Question

Billy Enterprises can issue floating-rate debt at LIBOR + 2 percent or fixed-rate debt at 10.00 percent. Kidd Manufacturing can issue floating-rate debt at LIBOR + 2.95 percent or fixed-rate debt at 10.45 percent. Suppose Billy issues floating-rate debt and Kidd issues fixed-rate debt. They are considering a swap in which Billy will make a fixed-rate payment of 7.95 percent to Kidd, and Kidd will make a payment of LIBOR to Billy.

a. What are the net payments of Billy and Kidd if they engage in the swap?

b. Will Billy be better off to issue fixed-rate debt or to issue floating-rate debt and engage in the swap? Why?

c. Will Kidd be better off to issue floating-rate debt or to issue fixed-rate debt and engage in the swap? Why?

Answer 1

Solution :-
(a)
		Floating		Fixed
Billy		LIBOR + 2%		10%
Kid		LIBOR + 2.95%		10.45%
Swaping Cost
Billy to Kid		7.95%
Kid to Billy		LIBOR
In Case of Billy -- Prefer Floating Rate
Payments		LIBOR + 2% + 7.95%		LIBOR + 9.75%
Received				LIBOR
Net Paid				9.75%
In case of Kid --- Prefer Fixed rate
Payments		10.45% + LIBOR		LIBOR + 10.45%
Received				7.95%
Net Paid				LIBOR + 2.5%
(b)
		Fixed Payment		Floating with Swap
Billy		10%		9.75%
Billy will be better off in issuing Floating with swap as it has low cost as compared to Fixed debt
( C )
		Floating Payment		Fixed With Swap
Kid		LIBOR + 2.95%		LIBOR + 2.5%
Kid will be better off in issuing Fixed with swap as it has low cost as compared to Floating debt

If there is any doubt please ask in comments  

Answer 2

Net payment of Billy = pay LIBOR + 2 percent on debt issued + fixed-rate payment of 7.95 percent to Kidd - payment of LIBOR from Kidd

Net payment of Billy =  LIBOR + 2% + 7.95% - LIBOR = 9.95%

Net payment of Kidd = pay 10.45 percent on fixed debt issued + payment of LIBOR to Billy - fixed-rate payment of 7.95 percent from Billy

Net payment of Kidd = 10.45% + LIBOR - 7.95% = LIBOR + 2.5%

Billy will be better off to issue floating-rate debt because if he issues fixed rate debt and engages in swap then his net payment will be:

pay 10 percent on fixed-debt issued + fixed-rate payment of 7.95 percent to Kidd - payment of LIBOR from Kidd = 17.95% - LIBOR

the above net payment of 17.95% - LIBOR will be higher than 9.95% net payment if Billy issues floating rate debt.

Kidd will be better off to issue floating rate debt because if he issues floating-rate debt and engages in swap then his net payment will be:

pay LIBOR + 2.95 percent on debt issued + payment of LIBOR to Billy - fixed-rate payment of 7.95 percent from Billy = 2LIBOR + 2.95% - 7.95% = 2LIBOR - 5%

the above net payment of 2LIBOR - 5% will be lower than LIBOR + 2.5% of net payment if Kidd issues fixed rate debt.