Each of two companies decides to issue $10 million in 5-year debt on the same da

Question

Each of two companies decides to issue $10 million in 5-year debt on the same date. Each company consults its investment banker to consider alternatives. Market conditions are the following:

• Company C has told its banker that it desires a fixed rate liability.

• Company C is advised that it can probably issue notes in a fixed rate structure at 4.30% or on floating rate terms at LIBOR + 90 bps.

• Company D has told its banker that it desires a floating rate liability.

• Company D is advised to expect a market rate of 4.85% for its fixed rate debt and LIBOR + 150 basis points (bps) for its floating rate debt.

• The banker also checks the swap market on each customer’s behalf. In an email to each customer, the banker notes the best terms in the dealer market on a standard US dollar swap for a 5-year fixed-for-floating swap:

Dealer PAYS 3.28% fixed to customer vs. RECEIVING LIBOR from customer

OR

Dealer RECEIVES 3.32% fixed from customer vs. PAYING LIBOR to customer

The investment banker should advise Company D to

A.   Issue floating-rate debt at LIBOR + 150 bps and not do any swaps. B.    Issue fixed-rate debt at 4.85% and enter a Pay fixed/Receive floating swap C.    Issue fixed-rate debt at 4.85% and enter a Receive fixed/Pay floating swap D.   Issue fixed-rate debt at 4.85% without doing any swaps.

Explanation / Answer

Company D wants a floating rate liability. Therefore, it will issue fixed rate Bond and swap it with a fixed rate bond. It clearly wants to pay a floating rate bond, therefore it will pay floating and receive a fixed at 4.85% interest rate.

Therefore, option C is correct.

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