Question

section A and B

Section A: Boeing & JAL - Initial Analysis
Japanese Airlines (JAL) wants to add one Boeing 787 to its fleet in January 2021. The current purchase price as provided by BA is $100M. JAL has the option to either purchase the aircraft or lease it. JAL is evaluating both the options, and needs your help
1. If JAL were to purchase the aircraft, it can borrow up to 70% of the value at Libor + 3%. Please calculate first year interest payment, assuming Libor is 2% -- 5pts
2. What will be JAL’s initial cash outlay? – 5pts
3. Since, the borrowing is planned for January 2021, what are some of the instruments, which JAL can use to fix its borrowing rate today? – 10 pts
4. BA is also offering a monthly lease option at a lease rate factor (LRF) of 0.7%, and a tenor of 12 years. Please calculate the monthly lease payments (Lease payments = LRF*Purchase Price) – 5pts

Section B: Boeing & JAL - Rate Locks
For the purchase option, an Investment Bank offered JAL the following rate lock strategy. JAL can enter into a forward contract with the bank,
where if Libor in January 2021 ends up higher than 2%, then the bank pays JAL the difference on $100M notional. The case will be reversed if
Libor ends up lower than 2%.
1. If Libor is 2.5% in January 2021, how much does JAL receive or pay to the investment bank in the first year? – 5pts
2. Continuing with 1 above, how much interest will JAL pay on its loan in the first year? – 10 pts
3. What kind of an instrument is this? – 5pts
For the lease option, the investment bank has offered to pay $80/bp for each basis point change in 7-year swap in January 2021 vs. now. From
Part A, remember that BA’s lease offer has $100/bp sensitivity to the 7-year swap…this $20/bp difference can be understood as risk
compensation…
4. If the 7-year swap in January 2021 is 3%, how much does JAL receive or pay to the investment bank? – 10 pts
5. Continuing with 4 above, what will be the monthly lease payments made to BA? – 10 pts
6. What is JAL’s net loss/gain on this deal? – 5 pts
7. What kind of an instrument is this? -- 5 pts

Answer 1

Section A: Initial Analysis

Basic Facts of the Question:

Buyer: Japanese Airlines
Seller: Boeing Aircrafts
Current Purchase Price: $ 100 Million

Whether to Purchase or Lease ?

1.  If JAL were to purchase the aircraft, it can borrow up to 70% of the value at Libor + 3%. Please calculate first year interest payment, assuming Libor is 2% :

LIBOR (London Interbank Offered Rate) ; 2%
Borrowing Rate: LIBOR + 3% = 2% + 3% = 5%
Borrowing Limit : 70% of Purchase Price

Borrowed Amount : 70 % of $ 100 Million = $ 70 Million

Therefore First Year Interest Payment: $ 70 Million * 5% = $ 3.5 Million

2. What will be JAL’s initial cash outlay?

Initial Cash Outlay : Purchase Price - Borrowed Amount

$ 100 Million - $ 70 Million

$ 30 Million

3. Since, the borrowing is planned for January 2021, what are some of the instruments, which JAL can use to fix its borrowing rate today?

a. Forward Rate Agreement
b. Interest Rate Futures : Allows the buyer and seller to Lock in Priceof Interest Bearing Asset for a Future Date.
c. Interest Rate Options (Cap , Floor , Collar)
d. Interest Rate Swaps

4. BA is also offering a monthly lease option at a lease rate factor (LRF) of 0.7%, and a tenor of 12 years. Please calculate the monthly lease payments (Lease payments = LRF * Purchase Price)

Lease Rate Factor: 0.7%
Purchase Price: $ 100 Million

Therefore Monthly Lease Payments = 0.7% * $ 100 Million = $ 0.7 Million

Section B: Rate Locks

JAL has entered into a Forward Contract to manage the Interest Rate Risk. This Rate Lock Strategy will enable JAL to keep its Interest Rate at Fixed Rate of 5%.

CASE 1: If LIBOR goes above 2 % , then JAL will receive the Interest Rate differential.

Therefore Effective Rate of Interest will be :
(LIBOR + 3%) - (LIBOR - 2%)
5%

CASE 2: If LIBOR goes down 2 % , the JAL will pay the Interest Rate differential.

Therefore Effective Rate of Interest will be :
(LIBOR + 3%) + (2% - LIBOR)
5%

1. If Libor is 2.5% in January 2021, how much does JAL receive or pay to the investment bank in the first year?

Actual LIBOR in January : 2.5 %
Notional Amount: $ 100 Million

As LIBOR goes above 2.5 % , JAL will receivethe Interest Rate differential.

(Actual LIBOR - 2%) * Notional Amount
( 2.5% - 2%) * $ 100 MIllion
$ 0.5 Million

2. Continuing with 1 above, how much interest will JAL pay on its loan in the first year?

Interest Payment on its Loan in First Year: $ 70 Million * 5.5% = $ 3.85 Million (SInce Interest Payment will based on Actual Rate)

Gain due to Forward Contract = (2.5% - 2%) * $ 100 Million = $ 0.5 Million

Net Interest Expense : $ 3.85 Million - $ 0.5 Million = $ 3.5 Million

Effective Interest Rate : $ 3.5 Million / $ 70 Million = 4.79% (This is not 5% because of the difference in Loan Amount and Notional Amount)

3. What kind of an instrument is this?

It is a Forward Rate Agreement through which a borrower/lender protects itself from the unfavourable changes to the Interest Rate.
Normally it is used by Banks to fix Interest costs on anticiapted future deposits or interest revenues on variable rate loans indexed to LIBOR
The Principal amount of the agreement is termed "notional" because it determines the amont of Payment , actual exchange of the Principal never takes place.
It is settled at maturity in cash representing the Profit or Loss.
A Bank that sells an Forward Rate Agreement agrees to pay the buyer the increased interest cost on some notional amount if some sprecified maturity of LIBOR ia above a stipulated Forward Rate. On the other hand , the buyer agrees to pay the Bank any decrease in Interest Cost if market interest rates falls below the forward rate.

It is a kind of Derivative Instrument which derives its value from the underlying Interest Rate u.e, LIBOR.

LEASE OPTION

4. If the 7-year swap in January 2021 is 3%, how much does JAL receive or pay to the investment bank?

Therefore Current Swap Rate :