IBM And GE Are Both In The Market For Approximately 1 641993

IBM And Ge Are Both In The Market For Approximately 10 Million Of Deb

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 instruction

The comparative advantages in borrowing between IBM and GE hinge upon their credit ratings, interest rate preferences, and market conditions. Analyzing these factors reveals insights into the optimal borrowing strategies and potential benefits from interest rate swaps that can maximize savings for both corporations.

Firstly, IBM's key advantage lies in its flexible access to both fixed and floating interest rate debt, although fixed-rate borrowing is considered more costly for them. Given that IBM’s fixed-rate debt carries a higher interest rate of 10%, compared to its floating rate of LIBOR + ¾%, IBM would favor borrowing at fixed rates to secure cost predictability. Conversely, GE has a higher credit rating of AAA, which affords it access to both fixed and floating debt at more attractive rates. Since GE prefers floating rate debt, its comparative advantage is in issuing floating-rate bonds at LIBOR + ¼%, which is a lower cost than fixed debt (9%). Consequently, GE’s advantage lies in issuing floating-rate debt, benefiting from lower interest costs and market conditions.

In terms of comparative advantage, IBM excels in the fixed-rate borrowing market, despite the expensive fixed rate, because its alternative involves higher floating rate costs or less favorable terms. Meanwhile, GE holds the advantage in floating-rate borrowing due to its superior credit rating and access to lower-cost floating debt. Therefore, IBM’s comparative advantage is in fixed-rate debt, whereas GE’s is in floating-rate debt.

Interest rate swaps can enable both firms to optimize their borrowing costs by effectively 'trading' their advantageous positions. The maximum savings from such a swap depend on the difference in borrowing costs—namely, the fixed rate of 10% for IBM versus 9% fixed rate— and the floating rate spread of LIBOR + ¾% for IBM against LIBOR + ¼% for GE. Theoretically, the maximum savings each party can realize from a swap are limited to these differentials.

If a swap is structured to benefit both parties equally, the total potential savings are split evenly. To illustrate, assume a swap agreement where GE agrees to pay IBM a fixed rate slightly below 10%, and IBM agrees to pay GE a floating rate slightly above LIBOR + ¼%. For example, the swap could involve GE paying IBM 9.5% fixed, in exchange for receiving LIBOR + ¼%. In this setup, IBM would lock in a fixed cost lower than 10%, and GE would benefit from paying a fixed rate close to 9.5%, which is advantageous given its access to cheaper floating debt.

Diagrammatically, the swap might be represented as follows:

This arrangement enables each firm to capitalize on its comparative advantage, reducing overall borrowing costs equally. The exact spread and fixed rate can be adjusted to ensure the total savings are evenly split, fulfilling the requirement of an even division of benefits without involving financial institutions.

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