Reference no: EM131941685
Case Study: Eurobond Financing Strategy
XYZ Company is a large nnillinational firm with operations all over the glebe. It has Plans to expand further, and for that reason, it needs to borrow 600 million curos (or an equivalent amount in another currency) through a bond issue with 5year maturity. It is considering borrowing in one of the following corm-wits.: the cum. the British pound, the Swiss franc. or the U.S. dollar.
As a matter of policy for XYZ Company, any borrowing that is not denominated in the cum currency needs to be hedged using forward agreements.
The reason for this policy is that should the curo depreciate over time then paying down debt denominated in another currency with the curo¬denominated each flow of XYZ Company becomes expensive.
The investment banker that XYZ Company hired estimates that the bond issue will sell at par value if the annual coupon rate is set at:
• 5.250% for a curo-denominated bond issue;
• 5.375% for a British pound-denominated bond issue;
• 3.625% for a Swiss franc-denominated bond issue; and
• 5.500% for a U.S. dollar-denominated bond issue.
Since the bonds would be offered in the Eurobond market, they arc subject to similar issuance costs. liquidity, and specifications regardless of the currency denomination. Also. Eurobonds follow an annual coupon payment convention.
At the time XYZ Company had to make a decision regarding its Eurobond financing strategy:
• The value of I unit of the euro currency (i.e., current spot exchange rate) was 0.628 British pound. 1.453 Swiss franc, and 1.115 U.S. dollar, and
• The risk-free rates for different maturities by currency denomination were as shown in Table I.
Please answer the following questions:
1. What does interest-rate parity say about international borrowing costs? Recall the formula that represents the interest-rate parity condition (using the Swiss franc and the cure as example): F SF cup = SSF EcR [(I 4" RST 01. / (I "" RW7(.7)9
where FSFELtR is the T-period franc to curo forward exchange rate, SSE as is the prevailing france to curo spot exchange rate, and RsEr and REt r are the T-period interest rate for the franc and curo. respectively.
2. Assuming the bonds am issued at par, what is the cost of borrowing in each of the bond issue alternatives? Show all computations. Hint: determine the cash flows in euros of the various alternatives using the parity forward rates. Also. use a financial calculator to find the cost of borrowing.
3. Which debt issue would you recommend? Explain.
Table I: Risk-Free (annual percentage) Rate by Maturity and Currency Denomination
|
Maturity
|
Euro
|
British pound
|
Swiss france
|
US. dolthr
|
|
1-year
|
3.514%
|
4.258%
|
1.125%
|
2.099%
|
|
2-year
|
3.816%
|
4.622%
|
1.713%
|
2.767%
|
|
3-year
|
4.110%
|
4,910%
|
2.172%
|
3.432%
|
|
4-year
|
4.342%
|
5.088%
|
2.498%
|
3.922%
|
|
5-year
|
4.530%
|
5.190%
|
2.743%
|
4.308%
|