ACCA Financial Management (F9) Certification Practice Exam

Why would a company opt for an interest rate collar?

1. To eliminate interest rate fluctuations

2. To limit borrowing costs while managing risk

3. To enhance capital investment

4. To increase its total shareholder return

The correct answer is: To limit borrowing costs while managing risk

A company would choose an interest rate collar primarily as a risk management strategy that allows it to limit borrowing costs while still managing the risk associated with interest rate fluctuations. An interest rate collar involves setting a maximum interest rate (cap) and a minimum interest rate (floor) on its borrowing. By establishing these boundaries, the company can limit how much its borrowing costs can rise if interest rates increase past a certain level, hence avoiding excessive interest payments. Simultaneously, the company also benefits from lower borrowing costs if interest rates fall, as they are protected from excessive rates on the upside while still enjoying lower rates on the downside. This mechanism balances the company’s desire for predictable financial planning and cash flow management with the need to protect against unexpected volatility in interest rates. The other options do not fully capture the purpose of an interest rate collar. For example, while it may help manage costs, the aim is not to eliminate all interest rate fluctuations or enhance capital investments directly. Similarly, while managing borrowing costs can indirectly influence total shareholder return, the primary function of a collar is more focused on risk management rather than directly increasing shareholder value.