Co with the variable rate payments by Millbridge Bank.
However, the value of the swap will not remain at zero. If interest rates increase more than expected, Pault Co will benefit from having to pay a fixed rate and the value of the swap will increase. The value of the swap will also change as the swap approaches maturity, with fewer receipts and payments left.
Discuss the disadvantages and advantages to Pault Co of not undertaking a swap and being liable to pay interest at floating rates.
Disadvantages of swap arrangement
The swap represents a long-term commitment at a time when interest rates appear uncertain. It may be that interest rates rises are lower than expected. In this case, Pault Co will be committed to a higher interest rate and its finance costs may be higher than if it had not taken out the finance arrangements. Pault Co may not be able to take action to relieve this commitment if it becomes clear that the swap was unnecessary.
On the basis of the expected forward rates, Pault Co will not start benefiting from the swap until Year 3. Particularly during Year 1, the extra commitment to interest payments may be an important burden at a time when Pault Co will have significant development and launch costs.
Pault Co will be liable for an arrangement fee. However, other methods of hedging which could be used will have a cost built into them as well.
Advantages of swap arrangement
The swap means that the annual interest payment liability will be fixed at $23·19m over the next four years. This is a certain figure which can be used in budgeting. Having a fixed figure may help planning, particularly as a number of other costs associated with the investment are uncertain.
The directors will be concerned not just about the probability that floating rates will result in a higher commitment than under the swap, but also be concerned about how high this commitment could be. The directors may feel that rates may possibly rise to a level which would give Pault Co problems in meeting its commitments and regard that as unacceptable.
Any criticism after the end of the loan period will be based on hindsight. What appeared to be the cheapest choice at that stage may not have been what appeared most likely to be the cheapest choice when the loan was taken out. In addition, criticism of the directors for not choosing the cheapest option fails to consider risk. The cheapest option may be the most risky. The directors may reasonably take the view that the saving in cost is not worth the risks incurred.
The swap is for a shorter period than the loan and thus allows Pault Co to reconsider the position in four years’ time. It may choose to take out another swap then on different terms, or let the arrangement lapse and pay floating rate interest on the loan, depending on the expectations at that time of future interest rates.