FINANCIAL INSTRUMENTS TAKE HOME RESEARCH PROJECT
Hydromaint is considering the purchase of another hydraulic services enterprise that is
much larger than itself. The target company has suffered from poor management the past decade
and Nick and Ray believe that with strong leadership, system innovations, and cost control the
acquisition can create value for Hydromaint’s shareholders. Nick and Ray project that the
investment will generate annual gross cash flows of at least $3,500,000 over the next ten years
with good, aggressive management. Hydromaint shareholders have indicated a willingness to
consider any acquisition that adds annual net cash flows of at least 25% of average equity
(average equity approximates $6,000,000) to the Company’s operations.
Midwest National Bank has indicated that they do not provide acquisition financing, but
it has recommended a national investment banking firm. After learning of the potential purchase,
the investment bankers indicated that the acquisition could easily be financed with a ten-year,
floating rate note (indexed to the one year U.S. Treasury Bill discount rate), interest payable
annually, with principal due at maturity. Nick and Ray were disappointed at the variable interest
rate features of the proposed financing. They had hoped to arrange a five year loan at a fixed
market rate of 9%. They asked the investment bankers about the possibility of a preferred stock
issuance, but were advised against it given market conditions. Sensing that the acquisition deal
on which they would likely earn large fees was about to fall apart, the investment bankers
proposed a shorter five year term, but retained the variable rate features. However, Nick and Ray
remained hesitant, the memory of the inflationary rates of the late 1970’s and early 1980’s
forever etched in their psyches.
Complete the following schedule assuming that Nick and Ray had succeeded in obtaining
9%, fixed rate financing for the entire $25 million acquisition. Assume that interest payments
are made at the end of each year on 12/31.
Year
1
2
3
4
5 Expected Cash Inflows
from Investment Cash Payments for
Interest Expense Net Cash Flow from
Acquisition Next, assume that the business purchase was financed with the five year, variable rate
financing recently proposed by the investment bankers. The interest rate was indexed to the one
year U.S. Treasury Bill with an annual reset. This means that every year beginning on the first
day of the loan, the interest rate on the obligation is set to equal the existing U.S. Treasury Bill
discount rate. Assume that the loan is executed on 1/1/X1, that the initial rate on the loan is 7%,
and each year the discount rate increases 2%; then complete the following schedule. Again,
assume that interest payments are made at the end of each year on 12/31.
Expected Cash Inflows Cash Payments for Net Cash Flow from Year
1
2
3
4
5 from Investment Interest Expense Acquisition Recognizing that Nick and Ray were not likely to agree to the five year financing
package without some protection for the floating rate feature, the investment bankers proposed
using a derivative product. They suggested an interest rate swap to hedge the acquisition’s cash
flows from potential future increases in the one year bill discount rate. Nick and Ray were very
aware of the negative press that financial derivatives had recently received, but indicated that
they were open-minded on the issue and needed more information. The investment bankers
provided them with the information on the attached sheet.
After a series of meetings to explain hedging to Nick, Ray, and Jerry, the investment
bankers proposed the following interest rate swap contract to complement the five year, $25
million, variable rate (indexed to the one year bill rate with an annual reset) financing package
they previously recommended.
Date: 1/1/X1 Notional amount: $25,000,000 Term: 5 years Collateral: Each party provides a letter of credit to guarantee
performance. Payment exchange: Hydromaint agrees to annually pay the
counterparty on 12/31 an amount equal to the
following: (9% minus the index rate) X the
notional amount, if the index rate < 9%.
The counterparty agrees to annually pay
Hydromaint on 12/31 an amount equal to the
following: (the index rate minus 9%) X the
notional amount, if the index rate > 9%. Index rate: The one year T-Bill discount rate which is reset
annually at the beginning of each year. Banker Fees: 1% of notional amount to be paid by each party. Assume that Hydromaint agrees to both the five year variable rate financing proposal and
the interest rate swap. Complete the following table for Hydromaint assuming that the initial rate on the loan is 7%, and each year the discount rate increases 2%. Investment banking fees are
paid on the date the financing package is executed (1/1/X1). As before, assume that interest
payments are made at the end of each year on 12/31. Year Investment
Cash Inflows Payments to
Investment
Banker (A) Interest
Payments
on Note (B) Swap
Payments/
Receipts
(C) Total
Payments
A+B+C Net Cash
Flow from
Purchase 1
2
3
4
5
Assume that Hydromaint adopted the complete financing package illustrated in the preceeding
table (increasing rate scenario). Answer the following questions in the space provided:
1.
How much total interest expense should Hydromaint record each year on the financing
package. The "financing package" includes both the note and the related derivative financial
instrument. 2.
Why is an interest rate swap considered a derivative for financial accounting purposes?
Be very specific and cite the appropriate authoritative literature. 3.
Is the interest rate swap a cash flow hedge, a fair value hedge, or a foreign currency
hedge? Why? Be very specific and cite the appropriate authoritative literature. 4.
Does the acquisition still meet the shareholders’ required investment threshold? Why or
why not?

 

• 1492742362-File 1.docx

SuperTutor

(15)

Status NEW Posted 21 Apr 2017 02:04 AM My Price 12.00

-----------

Attachments

file 1492742373-Solutions file.docx preview (56 words )

S-----------olu-----------tio-----------ns -----------fil-----------e -----------Hel-----------lo -----------Sir-----------/Ma-----------dam----------- T-----------han-----------k y-----------ou -----------for----------- yo-----------ur -----------int-----------ere-----------st -----------and----------- bu-----------yin-----------g m-----------y p-----------ost-----------ed -----------sol-----------uti-----------on.----------- Pl-----------eas-----------e p-----------ing----------- me----------- on----------- ch-----------at -----------I a-----------m o-----------nli-----------ne -----------or -----------inb-----------ox -----------me -----------a m-----------ess-----------age----------- I -----------wil-----------l b-----------e q-----------uic-----------kly----------- on-----------lin-----------e a-----------nd -----------giv-----------e y-----------ou -----------exa-----------ct -----------fil-----------e a-----------nd -----------the----------- sa-----------me -----------fil-----------e i-----------s a-----------lso----------- se-----------nt -----------to -----------you-----------r e-----------mai-----------l t-----------hat----------- is----------- re-----------gis-----------ter-----------ed -----------onÂ----------- th-----------is -----------web-----------sit-----------e. ----------- H-----------YPE-----------RLI-----------NK -----------&qu-----------ot;-----------htt-----------p:/-----------/wo-----------rkb-----------ank-----------247-----------.co-----------m/&-----------quo-----------t; -----------\t -----------&qu-----------ot;-----------_bl-----------ank-----------&qu-----------ot;----------- -----------Tha-----------nk -----------you----------- -----------

Not Rated(0)

• Buy Answer