B.F Goodrich/Rabobank interest rate swap case

By: Mitchell Gahan 13179537 James Grimard 13191612
Josh Hutchins 13220396

Lecturer: Colette Southam

Due Date: 17/06/13

The first key issue in the B.F Goodrich/Rabobank interest rate swap case was why they felt the swap was needed? B.F Goodrich was the fourth largest U.S producer of tires and the largest U.S producer of polyvinyl chloride (PVC) resins and compounds. During 1982 Goodrich announced a $33million dollar loss and needed to borrow 50 million to fund its ongoing financial needs. In addition Goodrich was disinclined to borrow the funds in the short term as they didn’t want to compromise its future flexibility by borrowing short term. The company also felt due to the general level of interest being so high and its downgraded credit rating to BBB- that long-term fixed-rate money would be too expensive, estimated at approximately 13% on a 30-year corporate debenture.

Another key Issue in the case was how could Goodrich reduce the rate of borrowing? During 1983 currency swaps and interest rate swaps were still a relatively new financial instrument. Although, the nature of a swap could be quite beneficially to both parties in theory as long as the swap was set up correctly. In theory Goodrich could reduce the rate of borrowing through an interest rate swap by paying a fixed rate and receive a floating rate payment. In this circumstance Goodrich could match its floating rate payments with their floating rate debt.

B.F. Goodrich is a diversified manufacturer of industrial products and components, it essential for their products to be of top quality if they want to remain in business. Quality can be represented in each of their products. Take for example Goodrich’s tires; the consumers who purchase and use the tires will be analyzing the products quality based on degradation and life expectancy. If the quality of the products at B.F. Goodrich were to fall the profitability and reputation of the company would fall with it. The capacity for the firm’s facilities can be analyzed through the property, plant and equipment, found on the balance sheet. From 1979-1982 the PP&E has grown 36.54% indicating an increase production capabilities and therefore the potential to meet the orders of consumers.

B.F. Goodrich has experienced a few years of great growth with sales increasing with demand in the market place, though in the year of 1983 we saw the net income decline significantly to a loss of $33m. This really shows the effect that the economy has on this segment of the market. The industrial sector that Goodrich operates out of is a clear representation of when times are good and bad. The growth of the economy is displayed through industrial growth and this shows that 1983 was a slow year with reference to the loss on the balance sheet.
Rabobank on the other hand is a completely different type of business in a completely different side of the world. Rabobank is a Dutch bank with a large amount of assets exceeding $42b, Rabobank offers financial services to roughly 90% of Dutch agricultural businesses. Over the past couple of years Rabobank has found profit in expanding the business into commercial lending and other traditional banking activities, growing internally. Rabobank has a direct relation with the global economy; the growth of the company is dependant on the businesses they associate with and the financial markets in which they invest their capital. Rabobank has a great market share with 40% of all Dutch deposits. This shows that Rabobank has a stable business environment with a strong brand name throughout the Netherlands and neighbouring countries.

The Morgan bank would be exposed to the credit risk in the event that either of the parties defaults. Therefore, there was the fee of $125,000 and an annual undisclosed fee for 8 years paid by Goodrich to Morgan bank as a premium for taking on the credit risk.

B.F. Goodrich known as the payer in this transaction receives a floating rate payment and pays a fixed rate. Goodrich would be exposed to the interest rate risk such that if the interest rates would change after half completed and the floating rate increases Goodrich will receive more, however if the floating rate decreases the company would receive less. The floating rate is pegged to LIBOR – X therefore the interest rate risks would dependant on the London interbank rate (Refer to Exhibit A). Conversely with Rabobank also known as the receiver in this transaction receiving fixed payments and paying a floating rate will make a profit if interest rates decrease and a loss if interest rates increase. (Refer to Exhibit B)

Interest rate swaps are very popular due to the arbitrage opportunities they provide. Due to varying levels of creditworthiness in companies, there is often a positive quality spread differential, which allows both parties to benefit from an interest rate swap. In the case of B.F. Goodrich and Rabobank the QSD was +1.675% (Refer to Exhibit C), indicating that the swap of the interest rates is in the interest of both parties. The arbitrage in affect between the two creditworthy firms moves the USD and the Euro currencies closer to purchasing power parity. This inturn contributes to the market becoming more efficient as trading institutions take action on potential price mismatches.
Exhibit A

Exhibit B

Exhibit C

| Floating | Fixed | | | BFGoodrich | LIBOR | 12.5% | | BFGoodrich wants floating. | Rabobank | LIBOR + 0.25 - 0.375 | 10.70% | | Rabobank wants fixed. | | -0.125% | 1.80% | | | | | | | | | QSD | 1.675% | | |