Question

Carter Enterprises can issue floating-rate debt at LIBOR + 2% or fixed-rate debt at 10%. Brence Manufacturing can issue floating-rate debt at LIBOR + 2.3% or fixed-rate debt at 12%. Suppose Carter issues floating-rate debt and Brence issues fixed-rate debt. They are considering a swap in which Carter makes a fixed-rate payment of 8.90% to Brence and Brence makes a payment of LIBOR to Carter. What are the net payments of Carter and Brence if they engage in the swap? Round your answers to two decimal places. Use a minus sign to enter negative values, if any.

What is the net payment of Carter?.......%

Answer 1

Let us assume the principal amount of Debt issue for both Carter and Brence is same and is equal to the swap principal.

For Carter

Carter issues floating rate debt at LIBOR + 2%

After Swap, Carter Receives LIBOR rate from Brence and makes fixed rate payment of 8.9%

Thus, On net basis, it is paying 2% on floating rate and 8.9% on fixed rate i.e. a total of 10.9%

Thus net payment for Carter is 10.9%

For Brence

Carter issues fixed rate debt at 12%

After Swap, Brence Receives 8.9% rate from Carter and makes floating rate payment of LIBOR to Carter

Thus, On net basis, it is paying 3.1% on fixed rate and LIBOR on floating rate i.e. a total of LIBOR+ 3.1%

Thus net payment for Brence is LIBOR + 3.1%

(In this case , they are better off issuing debts by themselves rather than converting it by a Swap as Carter has comparative advantage in issuing fixed rate loan and Brence has comparative advantage in issuing floating rate loan)