Question

In: Finance

b) Lois Company Ltd is a fast-growing Ghanaian Multinational Company looking for short term working capital...

b) 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.

Solutions

Expert Solution

Part i) Assume USD 20million borrowed @5% for 1year

Convert USD into cedi by using spot exchange rate (1USD=cedi5.8) USD 20million*5.8 = cedi 116million

Repayment of loan with interest = Loan amount*(1+USD interest rate) = USD 20million*(1+0.05) = USD 21million

Amount to be paid in cedi after 1year = Repayment of loan with interest in USD*forcasted exchange rate = USD 21million*6.45 = cedi 135.45million

Effective annual financing cost of the USD loan = (Amount to be paid in cedi-Loan amount in cedi)/Loan amount in cedi = (135.45million - 116million)/116million = 19.45million/116million = 16.77%

For Lois it is prudent to borrow USD at this stage because its effective annual financing cost is less than cedi interest rate.

Gain if Lois decided to borrow in USD = (cedi lending rate-Effective annual financing cost of the USD loan)*Loan amount in cedi = (17.5%-16.77%)*116million = cedi 846,800

Part ii)

If Interest rate parity theory (IRPT) holds good then exchange rate risk will exactly offset by interest rate.

Effective annual interest rate in this case is 17.5% because the IRPT takes existing interest rate to calculate forward exchange rate. In IRPT, would not exist arbitrage opportunites.

jeff jeffy answered 2 years ago
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