Airline Borrowing Case May 1985 UAL Inc Par

Airlineborrowing Case May 1985it Is May 1985 And Ual Inc Parent O

Airline Borrowing Case: May 1985 It is May 1985 and UAL, Inc., parent of United Airlines, needs to borrow $500 million to finance the purchase of Hertz. You are Assistant Treasurer and must make a recommendation about the choice between borrowing in the USA in U. S. Dollars or in Japan in Yen (¥). As background, UAL, Inc. owns United Airlines and Westin Hotels. It is buying Hertz from RCA. United Airlines will generate about 80% of the UAL revenue and the remainder will be evenly split between Hertz and Westin. United Airlines, Hertz, and Westin Hotels are worldwide service companies that generate revenue in many countries and currencies, mainly in the U.S., Canada, Latin America, and Europe.

The Treasurer considers this to be a “No Brainer.” If the loan is in U.S. Dollars in the USA, company policy requires the use of a specific investment banker. This firm describes the terms of the USA loan as follows: A coupon rate of 11% per year paid semi-annually in December and June for 10 years. The principal of $500 million would be repaid at the end of the 10-years. There would be a one-time underwriting fee of 0.5% (of the amount borrowed) to be paid when the loan funds are received. A leading Japanese bank is offering a loan with the interest and principal denominated in Yen. The interest rate will be 5% and there are no upfront fees. Both loans require interest payments in December and in June. The entire principal is due in June 1995. In May 1985, the exchange rate fluctuated between 250 and 252 yen to the dollar. For convenience, use 250 ¥ to the $ as the exchange rate in May 1985.

Each student must recommend the best alternative and discuss why it is best. Your solution should consist of three parts: First, create a schedule showing the interest, principal payments, and fees due for the dollar-denominated loan. Second, for the yen-denominated loan, create a schedule showing the interest and principal payments due (in yen). Then, right underneath, create another schedule showing those same interest and principal payments in dollars , under any assumption about the yen-dollar exchange-rate during the term of the loan. If you’ve done this second schedule correctly, you should be able to plug in 250 ¥ to the $, for instance, and see the second schedule update automatically. Third, use the tool you’ve just developed to find the exchange rate at which the two loans have the same NPV. To keep things simple, you may assume that U.S. interest rates remain at 11% and Japanese interest rates remain at 5% for the term of the loans in your NPV calculation. Based on the information available in May 1985, which loan alternative is best and why? Analyses and conclusion are only as good as the data and assumptions that they are based on. If your analysis contains data and/or assumptions unsupported by reasoning and explanations plus sources of the related data, a reader has no basis to accept your presentation as valid. Without proper support the reader is likely to disregard your analysis and/or conclusions, and may even begin to have some doubts about you. So ALWAYS support all of your numbers or calculations with reasoning, explanations and sources for all of your data. All answers should be placed in a single Excel file.

Paper For Above instruction

In May 1985, UAL, Inc., the parent company of United Airlines, faced a strategic financial decision: whether to finance a $500 million dollar borrowing in U.S. Dollars or Yen. This decision was critical given the company’s international operations spanning North America and Europe, with revenue streams denominated in multiple currencies. The aim was to optimize costs and minimize financial risk, particularly currency and interest rate risks, impacting the company’s ability to finance the acquisition of Hertz effectively.

Part 1: Schedule for the U.S. Dollar-denominated Loan

The terms of the U.S. dollar loan included an annual coupon rate of 11%, payable semi-annually in June and December over a 10-year period. The principal of $500 million is to be repaid at the end of ten years, with an underwriting fee of 0.5% of the borrowed amount payable upfront. The semi-annual interest payments are calculated as (Principal × Rate)/2 = ($500 million × 11%) / 2 = $27.5 million, due twice a year. The underwriting fee totals $2.5 million (0.5% of $500 million).

Amortization Schedule:

• Year 0: Loan amount = $500 million, Underwriting fee = $2.5 million, Net proceeds = $497.5 million
• Interest Payments (semi-annual): $27.5 million, paid in June and December each year, totaling $55 million annually.
• Principal Repayment: $500 million at the end of Year 10.

Part 2: Schedule for the Yen-denominated Loan

The Japanese bank offers a loan with a 5% interest rate, no upfront fees, and principal repayment at the end of 10 years, with interest paid semi-annually. The interest per period is (Principal × 5%) / 2, and principal in Yen is equivalent to $500 million at the May 1985 exchange rate of 250 ¥/$, i.e., ¥125 billion.

Interest payments in Yen: ¥6.25 billion per semi-annual period.

Repayment at maturity: ¥125 billion in Year 10.

Schedule of payments in Yen:

• Interest in each period: ¥6.25 billion
• Principal: ¥125 billion at Year 10

Equivalent dollar payments schedule, assuming the Yen-to-Dollar exchange rate remains at 250 ¥/$ throughout the loan period:

• Interest per period in dollars: ¥6.25 billion / 250 = $25 million
• Principal in dollars: ¥125 billion / 250 = $500 million

Note: Variations in the exchange rate during the loan period impact the dollar value of payments. If the Yen appreciates, payments in dollars increase; if it depreciates, they decrease. The schedule must be adaptable to changing exchange rates for precise analysis.

Part 3: Determining the Break-Even Exchange Rate and Comparative Analysis

To determine at which exchange rate the NPVs of both loans are equal, we must compare the present values of the total payments considering the current interest rates: 11% annual rate for USD and 5% for Yen based on the assumption of stable rates during the loan term.

NPV calculations:

- For the USD loan, the present value is straightforward, considering the fixed interest, principal, and fees.

- For the Yen loan, the NPV is sensitive to the exchange rate; thus, we derive the rate where the PV of Yen payments converted into dollars matches the PV of the USD loan.

Using discount factors according to the respective interest rates and assuming the Yen depreciates or appreciates at a certain rate, the critical exchange rate (at which NPVs are equal) can be solved via the following equation:

NPV USD = NPV Yen in dollars = (Yen payments / (1 + Yen rate)^n) × exchange rate

Calculations indicate that if, at the end of 10 years, the Yen depreciates above a certain threshold relative to the dollar, the Yen loan becomes more economical. Conversely, if Yen appreciates or remains stable, the dollar loan might be preferable due to predictable costs.

Based on the data and initial exchange rate of 250 ¥/$, the analysis suggests that if future yen-dollar exchange rate movements favor Yen depreciation, borrowing in Yen minimizes costs; otherwise, borrowing in USD is safer. The exact break-even exchange rate can be computed using present value formulas, considering the interest rates and projected exchange movements.

Conclusion

Given the stable interest rates (11% USD, 5% Yen) and current exchange rate of 250 ¥/$, the decision depends heavily on expectations of currency movements. If the Yen is expected to depreciate significantly within the next decade, the Yen loan emerges as the more economical choice. However, if the Yen remains stable or appreciates, the USD loan is less risky due to certainty in payment obligations.

Ultimately, in May 1985, considering the currency outlook, interest rates, and risk profiles, the USD loan is preferable for conservative management unless there are strong expectations of Yen depreciation. The company's foreign exchange risk management strategies should also factor into this decision.

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