Companies X and Y both wish to raise $100 million 10-year loans. Company X wishes to borrow at a fixed rate of interest as it wants to have a certainty about its future interest liabilities, while company Y wishes to borrow at a floating rate because its treasurer believes that interest rates are likely to fall in the future
a) Jetpack Ltd. has an all equity capital structure. It has total assets worth $10 million, 10,000 outstanding shares and an EBIT of $750,000. It is contemplating a move to incorporate debt to the tune of 25% of its
asset value and can arrange the borrowing at a 5% p.a. interest rate. Wendy, a shareholder in the company, has 700 shares.
i) What is Wendy's current percentage return if Jetpack follows a 100% dividend pay-out policy and there are no taxes?
ii) If Wendy prefers the company to remain all equity financed, show how she could unlever her position to maintain the same percentage return as she is earning currently?
b) Companies X and Y both wish to raise $100 million 10-year loans. Company X wishes to borrow at a fixed rate of interest as it wants to have a certainty about its future interest liabilities, while company Y wishes to borrow at a floating rate because its treasurer believes that interest rates are likely to fall in the future. Company X has been offered a fixed interest loan at 13% and a floating rate loan at LIBOR + 2.5%. Company Y has a better credit rating than X and has been offered a fixed interest loan at 10% and a floating rate at LIBOR + 1%. Describe through the use of a diagram how you can bring these companies together in an interest rate swap that would make them both better off without the intervention of a swap dealer. QSD distribution: 1% benefit to Company X.
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