Question

The following 4 strategies are being considered by a Multinational Enterprise (MNE) Each is intended to provide $1m in financing for a three year period. Strategy 1. Borrow $1m for 3 years at a fixed interest rate. 2. Borrow $1m for 3 years at a floating rate LIBOR +2% to be reset annually. 3. Borrow $1m for one year at a fixed rate then renew credit annually. 4. Borrow $1m for one year at a floating rate LIBOR+2% then renew credit annually. Required: Critically appraise the risks and the benefits of each strategy? Which strategy would you recommend and why?

Answer 1

Strategy 1 : Borrow $1m for 3 years at a fixed interest rate.

Risk :- Risk of Interest rate falling for 3 years at a time.

Benefit :- Fixed obligation and no chance of any extra payment in form of interest.

Strategy 2 : Borrow $1m for 3 years at a floating rate LIBOR +2% to be reset annually.

Risk :- Risk of rise in LIBOR at variation in interset payment and further fixation of LIBOR for a year where LIBOR rate can change for numerous time.

Benefit :- Benefit from reduction in interset rate and also fixation of interest amount of a year.

Strategy 3 :- Borrow $1m for one year at a fixed rate then renew credit annually.

Risk : Rate of interest rate falling for a year.

Benefit : Fixed rate of interest can be changed after a year depending upon the scenario prevaling.

Strategy 4 :-Borrow $1m for one year at a floating rate LIBOR+2% then renew credit annually

Risk :- Risk of variation in interset rate for a year.

Benefit :- Benefit of reduction in interst rate and further it can be changed after a year.

I will recommend strategy 4 and my reasoning is Fixation of LIBOR rate + 2% for a company is beneficial as in that case company has the option to take any other strategy after one year.Further in case of fixed rate inte is quite higher in comparison to floating rate as rate is fixed by considering the worst secanio not the best scenario so if there is any fluctuations in LIBROR rate then it will not exceed the fixed rate except in the case of any exceptional scenario.So strategy 4 is good option to opt for.