In: Finance
1. Boeing and Microsoft are expanding their research and development facilities and both wish to take out loans of $3 million. The recently hired KSU finance major working for Big Sky Bank sees a potential swap. Please answer the questions below.
Microsoft
Borrow at a floating rate of LIBOR + 4.5%
Borrow fixed at 5.5%
Boeing
Borrow at floating rate of LIBOR + 5.5%
Borrow fixed at 7.5%
__________________________________________________________________________
A.) Who has the absolute advantage in loan rates and why?
B) Who has the comparative advantage in the variable rate loan and why?
C) Suppose the firm in (B) above wants to make fixed-rate payments and the other firm wants to make variable-rate payments. Furthermore, Suntrust Bank requires 1/2% for arranging the swap. Fill in a box diagram showing the cash flows streams that will make this swap work if you split the gains equally. Also, show what type of loan each firm chooses as their legal loans that they take out.
Please include a detailed explanation! Thanks :)
a) As Microsoft can borrow at cheaper rates as compared to Boeing in both variable and fixed rate markets., Microsoft has an absolute advantage in loan rates. This may be because of the credibility, size or the present level of Cashflows and Debt level etc of Microsoft may be better than Boeing
b) Absolute Advantage of Microsoft in Variable rate loans over Boeing = (L+5.5%-(L+4.5%)) =1%
. Absolute Advantage of Microsoft in Fixed rate loans over Boeing =(7.5%-5.5%) = 2%
As the absolute advantage of Microsoft over Boeing is more in Fixed rate loans, the comparative advantage of Microsoft is in Fixed rate loans and Boeing has a comparative advantage in Variable rate loans
c) If Boeing wants to make payments in Fixed rate and Microsoft wants to make payments in Variable rate , both firms can benefit by choosing the loan in their comparative advantage and then effecting a swap. The total benefit shared between the firms and the Intermediary (Suntrust bank) is equal to the difference between the Absolute Advantage of Microsoft over Boeing in two different types of loans i.e. = 2%-1% =1%
The diagram showing the same is given below
Here it can be clearly seen that Microsoft borrows externally (legal loan) at a rate of 5.5% and Boeing borrows externally (legal loan) at LIBOR + 5.5%
In the swap, Microsoft receives 5.5% and pays LIBOR +4.25% , so the net payment of Microsoft is LIBOR +4.25% , an advantage of 0.25% over what Microsoft would have paid had it taken a Variable rate loan directly.
Boeing receives LIBOR +5.5% and pays 7.25% , so the net payment of Boeing is 7.25% , an advantage of 0.25% over what it would have paid had it taken a fixed rate loan directly.
Bank's advantage = (7.25%-5.5%) + (LIBOR+4.25%- (LIBOR+5.5%))
=1.75%-1.25% = 0.5%