Zenith Company has borrowed $1 million from Strong Capital Bank at an interest rate of LIBOR plus 2 percent.However,the CFO of Zenith fears that the short-term interest rates may rise in the near future and purchases an interest-rate cap of 5 percent from Strong Capital Bank.What will be the annual interest outflow for Zenith,if the LIBOR rate rises to 3.5 percent?

Question

Quizplus · Accepted Answer

The interest rate cap of 5 percent means that Zenith will not have to pay more than 5 percent interest, even if LIBOR rises above 5 percent. In this case, LIBOR has risen to 3.5 percent, which is below the cap of 5 percent. Therefore, Zenith will pay interest at the rate of LIBOR plus 2 percent, which is 3.5 percent + 2 percent = 5.5 percent. The annual interest outflow for Zenith will be $1 million x 5.5 percent = $55,000.

Zenith Company Has Borrowed $1 Million from Strong Capital Bank