Company X,a low-rated firm,desires a fixed-rate,long-term loan.X presently has access to floating interest rate funds at a margin of 1.25% over LIBOR.Its direct borrowing cost is 11% in the fixed-rate bond market.In contrast,company Y,which prefers a floating-rate loan,has access to fixed-rate funds in the Eurodollar bond market at 9% and floating-rate funds at LIBOR + 1/4%.Suppose they split the cost savings.
-How much would Y pay for its floating-rate funds?
A)LIBOR -.25%
B)LIBOR -.50%
C)LIBOR
D)LIBOR + .5%

Question

Quizplus · Accepted Answer

For Company Y to prefer floating-rate loan, the cost of funds from floating-rate bonds needs to be less than the fixed-rate funds in the Eurodollar bond market which is at 9%. Therefore, the floating-rate cost needs to be less than 9%. Given that Y has access to floating-rate funds at LIBOR + 1/4%, the cost of LIBOR -.25% (9% - 0.25%) is less than 9% and thus the best choice for Y.

Company X,a Low-Rated Firm,desires a Fixed-Rate,long-Term Loan