Question

On January 2, 2020, Whispering Company issues a 5-year, $10,300,000 note at LIBOR, with interest paid annually. The variable rate is reset at the end of each year. The LIBOR rate for the first year is 6.70%. Whispering Company decides it prefers fixed-rate financing and wants to lock in a rate of 7%. As a result, Whispering enters into an interest rate swap to pay 7% fixed and receive LIBOR based on $10.3 million. The variable rate is reset to 7.50% on January 2, 2021.

(a) Compute the net interest expense to be reported for this note and related swap transactions as of December 31, 2020.

Answer 1

The net interest expense for Whispering Company as of December 31, 2020, after entering into an interest rate swap, is $30,900, which is the difference between the fixed 7% interest rate paid ($721,000) and the LIBOR-based interest rate received ($690,100).

Step-by-step explanation:

The net interest expense to be reported by Whispering Company for the note and related swap transactions on December 31, 2020, can be calculated by first determining the interest expense for the year at the original LIBOR rate and then adjusting for the interest received and paid under the swap agreement.

For the original note, Whispering would have incurred an interest expense of 6.70% on $10,300,000, which is $690,100. However, with the swap, Whispering would receive that same amount (since LIBOR applies to the swap contract too, for the first year), but it would then pay 7% on the $10,300,000 as per the fixed rate decided in the swap, amounting to $721,000. The net interest expense for Whispering Company as of December 31, 2020, would therefore be the difference between the interest paid and the interest received, which is $721,000 (paid) - $690,100 (received), or $30,900.