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Dear John,
Ive got some issues tackling this question. Can you please work it out for me. The question is as follows:
A Co wishes to raise $1m debt finance. Because of a poor credit rating a debenture issue is not possible and the best fixed interest rate loan it can obtain is at 12.5%. It can, however, borrow at a variable rate of LIBOR + 0.5%.
B Co can issue fixed rate debentures at 11% or alternatively borrow at a variable rate equivalent to LIBOR. B wants $1m in floating rate finance.
A Co agrees to pay B interest of 11.75%(fixed) on $1m, while B Co agrees to pay A co an interest rate of LIBOR on the same sum.
Required:
Which company should borrow at fixed rate loan
Calculate swap savings for each company.Why are you attempting a question for which you do not have an answer? You should be using a Revision Kit from one of the ACCA Approved Publishers – they have answers and workings.
Also, have you not watched my free lectures on swaps??
If A borrows fixed and B borrows floating, then the total interest is 12.5 + L
If A borrows floating and B borrows fixed, then the total interest is L + 0.5 + 11 = L + 11.5%There is therefore a saving to be made by swapping of 1%. How this is shared between the two depends on what they have agreed.
As a result, A will borrow floating and B will borrow fixed, and they will swap so that the end result is that A pays fixed and B pays floating.
So A will L + 0.5
A pays 11.75 to B
A receives L from BThe net payment by A is L + 0.5 + 11.75 – L = 12.25% fixed
Without the swap A would have paid 12.5%
So A is saving 0.25%As far as B is concerned:
B will pay 11
B will pay L to A
B will receive 11.75 from AThe net payment by B is 11 + L – 11.75 = L – 0.75%
Without the swap, B would have paid L, and B is saving 0.75%
(As a check, the total saving is 0.25 + 0.75 = 1%)
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