Chapter 18: Long-Term Financing 231

Chapter 18
Long-Term Financing

Answers to End of Chapter Questions

1. What factors should be considered by a U.S. firm that plans to issue a floating rate Eurobond?

ANSWER: A U.S. firm should consider the interest rate for each possible currency as well as
forecasts of the exchange rate relative to the firm’s home currency. The firm should also
determine whether it has future cash inflows in any foreign currencies that could denominate the
bond. Finally, the firm should forecast the future path of the coupon rate.

2. What is the advantage of using simulation to assess the bond financing position?

ANSWER: Unlike point forecasts, simulation provides a distribution of possible outcomes. Thus,
the firm can determine the probability that a particular Eurobond will be a less expensive source of
funds than a locally issued bond.

3. 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.

ANSWER: The cost of financing with foreign currencies is low when the dollar strengthens, and
high when the dollar weakens.

4. Explain how a U.S.-based MNC issuing bonds denominated in euros may be able to offset a
portion of its exchange rate risk.

ANSWER: It may offset some exchange rate risk if it has cash inflows in euros. These euros
could be used to make coupon payments.

5. Is the risk of issuing a floating rate Eurobond higher or lower than the risk of issuing a fixed rate
Eurobond? Explain.

ANSWER: The risk from issuing a floating rate Eurobond is that the interest rate may rise over
time. The risk from issuing a fixed rate Eurobond is that the firm is obligated to pay that coupon
rate even if interest rates decline. Some firms may feel that a fixed rate Eurobond is less risky
since at least they know with certainty the coupon rate they must pay in the future. This question
is somewhat open-ended.
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6. Columbia Corporation is a U.S. company with no foreign-currency cash flows. It plans to either
issue (1) a bond denominated in euros with a fixed interest rate or (2) 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.

ANSWER: Exchange rates are generally more volatile than interest rates over time. Therefore
the dollar payments made on yen-denominated bonds would likely be more uncertain than the dollar
payments made on floating-rate bonds denominated in dollars. Also, the principal payment is
subject to exchange rate risk but not to interest rate risk.

7. Why would a U.S. firm consider issuing bonds denominated in multiple currencies?

ANSWER: The firm may issue bonds in multiple currencies to reduce exchange rate risk. This is
especially possible when the currencies used to denominate bonds are not highly correlated.

8. 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?

ANSWER: Kerr could invoice its exports in yen and use the proceeds to pay back loans. Its
economic exposure would be reduced because Japanese consumers would not be subjected to
exchange rate swings.

9. Katina, Inc., is a U.S. firm that plans to finance with Eurobonds denominated in euros to obtain a
lower interest rate than the dollar-denominated bonds. What is the most critical point in time when
the exchange rate will have the greatest impact?

ANSWER: The most critical time is maturity, since the principal will be paid back at that time.

10. 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 Eurobond to exhibit?

ANSWER: An investing firm prefers a bond denominated in a currency that is expected to

appreciate and with an interest rate that is high and expected to increase. A borrowing firm
prefers a bond denominated in a currency that is expected to depreciate and with an interest rate
that is low and expected to decrease.

11. 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
Chapter 18: Long-Term Financing 233

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
S$ payment S$1,400,000 S$1,400,000 S$1,400,000 S$21,400,000
Exchange rate $.52 $.56 $.58 $.53
$ payment $728,000 $784,000 $812,000 $11,342,000

The annual cost of financing with S$ is determined as the discount rate that equates the U.S. dollar
payments resulting from payments on the Singapore dollar-denominated bond to the amount of U.S.
dollars borrowed. Using a calculator, this discount rate is 8.97%. Thus, the expected annual cost
of financing with a Singapore dollar-denominated bond is 8.97%, which is less than the 12% cost of
financing with U.S. dollars. However, there is some uncertainty associated with Singapore dollar
financing. Seminole Inc. must weigh the expected savings from financing in Singapore dollars with
the uncertainty associated with such financing.

12. 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 presently 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?

ANSWER: Hurricane could invoice goods exported to Denmark in kroner instead of dollars.
Thus, it would now have inflows in kroner that could be used to make coupon payments on bonds
denominated in kroner that it could issue. This strategy achieves a cost of financing of 9 percent,
which is lower than the cost of other financing alternatives. To the extent that the inflows in
kroner can cover bond payments, this strategy is not exposed to exchange rate risk.

13. 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
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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.

ANSWER: The fixed rate of 10% to be received from the interest rate swap offsets the 10%
payments made on the debt. Therefore, the annual cost of financing on the debt over the next
three years is simply the variable rate that is paid out on the interest rate swap. This rate is derived
below:

End of Year LIBOR Variable Rate Paid Due to Swap

1 9.0% 9.0% + 1.0% = 10.0%
2 8.5% 8.5% + 1.0% = 9.5%
3 7.0% 7.0% + 1.0% = 8.0%

14. 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 pay its annual coupon payments to the U.S. creditors?

ANSWER: Since Grant Inc. needs 10 million pounds, Grant will need to issue debt amounting to
$17 million (computed as 10 million pounds × $1.70 per pound). Grant Inc. will pay 10% on the
principal amount of $17 million annually as a coupon rate, which is equal to $1.7 million. It should
specify that 1 million pounds are to be swapped for dollars in each of the next three years
(computed as $1.7 million dollars divided by $1.70 per pound = 1 million pounds).