Final answer:
Desert Trading Company's effective interest rate on its borrowing, after the interest rate swap, is 9%. This includes the original 8% bond interest and the 1% net benefit from the swap.
Step-by-step explanation:
The question pertains to the calculation of the effective interest rate of Desert Trading Company's bonds after entering into an interest rate swap. Initially, Desert Trading Company issued $100 million worth of long-term bonds at a fixed interest rate of 8%.
After entering into an interest rate swap, the company pays LIBOR at 5% and receives a fixed rate of 6% on the same notional principal of $100 million.
To calculate the effective interest rate, we need to consider both the interest payments on the bonds and the net outcome of the interest rate swap. The company pays 8% on the bonds and pays LIBOR (5%) on the swap while receiving 6% from the swap. The net payment on the swap is 5% - 6%, which equals -1%. This negative value means that the company receives 1% from the swap, thus reducing the overall interest expense.
The effective interest rate on the company's borrowing is the original interest rate (8%) minus the net swap benefit (1%). Therefore, the effective interest rate is:
8% - (-1%) = 8% + 1% = 9%