Your firm needs to raise $100 million in funds. You can borrow short term at a spread of 1% over LIBOR. Alternatively, you can issue 10-year, fixed-rate bonds at a spread of 2.50% over 10-year Treasuries, which currently yield 7.60%. Current 10-year interest rate swaps are quoted at LIBOR versus the 8% fixed rate.
Management believes that the firm is currently “underrated” and that its credit rating is likely to improve in the next year or two. Nevertheless, the managers are not comfortable with the interest rate risk associated with using short-term debt.
a. Suggest a strategy for borrowing the $100 million. What is your effective borrowing rate?
b. Suppose the firm’s credit rating does improve three years later. It can now borrow at a spread of 0.50% over Treasuries, which now yield 9.10% for a seven-year maturity. Also, seven-year interest rate swaps are quoted at LIBOR versus 9.50%. How would you lock in your new credit quality for the next seven years? What is your effective borrowing rate now?