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.