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The fundamental principles of valuation that ACME can apply to design its acquisition include collecting relevant information about the swap contract. The details must include the starting and ending dates, notional amount, rates to be used in payments, and settlement frequency. The following process is to calculate the present value of floating rates. This entails adding the current value of cash flows by first identifying the discount factor (df) for each time of the cash flow. The df should be defined according to the perception of ACME viewpoint of future rates using the forward rates such as the London Inter-Bank Offered Rate (LIBOR) (“SwapsInfo – ISDA,” 2022). It should be followed by calculating the present value of the notional principal. During the process, LIBOR forward rates will be used to discount the notional amount. The swap rate is determined and then used to determine its spread. Suing the approach, ACME will be able to design the right interest swap rate that suits the acquisition process.
Let interest rate swap be = IRS, present value = PV, notional principle =NP, floating rate payment = FRP
IRS= PV of FRP / PV of NP
Generally, an interest rate swap (IRS) refers to a mutual agreement between two parties to enable them to exchange interest payments in a given time. IRS is future contracts that are traded over the counter, which makes them customizable based on the preference of the involved groups. The focus is to enable a business organization to replace floating rate payments with fixed-rate based on LIBOR. The swap rate is the amount of interest demanded by the receiver during the exchange to cover for the possible uncertainty that is associated with paying the LIBOR rate on the specified time frame.
When the parties are making an agreement about the swap, the fixed rate flow must be equal to the expected value floating rate as per the LIBOR forward curve. A swap contract works in a way that when the receiver and payer agree, it is considered money whereby the lifetime value fixed interest cash flow must be equivalent to the speculated floating payments. In a case when the swap is less profitable, the counterparty has the potential of setting a countervailing trade (“Understanding Interest Rate Swaps | PIMCO,” 2022). Since ACME wants to finance its acquisition with equity capital and debt, the appropriate interest rate swap it should opt for is the fixed-to-floating swaps. By using the equity, the company will be able to receive reasonable rates following changes in the market. In other words, the floating rates will guarantee ACME a positive stream flow of interest rates during the period. The fixed-to-floating swap will integrate the restructuring of the acquisition by prompting the investors to choose the fixed rate.
Despite the effectiveness of fixed-to-floating rates, ACME might face several challenges that might affect its acquisition process. They include uncertainty associated with changes in the value of currencies on a daily basis. The company might not be sure of the potential income that might be received following possible changes in the market. There is a reduced investment because most investors may fear the unpredictable nature of the floating exchange rates. However, the shortfall falls are extremely outweighed by the benefits of the option. For instance, it lowers the interest expense that the company should pay. Moreover, it will allow the management to easily match the assets and debts that are sensitive to changes in interest rates.
References
Understanding Interest Rate Swaps | PIMCO. Pacific Investment Management Company LLC. (2022).
SwapsInfo – ISDA. Swapsinfo.org. (2022).
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