Reference no: EM132398347

Assume that a firm in England has a subsidiary in Mexico. The subsidiary is undertaking a new project that will require an immediate expenditure of 14,250,000 pesos. The project will generate funds over the next five years. The firm in England therefore wants to issue bonds with five years to maturity. The firm in England can issue bonds in Mexico at a coupon rate of 7.5%. Alternatively, the firm in England could issue bonds in England at a coupon rate of 5%. Assume the current exchange rate is equal to 20 pesos for one pound.

A Mexican firm has a subsidiary in England that wishes to expand operations and will need 712,500 pounds. The Mexican firm has two choices. It can issue bonds in England with a coupon rate of 7% or it can issue bonds in Mexico at a coupon rate of 6% and then convert the pesos into pounds.

• What risk is created if the firm in Mexico finances the expansion project of its subsidiary by issuing bonds in Mexico? Explain your reasoning.
• If the firm in Mexico issues bonds in England does it still face exchange rate risk? Explain.
• If the firm in Mexico and the firm in England agree to a currency swap, write out the inflows and outflows for each firm over the life of the swap.  Use a timeline.  
• Assume that if the firms had not engaged in the currency swap that the firm in England would have issued bonds in Mexico and the firm in Mexico would have issued bonds in England. What is the present value of the savings that each firm realizes through the swaps? Show your work. Express the savings for the Mexican firm in pesos and the savings for the English firm in pounds. Finally express savings using a common currency. Did both firms save the same amount? Does the result make sense? Explain.