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Question 1 (50 marks)

Leopard Automobile is a car manufacturing company and Road Creation is a 4A advertising firm. Leopard Automobile is looking for a floating rate loan, while Road Creation targets a fixed rate loan. The two companies have been offered the following borrowing rates on a $100 million 2-year loan:

Fixed rate (p.a.) Floating rate (p.a.)
Leopared Automobile 6.25% LIBOR + 4.75%
Road Creation 5.00% LIBOR + 2.1%

Required:

a What is the interest rate difference in borrowing a fixed rate loan between the two companies? What is the difference in borrowing a floating rate loan? Which company has a comparative advantage in the fixed rate loan and which company has a comparative advantage in the floating rate loan? Please explain. (10 marks)

b Suppose you are the Manager of the Bank and the two companies are your long-time customers. Design a swap structure that will allow your bank to be an intermediary with 0.40% per annum profit, and that both Leopard Automobile and Road Creation can benefit equally. (16 marks)

c If Road Creation agrees to engage the swap contract with the Bank according to the structure you proposed, evaluate the firm’s net borrowing cost. Compared with direct borrowing in the market, how many percentage points can Road Creation save from the swap contract? (12 marks)

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Reid Wolff
Reid WolffLv2
28 Sep 2019
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Related questions

Companies X and Y have been offered the following rates per annum on a $20 million five-year loan: Fixed Rate Floating Rate Company X 6% LIBOR + 0.25% Company Y 8.4% LIBOR + 1.25% Company X requires a floating-rate loan; company Y requires a fixed rate investment. Design a swap that will net a bank, acting as intermediary, 50bps per annum and appear to be equally attractive to X and Y.

Lluvia and Paraguas. Lluvia Manufacturing andParaguas Products both seek funding at the lowest possible cost.Lluvia would prefer the flexibility of floating rate​ borrowing,while Paraguas wants the security of fixed rate borrowing. Lluviais the more creditworthy company. They face the following ratestructure.​ Lluvia, with the better credit​ rating, has lowerborrowing costs in both types of borrowing.

Lluvia wants floating rate​ debt, so it could borrow atLIBOR+1.000%. However, it could borrow fixed at 9.500%and swap forfloating rate debt. Paraguas wants fixed rate​ debt, so it couldborrow fixed at 13.500%. However, it could borrow floating atLIBOR+2.000%and swap for fixed rate debt. What should they​ do?(LIBOR is 6.500%​.)

Lluvia’s comparative advantage is __% (Round to three decimalplaces)

Lluvia’s net interest after a swap with Paraguas is __% (Roundto three decimal places)

Paraguas’s net interest after a swap with Lluvia is __% (Roundto three decimal places)

Lluvia’s savings on borrowing versus net swap is __% (Round tothree decimal places)

Paraguas’s savings on borrowing versus net swap is __% (Round tothree decimal places)

Therefore, Lluvia should borrow at the __ rate and Paraguasshould borrow at the __ rate.

Company A is a blue chip company, headquartered in United State. It is considering raising $500 million to fund its major expansion in a whole new sector for the next 20 years. Company A can either borrow at a fixed rate of 11% or at a floating rate of prime rate + 7%. Given company A's own projection of its new business, it prefers to borrow at floating rate.

Company B is multi-national corporation based in France. It is also considering raising $500 million to expand its business in United States for the next 20 years. Company B can either borrow at a fixed rate of 15% or at a floating rate of prime rate + 9%. Company B prefers to borrow at fixed rate.

a. Explain the comparative advantage between company A and company B when it comes to borrowing.

b. Suppose you represent a swap bank and now both companies ask you to create an interest rate swap that would help both company save 0.8% in the interest annually. (Company A save 0.8% in floating rate and company B save 0.8% in fixed rate)

c. What is the net profit for your bank annually?

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