Alphabetical Company (ALP) prefers variable- to fixed-rate debt. On the other ha

Question

Alphabetical Company (ALP) prefers variable- to fixed-rate debt. On the other hand, Microsotical Company (MIC) prefers fixed- to variable-rate debt. Assume the following information for both Companies:

Fixed-Rate Bond              Variable-Rate Bond

      ALP                                                       12%                                          LIBOR + 2%

      MIC                                                     13.5%                                          LIBOR + 2.5%

As a rising star analyst in the ALP, you approach the Chief Financial Officer (CFO) and propose an interest swap deal that your firm can enter into with MIC. However, your CFO argues that an interest rate swap will probably not be advantageous to the company because it can issue both fixed and variable debt at more attractive rates than MIC.

Explain to your CFO why he is wrong. Make sure that your explanation includes the discussion about the absolute and comparative advantages and the potential savings from the interest rate swap deal?    (5 marks)

Now show your CFO the interest rate swap deal by completing the diagram below (Write your answers in the answer booklet provided)with the following assumptions:                                                                      (10 marks)

ALP will have 50% of the potential savings, and MIC will receive the rest. There is no swap bank.

LIBOR (floating rate) must be used in the transaction between ALP and MIC companies i.e. either transaction (iii) or (iv).

MIC

MIC

Explanation / Answer

ALP prefers variable while MIC prefers fixed rate interest so now the total interest for both the firm's is

ALP Fixed cost is LIBOR +2%

MIC variable cost is 13.5%

Therefore total interest cost is LIBOR +15.5 %

Now if we do a interest swap deal then the

Interest cost for AMC is 12% while for MIC is LIBOR+2.5%

Now total interest cost for both parties with swap deal is LIBOR+14.5%

Now the advantage of cost through swap deal is

LIBOR+15.5% - [LIBOR+14.5%]

Therefore the advantage is of 1%

Now ALP has 50% potential savings so

Interest benefit share of ALC due to swap is 0.50%

And of MLC is 0.50%

Here CFO can see the advantage of interest swap deal clearly

There is clear benefit of 0.50% cost of interest to both the parties

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