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Answer :
Under the swap agreement, Prime-Tec Ltd. would pay AUD fixed 6.85% to the bank to lower borrowing costs equally for both firms.
To lower borrowing costs equally for both firms, a cross-currency interest rate swap is needed. The swap dealer will act as an intermediary and facilitate the exchange of interest payments between Prime-Tec Ltd. and Black Inc.
The swap agreement would involve the following:
Prime-Tec Ltd:
- Pays fixed AUD at 7.5%
- Receives floating USD at LIBOR + 2.35%
Black Inc:
- Pays fixed USD at 7.0%
- Receives floating AUD at AUDIBOR + 2.35%
To calculate the net cash flow for Prime-Tec Ltd. under the swap agreement:
Net Cash Flow = Fixed AUD - Floating USD
Net Cash Flow = 7.5% - (LIBOR + 2.35%)
As the swap dealer earns 20 basis points per annum, the final cash flow for Prime-Tec Ltd. would be:
Net Cash Flow = 7.5% - (LIBOR + 2.35%) - 0.20%
Similarly, the net cash flow for Black Inc. would be:
Net Cash Flow = 7.0% - (AUDIBOR + 2.35%) - 0.20%
The swap agreement aims to equalize borrowing costs for both firms, so the net cash flow for both should be the same.
Given the choices provided:
- Pay AUD fixed 6.85% is the same as 7.5% - 0.65% (AUDIBOR + 0.35% - 0.20%), which matches the net cash flow for Prime-Tec Ltd.
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