Reference no: EM132473778

Problem: Lapareta Inc. has received a loan offer with principal €5 million and 4-year repayment plan through a floating rate basis. In the meantime, there are concerns about rising interest costs. Lapareta is now considering hedging against a rise in euro-LIBOR through Forward Rate Agreement (FRA) with an insurance company. According to the agreement, Lapareta would pay to the insurance company at the end of each year the difference between its initial interest cost (at LIBOR + 2.50%) and any fall in interest cost due to a fall in LIBOR. Conversely, the insurance company would pay to Lapareta 70% of the difference between Lapareta's initial interest cost and any increase in interest costs caused by a rise in LIBOR.

Purchase of the floating Rate Agreement will cost €100,000, paid at the time of the initial loan. 

a) What are Lapareta's All-in-Cost today if LIBOR rises ( for 0.5% each year) and if LIBOR falls(for 0.5% each year)? (Lapareta uses 12% as its weighted average cost of capital.)

b) Do you recommend that Lapareta purchase the FRA?

Assumptions

Values

Principal borrowing need € 5,000,000

Current LIBOR 4.000%

bank spread  2.500%

Proportion of differential paid by FRA70%

Cost of FRA € 100,000