Question 2.5: Bolt Industries is facing increased competition and wants to...
Bolt Industries is facing increased competition and wants to borrow $10 million in cash to protect against future revenue shortfalls. Currently, long-term AA rates are 10%. Given its credit rating, Bolt can borrow at 10.5%. The company is expecting interest rates to fall over the next few years, so it would prefer to borrow at short-term rates and refinance after rates drop. However, Bolt’s management is afraid that its credit rating may deteriorate as competition intensifies, which may greatly increase the spread the firm must pay on a new loan. How can Bolt benefit from declining interest rates without worrying about changes in its credit rating?
Plan
Bolt wants to convert its long-term fixed rate into a floating rate (one that will decline if market interest rates decline). It can do this by entering into a swap where it will receive a fixed rate (which can then be used to pay its fixed long-term obligation) and pay a floating rate. Its net exposure will be the floating rate.
Execute
Bolt can borrow at the long-term rate of 10.5% and then enter into a swap in which it receives the long-term AA fixed rate of 10% and pays the short-term rate \tilde{r_t} . Its net borrowing cost will then be:
Long-Term +Floating Rate -Fixed Rate Received = Net Borrowing Cost
Loan Rate Due on Swap from Swap
10.5% +\tilde{r_t} -10% =\tilde{r_t} +0.5\%
Evaluate
In this way, Bolt locks in its current credit spread of 0.5% but gets the benefit of lower rates as rates decline. The tradeoff is that if rates increase instead, the firm is worse off.