Question

A U.S. company needs to borrow $100 million for a period of seven years. It can issue dollar debt or yen debt.

a. Suppose the company is an MNC with sales in the U.S. and inputs purchased in Japan. How should this affect its financing choice?

b. Suppose the company is a multinational firm with sales in Japan and inputs that are primarily determined in dollars. How should this affect its financing choice?

Answer 1

The choice of financing will be based on majorly the currency risk involved in borrowing.

a. Since the MNC is purchasing its inputs in Japan, it is effectively short yen (to buy inputs the MNC will need to shell out yen). Based on the current scenario, interest rates in Japan are less than that of the US. Thus, based on the Fisher effect, the currency of the country with lower interest rates are more likely to appreciate in value. If the company borrows in Yen, and if yen appreciates, then the MNC will face a foreign exchange loss. Thus, the MNC should borrow in dollars. Additionally, the company will generate sales in dollars and if the company generates sufficent operating profits, the sales could be used to pay off debt in dollars itself which will minimize the exchange rate risk related to borrowing.

b. In this case, the MNC has sales in Japan. This essentially means the MNC will effectively have a long position in Yen. In this case, the company should consider borrowing in Yen as the company could use the Cash flows/operating profit generated from sales in Japanese Yen to pay off the debt denominated in Yen and thus minimizing the currency risk involved in borrowing.