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Financing – Debt finance

Example 1

Spray Co has a $10 million fixed rate borrowing. It has entered an interest rate
swap to swap the interest to a floating rate for a three year period.

The bank has quoted a swap rate of 4.10% for LIBOR, with interest fixing
dates on the start date of each year of the swap agreement.

Spray Co's fixed rate of interest is 4.40%.

LIBOR on the start date of year 2 of the three year swap agreement was
4.25%, but this had risen to 4.58% by the end of year 2 (12 months later).

What is the difference in Spray Co's overall net interest paid in the year
(year 2 of the swap agreement) as a consequence of using the swap?

A $15,000 saving

B $15,000 extra cost

C $18,000 extra cost

D $48,000 extra cost

Solution

The answer is (B).

Actual borrowing (4.40%)
Payment to bank (LIBOR)
Receipt from bank 4.10%
––––––
Net (LIBOR + 0.30%)
–––––––––––––––
The interest fixing date is the start date of the year, so this overall net rate of
LIBOR + 0.30% can be calculated as 4.25% (LIBOR on the year 2 start date)
+ 0.30% = 4.55%.

Hence, Spray Co pays 4.55% interest on its $10 million borrowing ($455,000
in the year) rather than the 4.40% fixed rate it would have paid without the
swap ($440,000 in the year).

This is an extra cost of $15,000.

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