Question

(Fair Value Hedge) On January 2, 2017, MacCloud Co. issued a 4-year, \(100,000 note at 6% fixed interest, interest

payable semiannually. MacCloud now wants to change the note to a variable-rate note.

As a result, on January 2, 2017, MacCloud Co. enters into an interest rate swap where it agrees to receive 6% fixed and pay

LIBOR of 5.7% for the first 6 months on \)100,000. At each 6-month period, the variable rate will be reset. The variable rate is reset

to 6.7% on June 30, 2017.

Instructions

(a) Compute the net interest expense to be reported for this note and related swap transaction as of June 30, 2017.

(b) Compute the net interest expense to be reported for this note and related swap transaction as of December 31, 2017

Short answer

1. Interest expense is $150
2. Interest received is $350

Step-by-step solution

Net interest expense on June 30, 2017

In this, first of all, the Interest received by Mac Cloud is calculated,

$\begin{array}{rcl}\mathrm{Interest}\mathrm{Revenue}& =& \mathrm{amount}\mathrm{of}\mathrm{note}\times \mathrm{interest}\mathrm{rate}\times \frac{6}{12}\\ & =& \$100,000\times 6\%\times \frac{6}{12}\\ & =& \$3,000\end{array}$

Now, the payment made is calculated.

$\begin{array}{rcl}\mathrm{Interest}\mathrm{Paid}& =& \mathrm{amount}\mathrm{of}\mathrm{note}\times \mathrm{interest}\mathrm{rate}\times \frac{6}{12}\\ & =& \$100,000\times 5.7\%\times \frac{6}{12}\\ & =& \$2,850\end{array}$

The amount of interest received is more than the amount of interest paid. Hence, Mac Cloud needs to pay interest.

$\begin{array}{rcl}\mathrm{Interest}\mathrm{payable}& =& \mathrm{Interest}\mathrm{received}-\mathrm{Interest}\mathrm{paid}\\ & =& \$3,000-\$2,850\\ & =& \$150\end{array}$

Hence, the interest expense is $150

Net interest expense on December 2017

The interest received semi-yearly is $3,000, now the interest payment is calculated.

$\begin{array}{rcl}\mathrm{Interest}\mathrm{payment}& =& \mathrm{Amount}\mathrm{of}\mathrm{notes}\times \mathrm{interest}\mathrm{rate}\times \frac{6}{12}\\ & =& \$100,000\times 6.7\%\times \frac{6}{12}\\ & =& \$3,350\end{array}$

This amount paid is greater than the amount received; hence interest income is $350.