Week 6 Analytical Application 1 Bond Financing Analysis

Week 6analytical Application 1bond Financing Analysisaltec Inc Can Is

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 franc–denominated 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?

WEEK 6 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 finance its production with yen and leave itself open to the exchange rate risk? Explain. b. Should LEXCO finance its production with yen and simultaneously engage in forward contracts to hedge its exposure to exchange rate risk? c. How could LEXCO achieve low-cost financing while eliminating its exposure to exchange rate risk?

Paper For Above instruction

Financial decision-making in multinational corporations involves complex considerations related to currency risk, interest rates, and international financial markets. This paper explores two case studies: one involving bond issuance in different currencies by ALTEC Inc., and another analyzing the financing options and exchange rate risk management strategies for LEXCO Co. when exporting to Japan. Through detailed calculations and theoretical frameworks such as interest rate parity and the international Fisher effect, this discussion aims to provide insights into optimal financing practices and risk mitigation strategies in international finance.

Bond Financing Analysis for ALTEC Inc.

ALTEC Inc. faces a critical decision regarding the currency denomination of its bonds—whether to issue in U.S. dollars or Swiss francs. The key factors influencing this decision include the coupon rates, exchange rates, and the projected currency movements over the bond’s lifespan. The bonds are worth $10 million, with a coupon rate of 15% for dollar-denominated bonds and 12% for Swiss franc-denominated bonds. The current exchange rate is $0.70 per Swiss franc, with a forecasted appreciation of the franc to $0.75 over the next three years.

To assess the annual cost of financing in francs, we consider both the coupon payments and the expected changes in exchange rates. The initial investment in Swiss francs equates to approximately 14.29 million CHF ($10 million / $0.70). With a forecasted exchange rate of $0.75 per franc, the future value of these francs in USD terms will be higher, providing an implicit gain due to currency appreciation. The effective annual cost of the franc bonds can be approximated by considering the coupon payments and the impact of exchange rate movements, which effectively lower the real cost of borrowing when measured in USD terms.

Since the franc is expected to appreciate from $0.70 to $0.75, the USD equivalent of the franc-denominated bonds will decline over time, reducing the effective interest cost. Calculating the precise cost involves adjusting the coupon rate by the expected rate of currency appreciation, which in this case is approximately 7.14% annually (using the formula for expected appreciation: [(Future rate / Current rate)^(1/number of years)] - 1).

Comparing the effective costs, the franc bonds’ lower coupon rate and the expected currency appreciation suggest that ALTEC should prefer issuing franc-denominated bonds if it is willing to bear the exchange rate risk. Conversely, if ALTEC seeks to avoid currency risk, issuing dollar-denominated bonds with higher coupon rates might be preferable, especially if the company can hedge currency risk or if currency movements are unpredictable.

Financial Strategies for LEXCO Co. in Japan

LEXCO Co. faces strategic choices regarding financing and hedging when exporting products to Japan. The company’s decision hinges on interest rate differentials, exchange rate expectations, and the availability of hedging instruments such as forward contracts.

Interest rate parity (IRP) indicates that the expected change in exchange rates offsets interest rate differentials between two countries. Given the U.S. long-term interest rate of 9% and a Japanese rate of 3%, IRP suggests that the USD/JPY exchange rate should adjust to equalize returns after accounting for interest rate differentials. The international Fisher effect (IFE) supports this, asserting that currencies with higher interest rates should depreciate relative to those with lower rates, thereby neutralizing yield differentials over time.

1. Should LEXCO finance with Yen and accept the exchange rate risk? If LEXCO refrains from hedging, it exposes itself to potential adverse currency movements that could increase its costs or reduce profit margins. Given the interest rate differentials and expected currency movements, financing in yen entails significant exchange rate risk, especially if the company’s income remains in USD.

2. Should LEXCO hedge using forward contracts? Engaging in forward contracts to lock in exchange rates is a prudent strategy to eliminate currency risk. Forward contracts allow the company to fix costs today for future transactions, ensuring cost predictability and protecting margins despite fluctuations in the USD/JPY exchange rate.

3. Achieving low-cost financing while eliminating exposure involves a combination of strategies such as borrowing in lower-interest-rate countries and using currency hedging instruments. LEXCO can seek to finance in jurisdictions with favorable interest rates and simultaneously hedge currency exposure through forward contracts or options. Such a strategy aligns with the theory of uncovered interest parity, which suggests that arbitrage opportunities and hedging can effectively neutralize exchange rate risks while minimizing financing costs.

In conclusion, multinational firms like ALTEC Inc. and LEXCO Co. must carefully analyze currency risks, interest rates, and market expectations. Effective use of financial instruments and theoretical principles can guide optimal decisions, balancing cost and risk in international financial operations.

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