UCD plc currently has a small overdraft and it expects that for the next two years the normal operating cash costs will equal its operating cash revenues. It cannot increase its overdraft.

In addition to normal operating revenues it is expecting to receive the sum of 10 million in March (exactly three months from now) from the sale of one of its subsidiaries. The contract for the sale of the subsidiary has already been finalised with a highly reputable, and financially strong, blue chip company.

The money is to be used to fund the purchase of a property as part of UCDs strategy of relocating its activities.

This contract has also been finalised with a contractual purchase price of 103 million and with completion to take place in September (exactly nine months from now).

UCD is contractually committed to both the sale and the purchase and regards both the March cash inflow and the September cash outflow as being certain.

UCD intends to invest, for the six-month (183 day) period, all the funds when received in March and because of the tight cash flow position it is imperative that UCD can rely on receiving a good return on the 10 million but is concerned that interest rates in March might be considerably lower than their current level. It is suggested that a Forward Rate Agreement (FRA) be entered into in order to minimise interest rate risks.

FRAs currently available for a sum of 10 million are:

LIBOR %

6V9 700730

3V9 710740

3V6 750780

Required:

(a) Explain a Forward Rate Agreement and show (without calculations) how UCD should attempt to minimise its interest rate risks by using a Forward Rate Agreement. Specify which FRA is appropriate for UCDs circumstances and indicate the appropriate interest rate. (7 marks)

(b) Over the three months to March, interest rates fell. In March the level of LIBOR was 5% and the bank deposit rate offered to UCD was 445%.

The bank, and the FRA, utilise a 365 day year for interest calculations over the 183 day period.

Required:

Utilising the interest rates in March shown above:

(i) determine the cash flows associated with the FRA and specify their PRECISE timing;

(ii) determine the final amount of money available in September and the effective rate of return achieved on the original 10 million as a result of utilising the FRA. Compare this position to the position which would have been achieved without utilising the FRA and comment on the outcomes.