Question

Lois Company Ltd is a fast-growing Ghanaian Multinational Company looking for short term working capital loan to support its expansion to other West African Countries. You have just been hired as a Senior Financial Analyst to help the firm secure a cheap source of funding to achieve its objective. The CEO of this company is concerned about the high interest rates in Ghana and has asked you to borrow in Dollars since USD interest rates have become cheaper since the beginning of the Covid-19 Pandemic and that an arbitrage opportunity exist. You have your own reservations about borrowing in USD due to exchange rate risk and looking for figures to explain to her. You had a chat with your relationship manager of your bank and they are willing to lend $20 million to you for 1 year at an interest rate of 5% which appears to be far better than the current 1 year cedi lending rate of 17.50% on the domestic market. Your intention is to borrow in USD and convert this to Ghana Cedis and use for your expansion program. The current exchange rate is 5.80 per USD and is forecasted to be 6.45 per USD in a year’s time. i. Calculate the effective annual Financing Cost of the USD Loan and advise Lois whether it is prudent to borrow USD at this stage. What is the gain/loss if Lois decide to borrow in USD? ii. Assume that Interest Rate Parity (IRP) holds and that you intend to hedge the exchange rate risk by entering into a 1 year Forward transaction with your Bank. What will be the effective annual interest rate in this case? Explain your answer

Answer 1

i) Effective interest rate = Nominal rate on loan * Forex Costs = (1 + 5%) * (6.45/5.80) = 1.05 * 1.112 = 1.16767

Hence, effective interest rate - 16.767% which is lower than the current cedi rate of 17.50%.

Accordingly it seems prudent to borrow in USD. Gain if we borrow in USD = 17.50 - 16.767 = 0.733% effective annually on the total borrowed amount of $20 Million * 5.80 Cedi (116 Million Cedi)

ii) Accordinly, if IRP holds true, effective annual interest rate will be the same as the cost in cedi, that means an effective 17.50% annual interest rate will be applicable in this case.