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Homework answers / question archive / 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
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%
b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Draw the cash flow chart and calculate net cashflows as Exhibit 14.4. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. Assume the swap bank is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat.
The QSD or Quality Spread Differential = (12.0% - 10.5%) minus (LIBOR + 1% - LIBOR) =0.5%.
Now the swap bank Quote difference = 10.7% - 10.8% = 0.1%
Hene Net savings to both Alpha & Beta = 0.5%-0.1% = 0.40%
Net savings to Alpha = 0.40% /2 = 0.20%
Net savings to Beta = 0.40% /2 = 0.20%
Alpha will issue fixed-rate debt at 10.5% and Beta will issue floating rate-debt at LIBOR + 1%
Alpha will receive 10.7% from the swap bank and pay it LIBOR. If this is done, Alpha’s floating-rate all-in-cost is= 10.5% + LIBOR - 10.7% = LIBOR -0.20%.
Previously Alpha could borrow at LIBOR. Now Alpha could borrow at net cost LIBOR -0.20%.Hence there is 0.20% savings due to Swap.
Beta will pay 10.8% to the swap bank and receive from it LIBOR. if this is done, Beta’s fixed-rate all in-cost is= LIBOR+ 1% + 10.8% - LIBOR = 11.8%
Previously Beta could borrow at 12.0% fixed rate. Now Beta could borrow at net cost 11.80%.Hence there is 0.20% savings due to Swap.
