Acme Manufacturing wants to raise 300 million of 3year debt

Acme Manufacturing wants to raise $300 million of 3-year debt Floors: Premiums for 3-year floors (with annual pay) on 1-year LIBOR in the Euromarket (where interest is quoted and paid on an annual basis). Its alternatives are either a 3-year fixed-rate note at a spread of 250 basis points over the 3-year U.S. Treasury (currently yielding 4.50%), or a 3-year floating-rate note on which it must pay yearly interest of 1.year LIBOR + 2% (1.year LIBOR currently yields 3.70%; therefore, the floating-rate notes first interest payment of $17.1 million would be paid at the end of year 1). However, Acme wants to have a fixed-rate liability for the entire 3 years. Assuming the following instruments also are available to Acme (with National Trust, an AAA-rated bank, as the counterparty), which strategy will enable Acme to pay the lowest all-in fixed rate of interest (assume all rates are quoted on an annual basis)? Strike Rate 4.00% 4.80% 5.00% 6.00% Premium 0.18% 0.70% 0.90% 3.22% Screen Shot 2018-07-03 at 5.51.49 PM Search Q i 3-year swap has all-in pay-fixed rate of 3-year Treasury Caps: Premiums for 3-year caps with annual pay) on 1-year LIBOR Swap: +30 basis points (-4.50% + 0.30%) versus receiving 1-year LIBOR FRAs: 14 12/24 FRA has all-in pay-fixed rate of 2-year Treasury + 90 basis points (-4.10% + 0.90%) versus receiving 1-year LIBOR. 24/36 FRA has all-in pay-fixed rate of 3-year Treasury 150 basis points (-4.50% + 1.50%) versus receiving 1-year LIBOR. Strike Rate Premium 4.00% 4.80% . 5.00% -6.00% 2.23% 0.70% 0.49% 0.08% dy

Solution

Greetings,

The question is about minimising the cost of funding via various alternatives including derivatives segment -

Option 1 - Issue Fixed Rate Note

Cost =4.5+20.5=7.0% Annually

Therefore Ist Payment = 300*0.07 = 21m

Option 2- Issued floating rate note

Cost = 3.7+2.0=5.7%

Therefore Ist Payment = 300*0.057=17.1m

Note It is imperative to note here that 5.7% vis a vis 17.1m is not fixed for the entire duration of the bond (3 years), it is only for the Ist year as LIBOR is decided at the beginning of the period. LIBOR relevant for 2nd year will be decided at the end of the 1st year. In the absence of any estimate about 2nd and 3rd LIBOR, I am concluding only on the basis of the Ist LIBOR. In actual, it may change in future.

Option 3 - 3 Year Swap Pay Fixed and Receive Floating

We will Pay fixed rate =4.5+.03=4.8%

We will receive LIBOR = 3.7%

So net payment from swap = 1.1%

We are receiving LIBOR in the swap. The leg what we receive in a swap is what we borrow funds from the market at. So we borrow at LIBOR + 200bp = 5.7%

Effective Cost = 5.7+1.1=6.8%

Option 4 - 3 year swap pay floating and receive fixed

Net receipt from swap =1.1 %

Payment in market on fixed borrowing= 7.00%

So effective cost =7.00-1.10=5.9%

Option 5 - Floor (I am taking strike rate of 4% and 4.8% only)

Floating Borrowing Cost =5.7%

Since we are short on interest rate ie lose when interest rate rise, so we should sell floor.

At 4%, floor will be exercised at LIBOR 3.7% < strike rate 4.0%. So relava t rate is 4% as floor can\'t be breached.

Premium Received = 0.18%

So effective cost = 4 + 2 - 0.18 =5.82%

At 4.8% also, floor will be triggered , so effective cost is 4.8+2.0-0.7=6.1%

Option 6 - Cap ( I am only considering 4% & 4.8 % cap)

Since we are afraid of interest rate rising, hence we will buy cap.

At both 4% and 4.8%, cap will expire unexersied as cap rate is greater than present LIBOR.

So effective cost will be 5.7% plus premium paid under respective cap. It would be costlier than option 2 where cost was only 5.7% hence not advisable.

So option 2 has the least cost = 5.7%, but as said earlier, it may shoot up if LIBOR rises at a later date, so in real life it should be supplemented by having a cap as well.

Note - I have already answered more than 4 parts, so I am not answering remaining two parts. Kindly post it as separate question.