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.

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.

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.

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?