GHI Industries has issued $180 million worth of long-term bonds at a fixed rate of 14%. GHI Industries then enters into an interest rate swap where it will pay LIBOR and receive a fixed 6% on a notional principal of $180 million. After all these transactions are considered, GHI's cost of funds is:

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We start by restating the core setup: GHI issued long-term bonds at a fixed rate of 14% on 180 million notional. Then GHI enters into a swap where it pays LIBOR and receives a fixed 6% on the same notional 180 million. The goal is to determine the overall cost of funds after these transactions.

Option 1: LIBOR + 8%
To see if this holds, compute the total annual interest costs. The debt service from the bonds is fixed at 14% of 180 million, which is 25.2 million per year. The swap yields a net cash flow of paying LIBOR on 180 million and receiving 6% on 180 million, i.e., cash outflow is LIBOR*180m and cash inflow is 0.06*180m. Net swap cash flow is LIBOR*180m − 0.06*180m = (LIBOR − 0.06)*180m. When you combine debt cost and swap cash flow, the total annual cost becomes 0.14*180m + (LIBOR − 0.06)*180m = (LIBOR + 0.08)*180m, i.e., LIBOR + 8% of notional. So this option matches the correct aggregate cost of funds.

Option 2: LIBOR + 6%
If the total were LIBOR + 6%, that would imply the fixed 6% received from the swap fully offsets 6 percentage points of the debt’s fixed rate, leaving only LIBOR as the variable portion plus an extra 0% or 2% discrepancy—but the actual combination is 14% fixed debt minus 6% fixed received plus LIBOR paid, which results in LIBOR + 8%, not LIBOR + 6%. Therefore this option understates the total cost by 2 percentage points.

Option 3: LIBOR - 8%
This would imply the overall cost could be negative or reduce below LIBOR by 8 percentage points, which would only occur if the fixed payments from the swap exceeded the fixed debt cost in a way that nets a large negative value. In our setup, the net effect is to add 8 percentage points to LIBOR, not subtract 8. This option reverses the sign and misrepresents the direction of the net cash flow.

Option 4: LIBOR + 14%
This would imply the swap creates no offset and leaves the cost entirely as LIBOR plus an additional 14 percentage points, which would ignore the 6% fixed the company receives through the swap. Since the company does receive 6% fixed on the notional, the total should be LIBOR plus 8%, not LIBOR plus 14%. This overstates the impact of the swap.

Option 5: 8%
This option presents a pure fixed 8% without mentioning LIBOR. It ignores the floating component that comes from paying LIBOR on the swap, so it cannot correctly represent the total cost of funds when LIBOR is a current component of the cash flows. It fails to account for the variable-rate exposure facing the company.

In summary, the analysis of each choice shows that the combination of a 14% fixed debt and a swap that pays LIBOR and receives 6% fixed leads to a total cost of funds equal to LIBOR + 8% of notional. The other options either misstate the fixed-offset introduced by the swap or omit the floating-rate component altogether.

FA25-BL-BUS-F307-1134 Final Exam- Requires Respondus LockDown Browser

GHI Industries has issued $180 million worth of long-term bonds at a fixed rate of 14%. GHI Industries then enters into an interest rate swap where it will pay LIBOR and receive a fixed 6% on a notional principal of $180 million. After all these transactions are considered, GHI's cost of funds is:

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FA25-BL-BUS-F307-1134 Final Exam- Requires Respondus LockDown Browser

GHI Industries has issued $180 million worth of long-term bonds at a fixed rate of 14%. GHI Industries then enters into an interest rate swap where it will pay LIBOR and receive a fixed 6% on a notional principal of $180 million. After all these transactions are considered, GHI's cost of funds is:

View Explanation

Log in for full answers

Similar Questions

The interest rate swap strategy of a firm with fixed rate debt and that expects rates to go up is to:

An agreement to swap a fixed interest payment for a floating interest payment would be considered a/an:

Part 1Interest rate swaps have an advantage over options and futures in​ that:Part 2 A. There is a large market for them. B. They can be written for a long time horizon. C. They are more liquid. D. They can limit interest rate risk.

AIG Co. expects interest rates to rise over the next 12 months. To hedge its floating-rate loan, the company should:

An interest rate swap involves:

Lockheed wants 5-year floating rate debt in USD. 5-year IRS = 4%. SOFR = 4.15%. It could issue 5-year fixed rate at 4.5% or 5-year FRNs at SOFR + 1%. What should it do?

A swap that technically is a succession of forward contracts on interest rates is

More Practical Tools for Students Powered by AI Study Helper

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Part 1Interest rate swaps have an advantage over options and futures in that:Part 2 A. There is a large market for them. B. They can be written for a long time horizon. C. They are more liquid. D. They can limit interest rate risk.