1. Alpha and Beta Companies can borrow for a five-year term at the following rat
ID: 2781315 • Letter: 1
Question
1. Alpha and Beta Companies can borrow for a five-year term at the following rates:
Alpha Beta
Moody’s credit rating Aa Baa
Fixed-rate borrowing cost 10.5% 12.0%
Floating-rate borrowing cost LIBOR LIBOR + 1%
a. Calculate the quality spread differential (QSD). b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. No swap bank is involved in this transaction.
My question is how is the value in percentage calculated. what alpha needs to pay and what beta needs to pay. Please explain in detail.
Explanation / Answer
a. The QSD = (12.0% - 10.5%) - (LIBOR + 1% - LIBOR) =0.5%
b. Alpha needs to issue fixed-rate debt at 10.5% and Beta needs to issue floating rate-debt at LIBOR + 1%.
Alpha needs to pay LIBOR to Beta. Beta needs to pay 10.75% to Alpha.
If this is done, Alpha’s floating-rate all-in-cost is: 10.5% + LIBOR - 10.75% = LIBOR -0.25%, a0.25% savings over issuing floating-rate debt on its own.
Beta’s fixed-rate all-in-cost is: LIBOR+ 1% + 10.75% - LIBOR = 11.75%, a .25% savings over issuing fixed-rate debt.
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