Loan by fixed vs floating rate bond

CFA Level II Corporate Finance
#1

Hey i hope this is the right place to post this, I’m having trouble understanding how to calculate this:

We are to find the cheapest borrowing option between:

1:issuing a bond at 7% fixed rate for 5 years, twice a year 2: issuing a floating rate bond for 5 years at central bank rate plus six hundred basis points, the payments are divided into 4 times a year

We are to assume the central bank rate is fifty basispoints and will increase by 25 every year for four years

This is our first task in this subject, and we have not even learned about floating bonds aand the book we use have no even remotely similar examples. Ive read some on the internet but i cant figure out how to solve this

After this we are to do the same over again, just that this time the demand for fixed rate bonds are lower so they must be issued at a discount - 99,25

#2

Use Excel and build the cash flow over the 5 years for both options and calculate the IRR. Choose the one with the lowest IRR.

#3

Thank you

Can i sum it up to once a year, as the rate is only increased once a year, or does it have to be for 4 times a year?

#4

You can’t sum up the cash flows across different time points, that violates the time value of money.

It should be 4 times a year for the floater.

#5

Certainly wouldnt want to violate anyone

So i got about 7% IRR for both on nr1, aka the coupon of the fixed.

And that the floating would be a bit cheaper in nr2. Sounds about right?

#6

hi,

here what I`ve got:

Option 1:

CF0=1,000

CF1,2,3,4,5,6,7,8,9,10=-35

IRR 16%

Option 2:

CF0=1,000

CF1,2,3,4=16.25

CF5,6,7,8=16.875

CF9,10,11,12=17.50

CF13,14,15,16=18.125

CF17,18,19,20=18.75

IRR 8%

As the IRR is the rate that gives the sum of PV of future CFs equal to the initial investment, the lower one would produce a greater sum of PV of positive future CFs to offset the initial negative investment (as a rule, here is vice versa), we chose Option 2 with the lower IRR.