IBM And GE Are Both In The Market For Approximately 10 Milli ✓ Solved

IBM And GE Are Both In The Market For Approximately 10 Million

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.

Paper For Above Instructions

In addressing the borrowing scenarios for IBM and GE, it's essential to analyze the comparative advantages both firms hold in fixed and floating rate debts. Understanding these advantages will subsequently guide us in the structuring of a potential interest rate swap that maximizes savings for both parties.

Comparative Advantage of IBM

IBM's comparative advantage lies in its ability to borrow at fixed rates. Although the fixed rate for IBM is higher at 10%, compared to GE’s fixed rate of 9%, IBM has significant cost disadvantages in floating rates. IBM’s ability to borrow at floating rates is at LIBOR + ¾%, which may be less favorable than GE’s floating rate of LIBOR + ¼%. With respect to its credit rating and the choices available, IBM is better positioned to take advantage of the fixed rates, despite those rates being relatively costlier.

Comparative Advantage of GE

Conversely, GE holds a comparative advantage in borrowing at floating rates due to its superior credit rating, which allows it to access financing at a lower cost corresponding to LIBOR + ¼%. Given GE's choice to prefer the floating rate, it stands to benefit significantly from choosing this mode of borrowing, as the lower overall interest payments associated with floating rates would reduce their total debt burden.

Maximum Savings from an Interest Rate Swap

To assess potential savings through an interest rate swap between IBM and GE, we should first determine the interest payments each firm would incur without the swap:

• IBM's interest payment on fixed rate: $10 million * 10% = $1 million per year.
• GE's interest payment on fixed rate: $10 million * 9% = $900,000 per year.
• IBM's interest payment on floating rate: $10 million (LIBOR + ¾%) = $10 million LIBOR + $75,000.
• GE's interest payment on floating rate: $10 million (LIBOR + ¼%) = $10 million LIBOR + $25,000.

In this scenario, without considering LIBOR fluctuations, the swap provides an opportunity for cost savings. If they enter into a swap where IBM pays GE a fixed rate and GE pays IBM a floating rate, they can maximize their savings:

• GE can pay IBM a fixed rate of 9% and receive LIBOR + ¼%.
• IBM pays GE a fixed rate of 10% and receives LIBOR + ¾%.

The maximum savings can be computed as:

Total savings = (cost of IBM’s fixed debt - cost of GE’s fixed debt) = $1,000,000 - $900,000 = $100,000.

Structuring the Swap

To ensure that the total savings from this swap are divided evenly, we can structure the transaction as follows:

Conclusion

This arrangement allows both IBM and GE to leverage their comparative advantages, reducing the overall costs of their borrowing. The structure of the swap helps maximize savings, and demonstrating this visually can be beneficial for understanding the transaction flow and the financial benefits involved.

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