Correct LIBOR floor implementation in model??
I've been seeing a mix of approaches in LBO models when it comes to calculating an all in rate based on a LIBOR spread with a LIBOR floor.
Question boils down to: Does the floor represent the minimum base rate or the minimum all in rate?
To further clarify, what would be the all in rate in the below scenario?
Term Loan Rate: L + 150bps
LIBOR: 0.25%
LIBOR Floor: 2.0%
a.) All in rate should be = 3.5% = 2.0% Base Rate Floor + 1.5% Spread
b.) All in rate should be = 2.0% = All in Floor, because 2.0% > 1.75% that you would otherwise pay without a floor (0.25% + 1.5%)
Might be a dumb question, but I do think most of the LBO practice models floating around the street are using a mix of the above approaches, so someone must be doing this wrong.
Can someone please clarify which is correct?
Option A is correct
I've never seen option B
I would ding someone for thinking Option B.
LIBOR (now SOFR) is an index. You’re spread “rides” the index. They are completely separate.
Think of the floor as a governor to the index. It protects a lender from interest rate risk that can be caused by market shocks. Look at the LIBOR and SOFR rates in 2020.
Option A is correct. It's the floor for LIBOR, not the overall facility. Hence, rate = Margin + the greater of the LIBOR floor or LIBOR rate.
Option A, in practicality it would be easy to understand it from the indicative term sheet or credit doc
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