Background
In the latter subsequent report, we primarily investigate the value of Premier Food to conclude whether it’s advisable for the proprietor to make a 5% stake investment or not. This particular report extracts significant evidence from the financial statements while carefully gauging the significance of Premier’s swap portfolio to make the concluding resolution on the matter.
Financial Statement Analysis
Premier Foods assimilated many establishments and furthermore exported to the countries worldwide which evidently also exposed the organization to many overseas risks, including rise in either the interest rate or exchange rate. In this way, Premier Food’s net borrowings had increased to £1766.8. Also, aggressive acquisitions in recent years had put Premier Foods in a position of unprecedented high leverage. The total liabilities were £3.1 billion in 2008. Its leverage ratio (total liabilities / total equities) increased from 1.80 to 3.13 between 2007 and 2008. Considering the net operating income became positive to negative from 2007 to 2008 and its cash and cash equivalents, only £33.7 million, in this period, Premier Foods was in a poor situation.
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Caps and floors portfolio
An interest rate cap is a type of interest rate derivative in which the buyer receives payments at the end of each period in which the interest rate exceeds the agreed strike price. Similarly, an interest rate floor is a derivative contract in which the buyer receives payments at the end of each period in which the interest rate is below the agreed strike price. Caps and floors can be used to hedge against interest rate fluctuations. Since Premier Foods was exposed to exchange rate risk and had a lot of liabilities, it had to hedge its risks. By combining caps and floors, Premier Foods can lock their cost. If it only used one of them, it might either earn or loss a lot. Taking collar (buy caps and short floors) as an example, if the interest risk decreased below the lower strike rate, the cost would be locked at the price of floors and if the interest risk increased over the higher strike rate, the profit would be locked at the price of caps. If the interest risk was between the two strike rates, the cost or profit would be between the price of caps and floors.
In addition, the option, which is similar to the caps and floors, is also an alternative strategy. Set the collar as an example, the Premier Foods can buy call options and short put options to lock its profits and losses.
Interest rate swap
An interest rate swap is an agreement between two counterparties to exchange interest payments based on a specific principal amount. General type of interest rate swaps is the exchange of a fixed interest rate for a floating rate, or vice versa, to reduce or increase exposure to fluctuations in interest rates or obtain a lower interest rate for future interest payment.
The reasons for the company to choose swaps are mainly two aspects. On the one hand, the case mentions that Premier Foods is world-wide food company. The raw materials for products comes from countries around the world. Meanwhile the company exported production to various other countries. Premier Foods must hedge against the exchange rate fluctuation.
On the other hand, the author indicates that Premier Foods’ had many mergers and acquisitions between 2005 and 2007. In 2005, Premier Food’ acquired Bird’ Custard and Angel Delight. In 2006, Premier Foods completed acquisition of Campbell’s UK and Irish business operation. In 2007, the firm executed acquisition of RHM. These large-scale acquisitions increased the company’s debt. Therefore, the interest rate swaps are necessary to acquire a lower overall interest rate for the uncertainty of future cash flows and future market condition.
To assess the value of Premier Food in detailed data, we calculate the liability of Premier Food’s interest rate swap and the value of interest rate cap and floor.
The value of Swap contract
Premier entered fixed rate swaps at rate of 4.9%. One with notional amount of £340 million matures in one year and the other, £125 million, expires in two years.
The value of the fixed rate side is £480.75 million. Combined with two swaps, the notional amount is £465 million in the first year and £125 million in the second year at interest rate of 4.9%. Each payment could be calculated through Notional Amount×4.9%×Days/365 and add notional amount in the fourth and eighth quarters. For example, the payment at the end of the first quarter is 465×4.9%×90/365=£5.62 million. Then, the payments should be discounted into present value. The formula is Payment/〖(1+Spot Rate)〗^(Days/365) . For the first quarter, the present value is 5.62/〖(1+2.793%)〗^(90/365) =£5.58 million. The sum of all the present value, the value of fixed rate payment, is £480.75 million. (Exhibit 1)
The value of floating payment is £465 million, exactly the notional amount, because it will reset to par value on each reset date. Therefore, the total value of the swap contracts is -£480.75+£465=-£15.75 million.
The liability of caps and floors
A nominal value of £350 million with caps set at 6.1% and floor rates at 4.3%, creates a collar strategy. The company receives a payment when LIOBR is over 6.1% and loses money when LIOBR is below 4.3%.
Following the expected LIBOR, caps will not be executed even in 1.5X LIBOR scenario. There will be no income cash flow from caps. However, all the floors will be exercised, and Premier will suffer a big loss from them. The first payment would be sent on July 2, 2009. The amount is (4.3%-2.23%)×350×91/365=£1.81 million, discounted at the swap midrate to 1.81/〖 (1+2.512%)〗^(181/365) =£1.78 million. The floor would mature on January 2, 2012 and the last payment would be £0.78 million on April 2, 2012. The present value of all the payments is £14.35 million. Thus, the liability of the caps and floors is £14.35 million.
In actual, LIBOR in this period was lower than expected. The liability of the floors greater than expected scenario. The value of payments, discounted to January 2, 2009, is £34.53 million. Premier suffered a huge loss from this collar. (Exhibit 2)
Conclusion
If the LIBOR hovers amid 0 and 1 percent, from preceding calculation, we can quantify the loss of Premier Foods would still be in a tremendously greater level. While since the main motive to accomplish the acquisition of a 5% stake is that the probability the LIBOR rate will reach the contracted caps and floors rate is big enough. Apart from that, from the financial statement, we know Premier Food’s has many risks including high leverage, high debt, negative operating income and so forth, although earlier this year, a string of U.S. hedge funds had picked up significant stake in Premier Food, we will not purchase the 5% stake.
