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Katangwa Limited will need to borrow ₦50 million in three months’ time for a period of six months. The company is concerned that interest rates are expected to rise over the next few months.
Interest rates and forward rate agreements (FRAs) are currently quoted as follows:
Required:
a. Explain how a forward rate agreement (FRA) may be useful to the company. Illustrate this on the basis that interest rates: i. Rise to 6.50% ii. Fall to 4.50%
(8 Marks)
b. Compare the use of interest rate futures with FRA in this instance. (4 Marks)
c. Explain how interest rate guarantees or a short-term interest rate cap could be used. (3 Marks)
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Kazaure Limited has a cash surplus of N20m, which the financial manager is keen to invest in corporate bonds. He has identified two potential investment opportunities in two different companies which are both rated A by the major credit rating agencies.
Bond A: The issuer plans to raise an N500m 2-year bond with a coupon rate of 10%. The bond is redeemable at a premium of 8% to nominal value.
Bond B: The issuer plans to raise an N800m 3-year bond with a coupon rate of 12% and redeemable at par.
The annual spot yield curve for government bonds is:
| Term | Spot Yield |
|---|---|
| 1-Year | 9.50% |
| 2-Year | 10.40% |
| 3-Year | 10.50% |
Extract from a major credit rating agency’s website:
| Rating | 1-Year Spread | 2-Year Spread | 3-Year Spread |
|---|---|---|---|
| AAA | 6 | 16 | 28 |
| AA | 15 | 25 | 40 |
| A | 20 | 30 | 50 |
Required:
a. For a nominal value of N1,000, calculate the theoretical issue prices of the two bonds and indicate how many of each of the bonds Kazaure Limited can buy, assuming it invests in only one of them. (5 Marks)
Note: Calculate issue prices to the nearest Naira.
b. Irrespective of your answer in (a), assume Bond A is issued at ₦1,054 and Bond B is issued at N1,026. Calculate the yield to maturity of each bond at the time of issue. (5 Marks)
c. Calculate the duration of each bond. What does duration measure? (6 Marks)
d. If you expect interest rates to increase in the market, which of the two bonds, A or B, would you like to buy and why? (4 Marks)
Note: No calculation is required.
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b) Most large companies maintain a treasury department to handle some specialized functions in finance. One of such functions is the management of financial risk, which includes interest rate risk.
Required:
Explain interest rate risk and suggest two ways of managing an entity’s exposure to interest rate risk. (5 marks)
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Exactly two years ago, JBL Plc took a 5-year US$ 20 million loan at a fixed interest of 12% from an investment bank to finance a plant expansion project. At the time the loan was taken, JBL was exporting a significant proportion of its output to a foreign market. Thus, it was sure that it would be able to earn U.S. dollars to make dollar payments on the loan. For about a year now, JBL has not been able to export its output to its foreign market due to trade restrictions. It sells only to buyers in Ghana for the Ghana cedi. The company now prefers to have its interest obligation in Ghana cedi rather than U.S. dollar.
On the advice of the Treasury Manager, JBL has entered a currency swap arrangement with a bank to manage the underlying risk exposure. Per the terms of the swap, JBL will continue to honour its obligations under the actual loan. Under the swap, JBL and the bank will exchange interests and principals in the appropriate currencies. With a pre-arranged exchange rate of GH¢6.5000/USD1, the notional principals under the swap arrangement are agreed at US$20 million and GH¢130 million. The 12% interest rate on the existing dollar loan will continue to apply to both the original dollar loan and the dollar interest payments under the swap arrangement. The interest rate that will apply to the cedi notional principal is set to 15%.
Required:
Evaluate how JBL Plc can use the currency swap to manage the underlying risk exposure. (5 marks)
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a) Sevista Ltd is evaluating the purchase of a new machine to produce product SEP, which has a short product life-cycle due to rapidly changing technology. The machine is expected to cost GH¢1 million. Production and sales of product SEP are forecasted to be as follows:
| Year | Production and sales (units/year) |
|---|---|
| 1 | 35,000 |
| 2 | 53,000 |
| 3 | 75,000 |
| 4 | 36,000 |
The selling price of product SEP (in current price terms) will be GH¢20 per unit, while the variable cost of the product (in current price terms) will be GH¢12 per unit. Selling price inflation is expected to be 4% per year and variable cost inflation is expected to be 5% per year. No increase in existing fixed costs is expected since Sevista Ltd has spare capacity in both space and labour terms. Producing and selling product SEP will call for increased investment in working capital.
Analysis of historical levels of working capital within Sevista Ltd indicates that at the start of each year, investment in working capital for product SEP will need to be 7% of sales revenue for that year. Sevista Ltd pays tax of 25% per year in the year in which the taxable profit occurs. The new machine is expected to have no scrap value at the end of the four-year period. Sevista Ltd uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.
Required:
i) Determine the net present value of the proposed investment in product SEP.
(13 marks)
ii) Advise whether the project should be undertaken.
(2 marks)
b) Fluctuations in interest rates are a major concern to entrepreneurs and business executives. It has been observed that interest rates on loans vary according to the term of the loan. Besides, interest rates vary over time for varied reasons.
Required:
i) Explain THREE (3) reasons why interest rates on loans may differ for different maturities as explained by the term structure of interest rates.
(6 marks)
ii) Suggest FOUR (4) ways of hedging the company’s exposure to interest rate risk.
(4 marks)
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Katangwa Limited will need to borrow ₦50 million in three months’ time for a period of six months. The company is concerned that interest rates are expected to rise over the next few months.
Interest rates and forward rate agreements (FRAs) are currently quoted as follows:
Required:
a. Explain how a forward rate agreement (FRA) may be useful to the company. Illustrate this on the basis that interest rates: i. Rise to 6.50% ii. Fall to 4.50%
(8 Marks)
b. Compare the use of interest rate futures with FRA in this instance. (4 Marks)
c. Explain how interest rate guarantees or a short-term interest rate cap could be used. (3 Marks)
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Kazaure Limited has a cash surplus of N20m, which the financial manager is keen to invest in corporate bonds. He has identified two potential investment opportunities in two different companies which are both rated A by the major credit rating agencies.
Bond A: The issuer plans to raise an N500m 2-year bond with a coupon rate of 10%. The bond is redeemable at a premium of 8% to nominal value.
Bond B: The issuer plans to raise an N800m 3-year bond with a coupon rate of 12% and redeemable at par.
The annual spot yield curve for government bonds is:
| Term | Spot Yield |
|---|---|
| 1-Year | 9.50% |
| 2-Year | 10.40% |
| 3-Year | 10.50% |
Extract from a major credit rating agency’s website:
| Rating | 1-Year Spread | 2-Year Spread | 3-Year Spread |
|---|---|---|---|
| AAA | 6 | 16 | 28 |
| AA | 15 | 25 | 40 |
| A | 20 | 30 | 50 |
Required:
a. For a nominal value of N1,000, calculate the theoretical issue prices of the two bonds and indicate how many of each of the bonds Kazaure Limited can buy, assuming it invests in only one of them. (5 Marks)
Note: Calculate issue prices to the nearest Naira.
b. Irrespective of your answer in (a), assume Bond A is issued at ₦1,054 and Bond B is issued at N1,026. Calculate the yield to maturity of each bond at the time of issue. (5 Marks)
c. Calculate the duration of each bond. What does duration measure? (6 Marks)
d. If you expect interest rates to increase in the market, which of the two bonds, A or B, would you like to buy and why? (4 Marks)
Note: No calculation is required.
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b) Most large companies maintain a treasury department to handle some specialized functions in finance. One of such functions is the management of financial risk, which includes interest rate risk.
Required:
Explain interest rate risk and suggest two ways of managing an entity’s exposure to interest rate risk. (5 marks)
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Exactly two years ago, JBL Plc took a 5-year US$ 20 million loan at a fixed interest of 12% from an investment bank to finance a plant expansion project. At the time the loan was taken, JBL was exporting a significant proportion of its output to a foreign market. Thus, it was sure that it would be able to earn U.S. dollars to make dollar payments on the loan. For about a year now, JBL has not been able to export its output to its foreign market due to trade restrictions. It sells only to buyers in Ghana for the Ghana cedi. The company now prefers to have its interest obligation in Ghana cedi rather than U.S. dollar.
On the advice of the Treasury Manager, JBL has entered a currency swap arrangement with a bank to manage the underlying risk exposure. Per the terms of the swap, JBL will continue to honour its obligations under the actual loan. Under the swap, JBL and the bank will exchange interests and principals in the appropriate currencies. With a pre-arranged exchange rate of GH¢6.5000/USD1, the notional principals under the swap arrangement are agreed at US$20 million and GH¢130 million. The 12% interest rate on the existing dollar loan will continue to apply to both the original dollar loan and the dollar interest payments under the swap arrangement. The interest rate that will apply to the cedi notional principal is set to 15%.
Required:
Evaluate how JBL Plc can use the currency swap to manage the underlying risk exposure. (5 marks)
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a) Sevista Ltd is evaluating the purchase of a new machine to produce product SEP, which has a short product life-cycle due to rapidly changing technology. The machine is expected to cost GH¢1 million. Production and sales of product SEP are forecasted to be as follows:
| Year | Production and sales (units/year) |
|---|---|
| 1 | 35,000 |
| 2 | 53,000 |
| 3 | 75,000 |
| 4 | 36,000 |
The selling price of product SEP (in current price terms) will be GH¢20 per unit, while the variable cost of the product (in current price terms) will be GH¢12 per unit. Selling price inflation is expected to be 4% per year and variable cost inflation is expected to be 5% per year. No increase in existing fixed costs is expected since Sevista Ltd has spare capacity in both space and labour terms. Producing and selling product SEP will call for increased investment in working capital.
Analysis of historical levels of working capital within Sevista Ltd indicates that at the start of each year, investment in working capital for product SEP will need to be 7% of sales revenue for that year. Sevista Ltd pays tax of 25% per year in the year in which the taxable profit occurs. The new machine is expected to have no scrap value at the end of the four-year period. Sevista Ltd uses a nominal (money terms) after-tax cost of capital of 12% for investment appraisal purposes.
Required:
i) Determine the net present value of the proposed investment in product SEP.
(13 marks)
ii) Advise whether the project should be undertaken.
(2 marks)
b) Fluctuations in interest rates are a major concern to entrepreneurs and business executives. It has been observed that interest rates on loans vary according to the term of the loan. Besides, interest rates vary over time for varied reasons.
Required:
i) Explain THREE (3) reasons why interest rates on loans may differ for different maturities as explained by the term structure of interest rates.
(6 marks)
ii) Suggest FOUR (4) ways of hedging the company’s exposure to interest rate risk.
(4 marks)
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