The Relative Advantage in Borrowing using Excel Formulas

Relative advantage in borrowing is the concept that different borrowers have different costs of borrowing in different markets, depending on their credit ratings, reputations, and access to financing sources1. A borrower with a relative advantage in borrowing in one market can benefit from swapping its debt obligations with another borrower who has a relative advantage in borrowing in another market. This way, both borrowers can lower their interest payments and diversify their sources of funding3.

For example, suppose that firm A has a relative advantage in borrowing in the fixed-rate market, while firm B has a relative advantage in borrowing in the floating-rate market. Firm A can issue fixed-rate debt at a lower cost than firm B, and firm B can issue floating-rate debt at a lower cost than firm A. If firm A prefers to have floating-rate debt and firm B prefers to have fixed-rate debt, they can enter into a swap agreement, where they exchange their interest payments. By doing so, they can both achieve their desired debt structure and save on their borrowing costs.

Relative advantage in borrowing is based on the idea of comparative advantage, which states that two parties can gain from trade if they have different opportunity costs of producing the same good or service. Similarly, two borrowers can gain from swapping their debt obligations if they have different opportunity costs of borrowing in the same market2. Relative advantage in borrowing can arise from various factors, such as differences in credit ratings, market segmentation, tax considerations, and regulatory constraints.

Basic Theory:

The relative advantage in borrowing is essentially the comparison of different loan options to determine which one offers the most favorable terms and conditions. Key factors include interest rates, loan duration, and any additional fees. The goal is to minimize the cost of borrowing over the life of the loan.

Procedures:

1. Define Loan Parameters:
   • Loan Amount
   • Interest Rate
   • Loan Duration
   • Additional Fees (if any)
2. Calculate Total Repayment:
   • Use the loan amount, interest rate, and loan duration to calculate the total repayment using appropriate financial formulas.
3. Compare Different Loan Options:
   • If considering multiple loan options, repeat the calculation for each to compare the total repayment.
4. Consider Additional Fees:
   • Factor in any additional fees to determine the overall cost of each loan option.
5. Determine Relative Advantage:
   • Compare the total repayments of different loan options to identify the one with the lowest overall cost.

Explanation:

Let’s consider a scenario where you are looking to borrow $10,000 for a period of 3 years. You have two loan options:

1. Loan Option A:
   • Interest Rate: 5% per annum
   • Loan Duration: 3 years
   • No additional fees
2. Loan Option B:
   • Interest Rate: 4.5% per annum
   • Loan Duration: 3 years
   • Additional Fees: $200 upfront

Scenario Calculation in Excel:

1. Loan Repayment Calculation (Using Excel PMT Function):
   • For Loan Option A:

     =PMT(5%/12, 3*12, -10000)

   • For Loan Option B:

     =PMT(4.5%/12, 3*12, -10000) + 200

2. Total Repayment Calculation:
   • For Loan Option A:

     =PMT(5%/12, 3*12, -10000) * 3 * 12

   • For Loan Option B:

     =(PMT(4.5%/12, 3*12, -10000) + 200) * 3 * 12

Result:

After performing the calculations in Excel, you find that Loan Option B has a lower total repayment despite the additional upfront fee. Thus, Loan Option B is the relative advantage in borrowing in this scenario.

Other Approaches:

1. Net Present Value (NPV):
   • Incorporate the time value of money using NPV to compare the present value of cash flows for different loan options.
2. Internal Rate of Return (IRR):
   • Determine the interest rate at which the net present value of cash flows is zero for each loan option.