Question

A financial institution has brought together two firms who seek access to new debt capital for expansions of their operations.

Company CCC is concerned about rising interest rates and seeks fixed rate financing, while company DDD is prepared to take what it believes to be the attractive current variable rate which is on offer.

The two firms have existing arrangements in place for sources of financing, however CCC can attract funds from the Eurodollar market at what it believes to be beneficial rates.

CCC: Fixed: 9%

CCC: Floating: LIBOR+3.5%

DDD: Fixed: 11%

DDD: Floating: LIBOR+6.9%

1. Assuming no transaction costs, clearly indicate the size of any observed mispricing of risk. (1 mark)
2. Clearly indicate any absolute advantage in financing. Why is this likely to be the case? (1 mark)
3. Clearly indicate any comparative advantages in financing. (1 mark)
4. The financial institution helps to create a swap which is beneficial to both parties and requires a net total compensation package of 0.2% of the total funds involved (this does not mean 0.2% from each company, this means 0.2% total compensation). Assume that any available benefits are split evenly between the two companies and design a swap which is acceptable to both companies and to the financial institution. Clearly indicate the swap rates that the two companies and the financial institution are using. Clearly indicate the final borrowing rate for each company.

Answer 1

a) The company CCC (CCC being the credit rating) is less riskier then the company DDD. A company who is risky or which has low credit rating will get finance at much higher rate as compared to the company who is less risky and which has high credit rating. This is simply because a riskier firm is more prone to default. In the case above, the firm CCC is getting finance at fixed rate of 9% while the firm DDD (which is more riskier then CCC) is getting finance at fixed rate of 11%. Also in floating rates terms, the firm CCC is getting finance at LIBOR+3.5% while the firm DDD is getting finance at LIBOR+6.9%.

b) The firm CCC is getting absolute advantage in financing as it is getting a finance at fixed rate of 9% while the firm DDD (which is more riskier then CCC) is getting finance at fixed rate of 11%. Also in floating rates terms, the firm CCC is getting finance at LIBOR+3.5% while the firm DDD is getting finance at LIBOR+6.9%. This is because a riskier firm is more prone to default, hence high cost of financing.

c) The firms which has high credit ratings have comparative advantages in financing. The firms with high credit ratings get credit/finance at much cheaper rate as compared to the firms with comparatively low credit ratings.

d)

Firm	Fixed Rates	Floating Rates
CCC	9%	LIBOR+3.5%
DDD	11%	LIBOR+6.9%
Quality Spread	2%	3.4%

Now the financial institution is helping the firms to create a swap which is beneficial to both parties. The institution requires a net total compensation package of 0.2% of the total funds involved. Also any available benefits are split evenly between the two companies.

So the total benefits available = Difference in Quality Spread - Financial institution total compensation package

                                                                = (3.4 – 2%) – 0.2%

                                                                = 1.2%

So now this total benefits available will split evenly between the two companies.

Company CCC should choose floating rate as it has more comparative advantage.

The swap should be as below:

The net rate after swap for Company CCC is 8.3%    [(LIBOR + 3.5% + 4.8%) – LIBOR]

The net rate after swap for Company DDD is LIBOR + 6.2%            [(LIBOR + 11%) – 4.8%]

Now 0.2% out of this will be given to the financial institution compensation package.