(Analyzing interest rate swaps) 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 cash payments to the swap counterparty equal to the fixed-rate coupon payments and receive in return coupon payments reflecting the floating rate.

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

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

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Year 6-Month LIBOR Rate 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