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.

A) 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?

B) 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:

? 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).

Answer 1

A. As we can see from the given data ALP has absolute advantage in raising debt funding over MIC since it can raise fixed funding at a 1.5% better rate and variable at 0.50% better rate. However this does not mean that they cannot enter into a swap and benefit since the swap benefit is based upon the relative advantage which is simply (). In this case the relative advantage will be (1.50% - 0.50%) = 1% or 100 bps. Hence this benefit is available for the two firms if they collaborate by swapping and can be shared among them. This benefit is the total benefit across both the firms and can be shared among themselves. ALP can borrow at 12% fixed and lend further to MIC at 12% + x%, whereas MIC can borrow at LIBOR + 2.5% and lend to ALP at (LIBOR + 2%). ALP will benefit on its variable cost loan by reducing its overall cost to (LIBOR + 2% - x%) which is a benefit of x%. For MIC the fixed cost will (12% + x% + 0.5%) or (12.5% + x%) which is a benefit of (1%-x%). We can also that the total benefit (excluding transaction costs) will x% + (1%-x%) = 1% which is the same as the relative advantage we calculated above.

B. We are given that 50% of potential savings from the swap go to ALP, hence x% = 0.50%. Then the swap will be as below:

• ALP borrows fixed at 12% and lends it to MIC at (12% + 0.50%) = 12.50% since MIC prefers fixed over variable rate.
• MIC borrows same amount at variable rate for same tenure, LIBOR +2.5% and lends it ALP at LIBOR + 2%.
• ALP net cost for variable funding = LIBOR + 2% - 0.50% (which they are receiving from MIC over and above fixed loan cost) = LIBOR + 1.50%.
• MIC net cost for fixed funding = 12.5% + 0.50% (which is the interest they are receiving less from ALP on the variable loan) = 13%
• Hence we see ALP has variable cost loan at 0.50% better than it could do on its own and MIC has fixed cost loan at 13% which is again 0.5% lower than it own fixed cost for debt.