Question

Company a & b require $50 million for a 3 year period. To reduce their financing needs, Company A would like to borrow at a fixed rate, whereas Company B would prefer to borrow at a floating rate. The cost to each party of accessing either the fixed or floating rates for a 3 year debt issue is as follows:

Borrower	Fixed rate available	Floating Rate available
A	8.5%	Prime+ 1.0%
B	7.5%	Prime+ 0.5%

Set up an interest rate swap. Both companies share equally from the interest rate differential with the investment bank keeping 0.10%.

Answer 1

Company A would like to borrow at a fixed rate which means B will borrow at 7.5% and Company A will pay the interest @7.5% to B, and Company A will borrow @ Prime+ 1.0% and Company B will pay interest @Prime+ 0.5%, the balance 0.5% will be added by company A to remit to the bank@Prime+ 1.0%

Here Company A saved 1% interest (pays @7.5% instead of 8.5%), and Company A has to add 0.5%, to remit to its bank, because Company B bear only its available rates ( Prime+ 0.5%) , so the net interest savings is (1% - 0.5%) 0.5%, 0.10% to investment bank the balance 0.40% will be shared equally by Company A & Company B, if so the net payment of interest by Company A = 8.30% and by Company B is Prime+ 0.30%,

We can check it

Evaluation in the hands of Company B

Company B pays to its Original Banker @ 7.5%, (out flow)

Company B will receive the reimbursement from Investment banker @7.50% and profit of 0.20% = 7.70%, (In flow)

Company B will reimburse to Investment banker@ its offered rate = Prime+ 0.50%, (out flow)

The net outcome will be 7.70% - (7.50%) - (Prime+ 0.5%) = (Prime+ 0.3%), the outflows are shown in brackets,

Evaluation in the hands of Company A

Company A pays to its Original Banker @ Prime+ 1.0% (out flow)

Company A will receive the reimbursement from Investment Bank@Prime+ 0.50% (In flow)

Company A will reimburse to Investment Bank @ 7.5% and profit of 0.20% and Investment Banker's fee of 0.10% = 7.80%, (out flow)

The net outcome will be = Prime+ 0.50% - (7.80%) - (Prime+ 1%) = (8.30%), the outflows are shown in brackets,

This can be expressed through A diagram called schematic diagram, in Schematic diagram we can uderstand easily, invetment Bank's margin = 7.80% received from Company A and payment to company B @ 7.70% = 0.10%

Please give maximum rating if you Convinced and satisfied, if remains any doubt on this Question or answer, please leave a comment,