Question

"Lluvia Manufacturing and Paraguas 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. Lluvia is the more credit-worthy company. With the better credit rating, Lluvia has lower borrowing costs in both types of borrowing. Assumptions   Lluvia   Paraguas Credit rating   AAA   BBB Prefers to borrow   Floating   Fixed Fixed-rate cost of borrowing   6.000%   12.000% Floating-rate cost of borrowing:         LIBOR (current=4%)   4.000%   4.000% Spread   1.000%   4.000% Total floating-rate   5.000%  
8.000%"However, it could borrow at LIBOR + 2.000% and swap for fixed rate debt. What should they do? (LIBOR is 5.500%)

Answer 1

Answer:

Paraguas should borrow at LIBOR + 2.000% and swap for fixed rate debt.

Lluvia should choose funding in floating rate

Explanation:

Paraguas wants the security of fixed rate borrowing; thus it should borrow at LIBOR + 2.000% and swap for fixed rate debt, in which Libor is 5.500%; their total cost at 7.5% is still lower than Fixed rate 12.0%

Lluvia prefer the flexibility of floating rate borrowing, and its rating is better; then it can enjoy lower cost of borrowing at 5%. However it may face the increase if LIBOR increase later; vice versa if LIBOR decrease, its cost of borrowing is able to reduce also.

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