Question

ANALYTICAL APPLICATION 1

Bond Financing Analysis ALTEC Inc. can issue bonds in either U.S. dollars or in Swiss francs. Dollar- denominated bonds would have a coupon rate of 15%; Swiss franc–denominated bonds would have a coupon rate of 12%. Assuming that ALTEC can issue bonds worth $10,000,000 in either currency, that the current exchange rate of the Swiss franc is $0.70, and that the forecasted exchange rate of the franc in each of the next 3 years is $0.75, what is the annual cost of financing for the franc- denominated bonds? Which type of bond should ALTEC issue?

ANALYTICAL APPLICATION 2

LEXCO Co. just agreed to a long-term deal in which it will export products to Japan. It needs funds to finance the production of the products that it will export. The products will be denominated in dollars. The prevailing U.S. long- term interest rate is 9% versus 3% in Japan. Assume that interest rate parity exists and that LEXCO believes that the international Fisher effect holds.

a. Should LEXCO finance its production with yen and leave itself open to the exchange rate risk? Explain.

b. Should LEXCO finance its production with yen and simultaneously engage in forward contracts to hedge its exposure to exchange rate risk?

c. How could LEXCO achieve low-cost financing while eliminating its exposure to exchange rate risk?

Answer 1

ANALYTICAL APPLICATION 1

If ALTEC Inc issues Swiss franc-denominated bonds, the bonds would have a face value of

$10,000,000 / 0.70 = CHF 14,285,714.3

Note: CHF is swiss franc

Coupon rate = 12%

Yearly payment = Coupon rate * face value

For last year payment will be = Face value + (Coupon rate * face value)

So, Payment schedule

	1st Year	2nd Year	3rd Year
Payment in CHF terms	1,714,285.71	1,714,285.71	16,000,000
Exchange rate	0.75	0.75	0.75
Payment in $ terms	1,285,714.3	1,285,714.3	12,000,000

Annual cost of financing = = 0.0714

So annual cost of financing = 15 - 0.0714 = 14.92% for CHF denominated bonds.

Since annual cost of financing of the dollar-denominated bonds is 15%

Altec Inc should issue the franc-denominated bonds.

ANALYTICAL APPLICATION 2

a) LEXCO shouldn't finance its production with yen and leave itself open to the exchangerate risk as the exchange rate of the yen is expected to rise according to the international Fisher effect that would offset the interest rate differential.

b) LEXCO shouldn't finance its production with yen and simultaneously engage in forward contracts to hedge its exposure to exchange rate risk as the forward rate premium should reflect the interest rate differential. If LEXCO used this strategy, the financing rate would be 9%.

c) LEXCO could achieve low-cost financing while eliminating its exposure to exchange rate risk by asking the Japanese importers pay for their imports in yen. If so, it could finance in yen at 3% and use a portion of the proceeds from its export revenue to cover its finance payments.