613 others answered this question

Question 3b

Sembilan Co, a listed company, recently issued debt finance to acquire assets in order to increase its activity levels. This debt finance is in the form of a floating rate bond, with a face value of $320 million, redeemable in four years. The bond interest, payable annually, is based on the spot yield curve plus 60 basis points. The next annual payment is due at the end of year one.

Sembilan Co is concerned that the expected rise in interest rates over the coming few years would make it increasingly difficult to pay the interest due. It is therefore proposing to either swap the floating rate interest payment to a fixed rate payment, or to raise new equity capital and use that to pay off the floating rate bond. The new equity capital would either be issued as rights to the existing shareholders or as shares to new shareholders.

Ratus Bank has offered Sembilan Co an interest rate swap, whereby Sembilan Co would pay Ratus Bank interest based on an equivalent fixed annual rate of 3•76¼% in exchange for receiving a variable amount based on the current yield curve rate. Payments and receipts will be made at the end of each year, for the next four years. Ratus Bank will charge an annual fee of 20 basis points if the swap is agreed.

The current annual spot yield curve rates are as follows:

YearOneTwoThreeFour
Rate2.5%3.1%3.5%3.8%

The current annual forward rates for years two, three and four are as follows:

YearTwoThreeFour
Rate3.7%4.3%4.7%

Required:

Demonstrate that Sembilan Co’s interest payment liability does not change, after it has undertaken the swap, whether the interest rates increase or decrease. (5 marks)

We use cookies to help make our website better. We'll assume you're OK with this if you continue. You can change your Cookie Settings any time.

Cookie SettingsAccept