Firenza Motors of Italy recently took out a 4-year €5 million loan on a floating rate basis. It is now worried, however, about rising interest costs. Although it had initially believed interest rates in the Euro-zone would be trending downward when taking out the loan, recent economic indicators show growing inflationary pressures. Analysts are predicting that the European Central Bank will slow monetary growth driving interest rates up.

Firenza is now considering whether to seek some protection against a rise in euro-LIBOR, and is considering a Forward Rate Agreement (FRA) with an insurance company. According to the agreement, Firenza would pay to the insurance company at the end of each year the difference between its initial interest cost at LIBOR + 2.50% (6.50%) and any fall in interest cost due to a fall in LIBOR. Conversely, the insurance company would pay to Firenza 70% of the difference between Firenza'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. What are Firenza's annual financing costs now if LIBOR rises and if LIBOR falls.? Firenza uses 12% as its weighted average cost of capital. Do you recommend that Firenza purchase the FRA?