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%

Calculate the quality spread differential (QSD). (10 pts)

What is the all-in interest rate cost for each of the firms? (20 pts; 10 pts for each firm)

How much does the swap bank make (in terms of interest rates)? (10 pts)

How much does each firm save per year? (10 pts)

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. (10 pts)

Explanation / Answer

1)

QSD = (LIBOR+12%) - (10.5% + (LIBOR + 1%)) = 0.5%

2)

Alpha

Rd = 10.5% (fixed)

floating-rate = 10.5% + LIBOR - 10.7% = LIBOR - 0.2%

0.2% savings over issuing floating-rate debt

Beta

Rd = LIBOR + 1% (floating)

fixed-rate = LIBOR+ 1% + 10.8% - LIBOR = 11.8%,

0.2% savings over issuing fixed-rate debt.

4)

Alpha = 10.5%*100000000 = 10500000

Beta = (7%+1%)*100000000 = 8000000

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