1.Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. Assu

Question

1.Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. Assume that a swap bank is involved as an intermediary and the bank is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat.

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. Graph the swap including the external financing costs.

b. What is the all-in interest rate cost for each of the firms?

c. How much does the swap bank make (in terms of interest rates)?

d. How much does each firm save per year?

e. Assume Alpha and Beta want to borrow $ 100,000,000 for 5 years. Further, the LIBOR rate over the next 5 years is expected to be 7%. Report the net borrowing costs (in dollar terms, not interest rates) for both parties.

Explanation / Answer

(a)

Alpha < 10.7% bank < 10.8% Beta

10.5%    L > bank L > L+1%

outside party   outside party

(b)

all in interest rate cost for

Alpha Beta

L-2% 10.8+1 i.e 11.8%

(c) swap bank make 10.8-10.7% i.e 0.1% profit

(d) Alpha saves 0.2% as its cost now is L-0.2 %if it does what it desires then cost would be L  

Beta also saves 0.2% as its cost now 11.8% if it does what it desires then cost would be 12%

(e) For Alpha cost would be 100,000,000*(7-0.2)% = 68,00,000 per yr

For Beta cost would be 100,000,000*11.8% =11,800,000 per yr.

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