Joanna P Smith

WEEK 6


ANALYTICAL APPLICATION 1

Bond Financing Analysis

ALTEC Inc. can issue bonds in either U.S. dollars or in Swiss francs. Dollar-
denominated bonds would have a coupon rate of 15%; Swiss francdenominated
bonds would have a coupon rate of 12%. Assuming that ALTEC can issue bonds
worth $10,000,000 in either currency, that the current exchange rate of the Swiss
franc is $0.70, and that the forecasted exchange rate of the franc in each of the
next 3 years is $0.75, what is the annual cost of financing for the franc-
denominated bonds? Which type of bond should ALTEC issue?

ALTEC Inc. issues Swiss franc-denominated bonds

Face Value:
$10,000,000/$.70= SF 14,285,714

SF Payment: SF14, 285,714 x .12= SF1,714,286
SF14,285,714 + SF1,714,286 = SF16,000,000 for year 3

Year 1 Year 2 Year 3
SF PMT SF1,714,286 SF1,714,286 SF16,000,000
Exchange Rate $.75 $.75 $.75
PMT in Dollars $1,285,715 1,285,715 $12,000,000

The annual financing is:
[(.75-.70)/.70]x(360/360)=.0714
15.00-.0714=14.92%

The annual cost of financing is 14.92% for the franc-denominated
bonds. The annual cost of financing of the dollar-denominated bonds
is 15% ALTEC can issue franc-denominated bonds.







ANALYTICAL APPLICATION 2

LEXCO 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% versus 3% in Japan. Assume that interest rate parity
exists and that LEXCO believes that the international Fisher effect holds.

a. Should LEXCO Co. finance its production with yen and leave itself open to
the exchange rate risk?
LEXCO Co. should not finance its production with yen because it is
expected to rise according to the IFE. There will interest rate
differential if that happens.
b. Should LEXCO finance its production with yen and simultaneously engage
in forward contracts to hedge its exposure to exchange rate risk?
LEXCO should not leave itself open to exchange rates. The
forward rate should reflect the interest rate differential (Madura,
2011), which means that interest rate will be 9% for the LEXCO Co.
c. How could LEXCO achieve low-cost financing while eliminating its
exposure to exchange rate risk?
LEXCO Co. should ask their Japanese importers to pay for the
imported products in yen, that way they could finance the yen at
3%. The differential can go towards covering the finance payment.



References:
Madura, J. (2011). International Financial Management, 11th
Edition. Cengage Learning. VitalBook file.