Question

In: Finance

Assume that on January 1, a Mexican firm wants to finance their Mexican operation and borrows...

Assume that on January 1, a Mexican firm wants to finance their Mexican operation and borrows $10 million for 1 year with 8% annualized interest from a US bank. At inception, the spot rate was Peso 3.40/$. The inflation is 2.00% and 12.00% respectively for US and Mexico. According to our class material, PPP between Mexican Peso and USD hold well. Thus, what is the actual cost to the firm of the loan, since the firm has to pay back USD?

Solutions

Expert Solution

Answer: In the question we are given that the Purchasing Power Parity between US and Mexico holds good.

That implies that the forex rates adjusts itself to the purchasing power parity of the countries.

Forward rate in 1 year (Peso per dollar)  = Spot Rate X (1 + Inflation in Mexico) / (1+ Inflation in US)

= 3.4 X 1.12/1.02 (Spot: 3.44 peso/ $ , i mexico=12%, i us= 2%)

= 3.733 peso

Loan borrowed from US Bank = $10 M

Interest Cost on loan in 1 year @ 8% p.a = $10M X 8%

= $ 0.8 M

Total Repayment of loan after 1 year = Principal +Interest cost

= $ 10.8 M

To pay $ 10.08 M the firm will require Peso equal to (10.8 M X 3.733) i.e.40.32 M Peso.

Total cost in Peso = (Repayment Amount X Forward rate)-(Borrowing Amount X spot rate )

= (10.8 X 3.733) - (10 X 3.4)

= 40.32 - 34

= Peso 6.32 M

Summary of Working:

In Mill
Particulars In $ Spot In Peso
A Borrowing Amount 10 3.4 34
Principal Repayment         10.00           3.73         37.33
Interest Repayment @ 8% p.a           0.80           3.73           2.99
B Total Repayment         10.80         40.32
C= (B-A) Total Cost of Loan           0.80           6.32

jeff jeffy answered 1 year ago
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