Question

(Cash Flow Hedge) On January 2, 2017, Parton Company issues a 5-year, \(10,000,000 note at LIBOR, with

interest paid annually. The variable rate is reset at the end of each year. The LIBOR rate for the first year is 5.8%.

Parton Company decides it prefers fixed-rate financing and wants to lock in a rate of 6%. As a result, Parton enters into an

interest rate swap to pay 6% fixed and receive LIBOR based on \)10 million. The variable rate is reset to 6.6% on January 2, 2018.

Instructions

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

(b) Compute the net interest expense to be reported for this note and related swap transactions as of December 31, 2018.

Short answer

1. Interest received is $20,000
2. Interest paid is $60,000

Step-by-step solution

Net interest expense on December 31, 2017

In this, first of all, the Interest paid by Parton is calculated,

$\begin{array}{rcl}\mathrm{Interest}\mathrm{Payment}& =& \mathrm{notes}\mathrm{amount}\times \mathrm{interest}\mathrm{rate}\\ & =& \$10,000,000\times 6\%\\ & =& \$600,000\end{array}$

Now, the payment received is calculated.

$\begin{array}{rcl}\mathrm{Interest}\mathrm{Received}& =& \mathrm{notes}\mathrm{amount}\times \mathrm{interest}\mathrm{rate}\\ & =& \$10,000,000\times 5.8\%\\ & =& \$580,000\end{array}$

In this, the amount paid as interest is more than the interest received; hence, Parton receives $20,000 interest on the settlement.

Net interest expense on December 31, 2018

Interest paid by Parton is $600,000. After this, the interest received by Parton is calculated.

$\begin{array}{rcl}\mathrm{Interest}\mathrm{Received}& =& \mathrm{amount}\mathrm{of}\mathrm{notes}\times \mathrm{interest}\mathrm{rate}\\ & =& \$10,000,000\times 6.6\%\\ & =& \$660,000\end{array}$

This amount received is greater than the amount paid; hence, the interest expense is $60,000.