Company A, a lower-rated firm, desires a fixed-rate long-term loan. Company A pr

Question

Company A, a lower-rated firm, desires a fixed-rate long-term loan. Company A presently has access to floating interest rate funds at a margin of 1.2% over LIBOR. In contrast, company B, a higher-rated firm, prefers a floating-rate loan. Company B has access to fixed-rate funds at 10.5% and floating-rate funds at LIBOR+0.7%. Both companies enter into an interest rate swap with Bank C. Based on the swap, Bank C would gain 0.2% and each of the two companies would gain 0.5%. What is the current fixed rate available for Company A? Select one: a. 9.6% b. 12.2% c. 11.8% d. 13.4% e. 12.9% f. 8.8%

Explanation / Answer

Given data:

Calculate the difference between fixed and floating rate by adding up the Bank gain and companies gain

Difference between fixed and floating rate = Bank gain + companies gain= 0.2% + 1% = 1.2%

The difference between fixed and floating rate is

X – 10.5% – 0.5% = 1.2%

= X –10% = 1.2%

Therefore, X = 12.2%

Hence, the correct option is (b) i.e. 12.2%

We can have a cross check over the calculations done:

Fixed

A

12.2%

Libor +1.2%

B

10.5%

Libor +0.7%

Difference

1.7%

0.5%

Thus, the difference between fixed and floating rate = 1.7 – 0.5% = 1.2%

Now, deduct the gain to bank C i.e. 0.2%. Thus, the gain after distribution to C = 1%

The companies share equally = 1% ÷ 2 = 0.5% each

Fixed

A

12.2%

Libor +1.2%

B

10.5%

Libor +0.7%

Difference

1.7%

0.5%

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