Hauser Corporation has $20,000,000 of outstanding debt that bears interest at a variable rate and matures on June 30, 2018. At inception of the debt, the company had a lower credit rating, and most available financing carried a variable rate. The company’s variable rate is the LIBOR rate plus 1%. However, the company’s credit rating has improved, and the company feels that a fixed, lower rate of interest would be most appropriate. Furthermore, the company is of the opinion that variable rates will increase over the next 24 months. In May 2016, the company negotiated with First Bank of Boston an interest rate swap that would allow the company to pay a fixed rate of 7% in exchange for receiving interest based on the LIBOR rate. The terms of the swap call for settlement at the end of June and December, which coincides with the company’s interest payment dates. The variable rates are reset at the end of each 6-month period for the following 6-month period. The terms of the swap are effective for the 6-month period beginning July 2016.The hedging relationship has been properly documented, and management has concluded that the hedge will be highly effective in offsetting changes in the cash flows due to changes in interest rates. The criteria for special accounting have been satisfied. June 30, 2016 Dec. 31, 2016 June 30, 2017 Dec. 31, 2017 LIBOR rate Swap value 7.0% 7.1% $27,990 6.9% $(19,011) 6.8% $(19,342) 1. Prepare the necessary entries to record the activities related to the debt and the hedge from July 1, 2016, through June 30, 2018.2. Prepare a schedule to evaluate the positive or negative impact the hedge had on each 6- month period of earnings.3. What would the LIBOR rate on December 31, 2017, have had to be in order for the interest expense to be the same whether or not there was a cash flow hedge?
Cost of Capital
Shareholders and investors who invest into the capital of the firm desire to have a suitable return on their investment funding. The cost of capital reflects what shareholders expect. It is a discount rate for converting expected cash flow into present cash flow.
Capital Structure
Capital structure is the combination of debt and equity employed by an organization in order to take care of its operations. It is an important concept in corporate finance and is expressed in the form of a debt-equity ratio.
Weighted Average Cost of Capital
The Weighted Average Cost of Capital is a tool used for calculating the cost of capital for a firm wherein proportional weightage is assigned to each category of capital. It can also be defined as the average amount that a firm needs to pay its stakeholders and for its security to finance the assets. The most commonly used sources of capital include common stocks, bonds, long-term debts, etc. The increase in weighted average cost of capital is an indicator of a decrease in the valuation of a firm and an increase in its risk.
Hauser Corporation has $20,000,000 of outstanding debt that bears interest at a variable rate and matures on June 30, 2018. At inception of the debt, the company had a lower credit rating, and most available financing carried a variable rate. The company’s variable rate is the LIBOR rate plus 1%. However, the company’s credit rating has improved, and the company feels that a fixed, lower rate of interest would be most appropriate. Furthermore, the company is of the opinion that variable rates will increase over the next 24 months. In May 2016, the company negotiated with First Bank of Boston an interest rate swap that would allow the company to pay a fixed rate of 7% in exchange for receiving interest based on the LIBOR rate. The terms of the swap call for settlement at the end of June and December, which coincides with the company’s interest payment dates. The variable rates are reset at the end of each 6-month period for the following 6-month period. The terms of the swap are effective for the 6-month period beginning July 2016.
The hedging relationship has been properly documented, and management has concluded that the hedge will be highly effective in offsetting changes in the cash flows due to changes in interest rates. The criteria for special accounting have been satisfied.
| June 30, 2016 | Dec. 31, 2016 | June 30, 2017 | Dec. 31, 2017 | |
|
LIBOR rate Swap value |
7.0%
|
7.1% $27,990 |
6.9% $(19,011) |
6.8% $(19,342) |
1. Prepare the necessary entries to record the activities related to the debt and the hedge from July 1, 2016, through June 30, 2018.
2. Prepare a schedule to evaluate the positive or negative impact the hedge had on each 6- month period of earnings.
3. What would the LIBOR rate on December 31, 2017, have had to be in order for the interest expense to be the same whether or not there was a cash flow hedge?
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