Present Value Analysis of Interest Rate Cap and Journal Entries At July I, 2013, Comiskey Company has $ 10,000,000 of debt due in four years with interest floating at prime. The rate is adjusted annually each July 1 and interest for the preceding year is payable on June 30. Comiskey closes its books on June 30 and December 31 of each year. Prime currently stands at 4 percent annually and is expected to fluctuate between 2 percent and 8 percent over the next four years. On July 1, 2013, Atlanta National Bank offers Comiskey a 4-year interest rate cap with a strike price of 5 percent for $400,000 payable immediately.
Required
a. Suppose the prime rate is expected to be 6 percent on July 1, 2014, 8 percent on July 1, 2015, and stay at 8 percent for the remaining two years. Use a present value analysis to determine whether purchasing the cap is a good economic decision in this set of circumstances. Hint: Let the applicable prime rate(s) when the interest changes occur be the discount rate(s).
b. Suppose instead that the prime rate drops to 2 percent on July 1, 2014, and stays at 2 percent for the remaining three years. Use a present value analysis to determine whether the savings in interest cost (2 percent versus the original 4 percent) will offset the cost of the cap.
c. Assume the cap is purchased and prime rises to 6 percent on July 1, 2014. Prepare the journal entries made by Comiskey to account for the periodic interest expense and the cap at December 31, 2014, and June 30, 2015. Assume that the fair value of the cap declines by $50,000 in each 6-month period.