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Topics to Stimulate Class Discussion
1. Why would U.S. firms consider issuing bonds denominated in a foreign currency?
2. What are the desirable characteristics related to a currency’s interest rate (high or low) and value
(strong or weak) that would make the currency attractive from a borrower’s perspective?
POINT/COUNTER-POINT:
Will Currency Swaps Result in Low Financing Costs?
POINT: Yes. Currency swaps have created greater participation by firms that need to exchange their
currencies in the future. Thus, firms that finance in a low interest rate currency can more easily establish
an agreement to obtain the currency that has the low interest rate.
COUNTER-POINT: No. Currency swaps will establish an exchange rate that is based on market forces. If
a forward rate exists for a future period, the swap rate should be somewhat similar to the forward rate. If
it was not as attractive as the forward rate, the participants would use the forward market instead. If a
forward market does not exist for the currency, the swap rate should still reflect market forces. The
exchange rate at which a low-interest currency could be purchased will be higher than the prevailing spot
rate, since otherwise MNCs would borrow the low-interest currency and simultaneously purchase the
currency forward so that they could hedge their future interest payments.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
ANSWER: The swap rates will be in line with forward rates, so that MNCs will not benefit from
Answers to End of Chapter Questions
1. Floating-Rate Bonds.
a. What factors should be considered by a U.S. firm that plans to issue a floating rate bond
denominated in a foreign currency?
b. Is the risk of issuing a floating rate bond higher or lower than the risk of issuing a fixed rate
Eurobond? Explain.
c. How would an investing firm differ from a borrowing firm in the features (i.e., interest rate and
currency’s future exchange rates) it would prefer a floating rate foreign currency-denominated
bond to exhibit?
2. Risk From Issuing Foreign Currency-Denominated Bonds. What is the advantage of using
simulation to assess the bond financing position?
3. Exchange Rate Effects.
a. Explain the difference in the cost of financing with foreign currencies during a strong-dollar
period, versus a weak-dollar period for a U.S. firm.
b. Explain how a U.S.-based MNC issuing bonds denominated in euros may be able to offset a
portion of its exchange rate risk.
4. Bond Offering Decision. Columbia Corp. is a U.S. company with no foreign currency cash flows. It
plans to either issue a bond denominated in euros with a fixed interest rate, or a bond denominated in
U.S. dollars with a floating interest rate. It estimates its periodic dollar cash flows for each bond.
Which bond do you think would have greater uncertainty surrounding these future dollar cash flows?
Explain.
5. Borrowing Combined with Forward Hedging. Cedar Falls Co. has a subsidiary in Brazil, where
local interest rates are high. It considers borrowing dollars and hedging the exchange rate risk by
selling the Brazilian real forward in exchange for dollars for the periods in which it would need to
make loan payments in dollars. Assume that forward contracts on the real are available. What is the
limitation of this strategy? ?
6. Financing That Reduces Exchange Rate Risk. Kerr, Inc., a major U.S. exporter of products to
Japan, denominates its exports in dollars and has no other international business. It can borrow
dollars at 9 percent to finance its operations or borrow yen at 3 percent. If it borrows yen, it will be
exposed to exchange rate risk. How can Kerr borrow yen and possibly reduce its economic exposure
to exchange rate risk?
7. Exchange Rate Effects. Katina, Inc., is a U.S. firm that plans to finance with bonds denominated in
euros to obtain a lower interest rate than is available on dollar-denominated bonds. What is the most
critical point in time when the exchange rate will have the greatest impact?
8. Financing Decision. Ivax Corp. (based in Miami) is a U.S. drug company that has attempted to
capitalize on new opportunities to expand in Eastern Europe. The production costs in most Eastern
European countries are very low, often less than one-fourth of the cost in Germany or Switzerland.
Furthermore, there is a strong demand for drugs in Eastern Europe. Ivax penetrated Eastern Europe
by purchasing a 60 percent stake in Galena AS, a Czech firm that produces drugs.
a. Should Ivax finance its investment in the Czech firm by borrowing dollars from a U.S. bank that
would then be converted into koruna (the Czech currency) or by borrowing koruna from a local
Czech bank? What information do you need to know to answer this question?
b. How can borrowing koruna locally from a Czech bank reduce the exposure of Ivax to exchange
rate risk?
c. How can borrowing koruna locally from a Czech bank reduce the exposure of Ivax to political
risk caused by government regulations?
Advanced Questions
9. Bond Financing Analysis. Sambuka, Inc. can issue bonds in either U.S. dollars or in Swiss francs.
Dollar-denominated bonds would have a coupon rate of 15 percent; Swiss franc-denominated bonds
would have a coupon rate of 12 percent. Assuming that Sambuka can issue bonds worth $10,000,000
in either currency, that the current exchange rate of the Swiss franc is $.70, and that the forecasted
exchange rate of the franc in each of the next three years is $.75, what is the annual cost of financing
for the franc-denominated bonds? Which type of bond should Sambuka issue?
ANSWER:
10. Bond Financing Analysis. Hawaii Co. just agreed to a long-term deal in which it will export
products to Japan. It needs funds to finance the production of the products that it will export. The
products will be denominated in dollars. The prevailing U.S. long-term interest rate is 9 percent
versus 3 percent in Japan. Assume that interest rate parity exists, and that Hawaii Co. believes that the
international Fisher effect holds.
a. Should Hawaii Co. finance its production with yen and leave itself open to the exchange rate
risk? Explain.
ANSWER: No. The exchange rate of the yen is expected to rise according to the IFE, which
b. Should Hawaii Co. finance its production with yen and simultaneously engage in forward
contracts to hedge its exposure to exchange rate risk?
ANSWER: No. The forward rate premium should reflect the interest rate differential, so the financing
c. How could Hawaii Co. achieve low-cost financing while eliminating its exposure to exchange
rate risk?
ANSWER: Hawaii could request that the Japanese importers pay for their imports in yen. It could
11. Cost of Financing. Assume that Seminole, Inc., considers issuing a Singapore dollar-denominated
bond at its present coupon rate of 7 percent, even though it has no incoming cash flows to cover the
bond payments. It is attracted to the low financing rate, since U. S. dollar-denominated bonds issued
in the United States would have a coupon rate of 12 percent. Assume that either type of bond would
have a four-year maturity and could be issued at par value. Seminole needs to borrow $10 million.
Therefore, it will either issue U. S. dollar denominated bonds with a par value of $10 million or bonds
denominated in Singapore dollars with a par value of S$20 million. The spot rate of the Singapore
dollar is $.50. Seminole has forecasted the Singapore dollar’s value at the end of each of the next
four years, when coupon payments are to be paid:
End of Year Exchange Rate of Singapore Dollar
1 $.52
2 .56
3 .58
4 .53
Determine the expected annual cost of financing with Singapore dollars. Should Seminole, Inc., issue
bonds denominated in U.S. dollars or Singapore dollars? Explain.
ANSWER:
End of Year:
1 2 3 4
12. Interaction Between Financing and Invoicing Policies. Assume that Hurricane, Inc., is a U.S.
company that exports products to the U.K., invoiced in dollars. It also exports products to Denmark,
invoiced in dollars. It currently has no cash outflows in foreign currencies, and it plans to issue bonds
in the near future. Hurricane could likely issue bonds at par value in (1) dollars with a coupon rate of
12 percent, (2) Danish kroner with a coupon rate of 9 percent, or (3) pounds with a coupon rate of 15
percent. It expects the kroner and pound to strengthen over time. How could Hurricane revise its
invoicing policy and make its bond denomination decision to achieve low financing costs without
excessive exposure to exchange rate fluctuations?
13. Swap Agreement. Grant, Inc., is a well-known U.S. firm that needs to borrow 10 million British
pounds to support a new business in the United Kingdom. However, it cannot obtain financing from
British banks because it is not yet established within the United Kingdom. It decides to issue dollar-
denominated debt (at par value) in the U.S., for which it will pay an annual coupon rate of 10%. It
then will convert the dollar proceeds from the debt issue into British pounds at the prevailing spot rate
(the prevailing spot rate is one pound = $1.70). Over each of the next three years, it plans to use the
revenue in pounds from the new business in the United Kingdom to make its annual debt payment.
Grant, Inc., engages in a currency swap in which it will convert pounds to dollars at an exchange rate
of $1.70 per pound at the end of each of the next three years. How many dollars must be borrowed
initially to support the new business in the United Kingdom? How many pounds should Grant, Inc.,
specify in the swap agreement that it will swap over each of the next three years in exchange for
dollars so that it can make its annual coupon payments to the U.S. creditors?
14. Interest Rate Swap. Janutis Co. has just issued fixed rate debt at 10 percent. Yet, it prefers to
convert its financing to incur a floating rate on its debt. It engages in an interest rate swap in which it
swaps variable rate payments of LIBOR plus 1% in exchange for payments of 10%. The interest
rates are applied to an amount that represents the principal from its recent debt issue in order to
determine the interest payments due at the end of each year for the next three years. Janutis Co.
expects that the LIBOR will be 9% at the end of the first year, 8.5% at the end of the second year, and
7% at the end of the third year. Determine the financing rate that Janutis Co. expects to pay on its
debt after considering the effect of the interest rate swap.
15. Financing and the Currency Swap Decision. Bradenton Co. is considering a project in which it
will export special contact lenses to Mexico. It expects that it will receive 1 million pesos after taxes
at the end of each year for the next 4 years, and after that time its business in Mexico will end as its
special patent will be terminated. The peso’s spot rate is presently $.20. The U.S. annual risk-free
interest rate is 6% while Mexico’s annual risk-free interest rate is 11%. Interest rate parity exists.
Bradenton Co. uses the one-year forward rate as a predictor of the exchange rate in one year.
Bradenton Co. also presumes that the exchange rates in each of the years 2 through 4 will also change
by the same percentage as it predicts for year 1. Bradenton searches for a firm with which it can swap
pesos for dollars over each of the next 4 years. Briggs Co. is an importer of Mexican products. It is
willing to take the 1 million pesos per year from Bradenton Co. and will provide Bradenton Co. with
dollars at an exchange rate of $.17 per peso. Ignore tax effects.
Bradenton Co. has a capital structure of 60% debt and 40% equity. Its corporate tax rate is 30%. It
borrows funds from a bank and pays 10% interest on its debt. It expects that the U.S. annual stock
market return will be 18% per year. Its beta is .9. Bradenton would use its cost of capital as the
required return for this project.
a. Determine whether the NPV of this project if Bradenton engages in the currency swap.
b. Determine the NPV of this project if Bradenton does not hedge the future cash flows.
ANSWER:
a. First, determine exchange rates to convert MXP into U.S. dollars.
a) No hedge
Year 1 Year 2 Year 3 Year 4
After tax profit
in MXP
MXP1,000,000 MXP1,000,000 MXP1,000,000 MXP1,000,000
b) Swap
Year 1 Year 2 Year 3 Year 4
After tax profit
in MXP MXP1,000,000 MXP1,000,000 MXP1,000,000 MXP1,000,000
16. Financing and Exchange Rate Risk. The parent of Nester Co. (a U.S. firm) has no international
business but plans to invest $20 million in a business in Switzerland. Since the operating costs of this
business are very low, Nester Co. expects this business to generate much cash flows in Swiss francs
that will be remitted to the parent each year.
Nester will finance half of this project with debt. It has these choices for financing the project:
* obtain half of the funds needed from parent equity and the other half by borrowing dollars
* obtain half of the funds needed from parent equity and the other half by borrowing Swiss francs
* obtain half of the funds that are needed from parent equity and obtain the remainder by borrowing
an equal amount of dollars and Swiss francs
The interest rate on dollars is the same as the interest rate on Swiss francs.
a. Which choice will result in the most exchange rate exposure?
b. Which choice will result in the least exchange rate exposure?
c. If the Swiss franc was expected to appreciate over time, which financing choice would result in
the highest expected net present value?
ANSWER:
17. Financing and Exchange Rate Risk. Vix Co. (of the U.S.) presently serves as a distributor of
products by purchasing them from other U.S. firms and selling them in Europe. It wants to purchase a
manufacturer in Thailand that could produce similar products at a low cost (due to low labor costs in
Thailand) and export the products to Europe. The operating expenses would be denominated in Thai
currency (the baht). The products would be invoiced in euros. If Vix Co. can acquire a manufacturer,
it will discontinue its existing distributor business. If Vix Co. purchases a company in Thailand, it
expects that its revenue might not be sufficient to cover its operating expenses during the first 8 years.
It will need to borrow funds for an 8-year term to ensure that it has enough funds to pay all of its
operating expenses in Thailand. It can borrow funds denominated in U.S. dollars, in Thai baht, or in
euros. Assuming that its financing decision will be primarily intended to minimize its exposure to
exchange rate risk, which currency should it borrow? Briefly explain.
18. Financing and Exchange Rate Risk. Compton Co. has a subsidiary in Thailand that produces
computer components. The subsidiary sells the components to manufacturers in the U.S. The
components are invoiced in U.S. dollars. Compton pays employees of the subsidiary in Thai baht and
makes a large monthly lease payment in Thai baht. Compton financed the investment in the Thai
subsidiary by borrowing dollars from a U.S. bank. Compton has no other international business.
a. Given the conditions, is Compton affected favorably or unfavorably, or not affected by
depreciation of the Thai baht? Briefly explain.
b. Assume that interest rates in Thailand declined recently, so Compton subsidiary considers
obtaining a new loan in Thai baht. Compton would use the proceeds to pay off its existing loan
from a U.S. bank. Will this form of financing increase, reduce, or have no impact on its economic
exposure to exchange rate movements? Briefly explain.
ANSWER:
19. Selecting a Loan Maturity. Omaha Co. has a subsidiary in Chile that wants to borrow from a local
bank at a fixed rate over the next 10 years.
a. Explain why Chile's term structure of interest rates (as reflected in its yield curve) might cause
the subsidiary to borrow for a different term to maturity.
b. If Omaha is offered a more favorable interest rate for a term of 6 years, explain the potential
disadvantage compared to a 10-year loan.
c. Explain how the subsidiary can determine whether to select the 6-year loan versus the 10-year
loan.
ANSWER:
20. Project Financing. Dryden Co. is a U.S. firm that plans a foreign project in which it needs
$8,000,000 as an initial investment. The project is expected to generate cash flows of 10 million euros
in one year, after the complete repayment of the loan (including the loan interest and principal). The
project has zero salvage value and is terminated at the end of one year. Dryden considers financing
this project with:
*all U.S. equity,
*all U.S. debt (loans) denominated in dollars provided by U.S. banks,
*all debt (loans) denominated in euros provided by European banks, or
*half of funds obtained from loans denominated in euros, and half obtained from loans denominated
in dollars.
Which form of financing will cause the project's NPV to be the least sensitive to exchange rate risk?
CRITICAL THINKING
Financing Foreign Business with Foreign Debt Spectra Energy Corp. (based in Houston) has
substantial operations in Canada, and generates much revenue in Canadian dollars. It borrows funds
denominated in Canadian dollars (rather than U.S. dollars) to finance its Canadian operations. Write a
short essay that explains the potential benefits from such a strategy. Explain the possible disadvantages
that might occur when some U.S.-based MNCs attempt this strategy in a country where interest rates are
high. Also, consider the alternative solutions such as not hedging, or selling forward contracts.
ANSWER
The financing with Canadian dollars allows Spectra to match its cash outflows (to repay debt) with its
cash inflows from revenue generated by operations in Canada. This strategy may not be as feasible if the
