Question

Sambuka, Inc. can issue annual coupon bonds in either U.S. dollars or in Euros that mature in three years. Dollar-denominated bonds would have a coupon rate of 5 percent; Euro-denominated bonds would have a coupon rate of 4 percent. Assuming that Sambuka can issue bonds worth $10,000,000 in US dollars or 8 million Euros, given that the current exchange rate is $1.25/1 Euro.

A) If the forecasted exchange rate for the Euro is $1.28/1 Euro for each of the next three years what is the annual cost of financing for the Euro-denominated bonds? Which type of bond should Sambuka issue?

B) If the forecasted exchange rate for the Euro is $1.21 for each of the next three years what is the annual cost of financing for the Euro-denominated bonds? Which type of bond should Sambuka issue?

Answer 1

Annual cost of financing is the cost at which the total present value (PV) of future cash flows equals the loan amount.

a). Annual cost of financing for Euro denominated loan is approximately 4.86% which is less than the 5% financing cost of the dollar denomiated loan so Euro denominated bonds should be issued.

Annual cost of financing is found using Solver. It will be the rate at which total PV = 10,000,000

b). Annual cost of financing for Euro denominated loan is approximately 2.84% which is less than the 5% financing cost of the dollar denomiated loan so Euro denominated bonds should be issued.

Again, Solver is used to find the annual financing cost.