IBM and GE are both in the market for approximately $10 million of debt for a fi
ID: 2780728 • Letter: I
Question
IBM and GE are both in the market for approximately $10 million of debt for a five year-period. GE has an AA credit rating while IBM has a single A rating. GE has access to both fixed and floating interest rate debt at attractive rates. However, GE would prefer to borrow at floating rates. Although IBM can borrow at both interest rates, the fixed rate debt is considered expensive. IBM would prefer to borrow at fixed rates. The information about the two firms is summarized as follows:
GE IBM
Credit Rating AAA A
Floating Rates LIBOR + ¼% LIBOR + ¾%
Fixed Rates 9% 10%
Preference Floating Fixed
Please answer the following questions:
1.In what type of borrowing does IBM have the comparative advantage? Why?
2.In what type of borrowing does GE have the comparative advantage? Why?
3.If a swap were arranged, what is the maximum savings that could be divided between the two parties?
4.Please arrange such a swap so that the total saving is divided evenly between the two parties. No financial institution is needed. Please use arrows and boxes to illustrate the deal.
Explanation / Answer
1.In what type of borrowing does IBM have the comparative advantage? Why?
IBM has the comparative advantage with the floating rate of Libor+0.75% because there is 1% difference in fixed of both the parties and only 0.5% difference in floating. So this difference can be shared by these two companies.
2.In what type of borrowing does GE have the comparative advantage? Why?
GE has the comparative advantage with fixed rate because IBM is getting @10% fixed rate that means 1% is more for IBM but if GE takes floating then the difference is only 0.5%.
3.If a swap were arranged, what is the maximum savings that could be divided between the two parties?
Maximum saving for both the parties is 0.5% that will be shared between both the parties.
4.Please arrange such a swap so that the total saving is divided evenly between the two parties.
In the above case, by swapping, GE is getting @ Libor only instead of Libor+0.25% because of swapping.
And IBM is getting @9.75% instead of 10% because both use their comparative loan and mutually benefitted by 0.5%
GE IBM Rating AA A Fixed rate 9% 10% Floating rate Libor+0.25% Libor+0.75% Quality spread differential (QSD) 0.50% The QSD = (10% - 9%) minus (LIBOR+ 0.75% - LIBOR+0.25%) = .5%