Doreland Corp. borrowed $3.5 million seven years ago at a floating rate of 5% compounded annual with annual interest payments and principle payable in full at maturity. It also purchased, as part of the loan package, a hedge for $80,000 that limited their rate movement exposure to 2%. Two years after the loan was initiated, interest rates rose by one percent and went up a further one percent, a year later. Rates then stayed the same until 12 months before maturity when they went up by 2%. At the time Doreland took out the loan it chose not to take the alternative of a fixed rate of financing at 7% for the full term of the loan. Ignoring the time value of money, what was the net effect of Doreland's choice of financing compared to locking in a 7% fixed rate of interest?

Question

Quizplus · Accepted Answer

The floating rate started at 5% and was capped at a 2% increase due to the hedge, making the maximum interest rate 7%. The interest rate increases occurred as follows: +1% in year 3, +1% in year 4, and +2% in year 7, but due to the hedge, the rate could not exceed 7%. Therefore, for years 1 and 2, the interest rate was 5%, for years 3 and 4, it was 6%, and for years 5 to 7, it was 7%. The fixed rate option was 7% for all seven years. Calculating the interest paid under both scenarios:- Floating rate:   - Years 1-2: 5% of $3.5 million = $175,000 per year, total $350,000  - Years 3-4: 6% of $3.5 million = $210,000 per year, total $420,000  - Years 5-7: 7% of $3.5 million = $245,000 per year, total $735,000  - Hedge cost: $80,000  - Total floating cost: $350,000 + $420,000 + $735,000 + $80,000 = $1,585,000- Fixed rate:  - 7% of $3.5 million = $245,000 per year for 7 years = $1,715,000Comparing the two:- Fixed rate total cost: $1,715,000- Floating rate total cost: $1,585,000- Savings with floating rate: $1,715,000 - $1,585,000 = $130,000The correct answer is not listed among the options provided based on the calculation. The calculation shows a savings of $130,000, but the closest provided option is C) Saved the company $95,000, which does not match the calculated savings. There seems to be a discrepancy in the provided options and the calculated outcome.