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Question 4c

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 number of concerns were raised at the recent board meeting when the swap arrangement was discussed.

– Pault Co’s chairman wondered what the value of the swap arrangement to Pault Co was, and whether the value would change over time.
– One of Pault Co’s non-executive directors objected to the arrangement, saying that in his opinion the interest rate which Pault Co would pay and the bank charges were too high. Pault Co ought to stick with its floating rate commitment. Investors would be critical if, at the end of four years, Pault Co had paid higher costs under the swap than it would have done had it left the loan unhedged.

Required:
(c) Discuss the disadvantages and advantages to Pault Co of not undertaking a swap and being liable to pay interest at floating rates. (9 marks)