Pierce Control Systems With $10 million in debt coming due, Sam Fenton was consi
ID: 2743862 • Letter: P
Question
Pierce Control Systems
With $10 million in debt coming due, Sam Fenton was considering two options. One was to reborrow the money on a five year basis with Prudential Insurance Company, a major lender to emerging firms. The loan would carry a flat 8 percent rate over the next five years. The principal would be due at the end of the life of the loan.
Sam considered the first option described above as relatively long term in nature. It would ensure that the firm would have adequate financing through 2021. A second option would be to borrow the money from a bank on a short term basis. Although banks normally lend funds for 90 to 180 day periods, he intended to ask for a one-year loan. He then would renew the loan each year over the five-year period. The loan officer at Bank of America told Sam that the bank always floats the interest rate on its loans with the prime interest rate. Right now, the prime interest rate was 6 percent or a full 2 percent less than the rate Sam would have to pay on the longer-term insurance company loan.
Furthermore, If Sam maintained compensating balance on 10 percent of the loan outstanding, the interest rate charge would be reduced to ½ percent below prime, or to 5 ½ percent. Clearly, there appeared to be a financial advantage to borrowing the money short term, but Sam also remembered that the prime interest rate could be quite volatile and had reached 20 percent back in 1981. He would look pretty foolish tom his boss. William Pierce III, if he were being forced to pay that kind of interest at some point in the future.
Sam Fenton was also concerned about the danger of a future credit crunch in the economy, as was witness in 2007 and 2008. At times banks become very hesitant to make loans because of an overabundance of bad loans already on their books and fears of federal regulators criticizing them. This is particularly true when the economy is in a recession and bank loan officers are fearful about future business conditions.
5.Assume the following projected interest rates for the prime rate over the next five years, what would be the total interest cost on the $10 million loan over that period? (Disregard the compensating balance alternative for purpose of this question.) How does this compare to the total dollar cost of the five-year, 8 percent insurance company loan?
Projected Prime
Year Interest Rate
2017 6%
2018 8%
2019 9%
2020 9%
2021 4%
6. As a second scenario. assume the prime rate would move more dramatically, as shown below:
Projected Prime
Year Interest Rate
2017 6%
2018 10%
2019 15%
2020 13%
2021 13%
What would be the total dollar cost under the five-year bank loan? How does this compare to the total dollar cost of the five-year insurance company loan?
7. With a probability of 70 percent of the interest rate scenario in question 5 and a 30 percent probability of the interest rate scenario in questions 6, what is the expected value of the dollar interest cost of short-term borrowing? Is this higher or lower than the total dollar interest cost of tge five-year insurance company loan?
8. At what relative probability between the two scenarious would the firm be indifferent between short-term and long-term borrowing?
9. Briefly explain how hedging can help the firm reduce the risk associated with the short-term borrowing arrangement.
Explanation / Answer
Answer 5 Calculation of the Interest cost if Sam takes loan from the bank Year Principal Interest rate Interest 2017 10000000 6 600000 2018 10000000 8 800000 2019 10000000 9 900000 2020 10000000 9 900000 2021 10000000 4 400000 3600000 Total Cost if borrowed from Insurance company Principal 10000000 Interest 8% Years 5 Interest Cost 10000000*8%*5 4000000 On comparison with the between to option we find that in bank option the Interest cost is lower Answer 6 Year Principal Interest rate Interest 2017 10000000 5.5 550000 2018 10000000 9.5 950000 2019 10000000 14.5 1450000 2020 10000000 12.5 1250000 2021 10000000 12.5 1250000 5450000 Total Cost if borrowed from Insurance company Principal 10000000 Interest 8% Years 5 Interest Cost 10000000*8%*5 4000000 On comparison with the between to option we find that in Insurance company option the Interest cost is lower Answer 7 Scenario Probability (P) Interest cost (I) I*P Que 5 0.7 3600000 2520000 Que 6 0.3 5450000 1635000 4155000 Total Cost if borrowed from Insurance company Principal 10000000 Interest 8% Years 5 Interest Cost 10000000*8%*5 4000000 On comparison with the between to option we find that in bank option the Interest cost is higher Answer 8 For calculation of relative propability , let us assume that the probability of Scenario of Que 5 is X , therefore probability of scenario of que 6 will be 1-X Now , the equation will be , 3600000X+5450000(1-X)=4000000 3600000X+5450000-5450000X=4000000 1850000X= 1450000 X= 0.783784 X=78.3784% Probability of Scenarion in Que 5 will be = 78.3784% Probability of Scenarion in Que 6 will be = (1-0.783784)=0.216216=21.6216% Scenario Probability (P) Interest cost (I) I*P Que 5 0.783784 3600000 2821622 Que 6 0.216216 5450000 1178377 4000000 Answer 9 Sam can adopt any of the following Hedging option in order to reduce the risk associated with the short term borrowing arragement 1) Go for Forward rate arrangement with the party in which he made a contract with the counter party that he will pay a certain fixed Interest rate and on contary the party will pay Floating interest rate. 2) Go for Future contract - It is same as Forward rate arrangement but in this there will no chance of counter party default or any liquidity issue. 3) Another type of hedging instrument are which Sam can consider ia a) Interest rate Swap and b) Interest rate options.