Question

Collette, Inc., is considering issuing an Canadian dollar denominated bond at its present coupon rate of 10 percent, even though it has no incoming cash flows to cover the bond payments. U. S. dollar-denominated bonds issued in the United States would have a coupon rate of 9 percent. Either type of bond would have a 4-year maturity and could be issued at par value. Collette needs to borrow $10 million. Therefore, it will either issue U. S. dollar denominated bonds with a par value of $10 million or bonds denominated in Canadian dollars with a par value of C$13 million. The spot rate of the Canadian dollar is $.77. Collette has forecasted the Canadian dollar’s value at the end of each of the next four years, when coupon payments are to be paid at: Year 1 $0.76, Year 2 $0.75, Year 3 $0.74, and Year 4 $0.73.

(1) Calculate the expected annual cost of financing, as a percentage, with Canadian dollars.

(2) Should Collette, Inc., issue bonds denominated in U.S. dollars or Canadian dollars? Explain.

Answer 1

(a) Canadian Bond Par Value = C $ 13 million, Canadian Bond Coupon Rate = 10%, Bond Tenure = 4 years,

Exchange Rates: Year 0 = $ 0.77 / C$

Year 1 = $ 0.76 / C $

Year 2 = $ 0.75 / C $

Year 3 = $ 0.74 / C $

Year 4 = $ 0.73 / C $

Let the financing cost (in US $ terms) be Y1 %

Annual Bond Coupons in C $ = 0.1 x 13 = C $ 1.3 million

Therefore, 13 x 0.77 = (1.3 x 0.76) / (1+Y1) + (1.3 x 0.75) / (1+Y1)^(2) + (1.3 x 0.74) / (1+Y1)^(3) + (1.3 x 0.73) / (1+Y1)^(4) + 13 x 0.73 / (1+Y1)^(4)

Using EXCEL's Goal Seek Function/ hit and trial method/ a financial calculator to solve the above equation, we get:

Y1 = 0.08545 or 8.545 % ~ 8.54 %

(b) Let the financing cost for the USD bond be Y2 %, Coupon Rate = 9 %, Bond PAr Value = $ 10 million and Tenure = 4 years

Annual Coupon = 0.09 x 10 = $ 0.9 million

Therefore, 10 = 0.9 x (1/Y2) x [1-{1/(1+Y2)^(4)}] + 10 / (1+Y2)^(4)

Using EXCEL's Goal Seek Function/ hit and trial method/ a financial calculator to solve the above equation, we get:

Y2 = 0.08999% or 8.999 % ~ 9 %

As the financing cost for the Canadian Bond is lesser than the corresponding financing cost for the US Bond, the firm should opt for Canadian Dollars.