Q7 a) Your firm needs to raise $97.7 million in funds. You can borrow short term...

Q7 a) Your firm needs to raise $97.7 million in funds. You can borrow short term at a spread of 1% over LIBOR. Alternatively, you can issue 10-year, fixed-rate bonds at a spread of 2.57% over 10-year Treasuries, which currently yield 7.62%. Current 10-year interest rate swaps are quoted at LIBOR versus the 8.1% fixed rate. Management believes that the firm is currently “underrated” and that its credit rating is likely to improve in the next year or two. Nevertheless, the managers are not comfortable with the interest rate risk associated with using short-term debt.'

Suggest a strategy for borrowing the $97.7 million. What is your effective borrowing rate?

b) Suppose the firm’s credit rating does improve three years later. It can now borrow at a spread of 0.50% over Treasuries, which now yield 8.99% for a seven-year maturity. Also, seven-year interest rate swaps are quoted at LIBOR versus 9.54%. How would you lock in your new credit quality for the next seven years? What is your effective borrowing rate now?

Expert Solution

(A) Calculation of effective borrowing rate

Effective borrowing rate = Short Term loan Rate + 10Year Fixed Rate - Received From Swap

= (LIBOR + 1%) + 8.1% - LIBOR

= 9.1%

Borrow $97.7m short term and paying LIBOR + 1.0%. Then enter a $97.7m notional swap to receive LIBOR and pay 8.1% fixed. Thus, its effective borrowing rate is (LIBOR + 1.0%) + 8.1% – LIBOR = 9.1%
The firm strategy for borrowing the $97.7 million effective borrowing rate is 9.1%

(B) Calculation of effective borrowing rate

Effective borrowing rate = Long Term loan Rate + 10Year Fixed Rate - Received From Swap + ShortTerm loan Rate + 10Year Fixed Rate

= (8.99+0.5%) + 8.1% - LIBOR + LIBOR - 9.54%

= 9.49% + 8.1% -9.54%

= 8.05%

Refinance $97.7m short-term loan with long-term loan at 8.99% + 0.50% = 9.49%. Unwind swap by entering new swap to pay LIBOR and receive 9.54%. Thus, its effective borrowing cost now: 9.49% + (8.1%–LIBOR) + (LIBOR – 9.54%) = 8.05%
The firm lock in your new credit quality for the next seven years the effective borrowing rate now is 8.05%

jeff jeffy answered 2 years ago

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