Question

Apple and Compaq both seek funding at the lowest possible cost. Apple would prefer the flexibility of floating rate borrowing, while Compaq wants the security of fixed rate borrowing. They face the following interest rate structure: (1) Apple could borrow floating at LIBOR + 1% or borrow fixed at 8%; (2) Apple prefers floating rate debt; (3) Compaq could borrow floating at LIBOR + 2% or borrow fixed at 12%; and (4) Compaq prefers a fixed rate. a. To arrange a swap contract that leads to a win-win outcome, which firm should borrow floating in the beginning and which firm should borrow fixed in the beginning? Why? b. Calculate the maximum combined savings of both firms.

Answer 1

	Apple	Compaq	Advantage to Apple
Fixed Cost	8%	12%	4%
Float Cost	Libor + 1%	Libor + 2%	1%
		Net Benefit	3%

Apple has an absolute advantage in both fixed and floating rate. However, it has a comparative advantage in the fixed rate market (cheaper by 4%). So Apple will borrow in the fixed rate market at 8%, while Compaq will borrow in the floating rate market at Libor + 2%. After that Apple and Compaq will enter into a swap to offset their exposure (Apple has fixed rate liability, while Compaq has floating rate liability). Apple will enter the swap as fixed rate receiver(floating rate payer), while Compaq will enter the swap as floating rate receiver(fixed rate payer).

The net benefit that arises from the swap is 3%. This 3 % will be shared between Apple and Compaq (not necessarily equally).