Credit Rating and Borrowing Cost
1. Alpha and Beta Companies can borrow for a five-year term at the following rates: Alpha Beta
Moody’s credit rating Aa Baa
Fixed-rate borrowing cost 10.5% 12.0%
Floating-rate borrowing cost LIBOR LIBOR + 1%
a. Calculate the quality spread differential (QSD).
b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. No swap bank is involved in this transaction.
Solution:
a. The QSD = (12.0% - 10.5%) minus (LIBOR + 1% - LIBOR) = .5%.
b. Alpha needs to issue fixed-rate debt at 10.5% and Beta needs to issue floating rate-debt at LIBOR + 1%. Alpha needs to pay LIBOR to Beta. Beta needs to pay 10.75% to Alpha. If this is done, Alpha’s floating-rate all-in-cost is: 10.5% + LIBOR - 10.75% = LIBOR - .25%, a .25% savings over issuing floating-rate debt on its own. Beta’s fixed-rate all-in-cost is: LIBOR+ 1% + 10.75% - LIBOR = 11.75%, a .25% savings over issuing fixed-rate debt.
2. Do problem 1 over again, this time assuming more realistically that a swap bank is involved as an intermediary. Assume the swap bank is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat.
Solution: Alpha will issue fixed-rate debt at 10.5% and Beta will issue floating rate-debt at LIBOR + 1%. Alpha will receive 10.7% from the swap bank and pay it LIBOR. Beta will pay 10.8% to the swap bank and receive from it LIBOR. If this is done, Alpha’s floating-rate all-in-cost is: 10.5% + LIBOR - 10.7% = LIBOR - .20%, a .20% savings over issuing floating-rate debt on its own. Beta’s fixed-rate all-in-cost is: LIBOR+ 1% + 10.8% - LIBOR = 11.8%, a .20% savings over issuing fixed-rate debt.
3. Company A is a AAA-rated firm desiring to issue five-year FRNs. It finds that it can issue FRNs at six-month LIBOR + .125 percent or at three-month LIBOR + .125 percent. Given its asset structure,
Moody’s credit rating Aa Baa
Fixed-rate borrowing cost 10.5% 12.0%
Floating-rate borrowing cost LIBOR LIBOR + 1%
a. Calculate the quality spread differential (QSD).
b. Develop an interest rate swap in which both Alpha and Beta have an equal cost savings in their borrowing costs. Assume Alpha desires floating-rate debt and Beta desires fixed-rate debt. No swap bank is involved in this transaction.
Solution:
a. The QSD = (12.0% - 10.5%) minus (LIBOR + 1% - LIBOR) = .5%.
b. Alpha needs to issue fixed-rate debt at 10.5% and Beta needs to issue floating rate-debt at LIBOR + 1%. Alpha needs to pay LIBOR to Beta. Beta needs to pay 10.75% to Alpha. If this is done, Alpha’s floating-rate all-in-cost is: 10.5% + LIBOR - 10.75% = LIBOR - .25%, a .25% savings over issuing floating-rate debt on its own. Beta’s fixed-rate all-in-cost is: LIBOR+ 1% + 10.75% - LIBOR = 11.75%, a .25% savings over issuing fixed-rate debt.
2. Do problem 1 over again, this time assuming more realistically that a swap bank is involved as an intermediary. Assume the swap bank is quoting five-year dollar interest rate swaps at 10.7% - 10.8% against LIBOR flat.
Solution: Alpha will issue fixed-rate debt at 10.5% and Beta will issue floating rate-debt at LIBOR + 1%. Alpha will receive 10.7% from the swap bank and pay it LIBOR. Beta will pay 10.8% to the swap bank and receive from it LIBOR. If this is done, Alpha’s floating-rate all-in-cost is: 10.5% + LIBOR - 10.7% = LIBOR - .20%, a .20% savings over issuing floating-rate debt on its own. Beta’s fixed-rate all-in-cost is: LIBOR+ 1% + 10.8% - LIBOR = 11.8%, a .20% savings over issuing fixed-rate debt.
3. Company A is a AAA-rated firm desiring to issue five-year FRNs. It finds that it can issue FRNs at six-month LIBOR + .125 percent or at three-month LIBOR + .125 percent. Given its asset structure,