(i) Calculate the net financing cost for ABC and XYZ. Include all outflows (thei

Question

(i) Calculate the net financing cost for ABC and XYZ. Include all outflows (their initial borrowing obligations and their swap payments) and their inflow (the payment they receive in the swap).

(ii) Calculate how much better off each firm is by engaging in the swap rather than taking out their desired loan type from the markets directly.

a) Companies ABC and XYZ have been offered the following rates per annum on a $20million 5-year loan. Company Name Company ABC Company XYZ Fixed rate 8.8% 10.5% Floating rate BBSW + 0.1 % BBSW+ 0.5% Company ABC requires a floating rate loan while company XYZ requires a fixed rate loan. However, ABChas a comparative advantage borrowing on the fixed rate market, while XYz has a comparative advantage borrowing on the floating rate market. Each company decides to borrow on the market where they have a comparative advantage and then engage in a swap agreement. A swap is organised where ABC will pay BBSW to XYZ, and XYZ will pay 9.5% to ABC.

Explanation / Answer

In this case, the parties are engaging in an interest rate swap. This is possible because the nominal value of the loan is same for both the parties i.e. $20 million and both of them have a comparative advantage in one or the other market. Here, BBSW is Bank Bill Swap Rate which just like the LIBOR is a benchmark rate used for pricing of Australian dollar derivatives and securities.

Now let's first understand how the companies arrived at the interest rate for swap agreement for a better understanding of the concept :

As is evident from the difference that Company XYZ will be in a much more advantageous position if it pays a fixed interest rate to the company ABC and in lieu receives floating rate from ABC company. This is what has been stated in the question as well hence now we can make out how companies agreed to the exchange in the first place.

Company XYZ pays 9.5% fixed rate to the Company ABC which is nothing but close to the average of (8.8% and 10.5%)

Company ABC will be benefitted if it pays less than the amount of floating rate interest at which it can borrow from the market so it pays only BBSW to Company XYZ.

Once we have understood the mechanism of this, we can now calculate what has been asked in the question.

i) Net Financing Cost for Company ABC will be = Outflows - Inflows

(Since in an interest rate swap the nominal value is also exchanged in the beginning and then again at the end of the agreement along with the interest rates.)

= [20 million + (20 million x 8.8%)] - [$20 million + (20 million x 9.5%)]

= 21,760,000 - 21,900,000

= - $140,000

Net Financing Cost for Company XYZ will be = Outflows - Inflows

= [20,000,000 x ( BBSW + 0.5% - BBSW)]

= $100,000

ii) We calculate how much better of the firm is by engaging in swap can be calculated by finding out the relative advantage to each company in both the markets. This has been calculated as follows:

Company ABC = ( 9.5% - 8.8%) + (BBSW + 0.1% - BBSW) = 0.8%

Company XYZ = ( 10.5% - 9.5%) + (BBSW - BBSW - 0.5%) = 0.5%

The above calculations show how swap aggrement benefits the companies. Company ABC is better off by a percentage of 0.8% and Company XYZ is better off by a percentage of 0.5%.

Company Name Fixed Rate Floating Rate Company ABC 8.80% BBSW + 0.1% Company XYZ 10.50% BBSW + 0.5% Difference 1.70% 0.40%

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