Question

Café Costa Rica" company wishes to raise $15,000,000 with debt financing. The treasurer of the company considers two possible instruments: i. A 4-year floating-rate note at 1.5% above the one-year dollar LIBOR rate on which interest is paid semiannually—no issuance costs. ii. A 4-year bond with an annual coupon rate of 2% paid quarterly and an issuance cost of 0.5% of the issuance proceeds. Currently, the dollar LIBOR is 1.0%. b. Suppose the treasurer believes that the one-year LIBOR rate one year from now will rise to 3.50%. After that, the LIBOR rate is forecast to be 2.00% and 1.50% for years 3 and 4, respectively. Which security has the lowest expected "all in cost" (AIC)? a. Floating-rate note b. Bond

Answer 1

The all in cost' (AIC) of two debt instruments for 'Café Costa Rica' involves analyzing the variable interest payments of a floating-rate note against the fixed payments of a quarterly bond, accounting for future LIBOR rate changes and issuance costs. A basic understanding of bonds and present discounted value is beneficial for computations related to such financial decisions. Examining similar scenarios provides insight into how changes in interest rates affect the value of bonds.

Step-by-step explanation:

The question at hand deals with determining the expected "all in cost" (AIC) of two debt instruments for the 'Café Costa Rica' company. To facilitate this, we need to appreciate the distinct components of each financing option and how they are influenced by the anticipated changes in the LIBOR rate.

For the floating-rate note, the interest payments will vary according to the future LIBOR rates as provided: 1.5% above 1.0% for the first year (total 2.5%), 1.5% above 3.5% for the second year (total 5.0%), and so forth.

Given the semiannual nature of payments, these rates would need to be halved for each period's calculation. For the quarterly bond, the coupon rate is fixed at 2% annually, but with the added complexity of an initial issuance cost of 0.5%.

Let us consider a simplified two-year bond example for instructional purposes. Such a bond pays 8% interest annually. If $3,000 is the principal, it will pay $240 (8% of $3,000) each year.

To find its present value at a discount rate of 8%, we attribute the current value of the interest payments and the principal at the end of the term. If the discount rate increased to 11%, the present value of the bond would decrease accordingly, as higher discount rates lead to lower present values of future cash flows.

The same logic would apply when assessing the present discounted value of future payments for the options provided by 'Café Costa Rica'.

Now, turning to a different ten-year bond example, suppose a local water company issued a $10,000 bond at 6%, and you consider purchasing it one year before maturity when the market interest rate is 9%.

With the rise in market rates, one would pay less than the bond's face value since the fixed payments are now less appealing compared to new bonds that offer higher yields at 9%.