September/December 2016 Q4

Hi Can you explain what is the technique to solve this question. Specially part A

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.
The current annual spot yield curve rates are as follows:
Year One Two Three Four
Rate 3·70% 4·25% 4·70% 5·10%
(a) (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.