Challenge/Optional - Adopted from ACCA AFM June 2012

Sembilan Co, a listed company, recently issued debt finance to acquire assets in order to increase
its activity levels. This debt finance is in the form of a floating rate bond, with a face value of $320
million, redeemable in four years. The bond interest, payable annually, is based on the spot yield
curve plus 60 basis points. The next annual payment is due at the end of year one.

Sembilan Co is concerned that the expected rise in interest rates over the coming few years would
make it increasingly difficult to pay the interest due. It is therefore proposing to either swap the
floating rate interest payment to a fixed rate payment, or to raise new equity capital and use that to
pay off the floating rate bond. The new equity capital would either be issued as rights to the
existing shareholders or as shares to new shareholders.

Ratus Bank has offered Sembilan Co an interest rate swap, whereby Sembilan Co would pay Ratus
Bank interest based on an equivalent fixed annual rate of 3.7625% in exchange for receiving a
variable amount based on the current yield curve rate. Payments and receipts will be made at the
end of each year, for the next four years. Ratus Bank will charge an annual fee of 20 basis points if
the swap is agreed. The current annual spot yield curve rates are as follows:
Year One Two Three Four

Rate 2.5% 3.1% 3.5% 3.8%

The current annual forward rates for years two, three and four are as follows:
Year Two Three Four

Rate 3.7% 4.3% 4.7%

Required:

(a) Explain the relation between current annual spot yield curve rates and current annual forward
rates.

(b) Based on the above information, calculate the amounts Sembilan Co expects to pay or receive
every year on the swap (excluding the fee of 20 basis points). Explain why the fixed annual rate of
interest of 3.7625% is less than the four-year yield curve rate of 3.8%.

(b) Demonstrate that Sembilan Co’s interest payment liability does not change, after it has
undertaken the swap, whether the interest rates increase or decrease.

(c) Discuss the factors that Sembilan Co should consider when deciding whether it should raise
equity capital to pay off the floating rate debt.
Solution:

(a) The forward rate, in simple terms, is the calculated expectation of the yield on a bond that,
theoretically, will occur in the immediate future, usually a few months (or even a few years) from
the time of calculation. The consideration of the forward rate is almost exclusively used when
talking about the purchase of Treasury bills. The yield curve clearly identifies what present-day
bond prices and interest rates are. It also goes beyond that by providing reasonable suggestions for
what the market postulates future interest rates are likely to be. The nature of the yield curve lends
itself to being a near-perfect metric for determining the forward rate (Refer to Week 4 the
expectations hypothesis). For example: year two 3.7% the forward rate can be calculated based on
spot yield curve (1+3.1%)^2 = (1+2.5%)*(1+3.7%).

(b) Gross amounts of annual interest receivable by Sembilan Co from Ratus Bank based on year 1
spot rate and years 2, 3 and 4 forward rates:

Year 1 0.025 x $320m = $8m

Year 2 0.037 x $320m = $11.84m

Year 3 0.043 x $320m = $13.76m

Year 4 0.047 x $320m = $15.04m

Gross amount of annual interest payable by Sembilan Co to Ratus Bank:

3.7625% x $320m = $12.04m

At the start of the swap, Sembilan Co will expect to receive or (pay) the following net amounts at
the end of each of the next four years:

Year 1: $8m – $12.04m = $(4.04m) payment

Year 2: $11.84m – $12.04m = $(0.20m) payment

Year 3: $13.76m – $12.04m = $1.72m receipt

Year 4: $15.04m – $12.04m = $3m receipt

The reason the equivalent fixed rate of 3.7625% is less than the 3.8% four-year yield curve rate, is
because the 3.8% rate reflects the zero-coupon rate with only one payment made in year four. Here
the bond pays coupons at different time periods when the yield curve rates are lower. Therefore the
fixed rate is lower.

(c) After taking the swap, Sembilan Co’s net effect is as follows:
 % Impact Yield Interest 3% Yield Interest 4%

Borrow at yield interest + 60bp (Yield+0.6)% 320m * 3.06% = -$11.52m $(14.72m)

Receive yield Yield 320m * 3% = $9.6m $12.8m

Pay fixed 3.7625% (3.7625)% 320m * 3.7625% = -$12.04m $(12.04m)

Fee 20bp (0.2)% 320m * 0.2% = -$0.64m $(0.64m)

Net Cost (4.5625)% $(14.6m) $(14.6m)

(d) Reducing the amount of debt by issuing equity and using the cash raised from this to reduce the
amount borrowed changes the capital structure of a company and Sembilan Co needs to consider all
the possible implications of this.

As the proportion of debt increases in a company’s financial structure, the level of financial distress
increases and with it the associated costs. Companies with high levels of financial distress would
find it more costly to contract with their stakeholders.

For example, they may have to pay higher wages to attract the right calibre of employees, give
customers longer credit periods or larger discounts, and may have to accept supplies on more
onerous terms.

Furthermore, restrictive covenants may make it more difficult to borrow funds (debt and equity) for
future projects. On the other hand, because interest is payable before tax, larger amounts of debt
will give companies greater taxation benefits, known as the tax shield.

Presumably, Sembilan Co has judged the balance between the levels of equity and debt finance,
such that the positive and negative effects of gearing result in minimising the required rate of return
and maximising the value of the company.

By replacing debt with equity the balance may no longer be optimal and therefore the value of
Sembilan Co may not be maximised. However, reducing the amount of debt would result in a
higher credit rating for the company and reduce the scale of restrictive covenants.

Having greater equity would also increase the company’s debt capacity. This may enable the
company to raise additional finance and undertake future profitable projects more easily. Less
financial distress may also reduce the costs of contracting with stakeholders.

The process of changing the financial structure can be expensive. Sembilan Co needs to determine
the costs associated with early redemption of debt. The contractual clauses of the bond should
indicate the level and amount of early redemption penalties.
Issuing new equity can be expensive especially if the shares are offered to new shareholders, such
as costs associated with underwriting the issue and communicating or negotiating the share price.
Even raising funds by issuing rights can be expensive.

As well as this, Sembilan Co needs to determine the extent to which the current shareholders will
be able to take up the rights and the amount of discount that needs to be given on the rights issue to
ensure 100% take up.

The impact on the current share price from the issue of rights needs to be considered as well.
Studies on rights issues seem to indicate that the markets view the issue of rights as a positive
signal and the share price does not reduce to the expected theoretical ex-rights price.

However, this is mainly because the markets expect the funds raised to be used on new, profitable
projects. Using funds to reduce the debt amount may not be viewed so positively.

Sembilan Co may also have to provide information and justification to the market because both the
existing shareholders and any new shareholders will need to be assured that the company is not
benefiting one group at the expense of the other.

If sufficient information is not provided then either shareholder group may discount the share price
due to information asymmetry. However, providing too much information may reduce the
competitive position of the company.