# ch16 - Chapter 16 Solutions Overview Problem Length{S{M...

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Chapter 16 - Solutions Overview: Problem Length Problem #s {S} 1-4, 7-9 {M} 10 1.{S}a. Because their stated interest rate remained constant at 6.5% on both 12/31/00 and 12/31/01, the Notes due 8/12/02 must be the fixed rate notes. The stated interest rate on the Notes due 5/01/02 was 6.81% at 12/31/00, but it declined to 1.88% at 12/31/01 – those must be the variable rate obligations. b. The difference between the stated and the effective rate on a variable rate obligation may result from an interest rate swap based on different indices. AXP must have swapped the variable rate obligation based on one underlying, e.g., LIBOR, for a rate based on a different index, e.g., the Federal Funds rate. c. Amounts in \$millions Effective Years Notes due Balance Interest Interest Ended Outstanding Rate Expense a B c b x c 12/31/2000 8/12/2002 \$400 6.83% \$27.32 5/01/2002 400 6.90% 27.60 Total \$54.92 12/31/2001 8/12/2002 411 6.43% 26.43 5/01/2002 400 1.88% 7.52 Total \$33.95 The interest expense for each note for each year is computed by multiplying the principal amount of the note by the effective interest rate. Interest expense based on the stated rates (assuming no swaps) is computed in the table on the following page. 16-1

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Amounts in \$millions Stated Years Notes due Balance Interest Interest Ended Outstanding Rate Expense a b c b x c 12/31/00 8/12/02 \$400 6.50% \$26.00 5/01/02 400 6.81% 27.24 Total \$53.24 12/31/01 8/12/02 411 6.50% 26.72 5/01/02 400 1.88% 7.52 Total \$34.24 Comparing interest expense from these two tables for both years, we compute the effect of the swaps on interest expense for both years: Effect of Swap Year \$ millions % ∆ 2000 \$ 1.68 3.2% 2001 (0.29) -0.8% The effect of the swaps was to increase 2000 interest expense by \$1.68 million or 3.2%. In 2001, the swaps decreased interest expense by \$.29 million or less than 1%. While the swaps may have provided AXP with protection against some possible interest rate changes, they had an immaterial effect on interest expense in 2000 and 2001. d. Both swaps were most likely intended to lower the exposure to changing interest rates. Because AXP expected lower rates, the fixed rate notes were swapped into variable rates; the swap increased 2000 interest expense (the effective rate was higher than the stated rate) but reduced interest expense in 2001 (the effective rate was lower than the stated rate). The underlying (index on which the effective rates were calculated) was changed on the variable rate obligations; AXP must have expected a decline in rates based on the new underlying index. However, the swap increase 2000 interest expense as the company paid 6.90% on obligations with a stated rate of 6.81%. There was no difference in rates at 12/31/01. 2.{S}a. PepsiCo likely wanted to reduce financing costs by replacing fixed rate debt with variable rate debt with lower interest rates. 16-2
b. The notional amounts of the swaps must have declined because the amount of the fixed rate debt declined. Another possible reason for the lower notional amounts of the swaps is a decline in the duration of PepsiCo debt.

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ch16 - Chapter 16 Solutions Overview Problem Length{S{M...

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