Reference no: EM131054932

Problem 1

Company A and B can borrow for a 3-year term at the following rates. While A desires fixed rate borrowing, B prefers floating rate borrowing.

               Fixed Rate      Floating Rate

A            8.5%                   LIBOR + 0.5%

B            7%                       LIBOR

The swap bank currently makes a market for plain vanilla 3-year interest rate swaps at 7.25% - 7.5%.

1)    Illustrate how Company A benefits from the use of interest rate swap.

2)    Summarize the risks taken by the swap bank in the interest swap with Company B.

3)    Is it feasible for the swap bank to customize an interest rate swap that provide a cost saving of 0.35% to B? Explain.

4)    Suppose both Company A and B entered into the 3-year swaps with the swap bank. One year after the inception of the 3-year swaps, the swap bank quotes 2-year interest rate swaps at 6.5% - 7%. Which company is willing to unwind the original swap? Explain how much it is willing to pay to unwind.

Problem 2

Dow Chemical (a U.S. MNC) and Michelin (a French tire manufacturer) need to borrow to finance their foreign direct investments. They can issue 10-year bond of $220 million or 10-year bond of €200 million. Although both companies have the same creditworthiness, they have to pay higher interest rates for the debt denominated in foreign currency. Their borrowing costs are as follows:

                                             $ Borrowing Cost                      € Borrowing Cost

Dow Chemical                   7.5%                                                 8.25%

Michelin                              7.7%                                                 8.10%

A swap bank currently quotes the following rates on 10-year swaps:

U.S. dollar ($): 7.5% - 7.6% against dollar LIBOR

Euro (€):          8.1% - 8.15% against dollar LIBOR

1)    Discuss the challenges encountered by the above two MNCs in financing for their foreign direct investments.

2)    Illustrate how both the MNCs benefit from the use of currency swaps.

3)    Suppose two years after both companies entered into the 10-year currency swaps, $ interest rate has changed to 7% and € interest rate changed to 8%. Exchange rate changed to $1.2/€. What is the value of the currency swap?

Problem 3

An Italian company is considering expanding the sales of its cappuccino machines to the U.S. market. As a result, the idea of setting up a manufacturing facility in the U.S. should be explored. The company estimates the initial demand in the U.S. will bring in an annual operating profit of $2,500,000, which is expected to keep track with the U.S. price level. The new facility will free up the amount currently exported to the U.S. market. The company presently realizes an annual operating profit of €1,000,000 on its U.S. export.

The manufacturing facility is expected to cost $24 million. The company plans to finance the project with a combination of debt and equity capital. The new project will increase the company's borrowing capacity by €10 million, and the company plans to borrow only that amount. The city in which the facility will be built has promised to provide a 5-year interest only loan of $7.5 million at 6% per annum (note: principal will be paid back in a lump sum at the end of year 5).

The U.S. IRS will allow the company to straight-line depreciate the new facility over a 5-year period. After that time, the company plans to sell all molding equipment (accounts for 55% of the project's cost). Although it is difficult to estimate the salvage value, the company is confident that the after-tax salvage value will be at least 25% of the original book value.

Corporate tax rates in the U.S. and Italy are the same as 35%. The long-term inflation rate is expected to be 3% in the U.S. and 5% in Italy. The current spot exchange rate is $1.5/€. The Italian company explicitly believes in PPP as the best means to forecast future exchange rate.

The company's U.S. sales affiliate currently holds $1.5 million ready for repatriation back to Italy. The money was accumulated under a special tax concession rate of 25%. If the fund were repatriated, additional tax will be due.

The company estimates its weighted average cost of capital to be 11%, and all-equity cost of capital to be 15%. It can borrow dollars at 9% per annum and Euros at 10%.

1)    What is the amount and the cost of debt used to finance the U.S. manufacturing facility?

2)    Why is the APV model better than NPV model for capital budgeting analysis?

3)    Specify the discount rate you would use for the calculation of the (1) present value of after tax operating cash flows; (2) PV of depreciation tax shield; (3) PV of terminal cash flows. Explain why.

4)    Illustrate how to calculate the PV of after tax operating cash flows in APV analysis (use the first two years in your illustration).

5)    Calculate the PV of interest tax shield from non-concessionary loan.

6)    Calculate the amount of funds that will be freed up by the new project.

7)    Calculate the subsidy provided by the host city.

8)    Assume the preliminary estimate of the 5-year project's APV is -€1,000,000 (negative €1,000,000). Which does not included the after tax salvage value of the equipment. Calculate the break even after tax salvage value. Do you recommend the project to the Italian company? Explain.

9)    Now assume the concessionary loan offered by the host city increases to $20 million. How much of the interest payment should be used to calculate interest tax shield? Explain.