Spalding Finance Inc. can borrow at a fixed rate of 10% or at LIBOR-50 basis poi

Question

Spalding Finance Inc. can borrow at a fixed rate of 10% or at LIBOR-50 basis points. Jamaica Manufacturing can borrow at a fixed rate of 13% or at LIBOR+100 basis points.

a. Suppose Spalding Finance prefers a floating rate loan while Jamaica Manufacturing prefers a fixed rate loan. Is there a mutually advantageous opportunity to engage in an interest rate swap? Briefly explain.

b. Jamaica Manufacturing proposes to pay 10.8% in return for LIBOR+0. What is the cost of borrowing for Spalding and Jamaica after the swap?

c. What is the cost saving that each party realizes under the swap terms in part b.?

Explanation / Answer

Solution:-

a)

i)Total cost of borrowing under own choice

Floating for Spalding Finance Inc.+ Fixed for Jamaica Manufacturing

=LIBOR-50 basis points +13% = 12.5%+LIBOR

ii) Total cost of borrowing under Swap

Under swap Spalding Finance Inc. will take fixed rate loan and Jamaica Manufacturing will take floating rate loan and will swap the loan.

Total cost of borrowing under Swap =Fixed cost Spalding Finance Inc.+ Floating cost Jamaica Manufacturing

=10%+[LIBOR+100basis points]

=11%+LIBOR

Net total saving = Total cost of borrowing under own choice- Total cost of borrowing under Swap

                     =12.5%+LIBOR-(11%+LIBOR)

                     =1.5%

Hence it is mutually advantageous to engage in an interest rate swap agreement.

b)Calculation of cost of borrowing after swap .

i)For Spalding Finance Inc. = It will receive LIBOR rate and pay 10.8%

   =10%(Loan taken)-10.80%(to be paid by other)+LIBOR( to be paid under swap)

=LIBOR-80 basis points

ii)For Jamaica Manufacturing

=LIBOR+100 basis points(loan taken)-LIBOR(to be paid by other)+10.80%(to be paid under swap )

=11.80%

c) Cost saving for

i)For Spalding Finance Inc. =Own cost-Swap cost

                                      = LIBOR-50 basis points-[ LIBOR-80 basis points]

                                       =30 basis points saving

ii)For Jamaica Manufacturing =Own cost-Swap cost

                                                =13%-11.80%

                                                =1.20%

Please feel free to ask if you have any query in the comment section.

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