On January 15, a firm takes out a loan of $30 million, with interest payments to be made on April 16, July 15, October 14, and the following January 15, when the principal will be repaid. Interest will be paid at LIBOR based on the rate at the exact number of days and 360-day year. The firm wants to buy a cap with an exercise rate of 10 percent and a premium of $125,000 but is concerned about the cost. Its bank suggests that the firm sell a floor with an exercise rate of 9 percent for the same premium. The current LIBOR is 10 percent. Determine the firm’s cash flows on the loan if LIBOR turns out to be 11.35 percent on April 16, 10.2 percent on July 15, and 8.86 percent on October 14. If you have a financial calculator or spreadsheet, determine the internal rate of return and annualize it to determine the cost of borrowing.
Interest Cap Floor Principal With Collar
Date Days LIBOR Payment Payment Payment Repayment Net Cash Flow
1/15 –– 10.00 $125,000 –125,000 125,000 0 30,000,000
4/16 91 11.35
7/15 90 10.20
10/14 91 8.86
1/15 93 ––