The Prince Racket Company manufactures a line of tennis and raquetball equipment. The firm recently entered into a loan agreement for $20 million that carries a floating rate of interest equal to LIBOR plus 100 basis points (1 percent). The loan has a five-year maturity and requires the firm to make semiannual payments. At the time the loan was being negotiated, the company was approached by its banker with a suggestion as to how the firm might lock in the rate of interest on the loan at 8 percent using a fixed-for-floating interest rate swap. Under the agreement the company would make a cash payment to the swap counterparty equal to the fixed-rate coupon payment and receive in return a coupon payment reflecting the floating rate.

a. Calculate the swap cash flows over the next five years based on the following set of hypothetical LIBOR rates:

Year (A)6-Month LIBOR Rate (B)

0.00 ...........6.80%

0.50 ........... 7.20%

1.00 ...........8.00%

1.50 ...........7.40%

2.00 ...........7.80%

2.50 ...........8.60%

3.00 ...........9.00%

3.50 ...........9.20%

4.00 ...........8.40%

4.50 ...........7.60%

5.00

b. What would motivate a firm’s management to enter into such a swap contract?