It Is May 1985 And UAL Inc Parent Of United Airlines Needs T

It Is May 1985 And Ual Inc Parent Of United Airlines Needs To Borr

It is May 1985 and UAL, Inc., parent of United Airlines, needs to borrow $500 million to finance the purchase of Hertz. The company's revenue streams are diversified across several countries and currencies, primarily in the U.S., Canada, Latin America, and Europe. Given this multinational exposure, UAL faces a strategic financial decision: whether to borrow in U.S. dollars within the United States or in Japanese yen through a Japanese bank. The decision hinges on considerations of exchange rate risk, interest costs, repayment currencies, and overall financial strategy.

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In the context of cross-border financing, multinational corporations like UAL, Inc. must carefully weigh the advantages and disadvantages of borrowing in different currencies and markets. In 1985, UAL had to decide between issuing a U.S. dollar-denominated loan within the United States or obtaining a yen-denominated loan from a Japanese financial institution. Each option carries distinct implications for currency risk, cost of borrowing, and cash flow management.

Analysis of Borrowing in U.S. Dollars

Borrowing in U.S. dollars offers UAL the advantage of simplicity and familiarity. Since UAL’s primary revenue streams are in U.S. dollars, debt service payments in the same currency reduce foreign exchange exposure. The terms of the U.S.-based loan include an interest rate of 11% per annum, paid semi-annually, with repayment of the principal at the end of ten years. The loan also incurs a one-time underwriting fee of 0.5%, amounting to $2.5 million. The fixed interest payments and predictable cash flows make this option attractive for a company with stable dollar revenues.

However, the dollar-denominated loan exposes UAL to currency risk if its revenues or expenses in other currencies fluctuate significantly. Given the company's worldwide operations, some variations in foreign currency revenues could translate into indirect currency exposure. Nonetheless, since UAL’s core operations are largely dollar-based, this risk is manageable.

Analysis of Borrowing in Yen

On the other hand, the Japanese bank offers a yen-denominated loan with a lower interest rate of 5%, and no upfront fees. The entire principal of ¥125 billion (using the exchange rate of 250 ¥ per dollar) is due in June 1995. Interest payments are scheduled semi-annually in December and June, similar to the U.S. loan. In theory, this lender provides a more cost-effective source of funds, thanks to the lower interest rate.

Nevertheless, borrowing in yen introduces currency risk. Although the initial exchange rate is 250 ¥ per dollar, currency exchange rates are volatile; the case notes the rate fluctuated between 250 and 252 yen to the dollar during May 1985. If the yen depreciates significantly against the dollar over the loan period, UAL could face higher costs when repaying the principal in yen and converting revenues from other currencies into yen for debt service. Conversely, yen appreciation would benefit the company by reducing the yen equivalent of the debt burden. This exchange rate volatility necessitates hedging strategies, which could offset some of the interest savings.

Strategic Considerations and Recommendation

Given these factors, the decision hinges on the company’s risk appetite and currency management strategy. Borrowing in U.S. dollars aligns with the company's revenue base and minimizes currency risks, providing predictable debt servicing costs. This approach is particularly prudent for a company predominantly earning in dollars, reducing the complexity associated with foreign exchange hedging.

Alternatively, borrowing in yen may appear attractive due to the lower nominal interest rate, potentially reducing overall interest expenses. However, the currency risk associated with the yen exposure — especially with rates fluctuating within a narrow range but still subject to volatility — makes this option more complex and potentially more costly if currency movements move unfavorably.

Considering the information provided and existing market conditions, the recommended strategy is to borrow in U.S. dollars within the United States. The primary reasons include currency risk mitigation, predictable cash flows, and the company’s significant dollar-denominated revenue streams. While the lower interest rate in yen is appealing, the additional risks and costs associated with currency fluctuations and hedging outweigh the interest savings. Managing currency risk through other financial instruments or operational strategies might be preferable than taking on exchange rate exposure through foreign currency borrowing.

Conclusion

In conclusion, for UAL, Inc., the prudent choice in 1985, given the financial landscape and currency considerations, is to secure the loan in U.S. dollars in the United States. This decision offers stability, reduces complexity and risk, and aligns with the company’s revenue currency profile. The cost savings from lower interest rates in yen are offset by potential currency fluctuations and hedge costs, rendering the dollar-denominated loan the more strategic and less risky funding option for a multinational corporation operating primarily in dollar-based markets.

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