Issuing floating rate obligation and buying bonds with proceeds

[johntavv]

Reading 29, practice problem 3b says:
Company issues floating rate note with face of 5,000,000 that pays a coupon of 2.5x Libor. Company plans to use the proceeds to purchsae a bond with a fixed coupon rate of 7%.
So the company issues floating rate notes and pays a coupon = Libor x 2.5 x 5,000,000
= 12,500,000 x Libor
The company then buys bonds with a face value = 2.5 x 5,000,000
=12,500,000
And they receive a coupon = 0.07 x 12,500,000
= 750,000
For the face value of the bonds we buy, why do we multiply by 2.5?
We issue a note worth 5,000,000, so i would have thought value of bonds to purchase = 5,000,000. Not 2.5x5,000,000

 

[cpk123]

1 $ invested, receive 2.5 x LIBOR
= (1 x 2.5) invested and receive LIBOR.

 

[ink]

cpk123 wrote:
1 $ invested, receive 2.5 x LIBOR
= (1 x 2.5) invested and receive LIBOR.

cpk, i’m not very clear on your explanation. this is clearly a leveraged interest rate swap, so there should be no upfront capital requirements, but there clearly are some upfront requirements.
1. they issue a bond worth 5mil, and will pay on it the coupon of 2.5L, which is the same as paying a coupon of L on 12.5 million
2. They use the reciepts from step 1 to buy a fixed bond. The question is how can they buy 12.5million fixed bond, when they recieved a notional principal of 5mil. This implies that they do need some upfront costs, while the CFAI text says that none are needed.

 

[Galli]

Bond fixed paying libor would be worth X, therefore a rational investor would pay 2.5x bond Fixed price (X*2.5) if it paid 2.5x the coupon from Bond X.

 

[S2000magician]

Galli wrote:Bond fixed paying libor would be worth X, therefore a rational investor would pay 2.5x bond Fixed price (X*2.5) if it paid 2.5x the coupon from Bond X.

Not if the final principal weren’t changed.
If you pay $1,000 for a $1,000 par bond paying a 2% coupon, you don’t pay $2,500 for a $1,000 par bond paying a 5% coupon.

 

[zulu007]

I am also confused as to why we are multiplying 2.5 x with the principal.
It should only be multiplied by LIBOR rate to arrive at coupon payment.

 

[cpk123]

Company issues floating rate note with face of 5,000,000 that pays a coupon of 2.5x Libor. Company plans to use the proceeds
you receive interest of 2.5 * 5 * L = 12.5L M
and you are issuing at Libor. So you can go upto 2.5 * 5 = 12.5 M.

 

[Galli]

S2000magician wrote:

Galli wrote:Bond fixed paying libor would be worth X, therefore a rational investor would pay 2.5x bond Fixed price (X*2.5) if it paid 2.5x the coupon from Bond X.

Not if the final principal weren’t changed.
If you pay $1,000 for a $1,000 par bond paying a 2% coupon, you don’t pay $2,500 for a $1,000 par bond paying a 5% coupon.

Can you clarify S2000?
The example in the book makes it sound like the bond paying the 2.5x libor coupon is worth 2.5x as much as it’s ‘par’ value which allows them to buy the fixed-rate bond at 2.5x the ‘par’ of the leveraged floater. Is it a close approxmiate or am I just not understanding the mechanics well enough?
Appreciate any thoughts you could share.