Question

ABC Company and XYZ Company need to raise funds to pay for capital improvements at their manufacturing plants. ABC Company is a well-established firm with an excellent credit rating in the debt market. It can borrow funds either at a 10 percent fixed rate or a LIBOR + 1 percent floating rate. XYZ Company is a fledgling start-up firm without a strong credit history. It can borrow funds either at 11 percent fixed rate or at LIBOR + 3 percent floating rate. Now suppose that XYZ obtains the 11 percent fixed rate loan and ABC obtains the floating rate loan at LIBOR +1. They enter into a swap whereby ABC pays 11 percent fixed to XYZ and XYZ pays Libor + 2.5 to ABC.

a) What is the net borrowing cost for ABC Company?

b) What is the net borrowing cost for XYZ Company?

Answer 1

ABC Company - Options for borrowing - Fixed Rate 10%

- Floating Rate LIBOR + 1%

Option availed - Floating Rate LIBOR + 1%

XYZ Company - Options for borrowing - Fixed Rate 11%

- Floating Rate LIBOR+2.5%

Option availed - Fixed Rate 11%

After entering into SWAP -

Let us assume that Loan taken by both the company as $10 Million each
Let us assume LIBOR = 5%
ABC pays to Bank	=LIBOR+1%	=10*(5%+1%)	$     0.60	Mn
ABC pays to XYZ		=11%	=10*11%	$     1.10	Mn
ABC receives from XYZ	=LIBOR+2.5%	=10*(5%+2.5%)	$     0.75	Mn
Net Payment by ABC	=LIBOR+1%+11%-(LIBOR+2.5%)	9.50%	$     0.95	Mn
Hence, net borrowing cost for ABC Company is 9.5% = $0.95 Mn
XYZ pays to Bank	=11%	=10*11%	$     1.10	Mn
XYZ pays to ABC		=LIBOR+2.5%	=10*(5%+2.5%)	$     0.75	Mn
XYZ receives from ABC	=11%	=10*11%	$     1.10	Mn
Net Payment by XYZ	=11%+LIBOR+2.5%-11%	7.50%	$     0.75	Mn
Hence, net borrowing cost for XYZ Company is LIBOR+2.5% = $0.75 Mn